March 2002 Vol. VI, No. 1

ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER

This past year has been busy indeed as a result of numerous legal changes brought about by the Economic Growth and Tax Relief Reconciliation Act of 2001 and pronouncements by the Internal Revenue Service, Department of Labor and Pension Benefit Guaranty Corporation. For the benefit of our clients and business associates, this newsletter summarizes these important changes in the employee benefits area. The newsletter is not intended as, and cannot be considered to constitute, specific legal advice, as each individual circumstance is unique. However, we are prepared to assist our clients and business associates in reviewing their employee benefit programs and in making any necessary or desirable revisions to take into account changes in the law.

Since our last newsletter, Marcia S. Wagner has continued to lecture and write extensively, has been quoted in several major newspapers and periodicals and has taught a graduate course in pension law at Bentley College; Marcia was also featured in the Bureau of National Affairs 2002 calendar as one of the twelve most prominent tax attorneys in the country. Ari J. Sonneberg has been appointed to the Tax Section Council of the Massachusetts Bar Association. Laura K. Plaut and David A. Appugliese have joined our firm as associates.

In the event you desire legal advice or consultation or wish to discuss the appropriate timing of necessary plan amendments or any other benefits issues, please feel free to contact Attorney Marcia S. Wagner, Attorney Christopher J. Sowden, Attorney Ari J. Sonneberg, or Attorney David A. Appugliese.

I. THE NEW COST OF LIVING LIMITATIONS, EFFECTIVE JANUARY 1, 2002

	2002	2001
Social Security Wage Base	$84,900	$80,400
Defined Benefit Plan Maximum Annual Benefit	160,000	140,000
Defined Contribution Plan Maximum Annual Contribution**	40,000	35,000
401(k) Plan Elective Deferrals	11,000	10,500
Catch-up Contributions to 401(k), 403(b), 457 or SARSEP Plans	1,000	0
Highly Compensated Employee	90,000	85,000
Annual Compensation	200,000	170,000
457 Plan Deferrals	11,000	8,500
Monthly Limitation for Transportation in Commuter Highway Vehicle	100	65
Monthly Limitation for Transit Pass	100	65
Monthly Parking Limitation	185	180
PBGC Benefit Guarantee	3,579.55 per month	3,392.05 per month
	42,954.60 per year	40,704.60 per year

II. TAX-QUALIFIED PLANS

A. GUST Remedial Amendment Period Extended

Nearly all tax-qualified plans must be amended retroactively to comply with "GUST," an acronym derived from the following four laws affecting tax-qualified retirement plans: GATT (General Agreement on Tariffs and Trade (the Uruguay Round Agreements Act)); USERRA (Uniformed Services Employment and Reemployment Rights Act of 1994); SBJPA (Small Business Job Protection Act of 1996), and TRA 97 (Taxpayer Relief Act of 1997). GUST also refers to the Internal Revenue Service Restructuring and Reform Act of 1998, and Consolidated Appropriations Act of 2001 which includes the Community Renewal Tax Relief Act of 2000.

The IRS, in Revenue Procedure 2001-55, extended the GUST remedial amendment period for tax-qualified retirement plans, as follows:

(i) to February 28, 2002 for all individually designed plans for which the deadline would otherwise sooner occur (such as a calendar year plan). Under previous guidance, individually designed plans are required to adopt GUST amendments by the last day of the first plan year beginning on or after January 1, 2001 (for calendar year plans, the deadline would have been December 31, 2001);

(ii) an additional extension to June 30, 2002, for plans that were "directly affected" by the September 11th terrorist attacks; and

(iii) an additional extension (at IRS discretion), up to December 31, 2002, in cases of "substantial hardship" resulting from the terrorist attacks.

 

Revenue Procedure 2001-55 modified Revenue Procedure 2000-20 by extending to February 28, 2002 the time by which an employer must either adopt a pre-approved plan (a master or prototype or volume submitter plan) or certify its intent to adopt such a plan in order to be eligible for an extension of the GUST remedial amendment period. In such cases, if an employer satisfies the applicable extension requirements, the GUST remedial amendment period for its plan will not end before the later of December 31, 2002, or the end of the twelfth month beginning after the date on which the IRS issues a GUST opinion or advisory letter for the pre-approved plan.

Comment: If a plan sponsor has any questions concerning applicable time limitations, it is urged to contact us as soon as possible.

B. Economic Growth and Tax Relief Reconciliation Act of 2001

1. Introduction.

On June 7, 2001, President Bush signed into law HR 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA" or the "Act"). EGTRRA made over 80 changes to the laws governing virtually all types of retirement plans and arrangements. The changes are designed to encourage savings for retirement through: (i) increased plan contribution limits; (ii) increased employer deduction limits; (iii) additional incentives for workers (in particular, older workers and low-to moderate-income workers); (iv) enhanced pension portability; and (v) reduced administrative burdens associated with plans.

These are the most comprehensive changes in pension law since ERISA was passed in 1974, and it is anticipated that EGTRRA will have a significant positive impact on the private pension system.

This part of the newsletter describes the changes in the law and new opportunities for plan sponsors and employees.

2. Effective Dates.

a. Sunset Provisions. Most of the changes enacted by EGTRRA are effective for plan years beginning after December 31, 2001. However, unless Congress acts to extend the effective dates, each of the changes enacted by the Act will expire or "sunset" after December 31, 2010. Unlike the estate tax area, however, it is considered almost a certainty that the retirement provisions will be extended beyond 2010. See Section II.B.9.d. below for a discussion concerning funding of defined benefit pension plans in light of the sunset provision.

b. Timing of EGTRRA Amendments. Certain provisions of EGTRRA are mandatory and certain are voluntary. For both types of EGTRRA changes, plan sponsors must have amendments in place by the end of the 2002 plan year, retroactive to the beginning of that year, for EGTRRA provisions taking effect in plan years beginning after December 31, 2001.

IRS Notice 2001-42 permits plan sponsors to make good faith EGTRRA plan amendments. Plan sponsors that make good faith amendments by the end of the plan year in which a provision takes effect will be entitled to an EGTRRA remedial amendment period that extends until the end of the 2005 plan year. Thus, plan sponsors that adopt such good faith EGTRRA amendments on a timely basis will be permitted to fix any disqualifying defect retroactively during this period. Plan sponsors that do not adopt any amendment before the end of a plan year may not later amend their plans for that plan year. This represents a significant change from the prior IRS position that plans could generally be amended retroactively at any time before the end of the extended "remedial amendment period".

Notice 2001-42 also states that the IRS will not issue determination, opinion or advisory letters with respect to EGTRRA amendments until further notice. Thus, plans that are contemplating including EGTRRA amendments with their GUST submissions should note that IRS determination letters will not take into account EGTRRA amendments.

Comment: To take advantage of the special EGTRRA remedial amendment period and good faith amendment relief, plan sponsors have only a short time (i.e., until the end of the 2002 plan year) to make decisions for the 2002 plan year, communicate changes to participants and implement revised administrative procedures. We will be sending tailored letters to our clients for whom we draft and maintain individually designed plans informing them of their options with respect to EGTRRA. If plan sponsors have any questions in the meantime, they are encouraged to call us.

 

3. Contributions Modified for Profit Sharing Plans.

a. Higher Deduction Limits for Profit Sharing Plans. Under pre-EGTRRA law, contributions to a profit sharing or stock bonus plan are deductible to the extent they do not exceed 15% of the aggregate compensation of the employees covered by the plan for the year. For a money purchase pension plan, the employer generally may deduct the amount necessary to satisfy the minimum funding cost of the plan for the year subject to the Internal Revenue Code (the "Code") Section 415 annual addition limitation of 25% of compensation.

For years beginning after 2001, contributions to a profit sharing or stock bonus plan are deductible to the extent they do not exceed 25% of compensation of the employees covered by the plan for the year. Thus, money purchase pension plans will be subject to the same limits on deductible employer contributions as profit sharing or stock bonus plans (Code Section 404(a)(3)(A), as amended by Act Section 616(a)).

Comment: In general, contributions to money purchase pension plans are fixed amounts which must be made once accrued. Under prior law, employers often sponsored two separate plans in order to achieve a 25% deductibility rate, while preserving contribution flexibility by maintaining a money purchase pension plan that required a 10% of compensation contribution and a profit sharing plan that enabled the employer in its discretion to contribute up to 15% of compensation to the plan. Since the law now enables employers to sponsor a 25% of compensation profit sharing plan, employers may have the best of both worlds - the higher deductible plan contribution and flexibility in determining the amount of the annual contribution. Thus, employers might consider merging their money purchase pension plan into their profit sharing plan for increased contribution flexibility and administrative ease.

 

b. Compensation will Include Elective Deferrals for Purposes of Definition of Compensation for Deduction Limits. Employer contributions to tax-qualified plans are deductible subject to certain limits. In some cases, the amount of deductible contributions is limited by compensation. As discussed above, for a profit sharing or stock bonus plan, the employer generally may deduct an amount equal to 15% (25% after 2001) of the compensation of the employees covered by the plan for the year.

Under pre-Act law, "compensation" for purposes of the deduction rules generally includes only taxable compensation, and thus does not include elective deferrals under a 401(k) plan or a 403(b) annuity, deferred compensation plan of a tax-exempt organization or a state or local government (Section 457 plan), or contributions under a Code Section 125 cafeteria plan.

For years beginning after 2001, the definition of "compensation" will include (i) elective deferrals under Code Section 402(g)(3) (e.g., to 401(k) plans and 403(b) annuities), and (ii) amounts contributed or deferred by an employer at an employee's election under a Code Section 125 cafeteria plan or a Code Section 457 plan, and not includible in the employee's income.

c. Elective Deferrals will not be Taken into Account for Determining Tax-Qualified Plan Deduction Limits After 2001. Employer contributions to one or more tax-qualified plans are deductible subject to the limitations discussed above. For purposes of the deduction limits, elective deferral contributions are treated under pre-Act law as employer contributions and thus are subject to the generally applicable deduction limits.

For years beginning after 2001, elective deferral contributions will not be subject to the deduction limits applicable to stock bonus and profit sharing plans under Code Section 404(a)(3), combination defined contribution and defined benefit plans under Code Section 404(a)(7), and ESOPs under Code Section 404(a)(9). Additionally, the application of a deduction limit to any other employer contribution to a tax-qualified plan will not take into account elective deferral contributions (Code Section 404(n), as amended by Act Section 614).

 

Comment: In order not to be in violation of the prior deductibility limits, many 401(k) and 403(b) plans limited the amount of elective deferrals to 15% (or less) of an employee's compensation. Such plans might consider eliminating such limitation.

d. Annual Addition Limitation Increased for Employer Plans. Under pre-EGTRRA law, the limit on annual additions that may be made to a defined contribution plan on behalf of an individual is the lesser of $35,000 (for 2001) or 25% of compensation.

For years beginning after 2001, the 25% of compensation limitation on annual additions under a defined contribution plan is increased to 100%.

Comment: Thus, some employers are enabling employees to elect to defer up to 100% of their salary to a 401(k) or 403(b) plan so long as the other applicable limitations are satisfied - e.g., nondiscrimination rules, $40,000 annual addition limitation (in 2002) and $11,000 elective deferral limit (in 2002).

 

4. Benefits to Small Employers.

a. Elimination of User Fees for Certain Determination Letter Requests by Small Employers. For requests made after December 31, 2001, user fees are not required for certain determination letter requests regarding the qualified status of a pension, profit sharing, stock bonus, annuity, or employee stock ownership plan. In Notice 2002-1, IRS has issued guidance to help plan sponsors determine if they are required to pay a user fee for a determination letter application.

A user fee will not be required for any determination letter request filed by an eligible employer before the first day of a plan's sixth plan year. Eligible employers are those with at least one nonhighly compensated plan participant and no more than 100 employees who received at least $5,000 in compensation in the preceding year.

EGTRRA does not eliminate user fees for determination letter requests for such plans after the later of the fifth plan year the plan is in existence or the end of the remedial amendment period with respect to the plan beginning within the first five plan years of its existence.

A plan is considered to be in existence on the first day the plan was in effect. A plan established as a spin-off from another plan will be treated as in existence on the first day the original plan was in effect, and a plan established as the result of a merger will be treated as in existence on the first day either of the merged plans was in effect.

User fees are also not eliminated for determination letter requests on the qualified status of a group trust under Revenue Ruling 81-100, requests for waiver of the minimum funding requirement, and any opinion or advisory letter requests made by sponsors of master and prototype or volume submitter specimen plans.

 

The Form 8717 has been revised to indicate that a determination letter application meets the requirements for elimination of the user fee.

b. Tax Credit Enables Small Businesses to Offset Cost of Setting up Plan. For tax years beginning after 2001, small employers will be able to claim a credit for part of the cost of adopting a new tax-qualified plan (including 401(k), SEP, or SIMPLE plan). The credit is equal to 50% of administrative and retirement-education expenses for the plan for each of the first three years, with a maximum credit of $500 for each year. It is available to businesses that do not employ, in the preceding year, more than 100 employees with compensation of at least $5,000. To be eligible for the credit, the plan must cover at least one nonhighly compensated employee.

Comment: Part of the case made against setting up a tax-qualified plan had been the relatively high administrative costs associated with establishing and maintaining such a plan. The elimination of user fees for small employers and the provision of tax credits are much needed steps in the right direction.

 

5. EGTRRA Changes Affecting 401(k) Plans.

a. Post 2001 Increases in Elective Deferral Limits. Under pre-Act law, the maximum annual elective deferral to a 401(k) plan, a 403(b) annuity or a salary reduction simplified employee pension plan ("SARSEP") was $10,500 (for 2001). The maximum annual elective deferral to a SIMPLE plan was $6,500 (for 2001). These limits are adjusted annually for inflation in $500 increments.

In 2002, the maximum annual elective deferral under 401(k) plans, 403(b) annuities and SARSEPs will be $11,000. In 2003 and later years, the limit will increase in $1,000 annual increments until it reaches $15,000 in 2006, with annual adjustments for inflation in $500 increments in years after 2006. The maximum annual elective deferral to a SIMPLE plan will be $7,000 for 2002. In 2003 and later years, the SIMPLE limit will be increased in $1,000 annual increments until it reaches $10,000 in 2005. After 2005, the $10,000 dollar limit will be adjusted annually for inflation in $500 increments (Code Section 402(g), as amended by Act Section 611(d) and Act Section 611(f)).

 

b. Catch-up Contributions for Individuals Aged 50 or Over.

(i) Dollar Limitations. For tax years beginning after 2001, EGTRRA added Code Section 414(v) which increases for individuals who have attained age 50 by the end of the year the otherwise applicable dollar limit on elective deferrals under a 401(k) plan, 403(b) annuity, SEP, or SIMPLE, or deferrals under a governmental Section 457 plan. The additional amount of contributions that may be made is the lesser of: (A) the applicable dollar limit, or (B) the participant's compensation for the year reduced by his other elective deferrals for the year. The applicable dollar limit under a 401(k) plan, 403(b) annuity, SEP, or Section 457 governmental plan is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and later years. The applicable dollar limit under a SIMPLE is $500 for 2002, $1,000 for 2003, $1,500 for 2004, $2,000 for 2005, and $2,500 for 2006 and later years. The $5,000 and $2,500 amounts are adjusted for inflation after 2006 (Code Section 414(v), as added by Act Section 631).

The following chart shows the maximum amount an individual 50 or over may contribute:

Salary Deferral Limitations

Year	401(k), 403(b), 457(b) Maximum Elective Deferrals	414(v) Maximum Catch-up Deferrals	Total Deferrals
2002	$11,000	$1,000	$12,000
2003	$12,000	2,000	14,000
2004	$13,000	3,000	16,000
2005	$14,000	4,000	18,000
2006	$15,000	5,000	20,000

(ii) Universal Availability. Under Code Section 414(v)(4)(A), a plan will be treated as failing to meet the nondiscrimination requirements under Code Section 401(a)(4) with respect to benefits, rights and features unless the plan allows all eligible participants to make the same election with respect to catch-up contributions. Under Code Section 414(v)(4)(B) - for purposes of this "universal availability requirement" - all plans maintained by employers who are treated as a single employer under the controlled group rules will be treated as one plan.

The IRS provided in Notice 2002-4 that a plan will not be treated as failing to comply with the universal availability requirement because other plans maintained by the controlled group offer the contributions beginning on different dates in 2002 as long as all such plans begin offering the contributions by October 1, 2002.

The following are limited exemptions from the universal availability requirement: (A) employers do not have to offer catch-up contributions to employees covered by a collective bargaining agreement in effect on January 1, 2002, until the first plan year beginning after the agreement expires; and (B) plans that are newly acquired due to a merger, acquisition or similar transaction must be amended to allow catch-up contributions as soon as practicable, but no later than the end of the year following the year in which the transaction occurs.

(iii) Eligibility to Make Catch-up Contributions. Eligible participants are those aged 50 or older. Under the proposed regulations, a participant who will attain age 50 before the end of a calendar year is deemed to be age 50 as of January 1 of that year, even if the participant dies before turning age 50, or terminates employment during the year.

(iv) Determination of Catch-up. Catch-up contributions are elective deferrals that exceed any of the following applicable limits: (A) the section 415 maximum or the section 402(g) dollar limit (i.e., the statutory limits); (B) any employer provided plan limit (e.g., 8% of pay); or (C) the actual deferral percentage ("ADP") limit.

At the end of a plan year, elective deferrals in excess of an otherwise applicable limit would be treated as a catch-up contribution to the extent the deferrals do not exceed the annual catch-up contribution limit (e.g., $1,000 for 2002).

(v) Treatment of Catch-up Contributions. A plan would not be treated as violating any nondiscrimination requirement solely because the plan permits catch-up contributions. For ADP testing, catch-up contributions would be subtracted from the participant's elective deferrals for the plan year before determining the actual deferral ratio. If corrective action is necessary after performing the ADP test, the plan must determine the amount of the elective deferrals that are catch-up contributions because they exceed the ADP limit. The deferrals that are treated as catch-up contributions must remain in the plan. Any remaining excess amounts must be corrected in order for an employer to avoid incurring a 10% excise tax.

Catch-up contributions for the current year are not taken into account for purposes of the section 416 top-heavy rules or the section 410(b) coverage rules. However, catch-up contributions made to a plan in prior years are taken into account in determining whether a plan is top-heavy, and for purposes of the average benefit percentage test.

 

Comment: Catch-up contributions are a significant benefit that employers will want to make available to eligible individuals. We are ready to assist you in designing and implementing a catch-up provision, and communicating it to employees.

 

c. Faster Vesting of Certain Employer Matching Contributions. A plan is not tax-qualified unless a participant's employer-provided benefit vests at least as rapidly as under one of two alternative minimum vesting schedules.

 

Generally, for contributions for plan years beginning after December 31, 2001, faster vesting schedules apply to employer matching contributions. Employer matching contributions must vest at least as rapidly as under one of the following two alternative minimum vesting schedules:

 

(i) A plan satisfies the first schedule if a participant acquires a nonforfeitable right to 100% of employer matching contributions on completion of three years of service.

(ii) A plan satisfies the second schedule if a participant has a nonforfeitable right to 20% of employer matching contributions for each year of service beginning with the participant's second year of service and ending with 100% after six years of service (Code Section 411(a), as amended by Act Section 633(a)).

The current 5-year cliff and 7-year graded schedules remain for employer non-matching contributions.

Comment: Plans must be reviewed to see if they comply with the new law.

 

d. Repeal of Section 401(k)/401(m) Multiple Use Test. EGTRRA repeals the current "multiple use test" that requires coordination of ADP testing of pre-tax deferrals with ACP testing of employer matching and employee after-tax contributions. This change should have a positive impact on many 401(k) plans, since the multiple use restrictions affect many plans with 401(k) and 401(m) contributions.

Comment: Plans that currently impose a maximum contribution limit on contributions of highly compensated employees due to the multiple use test may be able to increase or eliminate this limit.

e. 401(k) Plan Distributions on Severance from Employment. Prior to EGTRRA, one of the events permitting a distribution from a 401(k) plan was an employee's "separation from service." A separation from service occurred when a participant died, retired, resigned or was discharged. Under the so-called "same desk rule," there was no separation from service where an employee continued on the same job for a successor employer following a liquidation, merger or consolidation or other disposition of the former employer. Thus, a plan participant's severance from employment (i.e., when a participant ceased to be employed by the employer maintaining a plan) did not necessarily result in a separation from service for which he could receive a distribution of his 401(k) balance.

 

EGTRRA modifies the same desk rule for distributions made from 401(k) plans after 2001 by amending Code Section 401(k)(2) and Code Section 401(k)(10) to provide that a plan distribution may occur upon a "severance from employment" rather than upon a separation from service. This new rule makes it possible to distribute elective deferrals in circumstances where the pre-EGTRRA "same desk rule" would have barred distributions.

A 401(k) plan sponsor that intends to permit distributions following an employee's severance from employment must amend the plan to substitute severance from employment provisions for separation from service provisions. A plan may provide for severance from employment distributions on or after January 1, 2002, regardless of whether the severance from employment occurred before, on, or after January 1, 2002.

 

A 401(k) plan will not fail to comply with the Code Section 401(k) rules because it does not permit distributions in all situations in which a participant has a severance from employment.

Thus, for example, a plan could limit distribution to situations in which: (i) a participant has a separation from service, or (ii) following a disposition of assets or disposition of a subsidiary under circumstances under which a distribution is permitted under Code Section 401(k) rules in effect prior to the EGTRRA amendments. In other words, a 401(k) plan need not be amended to provide for distributions upon severance from employment. However, if the plan is not amended to provide for distributions following a severance from employment, elective deferrals can be distributed only to the extent permitted by the plan.

Notice 2002-4 also provides that ­ for purposes of the Code Section 401(k)(2)(B)(i)(I) rule that amounts attributable to elective deferrals may be distributed upon the employee's severance from employment with the employer maintaining the plan ­ the term "employer" includes all corporations and other entities treated as the same employer under the controlled group rules.

An employee does not have a severance from employment if, in connection with a change of employment, the employee's new employer maintains the 401(k) plan with respect to the employee, for example, by assuming sponsorship of the plan or by accepting a transfer of plan assets and liabilities (under the Code Section 414(l) rules on plan mergers and consolidations and transfers of plan assets) with respect to the employee.

f. Elective Deferrals After a Hardship Distribution. Elective deferrals under a 401(k) plan are not distributable before the occurrence of specified events, including the financial hardship of an employee. The applicable regulations provide that a distribution is made on account of hardship only if the distribution is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy that need. The regulations provide a safe harbor under which a distribution is deemed necessary to satisfy a financial need. One requirement of this safe harbor is that the employee be prohibited from making elective contributions for at least 12 months after receipt of the hardship distribution.

Section 636 of EGTRRA directs the IRS to revise the regulations concerning hardship distributions to reduce to six months (from 12 months) the period that an employee is prohibited from making elective deferrals in order for a distribution to be deemed necessary. Such change is to be effective for calendar years beginning after December 31, 2001.

Prior to EGTRRA, the plan and all other plans maintained by the employer must limit the employee's elective contributions for the next taxable year following the hardship distribution to the applicable limit under Code Section 402(g) for that year minus the employee's elective deferrals for the year of the hardship distribution (the "post-hardship contribution limit").

Under Notice 2002-4, the requirement that a participant's elective deferrals under a plan (and all other plans maintained by the employer) be limited to the post-hardship contribution limit may be eliminated by plans effective for calendar years beginning after December 31, 2001, for participants who received hardship distributions during 2001 and thereafter.

A 401(k) plan will not fail to comply with the hardship distribution safe harbor provisions solely because it retains its existing post-hardship contribution limit. However, in order to continue to rely on the matching or employer contribution safe harbor under Code Section 401(m)(11) and/or Section 401(k)(12) (which permits satisfaction of the ADP and ACP nondiscrimination requirements by matching elective deferrals at specified rates or making nonelective contributions equal to a specified percentage of employee compensation), a plan must eliminate the post-hardship contribution limit for calendar years beginning after December 31, 2001.

g. Post-2005 Option to Treat Elective Deferrals as Roth IRA Type Contributions. Elective deferrals to 401(k) plans and 403(b) annuities (and earnings on the deferrals) are not included in the participant's income until they are distributed from the plan. Under pre-Act law, participants cannot direct that their elective deferrals be treated as Roth IRA contributions.

 

For tax years beginning after 2005, a 401(k) plan or 403(b) annuity will be allowed to include a "qualified Roth contribution program" that allows participants to elect to have all or part of their elective deferrals treated as Roth contributions. These deferrals will not be excludable from gross income and will thus be taxed currently. The annual dollar limit on a participant's Roth contributions will be the then-applicable Code Section 402(g) limitation on elective deferrals ($15,000 in 2006), reduced by the elective deferrals that the participant does not designate as Roth contributions. A Roth contribution will be treated as any other elective deferral for purposes of nonforfeitability requirements and distribution restrictions.

The plan will have to establish a separate account and maintain separate recordkeeping for a participant's Roth contributions (and earnings). A qualified distribution from a participant's Roth contribution account will not be taxed to the participant (Code Section 402A, as added by Act Section 617).

Comment: This new option for elective deferrals will allow taxpayers to make larger annual Roth IRA contributions than they can make with regular Roth IRAs.

6. EGTRRA Changes Affecting Tax-Exempt Employers.

a. Code Section 457. Prior to EGTRRA, eligible 457(b) deferred compensation plans have been limited to a contribution of only $8,500 per year (for 2001), an amount reduced dollar-for-dollar by amounts contributed by salary reduction to a 403(b) plan or 401(k) plan. In other words, the limits under Section 457(b) and 401(k) and/or 403(b) were combined so that effectively an individual who deferred the maximum in a 401(k)/403(b) program could not make any deferrals under a 457(b) program. Since 403(b) and 401(k) plans were generally superior to eligible 457(b) plans in contribution limits and funding, this effectively eliminated most of the benefit of having a 457(b) plan (save for the inapplicability of the Code Section 72(t) 10% excise tax on early distributions from 457 plans).

Under EGTRRA, the dollar-for-dollar reduction of the 457(b) contribution limit for salary reduction 403(b) and 401(k) contributions has been eliminated after 2001 for 457(b) plans of both tax-exempt and governmental employers. Moreover, the 457(b) limit has been conformed to the salary reduction limits for 403(b) and 401(k) plans, which are $11,000 for 2002, going up $1,000 a year until they reach $15,000 in 2006. Governmental 457(b) plans, though not 457(b) plans of other nonprofit employers, will also be able to take advantage of a new catch-up contribution rule allowing employees age 50 and older to make additional contributions of an amount which is $1,000 in 2002, and will increase $1,000 each year until the amount is $5,000 for 2006 and thereafter. This is in addition to the current 457(b)(3) catch-up election, which the Act retains for 457(b) plans, that can be used to increase 457(b) contributions in the last three years prior to retirement. The age 50 catch-up election cannot, however, be used in the same year that the last-three-years rule is used.

 

Example: An executive of a tax-exempt institution who is at least age 50 can now contribute $12,000 to a 403(b) plan by salary reduction (the new limit of $11,000, plus $1,000, because he is over age 50) and can then contribute another $11,000 to a 457(b) plan, for a total contribution of $23,000 between the two plans. This amount will go up to $35,000 in 2006 ($15,000 plus $5,000 for the 403(b) and $15,000 for the 457(b)), and that is only taking into account possible salary reduction contributions. Note, too, that the executive only used $12,000 of the available $40,000 annual addition limit under the 403(b) plan in 2002, so that nonelective employer contributions of up to an additional $28,000 could be made to the 403(b) plan in 2002, subject to the nondiscrimination rules. This amount could be further increased, again subject to nondiscrimination rules, through additional nonelective employer contributions to a defined contribution 401(a) plan, or accruals under a defined benefit 401(a) plan, or both. This is because the Act retains the rules that, for purposes of the Code Section 415 limits, 403(b) plans and 401(a) plans, in most cases, will not be aggregated.

 

Due to ERISA's constraints, any 457(b) plan maintained by a non-governmental employer may cover only a "select group of management or other highly compensated employees." Nonetheless, these are the very employees who are most likely to take advantage of this increased deferral opportunity.

 

Comment: Many nonprofits that wish to allow their executives to defer more of their compensation should consider adopting a 457(b) plan in 2002.

 

b. The MEA Rules are Repealed. The complicated "maximum exclusion allowance" or MEA limit, peculiar to 403(b) plans, is repealed, effective 2002. In its place, the 415 defined contribution annual addition limit will apply. That limit is currently the lesser of $35,000 or 25% of compensation, but for 2002, the Act increases the dollar limit to $40,000, and increases the compensation limit to 100%. At least two special 403(b) distinctions were introduced into Code Section 415 by the Act. First, the definition of compensation for purposes of Code Section 415 will be different for 403(b) plans and 401(a) plans. For 403(b) plans, the limit will be the pre-Act definition of includible compensation used for the present law MEA calculation. This was added in order to preserve the MEA concept of looking to the last 12 months of service rather than to a limitation year for testing purposes. Second, such includible compensation may not include any amount received by a former employee after the fifth taxable year following the taxable year in which the employee terminated.

 

7. Top-Heavy Changes.

 

A plan is generally considered "top-heavy" if more than 60 percent of plan assets are held on behalf of "key employees." Due to the design of this test, top-heavy rules primarily affect only small businesses.

 

More rapid vesting and minimum contribution requirements for non-key employees apply to top-heavy plans. Under pre-Act law, a key employee is one who, during the plan year that ends on the determination date or any of the 4 preceding plan years, is: (i) an officer earning over one-half of the Code Section 415 defined benefit plan dollar limit ($70,000 for 2001), (ii) a 5% owner of the employer, (iii) a 1% owner of the employer earning over $150,000, or (iv) one of the 10 employees earning more than the defined contribution plan limit ($35,000 for 2001) with the largest ownership interests in the employer. Further, family members of 5 percent owners are deemed to be key employees under family attribution rules.

 

Under pre-Act law, employer matching contributions may be used to satisfy the minimum contribution requirements applicable to a top-heavy plan, but if they are, the contributions are not treated as matching contributions for purposes of the Code Section 401(m) actual contribution percentage ("ACP") test for determining if a defined contribution plan with employee contributions or employer matching contributions is nondiscriminatory. Thus, those contributions must meet the general nondiscrimination test of Code Section 401(a)(4), which is hard to satisfy.

 

For years beginning after 2001, the Act makes numerous technical changes that liberalize the top-heavy rules, as follows:

 

a. Simplified Definition of Key Employee. An employee will be a key employee for a plan year if during the plan year he is: (i) an officer with compensation over $130,000 (inflation-adjusted for plan years beginning after 2002 in $5,000 increments), (ii) a 1% owner of the employer with more than $150,000 in employer compensation, or (iii) a 5% owner of the employer (Code Section 416(i)(1)(A), as amended by Act Section 613(a)(1)(B) and Act Section 613(b)).

b. Funding of Top-Heavy Minimum. Employer matching contributions under Code Section 401(m)(4)(A) will count toward satisfying the top-heavy minimum contribution requirements, and may also be counted for ACP testing purposes.

c. Scope of Top-Heavy Rules. The top-heavy rules do not apply to safe harbor 401(k) plans consisting solely of 401(k) safe harbor deferrals and 401(m) safe harbor matching contributions. Any regular employer profit sharing contributions to a safe harbor 401(k) plan, however, remain subject to the top-heavy rules.

d. Look-Back Rule. The 5-year look-back rules applicable to distributions in determining top-heavy status (i.e., the benefits of key employees) will be shortened to one year. However, the 5-year look-back rule will continue to apply to in-service distributions.

e. Frozen Plans. A frozen top-heavy defined benefit plan will no longer be required to make minimum accruals on behalf of non-key employees.

 

8. Plan Loans Permitted for S Shareholders, Partners and Sole Proprietors.

 

Under pre-Act law, a plan loan to an owner-employee is treated as a prohibited transaction subject to excise taxes. Owner-employees include sole proprietors, partners who own more than a 10% interest in the partnership, more than 5% owner-employees or officers of an S corporation, and IRA owners.

 

For years beginning after 2001, the rule treating plan loans to owner-employees as prohibited transactions will apply only to an IRA participant or beneficiary (Code Section 4975(f)(6)(B), as amended by Act Section 612(a)).

 

Comment: Thus, plan loans to owner-employees that meet statutory rules will be exempt from the prohibited transaction rules, just as plan loans to participants who are not owner-employees. If the plan does not allow for owner-employee loans, it will have to be amended before the participant may request a loan.

 

SEPs and SIMPLEs are both IRA variations and, thus, loans from these plans will continue to be prohibited transactions.

 

9. Increased Plan Limitations Give Rise to Planning Opportunities and Necessities.

EGTRRA has provided three significant changes to the limitations concerning tax-qualified plans, which can drastically increase pension benefits for highly compensated employees:

a. Compensation Limitation. The limit on compensation that may be taken into account under a tax-qualified plan increases to $200,000 from $170,000. This is effective for years beginning after December 31, 2001. This limit will be indexed in $5,000 increments (Act Section 611 amending Code Section 401(a)(17)).

b. Limit on Annual Additions to Defined Contribution Plans. The dollar limit on annual additions to a defined contribution plan increases from $35,000 to $40,000. This is effective for plan years beginning after December 31, 2001. This amount will be indexed in $1,000 increments. In addition, as previously discussed, the related compensation limit for annual additions is increased to 100% of compensation from 25% (Act Section 611 amending Code Section 415(c)).

c. Limit on Annual Benefits under Defined Benefits Plans. The annual benefit limit under a defined benefit plan is increased from $140,000 to $160,000. The dollar limit is reduced for benefit commencement before age 62 (previously, it was reduced for benefits that commenced before the participant's social security retirement age) and increased for benefit commencement after age 65. The dollar limitation cannot increase between ages 62 and 65. In the case of a participant who continues to work past a defined benefit plan normal retirement age that is less than 65, the plan must provide in-service payment of the benefit or suspend benefits in light of the fact that the dollar limitation cannot be increased between 62 and 65 and Code Section 411 requires that a participant's benefit must be actuarially increased for late retirement. This provision is effective for limitation years ending after 2001 (Act Section 611 amending Code Section 415(b)).

d. Defined Benefit Funding and Deduction Issues. Revenue Ruling 2001-51 provides that increased liabilities from the new higher limits are deemed to arise from a plan amendment and thus must be amortized over a 30-year period. For Section 412 minimum funding purposes and Section 404 maximum deduction limits, the EGTRRA sunset provision is to be ignored; therefore, an employer must assume that the higher limits will remain in effect after 2010.

e. Plan Amendments. Defined benefit and defined contribution plans that do not incorporate Section 415 by reference must be amended in order to use the new higher EGTRRA limits. Also, if a plan sponsor wishes to maintain the pre-EGTRRA limits, depending on the language in the plan document, the plan may have to be amended.

Importantly, if a plan incorporates Section 415 by reference to the Code, the new limits will take effect automatically for limitation years ending after 2001 for defined benefit pension plans and for years beginning after December 31, 2001 for defined contribution plans. This has serious implications for noncalendar year defined benefit pension plans that incorporate Section 415 by reference and for which the 2001 limitation year has already commenced. For these plans, the new Section 415 limits are already in effect.

Comment: Plan sponsors should determine whether they want the new, higher EGTRAA limits to apply and review plan documentation to see if amendments are necessary.

f. Benefit Increases for Retirees. An employer may determine whether and when the higher limits actually take effect for a particular plan, and whether to apply them to people who have already retired as well as to future retirees.

Revenue Ruling 2001-51 confirms that people who retired before the EGTRRA amendments take effect can have their benefits raised to the new, higher levels. The concept is straightforward: the employer is to go back and recalculate each retiree's benefit at the date of retirement, but use the limits provided by the new law rather than the Section 415 limits that applied at the time. However, because the limits do not actually go up until 2002, those higher benefits are not payable until 2002.

 

An employer might want to prevent the new limits from taking effect immediately if: (i) retirees whose benefits were affected by Section 415 have already been made whole through, for example, a non-qualified plan, or (ii) the employer is not in the financial position to provide benefits up to the higher level.

 

Comment: Although EGTRRA allows retirees to receive higher pensions, any enabling plan amendment would nonetheless have to satisfy the general nondiscrimination rules of Code Section 401(a)(4), which could prove difficult in many circumstances.

 

10. Certain State Laws do not Conform with EGTRRA.

 

Under the tax codes of many states, conformity with changes in federal tax law occurs automatically. In other states, the revenue code must be explicitly amended by the state legislature to conform to any federal changes. As discussed, EGTRRA significantly increased deferral and other limits under plans, effective in 2002. However, many state legislatures have not adopted conforming changes to state tax law. This results in, among other things, subjecting some elective deferrals to state taxation that are exempt from federal taxation.

 

Of most immediate concern to employers is the impact of EGTRRA's elective deferral increases on defined contribution plans. For example, employees over age 50 are eligible to make special "catch-up" contributions of $1,000 in 2002, and the new limit on 401(k) and 403(b) contributions has been increased to $11,000.

 

Assuming that conforming legislation is not passed, employers and recordkeepers will have to modify their payroll and recordkeeping systems to keep track of the differing state and federal tax treatment of various amounts.

 

Those potentially affected by the nonconforming tax laws include participants in tax-qualified plans (including 401(k) plans), Code Section 403(b) plans or eligible nonqualified deferred compensation arrangements under Code Section 457(b) in the following states: Alabama, Arizona, Arkansas, California, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Massachusetts, Minnesota, New Jersey, North Carolina, Oregon, South Carolina, West Virginia and Wisconsin.

 

11. Notice of Significant Reduction in Benefits.

 

ERISA Section 204(h) requires employers who maintain defined benefit pension plans and money purchase pension plans to provide participants with a notice within 15 days before the effective date of a plan amendment when such amendment will significantly reduce the rate of future benefit accruals. Effective June 7, 2001 and pursuant to IRS Notice 2001-42, the definition of significant reduction in future accruals is expanded to include the elimination of an early retirement subsidy and any benefit reduction or elimination.

 

The 15-day requirement is now a reasonable period before the effective date of the amendment. The disclosure must describe the amendment and be written in a manner calculated to be understood by the average participant. In general, plan sponsors will be subject to a $100 penalty tax per individual for each day the required notice is not provided (maximum $500,000).

 

A simplified notice may be designed by the Department of Labor ("DOL") or the DOL may exempt from the notice requirement plans with fewer than 100 participants or plans that allow all employees to choose between the old and new benefit formulas.

 

12. Defined Benefit Pension Plan ­ Full Funding Limitation Eliminated.

 

Under prior law, contributions to a defined benefit pension plan are not deductible to the extent that plan assets exceed the lesser of: (i) 160% (in 2001) of the plan's current liability, or (ii) a limitation based on a reasonable projection of benefits.

 

Under EGTRRA, the full funding limit will be 165% of current liability for plan years beginning in 2002, 170% in 2003, and repealed in 2004 and thereafter.

 

Comment: Defined benefit pension plan sponsors will now be able to fully fund their plans without fear of losing deductibility of contributions because of the complicated full funding limitations.

 

13. Defined Benefit Pension Plan Valuations.

 

For plan years beginning in 2002, defined benefit pension plans with funding levels that are not below 125% of the plan's current liability may elect to use a valuation date that is up to one year prior to the beginning of the plan year. Thus, a full valuation would only be required every other year and a valuation based on projections of prior year data could be used in the interim years. However, prior year data would have to be adjusted for significant differences in plan demographics.

 

14. Treatment of Forms of Distribution.

 

In general, an amendment to a tax-qualified plan may not decrease the accrued benefit, including a particular form of payment or distribution, of a plan participant. This is known as the "anti-cutback rule".

 

For years beginning after December 31, 2001, a defined contribution plan to which benefits are transferred (e.g., by a plan merger) is not treated as reducing a participant's or beneficiary's accrued benefit, and is thus complying with the anti-cutback rules, even though it does not provide all of the forms of distribution previously available under the transferor plan if:

 

a. the plan receives from another defined contribution plan a direct transfer of the participant's or beneficiary's benefit accrued under the transferor plan, or the plan results from a merger or other transaction that has the effect of a direct transfer,

 

b. the terms of both the transferor plan and the transferee plan authorize the transfer,

 

c. the transfer occurs pursuant to a voluntary election by the participant or beneficiary that is made after the participant or beneficiary received a notice describing the consequences of making the election, and

 

d. the transferee plan allows the participant or beneficiary to receive distribution of his benefit under the transferee plan in the form of a lump sum distribution (Code Section 411(d)(6), as amended by Act Section 645).

 

Note that the "anti-cutback" relief described above does not permit a plan sponsor to divest spousal rights that are otherwise vested. Thus, certain joint and survivor annuities must be preserved unless, as part of their participant's transfer election, the spouse also consents to the benefit transfer.

 

The IRS has been instructed to revise its regulations under Code Section 411(d)(6) before 2004 so that they will not apply to any plan amendment that eliminates or reduces benefits or subsidies that create significant burdens and complexities for a plan, as long as the amendment does not adversely affect the participant's rights in more than a de minimis manner.

 

Comment: This codifies the regulatory guidance currently in effect and greatly enhances the ability of acquiring corporations to simplify their pension administration.

 

15. Employer-Provided Retirement Advice.

 

Effective in 2002, EGTRRA clarifies that the value of the provision of advice and information regarding retirement income and planning may be excludable from gross income either as a working condition fringe or under an employer-provided educational assistance plan. These services must be provided on a nondiscriminatory basis.

 

16. Rollover Rules Liberalized.

 

a. Rollovers of After-Tax Contributions. Employees are allowed to make after-tax contributions to defined contribution plans. Prior to EGTRRA, employees are not permitted to roll over distributions of those after-tax contributions into an IRA or another tax-qualified plan.

 

Beginning in 2002, after­tax employee contributions may be rolled over to other tax-qualified plans (but, according to IRS Notice 2001-57, not defined benefit pension plans) and IRAs. In the case of a rollover from one qualified plan to another qualified plan, the rollover must be a direct rollover.

 

Qualified plans may only accept after-tax rollovers if they have a separate accounting system for such contributions and earnings.

 

After-tax IRA contributions cannot be rolled over into a qualified plan, tax-sheltered annuity, or section 457 plan.

 

b. Rollovers from Contributory IRAs to Tax-Qualified Plans. Prior to EGTRRA, rollovers of amounts originally contributed directly into a traditional IRA ("contributory IRAs") into any type of tax-qualified plan generally are not allowed.

 

Beginning in 2002, contributory IRA amounts may be rolled over to a Section 401(a) plan, a Section 403(b) arrangement, a Section 457(b) plan maintained by a state or local government, or another IRA.

 

c. Portability of Benefits Between Different Types of Plans and IRAs. Currently, a plan participant may not roll over amounts from a 403(b) plan to a 401(a) plan, or vice versa.

 

Beginning in 2002, EGTRRA permits rollovers between certain types of plans. EGTRRA revises the eligible rollover distribution rules to permit a rollover of distributions from a 401(a) plan, 403(b) plan, governmental 457(b) plan (but not a 457(b) plan of a nonprofit employer), or IRA into any of those types of plans or an IRA.*

 

d. Spousal Rollovers. Previously, distributions from qualified plans received by surviving spouses could be rolled over to an IRA, but not to another qualified plan.

 

Beginning in 2002, an employee's spouse who receives an eligible rollover distribution from the employee's plan upon the death of the employee will also be able to roll it over into the spouse's employer's plan. If an individual makes a rollover of amounts received as a surviving spouse to a qualified plan, however, he will no longer be able to use 10-year averaging or capital gains treatment on a distribution from the qualified plan, if otherwise eligible.

 

Comment: Although the rollover rules have been significantly liberalized to enhance pension portability, tax-qualified plans, 403(b) annuities, and 457 plans are not required to accept rollovers.

 

Furthermore, a distribution from a tax-qualified plan is not eligible for capital gains or averaging treatment if there was a rollover to the plan that would not have been permitted under prior law.

 

e. Hardship Distributions not Eligible Rollover Distributions. Prior to EGTRRA, plan participants could roll over hardship distributions, except for hardship distributions of elective deferrals. This anomaly in the law has been rectified by EGTRRA. Thus, after 2001, no hardship distributions may be rolled over.

 

f. 60-Day Rollover Period Liberalized. Eligible rollover distributions are required to be rolled over within 60 days of distribution to preserve the tax-deferred status of the rollover assets. Under prior law, the IRS could only waive the 60-day requirement for rollovers during military service in a combat zone or by reason of a Presidentially declared disaster.

 

Under EGTRRA, the IRS can waive the 60-day rollover period if failure to waive the requirement would be against equity or good conscience. This would include events beyond the reasonable control of the individual subject to the requirement, such as financial institution error, postal error, death, disability, hospitalization, foreign country restrictions, military service in a combat zone, Presidentially declared disaster, or incarceration.

 

g. IRA Revises 402(f) Model Rollover Notice to Reflect EGTRRA. Under Notice 2002-3, the IRS has issued an updated "safe harbor explanation" that plan administrators may provide to recipients of eligible rollover distributions from employer plans in order to satisfy the requirements of Code Section 402(f). The new 402(f) safe harbor explanation has been revised to reflect changes made by EGTRRA. In addition to the general safe harbor explanation, the IRS has issued a separate safe harbor explanation that administrators of governmental Section 457 plans may use to satisfy the 402(f) requirements.

 

Code Section 402(f) requires a plan administrator of a tax-qualified plan to provide a written explanation to any recipient of an eligible rollover distribution. Under EGTRRA this requirement is extended to 403(b) plans and governmental 457 plans. The written explanation must cover the direct rollover rules, the mandatory tax withholding on distributions not rolled over, the tax treatment of distributions not rolled over, and when distributions may be subject to different restrictions and tax consequences when rolled over. The 402(f) notice must be given within a reasonable period of time before the plan makes an eligible rollover distribution.

 

As discussed above, EGTRRA made several changes to the rollover rules, effective for distributions on or after January 1, 2002, to wit: (i) the rollover of after-tax contributions is permitted; (ii) hardship distributions are not eligible rollover distributions; (iii) rollovers from governmental 457 plans to eligible retirement plans are permitted; (iv) rollovers from a 403(b) plan to an eligible retirement plan are permitted and a 403(b) plan is considered an eligible retirement plan for purposes of the rollover rules; and (v) surviving spouses may roll over distributions to qualified plans, 403(b) plans, and governmental 457 plans, in addition to IRAs.

EGTRRA specifically expanded the requirements for the 402(f) notice by requiring that the notice include a discussion of the potential restrictions and tax consequences that may apply to distributions from the plan to which the distribution is rolled over that are different from those applicable to the distributing plan.

The IRS has issued two safe harbor explanations, one for distributions from plans other than governmental 457 plans and one specifically for governmental 457 plans.

As a result of the changes made by EGTRRA, for post-2001 distributions, the existing 402(f) safe harbor explanation, provided in IRS Notice 2000-11 will not be considered a safe harbor explanation. No penalty, however, will be imposed for any failure to provide the expanded explanation required by EGTRRA with respect to any distribution made before April 14, 2002, provided the plan administrator makes a reasonable attempt to comply with the expanded notice requirements.

In using one of the safe harbor explanations, the plan administrator may "customize" the safe harbor explanation by omitting any portion that does not apply to the plan. Alternatively, a plan administrator can satisfy Code Section 402(f) by providing recipients with an explanation that provides additional information or that is otherwise different from one of the safe harbor explanations, as long as it contains the required information and is written in a manner designed to be easily understood.

h. Cash-Outs Exclude Rollovers. EGTRRA allows employers to cash out an employee's benefit if the value is $5,000 or less, without counting any portion attributable to rollover contributions and their allocable earnings. Thus, a participant may be involuntarily cashed out so long as his non-rollover vested account is $5,000 or less, even though his total vested account exceeds $5,000 when the rollover (and any gains/earnings thereon) is taken into account. A plan must be amended to provide for this treatment.

i. New Forced Automatic Rollovers. Employers cashing out an employee's vested account balance exceeding $1,000 must make the "default" option an automatic, direct rollover to an IRA. This new rule is effective for distributions after the DOL issues final regulations prescribing fiduciary safe harbors for choosing an institution to receive the rollover or designating investment funds. The final regulations must be issued within three years of enactment of the Act.

 

j. Capital Gain/10-Year Averaging Limits. A qualified plan distribution will not otherwise be eligible for capital gains or 10-year forward averaging tax treatment, unless the present law rules are satisfied. In other words, once these amounts are commingled with 403(b), 457 or traditional IRA amounts, the special favorable tax treatment will be lost.

 

Capital gains and 10-year forward averaging tax treatment can be preserved for qualified plan distributions that are rolled over to another qualified plan, either directly or through a "conduit IRA", as long as such amounts are not commingled with other retirement plan distributions.

 

17. Provisions Affecting Employee Stock Ownership Plans.

 

a. S Corporation ESOPs. For plan years beginning after December 31, 2004, certain S corporations that sponsor an ESOP must prohibit the allocation of S corporation employer securities to certain disqualified persons (i.e., a taxpayer seeking nonrecognition treatment under Code Section 1042 or any person who owns more than 25% of the stock of the corporation). If this requirement is not satisfied, the plan will be treated as having made a distribution of the amount allocated to such disqualified person. The S corporation will be liable for a 50% excise tax based on the amount allocated. The Act also prohibits the use of "synthetic equity" where an S corporation sponsors an ESOP. "Synthetic equity" is any stock option, warrant, restricted stock, or similar interest that gives the holder the right to acquire or receive stock of the S corporation in the future or similar right to a future cash payment based on the value of such stock or appreciation in such value. The S corporation will be subject to the 50% excise tax for any year in which a disqualified person has an interest in synthetic equity. These provisions apply to S corporation ESOPs established after March 14, 2001 or ESOPs established before that date which hold employer securities that elect S corporation status (Act Section 656 adding new Code Section 408(p) and amending Code Section 4979A).

 

b. Section 404(k) Dividend Deductions. Under pre-Act law, dividend deductions are allowed under Section 404(k) on dividends paid on employer stock to an unleveraged ESOP only if the dividends are paid to employees in cash; the deduction is denied if the dividends remain in the ESOP for reinvestment. Under EGTRRA, the deduction for dividends paid in cash on employer stock held by an ESOP has been expanded to include dividends payable at the election of participants: (A) in cash directly to plan participants or beneficiaries, (B) to the plan and subsequently distributed to the participants or beneficiaries in cash no later than 90 days after the close of that plan year, or (C) to the plan and reinvested in qualifying employer securities. The standard for disallowing abusive dividends has been broadened. This provision is effective for taxable years beginning after December 31, 2001 (Act Section 662 amending Code Section 404(k)).

 

18. Individual Retirement Arrangements.

 

a. Increase in Annual Contribution Limits. Under pre-Act law, an individual may make annual deductible contributions to a traditional IRA up to the lesser of $2,000 or his compensation if neither the individual nor his spouse is an active participant in an employer-sponsored retirement plan. For a married couple, deductible IRA contributions of up to $2,000 can be made for each spouse (including, for example, a homemaker who does not work outside the home), if the combined compensation of both spouses is at least equal to the contributed amount. If the individual is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out if AGI exceeds certain levels for the tax year. For example, for 2001, the IRA deduction for single taxpayers phases out over $33,000 to $43,000 of AGI ($53,000 to $63,000 for married taxpayers filing jointly). For a non-active participant who has an active-participant spouse, the IRA deduction phaseout begins at $150,000 of AGI.

 

Effective for taxable years beginning after December 31, 2001, the maximum annual dollar contribution limit for IRA contributions increases as follows: (a) for 2002 through 2004, from $2,000 to $3,000; (b) for 2005 to 2007, $4,000; and (c) for 2008 to $5,000. After 2008, the limit is adjusted annually for inflation in $500 increments (Act Section 601 amending Code Section 219(b)).

 

b. Additional Catch-up Contributions. Effective for taxable years beginning after December 31, 2001, individuals who have attained age 50 may make additional catch-up IRA contributions. The otherwise maximum contribution limit (before application of the AGI phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter (Act Section 601 amending Code Section 219(b)).

 

Comment: The higher IRA contribution limits also mean higher annual contribution limits for Roth IRAs. Annual nondeductible contributions to Roth IRAs can be made up to the amount that would be allowed as a deductible contribution to a traditional IRA, reduced by the amount of contributions for the tax year made to all other IRAs (other than Roth IRAs) but not reduced by contributions to a SEP or SIMPLE plan. The allowable Roth IRA contribution phases out over $150,000-$160,000 of AGI for joint filers ($95,000-$110,000 for others).

 

The higher annual deductible IRA contribution limits also result in higher annual nondeductible traditional IRA contributions. These can be made by a taxpayer not eligible to make deductible IRA contributions (in whole or in part) because of the active-participant AGI phaseouts. The annual nondeductible traditional IRA contribution limit is equal to the amount that would be allowed as an IRA deduction (but for the active-participant AGI phaseouts) less the amount actually allowed as a deduction. Nondeductible contributions to traditional IRAs generally would be made only by those with AGI above the Roth IRA contribution threshold.

 

c. Deemed IRAs under Employer Plans. Effective for plan years beginning after December 31, 2002, if an eligible retirement plan permits employees to make voluntary employee contributions to a separate account or annuity that: (i) is established under the plan, and (ii) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the Code. The deemed IRA, and contributions thereto, are not subject to the Code's rules pertaining to the eligible retirement plan. In addition, the deemed IRA, and contributions thereto, are not taken into account in applying such rules to any other contributions under the plan. The deemed IRA is subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan, but is not subject to the ERISA reporting and disclosure, participation, vesting, funding, and enforcement requirements applicable to the eligible retirement plan. An eligible retirement plan is a tax-qualified plan, a 403(b) annuity, or a governmental 457 plan (Act Section 602 amending Code Section 408).

 

Comment: This new elective feature for eligible retirement plans would make it more convenient for employees to save for retirement with a traditional or Roth IRA. For example, they presumably would be able to direct their employer to automatically deduct amounts from their pay and set them aside in the traditional or Roth IRA set up by their employer plan.

 

19. Modifications to Education IRAs.

 

a. Annual Contribution Limit and Phase-Out Contribution Limit. The Act increases the annual aggregate contribution limit to Education IRAs from $500 to $2,000. The phase-out range for eligibility to contribute to an Education IRA for married taxpayers filing a joint return is increased to $190,000 to $220,000 of adjusted gross income, twice the range for single taxpayers.

 

b. Qualified Education Expenses. The definition of qualified education expenses that may be paid tax-free from an Education IRA has been expanded to include qualified elementary and secondary school expenses. This includes expenses for tuition, fees, academic tutoring, special needs services, books, supplies, room and board, uniforms, transportation, and other expenses incurred as part of enrollment at a public, private or religious school that provides education from kindergarten through the 12th grade. Supplementary services, such as extended day programs, that are required or provided by the school in connection with the beneficiary's enrollment are also considered qualified expenses. The definition also includes the purchase of any computer technology, equipment, or internet access that is used by the beneficiary and his family while he is in school. Software must be educational in nature to be a qualified expense.

 

c. Contributions by Persons Other Than Individuals. Regardless of income, corporations and other entities are allowed to make contributions to Education IRAs.

 

d. Contributions Permitted until April 15. Individuals who contribute to an Education IRA may make a contribution for a year until April 15 of the following year (Act Section 401 amending Code Section 530).

 

20. Tax Credit to Help Lower-Income Taxpayers Save for Retirement. Pre-Act law does not provide a tax credit to encourage participation in any tax-favored retirement vehicle.

 

For tax years beginning after 2001 and before 2007, eligible lower-income taxpayers will be able to claim a nonrefundable tax credit for contributions to certain retirement plans and arrangements.

 

The credit rate (50%, 20%, or 10%) depends on the taxpayer's filing status and AGI, as follows:

 

a. Joint filers: $0-$30,000, 50%; $30,000-$32,500, 20%; and $32,500 to $50,000, 10% (no credit if AGI is above $50,000).

 

b. Heads of households: $0-$22,500, 50%; $22,500-$24,375, 20%; and $24,375-$37,500, 10% (no credit if AGI is above $37,500).

 

c. All other filers: $0-$15,000, 50%; $15,000-$16,250, 20%; and $16,250-$25,000, 10% (no credit if AGI is above $25,000).

 

The maximum annual contribution eligible for the credit is $2,000.

 

The credit will be in addition to any deduction or exclusion that would otherwise apply for a contribution and will offset regular tax liability. Only an individual who is 18 or over will be eligible for the credit.

 

The credit will be available for elective contributions to 401(k) plans, 403(b) annuities, Section 457 plans, SIMPLE or SEP plans, traditional or Roth IRAs, and voluntary after-tax employee contributions to a qualified retirement plan.

 

The amount of any credit-eligible contribution will be reduced by taxable distributions received by the taxpayer and spouse from any of the above savings arrangements or any other qualified retirement plan during: (i) the tax year for which the credit is claimed, (ii) the preceding two tax years, and (iii) the period after the end of the tax year and before the due date for filing the taxpayer's return for the year. This rule will apply to any Roth IRA distributions, whether or not taxable (Code Section 25B, as added by Act Section 618(a)).

 

C. Fiduciary's Receipt of Fees for Providing Financial Advisory Services does not Violate Prohibited Transaction Rules

 

In Advisory Opinion 2001-09A, the DOL's Pension and Welfare Benefits Administration ("PWBA") held independent investment advice to be offered through 401(k) provider SunAmerica will not constitute a per se violation of ERISA's prohibited transaction rules.

 

ERISA generally prohibits a fiduciary (and other parties in interest) from providing services to a plan. ERISA Section 406(a)(1)(D) prohibits the use of a plan's assets by or for the benefit of a party-in-interest. ERISA Section 408(b)(2), however, provides an exemption from the rules of ERISA Section 406(a) for making reasonable arrangements with a party-in-interest, including a fiduciary, for services necessary for a plan's establishment or operation, so long as only reasonable compensation is paid therefor.

 

SunAmerica applied to the PWBA for an exemption from the prohibited transaction rules of ERISA Section 406 so that it could provide asset allocation services to participants in ERISA plans. SunAmerica intends to offer its investment advisory program to defined contribution plans. Under the program, asset allocation services will be offered to plan participants either through the "discretionary asset allocation service" or the "recommended asset allocation service." Under the discretionary asset allocation service, a specific model asset allocation portfolio will be created automatically for a participant's account. Under the recommended asset allocation service, a specific model asset allocation portfolio will be recommended to a participant, but the participant may choose to disregard the recommendation and invest in a manner that does not conform to the model asset allocation portfolios.

 

The model asset allocation portfolios will be created using a computer program that applies an investment methodology developed and maintained by a financial expert who is independent of SunAmerica. The financial expert, using its own methodologies, will construct strategic "asset class" level portfolios using generally accepted principles of modern portfolio theory. The model asset allocation portfolio created for a particular participant, therefore, will reflect the application of the methodologies developed by the financial expert, taking into account individual participant data.

 

The fiduciary responsible for a plan's participation in the SunAmerica program (i.e., a fiduciary independent of SunAmerica) will receive information concerning the program and role of the financial expert in developing the model asset allocation portfolios. The plan fiduciary will also receive, on an on-going basis, disclosures concerning the program and core or designated investments, and any proposed increases in investment advisory or other fees.

 

The financial expert will be compensated by SunAmerica for its services, but the fees paid for those services cannot exceed 5% of the financial expert's annual gross income. Further, the fees paid to the financial expert will not be affected by investments made in accordance with any asset allocation portfolio under the program.

 

SunAmerica sought a prohibited transaction exemption because, by providing discretionary asset management services and investment advice to participants, it might be acting as a fiduciary with respect to the participating plans. Further, SunAmerica was concerned that implementing a model asset allocation portfolio might result in increased investment advisory fees for SunAmerica or an affiliated entity. Thus, the issue to be determined was whether SunAmerica's receipt of the fees from the asset allocation or investment advisory services provided to plan participants under the investment advisory program violates the prohibitions of ERISA Section 406.

 

The PWBA stated that providing investment advice for a fee is a fiduciary act. Thus, SunAmerica would be acting as a fiduciary to both the discretionary and nondiscretionary asset allocation services and, as such, would be subject to the fiduciary responsibility provisions of ERISA, including ERISA Sections 404 and 406. As a fiduciary, SunAmerica would be responsible for the prudent selection and periodic monitoring of its investment advisory services consistent with the requirements of ERISA.

 

As to the prohibited transaction rules of ERISA Section 406, the PWBA said that the individual investment decisions or recommendations (i.e., asset allocation portfolios) provided or implemented under the program would not be the result of SunAmerica's exercise of authority, control, or responsibility for purposes of ERISA Section 406. Thus, there would be no prohibited transaction.

 

The PWBA based on its opinion on the following:

 

1. The plan fiduciaries responsible for selecting the SunAmerica investment program would be fully informed about, and would have to approve, the program and types of services provided, including the role of the financial expert.

 

2. The investment recommendations provided to, or implemented for, participants would be the result of methodologies developed and maintained by a financial expert who is independent of SunAmerica and any of its affiliates.

 

3. The arrangement between SunAmerica and the financial expert would preserve the financial expert's ability to develop model asset allocation portfolios solely in the interests of the plan participants and beneficiaries.

 

Comment: Since Advisory Opinion 2001-09A is an advisory opinion, only SunAmerica can rely on it. Further, it can only be relied on to the extent that all the material facts and representations and the actual situation conform to those described in the opinion request. However, the Advisory Opinion explains how financial service providers can provide independent investment advice without running afoul of the ERISA prohibited transaction rules; therefore, financial services providers other than SunAmerica can use the Advisory Opinion to develop similar investment advisory products.

 

This firm was instrumental in developing the PWBA's theory of independence of the financial expert when it authored the prohibited transaction exemption submission on behalf of Trust Company of the West, which resulted in the significant Prohibited Transaction Exemption 97-60.

 

D. Treasury Suspends Sale of 30-Year Bonds ­ Defined Benefit Pension Plans Affected

 

The Treasury Department announced on October 31, 2001 that it will no longer issue 30-year bonds. Yield rates on the 30-year Treasury bond had been declining before the announcement and plummeted immediately thereafter. Since the yield rate on the 30-year Treasury bond is the benchmark for many defined benefit pension plan requirements, lower yields will have a significant impact on defined benefit pension plans, in terms of higher contributions and lump sum payouts.

 

Comment: Even before the elimination of the 30-year bonds, there had been broad dissatisfaction with their very low rates. Several pension consulting and lobbying firms are working to find a suitable replacement to recommend to Congress.

 

E. IRS Requires Use of Updated Mortality Tables

 

The IRS prescribes the use of specific mortality tables by defined benefit pension plans for various purposes. These tables must be based on "the prevailing Commissioner's standard tableused to determine reserves for group annuity contracts." Revenue Ruling 92-19 set the Commissioner's standard table as the 1983 Group Annuity Mortality Table ("83 GAM"). Revenue Ruling 95-6 provided that a 50% male/50% female blend of the 83 GAM was to be used for purposes of adjusting benefits or limitations under Code Section 415(b) and for determining present values under Code Section 417(e)(3).

 

Revenue Ruling 2001-62 has changed the mortality basis to be used for determining the maximum benefits and present values discussed above. The new basis is a 50% male/50% female blend of the unloaded mortality rates in the 1994 Group Annuity Reserving Table, projected to 2002.

 

The new mortality basis must be used for distributions with annuity starting dates on or after December 31, 2002. However, earlier adoption is permissible. Plans that incorporate the mortality basis by reference to the Code may not have to be amended, all other plans will have to be amended.

 

Comment: The use of the mortality basis provided in Revenue Ruling 2001-62 will generally result in higher minimum lump sum amounts and higher maximum benefit limitation amounts.

 

 

F. IRS Final Regulations on Cross-Testing Plans

 

1. Definition.

 

New comparability plans are defined contribution plans that provide different allocation rates to different classes of employees. Typically, a new comparability plan provides much larger allocations to some highly compensated employees than to most nonhighly compensated employees.

 

IRS regulations have allowed satisfaction of the nondiscrimination rules to be demonstrated by cross-testing ­ i.e., by comparing the benefits payable at normal retirement age instead of by comparing each year's allocations. Under this technique, allocations for all participants are projected with interest to normal retirement age and converted into annuity benefits. The projected annuity benefits of the younger employees, usually nonhighly compensated employees, often compare favorably with the projected annuity benefits of the older employees, usually highly compensated employees.

 

2. New Rules.

 

Effective for plan years beginning on or after January 1, 2002, the regulations allow a defined contribution plan to use cross-testing if it satisfies a gateway test. Alternatively, a plan can cross-test if it has broadly available allocation rates or if it uses certain age-based allocation rates. The regulations also provide rules applicable to combinations of defined benefit and defined contribution plans.

 

3. Gateway to Cross-Testing.

 

A defined contribution plan can cross-test if each eligible nonhighly compensated employee is eligible for an allocation rate equal to at least one-third of the allocation rate of the highly compensated employee with the highest allocation rate under the plan. For example, if the highest highly compensated employee's allocation rate is 12%, the plan can cross-test if an allocation rate of at least 4% is provided to each nonhighly compensated employee. When calculating the allocation rate (i.e., allocation amount divided by compensation) under this test, any definition of compensation under Code Section 414(s) can be used.

 

Alternatively, the regulations provide that a defined contribution plan can cross-test if each eligible nonhighly compensated employee is eligible for an allocation rate of at least 5% of compensation as defined in Code Section 415(c)(3).

 

Elective and matching contributions to 401(k) plans may not be used in performing the gateway test. However, if an employer sponsors a safe-harbor 401(k) plan that provides for at least 3% nonelective contributions, then those nonelective contributions can be taken into account in determining allocation rates for the nonhighly compensated employees under the 5% rule.

 

4. Broadly Available Allocation Rates.

 

Under the regulations, a defined contribution plan may cross-test without satisfying the gateway test if each allocation rate is available to a group of employees that satisfies the coverage rules of Code Section 410(b) without regard to the average benefit percentage test (i.e., the allocation rates are broadly available). For this purpose, two allocation rates can be aggregated if the higher allocation rate covers a nondiscriminatory classification of employees.

 

5. Age-Based Allocation Rates

 

A defined contribution plan does not have to satisfy the gateway test if the allocation rates increase as an employee ages or earns additional service, provided that the schedule of allocation rates is a "gradual age or service schedule." A gradual age or service schedule occurs where allocation rates increase smoothly at regular intervals.

 

For a schedule of allocation rates to have regular intervals, all the age or service bands, other than the band applicable to the highest age or last period of service, have to be of the same length. For example, bands covering ages 0 to 30, 30 to 40, 40 to 50, and 50 and over are considered to be regular intervals.

 

6. Target Benefit Plans.

 

A target benefit plan is a defined contribution plan in which the contribution is determined, under specified interest and mortality assumptions, as the amount needed to provide for a certain level of defined benefit. Some target benefit plans are safe harbor designs under the nondiscrimination regulations and are not affected by these final regulations.

 

A target benefit plan is deemed to have age-based allocation rates, and thus does not have to satisfy the gateway test, if it satisfies the definition of a safe harbor target benefit plan, except that it has one or more of the following provisions: (a) the interest rate for determining present values is lower than a standard interest rate (i.e., 7-1/2% to 8-1/2%); (b) the stated benefit is calculated assuming compensation increases; or (c) the current year contribution is calculated using the actual account balance instead of the theoretical reserve.

 

7. Combinations of Defined Benefit and Defined Contribution (DB/DC Plans).

 

If one or more defined benefit plans and one or more defined contribution plans are aggregated for nondiscrimination testing, the resulting defined benefit and defined contribution plan can be cross-tested only if it meets one of three requirements. The defined benefit and defined contribution plan would have to satisfy a gateway test, or be primarily defined benefit in character, or consist of broadly available separate plans.

 

a. Gateway for Benefits Testing of DB/DC Plans. The regulations provide a numeric gateway to cross-testing a defined benefit and defined contribution plan that resembles the gateway test previously described for stand-alone defined contribution plans. The gateway test is based on the calculation of an aggregate allocation rate for each employee. This rate is determined by adding the employee's allocation rate under the defined contribution plan to the allocation rate that is the actuarial equivalent of the normal accrual rate under the defined benefit plan.

 

Under the gateway test, if the aggregate allocation rate for the highly compensated employee with the highest aggregate allocation rate is less than 15%, then every eligible nonhighly compensated employee's aggregate allocation rate must be at least one-third of the highest highly compensated employee's aggregate allocation rate. If the highest highly compensated employee's aggregate allocation rate is between 15% and 25%, then every eligible nonhighly compensated employee's aggregate allocation rate must be at least 5%. If the highest highly compensated employee's aggregate allocation rate exceeds 25%, then every eligible nonhighly compensated employee's aggregate allocation rate must be at least 5% plus 1% for each 5% increment (or portion thereof) by which the highest highly compensated employee's aggregate allocation rate exceeds 25%.

 

Alternatively, the final regulations allow a plan to satisfy the minimum aggregate allocation gateway if the aggregate normal allocation rate for each nonhighly compensated employee is at least 7-1/2% of compensation as defined in Code Section 415(c)(3).

 

b. Primarily Defined Benefit in Character. A DB/DC plan can use cross-testing if it is primarily defined benefit in character ­ i.e., at least 50% of the nonhighly compensated employees benefiting under the DB/DC plan have normal accrual rates under the defined benefit plan that exceed their equivalent accrual rates attributable to allocations under the defined contribution plan.

 

c. Broadly Available Separate Plans. A DB/DC plan can use cross-testing if it consists of broadly available separate plans ­ i.e., each plan separately satisfies the nondiscriminatory coverage and nondiscriminatory benefit or contribution requirements of Code Section 410(b), other than the average benefit percentage test. In conducting separate testing, all plans of the same type (defined benefit or defined contribution) within the DB/DC plan would be aggregated and tested without regard to plans of the other type.

 

Comment: For many new comparability plan sponsors, the final regulations may require additional allocations to nonhighly compensated employees. If we have drafted an individually designed plan affected by these rules for your institution, we will contact you regarding these new rules and your options with respect thereto.

 

G. IRS Issues Revised Proposed Regulations Concerning Required Minimum Distributions

 

1. Introduction.

 

The IRS issued revised proposed regulations on required minimum distributions from tax-qualified plans, IRAs, Roth IRAs and Section 403(b) annuity contracts. The revised proposed regulations are designed to simplify the 1987 proposed regulations by: (i) providing a uniform table from which to calculate required distributions (table replicated below); (ii) allowing pre-death distributions to be calculated without regard to the beneficiary's age; (iii) permitting the beneficiary to be determined as late as the end of the year following the year of death; and (iv) allowing post-death distributions to be spread over the beneficiary's remaining life expectancy.

 

2. Required Minimum Distributions.

 

Under the new rules, most participants will be able to quickly determine the applicable yearly divisor by applying their current age to the required minimum distribution incidental benefit ("MDIB") divisor table. This table is identical to the MDIB divisor table used in the 1987 proposed regulations for joint life expectancy payouts when a non-spouse beneficiary is more than 10 years younger than the participant. The required minimum distribution would then be determined by applying the applicable divisor to the participant's account balance as of the end of the prior year. Participants no longer need to decide whether to recalculate their life expectancy each year in determining their required minimum distribution.

 

Comment: An exception applies if the participant's sole beneficiary is the participant's spouse and the spouse is more than 10 years younger than the participant. In such case, the participant is permitted to use the longer distribution period measured by the joint life expectancy of the participant and spouse.

 

3. Post-Death Distributions.

 

For years after the year of the participant's death, the distribution period is generally the remaining life expectancy of the designated beneficiary regardless of whether the participant died before or after his required beginning date. The beneficiary's remaining life expectancy is calculated using the age of the beneficiary in the year following the year of the participant's death, reduced by one for each subsequent year. If the participant's spouse is the participant's sole beneficiary at the end of the year following the year of death, the distribution period during the spouse's life is the spouse's single life expectancy based on the surviving spouse's birthday in each distribution calendar year. For years after the year of the spouse's death, the distribution period is the spouse's life expectancy calculated in the year of death, reduced by one for each subsequent year. If there is no designated beneficiary as of the end of the year after the participant's death and the participant dies after his required beginning date, the distribution period is the participant's life expectancy calculated in the year of death, reduced by one for each subsequent year. If there is no designated beneficiary as of the end of the year after the participant's death and the participant dies before his required beginning date, the 5-year default payout rule will apply.

 

4. Determination of the Designated Beneficiary.

 

The revised proposed regulations continue to permit the beneficiary of a trust to be a participant's designated beneficiary when the trust is named as the beneficiary of a retirement plan or IRA. The revised proposed regulations generally contain the same requirements as the 1987 proposed regulations regarding naming a trust as the beneficiary.

 

5. Election by Surviving Spouse to Treat Inherited IRA as Spouse's Own IRA.

 

Consistent with the 1987 proposed regulations, the revised proposed regulations continue to provide that a surviving spouse-beneficiary may elect to treat the spouse's interest in an individual's IRA as the spouse's own IRA, with the following modifications. First, the revised proposed regulations provide that this election can only be made after the distribution of the required minimum amount for the IRA for the calendar year containing the individual's date of death. Second, in order to make this election, the surviving spouse must be the sole beneficiary of the IRA and have unlimited right to withdraw amounts from the IRA. The revised proposed regulations, unlike the 1987 proposed regulations, provide that this requirement is not satisfied if a trust is named as beneficiary of the IRA even if the spouse is the sole beneficiary of the trust, e.g., a QTIP trust.

 

6. IRA Reporting of Required Distributions.

 

The revised proposed regulations require IRA trustees to annually calculate and report the amount of the required minimum distribution from an IRA to the IRA owner or beneficiary. This reporting is required regardless of whether the IRA owner is planning to take the required distribution from that IRA or from another IRA. The reporting requirements do not apply to qualified plan administrators.

 

Comment: This should improve compliance and reduce the burden on IRA owners.

 

7. Table for Determining Distribution Period for Lifetime Distributions.

Age of the employee	Distribution Period	Age of the employee	Distribution period	Age of the employee	Distribution Period	Age of the employee	Distribution period
70	26.2	79	18.4	88	11.8	97	6.9
71	25.3	80	17.6	89	11.1	98	6.5
72	24.4	81	16.8	90	10.5	99	6.1
73	23.5	82	16.0	91	9.9	100	5.7
74	22.7	83	15.3	92	9.4	101	5.3
75	21.8	84	14.5	93	8.8	102	5.0
76	20.9	85	13.8	94	8.3	103	4.7
77	20.1	86	13.1	95	7.8	104	4.4
78	19.2	87	12.4	96	7.3	105	4.1

Comment: For the majority of taxpayers, the minimum distribution amounts will be lower, leading to reduced income tax liability. Participants in tax-qualified plans will not be able to use the new proposed rules unless their plan adopts the model amendment published by the IRS or a substantially similar individually designed amendment. This restriction is not imposed upon IRA owners. Therefore, IRA owners may rely on the new rules immediately. However, when final regulations are issued, an IRA owner will not be able to use the final rules until the IRA sponsor amends the IRA documentation to reflect the final regulations.

H. Qualified Transportation Benefits Includible in Compensation

Salary reduction amounts or elective deferrals generally are treated as compensation for purposes of the limits on contributions and benefits under tax-qualified plans. In addition, an employer can elect whether to include these amounts for nondiscrimination testing purposes. The Consolidated Appropriations Act of 2001 treats nontaxable salary reduction amounts used for qualified transportation benefits (i.e., employer-provided transit passes, vanpooling, and qualified parking) the same as other salary reduction amounts for purposes of defining compensation under the qualified plan rules. The changes are retroactively effective for tax years beginning after 1997. Notice 2001-37 provides model plan amendments.

I. IRS Restructures Employee Plans Compliance Resolution System

The IRS issued Revenue Procedure 2001-17 which reorganizes the Employee Plans Compliance Resolution System ("EPCRS"). EPCRS is a comprehensive system of correction programs for sponsors of retirement plans that are intended to satisfy the requirements of Code Section 401(a), Code Section 403(a), or Code Section 403(b) but have not satisfied all of the applicable requirements. EPCRS provides a means for correcting a plan's failures so that the plan may continue to receive tax-favored treatment. Before the changes effected by Revenue Procedure 2001-17, EPCRS included: the Administrative Policy Regarding Self-Correction ("APRSC"), the Voluntary Compliance Resolution ("VCR") program, the Standardized VCR Procedure ("SVP"), the Walk-In Closing Agreement Program ("Walk-In CAP"), the Tax-Sheltered Annuity Voluntary Correction ("TVC") program and the Audit Closing Agreement Program ("Audit CAP").

 

Revenue Procedure 2001-17 makes the following changes to EPCRS:

1. renames APRSC as the Self-Correction Program ("SCP");

2. combines the previous programs for effecting voluntary corrections ­ VCR, Walk-In CAP, and TVC ­ into a single voluntary correction program, called the Voluntary Correction Program ("VCP"). VCP includes special procedures for certain operational failures: Voluntary Correction of Operational Failures ­ or VCO ­ and Voluntary Correction of Operational Failures Standardized, or VCS. VCO and VCS are the successors to VCR and SVP, respectively. VCP also includes special procedures for 403(b) failures called the Voluntary Correction of Tax-Sheltered Annuity Failures, or VCT. VCT replaces TVC, but it also includes additional, new procedures;

3. broadens the submission procedures under the VCP to allow certain organizations, such as master and prototype sponsors and third-party administrators, to receive a compliance statement for correcting failures that affect more than one plan sponsor; this is known as VCGroup;

4. revises the submission procedures under VCP to allow plan sponsors to submit a request on an anonymous or "John Doe" basis;

5. expands EPCRS to include new procedures designed for employers that sponsor simplified employee pensions ("SEPs"), permitting employers to self-correct insignificant SEP failures;

6. extends the duration of the self-correction period under SCP for significant operational compliance failures if the plan sponsor accepts a transfer of plan assets or effects a plan merger in connection with a corporate merger, acquisition, or other similar transaction;

7. facilitates correction under SCP, VCP, and Audit CAP of previous qualification failures by plan sponsors that accept transfers of plan assets or effect plan mergers in connection with corporate transactions;

8. permits correction through retroactive amendment where employees are permitted to begin participation before they are eligible under the terms of the plan;

9. allows correction through retroactive amendment under SCP and VCO for failures related to permitting hardship withdrawals, providing benefits based on compensation in excess of the Code Section 401(a)(17) limit, and premature participation by otherwise eligible employees;

10. permits correction by employers that were not eligible to sponsor 401(k) plans at the time they adopted their plans (e.g., 501(c)(3) organizations);

11. clarifies that the ability to self-correct insignificant failures continues to be available under SCP during a plan examination, whether the failure is identified by the plan sponsor or the IRS;

12. explains the reporting requirements applicable to excess distributions from qualified plans and SEPs;

13. indicates how fees are calculated for multiemployer and multiple employer plans;

14. clarifies that a failure not disclosed by the plan sponsor, but discovered by IRS during the processing of a determination letter submission, is subject to the sanction structure of Audit CAP; and

15. updates the definition of "favorable letter" to take into account changes effected by GUST.

As discussed above, components of revised EPCRS are the Self-Correction Program ("SCP"), the Voluntary Correction Program ("VCP"), and the Audit Closing Agreement Program ("Audit CAP"). They are designed to function as follows:

Under SCP, a plan sponsor that has established compliance practices and procedures may correct operational failures without paying any fee or sanction.

Under VCP, at any time before a plan audit, the plan sponsor may pay a limited fee and receive the IRS's approval for correction. VCP provides special procedures specifically designed for correcting only operational failures (Voluntary Correction of Operational Failures, or VCO), as well as procedures designed for correcting limited operational failures using standardized correction methods (Voluntary Correction of Operational Failures Standardized, or VCS). VCP also contains a special procedure that applies to 403(b) Plans (Voluntary Correction of Tax-Sheltered Annuity Failures, or VCT), a special procedure for anonymous submissions (Anonymous Submission Procedure), a special procedure for group submissions (Voluntary Correction of Group Failures, or VCGroup), and a special procedure for SEPs (Voluntary Correction of SEP Failures, or VCSEPs).

Under Audit CAP, if a failure is identified on audit, the plan sponsor may correct the failure and pay a sanction. The sanction imposed will bear a reasonable relationship to the nature, extent, and severity of the failure, taking into account the extent to which correction occurred before the audit.

Comment: The IRS views EPCRS as an alternative to costly plan audits, and has vowed to make improvements to the program in order to provide an incentive for plan sponsors to participate in EPCRS and comply with the tax-qualification rules.

Marcia Wagner has authored the preeminent research authority in this area for the BNA Tax Management Portfolio series entitled "Plan Disqualification and ERISA Litigation."

J. PBGC Issues Final Amendments to Premium Payment Regulations

Most private-sector defined benefit pension plans are required to pay annual premiums to the PBGC. The PBGC guarantees payment of basic pension benefits from these plans. The premium consists of a flat rate per participant, and a variable rate that is based on the amount of the plan's unfunded vested benefits.

The PBGC has issued final amendments to its premium payment regulations, which simplify the premium payment procedures. The final PBGC amendments make the following three changes to the premium payment regulations: (i) the premium for short plan years, (ii) the definition of participant, and (iii) the exemption for Section 412(i) plans.

 

1. Short Plan Year Premiums.

Prior to amendment, in the event of a short plan year, the plan administrator was required to pay the full-year PBGC premium and was permitted to then request a refund for the amount overpaid. The final amendments allow a plan administrator to pay a prorated premium.

2. Definition of Participant.

The PBGC premium is based on the number of participants on the "snapshot date," which is generally the last day of the plan year preceding the premium payment year. The final amendments change the definition of participant. Under the new definition, an individual is considered to be a participant on any date if the plan has "benefit liabilities with respect to the individual on that date." Therefore, individuals in a new plan which provides no past service credits would not be counted as participants. Similarly, in a plan with a 1,000-hour of service accrual rule, those individuals who do not reach the 1,000-hour threshold in any plan year would not be counted as participants.

The final amendments provide that an individual with no vested accrued benefit is treated as no longer being a participant in the event any of the following occurs: (i) the individual incurs a 1-year break in service; (ii) the individual's entire vested accrued benefit is distributed; or (iii) the individual dies.

An individual whose accrued benefit is fully or partially vested is treated as no longer being a participant after either of the following occurs: (i) an insurer makes an irrevocable commitment to pay all benefit liabilities with respect to the individual; or (ii) all benefit liabilities with respect to the individual are distributed.

3. Fully Insured Plans.

The PBGC regulations exempt certain plans from the variable rate portion of the premium. One exemption applies to fully insured Code Section 412(i) plans. Prior to these amendments, an insured plan qualified for the exemption only if it met the Section 412(i) requirements for the entire year. The amendments provide that a fully insured plan only has to meet the Section 412(i) requirements on the premium snapshot date in order to be exempt from the variable-rate premium.

Comment: The final amendments will result in lower premiums for many plan sponsors.

K. Only Nonvested Participants are Counted in Partial Termination Decision

A partial termination occurs, in general, when at least 20% of an employer's plan participants are terminated or otherwise excluded from future plan participation. Plan participants become fully vested in their pension benefits on the occurrence of a partial termination.

The Seventh Circuit reversed itself in a partial termination case. The decision followed a remand by the Supreme Court of an earlier Seventh Circuit decision, Matz v. Household International Tax Reduction Investment Plan, 2001 WL 1027275 (7th Cir. 2001). In its reversal, the Seventh Circuit held that in asserting a partial plan termination claim, a former employee was allowed to count only nonvested participants in trying to show that the reduction in his employer's work force was sufficient to constitute a partial termination. The court emphasized the ambiguity of the term "partial termination," stating that neither the statutory language, the Treasury regulations, nor the legislative history provide guidance. Therefore, in holding that only nonvested participants should be counted, the court looked to the partial termination statute's purposes of protecting employees' legitimate expectation of pension benefits, and of preventing employers from abusing pension plans for tax purposes. The court held that a finding of partial termination would not protect vested participants because their benefits are, by definition, nonforfeitable. Therefore, the court held that only nonvested participants should be counted when determining whether partial plan termination has occurred. The court let stand its earlier ruling that the number of participants terminated in all years of corporate reorganization could be counted, if the corporate transactions in those years were sufficiently related.

 

L. Enron ­ the Aftermath

Late last year, Enron, the seventh largest corporation in the U.S., declared bankruptcy. Employees have suffered devastating losses in retirement benefits. Enron offered its employees a 401(k) plan that included company stock as an investment option. In addition, Enron matched 50 percent of employees' elective deferrals with company stock. The employer match was designated as an employee stock ownership plan ("ESOP"). Section 401(k) plan participants were allowed to change investment elections daily; however, participants could not sell the Enron stock that the company had made as matching contributions to the ESOP until they reached age 50. Company stock that participants had purchased voluntarily through the 401(k) plan was not subject to this sales restriction.

In 2000, the company stock traded at about $90 per share. At the end of 2000, about 62 percent ($1.3 billion) of plan assets were held in Enron stock, of which about 89 percent had been purchased by employees on an elective basis. Earnings loss reports dropped the share price to about $34 per share in October 2001. The plan implemented a "blackout" period from mid-October to November 13, 2001 that prohibited any change in participant investments; Enron stated this was necessary to transition in a new recordkeeper. After the blackout window had expired, the share price had dropped from $13.81 to $9.98. By January 18, 2002, the share price had fallen to $0.63, wiping out the retirement savings of many employees.

Companies that sponsor ESOPs and 401(k) plans that hold employer stock are attempting to determine whether the national attention being paid to company stock in retirement plans in light of Enron's collapse has implications for their plans. Further, employers should question whether the use of employer stock in their plans creates unanticipated risks for the company, employees and/or plan fiduciaries.

As a result of the Enron fiasco, plan sponsors should examine each plan's balance of employer stock investments in view of standard diversification principles and restrictions on diversification out of company stock. Plan sponsors should also reexamine their employee communication, investment education and disclosure policies to ensure they are consistent with the overall plan purposes and the duties of fiduciaries. The plan sponsor must examine how the structure of its plans meets both the needs of plan fiduciaries and the company's financial and other objectives. Fiduciary management principles must be formalized and actively practiced, including: having a written investment policy; using professional retirement plan and investment advisors and counsel; conducting periodic reviews of the overall program design and policies; and reviewing investment structures, expenses and performance at least annually.

Various Congressional bills addressing the Enron 401(k) issues have been introduced, including proposals to limit the extent to which an employee's account balance can be held in a single stock. Proposals also would limit companies' ability to keep employees from selling company stock in their 401(k) accounts, and some limit the employer tax deduction for matching contributions made in the form of employer stock.

Comment: Enron's collapse and its effect on employees and investors have the attention of Congress and the Bush administration. Therefore, changes in the statutory and regulatory environment for 401(k) plan investments are widely expected. We will keep you informed of significant developments in this area.

 

III. WELFARE BENEFIT PLANS

A. DOL Finalizes ERISA Claims Procedure Regulations

1. Background.

After more than two years of debate, the DOL finalized the highly controversial ERISA claims procedure regulations on November 21, 2000 (65 Fed. Reg. 70245). Although the final regulations apply to all ERISA-covered plans, the significant modifications to the claims procedure regulations generally apply only to claims for health and disability benefits. The DOL noted in the preamble to the final regulations that plans that do not provide group health or disability benefits generally will not be required to revise their procedures. Thus, non-health or disability plans will continue to operate under the original regulations that have been in place since 1977.

2. Group Health Plan Claim Requirements.

ERISA Section 503 requires employers to maintain reasonable procedures governing the filing of claims, notice of determinations, and appeals of adverse determinations. The final regulations significantly modify the rules which must be satisfied in order for a health and disability plan to maintain reasonable claims procedures.

The final regulations repeal the exemption from the claim procedure requirements under Labor Reg. Section 2560.503-1(j) that formerly extended to HMOs maintaining claim procedures that comply with the Public Health Service Act. Thus, HMOs, like any other health plan, must comply with the rules herein described.

a. General Requirements for Reasonable Claims Procedures. A group health plan must provide that, if a claimant submits a claim for a benefit that does not satisfy the plan's claim procedures, the plan must provide the claimant with oral or written notice of any technical deficiency in the claim and the steps necessary to cure the deficiency within 5 calendar days of the discovery of the defect in the filing (24 hours, in the case of a claim involving urgent care, which is defined by Labor Reg. Section 2560.503-1(m)(1) to be one in which application of longer periods would threaten the claimant's life, health, or ability to regain maximum function (Labor Reg. Section 2560.506-1(c)(1)).

A group health plan cannot require a claimant to file more than two appeals before being able to pursue his remedies under ERISA Section 502 ­ i.e., the right to sue (Labor Reg. Section 2560.503-1(c)(2)). If a plan provides voluntary levels of appeals, including voluntary arbitration or other forms of alternate dispute resolution, then the plan: (i) must waive its right to assert that the claimant has failed to exhaust the plan's internal appeal procedures merely because the claimant does not elect to submit to any such voluntary review; (ii) must agree to tolling of any statute of limitations while a voluntary review is pending; (iii) must allow the claimant to submit the disputed claim to voluntary review only after exhaustion of the two appeals permitted by Section 2560.503-1(c)(2); (iv) upon request, must provide the claimant or his representative with sufficient information as to the voluntary appeals avenues available under the plan to make an informed choice about whether to submit to a voluntary review process; and (v) may not impose on the claimant any fees or costs in connection with the voluntary review process (Labor Reg. Section 2560.503-1(c)(3)).

Group health plans cannot include any provision for mandatory arbitration of disputed claims unless: (i) the arbitration is one of the two appeals procedures described in Labor Reg. Section 2560.503-1(c)(2); and (ii) the claimant is not precluded from pursuing any available remedies under ERISA Section 502 (Labor Reg. Section 2560.503-1(c)(4)).

The plan administrator must provide written or electronic notice of adverse benefit determinations. Notice must: (i) state specific reason for denial, (ii) reference specific plan provisions, (iii) describe additional information necessary to perfect the claim and why such information is necessary, and (iv) describe plan procedures, time limits and the right to sue.

A group health plan must also:

 

(i) give a claimant at least 180 days in which to request a review of an adverse benefit decision under the plan's internal review processes;

(ii) provide for a review that accords no particular deference to the initial adverse benefit determination;

(iii) with respect to adverse benefit determinations, provide that the review of any determination based on a medical judgment, including determinations whether a particular treatment, drug, or other item is experimental, investigational, or not medically necessary or appropriate, be conducted through consultation with a health care professional not involved in the initial denial decision and who has appropriate training and experience in the field of medicine involved in the medical judgment;

(iv) inform the claimant of the identify of any medical or vocational experts consulted in connection with a particular claim;

(v) disclose internal rules, guidelines, or protocols relied on in making the adverse determination (or state that such information is available for free);

(vi) provide the claimant with the opportunity to submit written comments, documents, or other information;

(vii) provide the claimant with access to all "relevant" documents; and