Current developments in employee benefits.

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part I, below, focuses on current developments affecting qualified retirement plans, including the pension provisions included in the General Agreement on Tariffs and Trade (GATT) and the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA), Employee Retirement Income Security Act of 1974 (ERISA) issues and various IRS releases providing guidance on qualified plan design. Part II, to be published in December, will focus on executive compensation and employee benefits issues, including IRS initiatives with respect to Sec. 403(b) plan compliance, the Financial Accounting Standards Board's statement on stock compensation, the Department of Labor's (DOL) Delinquent Filer Voluntary Compliance Program, and ERISA developments.

GATT

The GATT financing legislation adopted the Retirement Protection Act of 1994 (RPA), which included rounding rules for various pension cost-of-living adjustments, eliminated the quarterly contributions requirement for fully funded single-employer defined benefit plans, extended through 2000 Sec. 420 defined benefit pension asset transfers to fund retiree medical benefits, increased funding rates for uncertain plans less than 90% funded and expanded the data-gathering powers of the Pension Benefit Guaranty Corporation (PBGC).

Both the Code and ERISA impose minimum and maximum funding requirements on defined benefit plans. GATT's pension provisions are aimed at improving the funding of single-employer defined benefit plans and reducing the PBGC's exposure, at reducing or eliminating the PBGC's operating deficit and at reducing the defined benefit system's unfunded liabilities, for which the Federal government is potentially responsible.

Under prior law, the dollar limit on defined benefit plans under Sec. 415(b), the limit on elective deferrals under qualified cash or deferred arrangements under Sec. 402(g)(5), and the minimum compensation limit for determining eligibility for participation in a simplified employee pension (SEP) under Sec. 408(k)(2) were adjusted annually for inflation. Under RPA Section 732(b)(1), (c) and (d), GATT's simplified rounding rules, the dollar limit on benefits under defined benefit plans (currently, $120,000) and defined contribution plans (currently, $30,000) will be indexed in $5,000 increments, the limit on elective deferrals under Sec. 402(g) (currently, $9,240) will be indexed in $500 increments, and the minimum compensation limit for SEP participants (currently, $400) will be indexed in $50 increments.

Under Sec. 415(d)(2), as amended, the cost-of-living adjustment for any calendar year is to be based on the increase in the applicable index as of the close of the calendar quarter ending September 30 of the preceding calendar year, so that the adjusted dollar limits will be available before the beginning of the year to which they apply. RPA Section 732(e)(2) provides that no annual limit i reduced below the limit in effect for plan year beginning in 1994.

RPA Section 731(a) extends Sec. 420, originally scheduled to expire at the end of 1995, to Dec. 31 2000. This provision permits employers to transfer funds from defined benefit plans with assets in excess of 125% of current liability to pay for current retiree health benefits. There are also modifications to the maintenance-of-effort requirement and the rule relating to the set-aside of prior amounts to pay qualified retiree health liabilities.

Under RPA Section 754, effective for plan years beginning after Dec. 8, 1994, sponsors of single-employer defined benefit plans with assets equal to 100% of current liability in the prior plan year are not required to make quarterly estimated contributions during the current plan year. Pre-RPA Sec. 412(m)(1) had required quarterly installments, with the full minimum funding contribution due no later than 8 1/2 months after the last day of the plan year.

GATT will also have a dramatic impact on the calculation of benefits paid in a lump sum. Before GATT, the present value of the nonforfeitable accrued benefit was calculated under Sec. 417(e)(3)(a)(i) using an interest rate no greater than the rate that would be used (as of the distribution date) if the vested accrued benefit (using that rate) did not exceed $25,000, or 120% of such rate if the vested accrued benefit exceeded $25,000.

Under RPA Section 767(a)(2), the present value (PV) of a participant's nonforfeitable accrued benefit must be no less than the PV using the Treasury-prescribed mortality table based on the "prevailing commissioners' standard table" used to determine reserves for group annuity contracts issued on the date as of which is determined. Currently, the prevailing commissioners' standard table is the 1983 Group Annuity Mortality Table (GAM 83) prescribed by the National Association of Insurance Commissioners. PV for these purposes must be no less than the PV determined by using the annual interest rate on 30-year Treasury securities for the month before the distribution date, or such earlier time as provided in regulations.

RPA Section 767(d)(1) indicates that these changes are generally effective for plan years beginning after 1994, except that an employer can elect to treat them as being in effect after Dec. 7, 1994. Under a transition rule, RPA Section 767(C)(3)(B), PV may be calculated as under prior law until the earlier of (1) the first plan year beginning after 1999 or (2) the later of when a plan amendment applying the provision is adopted or made effective.

Under pre-RPA Sec. 412(e)(1), a special funding rule applied to underfunded defined benefit plans. Generally, the minimum required contribution was the greater of the amount determined under the normal funding rules, or the sum of (1) normal cost, (2) the amount necessary to amortize experience gains and losses over five years and gains and losses resulting from changes in actuarial assumptions over 10 years and (3) the deficit reduction contribution plus the amount required to fund contingent benefits. The contribution amount could not exceed the amount needed to increase the funded ratio of the plan to 100%. The RPA includes two exceptions to the special funding rules for underfunded plans. First, RPA Section 751(a)(1) provides that the underfunding rules do not apply to a plan with a funded liability percentage of at least 90%. Second, under RPA Section 751(a)(1)(b), adding Sec. 1412(l)(9), pension plans with funded current liability ratios of at least 90% for two immediately preceding years are exempt from deficit reduction contribution charges and participant notification requirements if the plan's funded ratio is at least 80% in the current year.

RPA Section 751(a)(3) substantially altered the calculation of the deficit reduction contribution for underfunded plans under Sec. 412(1)(2). The deficit reduction contribution is the sum of the unfunded old liability amount, the unfunded new liability amount, the expected increase in current liability due to benefits accruing in the plan year, and the amount needed to amortize the increase in current liability due to certain future changes in the required mortality tables. Under Sec. 412(1)(1), flush language, the minimum required contribution cannot exceed the amount needed to increase the funded current liability percentage of the plan to 100%, taking into account all charges and credits to the funding standard account and the expected increase in current liability attributable to benefits accruing during the plan year. RPA Section 751(a)(7)(a) lowered the maximum interest rate under Sec. 412(1)(7)(c) that can be used to determine the current liability, and all underfunded plans must use the same mortality table (currently, GAM 83).

Under pre-RPA Sec. 1412(c)(7)(a), pension assets had to equal the lesser of 100% of accrued liability or 150% of current liability to the extent the plan was at the full funding limit and no contribution was required under the minimum funding rules. "Current liability" is all liabilities to participants and beneficiaries under the plan, determined as if the plan terminated; it represents only benefits accrued to date, and does not depend on the actuarial funding method.

The RPA modified the way in which defined benefit plan sponsors determine the full-funding limit to conform to IRS practice. RPA Section 751(a)(10) retains the Sec. 412(c)(7) rules relating to determining the full-funding limit, but also provides that the expected increase in current liability due to benefits accruing during the plan year must be included in determining the employer's current liability. The RPA allows plans to determine their 150% of current liability limit for full-funding purposes without regard to the RPA changes in the interest rate and mortality assumptions; under Sec. 412(c)(7)(e)(i)(I), the fullfunding limit is not less than 90% of the plan's current liability (using the RPA-modified interest rate and mortality assumptions). To determine if a plan is at the 90% limit, Sec. 412(c)(7)(e)(ii)(II) provides that plan assets are not reduced by credit balances in the funding standard account.

In general, See. 404 limits the amount of annual deductible contributions. Pre-RPA plan sponsors maintaining both defined contribution and defined benefit plans that cover some of the same employees were limited to deducting the greater of 25% of compensation or the contribution needed to meet the defined benefit plan's minimum funding requirements. A 10% excise tax was imposed by Sec. 4972 on contributions that exceeded the deduction limit. Under RPA Section 755(a), amending Sec. 4972(c)(6), contributions to defined contribution plans that are nondeductible because they exceed the 25% limit on combined contributions are not subject to the excise tax, if the contributions to such plans do not exceed 6% of compensation.

Plan administrators were required under pre-RPA ERISA Section 4043(b) to notify the PBGC within 30 days of reportable events indicating risk to the financial condition of the plan or to the PBGC. Under RPA Section 771(b), contributing sponsors, as well as plan administrators, are required to notify the PBGC. Several new events involving changes in control of the sponsor or the plan are added to the list of reportable events by RPA Section 771(c), and the PBGC must be notified 30 days in advance of certain transactions when any party to the transaction has $50 million in aggregate plan underfunding and the companies are not subject to Securities Exchange Act of 1934 reporting requirements.

Under pre-RPA ERISA Section 4006(a)(3)(E), PBGC-covered plans were required to pay a flat per capita premium of $19; underfunded plans were required to pay an additional premium based on the amount of underfunding ($9 per $1,000 of underfunding, not to exceed $53 per participant). The total premium could not exceed $72. RPA Section 774(a) phases out the cap on the variable-rate premium for underfunded plans over three years. For plan years beginning after June 30, 1994 but before July 1, 1995, the maximum additional premium is $53 per capita, plus 20% of the total premium (determined without the cap) in excess of $53. For plan years beginning after June 30, 1995 but before July 1, 1996, the maximum additional premium is $53 per capita, plus 60% of the premium (determined without regard to the cap exceeding $53).

Pre-RPA ERISA Section 103(d)(11) required that the annual report of any plan less than 70% funded include the plan's funded percentage. Also, under ERISA Regs. Section 2520.102-3(m)(2), the plan's summary plan description, which must be given to all participants, had to include a description of the PBGC's guarantee. RPA Section 775(a) amends ERISA to require plan administrators of underfunded plans to notify participants of the plan's funded status and the limit on the PBGC's guarantee should the plan terminate while underfunded, unless the plan is exempt from the special funding rules for underfunded plans.

Under prior PBGC rules, if the plan administrator of a terminating plan was unable to locate participants after having made a reasonable effort to do so, the administrator was required either to buy irrevocable commitments to provide benefits for each participant who had not been located or, in certain circumstances, deposit the amounts in a bank. Under RPA Section 776, adding ERISA Section 4050, in the case of a missing participant, the plan administrator of a plan under a PBGC standard termination is required to transfer the participant's benefit to the PBGC or buy an annuity from, an insurer to satisfy the benefit liability to the participant.

The IRS has issued several revenue rulings to address some of the operational issues raised by GATT.(1) Similarly, the PBGC has issued regulations to implement the new notice requirements for plans that must make the deficit reduction contribution, as well as proposed regulations implementing the new requirements on missing participants.(2)

USERRA

Under prior law,(3) eligible veterans who voluntarily or involuntarily left civilian jobs to serve in the military generally had to be restored to their former positions or to a position of like seniority, status and pay. For certain benefits purposes, the U.S. Supreme Court held, in Alabama Power Co. v. Davis,(4) that a veteran's service in the military must be counted in determining the veteran's vested interest and accrued benefit in a defined benefit plan.

Prior law did not specifically deal with rights under retirement plans. In Alabama Power Co., the Supreme Court found, however, that because benefits under a defined benefit plan are in the nature of a reward for length of service and would have accrued with reasonable certainty had the veteran been continuously employed, they are perquisites of seniority. Consequently, pursuant to the requirement that eligible veterans be reemployed without loss of seniority, an eligible veteran's time in the military must be counted in determining his vested interest and accrued benefits in the plan. Lower courts are divided on whether benefits under defined contribution plans are perquisites of seniority, and thus guaranteed to a veteran under prior law.(5)

In part to address the issue of defined contribution plans, as well as to resolve issues that arose during the Desert Storm and Somalia interventions, Congress began to consider expansion of veterans' employment rights three years ago. The bills Congress passed amend the laws regarding reemployment rights and benefits for individuals who serve in the "uniformed services" (i.e., the Armed Forces, the Air or Army National Guard, or the commissioned corps of the Public Health Service).

USERRA changes prior law in several ways--it eliminates the distinction among categories of military service (e.g., "active duty," "active duty for training" and "initial active duty for training"), substituting "service in the uniformed services" as the basis for eligibility.(6) It provides that an employee is entitled to reemployment rights or other employment benefits only if the cumulative period of service in the uniformed services does not exceed five years; further, it sets time limits for reporting back to work or requesting reemployment after military service based on duration, rather than on type, of service, and requires that employees provide advance notice before departure for all types of duty.(7)

There are several new provisions with regard to benefits. Service in the uniformed services is considered service with the employer for vesting and accrual purposes for persons reemployed under USERRA.(8) The employer who reemploys the individual is liable for funding any resulting benefits obligation. For purposes of applying USERRA's provisions regarding a reemployed person's rights to benefits under a pension plan, "pension plan" includes any retirement plan defined under ERISA Sections 3(2) and 3(33) and any Federal or state and local government plan, including defined contribution and defined benefit plans.(9) All employees covered by employer-sponsored health plans are allowed to continue such coverage for a period of up to 18 months on the employee's departure for service.(10)

A person reemployed under USERRA "shall be treated as not having incurred a break in service with the employer or employers maintaining the plan by reason of such person's period or periods of service in the uniformed services."(11) Periods in the uniformed services are deemed to constitute service with the employer or employers maintaining the plan in determining the nonforfeitability of the person's accrued benefits and the accrual of plan benefits.(12)

USERRA specifically gives a reemployed veteran the opportunity to make after-tax contributions and elective contributions for periods of military service, over a period of at least three times the length of the absence, not to exceed five years.(13) Employers must give the veteran any matching contributions that ordinarily would have been made, if the veteran makes the missed contributions or deferrals. However, the employer is not required to credit earnings prior to the time any contribution is made, or to allocate forfeitures during the employee's absence.(14)

With regard to contributions under retirement plans for the period of military service, contributions must be based on the salary the employee would have received had he remained at work. If the employee's compensation was not at a fixed rate, contributions must be based on the employee's average compensation for the 12-month period preceding the leave of absence.(15)

In some cases, USERRA's requirements conflict with the Code and ERISA. The congressional tax-writing committees could not resolve the conflicts; thus, USERRA Section 8(h) provides a transition rule that gives plans up to two years after the date of USERRA's enactment to come into compliance. Bills have been introduced into the House and Senate that would add a Sec. 414(u) to address these conflicts.(16)

A senior member of the House Armed Services Committee, Rep. G.V. Sonny Montgomery (D-Miss.) argues very strenuously that the existing law has always required defined contribution plan contributions to be made for returning veterans, regardless of case law to the contrary. Consequently, some plan sponsors may be receiving demands from returning veterans for profit-sharing allocations. Conceivably, these demands could extend back to 1940, when the reemployment law was first enacted.

USERRA Section 8(h) specifies that nothing in USERRA shall be construed to relieve an employer of the obligation to provide contributions to the plan or to provide pension benefits that existed under prior law. Whether the prior law or USERRA requires past defined contribution plan benefits for returning veterans is likely to be resolved only by further litigation.

For most employers, the direct dollar effect of USERRA is likely to be small, but the questions and problems with its administration are likely to be extremely complex and burdensome.

ERISA Issues

* Fiduciary responsibilities

The DOL has released Interpretive Bulletin (IB) 95-1,(17) providing that in choosing an annuity provider to supply benefit distributions due to a participant's separation or retirement or plan termination, the plan sponsor must take steps calculated to obtain the safest annuity available. The retroactive effective date is Jan. 1, 1975.

Concerns about benefit distribution annuities arose in late 1990, when certain annuity providers (e.g., Executive Life Insurance Company) faced financial difficulties. In June 1991, the DOL and the PBGC issued a notice of advance rulemaking(18) on the purchase of annuities for benefits distribution and possible changes to the existing minimum standard in DOL Regs. Section 2510.3-:3(d)(2)(ii).

According to the DOL, this IB is in addition to and independent of the existing regulatory minimum standard. The DOL also notes these standards do not apply when purchasing annuities as investments; with investment annuities, the DOL acknowledges that it may be appropriate to accept more risk for higher possible rates of return.

The standard for selecting an annuity provider for benefits distribution requires the plan sponsor to take steps calculated to obtain the safest annuity available, unless under the circumstances it would be in the interests of participants and beneficiaries to do otherwise. At a minimum, the fiduciary obligation of prudence in ERISA Section 404(a) requires plan fiduciaries to conduct an objective, thorough and analytical search to identify and select providers from which to purchase annuities.

IB 95-1 states that reliance solely on ratings provided by insurance rating services will not be sufficient to meet the requirement; rather, in conducting such a search, a fiduciary must evaluate a number of factors relating to a potential annuity provider's claims-paying ability and creditworthiness. The IB lists the types of factors a fiduciary should consider, including the quality and diversification of the annuity provider's investment portfolio, the size of the insurer relative to the proposed contract, the level of the insurer's capital and surplus, the lines of business of the annuity provider and other indications of an insurer's exposure to liability, the structure of the annuity contract and guarantees supporting the annuities, and the availability of additional protection through state guaranty associations and the extent of their guarantees. Unless they possess the necessary expertise to evaluate such factors, fiduciaries will need to obtain the advice of a qualified, independent expert.

The DOL recognizes there are situations in which it may be in the interest of the participants and beneficiaries to purchase other than the safest available annuity, such as when the annuity is only marginally safer, but disproportionately more expensive than competing annuities, and the participants and beneficiaries are likely to bear a significant portion of the increased cost. It may also be in the interest of the participants and beneficiaries to choose a competing annuity if the annuity provider offering the safest available annuity cannot demonstrate the ability to administer the payment of benefits to participants and beneficiaries. The DOL warns that increased cost or other considerations can never justify putting the benefits of annuitized participants and beneficiaries at risk by purchasing an unsafe annuity. Also, the "cost" element does not mention additional cost to the plan sponsor, or cost to the plan if the plan assets after termination revert to the plan sponsor, as a trade-off against safety.

* Insurance company class exemption

The DOL has issued a class exemption from the Code's and ERISA's prohibited transaction rules for certain transactions involving insurance company general accounts in which an employee benefit plan has an interest.(19) The exemption, issued in response to the Supreme Court's decision in John Hancock Mutual Life Ins. Co. v. Harris Trust @ Savings Bank,(20) applies retroactively to Jan. 1, 1975, the effective date of ERISA's fiduciary provisions.

The Supreme Court had ruled in Harris Trust that certain pension funds held in an insurance company's general account (generally, the component of a deposit administration contract that varies with the investment experience of the insurance company) are plan assets; thus, the insurer's actions with respect to the management and disposition of such funds are subject to ERISA's fiduciary standards.

The American Council of Life Insurance sought the class exemption, claiming that Harris Trust has created uncertainty regarding the status of general account operations and would have a long-term adverse effect on plan participants, U.S. capital markets and the insurance industry. Prior to Harris Thust, the insurance industry had operated under the assumption that general account assets were not subject to ERISA's fiduciary provisions. Numerous transactions by insurance company general accounts prior to Harris Trust may have violated ERISA's prohibited transaction provisions, giving rise to the potential for significant additional litigation.

The class exemption exempts the following from ERISA Section 406(a) and 407(a) restrictions and from taxes imposed by Sec. 4975:

* Any transaction between a party in interest to a plan and an insurance company general account in which the plan has an interest either as a contract holder or as the beneficial owner.

* Any acquisition or holding by the general account of employer securities or employer real property.

* Any acquisition or holding of qualifying employer securities or qualifying employer real property by a plan (other than through an insurance company general account), if the acquisition or holding contravenes the ERISA restrictions solely by reason of being aggregated with employer securities or employer real property held by an insurance company general account.

The exemptions are conditioned on the requirement that the plan's participation in the general account, as measured by the reserves and liabilities arising from the contract held by the plan, does not exceed 10% of all reserves and liabilities of the general account, for transactions occurring after July 11, 1995.

The following three general conditions also apply:

* At the time the transaction is entered into, and at the time of any renewal that requires the insurance company's consent, the terms of the transaction must be at least as favorable to the general account as the terms generally available in arm's length transactions between unrelated parties.

* The transaction must not be part of an agreement, arrangement or understanding designed to benefit a party in interest.

* The party in interest must not be the insurance company, any pooled separate account of the insurance company or an affiliate of the insurance company.

The DOL's exemption also permits transactions involving persons who are parties in interest to a plan solely by reason of providing services to an insurance company general account in which the plan has an interest as a contract holder, if the three general conditions are met. The furnishing of services, facilities and any goods incidental to such services and facilities by a place of public accommodation (e.g., a hotel) owned by an insurance company general account to a party in interest is exempt if such services, facilities and incidental goods are furnished on a comparable basis to the general public.

The DOL rejected requests by commentators to expand the asset pool investment relief further at this time, although it did acknowledge it would be receptive to other requests for exemption relief in the area of pooled asset investments.

IRS Guidance

* Linking Sec. 401(k) and nonqualified plans 

The IRS recently issued Letter Ruling 9530038,(21) concerning the structure of an employer's executive compensation plan closely linked to the employer's qualified Sec. 401 (k) plan and enabling executives to maximize their contributions to the Sec. 401(k) plan. The ruling essentially provided that the arrangement's unique structure would satisfy both the nonqualified deferred compensation requirements and the Sec. 401(k) rules.

The IRS approved an earlier version of this arrangement in Letter Ruling 9317037.(22) The earlier arrangement permitted a deferral into the nonqualified plan during the year, and permitted an election into the Sec. 401 (k) plan after the plan year. Letter Ruling 9317037 addressed only the Sec. 401(k) rules; it expressed no opinion as to whether the arrangement satisfied the nonqualified plan rules. After practitioners and IRS personnel expressed concerns that the ruling appeared to approve an arrangement that did not satisfy basic nonqualified plan rules, the IRS withdrew it.

The employer that had originally requested the ruling asked the IRS to help design a program that would satisfy both the Sec. 401(k) rules and the nonqualified plan rules. Letter Ruling 9530038 approves an arrangement that satisfies both requirements while providing a workable mechanism for maximizing the amounts deferred into the Sec. 401(k) plan. The final product permits employers to allow their executives into the Sec. 401(k) plan and avoid distributions at the end of the year. Additionally, it may improve relations among the highly compensated groups, because the lower-paid highly compensated employees (HCEs) may be able to keep more of their elective deferrals in the Sec. 401(k) plan.

Letter Ruling 9530038 describes an unfunded, nonqualified deferred compensation plan, available to a select group of management employees, and a Sec. 401 (k) plan, available to all employees.

Step 1: The arrangement provides that the select group of management employees may elect to defer compensation into a nonqualified plan before the beginning of the year in which the amount will be earned and deferred. The nonqualified plan deferred compensation election provides that an amount equal to the maximum that will be permitted as a Sec. 401(k) deferral to the "select group" under the Sec. 401(k) actual deferral percentage (ADP) test for the following year will be distributed to an employee from the nonqualified plan once the ADP test has been run unless the employee has initially elected to have that amount contributed to the Sec. 401(k) plan.

Step 2: During the year, amounts are deferred from the executives' compensation into the nonqualified plan. These amounts are not held in trust, nor are they contributed to the Sec. 401(k) plan during the year. The amounts deferred into the nonqualified plan are part of the general assets of the employer. Such amounts may be credited with employer matching contributions during the year.

Step 3: After the end of the plan year, the record keeper runs the ADP test and determines the non-highly compensated employee (NHCE) average deferral percentage, and thus calculates the amount that may be deferred, on average, by the HCEs. This information is transmitted to the employer, who determines (1) which "select group" employees elected to have the permitted amount transferred to the Sec. 401(k) plan from the nonqualified plan, and (2) how much must be transferred from the nonqualified plan to the Sec. 401 (k) plan.

Step 4: The employer transfers the amounts to the Sec. 401(k) plan as elective deferrals. For any executive who did not make the Sec. 401(k) transfer election, the amount will be distributed to the executive and shown on a Form W-2 as taxable in the year deferred. Since the amounts contributed to the Sec. 401(k) plan on behalf of these executives are legitimate elective deferrals for the plan year, the amounts may be matched, once received by the plan, and are treated as elective deferrals for all purposes. The letter ruling provides that amounts contributed to the Sec. 401(k) plan after the end of the year cannot include earnings credited on the nonqualified deferred compensation.

The arrangement is designed to maximize top executives' Sec. 401(k) contributions, minimize post-year distributions (even though the total amount that can be contributed may not yet be known), and maximize the nonqualified compensation deferral. While the arrangement is complicated, it is the only arrangement the IRS has approved. The IRS has previously noted that most arrangements linking a nonqualified plan and a Sec. 401(k) plan do not work. Previous arrangements failed to satisfy the cash requirements, the prior year deferral requirements, or the contingent benefit rules. The arrangement described in Letter Ruling 9530038 satisfies all three requirements and provides a useful roadmap for establishing similar arrangements.

Eligibility

The IRS has issued a field directive(23) and a letter ruling(24) providing guidance on the exclusion of part-time employees under Sec. 410. Sec. 410(a) sets ceilings on minimum age and service conditions in a qualified plan. A qualified plan cannot condition participation on completion of a period of service extending beyond the later of the employee's twenty-first birthday or the date the employee completes one year of service. A year of service generally means a 12-month period in which the employee has at least 1,000 hours of service. Regs. Sec. 1.410(a)-3(d) provides that Sec. 410(a) does not preclude a qualified plan from establishing other types of conditions for plan participation (e.g., Sec. 410(a) does not preclude a plan from requiring, as a condition of participation, that an employee be employed within a specified "job classification".

Citing Regs. Sec. 1.410(a)-3(e), the field directive states that plan provisions may be treated as imposing age and service requirements even though the provisions do not specifically refer to age or service. Regs. Sec. 1.410(a)-3(e)(2), Example (3), states that a plan that excludes part-time employees as a class will not qualify under Sec. 410(a) because it could result in the exclusion, by reason of a minimum service requirement, of an employee who has completed a year of service within the meaning of Sec. 410(a)(3). The plan would not qualify even if, after excluding all employees in the part-time classification, it satisfies the coverage requirements of Sec. 410(b). Sponsors with a favorable determination letter for a plan that includes a provision excluding part-time employees from participation will be protected. However, future determination letters will consider this and changes to plan operations may be needed.

Plans should be reviewed and amended, if necessary, to ensure that the plan document does not exclude part-time employees as a class. In operation, if the plan contains the 1,000-hour rule, part-time employees will often accrue no benefits.

* Definitely determinable allocations

In a "Pension Field Directive on Definitely Determinable Allocations," issued in November 1994, the IRS alerted field agents to look for profit-sharing plan language that permits the employer to make different allocations to two or more groups, when those allocations are not spelled out in an allocation formula. A failure to specify how allocations will be divided among groups violates the Regs. Sec. 1.401-1(b)(1)(ii) requirement for definitely determinable benefits, even if the plan contains a definitively determinable formula for allocating contributions within each group.

The IRS warned its personnel to check the allocation formula to be sure it satisfies the regulation's definitely determinable allocation requirements. If the plan covers employees of controlled group, it should be ensured that definitely determinable allocations are made to employees of the members of the group. A employer may wish to allocate contribution based on profits among the members of a controlled group (not unreasonable when the employer] sponsors a "profit-sharing" plan). This "profit sharing" should be accomplished, according to the IRS, by providing that the contributions are allocated first to all covered employers of each member of the controlled group in proportion to profits of such members to total profits, and the between the employees of each such member in proportion to compensation.

The IRS does not address the fact that an employer could accomplish the same goal by simply having two or more profit-sharing plans and using discretion to make allocations to each one in any one year.

* Exclusive benefit rule

The IRS ruled in Letter Ruling (TAM) 9516005(25) that the assumption by a qualified plan of an acquired company's early retirement benefit liability would not violate the Sec. 401(a)(2) exclusive benefit rule, and that the assumption of the liability would not result in a prohibited transaction under Sec. 4975(c)(1)(d).

In the ruling, Company A acquired all of the stock of Company B. Both companies maintained qualified retirement plans. After the acquisition, B's plan was merged into A's, so that benefits payable under either plan became payable under A's plan.

B also maintained an arrangement in which supplemental retirement benefits were paid out of its general assets. The supplemental benefits represented early retirement benefits granted to employees affected by a reduction in B's work force. As part of the acquisition, A assumed the liability of the supplemental benefits and started paying them out of its general assets. A requested a determination letter on a proposed amendment to Plan A that would incorporate the supplemental benefit liability into Plan A. Under the proposed amendment, the supplemental benefits would be paid out of Plan A, rather than out of A's general assets.

The IRS ruled that the amendment would not cause the plan to violate the exclusive benefit rule. Sec. 401(a)(2) generally provides that a plan constitutes a qualified plan only if it is established by the employer for the exclusive benefit of his employees and their beneficiaries. The IRS reasoned that although A's obligation to pay the supplemental benefits is separate and apart from Plan A, the benefits are of a type that can be provided under a qualified plan and are owed to individuals who are employees and Plan A beneficiaries. Therefore, the plan amendment will not result in plan assets being used for or diverted to purposes other than the exclusive benefit of the employees or their beneficiaries.

The IRS also ruled that even though A would be benefiting by paying the supplemental benefit out of plan assets, the amendment would not be a prohibited transaction under Sec. 4975(c)(1)(d). Sec. 4975(c)(1)(d) provides that 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 generally is a prohibited transaction.

Finally, the IRS addressed whether the supplemental benefits were "definitely determinable benefits." Under Regs. Sec. 1.401-1(b)(1)(i), a pension plan is defined as a plan established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to its employees over a period of years after retirement. The IRS concluded that the designation by A of a list of employees to receive the supplemental benefits, which included a specific annual payment for each employee, payable in a form that complied with the requirements of Sec. 401(a)(11), constituted a definitely determinable benefit.

* Plan contributions

The IRS ruled in Letter Ruling 9507030(26) that a payment to a qualified plan to restore investment losses resulting from a breach of a fiduciary duty will not constitute a contribution for purposes of Sec. 401 (a)(4), does not give rise to an annual addition under Sec. 415 and may be deductible under Sec. 162.

In the ruling, P Corporation sponsored several qualified defined contribution plans (the Plans) on behalf of its employees and subsidiaries. P maintained a division (D) that performs all investment management duties related to the Plans. D is managed by an investment officer who is a P corporate officer and responsible for managing the assets of the Plans' investment funds. The investment officer also has authority to delegate this responsibility to outside investment advisers or manage the assets internally.

The Fund is one of the investment funds in which Plans participants may elect to have their account balances invested. The Fund's stated objectives include security of principal, liquidity and rates of return in excess of the rate for 90-day Treasury bills. In 1994, the Fund incurred a principal loss of several million dollars on debt instruments that were principal risk securities commonly known as derivatives. D directed the investment in these debt instruments between 1993 and 1994. During 1994, after P's management determined that the investment of the Fund may not have met the investment expectations of plan participants, D determined that it would be prudent to sell the investments, which resulted in a substantial principal loss.

The DOL investigated the loss and stated in a 1994 letter that P and D had breached their fiduciary duties in violation of ERISA. Also, a group of plan participants filed a class action suit in Federal district court, alleging violations by P of ERISA and Federal and state securities laws, and asserting various common-law causes of action with respect to the investments.

To resolve the actual and potential fiduciary claims of participants and others with respect to investment of the Plans' assets P wanted to restore the principal loss by making a restoration payment to the Fund. The restoration payment consisted of the amount of the principal loss reduced by amounts disclaimed by participants who were senior officers of P, plus interest at the actual rate the Fund earned from the date of the principal loss until the date of the restoration payment. No restored participant account would exceed the amount that would have been in the account but for the loss.

The IRS ruled that the proposed restoration payment by the investment manager did not constitute a contribution for purposes of Secs. 401(a)(4), 404 and 415, did not give rise to an annual addition under Sec. 415, and did not result in taxable income to the plan participants or beneficiaries.

P also asked the IRS to rule that the payment made for the resolution of actual or potential claims for breach of a fiduciary duty was deductible under Sec. 162. In general, payments in settlement of lawsuits or potential lawsuits can be deducted if the acts giving rise to the litigation were performed in the ordinary course of the taxpayer's business. Citing several cases,(27) the IRS stated that to determine the nature of the acts giving rise to the litigation, one must look to the nature and origin of the claim asserted, rather than the claim's potential impact on the taxpayer's business operations. The origin of the claim test may require allocation of a portion of the settlement payment to claims that were only threatened as well as to claims actually litigated.

The IRS found no cases involving a similar payment by an employer to a pension plan, but noted that authority existed in other contexts to support the deduction of payments in settlement of a breach of fiduciary duty. The IRS emphasized that the restoration payment was being made in response to actual and potential claims for breach of fiduciary duty; therefore, P's payment in settlement of such claims could be deducted in full under Sec. 162.

Actuarial Assumptions

After the Solicitor General refused to appeal the Citrus Valley(28) case to the Supreme Court, the IRS apparently conceded its legal arguments on the actuarial assumptions for small pension plans, announcing in a news release(29) that it will expedite the resolution of more than 2,000 pending small pension plan cases involving actuarial assumptions. According to the news release, the IRS is maximizing its efforts to speedily resolve these disputes and expects to contact taxpayer representatives soon about the disposition of their cases.

As was previously reported,(30) a series of cases arose from the IRS's Small Plan Audit Program, which had been prompted by the IRS's perception that there were abusive tax practices among small pension plans. The IRS audited numerous small plans and assessed deficiencies and penalties against the plan sponsors. Many of the plan sponsors petitioned the Tax Court for a redetermination. The Tax Court selected and tried three test cases,(31) and ruled in favor of the sponsors in each case. The Sixth Circuit issued a similar decision in Rhoades, McKee,(32), a case that originated in district court. The courts ruled consistently that an actuary's conservative assumptions in setting funding levels for individual defined benefit pension plans for small businesses and professional corporations satisfy the Code's requirement that they represent the actuary's best estimate of anticipated plan experience.

Examination Guidelines 

As a component of its continued enforcement initiatives for qualified plans, the IRS has released final guidelines for use by employee plans examiners when examining plans for qualified joint and survivor annuity and single-sum distribution issues.(33) The IRS also released for public comment its proposed field agent examination guidelines for leveraged employee stock ownership plans (ESOPs), plans that may be top heavy, and limitations for defined contribution plans.

In each case, the IRS cautions that the guidelines are not meant to be all-inclusive, are not a precedential or comprehensive statement of the IRS's legal position on the issues and cannot be relied on or cited to taxpayers as authority.

The final examination guidelines on single-sum distributions from defined benefit plans or other benefits subject to Sec. 417(e) (restrictions on cash-outs) focus on specific requirements under that section. Collateral issues are also discussed, including whether the plan benefits are definitely determinable and the actuarial equivalency requirements for different forms of distributions.

The IRS's guidelines instruct agents to check the plan for a definite benefit formula not subject to the employer's discretion, under which each participant's benefit can be computed. Agents are to check that actuarial assumptions used to determine plan benefits are specified in the plan in a way that precludes employer discretion, and to check the plan for either specific language as to the interest rate and mortality assumptions to be used in determining accrued benefits, or objective standards (e.g., a table of factors) to be used to determine benefits.

The guidelines address the specific limitations under Sec. 41 1 (c) (relating to allocation of accrued benefits between employer and employee contributions) and Sec. 417(e) (relating to interest rate restrictions) for plans that provide single-sum distributions. These rules do not take into account changes made under GATT.

Agents are to check whether a plan amendment eliminates any optional forms of benefit (e.g., a single-sum distribution option). The guidelines also instruct agents to check whether the actuarial assumptions used to compute accrued benefits have been amended, and if so, whether the amendment complies with Sec. 411(d)(6). The guidelines note that, in general, an increase in the interest rate will result in a decrease in the present value, thereby triggering a Sec. 41(d)(6) violation.

The IRS's proposed guidelines for leveraged ESOPs list the applicable rules and examination steps for each set of rules. The guidelines first instruct agents to determine whether a Form 5309, Application for Determination of Employee Stock Ownership Plan, has been filed. According to the guidelines, the absence of a Form 5309 is an indication that the plan was never intended to be a Sec. 4975(e)(7) ESOP, or that it has never been updated for changes in the regulations. If Form 5309 was filed, agents should check to make sure a determination letter was requested and received specifically with respect to whether the plan is a Sec. 4975(e)(7) ESOP.

Agents should examine the ESOP's investment accounts to make sure it is investing primarily in employer securities. If the employer has any readily tradable common stock, the ESOP cannot hold any closely held common stock of the employer. if the ESOP holds preferred stock, agents are to check whether the conversion price is reasonable. Some guidance is provided on whether a conversion price is reasonable. Because ESOPs must be designed to invest primarily in employer securities, guidance is offered on determining the value of qualified employer securities.

Agents are instructed to determine whether fair market value (FMV) was paid for the employer stock. Agents are to check the valuation report on the company's shares, check whether a company that makes products has share prices that rise and fall with its earnings, check the correlation between earnings and stock price if there is no valuation report, check the employer's audit report to see if the company's earnings have fallen after the valuation report was written, and ask to see documentation of the fiduciary's prudent investigation to ensure that the underlying assumptions have not changed since the last valuation.

An exclusive benefit violation may occur if an ESOP acquires stock for more than its FMV. In this regard, agents are to evaluate stock purchases by applying the FMV requirement of Rev. Rul. 69-494(34) at the time of the initial purchase and again at the time of any later purchase. Agents generally should not pursue an exclusive benefit rule violation when it appears that employer securities were acquired at an inflated price, but the stock subsequently increased in value, resulting in a benefit to participants.

An exempt loan must be primarily for the benefit of the participants. Agents are to determine whether the interest rate for the loan and the price for the securities are devices for draining off plan assets. The guidelines instruct agents to scrutinize the loan against prior loans of the same nature and loans to other entities to determine whether dealings were at arm's length. Agents are to analyze the loan contract, encumbrance account, allocation schedule, and receipts and disbursements accounts to verify compliance with the regulations relating to the release of stock from the suspense account. If contributions have been missed for a period of years, or if there have been large repayments to the lender, additional analysis should be undertaken to determine whether the effect of the nonpayment or large payments results in a violation of the exclusive benefit or nondiscrimination requirements. If securities are being released from suspense based on principal payments only, agents are to determine whether the loan period, and any renewal, extension or refinancing period, exceeds 10 years.

Agents are also to check the plan provisions on repaying a third-party loan to an ESOP to make sure it does not state that the loan can be repaid with proceeds from the sale of unallocated employer securities held in the suspense account. If the plan in operation does use the proceeds from the sale of suspense account assets to repay a loan, agents must determine whether the facts and circumstances support a finding that there has been no violation of the primary benefit requirement.

There is also guidance on how agents are to examine defined contribution plans with respect to the limits on annual additions under Sec. 415(c). The guidelines outline the steps to determine whether a qualified retirement plan is top-heavy and, if so, whether the minimum contribution requirement is satisfied.

Closing Agreement Program

In coordination with the DOL, the IRS has issued a field directive35 outlining very limited exceptions to the rule against using trust assets to pay Closing Agreement Program (CAP) sanctions. Trust assets can be used to pay CAP sanctions only in the following limited situations.

Trust assets may be used to pay CAP sanctions if the employer is unable to pay the costs, the employer's tax liability would be nominal if the plan were disqualified and the adverse effects of plan disqualification would fall most heavily on NHCEs. In these situations, the agent must consult with the IRS National Office, which will consult with the DOL to determine whether such payments constitute a violation of ERISA Title I or other prohibited transaction rules.

An owner-employee may pay sanctions and costs of correction from his accrued benefits as a plan participant, if the owner-employee is entitled by the terms of the plan to a current distribution, appropriate spousal consents are received and the portion of the distribution used as payment is a revocable arrangement meeting the requirements of Regs. Sec. 1.401(a)-13(e). These distributions are treated as distributions for all parts of the Code and are subject to any early distribution taxes under Sec. 72.

In cases involving multi-employer plans and plans in which the disqualifying defect was caused by a third-party fiduciary, if it appears there are no payment sources other than plan assets, the IRS may accept payment from plan assets only after it has sought help from the local DOL field office in bringing other parties (e.g., employers and third-party fiduciaries) to the table in negotiating other sources of payment. Presumably, only in situations in which the IRS and the DOL in concert are not able to convince employers connected with the multiemployer plan or third-party fiduciaries to pay for the sanctions will plan assets be used to pay them.

Under the Code, a disqualified plan trust is simply one of the taxpayers liable for the payment of taxes resulting from disqualification. However, in reality, a fiduciary is usually at least partly responsible for the disqualification. Under ERISA Title I, if a breaching fiduciary directed the plan's trust to relieve the fiduciary of the sanction or other costs, the fiduciary may be engaged in self-dealing with plan assets in violation of prohibited transaction rules under Sec. 4975 and ERISA Section 406, as well as the exclusive benefit and prudence rules under ERISA Section 404. Hence, simply paying CAP sanctions from plan assets involves ERISA issues that must be resolved. This field guidance is the IRS's and the DOL's first public attempt to address the dilemma of paying plan sanctions when the plan trust is the only solvent party or the remaining party involved with the plan.

These exceptions do not apply to penalties under the Voluntary Compliance Resolution program.

Nondiscrimination Rules

The IRS has announced that it is delaying the effective dates of certain nondiscrimination regulations and extending the remedial amendment periods for qualified plans maintained by governments or by tax-exempt organizations.(36) The new effective dates vary, depending on the type of plan and the particular regulations involved. The remedial amendment periods are extended until the effective dates of the regulations.

In the case of governmental plans, the regulations under Secs. 401(a)(4), 401(a)(26), 410(b) and 414(s) apply only to plan years beginning on or after the later of Jan. 1, 1999 (rather than 1996), or 90 days after the opening of the first legislative session beginning on or after Jan. 1, 1999, of the governing body with authority to amend the plan, if that body does not meet continuously. For plan years beginning before the effective date, governmental plans are deemed to meet the statutory requirements.

The regulations under Sec. 401(k) and (m) will apply only to plan years beginning on or after the later of Jan. 1, 1997, or 90 days after the opening of the first legislative session beginning on or after Jan. 1, 1997, of the governing body with authority to amend the plan, if that body does not meet continuously. For plan years beginning before the effective date, governmental plans are deemed to meet the statutory requirements. The special rule in Regs. Sec. 1.402(a)-1(d)(3)(v), providing an income tax deferral for certain elective contributions, is extended for the same period.

In the case of plans maintained by tax-exempt organizations (other than nonelecting church plans), the regulations under Secs. 401(a)(4), 401(a)(5), 401(1), 410(b), 414(r) and 414(s) apply only to plan years beginning after 1996 (rather than in 1996). For plan years beginning before the effective date, a plan maintained by a tax-exempt organization must be operated in accordance with a reasonable, good-faith interpretation of the statutory provisions.

For church plans that do not elect under Sec. 410(d) to have the Code's provisions on participation, vesting, etc., apply, the regulations under Secs. 401(a)(4), 401(a)(5), 401(1) and 414(s) will apply only to plan years beginning after 1998. For plan years beginning before the effective date, a nonelecting church plan must be operated in accordance with a reasonable, good-faith interpretation of the statutory provisions.

The IRS has not changed the dates by which plans must comply with the regulations under Sec. 401 (a)(17), as amended by the Revenue Reconciliation Act of 1993. Thus, for governmental plans, these regulations are effective for plan years beginning on or after the later of Jan. 1, 1996, or 90 days after the opening of the first legislative session beginning on or after Jan. 1, 1996, of the governing body with authority to amend the plan, if that body does not meet continuously. For plans of exempt organizations, the regulations are effective for plan years beginning after 1995. The statutory provisions of Sec. 401(a)(17) apply for plan years beginning after 1993, for plans maintained by exempt organizations.

Author's note: The authors gatefully acknowledge the contribution to this article of Ariana M. Raines, of KPMG Peat Marwick's Compensation & Benefits Practice in Baltimore, Md.

(1) See Rev. Ruls. 95-29, IRB 1995-15, 10; 95-31, IRB 1995-15, 7. (2) 60 Fed. Reg. 44158 (8/24/95). (3) The Selective Training and Service Act of 1940 (9/16/40). (4) Alabama Power Co. v. Davis, 431 US 581 (1977). (5) See, e.g., Raypole v. Chemi-Trol Chemical Co., 754 F2d 169 (6th Cir. 1985). (6) 38 USC Section 4303(13). (7) 38 USC Section 4312(a). (8) 38 USC Section 4318(a)(2)(B). (9) 38 USC Section 14318(a)(1)(A). (10) 38 USC Section 4317(a)(1)(A)(i) (11) 38 USC Section 4318(a)(2)(a). (12) 38 USC Section 4318(a)(1)(b). (13) 38 USC Section 4318(b)(2). (14) 38 USC Section 4318(b)(1). (15) 38 USC Section 4318(b)(3)(b). (16) H.R. 1469; S. 831. (17) IB 95-1, DOL Regs. Section 2509.95-1, 60 Fed. Reg. 12328 (3/6/95). (18) 56 Fed. Reg. 28638, 28642 (6/21/91). (19) Prohibited Transaction Class Exemption 95-60 (7/12/95). (20) John Hamcock Mutual Life Ins. Co. v. Harris Trust @ Savings Bank 114 Sup. Ct. 517 (1993). (21) IRS Letter Ruling 9530038 (5/5/95). (22) IRS Letter Ruling 9317037 (2/2/93). (23) IRS Field Directive (11/22/94). (24) IRS Letter Ruling (TAM) 9508003 (11/10/94). (25) IRS Letter Ruling (TAM) 9516005 (12/22/94). (26) IRS Letter Ruling 9507030 (11/18/94). (27) See, e.g., Don Gilmore, 372 US 39 (1963)(11 AFTR2D 758, 63-1 USTC [paragraph] 9285); Anchor Coupling Co., 427 F2d 429 (7th Cir. 1970)(25 AFTR2d 70-1282, 70-1 USTC [paragraph] 9431), cert. denied. (28) Citrus Valley Estates, Inc., 49 F3d 1410 (9th Cir. 1995)(75 AFTR2D 95-1349, 95-1 USTC [paragraph] 50,132). (29) IR-95-43 (6/7/95). (30) See Kundin and Walker, "Current Developments in Employee Benefits (Part 1), " 25 The Tax Adviser 686 (Nov. 1994), pp. 692-693. (31) Vinson @ Elkins, 7 F3d 1235 (5th Cir. 1993)(72 AFTR2D 93-6678, 93-2 USTC [paragraph] 50,632), aff'g 99 TC 9 (1992); Wachtell, Lipton, Rosen, @ Katz, 2d Cir., 1994 (73 AFTR2D 94-1007, 94-1 USTC [paragraph] 50,272), aff'g TC Memo 1992-392; Citrus Valley, note 28. (32) Rhoades, McKee @ Boer, 43 F3d 1071 (6th Cir. 1995)(75 AFTR2D 94-503, 95-1 USTC [paragraph] 50,027). (33) Ann. 95-33, IRB 1995-19, 14. (34) Rev. Rul. 69-494, 1969-2 CB 88. (35) IRS Field Directive (3/14/95). (36) Ann. 95-48, IRB 1995-23, 13.