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Current Developments (Part I) This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I focuses on general developments in retirement plan qualification requirements and employee stock ownership plans. Peter
I. Elinsky, Esq. Terrance
F. Richardson, Esq. Betsy
K. Rogers, CPA
Authors' note: The authors wish to acknowledge the significant contributions of Gary Cvach, Karen Field, Robert Masnik, Donna M. Prestia, Pamela Hobbs, Terri Stecher and Danielle M. Espinet, of KPMG LLP's Washington National Tax Compensation and Benefits Practice, in compiling information for this article.
Executive Summary
This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, below, focuses on general developments in retirement plan qualification requirements and employee stock ownership plans (ESOPs). Sec. 401(k) Plans Safe Harbors In Notice 2000-3,1 the IRS issued additional guidance on safe harbors for Sec. 401(k) and related plans. The Small Business Job Protection Act of 1996 (SBJPA), Section 1433, permitted Sec. 401(k) and (m) plans to meet the average deferral percentage (ADP) and average contribution percentage (ACP) nondiscrimination tests by making special contributions to plan participants. To satisfy the safe-harbor rules, a plan must provide either a fully vested: 1. Matching contribution (i.e., a 100% match on the first 3% of compensation and a 50% match on the next 2% of compensation to all contributing employees). 2. Nonelective contribution (i.e., 3% of compensation) to all eligible employees. Under the Code and Notice 98-52,2 an employer is required to notify employees of its intent to use the safe-harbor rules, generally before the beginning of the plan year. The safe harbors are effective for plan years beginning after 1998. Notice 2000-3 provides several rules giving employers greater flexibility in deciding whether to use the safe harbors in a given year. In each case, the plan may need to be amended to reflect the employer's intent. In Q&A-1, Notice 2000-3 provides that an employer can choose, up to 30 days before the end of the plan year, whether to use the safe-harbor rules for the year. Thus, if an employer realizes that the plan is likely to fail the ADP test for the year, it can decide to make a safe-harbor nonelective contribution for the year instead of running the ADP and ACP tests. The plan must be amended to provide this option; the employer must send a notice to employees at least 30 days before the end of the plan year. The employer can make the amendment flexible; the decision to use the safe harbors can be made annually. In Q&A-6, the notice provides that an employer can decide during the plan year that it is not going to use safe-harbor matching contributions and, instead, will meet the ADP and ACP tests. The plan must be amended to provide for the prospective reduction or elimination of matching contributions; a supplemental notice must be given to all eligible employees explaining that the matching contribution is being eliminated as of a specified date. The notice must be given no later than the later of 30 days before (1) the change is made or (2) the plan amendment is adopted; employees must have the right to make changes in their elective contributions. If the plan does not state that it will satisfy the ADP test, it will have to be amended to so provide. Matching contributions earned or contributed before the change date cannot be changed. Q&A-11 generally permits an employer to amend a profit-sharing or other eligible plan to add a Sec. 401(k) feature (for the first time) during the plan year and meet the safe-harbor rules for that plan. (Such a plan cannot be a successor to another Sec. 401(k) plan.) An amendment to add a cash or deferred arrangement feature must be effective at least three months before the end of the plan year. The Sec. 401(k) plan must also meet the safe-harbor rules. Q&A-11 provides an equivalent rule for matching contributions added in the same year as the new Sec. 401(k) plan. Q&A-2 provides that a plan specifically written to provide matching contributions separately for each payroll period (or all payroll periods within a month or quarter) can use such contributions as safe-harbor matching contributions. These matching contributions must be paid into the plan by the end of the following quarter. This rule applies for plan year quarters beginning after May 1, 2000. This timing rule may not be a problem for most such plans, because they tend to contribute matching contributions at the same time as elective deferrals. Under the safe-harbor rules, a plan cannot limit elective contributions in a way that interferes with an employee's right to receive a matching contribution. The notice clarifies in Q&A-3 that a plan can place administrative rules on elective deferrals (such as requiring that employees make elections based on a whole percentage of pay or based on whole-dollar amounts). However, this rule does not override other plan provisions. If the plan provides for a 12-month suspension of elective or after-tax contributions after an employee takes a hardship distribution or an after-tax employee contribution withdrawal, Q&A-4 provides that the plan can still meet the safe-harbor rules, even though certain employees do not have the right to matching contributions. Q&A-5 clarifies that a plan is still a safe-harbor plan if it matches both employee and after-tax contributions up to a stated limit. Q&A-10 provides that an employer can choose not to make safe-harbor contributions for employees that are excludible (but not excluded) from the plan because of the age and service rules. Because Sec. 410(b) permits a plan to separately test employees who could be excluded under those rules, the plan must actually state that the ADP and ACP tests will be met as to this group. Normally, this will not be difficult, because most age 21 and less-than-one-year employees are not highly compensated employees (HCEs). Notice 2000-3 provides additional guidance, in Q&As-7 and -8, on the method of providing safe-harbor notices. Safe-harbor notices can be given electronically, if it is likely that all employees can access the notice and obtain a free hard copy. The safe-harbor notice can cross-reference other documents provided by the employer, such as the summary plan description (SPD), if the notice actually provides all the following information: 1. The matching contribution or nonelective contribution formula. 2. The fact that matching or nonelective contributions are fully vested. 3. The method for making elective contributions and any periods available for such elections. 4. The location at which an employee can obtain further information (including phone numbers and e-mail addresses, if applicable).
Same-Desk Rule Representing a major policy shift, Rev. Rul. 2000-273 will substantially simplify Sec. 401(k) plan administration after a sale of corporate assets. A Sec. 401(k) plan has somewhat restrictive distribution rules. Generally, distributions can be made on death, retirement, age 591/2, disability or separation from service with the company that maintains the plan. Sec. 401(k)(10) provides that a plan can make distributions to employees affected by a sale of a corporation's subsidiary or a sale of "substantially all the assets of a trade or business" (i.e., at least 85%). When a company has sold less than substantially all of such assets, the IRS has historically taken the position that employees who left the seller's employ and began working for the buyer in the same capacity could not take Sec. 401(k) distributions. These employees were viewed as working at the "same desk" and doing the same work as before the sale; thus, they were not treated as having separated from service (the same-desk rule). Although this rule has protected employees from spending their Sec. 401(k) savings, it has been an administrative nightmare for plan administrators. Generally, plan administrators have access to employee information (such as whether the employee is still employed with the company), because the employee works for the company maintaining the plan. After a sale of less than 85% of the assets, plan administrators had to deal with former employees who were not considered terminated. Employers and plan recordkeepers have sought relief from the same-desk rule. Rev. Rul. 2000-27 apparently abandons the same-desk rule in these circumstances. Under the ruling, after a sale of less than 85% of the assets of a trade or business, employees will be considered separated from service if they immediately begin working for the buyer, at the same job as they had for the seller (assuming that the buyer is not a related organization), even if the buyer is contractually bound to hire the employees as part of the sale. Thus, the plan administrator must offer plan distributions to these employees. Employees will generally be able to roll over their account balances into (1) the buyer's plan (assuming it permits such rollovers) or (2) IRAs. (A seller cannot force distributions to a former employee, unless the latter's account balance is less than $5,000.) For corporate sales occurring before Sept. 1, 2000, the plan administrator did not have to offer distributions to employees if less than 85% of the trade's or business's assets were sold. After the issuance of Rev. Rul. 2000-27, the IRS issued Letter Ruling 2000300314 (revoking Letter Ruling 200009047,5 which held that a distribution from a 401(k) plan because of a merger was not on account of separation from service).
Revised Form 5500 The IRS, Department of Labor (DOL) and Pension Benefit Guarantee Corp. (PBGC) (collectively, the agencies) finalized the revised Form 5500 series for 1999 (except Form 5500-EZ, Annual Return/Report for One-Participant (Owners and Their Spouses) Retirement Plan).6 The new forms apply to plan years beginning after 1998. Plan sponsors file Form 5500 to meet the agencies' annual reporting requirements for employee pension, welfare and fringe benefit plans under the Employee Retirement Income Security Act of 1974 (ERISA) and the Code. The revisions were adopted concurrent with the implementation of the new computerized ERISA filing acceptance system (EFAST). The EFAST system was designed to simplify and expedite the receipt and processing of the Form 5500 series, by relying on computer-scannable forms and electronic filing technologies. As a result, 1999 Form 5500 is available in two computer-scannable formats—"machine print" and "hand print." Both formats have the same data elements, but provide filers with a choice of formats for preparing Form 5500. Under the machine-print format, a filer uses a computer and software to enter data and complete the form. On completion of the data entries, the completed forms (and any required attachments) may be filed electronically (provided the EFAST electronic specifications are met and a copy with all required signatures is retained as part of the plan's records). Or, the filer may print a paper copy; after the required signatures have been affixed, the return is mailed to the address specified in Form 5500. The completed machine-print Form 5500 return can be read by participants and beneficiaries; the EFAST system will collect the data by scanning bar codes printed at the bottom of each page. Under the hand-print format, the filer enters data by hand or typewriter on specially designed green drop-out ink forms; the EFAST system uses optical character recognition technology to scan the hand or typewritten data entries. This format can be filed only by mail. The agencies granted a 21/2-month filing extension for all 1999 Form 5500 reports due before Aug. 1, 2000, to provide time to make a smooth transition to new scannable forms and the EFAST system. Generally, filers seeking an extension past the normal July 31 Form 5500 filing deadline would have to file Form 5558, Application for Extension of Time to File Certain Employee Plan Returns. The requirement to file Form 5558 was waived for 1999 returns due before Aug. 1, 2000; an automatic extension to Oct. 16, 2000, was granted. The automatic extension could not be further extended by subsequently filing Form 5558. Filers with a deadline after July 31, 2000, that are otherwise eligible to file for an extension using Form 5558, still must timely file Form 5558 to obtain a 21/2-month extension. Qualified Plan Transactions The IRS issued guidance on qualified plans' acceptance of invalid rollover contributions, the treatment of certain hardship distributions, involuntary cashouts and changes in defined benefit plan funding methods.
Invalid Rollover Contributions Final regulations under Sec. 401(a)(31) grant relief to plans that accidentally accept an invalid rollover contribution, if two conditions are met.7 First, the receiving plan administrator must reasonably determine, when accepting the contribution, whether it is a valid rollover contribution. The distributing plan need not have received a determination letter for the receiving plan administrator to make such a determination. Second, if the plan administrator later concludes that the contribution was invalid, the plan must distribute the contribution and earnings thereon to the employee within a reasonable time. If these two conditions are met, the invalid rollover is treated as a valid rollover for purposes of applying the Sec. 401(a) or 403(a) qualification requirements.
Hardship Distributions The IRS released additional guidance on the treatment of certain hardship distributions, in Notice 2000-32.8 Before the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98), a plan participant could request a hardship distribution from a Sec. 401(k) plan and specify that it be rolled directly into an IRA. This position seemed contrary to the goal of the hardship distribution rules. Generally, a plan participant cannot ask for a hardship distribution unless most other sources of income and loans have been used and there is still a significant financial hardship. Asking for a rollover into an IRA suggests that other funds are available, or that the need is not that great. Generally, amounts distributed for hardship are taxable and may be subject to a 10% excise tax. However, if an individual can roll over the amount into an IRA, it is not taxed until he takes an IRA distribution. Under the IRSRRA '98, Congress provided that a hardship distribution of elective contributions (i.e., salary reduction contributions) from a Sec. 401(k) or a 403(b) plan would not be eligible for rollover into an IRA or another employer retirement plan. (Certain contributions treated as elective contributions—i.e., qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs)—are subject to the same rule.) Soon after the law change, the IRS issued transitional guidance in Notice 99-59 on application of the new rule. While the original IRS guidance answered many basic questions, a few additional issues arose as employees asked for hardship distributions. The IRS addressed unanswered or difficult issues in Notice 2000-32, which gives additional flexibility to plan administrators. Under Notice 99-5, a plan administrator was supposed to apply the new law only to QNECs and QMACs contributed after a 1989 transition date. Because many plan systems do not separately track amounts contributed before that date, Notice 2000-32 provides that the new law can be applied to all elective contributions (i.e., QNECs and QMACs), if necessary. Many Sec. 401(k) plans permit in-service distributions on hardship and attainment of age 591/2; others are more restrictive and permit in-service distributions only for hardship. Plan administrators from some of the more restrictive plans were concerned about language in Notice 99-5. If an employee asked for a hardship distribution and was over age 591/2, it suggested that if a hardship distribution was otherwise eligible for a rollover under the Code, it would not be subject to the no-rollover rule. Notice 2000-32 provides that a plan can choose between treating all hardship distributions the same, whether or not the employee is over age 591/2, or imposing the no-rollover rule only on employees who are under age 591/2. Some plans permit distributions that will be paid from the employee's profit-sharing account, after-tax contribution account and pre-tax account. Notice 2000-32 provides that any reasonable method can be used to allocate after-tax contributions among the various types of distributions, including allocating the full after-tax contribution to the portion of a distribution not eligible for rollover.
Involuntary Cashouts The IRS released final regulations10 and Rev. Rul. 2000-3611 on involuntary cashouts for qualified plans. The final regulations under Secs. 411(a)(7), (11) and 417(e)(1) increase the involuntary cashout limit to $5,000 and eliminate the "look-back rule." Rev. Rul. 2000-36 provides that an employer can use a direct rollover to an IRA as the default form of payment for an involuntary cashout. The final regulations under Secs. 411(a)(7), (11) and 417(e)(1), like the proposed regulations, increase the amount that can be involuntarily cashed out of a qualified plan from $3,500 to $5,000. An important change is the elimination of the lookback rule, which provided that the present value of a vested accrued benefit was treated as exceeding the cashout limit if such limit had ever been exceeded before the distribution. Thus, a participant with a vested accrued benefit of $5,000 or less can now be cashed out, even though the benefit had previously been greater than $5,000. The elimination of this rule provides for easier administration. Further, Rev. Rul. 2000-36 provides that an employer can amend a plan to provide that the default form of payment for involuntary cashouts is a direct rollover to an IRA. An employer can use the default rollover if an employee does not request either a cash payment or a direct rollover to another qualified plan or designated IRA. The amendment must provide that the plan administrator selects an IRA trustee, custodian or issuer unrelated to the employer; it must also provide that the plan administrator will establish the IRA and make the initial investment selections.
Defined Benefit Plan Funding Method Procedure The IRS released Rev. Proc. 99-45,12 which provides, in certain circumstances, automatic approval to change the funding method used for a defined benefit plan. Sec. 412(c)(5) and ERISA Section 302(c)(5) both provide that a change in a pension plan's funding method is effective only if the change is approved by Treasury. Rev. Proc. 95-5113 explained how to obtain automatic approval (subject to certain restrictions) for changes to any acceptable funding method. According to Regs. Sec. 1.412(c)(1)-1, "funding method" as used in Sec. 412 has the same meaning as "actuarial cost method" used in ERISA Section 3(31). A plan's funding method includes not only the overall funding method, but also each specific method of computation used in applying the overall method. A change in the actuarial valuation method used to value the plan's assets is a change in funding method under Sec. 412. In the past, if a company merged plans with different funding methods (including different asset valuation methods), it was required to request IRS approval before the merger to change method. Rev. Proc. 99-45 modifies Rev. Proc. 95-51 to provide automatic approval for a change in funding method following de minimis mergers (as described in Regs. Sec. 1.414(l)-1(h)) and other mergers if certain requirements are met (e.g., the merging plans have the same plan year and the valuation date is either the first or last day of such year, etc.). Rev. Proc. 99-45 clarifies that approval to change to a funding method described in Rev. Proc. 95-51, Section 3, does not apply if, after the change, a negative unfunded liability exists and the method is a spread-gain method and uses an unfunded liability to determine normal cost. In addition, it provides that the comparison of the results of new valuation software to the results of old valuation software may be made on the basis of the prior year; the requirement that the plan administrator approve the change in funding method is met if he is made aware of the change. Plan Administration The IRS issued guidance on default elections and the use of paperless notices and consents.
Default Elections The IRS issued new guidance in Rev. Ruls. 2000-8,14 2000-3315 and 2000-3516 to help employers increase rank-and-file participation rates in Secs. 401(k), 403(b) and 457 plans, by allowing default elections. It also issued Announcement 2000-60,17 encouraging prototype plan sponsors to add language permitting default elections. Treasury released a speech by Lawrence Summers that highlighted default elections as an important way to encourage employee savings. More than eight years ago, an employer asked the IRS whether it could "help" employees by making their Sec. 401(k) salary reduction election for them, while telling employees that they could elect out. The IRS unofficially agreed that this would be acceptable. In Rev. Rul. 98-30,18 the IRS set out rules for such default elections. Rev. Rul. 2000-8 updated and expanded Rev. Rul. 98-30 to facilitate "default" elections (also called "negative" or "automatic" elections) for Sec. 401(k) sponsors, including guidance on making default elections for current employees. Congress and the IRS have also long been concerned about the disparity between elective contributions made by higher-paid employees and rank-and-file employees. The safe- harbor Sec. 401(k) amendment effective in 1999 was a Congressional attempt to deal with the issue, encouraging employers to give matching contributions to rank-and-file employees in return for relief from the ADP and ACP tests. Unfortunately, safe-harbor plans require expensive contributions by employers, which not all are willing or able to make. In a default election, an employer makes the elective contribution election for an employee; the employee has a right to elect out. This approach is far cheaper and easier to implement than a safe-harbor plan; anecdotal evidence indicates that this strategy works. Rank-and-file employees give many excuses for not making elective contributions, including not being able to afford them. However, when small elective contributions are made for them, a large percentage of such employees fail to elect out. In a Sec. 401(k) plan, the increased participation rate directly benefits HCEs, by making it easier for the plan to meet the ADP and ACP discrimination tests. The default election increases the nonhighly compensated employees' (NHCEs') ADP and, thus, increases the amount that can remain in the plan for HCEs. For example, if NHCEs, on average, have deferred 3% of compensation into the plan, HCEs, on average, can only keep 5% deferrals in the plan. However, if the NHCE average can be raised to 4% using a default election, HCEs can keep an average of 6% of deferred compensation in the plan. Amounts above the permitted average must be distributed and taxed to HCEs, so they have an interest in raising the average NHCE contributions. In a Sec. 403(b) or 457 plan, the employer does not need to satisfy the ADP test (although a Secs. 403(b) plan has to meet the ACP test as to matching and after-tax employee contributions). However, many employers are concerned that their employees are not properly saving for retirement, or are relying too heavily on the company pension plan. Thus, even in Secs. 403(b) and 457 plans, the employer may be interested in increasing plan participation. Conditions: An employee must have an "effective opportunity" to elect out and receive cash instead of the plan contribution. He must have notice during a reasonable period before the choice is effective that explains the automatic election and election out. An employee hired after the effective date must also be given notice of the automatic election and the election out procedure. The election must be for an amount not yet "currently available" (i.e., not yet earned). For Sec. 457 plans, which do not technically have a "currently available" concept, an agreement made before the beginning of a month as an employee's compensation for the month is acceptable. Each employee is notified yearly of his deferral percentage and his right to change it or elect out. Until the participant directs otherwise, deferrals are invested in the plan's balanced fund, which includes both diversified equity and fixed-income investments. The IRS points out that the DOL believes that fiduciary relief under ERISA Section 404(c) does not apply if a participant has not elected the investments.
Paperless Notices and Consent Forms The IRS released final regulations19 on using "paperless" technology for notices and consent forms that must be given to qualified plan participants. Defined benefit plans, money-purchase plans, profit-sharing plans, Sec. 401(k) plans, ESOPs, etc., are required to give employees notices that explain their rights on plan distribution. For example, under Sec. 402(f), a participant must receive a notice explaining rollovers, 20% mandatory withholding and other distribution rules between 90 and 30 days before a plan distribution. Likewise, participants must consent to almost any plan distribution. The IRS was given a Congressional mandate several years ago to make plan administration more paperless. Proposed regulations in 1998 eased the burden for plan administrators. The final regulations contain several clarifications that commentators had sought, including: 1. How a company would provide Sec. 402(f) notice within 90 days before a plan distribution. 2. Whether consent (both participant and spousal) could be given electronically. 3. Whether Form W-4P, Withholding Certificate for Pension or Annuity Payments, information could be collected via phone or other electronic means. The final regulations provide easier rules. Regs. Sec. 1.402(f)-1, Q&A-2, clarifies providing Sec. 402(f) notice to a participant outside of the current 90-day window. The participant must be given a summary of the notice at least once and be advised as to where to find the latest version of the full notice, during the 90/30-day window before distribution. Thus, the notice can be given with (or as part of) the SPD, when a participant is first hired. Like the SPD, the notice must be updated as necessary, but does not have to be sent out periodically. Regs. Sec. 1.402(f)-1, Q&A-5, makes clear that the full notice can be placed on a Website; the summary notice can refer to the Website. Regs. Sec. 1.402(f)-1, Q&A-6, allows a company to collect a participant's consent to a distribution electronically, with a personal identification number (PIN) (even after a change in PIN), as long as adequate protective measures are in place. Q&A-6 also clarifies that Form W-4P information can be collected over the phone or a phone system (the same rules apply to Form W-4, Employee's Withholding Allowance Certificate). Further, the annual notice under Sec. 3405 (withholding on periodic payments) can be delivered electronically. Contrary to requests from commentators, the final regulations do not permit an employer to provide only electronic notice or consent forms; under Q&A-6, a participant must still be able to obtain a paper copy. Not surprisingly, an employer cannot obtain spousal consent via phone or other electronic means.
GUST Determination Letter Program/Extension of Remedial Amendment Period The IRS announced a determination letter program for plans making GUST20 amendments. Thus, employers could file for determination letters on updated plans starting on June 26, 2000. Because of the extent of the changes, the IRS is requiring that the plans be fully "restated" as part of this process. Thus, the GUST amendments cannot be handled by attaching amendments to the back of the document; instead, plans must be amended to incorporate all the amendments. Congress often tinkers with the laws affecting qualified plans (e.g., Sec. 401(k), profit-sharing, Keogh, defined benefit, money-purchase and Sec. 403(b) plans). A qualified plan is required to be amended to be current with all law changes, but not necessarily immediately. As a matter of convenience, the IRS offers an extended period during which a plan can be amended for new law changes. The "remedial amendment period" does not mean that the plan can ignore the laws' effective dates; rather, a plan has extra time to amend for those changes. As the name suggests, the plan must be retroactively amended to the effective date of any mandatory changes, although a later date can be applied to permissive changes. The remedial amendment period allows the IRS to issue guidance on new laws. There are several sets of legislative changes in the latest remedial amendment period, including those made by the various acts comprising GUST. Many of the changes being made in this set of amendments are beneficial to the plans and are far-reaching. For example, the laws contain:
Many of the beneficial changes do not apply to a plan unless the plan is amended for them. As the IRS has fallen behind on guidance schedules, it has extended the remedial amendment period. Under previous guidance, this period was supposed to end on Dec. 31, 2000. For a calendar-year plan, the period was extended to Dec. 31, 2001 by Rev. Proc. 2000-27, then extended to the last day of the first plan year beginning after 2000 for a non-calendar-year plan. The date may be later for government plans, depending on legislative schedules. Qualified Plan Cases and Rulings Deducting Plan Litigation Expenses In a case of first impression, the Tax Court held that an employer's direct payment of a plan's litigation expenses to a third party were deductible under Sec. 162.21 The court held this payment was not a contribution to the plan deductible under Sec. 404; further, the expenses did not need to be recurring to be deductible as Sec. 162 ordinary and necessary business expenses. The taxpayer was a professional corporation (Medical Group) and the sponsor of a money-purchase plan (Plan). Medical Group opened several accounts with Prudential, including personal accounts and an account for the Plan. Medical Group and the Plan filed a complaint against Prudential over account management. Medical Group and the Plan incurred substantial litigation costs; Medical Group deducted approximately half of them. After the settlement, the Plan received a portion of the settlement proceeds. The Plan provided that reasonable costs and expenses (including legal fees) incurred in connection with Plan administration or by the Plan administrator could be paid by the employer. If the employer did not pay the costs and expenses, they were to be paid by the fund. The issue of first impression for the Tax Court was whether Regs. Sec. 1.404(a)-3(d) restricted an employer's right to deduct an ordinary and necessary qualified pension plan expense that was not recurring. Law: Sec. 162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. However, Regs. Sec. 1.162-10(a) disallows a Sec. 162 deduction if the amounts are used to provide benefits under a deferred compensation plan. Sec. 404 preempts Sec. 162 if the expense is a contribution made by an employer to a deferred compensation plan. Sec. 404(a) provides that if an employer makes a contribution that would otherwise be deductible under Sec. 162, to a pension, profit-sharing or deferred-compensation plan, the deduction is limited by Sec. 404. Generally, Sec. 404(a)(1)(A) places the deduction limit for contributions at the amount necessary to satisfy the full funding required under Sec. 412(a). Regs. Sec. 1.404(a)-3(d) provides that expenses incurred by an employer for a plan (such as trustee's and actuary's fees), that are not provided for by plan contributions, are deductible by the employer under Sec. 162 (relating to trade or business expenses) or Sec. 212 (relating to expenses for the production of income), to the extent ordinary and necessary. Tax Court's analysis: Medical Group argued Regs. Sec. 1.404(a)-3(d) does not restrict the right to deduct nonrecurring expenses, but rather, allows the deduction of any expense that meets the Sec. 162 ordinary and necessary test. The IRS, relying on Rev. Rul. 86-142,22 argued that the regulation should be read narrowly to permit deductions of only administrative expenses that are ordinary, necessary and recurring. The issue in Rev. Rul. 86-142 was whether an employer could deduct amounts paid to a pension trust to reimburse a trustee for broker's fees paid by the trust. The IRS held the fees were not deductible, because the broker's commissions were not recurring administrative or overhead expenses, such as trustee or actuary fees. The Tax Court held that the IRS erroneously argued that a deduction under Sec. 162 was allowed only for recurring plan administration expenses. The Tax Court interpreted Regs. Sec. 1.404(a)-3(d) to mean that, if an employer pays ordinary and necessary plan-related expenses directly to a third party from its assets, and such expenses are not provided for by plan contributions, the payments are not deemed constructive contributions to the plan subject to Sec. 404 limits, but are deductible under Sec. 162. Regs. Sec. 1.404(a)-3(d) provides that an employer has two ways of meeting the ordinary and necessary expenses of administering pension plans for its employees: (1) it can pay the costs to the plan trustee as additional contributions deductible under Sec. 404 (in which case, the trustee is responsible for paying the expenses) or (2) the employer can pay the expenses out of general assets and deduct them under Sec. 162. The court held that the plan provided the employer the option of paying expenses, but did not require such payment by the employer. Thus, payment of the litigation costs was not an actual or constructive contribution to the plan. Therefore, the payment was not subject to Sec. 404; Sec. 162 applied to the extent the costs were ordinary and necessary expenses incurred by Medical Group in connection with the Plan. The court held that the portion of litigation expenses attributable to the Plan were ordinary and necessary business expenses.
Prohibited Transaction Penalties The Ninth Circuit23 affirmed a Tax Court ruling that the IRS can impose penalties on a defined benefit plan for violating the Sec. 4975 prohibited transaction rules, even though the DOL entered into a prohibited transaction consent agreement concerning the plan. This case serves as a reminder that the IRS and the DOL have separate jurisdiction over ERISA plans; plan sponsors must be mindful of both agencies' requirements. Neil Baizer was an officer, director and shareholder of an accounting firm. In 1981, the firm adopted a qualified defined benefit plan, administered by a committee comprised of Baizer and his partner. Baizer was a fiduciary under Sec. 4975(e)(3); thus, he was a "disqualified person" under Sec. 4975(e)(2). The Sec. 412 minimum funding requirements required an annual plan contribution of $186,200. Contributions were not made for the 1984 and 1985 plan years. There were two fictitious notes from a fictitious person stating that such contributions had been made. In 1988, the firm transferred $273,558 of accounts receivable into the plan, but the firm did not seek an exemption for the contributed amount. The accounts receivable were never collected or replaced. Both the IRS and the DOL audited the plan. While the DOL audit was under way, the IRS notified the plan that it intended to disqualify it for failure to satisfy the Sec. 401(a) exclusive benefit rule. In June 1993, Baizer entered into a "Stipulation for Consent Judgment: Judgment" (Consent Judgment) with the DOL, both as an individual and as a plan trustee. The Consent Judgment stated it was to act as a "final adjudication of all claims" made by the DOL against Baizer. The Consent Judgment specifically provided that it was "not binding on any government agency other than the DOL." The IRS issued a notice of deficiency to the taxpayer in August 1994, which included prohibited transaction penalties under Sec. 4975(a) and (b) for the transfer of the accounts receivable. Tax Court's analysis: Baizer argued that the Tax Court did not have jurisdiction because the DOL had determined that the transfer did not constitute a prohibited transaction. He also argued that the IRS was barred from relitigating an issue already investigated by the DOL; the Tax Court rejected both arguments. The Tax Court also imposed a second-tier tax because the prohibited transaction was not corrected within the taxable period. Ninth Circuit's analysis: Sec. 4975 imposes on a disqualified person a 5% per year tax on the amount of a prohibited transaction. The parties agreed that the taxpayer was a disqualified person who participated in the transaction. The Ninth Circuit was left to determine whether the transfer of the accounts receivable was a prohibited transaction. It reasoned that a transfer from accounts receivable was a prohibited transaction, because it was a sale, exchange or leasing of property between a plan and a disqualified person under Sec. 4975(c)(1)(A). The taxpayer argued that the IRS had no authority to impose the prohibited transaction penalty, because Reorganization Plan No. 4 of 197824 vested exclusive enforcement authority in the DOL. The court found, however, that the Reorganization Plan specifically excluded Sec. 4975(a), (b), (c)(3), (d)(3), (e)(1) and (e)(7) from the authority transferred to the DOL. Further, the Reorganization Plan specifically states that it does not affect Treasury's (and therefore, the IRS's) ability to audit plans and employers, enforce the Sec. 4975 prohibited transaction rules or exercise authority under ERISA Section 502. Baizer claimed the DOL's Consent Judgment was "primary authority" and that the IRS had overstepped its bounds. The court found this argument flawed, because the DOL-enforced prohibited transaction rules under ERISA Section 1106(a)(1)(A) are not equivalent to the IRS-enforced Sec. 4975(c)(1)(A) prohibited transaction rules. Under ERISA Section 1106(a)(1)(A), a determination must be made as to whether the taxpayer knew (or should have known) that the transaction was taking place. Sec. 4975(c)(1)(A) imposes penalties without regard to the taxpayer's state of mind. Sec. 4975(f)(2) defines the taxable period for a prohibited transaction as beginning with the date the prohibited transaction occurred and ending with the earliest of the date the transaction is corrected, a tax under Sec. 4975(a) is assessed or the date the IRS notice of deficiency is mailed. Baizer contended that a correction was made, because all the plan participants were paid the amounts owed from the plan. Testimony, however, contradicted this contention; the taxpayer claimed he never received his benefits. In addition, the Ninth Circuit upheld the Tax Court's second-tier penalty, rejecting Baizer's misapplication of Sec. 4963's penalty period as ending 90 days after the IRS notice date. The court found that, because the accounts receivable were never replaced with cash and never collected, no correction had been made.
Voluntary Compliance A recent Michigan district court case sheds light on the interaction between a participant's rights under ERISA and an employer's responsibility to participants if it has used one of the IRS voluntary compliance programs. The decision may be reassuring to employers who voluntarily correct plan defects.25 ERISA governs retirement plans (including both qualified and nonqualified plans) and most welfare-benefit plans (including many health benefits, insurance benefits, etc.). ERISA Title I has reporting requirements (generally, Form 5500), participation and vesting requirements and fiduciary (or trustee liability) requirements. Under Title I, an employer must have a plan administrator—i.e., someone who accepts responsibility for maintaining the plan in a manner that satisfies the plan rules and the fiduciary rules. ERISA gives both the DOL and plan participants the right to sue an ERISA plan if the plan administrator or trustee breaches its duty to plan participants. Unlike other areas of the law, ERISA suits generally allow only the recovery of amounts to which an employee is entitled, rather than punitive damages. Plan participants can use class-action suits to press their claims. Mrs. Cage worked for General Motors (GM) and was covered under the Defined Benefit Salaried Plan (Plan). The Plan was contributory; Mrs. Cage contributed to it (presumably, via after-tax employee contributions) while she worked for GM. When she was terminated in 1995, she elected a lump-sum distribution, which was paid to her in 1995. GM received a letter from the National Center for Retirement Benefits in 1996, stating that the Plan had incorrectly determined the portion of Mrs. Cage's benefits attributable to her own contributions. After going through the company's appeal process, Mrs. Cage sued in March 1997 to obtain the remainder of her benefits and interest on the amount not timely paid; several other former participants joined the suit. Mrs. Cage and the other plaintiffs later raised other miscalculation issues. In October 1997, GM submitted a request to the IRS's Voluntary Compliance Resolution Program (VCR). In May 1998, the court stayed the case pending the completion of the VCR submission. Under the VCR, GM paid the affected participants the additional amounts, plus earnings at 7% per year. In court, Mrs. Cage and the other plaintiffs argued that the rate of interest on the late payments was inadequate. Once the IRS issued the VCR letter to GM in March 1999, GM asked the court to dismiss the suit. The company argued that the participants had been made whole under the agreement with the IRS. District court's analysis: The court declared the participants' claims for benefits under ERISA moot, because they received the benefits sought in the original suit. Second, the participants' additional claims concerning other miscalculations were dismissed, because they had not been submitted first to the plan administrator. The judge noted that considering the merits of the new claims would have "placed the court in the role of the plan's fiduciary administrator" and refused to make a plan administrative decision for the former employees. Third, the participants' claim for a higher rate of earnings was dismissed. Mrs. Cage argued that the Plan had received a higher rate of interest during this period and that she should have received the higher of the market rate or the rate the Plan actually earned. The judge noted that this ignored the difference between a defined benefit plan (which promises fixed payments on retirement) and a defined contribution plan (under which the benefit paid is based on investment performance). For the period in question, interest on Treasury bills had ranged from 4.232%–6.06%; thus, GM's offer to pay 7% was more than reasonable under the circumstances. Finally, Mrs. Cage asked for payment of attorney's fees. The judge pointed out that she discovered the defect, the company "summarily denied" her claim at an administrative level and on appeal and admitted the error only after going to court. The participants' suit "prompted GM to remedy its mistake" whereas, in a similar suit, the company had already sought compliance before the plaintiffs sued. Thus, the judge determined that Mrs. Cage was entitled to reasonable attorney's fees.
Breach of Fiduciary Duty Citing correction under the IRS's VCR program, an Alabama district court granted summary judgment for an employer in an employee class-action suit for breach of fiduciary responsibility, for failure to disclose the miscalculation of benefits provided under a defined benefit plan's cashout provision.26 Amoco Corp. maintains a defined benefit plan for its employees. Cash distributions were made to employees from the plan according to its cashout language. Distributions for present values over $3,500 were not permitted. Distributions that undervalued the employee's accrued benefits were erroneously made, due to a miscalculation of employee benefits. Because amounts were understated, employees received distributions, even though they were not eligible to do so and were not offered the option to retain their pension annuity. If the amounts had been calculated correctly, the employees would have been eligible to receive a pension at normal retirement age. Amoco submitted a VCR request to make corrections to the erroneous distributions; the IRS accepted Amoco's proposed corrections. There were three choices for participants in the affected group:
Amoco sent out letters outlining the choices to the affected participants, but neglected to mention the erroneous distribution. Each participant chose the third option, but later requested a reinstatement of the annuity under the plan. Amoco refused additional benefits. District court's analysis: The court determined that the initial distribution was reasonable, due to a mistake in the interest rate used. The plan terms provided that if a distribution was made incorrectly, the plan administrator had the discretion to correct the mistake in a reasonable manner. The court found that the methods of correction from which the employee could choose were reasonable. IRS approval of the correction helped support Amoco's position that the methods were reasonable. The court agreed that there was a breach of fiduciary duty due to the lack of disclosure concerning the mistake in calculations. Although no damages resulted from this case, there may be damages on an individual basis for some participants.
Discriminatory Plan Amendments The IRS ruled that amendments to a defined benefit plan resulted in duplication of benefits to HCEs, causing discrimination in violation of Sec. 401(a)(4).27 An employer maintained a defined benefit plan that covered both HCEs and NHCEs. In 1998, the plan was amended and divided into two separate plans, one exclusively for HCEs and the other exclusively for NHCEs. The amendment also froze future benefit accruals under the HCE plan; benefits continued to accrue under the usual benefit formula for the NHCE plan. The NHCE plan was later amended to include the HCEs and gave the HCEs benefits calculated under the same formula as the old plan. However, the amended plan calculated the accrued benefit using the years of service during which the HCEs were covered by the frozen HCE plan and did not offset the benefits under the NHCE plan by the benefits already accrued under the HCE plan. Sec. 401(a)(4) provides that contributions or benefits under a Sec. 401(a) plan cannot discriminate in favor of HCEs. Regs. Sec. 1.401(a)(4)-1(c)(2) provides that the Sec. 401(a)(4) regulations must be interpreted in a reasonable manner consistent with preventing discrimination in favor of HCEs. Regs. Sec. 1.401(a)(4)-5(a)(1) and (2) provide that, in determining whether the timing of a plan amendment (or series of amendments) has the effect of discriminating significantly in favor of HCEs, a plan amendment includes plan establishment or termination and any change in plan benefits, rights, features or benefit formulas. Whether the timing of a plan amendment or series of plan amendments has the effect of discriminating significantly in favor of HCEs is determined when the plan amendment first becomes effective, based on all relevant facts and circumstances. These include the relative number of current HCEs and NHCEs affected by the plan amendment, the relative accrued benefits of current HCEs and NHCEs before and after plan amendment and any additional benefits provided to current HCEs and NHCEs under other plans. Regs. Sec. 1.401(a)(4)-11(d)(2) provides that, on the basis of all relevant facts and circumstances, the manner in which employees' service is credited for all purposes under the plan must not discriminate in favor of HCEs. Regs. Sec. 1.401(a)(4)-11(d)(3) provides that, except as otherwise provided, service for periods in which an employee did not participate in the plan may not be taken into account in determining whether the plan satisfies Sec. 401(a)(4). The IRS ruled that there was duplication of service and benefits that discriminated in favor of HCEs and resulted in the plan's failure to meet the Sec. 401(a)(4) nondiscrimination requirements.
ESOP Issues S Corp May Not Repay Exempt Loan from Allocated ESOP Share Earnings In Letter Ruling 9938052,28 the IRS ruled that an S corporation cannot use earnings on ESOP shares allocated to plan participants to repay an exempt loan, but can use earnings on unallocated shares held as loan collateral. The IRS did not rule on whether a change from a C corporation to an S corporation would result in the ESOP's disqualification. In the ruling, Plan X was a leveraged ESOP that borrowed money (Exempt Loan) from C corporation A to acquire A's common stock and to repay an earlier loan used to purchase A stock. The Exempt Loan met Sec. 4975(d)(3)'s requirements and was to be repaid using deductible A contributions to X and cash dividends on allocated and unallocated shares held by X. Collateral for the Exempt Loan consisted of unallocated shares of stock held in a suspense account. When X makes annual payments on the Exempt Loan, the unallocated shares are released and allocated to participants' accounts in accordance with the X terms. A intends to become an S corporation and to amend X to become a stock bonus and money-purchase pension plan. A plans to make the maximum contribution under Sec. 404. To the extent contributions are insufficient to make the annual Exempt Loan payments, X intends first, to use earnings on unallocated shares of A stock and then, if necessary, earnings on allocated shares. Such earnings may include dividends to the extent that A has accumulated earnings and profits (C E&P) from its prior status as a C corporation. If employer contributions and dividends are insufficient to make the annual Exempt Loan payment, additional amounts would come from A's accumulated adjustments account (AAA), maintained under Sec. 1368. All amounts held in the AAA would be payable as dividends under Sec. 301 if A remained a C corporation. If earnings on allocated shares are used to make Exempt Loan payments, the released shares will first be allocated to participants' accounts on a fair market basis, according to the amount of earnings taken from each such account to make the Exempt Loan payment. Analysis: Sec. 4975 provides a prohibited transaction exemption for a loan to a leveraged ESOP if it is primarily for the benefit of participants and beneficiaries, as long as interest rate and loan collateral requirements under Regs. Sec. 54.4975-7(b)(3) are met. In addition, under Regs. Sec. 54.4975-7(b)(5), parties entitled to payment under an exempt loan have no right to ESOP assets other than (1) loan collateral; (2) contributions (other than contributions of employer securities) made to meet the ESOP's loan obligations; and (3) earnings attributable to the collateral and the investment of such contributions. The IRS ruled that, because unallocated shares are held in a suspense account as collateral for the Exempt Loan, the earnings attributable to such shares may be used to make payments on that loan, to the extent the earnings are from either C E&P or the AAA. Thus, to the extent X fiduciaries use earnings (dividends or otherwise) received on unallocated shares of A stock held in the suspense account to repay the Exempt Loan, the transactions would not cause the Exempt Loan to fail to meet Sec. 4975(d)(3), if the earnings are from either C E&P or A's AAA. As to the allocated shares, the IRS ruled that Regs. Sec. 54.4975-7(b)(5) does not provide for payments to an exempt loan from earnings on such shares; such a transaction fails to meet the requirements of Regs. Sec. 54.4975-7(b)(5) and (3). To the extent that the X fiduciaries used earnings (dividends or otherwise) received on allocated shares of A stock held in participants' accounts to repay the Exempt Loan, the Exempt Loan failed Sec. 4975(d)(3). Using the earnings on allocated shares constituted a prohibited transaction. The IRS declined to rule on whether A's change in status from a C to an S corporation would change X's qualified status as an ESOP. Under Rev. Proc. 99-4,29 the IRS National Office does not ordinarily issue letters on a plan's qualified status. (Such a determination is made under the determination letter program by the key district offices.) This ruling demonstrates the differences in the treatment of a leveraged ESOP maintained by a C corporation versus an S corporation. Under Sec. 404(k)(5)(B), the use of C corporation dividends on allocated shares to repay an exempt loan does not violate Sec. 4975(d)(3). C corporations with leveraged ESOPs that are considering an S election should remember the effect such an election might have on loan repayment.
Disregarded Entities' Employees Could Participate in Parent's ESOP In Letter Ruling 9940946,30 the IRS held that the employees of several second- and third-tier subsidiaries, which were single-member limited liability companies (SMLLCs) and disregarded entities, were members of a parent's controlled group. This allowed the subsidiaries' employees to participate in the parent's ESOP. Further, the parent's common stock held by the ESOP was employer securities for purposes of Sec. 409(l). The parent, which maintained an ESOP, owned several subsidiaries. Sub 1 was the parent's wholly owned subsidiary; Sub 2 was an SMLLC, with Sub 1 as its sole owner. Sub 2 had not made an election under Regs. Sec. 301.7701-3(c) to be classified as a corporation for Federal tax purposes. (By not making the election, Sub 2 was a disregarded entity.) Subs 3, 4, 5 and 6 were SMLLCs, with Sub 2 as their sole member. Subs 3-6 were disregarded entities. Sub 7 was an SMLLC, with Sub 2 as its sole member. Sub 7 had elected to be classified as an association taxable as a corporation for Federal tax purposes. The IRS addressed three issues. First, were the employees of Subs 2–6 treated as part of the parent's controlled group under Sec. 1563(a), as it related to Sec. 409(l)(4)? Second, were Sub 7's employees treated as part of the parent's controlled group? Third, if Subs 2–7's employees participated in the parent's ESOP, would the parent's common stock held by the ESOP meet the definition of employer securities under Sec. 409(l)? Law and decision: Sec. 4975(d)(7) provides that an ESOP must invest primarily in "qualifying employer securities" (i.e., any employer security within the meaning of Sec. 409(l)). Sec. 409(l) provides that employer securities are common stock issued by an employer or by a corporation that is a member of the same controlled group. Further, the stock must be readily tradable on an established securities market. Under Sec. 409(l), a controlled group of corporations has the meaning given in Sec. 1563(a), which provides that a parent-subsidiary controlled group is any group of "one or more chains of corporations" meeting certain requirements. Sec. 7701(a)(3) provides that a corporation includes associations and joint-stock and insurance companies. Single-owner organizations can choose to be recognized or disregarded as entities separate from their owners for Federal tax purposes; if an election is not made, the association is disregarded as an entity. The IRS held that Subs 2–6 were not corporations, because they were disregarded entities. Sec. 1563(a) requires that controlled groups consist of corporations; thus, Subs 2–6 were not members of the parent's controlled group. Because Subs 2–6 are disregarded entities, their assets and liabilities are treated as being owned by Sub 1, which is a member of the parent's controlled group. The IRS held that the Subs 2–6 employees are treated as employees of Sub 1, which is part of the parent's controlled group; thus, Subs 2–6's employees are part of the parent's controlled group. Sec. 1563(a)(1) provides that a parent-subsidiary controlled group is any group of one or more corporations connected through stock ownership with a common parent. The common parent must own at least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of all classes of stock of at least one of the other corporations. Sub 7 elected to be treated as a corporation for Federal tax purposes. Sub 2 owns 100% of Sub 7's stock. Sub 2's assets are treated as owned by Sub 1; thus, Sub 1 is treated as the 100% owner of Sub 7. Because Sub 1 is currently a member of the parent's controlled group and holds at least 80% of Sub 7's voting power, the IRS held that Sub 7 is part of the parent's controlled group under Sec. 1563(a). Further, the IRS held that, because the Subs 2–6 employees are treated as part of the parent's controlled group, and Sub 7 is a member of the controlled group, the parent's common stock held in the ESOP would not fail to be employer securities under Sec. 409(l) due to Subs 2–7's employees' participation in the ESOP. Many corporations are creating SMLLCs to implement various business and tax strategies. This ruling provides support that employees of SMLLCs and other entities in a controlled group will still be able to participate in a parent's ESOP. On the other hand, all such employees clearly must be counted for purposes of the coverage tests.
ESOP May Repay Loan with Accumulated Earnings In Letter Ruling 200014043,31 the IRS ruled that an ESOP may repay a loan from its S corporation sponsor with earnings on unallocated shares, to the extent the earnings are attributable to either C E&P or the AAA, without failing Sec. 4975(d)(3)'s exemption requirements. A C corporation established an ESOP and lent it money to purchase stock. The loan was intended to be an exempt loan under Regs. Sec. 54.4975-7(b). The shares were placed in a suspense account in accordance with Regs. Sec. 54.4975-11(c). As contributions were made to the ESOP by the C corporation, dividends on unallocated corporate shares were used to repay the loan; a pro rata portion of the shares credited to the suspense account were released and allocated to individual participant accounts, according to the ESOP's allocation formula. Subsequently, the C corporation elected S status. The ESOP was amended to provide that S distributions from the C corporation on unallocated shares would be used to repay the loan. The S distributions consisted of amounts that would have been payable as dividends under Sec. 301 had the corporation maintained C status. Analysis: The IRS ruled that, as long as the S distributions stemmed from a Sec. 301 dividend (had the corporation been a C corporation), the loan's exempt status would not be jeopardized. Sec. 4975(e)(7) imposes a tax on prohibited transactions, but provides an exemption for a loan to a leveraged ESOP. This loan must be for the benefit of the plan participants and their beneficiaries. An exempt loan is subject to special scrutiny to ensure that participants' and beneficiaries' benefits are protected. Regs. Sec. 54.4975-7(b)(5) states that no person entitled to payment under the exempt loan shall have any right to ESOP assets other than collateral given for the loan, contributions made under an ESOP to meet its obligations under the loan and earnings attributable to such collateral and the investment of such contributions. Payments made on an exempt loan by an ESOP during a plan year cannot exceed the sum of such contributions and earnings received during or before the year, less such payments in prior years. The IRS explained that, because the S distributions consisted of amounts from both C E&P and the AAA, these amounts would be considered earnings attributable to unallocated securities of the C corporation; thus, use of these amounts to repay the loan will not cause the loan to lose exempt status under Sec. 4975(d)(3). This ruling offers some advice on how an exempt loan can and should be treated when a company moves from C to S status. Assuming the Sec. 4975 regulations are followed, repaying the loan in the above fashion will not cause an ESOP loan to lose its exempt status.
Conclusion In the next issue, Part II of this article will focus on executive compensation, health and welfare and fringe benefit issues. |
