Current developments in employee benefits.

Distribution Rule Changes; Nondiscrimination Rules; and ESOPs

This three-part article provides an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and employee benefits. Part I, published in November, focused on executive compensation and employee benefits, including changes not only under the Code, but also various other Federal laws, most notably the Employee Retirement Income Security Act of 1974 (ERISA) and the Age Discrimination in Employment Act (ADEA). Part II, below, will focus on current developments affecting qualified retirement plans, including recently enacted rules facilitating retirement plan rollovers and imposing a 20% withholding tax on certain qualified plan distributions; changes to the qualified plan nondiscrimination rules and transition rules for easing compliance with such rules; and additional IRS guidance on employee stock ownership plans (ESOPs). Part III, to be published in January, will focus on judicial consideration of the prohibited transaction and minimum funding rules; IRS liberalization of the distribution rules for plans whose assets are held in receivership; IRS guidance on early retirement windows; and the Supreme Court's determination that certain retirement assets are protected from an individual's bankruptcy creditors. Many of these developments indicate a growing awareness that retirement savings should be conserved for retirement and employers should be aided in offering such benefits to employees.

Legislative Changes To Distribution Rules

On July 2, 1992, Congress passed legislation(65) to extend unemployment benefits, and President Bush later signed the bill into law. As part of the financing of that law, Congress also adopted changes to the qualified plan rules governing the treatment of distributions from qualified plans or tax-deferred annuities. The changes require that after Dec. 31, 1992, most distributions from qualified plans that are not directly transferred into an individual retirement account (IRA), IRA annuity, Sec. 403(a) annuity, or another qualified plan accepting such transfers, will be subject to tax withholding of 20% by the plan sponsor.

The good news is that the treatment of distributions is greatly simplified. Any distribution after 1992 from a qualified plan, other than (1) a required minimum distribution, (2) distributions over life expectancy or (3) distributions over a specified period of 10 or more years, can be rolled over into an IRA or other qualified plan or annuity. Under a transition rule, a partial distribution made before 1993 will not be considered one of a series of payments if the payment is not substantially equal in amount to other payments in the series.(66) Unfortunately, this rule will be of little relief to the taxpayer who was properly advised that such distributions could not be rolled over and whose 60-day rollover period has expired.

On Oct. 20, 1992, the IRS issued temporary regulations on the changes to the distribution rules.(67) Highlights of the temporary regulations include: * A de minimis exception, at the employer's discretion, under which the direct rollover/withholding rules do not apply for annual distributions of less than $200. * An exception for distributions of excess contributions or deferrals under Sec. 401(k) plans, deemed distributions of P.S. 58 costs, and deemed distributions for employee plan loan defaults. * A provision that penalties for failure to withhold on lump-sum distributions made after Dec. 31, 1992 and before July 1, 1993 will be abated if the payor or plan administrator acted in good faith. * A provision that direct rollovers may be made by giving the employee a check if made payable only to the recipient plan. * A requirement that the Sec. 402(f) notice of the tax treatment of distributions must be given to distributees within a reasonable time before the distribution, defined as no more than 90 days nor less than 30 days before, for distributions requiring spousal consent, and generally 30 days for others; however, this 30-day period may be waived for employees affirmatively electing to make or not make a direct rollover.

The choice between a mandatory transfer of retirement plan benefits by the employer or withholding is thought by some to be good retirement policy. ff employees are discouraged from actually getting access to the qualified plan savings money directly, they will be less likely to spend their retirement savings when they change jobs. Unfortunately, this change does place an additional burden on the employer to either withhold 20% in taxes from the distribution or arrange a direct transfer to an account chosen by the employee.

Fortunately, the changes do not require employer plans to accept transfers. However, employers will need to amend their plans to provide for the direct rollover of eligible rollover distributions.

Other Distribution Rule Changes

A number of IRS rulings and judicial decisions clarify certain rules regarding special averaging and rollovers of retirement plan distributions. * Substantially equal periodic payments In Letter Ruling 9221052,(68) the IRS allowed a participant receiving substantially equal periodic payments from a terminating qualified money purchase plan to roll over the assets and continue receiving payments from an IRA without incurring ring a Sec. 72(t)(1) early withdrawal penalty. The IRS ruled that continuing to receive substantially equal periodic payments from the IRA will not constitute a change in substantially equal periodic payments within the meaning of Sec. 72(t)(4).

Company maintained a qualified money purchase pension plan (the Plan) for its employees. Taxpayer, a former employee of Company, accrued benefits under the plan before retiring. After separating from service, Taxpayer began receiving substantially equal periodic payments annually from the Plan in accordance with Sec. 72(t)(2)(A)(iv).

Company is currently in the process of terminating the Plan and all plan assets are being distributed. Taxpayer will receive a single sum distribution of his entire account balance and will roll over the assets into an IRA within 60 days of receipt. Taxpayer wants to continue receiving substantially equal periodic payments annually from the IRA in the same manner as payments were received under the Plan.

Sec. 72(t) provides that any taxpayer receiving a distribution from a retirement plan prior to attaining age 59 1/2 will pay an additional 10% tax on the distribution. Sec. 72(t)(2) provides exceptions to this general rule, including one for distributions received that are part of a "series of substantially equal periodic payments."

A distribution may be part of a series of substantially equal periodic payments if it is - a distribution that is received from a retirement plan; - payable at least annually; and - paid for the life of the employee or the joint lives of the employee and his designated beneficiary. Notice 89-25(69) provides guidance on how to calculate substantially equal periodic payments for this purpose.

Sec. 72(t)(4) provides that if the series of substantially equal periodic payments is modified, for reasons other than death or disability, before the later of the taxpayer attaining age 59 1/2 or the close of a five-year period, the additional 10% tax will be applied to all distributions received from the plan. In other words, if the substantially equal periodic payments are changed within five years, or, if later, age 59 1/2, the exception to the 10% additional tax does not apply to any of the substantially equal periodic payments received.

The IRS concluded that if Taxpayer continued to receive a series of distributions from an IRA that are the same as the series of substantially equal periodic payments currently being made under the Plan, this would not constitute a modification under Sec. 72(t)(4). Hence, based on this ruling, a taxpayer receiving substantially equal periodic payments from one retirement plan may terminate this plan and roll over the assets into another plan, then continue the periodic payments without incurring the 10% additional tax on early withdrawals, provided the payments are made on the same basis. * Lump: sum distribution treatment

The IRS has issued Letter Ruling 9139031(70) revoking an earlier letter ruling that held that a distribution of a participant's remaining account balance, after a portion of the plan's assets was transferred to another plan, is a qualified total distribution and a lump-sum distribution if the participant was over age 59 1/2.

Company N and Company M merged. Both companies had maintained profit-sharing retirement plans with a cash or deferred arrangement (CODA). To simplify administrative costs, the CODA portion of Company N's profit-sharing plan was transferred to Company M's profit-sharing plan. The Company N profit-sharing plan was then terminated and the remaining assets were distributed to the plan's participants. Company N requested rulings on whether the distribution of plan assets would be a qualified total distribution or a lump-sum distribution for participants age 59 1/2 at the date of distribution.

The IRS did not consider Rev. Rul. 72-242(71) in its original ruling. There the IRS concluded that a participant receiving a total distribution of plan assets immediately following a transfer of 50% of a participant's account balance to another qualified plan does not constitute a total distribution of a participant's account balance. The ruling provided that a participant's accumulated account balance prior to separation from service is unchanged by the transfer of assets immediately before retirement. Therefore, participants receiving their entire posttransfer account balances in the plan will not be treated as having received a total distribution of plan assets.

The IRS's current position, as stated in Letter Ruling 9139031, is that a participant's accumulated account balance is determined immediately before the transfer of plan assets. Since the participants in the Company N plan will receive their account balances after the transfer of the CODA portion of plan assets, the distributions will be neither qualified total distributions for Sec. 402(a)(5)(E) purposes nor lump-sum distributions for Sec. 402(e)(4)(A) purposes. * Forward averaging

In Fowler,(72) the Tax Court denied 10-year averaging for a taxpayer who received lump-sum distributions from his former employer's incentive savings plan and profit-sharing plan and chose to roll over part of the savings plan distribution. The court ruled that all the lump-sum distributions should have been included in the averaging election in order to qualify for 10-year averaging.

In 1986, Robert Fowler terminated employment and received lump-sum distributions from both his incentive savings plan and his profit-sharing plan. He rolled over most of the incentive savings plan distribution into an IRA and claimed 10-year averaging for the profit-sharing distribution. The IRS found that the approximately 125,000 of ordinary income from the profit-sharing distribution did not qualify for 10-year averaging under Sec. 402(e)(1) (Sec. 402(d)(1) after amendment by the UCA).

The IRS argued that Fowler's use of the rollover provision of Sec. 402(a) prohibited his use of the averaging rules. Old Sec. 402(e)(2),stated that "in computing the tax imposed by paragraph (1)(A), the total taxable amounts of all such distributions during such 6-taxable-year period shall be aggregated ...." Old Sec. 402(e)(4)(B), discussing the election of 10-year averaging, stated that "no amount which is not an annuity contract may be treated as a lump sum distribution ... unless the taxpayer elects for the taxable year to have all such amounts received during such year so treated at the time and in the manner provided under regulations ...." (Emphasis added by the court.) (The court noted that Sec. 402(e)(4)(B) has since been revised; however, the revisions are not material to the outcome here.)

Fowler argued that the rollover amount was not "taxable" and, therefore, did not need to be included in the lump sum. The Tax Court disagreed. The court cited language in the Conference Report and House Report on the 1974 changes - particularly the Conference Report, which stated that a taxpayer who wishes to use lump-sum averaging and capital gains treatment must do so for the "aggregate of the lump-sum distributions he receives in the same taxable year."(73) The court rejected Fowler's interpretation of "taxable" amount, saying his interpretation was tantamount to "gross income." The term as used in Sec. 402(e) did not mean "gross income," but rather amounts subject to tax. Absent the rollover provision in Sec. 402(a), which provides a condition subsequent to payment, the amounts distributed are taxable. Therefore, they should have been included in the lump-sum amount, according to the court.

In some comfort to Fowler, the court did refuse to assess the additional penalty tax for substantial understatement of tax under old Sec. 6661(a), which would have exceeded $25,000. * Rollovers

The IRS has ruled in Letter Ruling 9211035(74) that a rollover that failed to meet the 60-day time limit was taxable to the participant, even though the failure was due to a bookkeeping error by a mutual fund investment manager. The ruling reflects the IRS's position that it has no authority to extend the 60-day period.(75) In contrast, the Tax Court has taken the position that a mere bookkeeping error will not preclude rollover treatment.(76)

In Letter Ruling 9211035, the employer maintained a money purchase pension plan in which Participant was the sole participant and trustee. The plan invested its, assets in five different mutual funds. To register any changes in ownership of mutual fund shares, Participant, in his capacity as trustee, would give written instructions to the investment manager of the funds. These instructions were then relayed to a transfer agent, who would make the actual change of ownership.

The plan was terminated in 1989 because it would not have satisfied the minimum participation rules under Sec. 401(a)(26). The plan received notice of its qualified status of termination on July 11, 1990. In a letter dated July 27, 1990, Participant directed the investment manager to distribute all the plan's assets on Aug. 23, 1990, and to roll over the fund shares into an IRA.

Due to a transcription error by a clerk, the shares in only four of the five mutual funds were reregistered in the name of the IRA on Aug. 23, 1990; the shares in the fifth mutual fund were left in the plan's name. This error was not discovered until April 1991. The reregistration of the fifth fund's shares into the IRA's name occurred on Apr. 10, 1991, but was listed as retroactively effective to Aug. 23, 1990, on the transfer agent's records.

The IRS ruled that the rollover of the fifth fund's shares was not timely. A transfer of a distribution must be made within 60 days of the distribution to qualify as a rollover.(77) The IRS first cited Rev. Rul. 81-158,(78) which provided that, in the case of a transfer of shares of a regulated investment company (mutual fund), the transfer is made when the custodian relinquishes his legal control in the regulated investment company, as evidenced by a written order to transfer the shares. Thus, in Letter Ruling 9211035, the assets were considered distributed from the plan when the transfer agent received the order to transfer title to the funds from the plan to the IRA - i.e., on Aug. 23, 1990.

The IRS then looked to the date of the actual, not the retroactive, transfer of the shares of the fifth fund to the IRA - Apr. 10, 1991 - and ruled that those assets were taxable to Participant, since they were not transferred to an IRA within the 60 days allowed by old Sec. 402(a)(5)(C). * Citizens abroad and nonresident aliens

The IRS ruled in Letter Ruling 9206015(79) that an otherwise taxable distribution from a qualified plan is not subject to withholding if the recipient is a nonresident alien or a U.S. citizen residing abroad and directs the plan trustee to deposit the distribution directly into an IRA that has been established for at least 10 days.

Corporation X maintains numerous qualified retirement plans. Some of those plans provide benefits in the form of an annuity, others in the form of a lump-sum distribution, and others in either form, as directed by the participant. Several participants in X's qualified plans are nonresident aliens or U.S. citizens living abroad at the time they receive distributions from the plans. Many of these individuals elect to roll over qualified plan distributions to IRAs. X requested rulings that the qualified plan trustee is not required to withhold income tax under Secs. 1441 and 3405 if a plan participant directs the plan trustee to deposit the distribution directly into an IRA.

A payor is required to withhold Federal income tax under Sec. 3405,on a periodic or nonperiodic distribution that is a "designated distribution." A designated distribution is any distribution or payment from or under an employer deferred compensation plan, an individual retirement plan or a commercial annuity.(80) A "periodic payment" is a designated distribution that is an annuity or similar periodic payment.(81) A "nonperiodic distribution" is a designated distribution that is not a periodic payment.(82) In general, a payment to a participant of his entire account balance from a qualified plan is a nonperiodic distribution.

Sec. 3405(a)(1) generally requires the payor of any periodic payment to withhold an amount equal to the amount that would be withheld if the payment were wages. Old Sec. 3405(b)(2) requires the payor of any nonperiodic distribution to withhold from such distribution 10% for distributions that are not qualified total distributions, and an amount determined under IRS tables for qualified total distributions. (New Sec. 3405(b)(1) requires 10% withholding for any nonperiodic distribution, and new Sec. 3405(c) requires 20% withholding for any designated distribution that is an "eligible rollover distribution" and that is not rolled over directly into an eligible retirement plan.)

There are exceptions to the Sec. 3405 rules. Sec. 3405(d)[now (e)](1)(B)(ii) exempts from the definition of "designated distribution" the portion of a distribution that it is reasonable to believe is not includible in gross income. Sec. 3405(a)(2) and (b)(3)(A)[now (b)(2)] provide elections out of withholding. Sec. 3405(d)[now (e)](13)(A) provides that an election out of withholding cannot be made for a designated distribution delivered outside the United States or one of its possessions. Sec. 3405(d)[now (e)](13)(B), however, provides an exception to this rule if the distributee certifies that the person receiving the distribution is not a U.S. citizen or resident alien, or a nonresident alien who lost U.S. citizenship to avoid income tax. A U.S. citizen living abroad cannot come within the Sec. 3405(d)[now (e)](13)(B) exception. Therefore, withholding is required on a distribution from a qualified plan to a U.S. citizen living abroad unless it is reasonable to believe the distribution or payment is not includible in gross income.

Sec. 1441(a) provides that ihe 30% tax imposed on U.S.-source non-effectively connected income (non-ECI) of a nonresident alien under Sec. 871(a) must be collected through withholding at the source. Sec. 1441(c)(1) provides that ECI is not subject to Sec. 1441(a) withholding, except for compensation for personal services. Regs. Sec. 1.1441-4(b)(1)(i) exempts from Sec. 1441(a) withholding compensation for personal services that is subject to wage withholding under Sec. 3402. Such income is, instead, subject to the Sec. 3405 withholding rules. Nonresident aliens who make an election out of Sec. 3405 withholding under Sec. 3405(d)[now (e)](13)(a) are again subject to Sec. 1441 withholding. Temp. Regs. Sec. 1.1441-4T(b)(1)(ii) provides that Sec. 1441 withholding will apply to qualified pension payments attributable to personal services and treated as ECI under Sec. 864(c)(6) unless withholding is imposed under Sec. 3405.

According to the IRS, the reason for imposing withholding tax at the source on distributions to nonresident aliens and U.S. citizens abroad is that it may be difficult or impossible to collect the tax once the income is outside the United States. This concern is addressed, however, if a qualified plan distribution is rolled over to an IRA: The withholding tax is imposed when proceeds are distributed from the IRA. The IRS then ruled that an otherwise taxable distribution from a qualified plan is not subject to withholding under Sec. 3405 or 1441 if the recipient is a nonresident alien or U.S. citizen abroad who directs the plan trustee to deposit the distribution directly into an IRA that the participant certifies to the plan trustee has been established for at least 10 days. Unfortunately, the recently enacted expansion of the withholding provisions to eligible rollover distributions will limit the tax planning available as a result of this ruling. * Qualified domestic relations orders 

A distribution from a qualified plan to an alternate payee may be subject to the Sec. 4980A tax on excess distributions, even though the distribution is made under a qualified domestic relations order (QDRO). In such a case, the alternate payee is subject to the tax if the amount of the distribution in any year exceeds the alternate payee's Sec. 4980A limits. What if the plan participant has made a grandfather election? In Letter Ruling 9138004,(83) the IRS ruled that the grandfather election does not transfer to the alternate payee to protect pre-August 1986 balances from the excess distributions tax. The grandfathered amount stays with the participant who made the election, and is not reduced by amounts included in the original election that are paid to an alternate payee.

Taxpayer was a participant in a defined benefit plan (the Plan), and had an IRA. The accrued balances in the Plan and the IRA were large enough as of Aug. 1, 1986 that Taxpayer made a Sec. 4980A(f) election to exclude the pre-August 1986 amounts from the distributions subject to the excess distributions tax. At that time, Taxpayer's spouse was not an alternate payee under either plan. Spouse did not have sufficient balances in retirement plans to make a Sec. 4980A(f) election, and so no election was made.

In 1990, Taxpayer and Spouse were getting divorced and proposed that Spouse would receive 100% of the account balance in the Plan as an alternate payee. Taxpayer and Spouse requested rulings on the application of Taxpayer's grandfather amount to distributions to Spouse as the alternate payee, and on whether Taxpayer's grandfather election will apply to amounts accrued under plans not in existence as of Aug. 1, 1986.

Sec. 4980A imposes a tax on excess distributions with respect to any individual during any calendar year. The liability for the tax generally rests with the person with respect to whom the excess distributions are made; however, this rule does not apply for distributions with respect to an individual that are payable to an alternate payee under a QDRO, if includible in the income of the alternate payee.(84) In such cases, the distributions are treated as distributions to the alternate payee for purposes of fixing liability for the Sec. 4980A tax.

Sec. 4980A(f), referring to the grandfather election, states that the election may be made by an eligible individual - meaning any individual if, on Aug. 1, 1986, the present value of that individual's interest in qualified employer plans and individual retirement plans exceeded $562,500. Such interest as of Aug. 1, 1986 does not include any portion that was payable to an alternate payee under a QDRO.

Under the facts in Letter Ruling 9138004, Spouse cannot treat Plan benefits distributed under a QDRO as a recovery of benefits grandfathered under Sec. 4980A(f), because no grandfather election was made with respect to Spouse. These benefits are, therefore, subject to the excess distributions tax under Sec. 4980A.

Since the Plan benefits were not payable to an alternate payee at the time the election was made, these amounts were properly included in Taxpayer's grandfather amount. Temp. Regs. Sec. 54.4981A-1T, b-5: Q&A provides that, when an individual has elected the special grandfather rule, the grandfather amount determined under that rule may be applied against distributions as determined under that section, whether or not the distributions are from the same plan or IRA for which the grandfather amount is determined. Thus, the distribution of Plan benefits to Spouse will not reduce or affect the amount grandfathered with respect to Taxpayer. Taxpayer may apply the grandfather amount so established to future distributions from qualified plans - even if the distributions are from a plan formed after Aug. 1, 1986. This tax consequence should be understood by all parties negotiating divorce agreements.

Nondiscrimination Rules Guidance

The past 12 months have resulted in an unprecedented amount of guidance designed to ease compliance with recently finalized discrimination regulations. Much of this guidance will be incorporated into final regulations before taxpayers are required to amend their plans and conform operation of qualified retirement plans to such rules. * Effective dates delayed

On Aug. 7, 1992, the IRS issued proposed amendments to regulations and a notice delaying (1) the effective dates of the final nondiscrimination regulations and (2) the remedial period for plan amendments under Sec. 401(b). The proposed regulations cover the effective dates for the final regulations under Secs. 401(a)(4), 401(a)(5), 401(a)(17), 401(l), 410(b), 414(r) and 414(s), released in late 1991. For private-employer plans, the proposed new effective date is the first day of the plan year beginning on or after Jan. 1, 1994. For employers exempt from tax under Sec. 501(a), the proposed new effective date is the first day of the plan year beginning on or after Jan. 1, 1996.

For government plans, the proposed new effective date for the nondiscrimination rules, including the Sec. 401(a)(26), 401(k) and 401(m) rules, is the first day of the plan year beginning on or after the later of (1) Jan. 1, 1996, or (2) 90 days after the opening of the first legislative session after Jan. 1, 1996, if the legislature does not meet continuously. Government plans will be deemed to be in compliance with the rules under Secs. 401(a)(4), 401(a)(5), 401(a)(17), 401(a)(26), 401(k), 401(l), 401(m), 410(b), 414(r) and 414(s) until the applicable effective date.

Notice 92-36,(85) which was issued concurrently with the proposed regulations, addresses four issues. * The plan amendment remedial period in Sec. 401(b) is extended until the last day of the plan year beginning on the relevant effective date for the plan in the proposed regulations; the requirement that the plan sponsor must operate the plan in compliance with the rules from the effective date remains. * The transition relief granted by Notice 91-38(86) with respect to the continued use of Alternative II D, regardless of whether the employer had used the Alternative II D method of benefit accrual in any prior year, is extended. * A plan will be deemed to be maintained by a tax-exempt organization if 50% or more of the employees benefiting under the plan are employees of the tax-exempt organization. In multiple employer plans, if 50% of the aggregate employees are not employees of a tax-exempt entity, a single employer may apply the 50% test solely to that employer's plan. * Until further notice, Sec. 403(b) plans may continue to rely on Notice 89-23,(87) which imposes on the Sec. 403(b) plan sponsor a reasonable, good-faith standard for the application of the nondiscrimination rules in Sec. 403(b)(12).

Notice 92-36 adds some details on the operation of Notice 91-38 and Alternative II D during the remedial period. The use of Alternative II D may extend through the remedial period for individual plan sponsors and, for employers adopting master or prototype plans or regional prototype plans, through the later of the remedial period or the periods outlined in Rev. Proc. 89-9(88) or Rev. Proc. 89-13,(89) whichever is applicable. Excess accruals under Alternative H D can be disregarded in testing under Sec. 40 1 (a)(4), and the use of Alternative II D does not limit the use of fresh-start rules under the nondiscrimination rules.

With respect to amendments for nondiscriminatory benefits, rights and features, Notice 92-36 provides that the current and effective availability requirement will be met if it is satisfied on the last day of the first plan year in which the standard applies. Any amendment regarding such eligibility, adopted at any time during that plan year, will be treated as though it were in effect for the entire plan year. Amendments adopted during the remedial period may be treated as a single amendment to satisfy the final nondiscrimination regulations. * Reasonable, good-faith compliance

In the latter part of 1991, the IRS released a memo to its assistant regional commissioners concerning application of the reasonable, good-faith compliance standard for qualified plans in certain transition years. The standard may be applied to certain nondiscrimination and other provisions enacted or changed in the Tax Reform Act of 1986 (TRA) and subsequent acts. Guidance relating to this standard is important to plans that do not meet the requirements of new regulations issued in the qualification sections, but that do meet a lesser "reasonable, good-faith interpretation of the statute" standard. Secs. 401(a)(4), 410(b), 401(a)(17), 401(a)(26) and 414(q) are subject to the interpretation under the memo. In the summer of 1992, the IRS released its most recent field directive on "good-faith compliance" for Sec. 401(a)(4) and other changes made by the TRA. Following are some brief observations on the recent directive.

Regulatory safe harbor. Compliance with proposed, temporary or final regulations under Secs. 401(a)(4), 401(a)(5), 401(a)(17), 401(l), 410(b), 414(r) and 414(s) is one way to fulfill the good-faith compliance standard.

Sec. 401(a)(4) issues: There is a long section on Rev. Rul. 81-202.(90) For the transition period, taxpayers can still use the projected benefits version of the old "general test." The directive also describes the modifications that must be made to Rev. Rul. 81-202 - i.e., modifications relating to the $200,000 cap under Sec. 401(a)(17), the Sec. 414(s) definition of compensation and imputed disparity.

Nondiscriminatory rights and features: The optional benefits regulations that were issued in July 1988 apply for plan years beginning on or after Jan. 1, 1989.(91)

Past service grants: Use the preexisting guidance in Rev. Rul. 62-139(92) and Rev. Rul. 81-248.(93)

Top 25 early termination restrictions: See Regs. Sec. 1.401-4(c) for the old rules to be applied before May 14, 1990. After May 14, 1990, either these old rules or, if plan language permits, the new proposed or final regulations under Sec. 401(a)(4) can be used during transition.

Sec. 410(b): Following the final regulations in Regs. Secs. 1.410(b)-2 through -9 will be accepted as good-faith compliance. Facts and circumstances will control for the "classification" and average benefits test. During the transition period, eligible employees who failed to accrue a benefit simply because of the 1,000-hour rule or the "last day of the plan year" requirement may be counted as benefiting under the plan.

SLOB: The employer-wide nondiscrimination requirement will be judged on a facts and circumstances basis; otherwise, the guidance follows the statute and notes that notice to the IRS of separate-line-of-business (SLOB) usage is not required until further IRS guidance.

PIA offset plans: Such plans are acceptable if the offset is never more than the maximum Sec. 401(l) amount. Unfortunately, IRS personnel had been telling practitioners that primary insurance amount (PIA) plans are dead, and so practitioners have been relaying that word to their clients. Now, those who have ignored the IRS can have their "bad" plans.

Sec. 401(a)(17): The 1992 limit can be used for the transition period even though that will not be permitted after 1992.

Sec. 401(a)(26): Retroactive correction can occur up to the end of the 1993 plan year. * Investment options

There are many plans under which certain investment options are not offered to all participants - just to officers, shareholders or highly compensated participants. The rank-and-file employees' accounts are put in a "safe" investment, such as U.S. Treasury notes or savings accounts, with a low rate of interest. The final regulations under Sec. 401(a)(4) specify that the opportunity to direct investment is an "other right or feature" of a plan that must be nondiscriminatory as to current and effective availability. Moreover, the IRS has issued a technical advice memorandum, Letter Ruling 9137001,(94) indicating that the same is true for plan years before the effective date of the Sec. 401(a)(4) final regulations - and that the result of noncompliance is plan disqualification.

The plan sponsor was a corporation of eight doctors, each of whom was incorporated and whose professional corporations (PCs) were shareholders in the plan sponsor. The arrangement constituted an affiliated service group under Sec. 414(m). The plans, a profit-sharing plan and a money purchase pension plan, covered the doctors and six rank-and-file employees. Three of the doctors served as the plans' trustees.

The plans provided for directed investments by each "adopting employer" - that is, each participating PC. During the years at issue (pre-1989 plan years), each PC would direct the trustees - through an "investment committee" composed of some of the doctors - to invest its contribution in particular investments. These investments earned between 11% and 41% in the pension plan, and between 8% and 23% in the profit-sharing plan. For the same years, the investment committee directed the investment of contributions on behalf of the rank-and-file employees. Those investments showed only a 6% rate of return.

Sec. 401(a)(4) provides that a plan is qualified only if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees (officers, shareholders or highly compensated employees for plan years beginning before Jan. 1, 1989). Regs. Sec. 1.401-1(b)(3). provides that if the plan fails this test, either in the plan's form or its operation, the plan is not for the exclusive benefit of employees.

The IRS relied on its ruling in Rev. Rul. 70-370,(95) which disqualified a plan under which a self-employed individual could elect the percentage of contributions allocated to the plan's variable annuity fund, but the common-law employees could not. Rev. Rul. 70-370 held that unless a plan provides that all participants are allowed to direct their investments, a provision allowing the prohibited group to direct investments is discriminatory on its face, since that group would be allowed to select investments providing a higher rate of return.

In Letter Ruling 9137001, the plans operated to allow the doctors, but not the rank-and-file employees, to direct investment of plan assets. The return on investment for the prohibited group substantially exceeded that of the rank-and-file employees; but even if the doctors' self-direction had resulted in a lower return or a loss, their opportunity to self-direct their investments still would have resulted in prohibited discrimination under Sec. 401(a)(4). Therefore, the plans were disqualified for the years at issue. * Proposed procedure for nondiscrimination testing

The IRS has issued a proposed revenue procedure that would allow employers to use alternative methods for substantiating compliance with the pension plan nondiscrimination requirements. Ann. 92-81,(96) containing the proposed revenue procedure, focuses on comments the IRS has received about data collection and substantiation under the final nondiscrimination regulations issued in September 1991. Employers may rely on the alternative substantiation guidelines even though they are in proposed form.

The proposed revenue procedure simplifies the administrative process of substantiating compliance in the following ways. * Employers that do not have precise data available at reasonable cost may substantiate compliance with the nondiscrimination requirements by using a reliable substitute. * Employers may substantiate compliance with the nondiscrimination requirements by using snapshot testing on a single representative day. * Employers may use a simplified method for determining highly compensated employees (HCEs) to facilitate snapshot testing. * Employers will not be required to test a plan more than once every three years, provided there is no significant change.

An employer relying on these simplified methods for substantiating that a plan is nondiscriminatory under Secs. 401(a)(4), 410(b) and 414(s) must show that there is a high likelihood that the plan satisfies the nondiscrimination requirements. Sec. 401(k) or 401(m) plans may generally use these alternative methods only to substantiate compliance with the current availability of benefits, rights and features nondiscrimination requirements; these plans cannot use the alternative substantiation methods for amounts testing under Secs. 401(k)(3) and 401(m)(2).

Quality of data: An employer that does not have precise data available at a reasonable cost to substantiate that its plan satisfies the nondiscrimination requirements may use less-than-precise data, provided the following conditions are met. * The data being used is the best data available at a reasonable expense. * The employer reasonably concludes that demonstrating compliance using this data establishes a high likelihood that the plan would satisfy the nondiscrimination requirements if the precise data were available.

Data that satisfies these conditions is referred to in the revenue procedure as "substantiation-quality data."

Substantiation-quality data can be comprised of precise data and less-than-precise data, depending on the data available. For example, if an employer sponsoring a plan has age and compensation information for all employees, and hire dates for all but a few employees, the employer can estimate the years of service for those few employees based on the average number of years of service for other employees the same age. This estimation of missing data does not preclude the employer from reasonably concluding that there is a high likelihood that the plan would satisfy the nondiscrimination requirements using precise data.

Single-day snapshot testing: An employer can substantiate that a plan satisfies the nondiscrimination requirements on the basis of the employees present on a single day (snapshot day), provided the day is reasonably representative of the employer's work force and the plan's coverage throughout the plan year. Generally, the snapshot day must be consistent from year to year. The employees tested are solely the employees present on the snapshot day and as such are part of the "snapshot population."

To satisfy the nondiscrimination requirements using this revenue procedure, an employer must test the amount of benefits or contributions and the current availability of benefits, rights and features using substantiation-quality data for the snapshot population. While in most cases it will be practical for employers to select a snapshot day that is the same day for which substantiation-quality data is available, the employer is not required to do so. For example, an employer maintaining a defined contribution plan may use January 1 as the snapshot day and December 31 as the date for collecting the substantiation-quality data.

Under certain circumstances, the snapshot day will overstate the percentage of employees actually benefiting under a plan. This typically will occur when a defined benefit plan has a minimum-hours-of-service requirement for a plan year and the snapshot day is early in the year. For example, if the snapshot day is the first day of the plan year and the plan provides that only employees with more than a 1,000 hours will receive a benefit under the plan, employees terminating after the snapshot day with less than 1,000 hours will be counted as benefiting even though they do not, in fact, benefit. The result is more plans will satisfy the Sec. 410(b) coverage requirements than actually should. To correct this, employers must make adjustments to the ratio percentage or nondiscriminatory classification test to reflect terminations. A 5% adjustment attributable to employee terminations would increase the 70% minimum nonhighly compensated employee requirement by 3.5% (0.70 x 0.05) to 73.5%.

Highly compensated employees (HCEs): As part of the process of determining whether the nondiscrimination requirements have been satisfied, an employer is required to determine, as of the snapshot day, which employees are HCEs. Generally, an employee in the snapshot population is an HCE if - the employee is a 5% owner; - the employee's compensation for the year exceeds the Sec. 414(q)(1)(B) amount (indexed to $93,518 for 1992); - the employee's compensation for the year exceeds the Sec. 414(q)(1)(C) amount (indexed to $62,345 for 1992) and the employee is in the top paid group as defined in Sic. 414(q)(4); or - the employee is an officer described in Sec. 414(q)(1)(D).

This definition of an HCE differs from the Sec. 414(q) definition because it does not consider whether employees were highly compensated in prior years.

If the determination of which employees are HCEs is done before the plan year ends, the employee's compensation used to make this determination must be projected through the plan's year-end.

Sec. 401(k) and 401(m) plans may rely on this revenue procedure to determine HCEs, provided some modifications are made. In addition to the employees included as HCEs in the above test, employers must also include as an HCE any eligible employee who - terminated before the snapshot day and was an HCE in the prior year; - terminated before the snapshot day and had compensation greater than or equal to the projected compensation of any employee treated as highly compensated on the snapshot day (except those employees treated as highly compensated solely because they are 5% owners or officers); or - becomes eligible after the snapshot day and has compensation greater than or equal to the projected compensation of any employee treated as highly compensated on the snapshot day (except those employees treated as highly compensated solely because they are 5% owners or officers).

Three-year testing cycle: The tests in the proposed revenue procedure substantiating that a plan complies with the nondiscrimination requirements may be relied on for the two succeeding years, provided there are no significant changes (e.g., changes in the plan, the work force or compensation practices) subsequent to the testing date. The determination of whether a change is significant is based on the margin by which the plan has satisfied the nondiscrimination requirements in the most recent year tested and the likelihood that the change would eliminate that margin. For example, if the plan satisfied the minimum coverage test by 5% (0.75 - 0.70) and the change is likely to cause the percentage to fall below 70%, the change is significant. Thus, the greater the original passing margin, the more significant the change must be to require that the plan be retested.

If there is a change in a plan provision that will not affect other plan provisions, the employer can continue to rely on the tests for the next two years to satisfy the unaffected provisions. For purposes of the three-year testing cycle, the year in which the final regulations under Secs. 401(a)(4) and 410(b) are effective will be considered a year of significant change requiring actual testing. * Sec. 401(a)(4) and PIA offset safe harbors

On June 29, 1992, the IRS released Notice 92-31 and Notice 92-32.(98) The IRS used the notice mechanism to permit the public to comment before the proposals are issued formally as notices of proposed rulemaking. Notice 92-31 would expand the existing safe harbors under Sec. 401(a)(4); Notice 92-32 would add a safe harbor for primary insurance amount (PIA) offset plans.

Employee Stock Ownership Plans

* Nonfinancial factors in tender offer

In GCM 39870,99 the IRS Office of Chief Counsel has concluded that language in a trust agreement permitting the trustee of an ESOP to consider non-financial, employment-related factors in acting on tender offers violates the exclusive benefit rule of Sec. 401(a)(2).

The GCM involved two ESOPs of the same employer. The trust agreements of both ESOPs included the following language:

[T]he Trustee, in addition to taking into consideration any relevant financial factors bearing on any such decision, shall take into consideration any relevant non-financial factors, including, but not limited to, the continuing job security of Participants as employees of the Company or any of its subsidiaries, conditions of employment, employment opportunities and other similar matters, and the prospect of the Participants and prospective Participants for future benefits under the Plan.

In both trust agreements, this language appears in a section instructing the trustee on exercising his fiduciary obligations in the event he receives a tender offer for stock held in the trust. Generally, when company stock is allocated to participants' accounts, the trustee is required to solicit the participants' instructions on the sale, exchange or transfer of those shares. However, the trustee is responsible for voting and tendering the stock (1) in the case of tender offers for fewer than a stated number of shares, or (2) in the event that a passthrough vote (to employee/shareholders) or tender direction is found to be ineffective for any reason.

Under Sec. 401(a)(2), a trust is qualified only if, under the trust instrument, it is impossible (before satisfaction of all plan liabilities to employees and their beneficiaries) for any part of the trust principal or income to be used for or diverted to any purpose other than the exclusive benefit of employees or their beneficiaries. To satisfy this exclusive benefit/antidiversion requirement, the trustee's investment decisions can have no purpose outside of satisfying its liabilities to the participants and their beneficiaries.(100) Further, in order for an investment in employer securities to be consistent with the exclusive benefit requirement, the safeguards to which a prudent investor would adhere must be present.(101)

According to the GCM, allowing the trustee to consider nonfinancial, employment-related factors violates the exclusive benefit requirement of Sec. 401(a)(2). First, it constitutes a purpose that goes beyond satisfying liabilities under the plans. Second, it would permit the trustee to violate the prudent investor standard in that it could sway the trustee to reject tender offers that otherwise would be acceptable had the decision rested solely on financial criteria.

The Office of Chief Counsel was also concerned that investment decisions based on nonfinancial, employment-related factors may reflect management concerns in hostile takeover situations; while Congress has recognized ESOPs as a tool of corporate finance, it has not gone so far as to endorse their use as an antitakeover device. The GCM also noted that by permitting the trustee to consider nonfinancial, employment-related factors, the plans allow the trustee to engage in a form of "social investing" - i.e., to make investment decisions with an eye toward achieving certain social goals, such as continuing job security. According to the GCM, this type of social investing requires the trustee to go beyond the fiduciary duty of satisfying the plan's liabilities and to consider purposes not authorized by the Code.

In a footnote to its discussion of social investing, the GCM questions the continued viability of Rev. Rul. 70-536.(102) There, the IRS ruled that the taxexempt status of a Sec. 501(c)(17) trust providing collectively bargained supplemental unemployment benefits was not affected by an amendment permitting social investing (i.e., investment in projects providing community and social benefits, but at a below-market rate of return). According to the GCM, Rev. Rul. 70-536 is inconsistent with Sec. 501(c)(17)(a)(i), Which contains an antidiversion rule similar to that in Sec. 401(a)(2).

In valuing stock for sales or transfers to an ESOP it is important that an independent appraisal be obtained. While it is generally agreed that the appraisal does not have to consider the fact that the purchase is leveraged by the assets being purchased, the ESOP trustee should be careful to consider whether a minority or lack of marketability discount is appropriate. * Write-down of ESOP loan

A recent private letter ruling provides some answers to questions arising when the stock of a company with an ESOP drops significantly in value. Letter Ruling 9237037(103) permitted a plan sponsor to write down ESOP loans and amend the plan to permit stock distributions from the suspense account more quickly without treating the write-down as a deduction under Sec. 404(a)(9) or as an annual addition under Sec. 415(c)(2).

The ruling involved an ESOP with a favorable determination letter. In January 1989, the ESOP trust purchased all of Company's outstanding common stock (Trust Shares) from Company's shareholders. To finance the purchase, the ESOP trust borrowed from Company an amount equal to the purchase price under six separate loans (Trust Loans), pledging the Trust Shares as security. To make the loans and pay transaction costs, Company issued preferred stock and borrowed from Bank under five separate loans (Company Loans). Each of the Company Loans had terms substantially similar to the parallel Trust Loan in order to qualify as a securities acquisition loan under Sec. 133.

Under the ESOP, Company is obligated to make annual contributions in amounts sufficient to enable the ESOP trust to pay each installment of principal and interest due under each Trust Loan. The ESOP requires that the Trust Shares be held in a suspense account. On payment of principal or interest under a Trust Loan, Trust Shares are released from the suspense account in accordance with an allocation formula and allocated to the accounts of the participants. In accordance with Regs. Secs. 54.4975-7(b)(8) and 54.4975-11(c), the number of shares released from the suspense account each year is the total number of shares held in the suspense account immediately before the release, multiplied by a fraction. The fraction's numerator is the amount of the principal and interest paid under a Trust Loan for the year, and the denominator is the sum of the numerator and the principal and interest to be paid for all future years under a Trust Loan.

The appraised value of the Trust Shares immediately after the purchase by the ESOP trust was v dollars, taking into account the Company Loans and preferred stock. During 1989, Company experienced operating and other losses, and as of Dec. 31, 1989, the Trust Shares were appraised at w dollars, which was less than v dollars.

Company continued to experience losses, and in March 1991, it underwent a restructuring. Additional shares of common stock were issued to new investors, and Company's debt and preferred stock were restructured. (The letter ruling does not mention whether this dilution of the ESOP's 100% ownership of the common stock raised ERISA fiduciary issues. It appears that without the infusion of cash from the newly issued common stock, Company - and the ESOP - might have collapsed; thus, it appears that these actions were in the best interests of the plan beneficiaries.) After the restructuring, the Trust Shares represented z% of Company's outstanding common stock, with an appraised value of x dollars. As a result of various transactions, including the restructuring, only one of the Company Loans (Company Loan 1) continued to qualify as a securities acquisition loan under Sec. 133. At the time of the restructuring, Company Loan 1 had a principal amount of y dollars. Also, at that time, a Trust Loan (Trust Loan 1) had a principal amount of y dollars and substantially similar terms to Company Loan 1.

Because the Trust Shares had declined in value, Company and the ESOP trust have agreed to eliminate each of the Trust Loans, except Trust Loan 1, by writing them down to zero. Although the Trust Shares had declined in value by 65%, the write-down will be less than this percentage because Bank, in order to protect the status of Company Loan 1 as a securities acquisition loan, would not agree to a write-down in excess of the aggregate principal amount of all of the Trust Loans except Trust Loan 1. Trust Loan 1 will not be altered by the write-down. To facilitate the write-down, Plan will be amended to provide for allocation of the Trust Shares based entirely on payments of principal and interest on Trust Loan 1.

Under this amendment, no Trust Shares held in the suspense account will be released from the suspense account as a result of the write-down. Instead, such Trust Shares will be released from the suspense account under the allocation formula based entirely on payments of principal and interest on Trust Loan 1. Trust Shares will be released from the suspense account more rapidly after the write-down and plan amendment because all but one of the Trust Loans being eliminated he write-down had later maturity dates than Trust Loan 1.

Sec. 404(a)(9) provides in general that if contributions are paid into an ESOP trust and applied by the plan to the repayment of the principal or interest of a loan incurred for acquiring qualifying employer securities, such contributions are deductible within the limitations of that subsection. For a contribution to be made to an ESOP under Sec. 404(a)(9), an amount must be paid into a trust. No amount would be paid into the ESOP as a result of the write-down. Thus, the IRS ruled that the write-down and amendment to the ESOP would not result in a contribution to the ESOP trust under Sec. 404(a)(9), and the employer would not be entitled to a deduction under Sec. 404 as a result of the write-down.

Sec. 415(c)(2) defines the term "annual addition," for purposes of determining the limitation on contributions to a participant's account in a defined contribution plan, as the sum for any year of the employer contributions, employee contributions and forfeitures. Since the IRS found that there was no employer contribution deductible under Sec. 404, the write-down did not result in any contribution under Sec. 415(c)(2). Following the write-down, no Trust Shares will be released from the suspense account, and there will be no allocation to the accounts of the participants. Thus, the write-down and amendment to the ESOP would not result in an annual addition.

Addressing Sec. 4975, the tax on prohibited transactions, and the exception for loans to leveraged ESOPs, the IRS noted-that the exception applies if (1) the loan is primarily for the benefit of participants and beneficiaries of the plan, (2) the loan is at a reasonable rate of interest and (3) any collateral given to a disqualified person by the plan consists only of qualifying employer securities. The IRS focused on whether the write-down was primarily for the benefit of the participants and beneficiaries of the ESOP, noting that such cases will be subject to special scrutiny. Under Regs. Sec. 54.4975-7(b)(3), whether a loan satisfies the "primary benefit requirement" will be determined based on all the facts and circumstances.

Here, the amendment to the ESOP would provide that all Trust Shares will be released from the suspense account based entirely on payments of principal and interest on Trust Loan 1. Any change in the release of collateral from the original loan's terms also must meet the general requirement. in the case of the amendment to the ESOP, the remaining loan (Trust Loan 1) will be repaid earlier, resulting in Trust Shares being released to the participants more rapidly than if the write-down had not occurred. After the write-down, the plan assets will remain the same, and the loan provisions of Trust Loan 1 will remain the same. The IRS found that based on all the facts and circumstances, the Trust Loan would continue to be an exempt loan under Sec. 4975(d)(3) and would not fail to satisfy the requirements of Regs. Sec. 54.4975-7(b)(3) as a result of the write-down.

Regs. Sec. 54.4975-7(b)(8)(i) provides that for each plan year of the loan, the number of securities released must equal the number of encumbered securities held immediately before the release of the current plan year, multiplied by a fraction. The fraction's numerator is the amount of principal and interest paid for the year, and the denominator is the sum of the numerator and the principal and interest to be paid for all future years. The number of future years under the loan must be definitely ascertainable and must be determined without taking into account any possible extensions or renewal periods.

Regs. Sec. 54.4975-11(c) provides that all assets acquired by an ESOP with the proceeds of an exempt loan must be added to and maintained in a suspense account. They are to be withdrawn from the suspense account by applying Regs. Sec. 54.4975-7(b)(8) as if all securities in the suspense account were encumbered. After the write-down and the proposed amendment to the ESOP, the Trust Shares would be released from the suspense account significantly faster than under the release schedule before the write-down; thus, more shares for allocation to plan participants will be available in each year following the write-down, except for the final year of repayment of Trust Loan 1. Based on all the facts and circumstances, Trust Loan 1 would continue to be an exempt loan and would not fail to satisfy the requirements of Regs. Sec. 54.4975-7(b)(8) solely on account of the write-down.

The taxpayer's ruling request regarding the status of Company Loan 1 as a securities acquisition loan under Sec. 133 was transferred to the Office of Associate Chief Counsel of Employee Benefits and Exempt Organizations. To date, no ruling has been issued.

(65) PL 102-318, Unemployment Compensation Amendments of 1992 (UCA). (66) PL 102-318, Section 521(e)(2). (67) TD 8443 (10/20/92). (68) IRS Letter Ruling 9221052 (2/26/92). (69) Notice 89-25, 1989-1 CB 662. (70) IRS Letter Ruling 9139031 (7/3/91), revoking IRS Letter Ruling 9025092 (3/29/90). (71) Rev. Rul. 72-242, 1972-1 CB 116. (72) Robert O. Fowler, Jr., 98 TC No. 34 (1992). (73) H. Rep. No. 93-1280, 93rd Cong. 1974). (74) IRS Letter Ruling 9211035 (12/16/91). (75) See also IRS Letter Rulings 8819074 (2/17/88) and 8842014 (7/22/88). (76) William Wood, 93 TC 114 (1989). (77) Old Sec. 4021(a)(5)(C). (78) Rev. Rul. 81-158, 1981-1 CB 205. (79) IRS Letter Ruling 9206015 (11/7/91). (80) Sec. 3405(d)(1)(A) [(e)(1)(A) under the UCA]. (81) Sec. 3405(d)(2) [(e)(2) under the UCA]. (82) Sec. 3405(d)(3) [(e)(3) under the UCA]. (83) IRS Letter Ruling 9138004 (10/18/90). (84) Sec. 4980A(c)(2)(B). (85) Notice 92-36, IRB 1992-35, 12. (86) Notice 91-38, 1991-2 CB 636. (87) Notice 89-23, 1989-1 CB 654. (88) Rev. Proc. 89-9, 1989-1 CB 780. (89) Rev. Proc. 89-13, 1989-1 CB 801. (90) Rev. Rul. 81-202, 1981-2 CB 93. (91) See Regs. Secs. 1.401(a)-4 and 1.411(d)-4. (92) Rev. Rul. 62-139, 1962-2 CB 123. (93) Rev. Rul. 81-248, 1981-2 CB 91. (94) IRS Letter Ruling (TAM) 9137001 (4/24/91). (95) Rev. Rul. 70-370, 1970-2 CB 84. (96) Ann. 92-81, IRB 1992-22, 56. (97) Notice 92-31, IRB 1992-29, 6. (98) Notice 92-32, IRB 1992-29, 9. (99) GCM 39870 (4/7/92). (100) Regs. Sec. 1.401-2(a)(3). (101) Rev. Rul. 69-494, 1969-2 CB 88. (102) Rev. Rul. 70-536, 1970-2 CB 120. (103) IRS Letter Ruling 9237037 (6/16/92).