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Current Developments (Part II)
This two-part article provides an
overview of current developments in employee benefits.
Part II focuses
on significant retirement plan developments, including proposed and
final regulations and revenue and letter rulings. Deborah Walker, CPA
For more
information about this article, contact Ms. Walker at
debwalker@deloitte.com
or Mr. Wagenbach at
pwagenbach@deloitte.com. Executive Summary
Part I of this two-part article, published in the Nov. 2003 issue, focused on recent developments in executive compensation and welfare plans. Part II, below, highlights last years most significant retirement plan developments, including both IRS and Department of Labor (DOL) guidance.
Qualified Plans Proposed Regulations In July 2003, the IRS published proposed regulations33 on cash-or-deferred arrangements (CODAs) and employee and matching contributions. When published as final regulations, these rules will completely overhaul existing Sec. 401(k) and (m) regulations, incorporating all of the statutory amendments and administrative guidance accumulated since the 1991 regulations. The proposed regulations eliminate the ability to accelerate deductions, restrict the use of bottom-up qualified nonelective contributions (QNECs) as a way to pass the discrimination tests with minimal contributions and reflect a decade of statutory changes. While many provisions are not new, the following important changes were made:
The proposed regulations would become effective no earlier than the first plan year beginning at least 12 months after their adoption in final form. Until then, taxpayers need to adhere to the existing final regulations.
Catch-Up Contributions Final regulations35 relaxed the universal availability requirement, under which a controlled group cannot pick and choose which of its plans will allow catch-up contributions. The option must either be available under all plans that permit elective deferrals, or under none of them. Under the final regulations, collective bargaining employees and nonresident aliens without U.S.-source income may be ignored. Plans may also limit deferrals (including catch-ups) to (1) 75% of compensation or (2) the cash available after all required withholding from the participants paychecks. A transition rule modeled on Sec. 410(b)(6)(C) is provided for mergers, spinoffs and acquisitions. Separately from these exemptions, Notice 2002-436 offered relief to employers that maintain plans qualified under Puerto Rico law, which has no provision for catch-ups. In addition, the final regulations noted that the identification of catch-ups is made annually. Plans can choose whether to offer matching contributions for catch-up deferrals without any nondiscrimination implications. Individuals participating in two or more plans of unrelated employers may take the catch-up rules into account in determining whether the Sec. 402(g) limit has been exceeded, regardless of whether the plans allow catch-up contributions. The regulations apply to plan years beginning after 2003 and may be relied on immediately.
Restorative Payments Two letter rulings illustrated when the IRS will treat a contribution as a deductible restorative payment under Sec. 162, rather than a contribution subject to normal allocation and deduction restrictions (applying Rev. Rul. 2002-4537). In Letter Ruling 200317050,38 a defined contribution plan had incurred a large loss on a secured loan to an unrelated party. The employer agreed to restore the plans loss and to reimburse part of its legal and accounting fees, to head off participant and DOL lawsuits. The IRS agreed that these payments fell within the purview of Rev. Rul. 2002-45. Thus, because they were a bona fide settlement of a potential fiduciary liability, they (1) were not treated as annual additions to participants accounts, (2) did not have to satisfy nondiscrimination standards and (3) were fully deductible under Sec.162, without regard to Sec. 404 limits. In contrast, in Letter Ruling 200317048,39 the IRS found no genuine apprehension of fiduciary liability when a plan incurred early withdrawal penalties on the withdrawal of deposits made under insurance company annuity contracts. The facts did not demonstrate a reasonable risk of liability to the employer for breach of fiduciary duty; the deposits were deductible plan contributions under Sec. 404 and subject to Sec. 415s annual addition limits and Sec. 401(a)(4)s nondiscrimination rules.
Compensation Limit Rev. Rul. 2003-1140 allowed plans to increase retiree benefits by using the new, higher Sec. 401(a)(17) limit for past years. In the ruling, a plan amendment adopted in 2002, adjusted future benefit payments to retired participants to reflect compensation that could not be considered under prior Sec. 401(a)(17) limits. The IRS ruled that the amendment did not violate Sec. 401(a)(4), because the HCEs did not gain any benefit that they would not have had if the new provision had actually been in effect in earlier years, and the amendments timing did not favor HCEs over NHCEs. However, the ruling failed to address Sec. 401(a)(26), which requires that a benefit structure in a qualified DB plan benefit the lesser of (1) 50 employees or (2) the greater of 40% of all employees or two employees. Any plan taking advantage of this ruling needs to be sure benefit increases do not violate Sec. 401(a)(26).
Prohibited Transaction Exemptions In a move of interest to cash-strapped employers, the DOL granted a prohibited transaction exemption41 to allow Northwest Airlines to contribute stock of its Pinnacle Airlines subsidiary to one of its pension plans to satisfy the plans minimum funding requirements.42 The airline asked the DOL for an individual exemption, because the shares are not qualifying employer securities as defined in Employee Retirement Income Security Act of 1974 (ERISA) Section 407(d)(5), as they do not meet ERISA Section 407(f)(1)s widely held requirement. In addition to authorizing the contribution and allowing the plan to hold nonqualifying employer securities, the exemption requires the employer to offer the plan an option to resell the stock for the greater of fair market value or its value on the contribution date. By granting the exemption, the DOL is accepting the employers arguments that the Pinnacle stock is a sound investment for the plan, especially in light of the put option protection, and that reducing the sponsors cashflow burdens is also beneficial to the plan and its participants. Other companies with valuable but illiquid investments may be able to obtain a similar exemption.
Sec. 72(t) Penalty Tax One way to avoid the Sec. 72(t) 10% penalty tax on qualified plan and IRA distributions before age 591/2 is to establish a stream of substantially equal periodic payments. Modifying the distribution schedule before age 591/2 (or the passage of five years, if payments began after age 541/2) leads to retroactive imposition of the penalty. Under Notice 89-25,43 there are three permissible distribution methods, two of which mimic mortgage amortization or annuity payouts, thus producing equal distributions each year. The third method is used to calculate minimum required distributions under Sec. 401(a)(9) and backloads the payment stream. Prompted by the bear market, Rev. Rul. 2002-6244 relaxed Notice 89-25s principle that, once selected, the distribution method may not be changed. Distributees will henceforth be allowed to switch freely from the amortization or annuity method to a schedule that satisfies Sec. 401(a)(9). Further, Sec. 401(a)(9) distribution schedules that began under the pre-2002 regulations may be modified by substituting the current mortality table for the one previously required. Hence, an IRA participant whose balance is being dissipated more rapidly than originally anticipated can slow distributions and preserve the IRA for a longer period. However, the converse is not truea distributee whose IRA income is disappointingly low cannot increase distributions by switching from the Sec. 401(a)(9) method to another. Changes to the Sec. 401(a)(9) method cannot be rescinded if the market rises again.
Reversions In Rev. Rul. 2003-85,45 the IRS again reversed itself on more-than-25% transfers by DB plans to qualified replacement plans. Under Sec. 4980(d)(2), the excise tax on employer reversions from a terminating DB plan is reduced from 50% to 20%, if 25% of the plans residual assets are transferred to a replacement plan. The transferred amount is neither included in, nor deductible from, the employers taxable income. A set of 1998 letter rulings46 held that any portion of the transfer in excess of 25% was subject to the reversion excise tax, but was otherwise treated in the same manner as the qualifying portion of the transfer. Letter Ruling 20022704147 revoked those rulings, concluding that the excess transfer is includible in the employers income, with an offsetting deduction to the extent allowable under Sec. 404(a). A corollary is that the excess must be allocated in the year of transfer, whereas the qualifying portion is allocable over up to seven years. Rev. Rul. 2003-85 returned to the 1998 view of the income tax consequences and is even more favorable on the excise tax. It considers a situation in which a terminating plan has $60x of residual assets, one-third of which ($20x) is transferred to a qualified replacement plan. The IRS ruled that only the $40x that the employer receives directly is subject to reversion tax and included in taxable income. By implicationthe ruling does not address the issuethe entire transferred amount may be allocated to replacement plan accounts over a seven-year period. This result is difficult to reconcile with the statutory language, which on its face limits the favorable tax treatment to precisely 25% of the terminating plans residual assets. However, taxpayers can rely on the latest ruling until it is modified or revoked.
Expense Allocations The DOL has markedly eased the past formal and informal positions on the manner and extent to which plan expenses can be charged to participants, by stating that, [i]f the plan document sets forth rules for allocating expenses among participants accounts, those rulesmust be adhered to by the plan administrator.48 In the absence of specific plan provisions, a plans overhead expenses may be allocated pro rata, per capita or on any other basis, as long as the method bears a reasonable relationship to the services furnished or available to an individual account. The plan administrator is not required to determine whether the method is equally favorable to all participants. Thus, the plans fixed administrative expenses, such as recordkeeping, legal, auditing, annual reporting, claims processing and similar administrative expenses, can reasonably be allocated either pro rata or per capita; those that vary with the value of assets, such as investment management fees, should have a pro-rata allocation. Another alternative is allocation on the basis of use (e.g., the plan arranges for investment advisers to consult with participants). Thus, specific charges may be allocated to specific accounts (e.g., costs associated with qualified domestic relations orders, hardship withdrawals, calculation of benefits payable under different distribution options and benefit distributions). In addition, accounts of separated participants can be charged a reasonable share of plan administrative expenses, even if the employer otherwise pays all plan costs.
ESOPs SESOP Management Companies Temp. Regs. Sec. 1.409(p)-1T49 aimed to shut down S corporation/ ESOP management companies. Published as both temporary (for three years) and proposed regulations, the new regulations ensure that ESOP-owned S corporations (SESOPs) benefit more than a scant few individuals. Some SESOPs may unwillingly run afoul of the rule, with disastrous consequences. The temporary regulations treat the executives deferred compensation as synthetic equity, a concept unique to Sec. 409(p). Under the statute, if disqualified persons own 50% or more of a SESOPs stock, including stock deemed to be held through the ESOP and synthetic equity (options, restricted stock, stock appreciation rights, etc.), the corporation is subject to Sec. 4979A excise tax and the individual is treated as having received a distribution. Ordinarily, persons with less-than-10%-ownership interests are not disqualified persons, but the temporary regulations authorize the IRS to include anyone in that category to prevent Sec. 409(p) avoidance by groups of executives. SESOPs that existed on March 14, 2001 are exempt from Sec. 409(p) until plan years beginning after 2004 and, thus, are not immediately affected. Otherwise, the temporary regulations are effective for plan years ending after Oct. 20, 2003, except that deferred compensation distributed by July 21, 2004, will not be treated as synthetic equity.
SESOP Shells Rev. Rul. 2003-650 aimed at a device marketed to postpone Sec. 409(p)s effective date for newly established SESOPs. Sec. 409(p)s effective date is plan years beginning after March 14, 2001, but ESOPs existing on that date are grandfathered until years beginning in 2005. Several consulting firms offered for sale SESOPs created before March 14, 2001 with only nominal business operations. Rev. Rul. 2003-6 holds that an ESOP is not established until it is adopted by an employer for the purpose of enabling its employees to participate in a more than insubstantial manner in the ownership of the employers business and to provide its employees with more than insubstantial benefits under the ESOP. Hence, ESOPs of shell corporations do not qualify.
Dividend Deductions In Letter Ruling 200237026,51 the IRS granted a U.S. subsidiary a deduction under Sec. 404(k) for dividends paid on the foreign parents stock. A U.S. subsidiary of a foreign corporation established an ESOP to invest in the parents publicly traded stock and offered participants an election to receive dividends. The letter ruling holds, routinely, that the parents shares are qualifying employer securities and, less expectedly, that the subsidiary can deduct the dividends under Sec. 404(k), which grants the deduction to the issuer of the stock. One might think that the subsidiary has no deduction, while the parent has one that is probably useless. To support letting a non-issuer take the deduction, the IRS invoked the Sec. 414(b) controlled-group rules, which treat all members of a group as a single employer for various purposes. That section makes only a limited reference to Sec. 404, however: With respect to a plan adopted by more than one employer, the applicable limitations provided by 404(a) shall be determined as if all such employers were a single employer.... Taxpayers should exercise caution in relying on Letter Ruling 200237026; the IRS is currently reviewing its position and determining whether it will issue additional rulings.
Basis In Rev. Rul. 2003-27,52 the IRS ruled that net unrealized appreciation (NUA) is reduced by undistributed income allocable to S stock held by a SESOP. SESOPs can own S stock but, unlike other S shareholders (including non-ESOP qualified plans), they pay no tax on their share of the corporations income. Despite that exemption, Rev. Rul. 2003-27 held that the SESOPs basis in its stock is (like that of any other shareholder) increased by undistributed income allocable to the stock and decreased by return-of-capital distributions (miscalled dividends for the balance of this discussion to avoid confusion with SESOP distributions to participants). Basis has no effect on the SESOP itself, but does affect the taxation of distributions. If a participant or beneficiary receives a lump-sum distribution of employer stock, he or she may elect, under Sec. 402(e)(4), to recognize ordinary income equal only to the plans basis in the distributed shares. Any value beyond that (i.e., NUA) is taxed when the stock is sold at long-term capital gain rates, regardless of the length of the holding period. SESOPs are not required to make distributions available in the form of stock, but the possibility of deferring tax on NUA is an incentive to give participants that option, despite potential complications in complying with the 75-shareholder limit for S corporations. By increasing basis and reducing NUA, Rev. Rul. 2003-27 makes stock distributions somewhat less attractive than they would be if the basis adjustment were not required. Although the IRSs position may seem theoretically oddthe standard rationale for adjusting basis is that the shareholder has paid tax on undistributed incomeit ensures consistency between SESOPs that do and do not pay dividends. Without the adjustments, avoiding dividends would be advantageous to participants, because the stocks basis would remain low, while the retained cash increased NUA. Dividends, by contrast, would both lower NUA and be taxed as ordinary income when ultimately distributed by the SESOP.
SESOP Rollovers Rev. Proc. 2003-2353 provided that a SESOP may make a direct rollover of stock to a participants IRA, as long as the IRA immediately sells the shares back to the corporation. This ruling resolves a technical conflict between Sec. 401(a)(30) (which requires qualified plans to allow participants to elect to have distributions rolled directly into IRAs) and the S corporation rules (which do not allow IRAs to hold S stock). Stock rollovers normally are not a problem, because most SESOPs use the special rule that lets them make distributions solely in cash.
Sec. 1042 Elections A taxpayer who elects to use Sec. 1042 to defer gain recognition on stock sold to an ESOP must file a notarized statement with the IRS describing the qualified replacement property that he or she purchases with the sales proceeds. Temp. Regs. Sec. 1.1042-1T requires that the statement be notarized within 30 days after the purchase, a deadline that has led to the issuance of numerous letter rulings granting relief to tardy taxpayers. Recognizing a problem, the IRS published a proposed amendment54 that extends the notarization deadline. Under the new rule (which taxpayers may rely on immediately for all open years), the statement covering qualified replacement property purchased up to the date on which the sellers return is filed for the year of the Sec. 1042 transaction must be notarized by the filing date (not the return due date). The statement covering any subsequent purchases must be notarized by the filing date of the following years return.
IRAs Excess Contributions The IRS published final regulations55 establishing a revised method of calculating income attributable to excess IRA contributions, as the only method beginning in 2004. This calculation needs to be made when excess contributions to a traditional IRA are returned under Sec. 408(d)(4) or contributions are recharacterized under Sec. 408A(d)(6). The regulations bring to an end a revision process that began with Notice 2000-39,56 which made the calculation of attributable income more realistic, by (1) basing it only on the period during which the IRA held the excess contribution and (2) allowing income to be negative as well as positive. Proposed regulations published in July 2002 made minor changes to the calculation method. Since the issuance of Notice 2000-39, IRA owners have been permitted, at their election, to follow either the notice or the prior regulations. The final regulations adopt the proposed regulations method without change. To calculate attributable income, the excess or recharacterized contribution is divided by the value of the IRA assets on the date made. The quotient is then multiplied by the difference between the closing balance (as of the date of distribution or recharacterization) and the opening balance. The opening balance is adjusted by adding any contributions or transfers received during the computation period; the closing balance by adding any distributions or outgoing transfers. There are special rules for dealing with assets whose value is not available on a daily basis. IRAs may choose among the methods set forth in the old regulations, Notice 2000-39 or the new regulations, until the end of 2003. For distributions or recharacterizations after 2003, the new regulations are the sole alternative. None of these rules apply to attributable income calculations for qualified plans (e.g., for refunds to correct ADP/ACP violations). In general, the plan administrator may employ any reasonable calculation method in those situations.
Beneficiary Designations Letter Ruling 20031704157 highlighted a beneficiary designation trap for unwary IRAs. An IRA owner named a trust for his three children as the beneficiary of the account. The trust terms required the trustee to divide the trust into three subtrusts, one for each child, on the IRA owners death. When the owner died before the Sec. 401(a)(9) required beginning date, the trustee duly created the subtrusts, and the IRA was split into three corresponding IRAs. Nothing was distributed from the undivided IRA to the undivided trust. One of the younger children asked the IRS to rule that distributions to the subtrust for his benefit could be made over his own life expectancy, rather than that of the oldest of his siblings. He argued that the decedent had, for practical purposes, set up three separate IRAs and that the measuring life for each account should be that of its own beneficiary. The IRS disagreed; the regulations state that, when a trust is an IRA beneficiary, the longest possible distribution period is the oldest beneficiarys life expectancy. Applying that rule literally, the IRS viewed the undivided trust as the beneficiary, regardless of the later division of the trust and the IRA. The moral is that, despite the eased distribution rules in the final Sec. 401(a)(9) regulations, estate planners must pay careful attention to details. In this case, the IRA owner should have named separate trusts as beneficiaries, to ensure the maximum distribution period for each child. |
