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Current Developments (Part II) 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, Pamela Hobbs and Terri Stecher 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 (but does not discuss the Economic Growth and Tax Relief Reconciliation Act of 2001). Part I, below, focuses on general developments in retirement plan qualification requirements. Final Regulations The IRS issued final regulations on protected benefits and cross-testing.
Protected Benefits The IRS issued Sec. 411(d)(6) final regulations1 that set forth workable rules for defined-contribution plans. In addition, the new rules somewhat simplify the transfer of assets from one plan to another in mergers and acquisitions (M&A) and similar transactions. Under Sec. 411(d)(6) generally, an employer cannot retroactively revoke a plan distribution option to which participants have a right. Thus, if a Sec. 401(k) plan has offered a 10-year installment-payment option, an employer can revoke that distribution option only for contributions made after the plan amendment date. This rule has increased the complexity of plan administration, because every plan merger brings in all the plan distribution options of the plan being merged. The IRS has been working with benefits practitioners and employers on equitable ways to simplify administration, while protecting plan participants. In a significant departure from old rules and the proposed regulations, Regs. Sec. 1.411(d)-4 now permits a defined-contribution plan to eliminate almost any form of distribution (including annuity provisions), as long as the plan has a lump-sum distribution provision that allows distributions at about the same time as under the other form of distribution. However, a transition rule applies to employees who retire shortly after the plan is amended. As under the proposed regulations, the final regulations also provide that most plans may revoke a right to an in-kind payment, including employer securities purchased as a directed investment under the plan or annuity contracts in a defined-benefit plan. As part of a merger, acquisition or other such transaction, a defined-contribution plan can transfer assets to another such plan under the "elective transfer" provisions—even if the employee does not yet have a current right to a distribution. However, such transfers must generally remain with an equivalent plan (i.e., employee stock option plan (ESOP) transfers to a new-company ESOP, Sec. 401(k) transfers to a new-company Sec. 401(k) plan, etc.).
Cross-testing The IRS issued cross-testing final regulations that differ somewhat from the proposed regulations.2 "Cross-testing" refers to tests that determine if a plan discriminates in favor of highly compensated employees (HCEs), based on the opposite plan type. Defined-contribution plan allocations are tested by the amount of benefit they will purchase; defined-benefit plan accruals are tested by cost. Regs. Sec. 1.401(a)(4)-8, first published in 1991, contains cross-testing rules (i.e., changing allocations into equivalent accruals and accruals into equivalent allocations). This area has been controversial for many years; Treasury and Congress disagree on the propriety of cross-testing. Proposed regulations issued in October 2000 preserved the existing cross-testing rules, but a plan had to make a "gateway contribution" to use them. The contribution could be avoided if the plan had "broadly available" allocation rates. The proposed regulations addressed new comparability plans (which combine a defined-benefit plan for HCEs and a defined-contribution plan for nonhighly compensated employees (NHCEs)) and provided a gateway contribution for them as well. There are several differences between the final and proposed cross-testing rules. The minimum gateway contribution for defined-contribution plans applies only to employees otherwise benefiting (as defined in Regs. Sec. 1.410(b)-3(a)) under the plan; an employee not so benefiting does not need a contribution. The gateway contribution applies only to compensation earned by an employee while participating during the plan year. Regs. Sec. 1.401(a)(4)-8(b)(1)(iii) eases the definition of "broadly based" allocation rates, which enable a plan to avoid making the five-percent gateway contribution by permitting aggregation of allocation rates (using the same method as is used in aggregating benefits rights and features). Also, differences in allocation rates caused by permitted disparity are ignored. Differences in allocation rates caused by accruals and allocations grandfathered as the result of M&A are also disregarded in determining whether a plan meets the broadly based allocation rate exception. Such "transition allocations" include defined-benefit replacement allocations, pre-existing replacement allocations and pre-existing M&A allocations. Transition allocations must be provided to a closed group of employees and established under plan provisions. Rev. Rul. 2001-303 explains these requirements. A plan has broadly based allocation rates if each allocation rate is provided to a group of employees who would pass minimum coverage. An exception from the gateway contribution exists for target benefit plans that do not satisfy the safe harbor in Regs. Sec. 1.401(a)(4)-8(b)(3). The gateway exception applies to a target benefit plan that would be a safe-harbor plan except for the fact that it does not use a standard interest rate, the stated benefit is calculated assuming compensation increases or the plan computes the current-year contribution using the account balance rather than a theoretical reserve. The plan may not impute permitted disparity. For combined defined-benefit/ defined-contribution plans, there is a new 7.5% aggregate normal allocation rate gateway for NHCEs. The gateway contribution can be avoided if the defined-benefit and defined-contribution plans are broadly available separate plans (i.e., each plan would pass coverage separately, and separately are nondiscriminatory as to benefits). Age-weighted plans that escape the gateway contribution (by having smoothly increasing allocation rates) may not impute disparity. These plans may, however, provide a minimum allocation rate for all employees and may base allocations on the sum of age and service. The new regulations are effective for plan years beginning after 2001. The IRS is now exacting a price (a gateway contribution) for using a method of nondiscrimination testing that previously required no minimum contribution. This new requirement may make cross-tested plans more expensive for employers to maintain, while simultaneously reducing the differences in allocations as a percentage of compensation between NHCEs and HCEs.
Qualified Plan Procedural Changes The IRS issued new Employee Plans Compliance Resolution System (EPCRS) guidance, modified the qualified plan determination-letter program and extended relief from nondiscrimination regulations for government and church plans.
EPCRS Revised Rev. Proc. 2001-174 offers new EPCRS guidance. EPCRS was created to allow qualified plan (and tax-sheltered annuity) sponsors to voluntarily correct certain operational defects. EPCRS provides sanctions as an alternative to plan disqualification; it encourages sponsors to review plans for operational compliance and either self-correct or bring deficiencies to the IRS's attention. Rev. Proc. 2001-17 divides EPCRS into three parts. The first is the Self-Correction Program (SCP). A plan sponsor that has established compliance practices and procedures may at any time correct insignificant operational failures without the IRS's consent or sanction. In addition, a tax-sheltered annuity arrangement (Sec. 403(b) plan) or qualified plan sponsor with a favorable IRS determination letter may correct significant operational failures without fee or sanction. The second part is the Voluntary Correction Program with IRS Approval (VCP). A plan sponsor may (at any time before the plan is audited) pay a limited fee and receive the IRS's approval for correction. There are specialized procedures under VCP: 1. Voluntary Correction of Operational Failures (VCO), for submissions involving only operational failures. 2. Voluntary Correction of Operational Failures Standardized (VCS), for limited operational failures corrected using standardized corrections. 3. Voluntary Correction of Tax-Sheltered Annuity Failures (VCT), for Sec. 403(b) plans. 4. Anonymous Submission Procedure, which—for the first time—permits anonymous submissions; the plan sponsor's name need not be disclosed until after an agreement is reached with the IRS. 5. Voluntary Correction of Group Failures (VCGroup), for failures in more than one plan. 6. Voluntary Correction of Simplified Employee Pension Failures (VCSEPs), which applies voluntary correction principles to simplified employee plans (SEPs) for the first time. The third part is Correction on Audit (Audit CAP). If an uncorrected failure is identified in an IRS audit, the plan sponsor may correct and pay a sanction. The sanction will bear a "reasonable" relationship to the nature and extent of the failure and take into account any pre-audit correction. Rev. Proc. 2001-17 also (1) combined the prior programs for voluntary correction with IRS approval, Voluntary Compliance Resolution (VCR), Walk-in CAP and Tax-Sheltered Annuity Voluntary Correction (TVC) into a single voluntary correction program (VCP), which includes special procedures for certain operational failures (VCO and VCS) and Sec. 403(b) failures (VCT); (2) renamed the Administrative Policy Regarding Self-Correction Program (APRSC) the SCP; (3) broadened the submission standards under VCP to permit third-party administrators and master and prototype sponsors to correct failures affecting more than one plan (VCGroup); (4) revised VCP to permit anonymous submissions; (5) expanded EPCRS to include SEPs, permitted self-correction of insignificant SEP failures and made special accommodations for SEP sponsors; (6) extended the self-correction period under SCP (formerly APRSC) for operational failures resulting from a plan merger or asset transfer stemming from a corporate merger, acquisition or other transaction; (7) facilitated correction under SCP, VCP and Audit CAP of previous qualification failures by plan sponsors that accept asset transfers or plan mergers in corporate transactions; (8) permitted correction by retroactive plan amendment when employees are permitted to begin participation before eligible; (9) permitted correction (through retroactive amendment under SCP and VCO) for failures related to hardship withdrawals, benefits based on compensation in excess of the Sec. 401(a)(17) limit and premature participation by otherwise eligible employees; (10) permitted correction by employers ineligible to sponsor Sec. 401(k) plans at the time they were adopted; (11) clarified that insignificant failures may be self-corrected during an IRS audit, even if discovered; (12) explained the reporting requirements applicable to excess distributions from qualified plans and SEPs; (13) clarified the fee calculation for multiemployer and multiple-employer plans; (14) stated that a failure not disclosed by the plan sponsor and discovered by the IRS during the determination-letter process is subject to the Audit CAP fee structure; and (15) updated the definition of "favorable" letter to include GUST.5
Qualified Plan Determination-letter Program Modified In Ann. 2001-77,6 the IRS simplified its application procedure for determination letters on qualified retirement plans. The changes give plan sponsors the flexibility to request a determination letter that considers only the plan form or both the plan form and its operational compliance with the Code's minimum coverage, defined-benefit minimum participation and nondiscrimination standards. (Carol Gold, IRS Director of Employee Plans, has said publicly that there are between 200,000 and 300,000 plans awaiting IRS determination letters on GUST.) Ann. 2001-77 appears to be the IRS's first attempt to streamline its determination-letter process and lighten its workload. The announcement offers reliance, in certain cases, to adopters of nonstandardized master and prototype or volume-submitter plans without a determination letter. Second, it permits employers to limit IRS review to the plan form, rather than to plan form and operation. Further, Ann. 2001-77 provides that the IRS is: 1. Revising its determination-letter application forms and procedures to permit plan sponsors to request determination letters without providing information on how the plan satisfies the requirements for Sec. 401(a)(4) nondiscrimination, Sec. 401(a)(26) additional participation for defined-benefit plans or Sec. 410(b) minimum coverage. 2. Modifying its procedures to permit adopting employers of nonstandardized master and prototype plans or volume-submitter plans to rely on a favorable opinion or advisory letter without requesting a determination letter. Adopting employers can rely on the plan sponsor's letter if they select options set out in the announcement. 3. Changing its procedures to permit an employer maintaining a multiple-employer plan to rely on a favorable determination letter for the plan without submitting a separate application for a determination letter. 4. Encouraging practitioners to highlight changes to plans that have previously received favorable determination letters. 5. Aiding plan adopters, during the second half of 2001, by publishing a list of master and prototype and volume-submitter plan sponsors that requested letters before 2001. The list will indicate the date a letter was issued or a request withdrawn. The IRS's changes to the individually designed plan determination-letter process permit employers to avoid supplying demographic information at the price of reduced reliance. If successful, these procedural changes will enable the IRS to concentrate its limited resources on individually designed plans and process them faster.
Nondiscrimination Regulation Relief Extended In Notice 2001-46,7 the IRS extended the date by which nonelecting church plans and certain government plans must comply with the Code's and regulations' nondiscrimination provisions. Several years ago, the IRS published final nondiscrimination regulations under Secs. 401(a)(4), (a)(5), (l) and 414(s). Section 1505 of the Taxpayer Relief Act of 1997 (TRA '97) provides that the Code's nondiscrimination rules do not apply to state and local government plans. The IRS delayed the nondiscrimination regulations' effective date for nonelecting church plans. Previously, Notice 2001-98 extended the regulatory effective date until plan years beginning after 2001, for church plans operated in accordance with a reasonable, good-faith interpretation of the statute. It also provided that government plans not covered by TRA '97 Section 1505 (as described in Sec. 414(d)) were deemed to satisfy the Code's nondiscrimination rules until the first plan year beginning after 2001. The TRA '97 made Sec. 401(k) plans available to government sponsors. Notice 2001-9 stated that government plans satisfy Secs. 401(k) and (m) until the first plan year beginning after 2001. Notice 2001-46 extends the Notice 2001-9 effective dates for both nonelecting church plans and government plans not covered by TRA '97 to the first plan year beginning after 2002.
Employee Classification Issues The IRS released rulings on the classification of workers versus independent contractors.
Plan Inoculation Language In 1989 and 1990, the IRS examined Microsoft's employment records and, applying the 20-factor test in Rev. Rul. 87-41,9 found that certain workers Microsoft treated as independent contractors were actually employees. After learning of the IRS's finding, some of these workers sued Microsoft for benefits for which they had been advised they were ineligible. A divided Ninth Circuit found that, based on the terms of Microsoft's plans, the employees were entitled to benefits.10 Under Rev. Proc. 2001-17, a plan not operated according to its terms is not qualified. Microsoft's plan covered employees; thus, the reclassified employees had to be covered. Because they were not, the plan technically was not qualified. An employer that runs afoul of the "Microsoft issue" risks not only losing an Employee Retirement Income Security Act of 1974 (ERISA) suit to its employees, but also having the plan disqualified by the IRS. Generally, the correction for failure to cover employees who should have been eligible is to cover them retroactively. In a defined-benefit plan, this may not be a problem, although the correction may change the plan's funding status. In a defined-contribution plan, the employer generally contributes to the plan for unexpected "employees" and also contributes the earnings they would otherwise have received in the plan. If part of the plan is a Sec. 401(k) plan, the employer contributes to approximate the amounts the employees would have contributed. The IRS generally requires a contribution equal to the average deferral percentage (the NHCE deferral percentage or the HCE deferral percentage). This can be very expensive, especially given the high interest earned in many plans over the last few years. Several employers have attempted to amend plan language to exclude a class of workers viewed as independent contractors, even though the IRS or a court found them to be common-law employees. These provisions were meant to inoculate plans against the Microsoft issue. The IRS's Cincinnati field office believed that these "inoculation" plan provisions violated Sec. 410(a)'s minimum eligibility requirements and Regs. Sec. 1.401-1(a)(2)'s requirement that a plan be a definite written program. The IRS's National Office disagreed with the Cincinnati field office and issued a Letter Ruling (TAM).11 While a TAM can be relied on only by the taxpayer to whom issued, the IRS has made extraordinary efforts to disseminate it. IRS National Office officials have expressed strong support for it in meetings with benefits associations. These officials state that more guidance cannot be issued this year due to the press of other important business. The plan in the TAM contained a provision excluding workers classified as independent contractors, as well as workers in certain payroll codes. The independent contractors were excluded regardless of whether they were found by a court or administrative agency to be common-law employees. The TAM concluded that the definite-written-program requirement is not violated by the exclusion of workers engaged as independent contractors but later determined to be employees, because the terms have independent legal significance. The reference to the payroll system is not ambiguous. The trustees and employer can determine who is covered by the plan by reading it. The TAM opines that a plan must be definite as to which workers are covered and which are not; further, the employer must communicate this fact to employees. According to Regs. Sec. 1.401-1(a)(2), plan terms cannot leave the determination of which workers are covered and which are not to the employer's discretion without violating the definite-written-program rule. Thus, an employee should be able to enforce his rights based on the plan document. However, a plan does not fail this requirement if facts extrinsic to the plan document need to be examined to determine who is covered. The TAM's test for a plan provision is "can the employees and plan administrators determine who is and isn't covered when they read the plan and examine all the surrounding facts?" Sec. 410(a) precludes a plan from limiting participation on the basis of age or service in excess of the minimum. The employer may design a plan to cover any other nondiscriminatory classification of employees it chooses. Sec. 410(a) does not preclude an employer from retroactively excluding reclassified employees from a plan. An exclusion by payroll code could be an indirect age or service exclusion prohibited by Regs. Sec. 1.410(a)-3(d). This question can be answered only by examining all the facts and circumstances.
No 20-factor Test In Letter Ruling 200119035,12 the IRS did not cite the Rev. Rul. 87-41 20-factor test in determining whether a worker was an independent contractor for FICA purposes. The person at issue (the Worker) was a state-licensed soil evaluator and sanitarian. Under a contract with a governmental board, the Worker provides reports of on-site inspections she has done on an as-needed basis without supervision. The Worker maintains a home office, provides her own tools, provides services under her own name, maintains her licenses and is paid on an hourly basis. The ruling notes that for FICA purposes, an individual is an employee if, under the common-law rules, the relationship between the individual and the person for whom he performs the services is the legal relationship of employer and employee. The common law finds an individual to be an employee when the employer has the right to control and direct the individual not only as to the result, but as to the means and details by which the result is to be accomplished.13 The ruling stated that, in applying the common-law rules, the IRS considers whether the service recipient has behavioral and financial control over the worker and evaluates the relationship between the parties (including how they view their relationship). Behavioral controls are evidenced by facts that indicate whether the service recipient has the right to direct or control how the worker performs the tasks for which he is hired. Facts that illustrate the right to control include the provision of training. Financial controls are evidenced by facts that indicate whether the service recipient has a right to control the financial aspects of the worker's activities. These include significant investment, unreimbursed expenses, making services available to the relevant market, the method of payment and the opportunity for profit or loss. The IRS stated that it will look at the parties' agreements and actions with respect to each other, paying close attention to facts that show how the parties perceive their relationship and how they represent that relationship to others. On this basis, the Worker was an independent contractor, but not a government official. Although the ruling mentioned Rev. Rul. 87-41, it did not cite it as authority for its conclusion. Letter Ruling 200119035 may be an indication that the IRS is moving away from the rigid 20-factor test of Rev. Rul. 87-41 toward a more flexible facts-and-circumstances test, to determine whether an individual is an employee for FICA purposes.
Qualified Plan Cases and Rulings Cash-balance Plan Distributions The Eleventh Circuit reversed a district court decision and required a cash-balance plan to distribute a greater lump-sum amount based on the interest-rate assumptions in Sec. 417(e).14 The plan had failed to discount to present value the participant's lump-sum distribution. Lyons terminated employment with Georgia-Pacific Corp. (GP) in 1991 and was entitled to the vested portion of his benefit under the cash-balance plan. In 1992, Lyons elected to receive his accrued pension benefit as a lump sum, which he received in 1993. Because the GP plan was a cash-balance plan, the plan administrator paid Lyons his "hypothetical account balance." Lyons later consulted with the National Center for Retirement Benefits (NCRB) and found that the plan had distributed to him substantially less than he was entitled to receive under ERISA Section 203(e). The NCRB informed GP that Regs. Sec. 1.417(e)-1 required a minimum lump sum payable from a defined-benefit plan to be no less than the present value of the participant's normal retirement benefit; the present value of Lyons' normal retirement benefit exceeded the amount in his "hypothetical account." GP explained to NCRB that the defined-benefit plan was a cash-balance plan. GP paid the amount in Lyons' hypothetical account without adjusting for the interest rate for discounting required in the regulations. The company believed that the Sec. 417 interest-rate restrictions applied only to involuntary distributions under $3,500. The district court granted summary judgment for GP, finding that it had not violated ERISA Section 203(e), because the regulations were an "unreasonable construction." Court's analysis: The principal issue for the Eleventh Circuit was whether a lump-sum distribution has to be calculated using the present-value method in the regulations. Unlike a defined-contribution plan, a cash-balance plan does not have individual accounts; thus, the "accrued benefit" under the plan is not the amount in the participant's personal account but, rather, an amount derived from the plan's formula. The formula roughly approximates the employee's hypothetical account, but is not necessarily the same. Thus, Lyons did not have a statutory right to the amount found in his hypothetical account prior to normal retirement date, and GP had no right to limit any distribution to him to that amount. Instead, Lyons earned a vested interest in an amount at normal retirement date, to be calculated under the plan by projecting forward the amount in his hypothetical account using the plan's interest-credit rates. According to the regulations, once the normal retirement benefit is determined, it is then discounted to present value using the Pension Benefit Guaranty Corporation (PBGC) rate to calculate the participant's lump-sum distribution. The court determined that the lump-sum distribution had to be calculated using the regulations; thus, the amount distributed to Lyons was incorrect. Distribution of the hypothetical account balance alone is insufficient when the interest-credit rate exceeds the PBGC rate. A cash-balance plan may look like a defined-contribution plan, but it differs. Under a cash-balance plan, participants may actually be entitled to much more than the hypothetical account balance, depending on the interest rate used for projections. The distribution is linked to the interest-credit rate and the prevailing PBGC rate.
Tax Levy and Plan Loan An IRS Technical Assistance15 from the IRS's Office of Associate Chief Counsel (EBEO) (prepared before the recent IRS reorganization) to Central California District Counsel stated that a plan which, by its terms, prohibited distributions until all outstanding loans are repaid did not have to honor a Federal tax levy. This position is contrary to the regulations. The issue was whether the Service can properly levy on a participant's interest in a profit-sharing plan if the plan terms bar the distribution of participants' interests under the plan before the repayment of all outstanding loans, and a participant's loan is outstanding. The document states, "In general, a qualified plan under IRC section 401(a) is not required to surrender pursuant to a levy assets held on behalf of a participant until the participant is entitled to receive benefits under the terms of the plan. Accordingly, if, under the terms of the plan, the participant is not entitled to a distribution because he has not yet repaid an outstanding plan loan, a plan may not be obligated to surrender plan assets pursuant to the Service's levy." The document cites no authority for this conclusion. Sec. 401(a)(13) requires a qualified plan to prohibit assignment or alienation of its benefits. Regs. Sec. 1.401(a)-13(b)(1) states that to satisfy Sec. 401(a)(13), a plan must provide that its benefits are not subject to, among other things, levy. Regs. Sec. 1.401(a)-13(b)(2) states that a plan provision satisfying Regs. Sec. 1.401(a)-13(b)(1) "shall not" preclude the enforcement of a "Federal tax levy."
Division Was Trade or Business The IRS ruled that a Sec. 401(k) plan can distribute benefits to transferred employees after the sale of an employer division, because the sale was one of a trade or business of the employer.16 The facts presented by the employer showed that the division was an independent business. The employer, a manufacturing business that maintained a Sec. 401(k) plan, was organized in three divisions. One division had separate production, workforce, management and customers, and maintained separate accounts and product lines, as well as a separate budget and invoicing. The division also appeared separately on the employer's balance sheet and maintained its own parts, personnel and sales departments. Its general manager was the only division employee to report to the employer's management; after the division was sold, the employer sought two rulings, that the (1) sale of the division constituted a disposition of substantially all of the assets of a trade or business (as required by Sec. 401(k)(10)(A)(ii)); and (2) distribution from the employer's Sec. 401(k) plan would not violate Sec. 401(k)(2)(B)(i). Sec. 401(k)(2)(B)(i) provides that distributions from a qualified cash or deferred arrangement (CODA) may not be made earlier than the occurrence of certain stated events, one of which is the sale by a corporation of substantially all the assets used in a trade or business. Regs. Sec. 1.401(k)-1(d)(4)(iv) defines "substantially all" as 85%. Because the division constituted a separate business of the employer and over 85% of its assets were sold, the IRS ruled favorably. Rev. Rul. 2000-2717 held that when an employer sold less than 85% of its assets to an unrelated buyer and the transferred employees continued to perform, without interruption, the same functions for the new employer as the old, there was a separation from service permitting a Sec. 401(k) distribution. Although issued later, Letter Ruling 20003604818 made no reference to Rev. Rul. 2000-27, which in effect repealed the Regs. Sec. 1.401(k)-1(d)(4)(iv) 85% rule.
Restorative Payment Was Business Expense The IRS ruled that payments made to a defined-contribution plan by its sponsoring employer to compensate the plan for a breach of fiduciary duty were deductible and did not disqualify the plan.19 From 1992–1997, a Sec. 401(k) plan provided that a participant could elect to receive a distribution as of the date of termination of employment. The plan provided that the value of the participant's account was determined as of the most recent "practicable" valuation date preceding the distribution date. On average, between two and 31Ž2 months elapsed between the valuation date and the actual distribution. During that time, the value of the account was fixed; thus, there were no allocations of investment gains or losses to the accounts during this period. After an investigation, Department of Labor (DOL) advised the plan sponsor that the plan fiduciaries had violated ERISA, because the plan failed to pay terminated plan participants earnings for the period from the valuation date to the distribution date. The DOL also advised the plan sponsor that it was liable for these amounts and that failure to restore them to participants might lead to legal action by the DOL and plan participants. The plan sponsor made a "restorative payment" to the plan, held in an unallocated account in the plan's trust and used to compensate affected participants for lost earnings. The plan's sponsor requested rulings that the restorative payment (1) is not a plan contribution; (2) will not cause the plan to be disqualified because it is a discriminatory or excess contribution; (3) will not result in taxable income to the plan participant when made; (4) will be deductible as a business expense. It also requested a ruling that distributions from the unallocated account will be eligible rollover distributions. Rulings: The IRS ruled that the restorative payment was not a contribution. The IRS noted that neither the Code nor regulations offer guidance on whether "restorative payments" are contributions subject to the law's various limits. Because the payment was made to replace investment gains, it was not a contribution. Further, the restorative payment will not disqualify the plan, but the IRS does not cite why. It appears that, because the restorative payment is not a contribution, its receipt by the plan and subsequent allocation could not cause the plan to be discriminatory or violate the Code's contribution limits. The restorative payment also will not result in currently taxable income to plan participants or their beneficiaries. Because the plan remains qualified, there is no question of current inclusion. The restorative payment is deductible under Sec. 162. Expenses to resolve actual or potential liability or uphold a business's reputation are deductible. For the payment to be deductible, the acts that gave rise to the litigation (or potential litigation) must have been performed in the ordinary course of business. There need not be a legal obligation to pay for the payment to be deductible. Finally, distributions of the restorative payments to plan participants are eligible rollover distributions, because the distributions came from a qualified plan. This ruling is not precedential, but it indicates the IRS's thinking on restorative payments. The restorative payment in the ruling was made to replace earnings. This fact made it easy for the IRS to rule that the payment was not a contribution that would be subject to the Code limits. It would be more difficult for the IRS to make the same finding for a payment on account of a missed or insufficient contribution.
Denial of Benefits Was Not Unreasonable An executive sued to force his employer to make a contribution to a qualified plan.20 The claim arose out of a dispute between the executive and the employer over whether certain amounts paid him were compensation as defined by the plan. The executive claimed that he did not need to name the plan as a defendant, because the contribution was to be made by the employer. Mein was an executive with Carus Corp. He was to earn a royalty on products sold and was provided "phantom equity" in the employer division he managed. As long as Mein was a Carus employee, his royalty payments were deemed compensation for Sec. 401(k) purposes. The plan defined "compensation" as all amounts received for services rendered and includible in gross income for income tax purposes. A difference of opinion arose over Mein's compensation agreement; Mein and Carus settled the dispute after arbitration. Under the settlement, Mein was to remain an employee until the end of 1989 and was to be paid $575,000 in four installment payments with interest, in exchange for release of any equity he had in the division he had managed. Carus gave Mein W-2 forms including these payments in gross income. In 1991, Mein wrote Carus asking whether the equity payments were compensation under the Sec. 401(k) plan. Carus, in correspondence that spanned two years, said that the payments were not compensation under the plan and no employer contributions would be made to the plan. After nearly 10 years of state court litigation, Mein filed suit in Federal district court against Carus and a minority shareholder, but did not name the plan as a defendant. He claimed that the plan terms required a contribution of four percent of his severance payment and sought a court order directing Carus to pay the contribution. The defendants moved for dismissal on the grounds that the plan was the only proper defendant. The district court agreed, but permitted Mein to file an amended complaint to add the plan as a defendant. Mein still insisted that he had no claim against the plan, only against the employer that had promised to contribute to the plan. A motion to dismiss was granted; Mein appealed. Seventh Circuit's analysis: The court noted that the Carus plan administrator was the corporation. Nevertheless, the court dismissed Mein's complaint, because the plan gave the administrator discretion to construe the plan; thus, the court could overrule the administrator's decisions only if unreasonable. The court found that the administrator's finding that the payments to Mein were not compensation for services was not unreasonable.
Transfer Did Not Disqualify CODA The IRS ruled that funds deposited into a nonqualified plan may be transferred to a qualified Sec. 401(k) plan without affecting CODA qualification.21 An employer maintains two plans. Plan A is a qualified plan that includes a CODA; Plan B is an unfunded nonqualified plan established to benefit certain of the employer's management HCEs. Plan A provides that employees make elective deferrals within the various statutory limits. Plan B provides that participants may defer up to the lesser of 25% of compensation or $30,000 per year (without statutory limits). All Plan B deferrals and earnings thereon are general assets of the employer and maintained either as book accounts or as assets of a rabbi trust established by the employer. Plan B deferrals are made under a salary-reduction agreement. Plan B permits the transfer of deferrals, earnings and related employer matching contributions to Plan A. The transfer must be completed by March 15 of the year following the year of the deferral. The transfer provision permits the employer to calculate the maximum permitted contribution to Plan A that can be made for a Plan B participant. Plan A was amended to provide that only amounts placed in Plan B that could have been deferred to Plan A could be transferred. The determination of the amount of pre-tax deferrals transferred from Plan B to Plan A would be calculated under the written plan terms. The plans precluded employer discretion as to the amounts transferred between the plans. Ruling: The IRS ruled that the transfer did not disqualify Plan A, because (1) the deferral to Plan B would have satisfied the requirements for a deferral to a qualified CODA, (2) employer discretion as to the transfer amount was barred by the plan terms and (3) the transfer was accomplished within 21/2 months after the close of the year during which compensation relating to the deferral was earned (Sec. 401(k)(3)). This ruling provides the IRS-approved system of ensuring the maximum deferral to a qualified plan and maintaining the balance of the employee's deferral in a nonqualified plan. According to the ruling, if the participant's Plan B salary deferral is more than the salary deferral the participant authorized to be made to Plan A, the difference will be refunded to him. If the amount transferred to Plan A from Plan B exceeds the amount that may be contributed by the employee to Plan A, the excess will be paid to the employee in cash. Once the money becomes a Plan A asset, it cannot revert to the employer without violating the Sec. 401(a)(2) "exclusive benefit" rule.
City Can Expand Grandfathered Sec. 401(k) Plan The IRS ruled that a city can expand its grandfathered Sec. 401(k) plan to employees not originally covered.22 The IRS declined to rule on whether the agencies whose employees were newly covered by the plan would be a single employer with the city. City M adopted two Sec. 401(k) plans before the passage of the Tax Reform Act of 1986 (TRA '86). M applied to the IRS for determination letters on June 25, 1985, and Jan. 24, 1986, which were issued. TRA '86 Section 1116(f)(2)(B)(i) provides that a government Sec. 401(k) plan cannot qualify if adopted after May 6, 1986. In the ruling, M sought to merge its Sec. 401(k) plans and make the combined plan available to several of its agencies, some or all of whose board members are appointed by M's mayor. M requested a ruling that would allow (1) restatement of the plan (and the adoption of the new plan without disqualifying it) and (2) offering the plan to city agencies without disqualifying it. Ruling: Regs. Sec. 1.401(k)-1(e)(4)(iv) provides that if a government unit adopted a Sec. 401(k) plan before May 6, 1986, a CODA adopted by the government at any time is treated as adopted before May 6, 1986. Further, if a government employer adopted a CODA before May 6, 1986, all its employees may participate. The IRS ruled that the restatement of the old plan into a new plan, and the adoption of the new plan by M, did not disqualify the new plan. However, the IRS declined to rule on M's request for a ruling extending the plan to other city agencies. According to Notice 96-6423 and Ann. 95-4824 (both cited in the ruling), until further guidance is issued, governments and tax-exempt entities may rely on a reasonable, good-faith interpretation of Sec. 414(b) and (c) to determine which government or tax-exempt entities must be deemed a single employer. The notice also states that when guidance is issued, it will be prospective and will not apply to plan years before 2001. Rev. Proc. 2001-4,25 also cited in the ruling, states that the IRS will not ordinarily rule on plan qualification or situations in which the problem is inherently factual. This ruling confirms that the IRS will permit a government body to expand coverage in (and restate a grandfathered CODA into) a new CODA without disqualifying the plan. Further, it confirms that Notice 96-64 is still valid.
ESOP Issues NUA Treatment for Lump-sum Distribution The IRS ruled that a plan participant who received a qualified plan single-sum distribution consisting of cash and employer securities can roll over the cash directly to an IRA, without having to recognize the net unrealized appreciation (NUA) on the employer securities.26 The plan had an elective contribution account, a matching contribution account and an ESOP account. The participant's ESOP account contained employer securities. The employer treated the plan as a single plan in its IRS determination-letter application, summary annual report and tax filings. On termination of employment, the plan participant was entitled to his entire plan interest. The participant transferred the employer securities to a brokerage account and rolled over the balance of the distribution to an IRA. The plan participant sought a ruling that he did not need to recognize the NUA, because the securities were part of a lump-sum distribution. Sec. 402(e)(4)(B) permits nonrecognition of NUA until the securities part of a lump-sum distribution under Sec. 402(e)(4)(D) are sold by the plan participant. Ruling: The IRS ruled that because the plan participant received the entire balance within one tax year, the distribution was a lump-sum distribution as defined in Sec. 402(e)(4)(D). The IRS also ruled that neither the Code nor regulations precludes a distribution from being treated as a lump sum for NUA nonrecognition purposes if part of the distribution is rolled over, even if directly. Regs. Sec. 31.3405(c)-1, Q&A-11, states that when part of a distribution is employer securities and part is directly rolled over, no withholding is required. This ruling makes clear that the recipient of a lump-sum distribution can use the direct rollover and NUA provisions simultaneously; the individual may also avoid withholding.
Stock Contribution Was Prohibited Transaction The IRS Chief Counsel's Office issued an Advice (CCA) adopting the DOL's position that the contribution of unencumbered property that reduces an employer's cash obligation to a defined-contribution plan is a prohibited transaction.27 It further concludes that, for purposes of obtaining the statutory exemption in Sec. 4975(d)(13), the term "qualifying employer securities" is defined in ERISA Section 407(d)(5), not Sec. 409(l). The CCA concludes that the Sec. 409(l) definition of qualifying employer securities is used to determine whether a plan qualifies as an ESOP, while the ERISA definition is used for prohibited-transaction purposes. The taxpayer, a corporation, established a combination stock-bonus/ money-purchase plan in 1990 intended to qualify as an ESOP. The IRS issued a favorable determination letter in 1994. The corporation was capitalized with voting common stock, Series A preferred stock and Series B preferred stock, none of which was publicly traded. The Series B preferred stock is nonvoting stock not convertible into common. It initially carried a dividend rate of 15.5%; after April 1991, the corporation could adjust the dividend rate to keep the share price at $1,000. Series B preferred stock, which was created solely to fund the plan, was contributed from 1991–1993. Contributions in 1994– 1996 were made in common stock. The stock-bonus plan language made employer contributions discretionary; the corporation's board passed resolutions authorizing contributions to the plan payable in stock. Advice: The IRS cited Keystone Consolidated Industries, Inc.,28 which held that the contribution of unencumbered property to a defined-benefit plan was a prohibited transaction; it also noted that it had never addressed the application of Keystone to a defined-contribution plan. It also cited DOL Interpretive Bulletin 94-3,29 which holds that an in-kind contribution to a defined-contribution plan that reduces an employer's obligation to make a cash contribution is a prohibited transaction (i.e., is a sale or exchange between the plan and the employer). Thus, the DOL has applied Keystone to defined-contribution plans. Neither the IRS nor the DOL opined on whether the board resolutions in the case created an employer obligation to make a cash contribution. Sec. 4975(d)(13) provides a statutory exemption from the prohibited-transaction sanctions for a plan that acquires qualifying employer securities, citing ERISA Section 408(e). The IRS found that because the Code relies on ERISA Section 408(e), the definition of qualifying employer securities is the one found in ERISA Section 407(d)(5)—not Sec. 409(l). The DOL has agreed to this finding. The IRS also found that the Sec. 409(l) definition of qualifying employer securities governs when determining whether a plan qualifies as an ESOP, because ERISA Section 407(d)(6) and ERISA Regs. Section 2550.407d-6(c) require an ESOP to qualify under the Code. Conclusion In the next issue, Part II of this article will focus on executive compensation, health and welfare and fringe benefit issues. |
