Benefits Under PPA ’06 Expand to Include Beneficiaries
The IRS has begun to follow through on the Pension Protection Act of 2006,
P. L. 109-280 (PPA ’06), to revise the rules for 401(k), 403(b), and
457(b) plans to allow for distributions to beneficiaries on account of hardship
or unforeseeable emergency.
Hardship Distributions
Under the old rules, hardship distributions from qualified cash or deferred
arrangements, such as Sec. 401(k) or governmental Sec. 403(b) plans, could
not be made before the occurrence of specific events. The hardship distribution
rules mandated that (1) these distributions be made on account of an “immediate
and heavy financial need” of the participant or the participant’s
spouse or dependent and (2) the distribution be necessary to satisfy their
financial need.
In an effort to use the safe-harbor standards provided in the regulations,
and to ensure that allowable distributable events met the permitted criterion
of being an “immediate and heavy financial” need, plans often
permitted distributions of elective contributions to a participant or a
participant’s spouse or dependents only for expenses described in
Regs. Sec. 1.401
(k)-1(d)(3)(iii)(B).
For example, plan sponsors and administrators would build into the terms
of their plan documents language that limited participant distributions
to those events listed specifically in the relevant regulations. Although
whether a condition will satisfy the requirement of being “an immediate
and heavy financial need” remains essentially determinable on the
basis of the relevant facts and circumstances in a particular case, certain
costs are deemed to per se satisfy this requirement. These costs
include but are not limited to:
- Costs for medical care that would otherwise be deductible under Sec.
213(d) (without regard to whether the cost exceeds 7.5% of taxpayers’ adjusted
gross income);
- Costs directly related to the purchase of a principal residence;
- Costs of tuition, related education fees, and room and board expenses
for up to 12 months of postsecondary education for the employee or the
employee’s spouse, children, and dependents (for tax years after
January 1, 2005);
- Costs necessary to prevent the employee’s eviction from his or
her principal residence or foreclosure on the mortgage on that residence;
- Costs for burial and funeral expenses for the employee’s deceased
parent, spouse, child, or dependent; and
- Costs for repairing damage to the employee’s principal residence
that would qualify for the casualty deduction under Sec. 165.
Allowing for these specific events in a plan document creates a safe-harbor
list of events that are per se acceptable to the IRS in satisfying
the immediate and heavy financial need standard. For example, the need to
pay funeral expenses would constitute an immediate and heavy financial need,
while the need to purchase a boat or a television would not. In addition,
because plan administrators are generally required to determine for themselves
whether these requirements have been satisfied, consideration of other sources
of plan funds (i.e., borrowing against account balances allowed under the
plan) or nonplan fund sources must be considered if known (though employers
may generally rely on written representations of the employee as to the
availability of other sources of funds).
PPA ’06
Under the new rules, as described in Notice 2007-7, plans permitting hardship
distributions of elective contributions using the safe-harbor costs listed
in the regulation may expand the class of individuals having the ability
to receive hardship distributions to include a primary death beneficiary
under the plan. This distinction is important; the rules as they existed
did not provide primary death beneficiaries (i.e., people with a beneficial
interest in an account on the death of the employee participant) with the
ability to receive hardship distributions as provided by the safe-harbor
event descriptions under the regulations. Notice 2007-7 elevates a person’s
beneficial interest, in that he or she may receive benefits on the death
of the plan participant, to the same level as a participant’s direct,
spousal, or family relationship interest (at least for purposes of taking
advantage of the hardship distribution regulations). Note, however, that
for this purpose, a “primary beneficiary under the plan” is
an individual who is named as a beneficiary under the plan and has an unconditional
right to all or a portion of the participant’s account balance under
the plan on the participant’s death.
Plans adopting these expanded hardship classifications must still meet all
other requirements applicable to hardship distributions—namely, the
requirement that the distribution be necessary to meet the financial need.
In addition, the same expansion to the class of individuals is applicable
to Sec. 403(b) plans, and these other requirements also continue to apply.
Unforeseeable Financial Emergency
In addition to its implications for Sec. 401(k) and 403(b) plans, Notice
2007-7 provides guidance on certain distributions made from Sec. 457(b)
or Sec. 409A arrangements (or deferred compensation arrangements for executives).
Under the new rules, these types of plans may treat participants’ beneficiaries
the same as they treat participants’ spouses or dependents in determining
whether the participant has incurred an unforeseeable financial emergency
as described in the regulations.
From Kirk Sinclair, J.D., Holtz Rubenstein Reminick LLP, Melville, NY
Nonqualified Deferred Compensation and Sec. 409A Final Regs.
Prior to Sec. 409A, the regulations applicable to deferred compensation plans,
particularly nonqualified deferred compensation (NQDC) plans, were somewhat
murky. After a number of corporate scandals, Congress legislated restrictions
for NQDC plans in 2004.
Since the enactment of Sec. 409A, interpretive guidance and proposed regulations
have been issued. On April 10, 2007, the IRS released final regulations
for Sec. 409A relating to NQDC plans (TD 9321). The new regulations are
applicable for tax years beginning on or after January 1, 2008. If the plan
was acting in “good faith” prior to the effective date of the
new regulations, relief will generally be granted if the plan was
not fully compliant with the guidelines issued. No extension beyond the
effective date is expected. Thus, every NQDC plan should be evaluated for
compliance with the new regulations and amended (if necessary) before the
end of 2007.
An NQDC plan is an arrangement compensating an employee for services after
the year in which they were actually performed. The purpose of many plans
is to defer compensation to later years when the recipient is expected to
be in a lower tax bracket or to merely defer payment of a tax (which has
value in and of itself). Organizations are using NQDC plans to provide top
executives with substantial retirement benefits that cannot be achieved
with qualified plans, such as a Sec. 401(k) plan. Currently many of these
plans are being marketed as supplemental executive retirement plans (SERPs).
NQDC plans can be very flexible and set up to the employer’s custom
needs to benefit a select few top executives, which is not normally allowed
under a qualified plan. The most common options made available to attract
and maintain key executives using NQDC plans are life insurance plans, excess-benefit
plans, top-hat plans, severance plans, deferred bonuses, vested trusts,
rabbi trusts, secular trusts, stock options, phantom stock, stock appreciation
rights, and golden, silver, tin, and pension parachutes. Many of these arrangements
are considered abusive, particularly in light of the events surrounding
Enron and other corporate scandals, allowing select members of management
to gain access and control of the monies while still deferring the compensation.
Before the final Sec. 409A regulations were issued, there was little statutory
guidance on NQDC plans. In order to clear up confusion, the American Jobs
Creation Act, P. L. 108-357, was signed into law in October 2004, with Sec.
409A effective on January 1, 2005. NQDC plans were required to act in good
faith during 2005 and amend plan provisions by December 31, 2005. The sponsor
was expected to amend any plan documentation in accordance with Sec. 409A
in 2005. Many organizations were changing their plans to comply when the
IRS introduced proposed regulations in September 2005, extending the compliance
date to the end of 2007. The final Sec. 409A regulations clarify the previously
proposed regulations, establish final rules for NQDC plans, and impose strict
penalties on any plan that does not comply.
Penalties
The penalties for noncompliant NQDC plans are extremely steep. With a noncompliant
NQDC plan, all amounts deferred are included in the individual’s gross
income to the extent these deferred amounts are not subject to a substantial
risk of forfeiture. For the years in which the plan was noncompliant, interest
is imposed on the amount of income not included calculated using a rate
of 1% greater than the interest rate on tax underpayments. Also, the amount
required to be included in the participants’ income is subject to
an additional 20% penalty tax. To avoid these harsh penalties, NQDC plans
need to comply with the finalized election, distribution, and funding rules.
Elections
The timing of the initial deferral election is well defined under Sec. 409A.
The initial deferral elections must be made by the participant before the
beginning of the tax year during which the compensation is to be earned
(Regs. Sec. 1.409A-2(a)(3)). There are two exceptions to this rule. The
first applies when the participant originally becomes eligible to participate
in the NQDC plan (Regs. Sec. 1.409A-2(a)(7)); the initial deferral election
can be made 30 days after the participant becomes eligible to participate
in the plan. The second exception applies to performance-based compensation
(Regs. Sec. 1.409A-2(a)(8)). The deferral election can be made as late as
six months before the end of a 12-month service period for performance-based
compensation (such as nonsalaried incentive pay).
Once the elections are set, Sec. 409A limits the ability to change the timing
of distributions. If an NQDC plan permits a change or delay in a distribution
from the plan, three conditions must be met: (1) A change to the election
may not take effect until at least 12 months after the date on which it
was made; (2) an election must be changed on a fixed schedule and may not
be made earlier than 12 months before the date of the first scheduled payment;
and (3) any payment redeferral must be made at least five years from the
original payment date.
Distribution Rules
Distributions from an NQDC plan must be made on a fixed schedule with payments
made only on fixed dates. Under Regs. Sec. 1.409A-3(a), there are a few
exceptions to this rule that permit early distributions in the event of
separation of service, disability, death, a change in control of the employer
corporation, or an unforeseeable emergency:
- The distribution to an employee separated from service cannot be made
until six months after the separation from service.
- A participant is “disabled” when he or she is physically
or mentally impaired for longer than 12 months.
- A change in ownership or control of a corporation can occur in three
ways:
- A person or group obtains more than 50% of the corporation’s
stock.
- 35% of the stock is acquired by a person or group over a 12-month
period, or the majority of the board members are replaced by directors
not endorsed by the prior members; both qualify as a change in effective
control.
- A change in control based on the sale of assets occurs when 40%
or more of the gross fair market value of the assets is acquired
by a person or group.
- Rules defining an unforeseeable emergency will be based on the definition
of that term used in Sec. 457. Included in the definition is a severe
financial hardship arising from illness, accident, casualty loss, or
similar unforeseeable circumstances arising to the employee, spouse,
or any dependents. The amount distributed may not be more than what
is reasonably necessary to meet the emergency needs and to pay any anticipated
tax on the distribution.
The timing of payments must be set on a fixed schedule with an ascertainable
beginning date (Regs. Sec. 1.409A-3(i)(1)(i)). Distributions cannot be made
simply on an agreement, such as “when I retire.” Sec. 409A prohibits
any acceleration of a distribution. This rule includes “haircut” provisions,
under which a beneficiary may take payments at any time, subject to a reduction
in amount. Also, any type of accelerated vesting is prohibited when used
as a device to accelerate benefits.
Under Regs. Sec. 1.409A-1(b)(4), there is an exception for short term deferrals
made 2½ months or less before the end of the tax year, in which the
amount is no longer subject to forfeiture. For example, if a calendar-year
employer awards a bonus on November 15, there is no noncompliant deferral
of compensation if the bonus is paid or made available to the employee by
the following March 15.
Assuming the plan complies with the distribution rules, it also has to meet
the funding requirements.
Funding
If an NQDC plan funds an offshore trust or places assets outside the United
States, the plan will not defer the compensation. Regs. Sec. 1.409A-1(a)(3)
abolishes the use of the popular offshore irrevocable trusts frequently
structured as “rabbi trusts,” making them subject to the Sec.
409A penalties. Rabbi trusts were initially popular because their funding
was subject to the employers’ creditors and therefore the compensation
was considered deferred. To make it more difficult for creditors to access
the funds, many of these trusts were set up offshore. Under Sec. 409A, contributions
or any assets transferred to trusts placed outside the United States for
the purpose of paying nonqualified deferred compensation are considered
property transferred and are taxed in accordance with Sec. 83, regardless
of whether or not the trust assets are reachable by creditors.
Under Regs. Sec. 1.409A-6, any assets transferred before March 22, 2006,
are not subject to penalties if the NQDC plan is brought into compliance
with Sec. 409A by January 1, 2008. Congress also enacted Sec. 409A(b)(3)
in the Pension Protection Act of 2006 for at-risk status employers. If an
employer or sponsor is experiencing financial difficulties such as bankruptcy,
the contributions will not be deferred.
How to Comply
To comply with the new distribution, election, and funding rules, organizations
will likely need to make changes to their NQDC plans. Any new payment elections
from plan participants that are permitted must be obtained and implemented
timely. The total amounts of deferrals are required to be shown on the individual’s
Form W-2, Wage and Tax Statement. If the individual is not an employee,
the deferrals must be shown on a Form 1099. The plan or arrangement should
be finalized and set forth in a written plan document, compliant with Sec.
409A, by December 31, 2007. Finally, the plans should be operated post-2007
in accordance with Sec. 409A and the new regulations thereunder.
From Jonathan Rose, Aidman, Piser & Company, P.A., Tampa,
FL
