Current developments in employee benefits.

Qualified Plan Qualification and Distribution Rules, DOL and IRS Positions on Qualified Plans

This two-part article provides an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and welfare benefit plans. Part I, published in November, focused on executive compensation and welfare benefit plans, including the special rules that apply to tax-exempt organizations and employee business expense arrangements. Part II, below, will focus on the recently released final nondiscrimination and coverage regulations under Secs. 401(a)(4) and 410(b); the final regulations on cash or deferred arrangements (CODAs) and employer matching plans; recent programs instituted by the IRS National Office to restore the qualified status to certain plans that inadvertently become disqualified; and new developments in the deduction for qualified plan contributions and the taxation of qualified plan distributions. The Revenue Reconciliation Act of 1990 (RRA) provided certain employers with overfunded defined benefit plans that currently provide retiree medical benefits with the ability to increase cash flow by using retirement plan assets to fund these medical benefits. At the same time, the excise tax on the reversion of plan assets was increased. These provisions will be discussed. The activities at the Department of Labor (DOL) regarding plan investments and recent court decisions on prohibited transactions between qualified plans and the employer will also be addressed.

Nondiscrimination Rules

On Sept. 9, 1991, final regulations outlining in detail the coverage and discrimination tests for qualified retirement plans were released. Known collectively as the nondiscrimination regulation package, regulations under Secs. 401(a)(4), 410(b), 401(a)(17), 401(1) and 414(s) were released together. Many practitioners have asked why it was necessary to release over 600 pages of regulations to interpret less than three lines of the Code, lines that have remained essentially unchanged for decades. The regulations represent an effort by the Service to impose consistency within government enforcement offices and among practitioners in the application of nondiscrimination rules for qualified retirement plans. Although practitioners will find the regulations voluminous, they are presented logically and their format will facilitate the researching of specific questions.

While a complete review of these regulations is beyond the scope of this article, the new rules on the following topics will be discussed: defined contribution plans; coverage (which is where most practitioners will focus their attention to determine whether a plan or component of a plan satisfies these rules); plan benefits, rights and features; allowing discrimination and coverage violations to be retroactively corrected; and age-weighted profit-sharing plans, an important type of retirement plan whose use will become much more prevalent as a result of these regulations.

* Defined contribution plans In general, a plan is qualified only if the contributions or the benefits provided under the plan do not discriminate in favor of highly compensated employees.(58) This test applies both to the form of the plan document and to the plan's operation.

A plan must meet the following three requirements to be considered nondiscriminatory. 1. Either the contributions or the benefits provided under the plan must be nondiscriminatory in amount.(59) 2. The benefits, rights and features of the plan must be available to employees in a nondiscriminatory manner.(60) 3. The effect of plan amendments (including amendments granting past service credit) and plan terminations must be nondiscriminatory.(61)

The regulations provide that certain employee groups (such as former employees) and certain benefits (such as those provided by employee contributions and health benefits under Sec. 401(h)) must be separately tested for discrimination.

Generally, the definition of a plan subject to testing under Sec. 401(a)(4) is the same as the definition of a plan under Sec. 410(b), applying the same permissive aggregation and mandatory disaggregation rules. A plan may be restructured into two or more plans based on employee groups, as long as each of the restructured plans independently satisfies the requirements of Secs. 401(a)(4) and 410(b).

A defined contribution plan generally will satisfy the nondiscriminatory amount requirement by showing that the contributions provided under the plan satisfy either the safe harbors in Regs. Sec. 1.401(a)(4)-2(b) or the general test in Regs. Sec. 1.401(a)(4)-2(c). Except in the case of an employee stock ownership plan (ESOP), a Sec. 401(k) plan or a Sec. 401(m) plan, a defined contribution plan can also satisfy the nondiscriminatory amount requirement by showing that the equivalent benefits provided under the plan are nondiscriminatory in amount under the cross-testing rules of Regs. Sec. 1.401(a)(4)-8. This results in higher contribution allocations for older employees, a technique that is becoming known as an age-weighted profit-sharing plan.

Using the cross-testing approach for testing discrimination, the older employee receives a larger allocation of the annual contribution because the amount provided to such an employee will not have as long a period to accumulate income to provide the prescribed benefit as an allocation provided for a younger employee. This test uses the length of time until retirement benefits are paid to favor the older employees. The allocation of larger amounts for older employees to achieve a retirement benefit that is a consistent percentage of compensation for all employees is not considered discriminatory.

Planning: To take advantage of the rule that allows an employer to consider the time until benefits will be paid out in testing for discrimination, the employer can design an allocation schedule that provides a uniform allocation of benefits as a percentage of compensation for each participant. The plan can be designed with a discretionary contribution or by specifying that a given percentage of compensation will be contributed annually for each participant. A defined contribution plan that converts contributions to benefits to test for discrimination in benefits can take advantage of the permitted disparity rules and include a vesting schedule.

In general, the contribution allocated to each employee is projected to the future value at the employee's retirement age using an interest rate of 7 1/2% to 8 1/2%. This amount is then converted to a life annuity, using a standard mortality table and an interest rate between 7 1/2% and 8 1/2%. The annuity is then expressed as a percentage of current compensation. As long as employees receiving equivalent percentages of compensation satisfy the Sec. 410(b) rules, the plan is nondiscriminatory. In adopting these plans, the employer will need to take care that no employee receives an allocation of more than $30,000, or 25% of compensation. In addition, if the plan is top heavy, a minimum benefit must be provided.

Alternative methods: Plans may use certain alternative methods to demonstrate that contributions are nondiscriminatory in amount. For example, plans may satisfy the nondiscriminatory amount requirement on a restructured basis by separating one plan into component plans that provide different benefits. The regulations also permit plans with multiple formulas to satisfy the nondiscriminatory amount requirement on the basis of each separate formula, provided that each formula separately satisfies the safe harbor requirements in Regs. Sec. 1.401(a)(4)-2(b).

Safe harbors: The safe harbors require that the plan have a uniform normal retirement age for all employees and a uniform benefit formula for allocations, and base allocations or benefits on a nondiscriminatory definition of compensation. In addition, uniform vesting and service crediting rules apply under the safe harbors, although plans may use different methods of calculating service for different purposes, provided they are uniform within each application.

There are two safe harbor tests for defined contribution plans. The first is design-based and permits a defined contribution plan with a uniform allocation formula to satisfy the nondiscriminatory amounts test without calculating allocation rates for individual employees. This test is satisfied if all employees receive an allocation of a uniform percentage of compensation or a uniform dollar amount.(62)

The second safe harbor permits a defined contribution plan with a uniform allocation formula weighted for age or service to satisfy the nondiscriminatory amount test if the average allocation rate for highly compensated employees does not exceed the average allocation rate for nonhighly compensated employees. Plans using this safe harbor must provide the same number of points for each age, year of service and unit of compensation, not to exceed $200. This safe harbor applies only to plans in which (1) points are provided on a uniform basis for compensation and for age or service and (2) an employee's allocation for a plan year is determined by multiplying the total amount to be allocated to all employees by a fraction, the numerator of which is the employee's points for the plan year, and the denominator of which is the sum of the points of all employees in the plan for the plan year.(63)

Rate-segment restructuring: The final regulations reformulate the general (non-safe harbor) test to incorporate the concept of rate-segment restructuring. In applying the general test, the employer must identify, for each highly compensated employee, the group of employees consisting of that highly compensated employee and all other employees (both highly compensated and nonhighly compensated) with equal or greater allocation rates (a "rate group"). Thus, depending on their allocation rates, employees may be included in more than one rate group. A rate group must be determined for each highly compensated employee benefiting under the plan. Each rate group must satisfy Sec. 410(b) as though it were a separate plan. Special rules are provided for applying the nondiscriminatory classification test and the average benefits test to rate groups.(64)

Thus, the plan is first restructured into rate groups, each of which is tested as though it were a separate plan currently benefiting the group of employees included in the rate group. If each of these rate groups satisfies the requirements of Sec. 410(b) as though it were a separate plan, the plan in total satisfies the nondiscriminatory amount requirement. Because restructuring on the basis of rate groups takes into account all employees with allocation rates at or above the allocation rate being tested, this approach automatically achieves the most favorable results that were available under the restructuring rules in the proposed regulations. A similar rate group testing method applies for testing benefits under the general test--the test that must be satisfied in an age-weighted profit-sharing plan.

* Coverage requirements The coverage rules apply to determine whether a plan benefits employees on a nondiscriminatory basis. The test is generally applied on a plan basis, taking into account certain mandatory disaggregation and permissive aggregation rules. Under these rules, the portion of a plan that is a Sec. 401(k) or 401(m) plan, an employee stock ownership plan, or a plan benefiting collectively bargained employers or employees in a separate line of business in accordance with Sec. 414(r), is disaggregated.(65) Under the permissive aggregation rules, any two or more plans not required to be disaggregated can be aggregated. No plan or component plan can be combined with two or more plans to form more than a single plan.(66)

Having defined the plan that will be tested for coverage, either of two tests can be satisfied. If the ratio of the percentage of nonhighly compensated employees benefiting under the plan to the percentage of highly compensated employees benefiting under the plan is at least 70%, the Sec. 410(b) coverage rules are satisfied.(67) Alternatively, the plan can satisfy a nondiscriminatory classification test and meet an average benefit percentage test to satisfy Sec. 410(b).(68)

To satisfy the nondiscriminatory classification test, the classification of employees benefiting under the plan must be reasonable and nondiscriminatory.(69) A classification is reasonable if it is established under objective business criteria, e.g., specified categories, salaried versus hourly workers, or geographic location. Enumeration of employees by name is not reasonable.(70) To be nondiscriminatory, a certain percentage of employees must benefit under the plan. The percentage of employees that needs to benefit under the plan is lower if the employer has a high concentration of nonhighly compensated employees in its work force.(71)

Thus, if 90% of all employees in the employer's work force are nonhighly compensated, a plan that benefits 27 1/2% of all nonhighly compensated employees benefits a nondiscriminatory classification of employees. In fact, if the plan benefits at least 20% of the nonhighly compensated employees and certain other facts and circumstances exist, the nondiscriminatory classification test will be satisfied.

To satisfy the average benefit percentage test, the benefit percentage for nonhighly compensated employees must be at least 70% of the benefit percentage of highly compensated employees.(72) To determine the benefit percentage for each group of employees, the benefits realized under certain of the employer's plans for each employee are expressed as a percentage of compensation. Having determined each employee's benefit percentage, an average benefit percentage is then calculated for each group. The employee's benefit percentage for defined benefit and defined contribution plans of the employer can be computed separately.(73) In making these calculations, social security benefits can be considered and various alternative definitions of compensation can be used.(74)

In applying the ratio percentage test, the nondiscriminatory classification test and the average benefits test, certain employees can be excluded.(75) Former employees are tested separately and special rules apply for them.(76) If

an employer has only highly compensated employees, its plans are deemed to satisfy these rules.(77) Similarly, if a plan covers only nonhighly compensated employees, the rules are deemed satisfied.(78)

* Benefits, rights and features The final Sec. 401(a)(4) regulations also require that benefits, rights and features provided under a qualified plan must not discriminate in favor of highly compensated employees.(79) The benefits, rights and features subject to this requirement are all optional forms of benefit, ancillary benefits, and other rights and features available under the plan. A benefit, right or feature is available on a nondiscriminatory basis only if it separately satisfies current and effective availability requirements.(80)

An optional form of benefit is a distribution alternative (including the normal form of benefit) that is available under a plan with respect to protected or early retirement benefits and retirement subsidies. Different benefit formulas or accrual methods within the same form of benefit do not necessarily create more than one optional form of benefit for testing purposes.(81) An ancillary benefit includes social security supplements, most disability benefits, ancillary life and health insurance benefits, death benefits, shut-down benefits and other similar benefits.(82) Rights and features include any right or feature available to employees under the plan, other than those previously described as optional forms of benefit or ancillary benefits, e.g., plan loan provisions, the right to direct investments, the right to a specific class of employer stock, and the right to make rollover contributions and transfers to and from the plan. Different rights or features exist if the right or feature is not available on substantially the same terms.(83)

For a benefit, right or feature to be "currently available," the plan must provide the benefit, right or feature to a group of employees that satisfies either the ratio percentage test of Regs. Sec. 1.410(b)-2(b)(2) or the nondiscriminatory classification test of Regs. Sec. 1.410(b)-4, without regard to the average benefit test of Regs. Sec. 1.410(b)-5.(84) Whether a benefit, right or feature subject to specified eligibility conditions is currently available to an employee is a facts and circumstances determination. Generally, the fact that an employee may, in the future, satisfy a precondition of receipt of the benefit, right or feature (such as an age or service requirement) does not make the benefit, right or feature currently available to the employee.(85) However, any specified age or service condition with respect to an optional form of benefit or social security supplement (but not with regard to ancillary benefits, supplements or other rights and features) is disregarded in determining whether the benefit is currently available.(86)

Age and service conditions are not disregarded for determining current availability of a time-limited benefit or feature, such as an early retirement window benefit. Conditions on a benefit or feature that may be disregarded include the following.

* Specified conditions on availability, such as requiring termination of employment, death, satisfaction of a specified health condition, disability, hardship, marital status, etc.(87) * For plans that provide mandatory cash-outs for terminating employees with a vested accrued benefit having an actuarial present value of $3,500 or less, any condition on a benefit, right or feature that requires the employee to have a vested accrued benefit greater than $3,500.(88) * For plan loans, a provision that a participant must have an account balance sufficient to be eligible to receive the minimum loan amount (not to exceed $1,000).(89)

An optional form of benefit or other right or feature (not an ancillary benefit) that is permanently and prospectively eliminated is treated as being currently available to a nondiscriminatory group of employees if it satisfied these rules as of the elimination date.(90)

Under the effective availability test, the group of employees to whom the benefit, right or feature is effectively available must not discriminate in favor of highly compensated employees.(91) This is a facts and circumstances test that must be satisfied in addition to the current availability test.

An optional form of benefit or other right or feature under a plan (not an ancillary benefit) that satisfied the nondiscriminatory availability rules both immediately before and immediately after a merger, stock or asset acquisition, or similar transaction (and continues to be offered on the same terms) will be deemed to satisfy the current availability requirements for all subsequent years. The "immediately before and after" test is applied without taking into account the Sec. 410(b)(6)(C) grace period; the "immediately before" test is applied to employees of the former employer, and the "immediately after" test is applied to the employees of the current employer.(92) The employer may expand the group to whom this special rule applies to include new employees of the acquired employer hired during a transition period.

A plan must satisfy the nondiscrimination provisions with respect to benefits, rights and features provided to nonexcludible employees with accrued benefits who are not currently benefiting under the plan, i.e., "frozen participants."(93)

Benefits, rights and features generally must each be separately tested, unless a special aggregation rule is met.(94) The rule allows permissive aggregation when one of the aggregated benefits is, in all cases, of inherently equal or greater value than the other, and the benefit with the higher inherent value passes the nondiscriminatory current and effective availability tests.

* Correction period To ease compliance, the final regulations provide a retroactive correction period. This enables the employer to increase benefits or coverage after the plan year-end in order to satisfy these rules. The regulations limit the circumstances in which the retroactive amendment may be made, and the amendment must be made within a 9 1/2-month period after the plan year-end.(95)

For purposes of satisfying the nondiscriminatory amount requirement of Regs. Sec. 1.401 (a)(4)-1(b)(2) or the minimum coverage tests of Sec. 410(b), a plan may be retroactively amended to increase accruals or allocations for employees who benefited under the plan in the preceding year, or to grant accruals or allocations to employees who did not benefit under the plan during the preceding year. A plan may also be amended to correct a discriminatory plan amendment that causes the plan to fail the requirements of Regs. Sec. 1.401(a)(4)-5(a).

A plan cannot be retroactively amended to provide a benefit, right or feature that was previously not available (e.g., the right to direct investment) to satisfy the nondiscriminatory availability requirements of Regs. Sec. 1.401(a)(4)-4, unless the benefit, right or feature is directly related to an increase in allocations or accruals described above.

Retroactive plan amendments must meet the following conditions.(96)

* Accruals or allocations may only be increased (not decreased) by plan amendment. * The amendment must be effective as if it had been in place on the first day of the preceding plan year. * The amendment must be adopted and implemented by the fifteenth day of the tenth month after the close of the plan year in order to be effective for the preceding plan year (an extension is provided if a determination letter is requested). * The additional allocations and accruals under the amendment must separately satisfy Sec. 410(b) and Sec. 401(a)(4) for the preceding plan year. This rule, which is incorporated to prevent employers from using this retroactive correction period to increase benefits for highly compensated employees, does not apply if the amendment is made solely to conform to one of the safe harbors in Regs. Sec. 1.401(a)(4)-2(b) or -3(b).

A retroactive amendment is effective only for purposes of Sec. 401(a), including Secs. 401(a)(4), 401(a)(26), 401(1) and 410(b). The amendment is not given retroactive effect for purposes of deductions under Sec. 404 or minimum funding requirements under Sec. 412. In addition, the retroactive amendment is not applicable to nonvested terminated employees.

Sec. 401(k) and 401(m) Plans

On Aug. 9, 1991, the IRS issued final regulations relating to certain cash or deferred arrangements under Sec. 401(k) and employee and matching contributions under Sec. 401(m). These regulations consolidate and modify 1988 proposed and final regulations and the 1990 amendments to those regulations.

Plans must be amended to restrict participant elective deferrals in plans maintained by the same or a related employer to the Sec. 402(g) dollar limit (currently $8,475). Corrective distributions of deferrals that exceed this dollar limit prevent disqualification in operation under Sec. 401(a)(30).(97)

A partnership can maintain a Sec. 401(k) plan covering partners. An arrangement that directly or indirectly permits individual partners to vary the amount of contributions made on their behalf is a Sec. 401(k) plan. For example, a plan that provides for contributions of 10% of compensation for each partner or employee, but permits any partner to elect to have no contributions (or a contribution of less than 10%) made, is deemed to be a Sec. 401(k) plan. Thus, such a plan would be subject to the limits imposed by Secs. 401(k) and 402(g).(98) One-time irrevocable elections on commencement of employment, or initial eligibility under an employer plan, to have a specified amount or percentage of compensation (including no amount) contributed to the plan are not treated as Sec. 401(k) plan elections.(99)

The final regulations clarify the timing of a partner's election to defer compensation. According to the regulations, the election may be made at any time before the end of the partnership's tax year. For plan years beginning before Oct. 14, 1991, a plan may permit a partner to make a cash or deferred election until the due date, including extensions, for filing the partnership federal income tax return for its tax year ending with or within the plan year.(100) Thus, if a partnership and its plan both have calendar year-ends, partner elections for the 1991 plan year are not required until the partnership's federal income tax return's extended due date.

The final regulations treat any matching contributions based on a partner's elective or after-tax contributions as elective contributions made on behalf of the partner.(101) Thus, the matching contributions will be subject to the Sec. 402(g) and 401(k) tests.

* Conditions for relief In conjunction with the release of the final Sec. 401(k) regulations, the IRS released Rev. Proc. 91-47,(102) providing limited relief for certain partnership Sec. 401(k) plans. If certain procedures are followed, a partnership deferral arrangement will be treated as qualified, even if the plan was not timely amended in accordance with Notice 88-127.(103)

To qualify for relief, the following conditions must be satisfied by the last day of the first plan year beginning on or after Jan. 1, 1992 (unless the plan is already under examination).

* The plan must distribute the excess deferrals and all income allocated to them. * The plan must satisfy the actual deferral percentage (ADP) test by distributing excess contributions with earnings or contributing qualifying nonelective contributions. * The plan administrator must issue a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc., for the corrective distribution, which is taxable in the year distributed. * The plan must meet the Sec. 401(a) qualification requirements for future years.

If the conditions for relief are met, the following provisions apply. * The IRS will not treat the deferral arrangement as nonqualified for plan years beginning before Jan. 1, 1992. * The plan will not be disqualified solely because of the existence of excess deferrals. * Deductions for elective contributions will not be disallowed. The excess deferrals need be taken into account only once in the year of distribution. * Elective distributions for the years in question may be distributed without regard to Sec. 401(k) distribution restrictions. * The nondeductible Sec. 4972 excise tax will not apply to contributions nondeductible by operation of Rev. Proc. 91-47.

The final regulations clarify that a collectively bargained plan (or portion of a plan) automatically satisfies the nondiscrimination requirements of Sec. 401(a)(4). Thus, the plan does not need to satisfy the ADP test or the actual contribution percentage (ACP) test to satisfy the qualification rules. However, if a collectively bargained plan does not pass the ADP test, an elective contribution by an employee is includible in the employee's gross income under Sec. 402(a)(8).(104) A special transition rule provides that the elective contributions under a nonqualified CODA do not need to be included in gross income for plan years beginning before Jan. 1, 1993.

The regulations clarify that the requirements of Sec. 401(k) and (m) are applied separately to separate plans as defined under Sec. 414(1), taking into account the mandatory disaggregation and permissive aggregation rules under Sec. 410(b).(105) The portion of a plan that is an ESOP cannot be combined with the non-ESOP portion of a plan to satisfy the requirements of Sec. 401(k). In addition, plans cannot be aggregated unless they have the same plan year.

Restructuring cannot be used to comply with the requirements of Sec. 401(k) and (m) for plan years beginning after Dec. 31, 1991. For plan years beginning before Jan. 1, 1992, such plans may be restructed on the basis of employee groups as permitted under the regulations proposed on May 14, 1990. The employee groups must be based on some employment-related commonality other than identical deferral percentages, e.g., hourly and salaried workers, or employment in a specific division or location.(106)

* Distribution rules The final regulations clarify the hardship distribution rules to permit distributions on account of tuition and related education fees for the "next 12 months" of post-secondary education, instead of only for the "next semester or quarter." The final regulations also allow distributions necessary for the taxpayer (or spouse or dependents) to obtain medical services, as well as for previously incurred medical expenses. Finally, a distribution may include a gross-up for anticipated federal and state income taxes and penalties.(107) An employer can amend a plan to specify or modify nondiscriminatory and objective standards for meeting the hardship distribution requirements or eliminate hardship distributions without violating the Sec. 411(d)(6) rule prohibiting a cutback in benefits.(108)

While Sec. 401(k) and 401(m) plans do not generally permit distributions, other than hardship distributions and distributions after an employee reaches age 59 1/2, distributions in the event of mergers and acquisitions are facilitated.(109) A special de minimis 2% employee eligibility rule is available for determining successor plans following a Sec. 401(k) plan termination. For distributions made in connection with the disposition of a subsidiary's assets, the regulations provide that the distribution will not be in connection with such an event unless made by the end of the second calendar year after the calendar year in which the disposition occurred. The sale of substantially all the assets used in a trade or business means the sale of at least 85% of the assets. Unfortunately, the rules will not apply to partnership plans.(110)

* Elective deferrals A Sec. 401(k) plan is not qualified if any other benefit is contingent on the employee's elective deferrals. The regulations clarify that participation in a nonqualified deferred compensation plan is contingent on an employee's elective deferrals if an employee may receive additional deferred compensation under such a plan if the employee makes elective contributions.(111) Thus, an arrangement that allows an employee a 10% deferral and allows the employee to choose between deferring amounts into a Sec. 401(k) plan or nonqualified deferred compensation plan is not qualified. Deferred compensation under a nonqualified plan that is dependent on an employee making the maximum Sec. 402(g) deferral, the maximum Sec. 401(k)(3) elective contribution, or the maximum elective contribution permitted under the terms of the plan does not violate the contingent benefit rule.

In general, compensation for purposes of the Sec. 401(k)(3) test is compensation as defined in Sec. 414(s).(112) The period used for determining an employee's compensation must be either the plan year or the calendar year ending within the plan year. Alternatively, an employer may limit the period to that portion of the plan year or calendar year in which the employee was an eligible employee. If the employer uses this alternative, it must be applied uniformly to all eligible employees for the plan year. In addition, compensation is limited to $200,000 (indexed to $222,220 for 1991).(113)

A frequent problem with Sec. 401(k) plans is that elective deferrals cause the plan to exceed the Sec. 415 annual addition limitations. The regulations provide a simple method of correcting this problem. The regulations allow plans to distribute elective contributions to correct excess annual additions if the excess resulted from a reasonable error in determining compensation because of the amount of elective deferrals that a participant would make.(114) Unfortunately, this exception is intended to be narrowly interpreted to include only those instances in which compensation is not accurately determined, and not to include those instances in which elective contributions exceed the Sec. 415 limits because the employee deferred amounts under the assumption that a lower employer contribution would be made.

* Excise tax The regulations clarify that the 10% excise tax on excess contributions and excess aggregate contributions not distributed within 2 1/2 months after the plan year-end is due on the last day of the fifteenth month after the plan year of the excess contribution or excess aggregate contribution. In addition, the regulations provide a special rule for simplified employer pension plans: The employer is exempt from the excise tax if the employer provides a special notice to employees concerning the effect of excess contributions.(115)

* Employer deductions In releasing Rev. Rul. 90-105,(116) the IRS halted the practice of accelerating deductions for Sec. 401(k) elective deferrals. Plan contributions made after the close of the employer's tax year must be on account of that tax year to be deductible on the employer's tax return for that year. Payments made for Sec. 401(k) deferrals and Sec. 401(m) matching contributions relating to compensation earned after the end of that tax year do not meet this test. The ruling applies prospectively, requiring a change in accounting method for taxpayers who had previously deducted post-year-end contributions.

Under the ruling, a plan cannot properly treat post-year-end contributions attributable to compensation earned after the close of the tax year "in the same manner" as it would treat a payment actually received on the last day of the employer's tax year, because the underlying compensation for those contributions was not yet earned as of the last day of the employer's tax year. Thus, the corporation in the ruling did not satisfy the requirements of Sec. 404(a)(6) as to the contributions attributable to compensation earned after the corporation's year-end. This is true regardless of whether the taxpayer is a cash- or accrual-method taxpayer. The ruling stated that Sec. 404(a)(6) does not make a contribution deductible in a tax year when the contribution could not otherwise have been deducted in that tax year had it actually been paid on the last day of the tax year.

Employers using a method of accounting that is inconsistent with Rev. Rul. 90-105 must change their method of accounting. If the employer makes the change in accordance with Rev. Rul. 90-105, the change will be effective for purposes of claiming deductions under Sec. 404(a) for all elective deferral and matching contributions actually paid after Dec. 31, 1989, except to the extent the contributions were deducted on a return filed before Dec. 7, 1990. (Note: The Cumulative Bulletin erroneously lists this date as Dec. 7, 1989.) There is no Sec. 481 adjustment for this change in method. Rev. Rul. 90-105 also includes procedural information on how to report the change in accounting method on the corporation's first return filed after Dec. 7, 1990. Any contributions previously deducted before the effective date of Rev. Rul. 90-105 cannot be deducted again under the method of accounting prescribed by Rev. Rul. 90-105. Therefore, corporations that previously accelerated deductions will have a reduced contribution deduction for the year of change (generally 1990).

Requalifying Disqualified Retirement Plans

The IRS has two new programs for dealing with plans with qualification problems that do not warrant plan disqualification. The Employee Plans Closing Agreements Pilot Program (CAP) allows key districts to enter into closing agreements that impose monetary tax sanctions on plan sponsors, instead of disqualifying the plan. The Administrative Policy Regarding Sanctions (Administrative Policy) provides guidelines under which six criteria are examined to determine whether a plan should be disqualified.

* CAP provisions The CAP provides for continued qualification of a plan when an operational or formal qualification requirement has not been met. Through the closing agreement, the qualification failure must be retroactively (for all years, not just years open under the statute of limitations) and prospectively corrected. Any contributions made to the plan to correct the defect will be deductible up to the Sec. 404 limits.(117)

The CAP also provides for a monetary sanction, which is not deductible by any party. The IRS will determine the total amount of tax that would have been owed by the employer, the plan and the participants for all years that the plan would have been disqualified. This amount may be negotiated downward as part of the closing agreement, but negotiation is not mandatory. The employer/sponsor may decide to pay the entire monetary sanction to maintain employee goodwill associated with the plan. In that case, only one closing agreement is necessary. If the employer pays only its portion of the sanction, the IRS may enter into closing agreements with the plan for the sanction against the trust, and with the individual participants.

The CAP gives the key district offices the discretion to enter into closing agreements primarily in the following four areas.

1. Failure to timely amend a plan for the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Tax Reform Act of 1984 (TRA 1984) and Retirement Equity Act (REA). 2. Improper application of an integration formula. 3. Failure to apply full vesting in a partial termination. 4. Any operational top-heavy violation under Sec. 416.

The key district offices also have the latitude to enter into closing agreements in other areas in which qualification defects exist. The IRS will consider the tax equities of each situation in determining whether a closing agreement is warranted. However, the following three areas are not available for closing agreement relief from disqualification.

1. Exclusive benefit violations. 2. Situations involving significant discrimination in favor of highly compensated employees. 3. Repeated, deliberate or intentional violations.

* Administrative Policy provisions The Administrative Policy relief from disqualification is more narrowly drawn than the CAP. It is generally available only when plans comply with the qualification requirements in both form and operation, but through some oversight an isolated disqualifying operational defect occurs. It is not available for late amenders (for the TEFRA, the TRA 1984 or the REA) or exclusive benefit violations. If a plan does not fit the criteria for Administrative Policy relief, it may still qualify for relief from disqualification under the CAP. The monetary tax sanction of the CAP is not discussed in the Administrative Policy.

To qualify for Administrative Policy relief, a plan must meet six criteria for the defect to be considered "nondisqualifying."(118)

1. The operational defect must be an isolated, insignificant occurrence. 2. The plan must have either a history of compliance with the qualification requirements or, if a relatively new plan, the violation must be corrected before examination. 3. The plan must have established operational procedures to ensure compliance with Sec. 401(a), including procedures in the area in which the violation occurred. 4. The procedures must have been followed, but through an oversight or a mistake in applying those procedures, an operational violation occurred. 5. If dollar amounts are involved in the violation, the amounts are insubstantial in view of the total facts of the case. 6. The taxpayer must have made an immediate and complete correction of the violation once it was discovered.

Employers that maintain retirement plans that could be disqualified should review the facts surrounding the qualification violation and determine if they should take advantage of one of these programs. In some cases, it may be appropriate to contact the IRS and initiate these procedures.

Qualified Plan Contribution Deductions

In Sargent,(119) the Eighth Circuit reversed a Tax Court finding that two professional hockey players were employees of their NHL team, holding that the players were instead employed by their respective personal service corporations (PSCs), thus enabling each PSC to adopt a qualified retirement plan without considering other entities' employees in satisfying the discrimination and coverage tests. The players had entered into employment contracts with the PSCs, which in turn entered into service contracts with the team. The court upheld the validity of the PSCs as separate entities, and refused to impute directly to the players all payments made by the team to the PSCs.

Originally, the IRS issued deficiency notices to the players for not including in income the entire amount the NHL club paid to their respective PSCs. The Tax Court upheld the deficiencies, holding that because the players were members of a "team," the requisite control of the players lay with the team and not the PSCs. The Eighth Circuit reversed, holding that the players were employees of their respective PSCs and not the team. The appeals court rejected the Tax Court's "team" concept and looked to two factors in determining whether the PSC, rather than the service-recipient, was the true controlled of the service-provider.

* The service-provider must be an employee of the PSC, whom the PSC has the right to direct or control in some meaningful sense. * There must exist between the PSC and the service-recipient a contract or similar indicium recognizing the PSC's controlling position.

Each player had negotiated a bona fide, arm's-length contract between his PSC and the team before signing on with the team. Therefore, the court held that the contracts should and do provide the requisite control for the players to be considered employees of their respective PSCs.

The court also discarded the Tax Court's application of the assignment-of-income doctrine by finding bona fide contracts between the team and the PSCs and between the PSCs and the players. According to the court, recognition must be given to corporations as taxable entities that, to a great extent, rely on the personal services of employees to produce corporate income. As long as the corporation carries on some form of business, the tax advantages properly flowing form incorporation should nto be questioned.(120) Here, the PSCs withheld income and employment taxes from payments to the players, made contributions to retirement plans, filed employment and corporate income tax returns and paid appropriate taxes. These actions were far removed from the type of conduct forbidden under the assignment-of-income doctrine, thus convincing the court of the validity of the corporate entities.

In this case, the hockey players established qualified plans for themselves and retained the flexibility over the design and level of benefits provided by the plans. However, Sec. 414(m)(5) was enacted after the years at issue. While that section must be considered before the availability of separate plans for the individual players can be determined, it does not appear that professional sports would constitute a management activity that would require aggregation between the team and the PSC.

Calculating the maximum deductible contribution for a self-employed person (including partners and sole proprietors) can be difficult. The definition of earned income, as it is adjusted for employment taxes, complicates the calculation. Although the definition of earned income has not changed for 1991, the contribution bases for both the old age survivors' and disability insurance (OASDI) and hospital insurance portions of the self-employment tax are increased over their 1990 levels. Because these amounts are deductible in computing contributions on which deductions are based, the calculations are complicated. With two different wage bases for calculating self-employment taxes, it will be easiest to calculate the tax and then reduce net earnings from self-employment before the plan contribution by the deduction for self-employment taxes. Done this way, the maximum contribution will be 13.0435% of the adjusted number. The maximum $30,000 plan contribution is achieved in a 15% profit-sharing plan at an earnings level of $235,123. Self-employed persons adopting a 25% money purchase pension plan will realize their maximum $30,000 contribution at a $155,123 earnings level.

Qualified Plan Distribution Rules

With the gradual increase in individual tax rates after the 28% tax rate adopted in 1986 and the growing realization that many qualified plan distributions will be subject to the excise tax for excess distributions, many plan participants and beneficiaries are reviewing the possibility of taking lump-sum distributions. If the participant has made an election under the transition rules of TEFRA Section 242, any modification of the terms of the election (other than changing or adding beneficiaries) will revoke the original election; if installment distributions were originally elected, the distribution of a lump sum will be a modification.

If a participant modifies his election, the change will constitute a retroactive revocation of the election. Thus, if an employee who was age 74 in 1990 changes the method of distribution under his Sec. 242(b)(2) election to receive an installment payment instead of the annuity he had elected, the required minimum distributions for prior years will need to be made. Such a revocation puts the participant in the same position he would have been in had the election never been made. As long as the amounts are distributed by the end of the calendar year in which the revocation occurs, no excise tax will apply.(121)

Two recent IRS letter rulings highlight the importance of triggering events in determining whether an employee has received a lump-sum distribution. In Letter Ruling 9031028,(122) an employee had been taking minimum required distributions from a qualified retirement plan since 1985, when he was 73. Although he planned to continue working for the employer, he now wanted to receive a complete distribution of the remaining balance in his account. The IRS ruled that a distribution will qualify as a lump-sum distribution only if the entire balance to the employee's credit is distributed within one tax year, determined as of the first distribution after a triggering event. Because this individual had received amounts since 1985, and because no other triggering event occurred, the distribution was not a lump-sum distribution.

In Letter Ruling 9114034,(123) an employee who transferred employer contributions from one defined benefit plan to another defined benefit plan and received a distribution of his employee contributions shortly before his retirement could not roll over the distributed employee contributions into an individual retirement account (IRA). The IRS ruled that the distribution was on account of the transfer between plans and not on account of the separation from service, so it did not qualify as a partial distribution eligible for rollover under Sec. 402(a)(5)(D).

For a partial distribution to be eligible for rollover treatment, the distribution must consist of at least 50% of the balance to the credit of the employee, and must be made on account of death, disability or separation from service.(124) The IRS ruled that the employee did not receive his distribution on account of separation from service, because the event allowing him to receive the distribution was the transfer from Plan X to Plan Y. Even though the transfer was made almost coincident with, and in contemplation of, retirement, it was not on account of separation from service. In general, to be on account of separation from service, the payment must be after separation from service, i.e., the triggering event.

Sometimes plan assets cannot be distributed because litigation is pending or state or federal regulatory agencies have limited payments. Two letter rulings highlight the IRS position on whether a distribution of the remaining assets qualifies as the balance to the credit of the employee. In Letter Ruling 9137046,(125) the IRS ruled that amounts distributed from a terminating profit-sharing plan would not constitute the "balance to the credit" of the employees in the plan if 31% of the plan's assets will remain in a fund that is tied up in litigation. The fund is in litigation to prevent its participating plans from withdrawing, thus making those assets unavailable for distribution to participants.

In Rev. Rul. 83-57,(126) the IRS had ruled that a distribution of the total amount credited to an employee's account from a profit-sharing plan--except for certain court-impounded amounts--qualified as a lump-sum distribution under Sec. 402(e)(4)(A). Absent the court order, the impounded funds would have been forfeited and reallocated to the accounts of other participants. This position was also taken in Letter Ruling 9028103:(127) because the participants had only a contingent right to a distribution from the litigation account, the interest in the litigation account was not considered part of the balance to an employee's credit when determining whether a qualified total or a partial distribution had been made.

The facts in Letter Ruling 9137046 are different than those in Rev. Rul. 83-57 and Letter Ruling 9028103. In Rev. Rul. 83-57 and Letter Ruling 9028103, the litigation ultimately determined the exact value of the accounts. In Letter Ruling 9137046, the pending litigation would determine only the permitted procedures for processing withdrawal requests from the plan. Thus, according to the IRS, the rationale of Rev. Rul. 83-57 was not applicable to the facts in Letter Ruling 9137046. Instead, the IRS ruled that because the plan balances would not be distributed in the same tax year as all other distributions on the termination of the plan, the distributions would not meet the "balance to the credit of an employee" test of Sec. 402(a)(5). Therefore, the distributions would not qualify for special lump-sum treatment as a qualified total distribution, and would qualify for rollover only if the distributions met the partial distribution rules of Sec. 402(a)(5)(D).

In a similar situation, the IRS has stated in a letter to a practitioner that annuity payments that are owed by an insurance company to a qualified plan participant, but which are not being made because the company is under court-authorized supervision, may be excluded from the participant's "balance to the credit" for Sec. 402 and 4980A purposes.

Finally, two letter rulings indicate the IRS's position on applying the Sec. 72(t)(2)(A)(iv) exception to the 10% tax on early distributions. It is unclear whether individuals holding multiple individual retirement accounts must aggregate such accounts for calculating substantially equal payments. Notice 89-25(128) did not expressly address the situation in which a person with multiple IRAs receives substantially equal periodic payments determined using only one IRA balance. However, Letter Ruling 8946045(129) specifically allowed the IRA-splitting technique, stating that multiple IRA accounts do not need to be aggregated for purposes of determining substantially equal periodic payments.

Letter Rulings 9123062(130) and 9121047(131) involved multiple IRA accounts that were aggregated for determining the amounts required to be distributed to obtain substantially equal periodic payments. Sec. 408(d)(2) provides that accounts are aggregated for purposes of applying Sec. 72 to any amount paid or distributed from an IRA. Therefore, according to the IRS, all IRAs are treated as one contract for purposes of computing such equal payments. A position can also be taken that Sec. 408(d)(2) does not apply for purposes of the tax under Sec. 72(t), but only for applications of Sec. 72 in determining amounts to be included in gross income.

RRA Provisions

The RRA contained two important employee benefit provisions: an increase in the excise tax when plan assets revert to the employer; and the ability to use qualified retirement plan assets to satisfy an employer's current liability for retiree medical expenses.

For reversions occurring after Sept. 30, 1990, unless a plan termination was already initiated before Oct. 1, 1990, the 15% excise tax on assets that revert to an employer when a defined benefit pension plan terminates is increased to 50%. The rate is 20% if the employer maintains a qualified replacement plan following the plan termination, provides certain pro rata benefit increases in connection with the termination, or is in a Chapter 7 bankruptcy liquidation or similar state law proceeding at the time of the termination.(132)

Sec. 4980(d)(2) defines a qualified replacement plan as a qualified plan that meets (1) a participation requirement, (2) an asset transfer requirement and (3) if the plan is a defined contribution plan, certain allocation requirements. The participation requirement is met if at least 95% of the active participants in the terminating plan who remain as employees are active participants in the replacement plan. Generally, if 25% of the maximum reversion is transferred from the terminating plan to the replacement plan, the asset transfer requirement will be met. The 25% cushion can be reduced by the value of certain benefit increases. The allocation requirement is met if the amount transferred to a defined contribution replacement plan is allocated to participants in the transfer year or credited to a suspense account and allocated ratably over a seven-plan-year period.

A pro rata benefit increase occurs if the aggregate increased benefits to plan participants (including both active and nonactive participants) are at least 20% of the maximum reversion that the employer could receive and are increased on a pro rata basis. Generally, not more than 40% of the aggregate increase can go to nonactive participants.(133)

If the employer elects to take advantage of the 20% rate by using a replacement plan or increasing benefits, additional fiduciary duties are imposed to ensure compliance. An employer may elect to pay the 50% excise tax, and avoid the additional fiduciary duties.

* When assets fund retiree medical benefits Employers with overfunded defined benefit plans may find plan assets useful in funding retiree medical benefits. Certain transfers of excess assets to a Sec. 401(h) account for retiree medical benefits in a defined benefit plan are permitted effective for transfers in tax years beginning after Dec. 31, 1990 and before Jan. 1, 1996.(134) The assets transferred are excluded from the employer's gross income and are not subject to the reversion excise tax. Sec. 420(c) lists the requirements that apply to such transfers.

* A transfer can be made only once in each tax year of an employer. * Transferred assets (and income thereon) must meet a use requirement. This requirement is met if the assets transferred are used only to pay current retiree health benefits for participants other than key employees. Unused amounts must be transferred back and are subject to the reversion excise tax. * Certain vesting requirements must be satisfied. The vesting requirement is met if all participants' accrued benefits at the time of the transfer are 100% vested, including participants who separated from service within one year of the transfer. * Certain minimum cost requirements must be satisfied. The minimum cost provision requires the employer to maintain employer-provided retiree health expenditures for covered retirees at a minimum dollar level for the tax year of the transfer and the following four tax years. The minimum level is generally equal to the employer's cost for the higher of the two preceding tax years. The limit on excess assets that may be transferred in a tax year is the reasonably estimated amount that the employer will pay from the Sec. 401(h) account during the tax year for qualified current retiree health liabilities. The amount that can be transferred is reduced to the extent the employer has previously made a contribution to a Sec. 401(h) account or a welfare benefit fund relating to the same liabilities. The portion of existing reserves that relates to qualified current retiree health liabilities is determined on a pro rata basis. Notice of a proposed transfer must be provided to the IRS, the DOL, plan participants and unions at least 60 days before the transfer. * The amount transferred cannot exceed specified limits. * The transfer cannot contravene any other law.

This provision will enable some employers with overfunded defined benefit plans to pay current retiree medical benefits with accumulated pension asset surplus. Drawing down the pension surplus will conserve current cash and will accelerate the time that a deductible contribution can be made to the pension plan.

While this provision will be useful for certain taxpayers, the number of taxpayers that will apply the provisions is limited. For this reason, official IRS guidance concerning these transfers is not expected. However, the IRS National Office has issued an information letter responding to some of the questions that arise.(135) A plan may be amended to establish a Sec. 401(h) account up to the date the excess assets are transferred to it. A qualified transfer for 1991 and subsequent year expenditures must be made by the end of the employer's tax year to which the expenditures relate, so the Sec. 401(h) account must be established by that time.

An employer may make direct payments for retiree health benefits and be reimbursed for such amounts through a Sec. 401(h) account. For the 1991 year, this means that a qualified transfer may be made based on the amount of retiree health benefits paid by the employer throughout the year, even if such amounts are attributable to periods before the Sec. 401(h) account was actually established. Such reimbursement in 1991 will not result in a prohibited transaction.

An employer may make contributions to a Sec. 401(h) account or a voluntary employee benefit account (VEBA) for qualified liabilities and retain its ability to make a qualified transfer, but the amount contributed to the VEBA will reduce, dollar for dollar, the amount that can be transferred. It is unclear whether the VEBA reserves must be taken into account when determining the amount that can be transferred to a Sec. 401(h) account.

Any employee who has received a pension distribution, is receiving a pension distribution or has retired and is entitled to a future pension distribution, and the employee's spouse and dependents, can be considered in calculating the current retiree medical liabilities. Under Sec. 420(c)(3)(A), the applicable employer costs for each year during the cost maintenance period cannot be less than the higher of the applicable employer costs for each of the two tax years immediately preceding the tax year of the qualified transfer. This rule can be satisfied for a tax year if the employer continues to provide the same or greater medical benefits for the same or lesser costs. Thus, a decrease in the employee's medical premiums will not prevent the employer from using these provisions. All participants or their beneficiaries under the plan, and those former participants who separated from service within the one-year period ending on the date of the transfer, must become vested in their retirement benefits if these provisions are tested with a special rule for participants who separated in 1990.

Prohibited Transaction Developments

Often, employers that are required or want to make retirement plan contributions do not have available liquid assets. Sometimes, the employer can transfer property to satisfy this obligation. There has always been a concern that the contribution of property to satisfy the employer's obligation to make a retirement plan contribution would be a prohibited exchange of property between the plan and the employer.

* Contributions of property The DOL has issued opinions that state that an employer's contribution of property to a defined benefit or defined contribution plan in satisfaction of the employer's obligation to make a contribution to a plan constitutes a prohibited sale or exchange of property between the plan and a party of interest under Section 406(a)(1)(A) of the Employee Retirement Income Security Act of 1974 (ERISA).(136) In Wood,(137) the Tax Court declined to follow the DOL's position. In that case, the employer contributed third-party promissory notes to a defined benefit plan in satisfaction of the required contribution as determined by the plan's actuary. The third-party obligors were not disqualified persons for Sec. 4975 purposes.

The Tax Court held that although the contribution of property to a defined benefit plan may require the employer to recognize income, it does not constitute a sale or exchange of property for Sec. 4975(c)(1)(A) purposes unless Sec. 4975(f)(3) applies. Sec. 4975(f)(3) provides that the transfer of encumbered property by a disqualified person to a plan is treated as a sale or exchange between the plan and a disqualified person if either the plan assumes the debt or the encumbrance was placed on the property by the disqualified person within the 10-year period ending on the date of the transfer. The court reasoned that because contributions of property are permitted in determining an employer's deduction under Sec. 404, Congress could not have intended that such transfers be deemed prohibited transactions under Sec. 4975(c)(1)(A).(138) The court found no authority for the proposition that the determination of whether such transfers are prohibited transactions depends on whether the transfer was voluntary or in satisfaction of a funding obligation.

* Loan transactions Loan transactions are also common prohibited transactions. It is important to realize that a prohibited transaction can result from a loan, even if the loan is not with a disqualified person. In Letter Ruling (TAM) 9118001,(139) a law firm that lent money from its qualified retirement plans to its clients who were awaiting settlements was found to be engaging in prohibited transactions. The IRS ruled that the loans were transactions under both Sec. 4975(c)(1)(D) and (E).

Letter Ruling 9118001 involved a two-partner law firm that maintained a money purchase pension plan and a profit-sharing plan, each with eight participants. If a client of the law firm was involved in litigation from which the client expected a settlement, the law firm would lend the client money until the case was settled. A partner in the law firm would notify the bank (plan trustee) to lend a certain amount to the client from one of the qualified plans, the bank would enter into a one-year loan agreement with the client and the balance of the loan would be deducted from the client's settlement proceeds when the case was settled. If the case was not settled within the term of the loan, the loan was extended for another year. If the client lost the case, the client was expected to pay back the loan out of personal funds. The default rate on the loans was very low; it is assumed that the loans paid a market rate of interest.

The law firm's partners are fiduciaries with respect to the plan because they exercise discretionary authority over the management and the assets of the plan by their ability to direct the trustees to make loans to specific individuals in specific amounts. As fiduciaries, they are "disqualified persons" as defined in Sec. 4975(e)(2).

Sec. 4975(c)(1)(D) defines a prohibited transaction to include any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan. Sec. 4975(c)(1)(E) provides that any act by a disqualified person in which he deals with the income or assets of the plan in his own interest or for his own account is a prohibited transaction.

The taxpayers argued that the loans were made solely to benefit plan participants, and that it is common practice for law firms to advance funds to clients awaiting settlements. The IRS ruled that the law firm was, in essence, acting as a bank for its clients. The law firm benefited from the availability of plan assets from which to make the client loans. The law firm's self-described obligation to help its clients "obtain funds for survival during the pendency of the action" is being satisfied by using assets of the qualified plans, resulting in the prohibited transactions. It does not matter that the clients could have obtained loans from outside the law firm, or that the loans performed well for the plan. The IRS's long-standing position is that it is irrelevant how well the assets associated with a prohibited transaction perform for the plan when determining whether a prohibited transaction exists.

Similarly, in Letter Ruling (TAM) 9119002,(140) the IRS concluded that a trustee of a qualified pension plan had engaged in a prohibited transaction when the plan lent assets to a partnership in which the trustee held a 39% ownership interest. Again, the loan was to someone other than a disqualified person. However, the loan was deemed to benefit a disqualified person.

In Letter Ruling 9119002, a husband and wife were the sole owners of a corporation that maintained a qualified pension plan for its employees. The husband also served as a co-trustee of the trust underlying the plan. In February 1984, the plan lent a portion of its assets to a partnership in which the husband owned a 39% capital and profits interest. The partnership began making monthly interest payments in March 1984, signed an unsecured promissory note for the loan in January 1985, and made the final payment in April 1987.

The IRS found that as a trustee of the plan, the husband had authority and control over the management and disposition of plan assets. That made him a fiduciary of the plan--and a disqualified person with respect to the plan. As such, he was prohibited from dealing with the plan for his own interest. According to the IRS, the husband violated that prohibition through his participation in (1) the decision to make the loan (there was no evidence that he did not participate in that decision) and (2) the benefit that inured to the partnership as a result of the loan. Thus, even though the loan was not to a disqualified person, a prohibited transaction resulted because a plan fiduciary benefited from the loan.

The prohibited transaction excise tax is not imposed on a fiduciary acting solely in his capacity as a fiduciary. However, with his substantial ownership interest in the partnership, the husband stood to benefit personally from the loan. Therefore, by participating in the loan transaction, he was acting in a capacity other than solely as a fiduciary, and was thus subject to the 5% excise tax.

* Plan loans It is important to remember that a prohibited transaction violates both ERISA and Internal Revenue Code provisions. Two recent Tax Court cases dealing with plan loans indicate that the IRS is not precluded from assessing the Sec. 4975 excise tax on prohibited transactions when the taxpayer has entered into a settlement agreement with the DOL in connection with the same prohibited transaction. The court also held that the six-year statute of limitations under Sec. 6501(e)(3) applied to the taxpayers because the plans failed to disclose the prohibited transactions on their Forms 5500, Annual Return/Report of Employee Benefit Plan.

In Thoburn,(141) the IRS and the DOL were simultaneously examining loans from a qualified profit-sharing plan to certain plan participants. The plan's trustees entered into a settlement agreement with the DOL, under which loan interest was calculated at a rate of 10%, rather than at the 8% rate provided in the plan. The DOL settlement agreement specifically stated that it did not represent that no other governmental agency would take action against the plan.

Subsequently, the IRS sent deficiency notices to several employees who had borrowed money from the plan. The deficiency notices asserted a Sec. 4975 prohibited transactions excise tax based on the same plan loans that were involved in the DOL settlement. But while the DOL settlement provided for loan interest at a 10% rate, the IRS calculated the Sec. 4975 excise tax based on interest rates of between 13% and 23 1/2% for the same loans. The Tax Court held that the IRS was not bound by the terms of the settlement with the DOL, and that the IRS had properly substituted its interest rates in calculating the "amount involved."

The taxpayers in both Thoburn and Goulard(142) argued that certain years should be disregarded as a result of the expiration of the three-year statute of limitations. The Tax Court upheld the IRS's argument that the six-year limitations period under Sec. 6501(e)(3) should apply. That section, which refers to excise taxes, provides a six-year period in the case of a return that omits an amount of tax properly includible in the return that exceeds 25% of the tax reported on the return. While the plans' Forms 5500 showed no tax liability, and no tax was properly includible, the court held that the failure to disclose the prohibited transactions on the Forms 5500 was tantamount to omitting the excise taxes attributable to the transactions. Therefore, the six-year period applied to all years in which the plan failed to disclose the existence of the prohibited loans.

It is interesting that in Thoburn, in addition to the 5% excise tax of Sec. 4975(a), the IRS assessed the 100% tax of Sec. 4975(b) on each of the disqualified persons who obtained prohibited loans from their plan. The Sec. 4975(b) tax applies to disqualified persons when the prohibited transaction is not corrected within the taxable period. The tax can be imposed on any disqualified person who participated in the prohibited transaction, other than a fiduciary acting only in his fiduciary role.

* Bank services Many financial institutions provide incentives to depositors for opening retirement accounts, but many are concerned that it is a prohibited transaction when the depositor receives an additional benefit as a result of the plan or account's activity. A proposed class exemption would permit an individual who establishes an IRA or Keogh plan at a bank to receive services from that bank at reduced or no cost if certain conditions are met. If adopted, the proposed exemption would be effective as of the date the final exemption is published in the Federal Register.

The proposed exemption contains conditions the DOL views as necessary to ensure that the retirement income of IRA and Keogh plan participants is not jeopardized by relationship banking arrangements.

* The IRA or Keogh plan, the deposit balance of which is taken into account for purposes of determining eligibility to receive services at reduced or no cost, is established and maintained for the exclusive benefit of the participant, his spouse or their beneficiaries. * The services are of a type the bank could offer under applicable federal and state banking law. * The services are provided by the bank (or an affiliate of the bank) in the ordinary course of the bank's business to customers who do not qualify for reduced-cost or no-cost services. * For purposes of determining eligibility to receive reduced-cost or no-cost services, the deposit balance in the IRA or Keogh plan is treated in the same manner as account balances (maintained by customers of the bank) of the same dollar amount other than those in IRAs or Keogh plans. * The rate of return on the IRA or Keogh plan is no less favorable than the rate of return on an identical investment that could have been made at the same time by a customer of the bank who is not eligible for (or who does not receive) reduced-cost or no-cost services.

Until the effective date of the final prohibited transaction class exemption, the IRS's nonenforcement policy, as described in Ann. 90-1,(143) will be in effect. The policy provides that the IRS will not raise issues concerning the tax effects resulting from possible prohibited transactions arising from certain cash, property or services offered by financial institutions to individuals for whom the financial institution maintains certain IRAs and Keogh plans.

Qualified Plan Expenses

The IRS recently revoked four letter rulings dealing with an employer's deduction for trustee expenses it reimburses to a qualified plan.(144) The IRS's position now is that plan expenses paid by the plan and reimbursed by the employer must be deducted under Sec. 404 instead of Sec. 162 or 212. Reimbursement amounts would also constitute an annual addition under Sec. 415.

Expenses incurred by an employer in connection with a plan, such as trustees' and actuaries' fees that are not provided for by contributions under the plan, are deductible by the employer under Sec. 162 or 212 if ordinary and necessary. To avoid the Sec. 404 and 415 limits with respect to such amounts, the employer should pay the expenses directly and not reimburse the plan for such amounts. The IRS's position is that if the plan pays the expense and then looks to the employer for reimbursement, the amount contributed to the plan for the expense must be deducted by the employer under Sec. 404 and must be considered an annual addition for Sec. 415 purposes.

Benefit Plan Investments

* Exercise of control The DOL has reproposed regulations under ERISA Section 404(c) pertaining to participant-directed accounts, effective 180 days after publication as final regulations. Under ERISA Section 404(c), when a participant or beneficiary of an employee pension benefit plan exercises control over assets in an individual account maintained for him under the plan, his exercise of control does not make him a fiduciary, and other plan fiduciaries are relieved of the ERISA's fiduciary liability as a result of that exercise of control.

In general, for a participant to exercise control over the assets in his account, the participant or beneficiary must have the opportunity to

--choose from a broad range of investment alternatives that consist of at least three diversified investment categories, each having a materially different risk and return characteristic;(145) --give investment instruction with a frequency that is appropriate in light of the market volatility of the investment alternatives, but not less frequently than once within every three-month period; and(146) --diversify investments generally and within investment categories.(147)

Relief from fiduciary responsibility is available only if the plan is an individual account plan that allows the participant or beneficiary the opportunity to exercise control over the assets in his account, and gives him an opportunity to choose, from a broad range of investments, the way some or all of the assets in his account are invested.

In addition, a plan whose terms allow the participant or beneficiary an opportunity to give written investment instructions to an identified fiduciary who is obligated to comply with those instructions will satisfy the "opportunity to exercise control" requirement.(148) However, a plan fiduciary is not obligated to carry out investment instructions that would or could result in

--a transaction not in accordance with the terms of the plan; --a fiduciary's maintaining indicia of ownership of plan assets outside the jurisdiction of the U.S. district courts; --a transaction jeopardizing the plan's tax-exempt status; --a transaction that would result in the direct or indirect sale or exchange, or lease of property between the plan sponsor and the plan, except for the sale or purchase of a qualifying employer security, a loan to a plan sponsor, acquisition or sale of any employer real property, or acquisition of any employer security, unless it meets the requirements of employer securities defined in ERISA Section 407(d);

--a prohibited transaction; --a loss in excess of the participant's account balance; or --taxable income being generated to the plan.(149)

A reasonable charge for carrying out a participant's investment instructions is not considered a limitation on the opportunity to exercise control.

A plan may impose reasonable restrictions on the frequency of investment instructions. For such restrictions to be reasonable, they must

--be applied on a uniform and consistent basis to all directing participants and beneficiaries of the plan, and with respect to each investment alternative made available by the plan; and --permit the participant or beneficiary to give investment instructions with a frequency appropriate for the market volatility of the investment.

To meet the second requirement, for at least three diversified categories of investments, the participant or beneficiary must be able to give investment instructions no less frequently than once within every three-month period, and the participant or beneficiary must be allowed to change his investment in the least volatile of such investment options at least as frequently as he is permitted to change his investment in the most volatile alternative made available under the plan.

A plan offers a broad range of investments only if the available investment options provide the participant or beneficiary the opportunity to

--materially affect the potential return on his account and the degree of risk to which his account is subject; --choose from at least three diversified categories of investments (diversified both within each category and as compared to each other category); and --diversify the investment of that portion of his account that he is able to direct to minimize the risk of large losses, taking into account the nature of the plan and the size of the account. When the account is of such limited size that investment in "lookthrough investment vehicles" is the only prudent means to ensure appropriate diversification, a plan may satisfy the diversification requirement only by offering lookthrough investment vehicles.(150)

An investment alternative will not be considered made available to a participant unless sufficient information regarding that investment is available to the participant to permit informed investment decisions.(151)

* Fiduciary liability To avoid fiduciary liability, the participant or beneficiary must in fact have exercised independent control in an investment transaction of the assets of his account. This is a facts and circumstances determination, although the regulations provide examples of situations in which the participant's exercise of control will not be considered independent. These include situations in which the participant or beneficiary is unduly influenced by a plan fiduciary or sponsor; when the fiduciary conceals material, nonpublic information from the participant or beneficiary; and when the participant or beneficiary is legally incompetent. If a participant or beneficiary of an ERISA Section 404(c) plan exercises independent control over assets in his individual account in accordance with the regulations, no other person who is a fiduciary with respect to that plan will be liable to the participant or beneficiary for any loss that is the direct and necessary result of that participant's or beneficiary's exercise of control.

There is limited relief from the fiduciary rules for participants' investment in employer securities, if certain conditions are met. The securities must be stock that is a qualifying employer security, and must be publicly traded with sufficient frequency and volume to ensure prompt execution of investment instructions; information provided to shareholders must be available to participants; voting and similar rights must pass through to the participant; and activities relating to the sale, purchase or exercise of rights must be carried out by an independent fiduciary on a confidential basis.(152) Because investment in employer stock is not a diversified category of investment, the option to purchase employer stock under an ERISA Section 404(c) plan will not qualify as one of the required three diversified investments.

With increasing numbers of financial institutions and insurance companies being unable to pay their obligations, fiduciary liability with respect to the choice of plan investments, including the purchase of annuities at plan termination, is becoming increasingly important. It is clear that the ERISA's fiduciary standards govern a plan fiduciary's consideration and selection of annuity providers. Merely bidding for annuities will not always satisfy a person's fiduciary duties and insulate annuity purchases from challenge. The bidding process must allow enough time for the bidders to analyze data and produce credible bids. At a minimum, one bidder should not be given a "head start." Certainly, companies with any affiliation with the plan sponsor should be avoided. In general, anyone advising a plan should do so with the utmost care. An imprudent choice of an annuity contract may result in suits by participants or the DOL. Choosing the annuity company with the highest rating may not always be appropriate; similarly, choosing the most inexpensive contract is unlikely to be appropriate.

(58)Sec. 401(a)(4) and Regs. Sec. 1.401(a)(4)-1. (59)Regs. Sec. 1.401(a)(4)-1(b)(2). (60)Regs. Sec. 1.401(a)(4)-1(b)(3). (61)Regs. Sec. 1.401(a)(4)-1(b)(4). (62)Regs. Sec. 1.401(a)(4)-2(b)(3). (63)Regs. Sec. 1.401(a)(4)-2(b)(4). (64)Regs. Sec. 1.401(a)(4)-2(c)(3). (65)Regs. Sec. 1.401(b)-7(c). (66)Regs. Sec. 1.410(b)-7(d). (67)Regs. Secs. 1.410(b)-2(b)(2) and 1.410(b)-9. (68)Regs. Sec. 1.410(b)-2(b)(3). (69)Regs. Sec. 1.410(b)-4(a). (70)Regs. Sec. 1.410(b)-4(b). (71)Regs. Sec. 1.410(b)-4(c). (72)Regs. Sec. 1.410(b)-5(a). (73)Regs. Sec. 1.410(b)-5(e)(3). (74)Regs. Sec. 1.410(b)-5(e)(10). (75)Regs. Sec. 1.410(b)-6. (76)Regs. Sec. 1.410(b)-2(c). (77)Regs. Sec. 1.410(b)-2(b)(5). (78)Regs. Sec. 1.410(b)-2(b)(6). (79)Regs. Sec. 1.401(a)(4)-4(a)(1). (80)Regs. Sec. 1.401(a)(4)-4(b) and (c). (81)Regs. Sec. 1.401(a)(4)-4(e)(l)(ii). (82)Regs. Sec. 1.401(a)(4)-4(e)(2). (83)Regs. Sec. 1.401(a)(4)-4(e)(3). In Letter Ruling (TAM) 9137001 (4/24/91), the IRS ruled, based on Rev. Rul. 70-370, 1970-2 CB 84, that a plan was disqualified when only highly compensated employees could direct their plan investments for plan years before the effective date of the Sec. 401(a)(4) final regulations. (84)Regs. Sec. 1.401(a)(4)-4(b)(1). (85)Regs. Sec. 1.401(a)(4)-4(b)(2)(i). (86)Regs. Sec. 1.401(a)(4)-4(b)(2)(ii)(A). (87)Regs. Sec. 1.401(a)(4)-4(b)(2)(iii). (88)Regs. Sec. 1.401(a)(4)-4(b)(2)(iv). (89)Regs. Sec. 1.401(a)(4)-4(b)(2)(v). (90)Regs. Sec. 1.401(a)(4)-4(b)(3). (91)Regs. Sec. 1.401(a)(4)-4(c). (92)Regs. Sec. 1.401(a)(4)-4(d)(l)(i). (93)Regs. Sec. 1.401(a)(4)-4(d)(2). (94)Regs. Sec. 1.401(a)(4)-4(d)(4). (95)Regs. Sec. 1.401(a)(4)-11(g). (96)Regs. Sec. 1.401(a)(4)-11(g)(3). (97)Regs. Sec. 1.402(g)-1(e)(1)(i). (98)Regs. Sec. 1.401(k)-1(a)(6)(i). (99)Regs. Sec. 1.401(k)-1(a)(3)(iv). (100)Regs. Sec. 1.401(k)-1(a)(6)(ii)(B). (101)Regs. Sec. 1.401(k)-1(a)(6)(iii). (102)Rev. Proc. 91-47, IRB 1991-34, 10. (103)Notice 88-127, 1988-2 CB 538, gave partnership plans until the later of Mar. 31, 1989, or the first day of the first plan year beginning after Dec. 31, 1988, either to amend the plan to qualify as a Sec. 401(k) plan, or to require employees and partners to make one-time irrevocable elections on the amount to contribute to the plan. (104)Regs. Sec. 1.401(k)-1(a)(7). (105)Regs. Sec. 1.401(k)-1(b)(3). (106)Regs. Secs. 1.401(k)-1(b)(3)(iii) and (h)(3)(iii). (107)Regs. Sec. 1.401(k)-1(d)(2). (108)Regs. Sec. 1.411(d)-4, A-2(b)(2). (109)Regs. Sec. 1.401(k)-1(d)(3) and (4). (110)See IRS Letter Ruling 9102044 (10/19/90). (111)Regs. Sec. 1.401(k)-1(e)(6)(iv). (112)Regs. Sec. 1.401(k)-1(g)(2). (113)Sec. 401(a)(17). (114)Regs. Sec. 1.415-6(b)(6). (115)Regs. Sec. 54.4979-1(a). (116)Rev. Rul. 90-105, 1990-2 CB 69. (117)Employee Plans Closing Agreements Pilot Program, Dec. 21, 1990. (118)IRM 7(10)54, 660 (7/19/91). (119)Gary A. Sargent, 929 F2d 1252 (8th Cir. 1991) (67 AFTR2d 91-718, 91-1 USTC [P] 50,168). (120)Moline Properties, Inc., 319 US 436 (1943)(30 AFTR 1291, 43-1 USTC [P] 9464). (121)Prop. Regs. Sec. 1.401(a)(9)-1, Q&A J-4. (122)IRS Letter Ruling 9031028 (5/7/90). (123)IRS Letter Ruling 9114034 (1/9/91). (124)Sec. 402(a)(5)(D). (125)IRS Letter Ruling 9137046 (6/20/91). (126)Rev. Rul. 83-57, 1983-1 CB 92. (127)IRS Letter Ruling 9028103 (4/20/90). (128)Notice 89-25, 1989-1 CB 662. (129)IRS Letter Ruling 8946045 (8/22/89). (130)IRS Letter Ruling 9123062 (3/14/91). (131)IRS Letter Ruling 9121047 (2/26/91). (132)Sec. 4980(d)(1), added by RRA Section 12002(a). (133)Sec. 4980(d)(3). (134)Sec. 420, added by RRA Section 12011(a). (135)Letter from IRS to Ann Moran, Miller & Chevalier, July 8, 1991. (136)DOL ERISA Advisory Opinions 81-69A (7/28/81) and 90-05/A (3/29/90). (137)Dallas C. Wood, 95 TC 364 (1990). (138)See The Colorado National Bank of Denver, 30 TC 933 (1958), in which the Tax Court held that the contribution of land to a pension trust was a payment to the trust for Sec. 404(a)(1)(C) purposes. (139)IRS Letter Ruling (TAM) 9118001 (12/5/90). (140)IRS Letter Ruling (TAM) 9119002 (10/4/90). (141)Robert Thoburn, 95 TC 132 (1990). (142)Alexander Goulard, Jr., TC Memo 1990-448. (143)Ann. 90-1, IRB 1990-2, 31. (144)IRS Letter Rulings 9124034 (3/19/91), 9124035 (3/19/91), 9124036 (3/19/91) and 9124037 (3/19/91), revoking IRS Letter Rulings 8941010 (6/30/89), 8941009 (6/30/89), 8940013 (6/30/89) and 8940014 (6/30/89), respectively. (145)DOL Prop. Regs. Section 2550.404c-1(b)(1)(ii). (146)DOL Prop. Regs. Section 2550.404c-1(d)(2)(ii)(C). (147)DOL Prop. Regs. Section 2550.404c-1(b)(3)(i)(C). (148)DOL Prop. Regs. Section 2550.404c-1(b)(2)(i). (149)DOL Prop. Regs. Section 2550.404c-1(e)(2)(ii). (150)DOL Prop. Regs. Section 2550.404c-1(b)(3)(i). (151)DOL Prop. Regs. Section 2550.404c-1(b)(3)(iii). (152)DOL Prop. Regs. Section 2550.404c-1(e)(2)(ii)(D)(4).