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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. Deborah Walker, CPA James Lutz, CPA For more information about this article, contact Ms. Walker at debwalker@deloitte.com or Mr. Lutz at jalutz@deloitte.com. Executive Summary
Part I of this two-part article, published in the November 2004 issue, focused on recent developments in executive compensation and welfare plans. Part II, below, highlights the significant retirement plan developments of the last 12 months. During that time, the IRS issued several regulations and numerous revenue rulings and procedures on qualified plans; the Department of Labor (DOL) also issued significant regulations and advisory opinions. Qualified Plans Audit Programs The Service started two separate audit programs targeting qualified retirement plans—the Focused Audit (FA) initiative and the Employee Plans Team Audit (EPTA) program. Under the FA initiative, it is targeting plan sponsors in certain geographical locations for specific issues endemic to certain types of plans in particular industries. Initially, the Service selected approximately 1,000 plans for examination. For issues with significant noncompliance, it will expand the scope to include more plans. The EPTA program targets large plans in conjunction with the Large and Mid-Sized Business Division function, rather than specific issues. A large plan is one with more than 2,500 participants. Although IRS research indicated that such plans hold assets of around $2 trillion, historically, the Service has not audited them. The Service recently announced that large plans are subject to selection under either the FA initiative or the EPTA program. Currently, the EPTA program has approximately 50 plan sponsors under examination. Cash-Balance Formulas In Cooper,27 the litigants challenged two successive incarnations of a defined-benefit plan—the first, a version of a pension-equity plan, and the second, a cash-balance formula. The court concluded that the plan violated both Sec. 411(b)(1)(G) and (H). Under Sec. 411(b)(1)(G), a defined-benefit plan is not qualified if it reduces a participant’s accrued benefit on account of any increase in his or her age or service. That did not occur under either of the plan’s formulas. The court, however, compared the benefit accruals of two participants of different ages, with the same compensation and service, and held that the formulas were illegal. The younger participant’s annual accrual translated into an annuity beginning at normal retirement age that was larger than the older participant’s. This application of the statute is controversial. The court also cited a violation of Sec. 411(b)(1)(H), which bars any benefit formula that reduces the rate of an employee’s benefit accrual because of the attainment of any age. Under both of the formulas at issue, the participant’s accrued benefit was a lump sum that increased yearly at a rate that did not diminish. Thus, on its face, neither formula presented an age discrimination issue. However, the court found a prohibited reduction, by interpreting “rate of benefit accrual” to mean the rate at which the participant’s accrued benefit, as defined in Sec. 411(a)(7), increases. As this section converts lump-sum benefits into annuity form, the effect was to make equal lump-sum accruals into unequal annuity accruals at different ages. On Sept. 29, 2004, IBM announced that it agreed in principle to a partial settlement, in which plaintiffs would receive an incremental pension benefit in exchange for the settlement of some claims. IBM will appeal to the Seventh Circuit the remaining two claims—that its cash-balance formula and transition arrangements were age discriminatory. Some in the benefits community have concluded that Cooper’s reasoning is unlikely to survive on appeal. If it does survive, it could have an adverse effect on all cash-balance plans, by requiring employers to provide significantly more generous interest credits for older workers than for younger ones. Master Trusts An Employee Retirement Income Security Act of 1974 (ERISA) Advisory Opinion28 serves as a reminder that a master trust and the plan trusts that use it as an investment vehicle are separate entities. Five defined-benefit plans within a controlled group pooled all of their investments into a master trust that held employer stock. No plan’s holding exceeded the 10% limit on employer stock imposed by ERISA. In the course of union negotiations, the employer agreed to spin off plan assets and liabilities to a multiemployer plan, whose trustee declined to accept the employer stock as an investment. The master trustee thus proposed to allocate the employer stock to the remaining four plans, leaving only liquid assets to be spun off. Unfortunately, after the spinoff, one plan’s holding exceeded the 10% limit on employer securities. The parties hoped to obviate this surface violation by arguing that compliance is tested only when new shares are acquired, which is true, and that the reallocation was not an “acquisition.” The DOL disagreed, viewing the transaction as an exchange between the departing plan and the other plans. Moreover, to the extent that the same fiduciary made the investment decision for plans on both sides of the exchange, it was, the DOL averred, representing adverse parties in violation of ERISA Section 406(b)(2). While that would probably not have mattered had the stock been publicly traded, it did when the shares’ value was not ascertainable by reference to sales between unrelated parties. PEO Plans Rev. Proc. 2002-2129 effectively required professional employer organizations (PEOs) that maintain defined-contribution plans for the benefit of their clients’ employees either to terminate the plans or convert them into multiple employer plans. The alternative is to face disqualification under Sec. 401(a)(2), which permits qualified plans to cover only employees of the employer maintaining the plan. The deadline for termination or conversion is the end of the plan year beginning in 2003. Rev. Proc. 2003-8630 presented transition rules for plans to comply with the earlier procedure. Terminated Sec. 401(k) plans can make distributions to participants, even if the client company establishes its own successor defined-contribution plan. In performing top-heavy and actual deferral percentage/actual contribution percentage (ADP/ACP) testing for plans converted into multiple employer plans, each participating employer’s portion of the plan may be treated as if it were new; thus, assets accumulated before the conversion are ignored in top-heavy calculations and the special first-year rule for nonhighly compensated employees’ (NHCEs’) ADP percentages may be used. Following a conversion, the required beginning date for minimum distributions to 5% owners who remain employed after age 7012 will be no earlier than April 1, 2005. On the other hand, compensation received before the conversion must be taken into account in determining HCE status. Disclosure of Benefit Relative Values For distributions beginning after Sept. 30, 2004 (see below for special transition rules), Regs. Sec. 1.417(a)(3)-131 requires all nongovernmental, nonchurch defined- benefit plans to provide a plethora of comparative data on the present values of different forms of benefits, as part of written explanations furnished to participants making benefit elections. At a minimum, the explanation must describe all of the forms of distribution generally available under the plan and present examples showing their relative value for representative participants. On a participant’s request, the plan administrator must disclose all of the options specifically available to him or her and compute their relative value based on the participant’s facts. A few simplifications are allowed, such as grouping benefit forms with nearly equal value. The actuarial assumptions used for comparative purposes do not need to be included in the explanation, but must be disclosed on request. Responding to complaints about the burdens imposed by this scheme, Ann. 2004-5832 limits the information that must be furnished to participants whose annuity starting dates fall between Oct. 1, 2004 (the original effective date) and Feb. 1, 2006. During that period, relative value disclosure is required only for lump-sum and period-certain install-ment options and if the optional form is less valuable than a qualified joint and survivor annuity (QJSA) (or a life annuity for an unmarried participant). That situation arises when the plan’s lump-sum benefit disregards early retirement subsidies, as permitted by the Sec. 411 regulations. In those cases, early retirement benefits may be substantially more valuable than the lump-sum cashout that many participants more or less automatically elect. The announcement does not change the July 1, 2004 effective date for disclosures about qualified pre-retirement survivor annuities. Sec. 403(b) Annuities in Bankruptcy Relying on the precise statutory language, a 2-1 majority of the Sixth Circuit’s bankruptcy appellate panel held in Rhiel33 that annuity contracts purchased under an ERISA-covered Sec. 403(b) plan are not exempt from the claims of the participant’s creditors in bankruptcy, reversing a district court decision. At issue was Bankruptcy Code Section 541(c)(2), which states, “[a] restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” In Shumate,34 the Supreme Court previously held that this provision makes ERISA’s anti-alienation rule enforceable in bankruptcy. The majority in Rhiel held that Shumate was inapplicable, because plan assets were held in an insurance company annuity contract, rather than a trust. If other courts follow the Sixth Circuit, qualified plans will be notably safer retirement vehicles for Sec. 501(c)(3) organizations and public schools, which have a choice between the two plan types. Plan Loans to Active-Duty Military Personnel The Servicemembers’ Civil Relief Act,35 signed into law in December 2003, clarified and updated the longstanding, but widely ignored, ban on charging active-duty military personnel interest higher than 6% on loans taken out before entering service. This restriction applies to plan loans to participants. The participant must, however, request the interest abatement. Plans are under no obligation to apply it automatically; many participant borrowers, who usually pay interest only to themselves, may not wish to take advantage of it. Expense Allocations to Former Employees’ Accounts Rev. Rul. 2004-1036 held that it is proper for a defined-contribution plan to allocate reasonable administrative expenses to the accounts of separated participants, even if the employer pays expenses attributable to active employees. The DOL took the same position,37 but did not explicitly consider whether that fee structure might violate ERISA Sections 203(e) and 411(a)(11), by punishing participants who refrain from electing immediate distributions.38 There are two cautionary notes. First, a plan cannot make terminated participants’ accounts pay both their own administrative costs and a share of the costs attributable to actives’ accounts. Second, “nondiscrimination” standards apply to the method of allocating administrative expenses. The ruling’s example of “discrimination” in this area is a decision to spread the cost of qualified domestic relations order (QDRO) determinations over all accounts, instead of allocating them to the account to which the QDRO relates, immediately before an HCE’s divorce. SESOP Listed Transactions Rev. Rul. 2004-439 addressed techniques that try to circumvent Sec. 409(p) and keep the value of an S corporation owned by an employee stock ownership plan (ESOP) in the hands of a limited number of persons, without suffering a “nonallocation year.” The concept in each scenario is a corporate structure that sidesteps the definition of “disqualified person,” by holding the favored individuals’ deemed-owned shares and synthetic equity below the 10% threshold. The IRS’s response is to use its authority, granted by Sec. 409(p)(7)(B), to expand the scope of the section “in any case in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of this subsection.” The new ruling deals with three variations on a common theme: an S corporation creates wholly owned qualified S or limited liability company subsidiaries, each of which operates an active business (e.g., a medical practice). The principal of each business has no current ownership interest in the subsidiary for which he or she works, but is granted an option to purchase the majority of its equity. The parent establishes an S corporation ESOP (SESOP), which owns 100% of its stock and does not cover the subsidiaries’ principals; all of the rank-and-file work for the parent or the subsidiary and participate in the SESOP. The subsidiaries pay out only a portion of their profits as compensation. The remainder is reinvested at the subsidiary level but flows up to the parent, and then to the SESOP, as taxable income; of course, no tax is paid, because the SESOP is a tax-exempt entity. According to the Service, these structures can avoid triggering Sec. 409(p), while gaining most of the benefits of the devices that the statute is trying to ban (i.e., tax-free accumulation of income until the principal decides to take possession by exercising his or her option). The ruling invokes Sec. 409(p)(7)(B), declaring in each case that the SESOP has a nonallocation year, which results in the imposition of excise taxes. Effective with the issuance of the ruling, these and substantially similar transactions are listed tax shelters. The diagnostic elements of the listed transactions are (1) an ESOP owns at least 50% of the shares of an S corporation; (2) the profits generated by the business activities of specific individuals accumulate in subsidiaries for their benefit; (3) those profits are not paid out as compensation within 212 months after the end of the year in which earned; and (4) the individuals hold options to acquire 50% or more of the equity of the subsidiaries in which the earnings attributable to their services accumulate. ERISA Applied to Self-Employed Participants Lower courts have reached conflicting conclusions about the extent to which ERISA governs the rights of self-employed individuals who participate in a pension plan along with common-law employees. The Supreme Court, in Yates,40 resolved that question, by holding that the inclusion of employees in a plan extends ERISA coverage to those to whom ERISA would otherwise not apply. At issue was the anti-alienation rule, but the same principle would apply to the statute’s other benefits and burdens. Yates arose from the personal bankruptcy of a plan sponsor’s sole shareholder. Shortly before bankruptcy, he repaid a delinquent loan to the plan. The bankruptcy trustee challenged the repayment as a preferential transfer (as it undisputedly was) and sought recovery from the plan. The participant argued that his account balance was protected by ERISA’s ban on assignment or alienation. The district court and the Sixth Circuit disagreed, declaring that, as the sole owner of the plan sponsor, he was treated as a nonemployee under DOL regulations; further, plan accounts held for the benefit of nonemployees are not immune to creditors’ claims. The Supreme Court reversed. Thus, plans with a mixed bag of employees and self-employed individuals should treat them all as ERISA-covered employees. Those covering only the self-employed (or the sole owner of a business and his or her spouse) will, however, remain outside the statute’s ambit. Sec. 412(i) Plans Defined-benefit plans funded with individual, level-premium life insurance or annuity contracts (governed by Sec. 412(i)) have been heavily promoted in recent years as a way to obtain (1) higher deductions than would be possible under conventional plans and (2) tax-free or -deferred distributions. The traditional Sec. 412(i) selling point is the use of very conservative actuarial assumptions, which result in accelerated funding, but do not produce larger benefits than other defined-benefit plans. The new planning techniques add other elements, such as the purchase of life insurance with cash and reserve values artificially depressed until late in the policy’s life. The policy is structured so that it is not a “springing value” policy as described in Notice 89-25,41 Q&A-10. When the ostensible value is low, the participant receives it in a distribution or buys it from the plan. After the value increases, he or she withdraws cash in the form of policy loans. To counter these perceived abusive structures, the IRS issued Rev. Proc. 2004-1642 (specifying conditions under which a policy’s cash value may be used as its fair market value), Rev. Rul. 2004-2043 (denying deductions for excessive contributions to Sec. 412(i) plans) and Rev. Rul. 2004-2144 (requiring Sec. 412(i) plans to give NHCEs access to the same types of life insurance policies as HCEs). One form of transaction, in which the employer pays premiums on life insurance policies with cash values exceeding their death benefits, was added to the tax shelter list. (The concept is that the excess cash value will revert to the plan and be used to offset future premiums. In effect, the employer deducts contributions before the liability that they fund comes into existence.) The rulings rely to a large extent on previous authorities and essentially hold that (1) contributions to a Sec. 412(i) plan, like those to any other defined-benefit plan, may not exceed the amount reasonably necessary to provide participants’ anticipated benefits; (2) contributions that do not benefit any participant, but simply establish a fund for meeting future plan costs, are not currently deductible; and (3) HCEs cannot be offered investment options (in this case, special classes of life insurance) not available to the rank-and-file. Rollovers of Lost Participants Sec. 401(a)(31)(B) requires plan administrators to set up IRAs to receive mandatory distributions of $1,000 or more for recipients who cannot be located. However, this mandate is not effective until the DOL issues final regulations giving employers and administrators a “safe harbor” against claims of fiduciary breach that might arise from their choice of account custodians or investments. The final regulations, published on Sept. 28, 2004,45 specify five conditions for a safe-harbor IRA. If they are met, the fiduciary responsible for establishing the IRA is automatically deemed to have satisfied its duties under ERISA Section 404(a). The conditions are: 1. The distribution to the IRA does not exceed the de minimis cashout limit (currently, $5,000), plus the amount held in the participant’s rollover accounts under the plan (which do not count toward the limit). The safe harbor also applies to distributions of less than $1,000, even though Sec. 401(a)(31)(B) does not apply to these accounts. 2. The distribution must be made to an IRA account or an annuity. This means the IRA trustee must be a bank, credit union or other entity approved by the IRS. 3. The fiduciary must enter into a written agreement with the IRA provider receiving the rollover. Among other things, it must provide the funds will be “invested in an investment product designed to preserve principal and provide a reasonable rate of return, whether or not such return is guaranteed, consistent with liquidity.” The agreement must also provide fees and expenses associated with the IRA. 4. The automatic rollover rules must be described in the plan’s summary plan description or summary of material modifications. 5. The selection of the custodian and the choice of investment funds must not result in prohibited transactions. Banks and other regulated financial institutions may select themselves as the IRA trustee and invest the rollover funds in their own investment products, if the requirements of the class exemption46 issued in conjunction with the final regulations are met. The regulations will become effective March 28, 2005. Sec. 401(k) Plans of Exempt Employers’ Affiliates After the Tax Reform Act of 1986 made exempt organizations ineligible to maintain Sec. 401(k) plans, the IRS issued Regs. Sec. 1.410-6(g), allowing Sec. 401(k) plans of their for-profit affiliates to disregard statutorily ineligible employees in their minimum coverage testing, provided the plan covered at least 95% of the employees of the for-profit members of the controlled group. The Small Business Job Protection Act of 1996 made the regulatory relief obsolete, except that many universities and hospitals were quite content with their Sec. 403(b) plans. Hence, the latter continued to experience “nondiscrimination” problems, to which Congress responded in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), by directing the IRS to reinstate the former exemption. A proposed regulation,47 published on March 16, 2004, carried out this mandate. Under the proposal, a Sec. 401(k) plan sponsor (which may be for-profit or exempt) may treat as excludible for minimum coverage purposes all employees of its controlled group members that have not adopted the plan, provided that the excluded employees are eligible to make salary reduction contributions under a Sec. 403(b) plan. (The proviso does not apply if they work for a governmental unit.) If a plan makes use of this rule, it must cover at least 95% of the employees who do not work for the excluded organizations. When adopted, the regulations will be effective retroactive to 1997. Taxpayers may rely on the proposed regulations pending adoption in final form. S Corporation Tax Shelters Notice 2004-3048 targets transfers of nonvoting S stock to exempt entities without a corresponding transfer of a real economic interest. The concept is similar to the SESOP schemes. An S corporation issues nonvoting stock and warrants to acquire nonvoting stock to its shareholders, who then donate the stock to a Sec. 501(c)(3) organization or qualified plan and retain the warrants. The ideal donee is a plan maintained by a state or local government, which will not have to treat its share of S income as unrelated business taxable income. The nonvoting shares nominally represent most of the corporation’s value, but the warrants are for a vastly greater number of shares and can be exercised at any time, to completely dilute the exempt shareholder’s interest. The voting shareholders let income accumulate in the corporation, paying tax only on their minuscule share, then exercise the warrants when they wish to cash out. Notice 2004-30 requires that these arrangements be registered, listed and disclosed as tax shelters. Temporary Pension Funding Fix The Pension Funding Equity Act of 2004,49 signed by President Bush on April 10, 2004, was enacted just before the April 15 quarterly contribution due date. For most companies, the only important component is the simplest one: for plan years beginning in 2004 and 2005, the interest rate for calculating current liability, the starting point for determining Pension Benefit Guaranty Corporation (PBGC) variable-rate premiums and whether a plan requires deficit-reduction contributions, will be based on a composite index of the yields on long-term, high-quality corporate bonds, rather than on 30-year Treasury bonds. The IRS published the details of the new index almost immediately, in Notice 2004-34.50 The index currently produces rates roughly 100 basis points above those that would have applied had Congress done nothing. The new rates do not apply in two important areas—lump-sum distributions and deductions. The 30-year Treasury rate will remain the standard for converting accrued benefits into lump sums and may, at the plan sponsor’s option, be used to calculate current liability under Sec. 404(a)(1)(D). Of importance to a minority of employers is the special relief provided to the airline and steel industries. Their deficit-reduction contributions will be reduced by 80% in 2004 and 2005, although the deficiencies will have to be made up in later years. The procedure for obtaining this benefit was set forth in Ann. 2004-38.51 Ann. 2004-4352 contained guidance on the notices that must be given to plan participants and the PBGC. Multi-employer plans also get limited relief (postponed amortization of experience losses if they suffered at least a 10% decline in asset value in 2002) but, as an apparent quid pro quo, must give participants and the PBGC annual notices of their funded status, starting in 2005. Finally, as a revenue-raising measure, the sunset of Sec. 420, which allows limited use of surplus pension plan assets to fund retiree health benefits, has been pushed back from the end of 2005 to 2013. Spinoffs to Foreign Plan The IRS held53 that a spinoff of assets to a foreign plan would not violate any qualification rules and would not result in taxable distributions to the participants. In the ruling, a U.S. company with some operations in country C did not exclude nonresident aliens (NRAs) from its qualified defined-benefit plan. A small number of employees working in C, who were not U.S. citizens and had no U.S.-source income, became participants and accrued benefits under the plan. At some point, the employer discovered that participating in a U.S. plan would have unfavorable tax consequences in C and decided to transfer the C group to C’s equivalent of a qualified plan. It sought to spin off the C participants’ share of plan assets and liabilities into the C plan. A plan qualified in C would not, however, meet U.S. qualification standards, and most practitioners would hesitate to recommend a spinoff from a qualified to a nonqualified plan. The structure of the transaction was convoluted. The employer would set up two new plans—a C-qualified plan, under which C participants began accruing benefits, and a plan whose trustee resided in C but otherwise was qualified under Sec. 401(a). The spinoff would be to the latter plan, with the intention of later merging it into the C-qualified plan. This roundabout course apparently would be adopted to make it easier for the IRS to rule favorably. The transfer of assets and liabilities was from a qualified plan to one that failed qualification because it lacked a domestic trust and, thus, would be entitled to treatment as a qualified plan for distribution and deduction purposes (under Secs. 402(d) and 404(a)(4)). Under the facts, the subsequent conversion of the recipient into a plan that presumably failed to satisfy many U.S. requirements was not abusive. The ruling spells out the fact that plan assets will remain dedicated to the exclusive benefit of participants and that no actual distributions will occur. It may prove useful to companies that have pockets of NRAs in their plan populations and wish to separate them in an expedient way. Adding Conditions to Past Accrued Benefits In Central Laborers’ Pension Fund,54 the Supreme Court held that amending a multiemployer pension plan to add new circumstances under which reemployment would result in suspension of benefits, violated the anti-cutback rule. A concurring opinion joined by four Justices agreed, with the qualification that the holding was subject to reversal by regulation. The case involved the plan’s unreduced early retirement benefit, which, under the plan terms, was suspended for pensioners who returned to “disqualifying employment.” At the time the plaintiff retired and began receiving his pension, the definition of disqualifying employment did not include work as a supervisor. Two years later, an amendment expanded the definition, and the plaintiff’s pension was stopped, because he had taken a supervisory job in the construction industry. He brought suit for restoration of his benefits, lost in the district court, and then won in the Seventh Circuit in a case that directly conflicted with a Fifth Circuit decision.55 Affirming the appellate decision, the Court held that adding a new condition to the right to receive benefits is unfavorable to participants and, thus, is a reduction in their early retirement benefits protected by ERISA and the Code. The Court found support for its position in IRS regulations and was not swayed by the government’s amicus brief that noted the Internal Revenue Manual, and consistent IRS practice, approved amendments expanding suspension conditions. Although this case involved multiemployer plans, the decision may affect single-employer plans in certain circumstances. For example, if a plan sponsor wants to add a suspension-of-benefits rule to a plan that currently does not have one, the new rule would apply only to benefits not yet accrued. Thus, it would apply only to active participants’ future benefit accruals, not to participants already in pay status. RMDs In June 2004, the IRS filled the last gap in the Sec. 401(a)(9) regulations by finalizing the portion on defined-benefit plans (published in proposed and temporary form in 2002) and slightly modifying the previously adopted rules for defined- contribution plans.56 For most defined-benefit plans, required minimum distributions (RMDs) are a nonissue. Although the regulations deal primarily with atypical situations, there are several important points: 1. If the participant elects a QJSA with a beneficiary other than his or her spouse, the regulations limit the survivor percentage, to ensure that most of the benefit’s actuarial value is payable during the participant’s lifetime. A joint-and-50%-survivor annuity is always permissible. A table in the regulations sets forth the maximum survivor percentages, based on the difference between the participant’s and beneficiary’s ages. For instance, a joint-and-100%-survivor annuity is allowed only if the beneficiary is no more than 10 years younger. 2. The proposed regulations treated installment distributions for a term certain (i.e., with no life contingency) just like defined-contribution plans. The final regulations drop that provision. Installments must be in level amounts over the participant’s (or participant’s and beneficiary’s) life expectancy(ies). There is, however, wide latitude to change the distribution period or benefit form. 3. As a general rule, the regulations permit only nonincreasing annuities, but exceptions are allowed for cost-of-living increases, for annuities purchased from insurance companies and for some variable annuities paid from trust assets. Cost-of-living adjustments must be based on a recognized index and may not exceed the cumulative index increase since the annuity starting date. Governmental plans, however, are allowed to adjust annuity payments to track pay increases for the pensioner’s former position (a common feature in plans for judges and some other public officeholders). Private plans may do the same if the plan provision was in effect on April 17, 2002. 4. Once a distribution has begun, the regulations allow changes in form in some circumstances. Payments under an annuity purchased from an insurance company may be accelerated, with few restrictions (other than those imposed by the contract). This option is not available when benefits are paid from the plan’s trust, but the plan may, if desired, permit pensioners to make certain changes: (1) if payments began before retirement, the form may be changed on retirement; (2) new forms may be elected on plan termination (e.g., participants in pay status may be allowed to elect lump-sum distributions); (3) on marriage, a pensioner may be allowed to elect a QJSA; and (4) on a participant’s death, his or her beneficiary may be allowed to elect a lump-sum distribution. The regulations were effective Jan. 1, 2003, but plans may continue to rely on any prior proposed version or on a reasonable, good faith interpretation of the statutory language, through the end of 2005. Contributions to Defined-Benefit Plans for NRAs Rev. Proc. 2004-3757 addressed how to determine the taxable portion of a defined-benefit plan distribution to an NRA who worked outside the U.S. and who was not covered by a tax treaty. In general, the distribution is subject to a 30% withholding tax, except to the extent that it represents compensation (i.e., employer contributions) for services performed abroad. In a defined-contribution plan, the amount of employer contributions should be a matter of record, but there is no clear relationship between defined-benefit plan contributions and any particular participant. The procedure described a method for deriving contributions from benefits, similar to that formerly used by Sec. 403(b) plans in the exclusion allowance calculations. The benefit’s present value is multiplied by a factor (given in a table), and the result is the annual level contribution needed to accumulate that value over the individual’s period of plan participation. For example, if an individual participated for 15 years and now has a benefit worth $250,000, the factor is 0.0398. The inferred employer contribution to fund the benefit was $9,950 per year. Multiplying by 15 yields a total contribution of $149,250, which will be exempt from withholding tax. If services were performed both within and without the U.S., the contribution would be prorated based on the relative number of months in each jurisdiction. Contributions to Leveraged ESOPs IRS Letter Ruling 20043601558 departed from longstanding assumptions about the relationship between the general defined-contribution plan deduction limits and the special rules for ESOPs in Sec. 404(a)(9). Under that section, notwithstanding the normal limits, contributions to pay interest on an ESOP loan are fully deductible, while contributions to repay principal are deductible up to 25% of participants’ compensation. When Sec. 404(a)(9) was enacted, the Sec. 404(a)(3) limit was 15% of compensation. Most practitioners assumed that the more liberal ESOP limit was integrated with the normal defined-contribution limit, so that total contributions could not exceed 25% of aggregate pay, and the non-ESOP portion could not exceed 15%. On that reading, the EGTRRA’s expansion of the general deduction limits rendered obsolete the part of Sec. 404(a)(9) on contributions to repay principal. The ruling interpreted Sec. 404(a)(9) more literally—as exempting leveraged ESOPs from Sec. 404(a)(3) (and by implication, Sec. 404(a)(7), which was not directly addressed) and establishing an independent ESOP limit. Thus, an employer could, in principle, contribute up to 25% of participants’ compensation to defined-contribution plans other than leveraged ESOPs, then add ESOP contributions on top of that. Also, both Sec. 401(k) elective deferrals and contributions to pay ESOP loan interest are subject to no limit. However, one must continue to apply the Sec. 415(c) rules, which may limit annual additions. A provision in the American Jobs Creation Act of 2004 (Act)59 also allows for quicker repayment of SESOP loans. It allows a SESOP to use distributions on the S stock held by it to repay a loan used to purchase the S stock. This provision places S corporations on equal footing with C corporations, which can use dividends to repay ESOP loans. It is effective for distributions made after 1997. Deemed IRAs Deemed IRAs—employee-funded accounts that follow IRA rules, but are held inside a qualified plan—were created by the EGTRRA and became effective in 2003. Final and temporary regulations60 were published in July 2004 and clarify that deemed IRAs are separate from the host plans and are exempt from requirements that apply to qualified plans. Although deemed IRAs have met with little fanfare to date, one reason why a company may consider them is to make available plan investment options (such as closely held employer stock) that are not normally available. Some executives of small companies may find it convenient to aggregate all of their retirement accounts with a single trustee. The regulations do not require a separate trust for each IRA, so some economies of scale may be possible. Amortization of Unfunded Liabilities Rev. Proc. 2004-4461 describes how to request an extension of the amortization period for unfunded defined-benefit plan liabilities. An extension of up to 10 years is authorized by ERISA and the Code. In general, Sec. 412 requires plans to amortize unfunded past service liabilities or net experience losses over a specified period. However, under Sec. 412(e), Treasury can extend this amortization period by as many as 10 years, if it is in the plan’s best interests. The procedure is effective for all requests received after Aug. 2, 2004. |
