Current developments.

This two-part article provides an overview of current developments in employee benefits. Part II focuses on significant retirement plan developments, including proposed and final regulations and revenue and letter rulings.

Part I of this two-part article, published in the Nov. 2003 issue, focused on recent developments in executive compensation and welfare plans. Part 11, below, highlights last year's most significant retirement plan developments, including both IRS and Department of Labor (DOL) guidance.

Qualified Plans

Proposed Regulations

In July 2003, the IRS published proposed regulations (33) on cash-or-deferred arrangements (CODAs) and employee and matching contributions. When published as final regulations, these rules will completely overhaul existing Sec. 401 (k) and (m) regulations, incorporating all of the statutory amendments and administrative guidance accumulated since the 1991 regulations. The proposed regulations eliminate the ability to accelerate deductions, restrict the use of "bottom up" qualified nonelective contributions (QNECs) as a way to pass the discrimination tests with minimal contributions and reflect a decade of statutory changes. While many provisions are not new, the following important changes were made:

* Undoing Notice 2002-48, (34) the proposal would prohibit employers from prefunding elective deferrals or matching contributions, a practice that the preamble notes is inconsistent with Sec. 401 (k) and (m).The proposed regulations do not distinguish transfers from terminating Sec. 4980(d) defined benefit (DB) plans, the use of forfeitures to offset elective or matching contributions or allocations of matches from employee stock ownership plan (ESOP) suspense accounts. The IRS has informally stated that these amounts will be exempt from the rule.

* The proposal noted that year-to-year changes in actual deferral percentage/ actual contribution percentage (ADP/ ACP) testing methods may arouse IRS suspicion. Thus, employers must not continually manipulate testing to significantly increase the permitted ADP or ACP for highly compensated employees (HCEs). However, plans would be allowed to perform the ADP test on a prior-year basis and the ACP test on a current-year basis (or vice versa); movement of contributions from one test to another will be prohibited.

* A favorable change eliminated separate ADP/ACP testing of the ESOP and non-ESOP portions of a plan and allows permissive aggregation of ESOPs and non-ESOPs for testing purposes. This change accommodates the many Sec. 401 (k) plans that have created component ESOPs to take advantage of the expanded deduction opportunities under Sec. 404(k). However, the group of employees eligible for the ESOP still must satisfy Sec. 410(b). Thus, a plan could not take advantage of this relaxation to limit participation in its ESOP component to a predominantly highly compensated group.

* The rules for sole proprietors' plans provided another favorable change, permitting all of their compensation to accrue on the last day of their tax year and allowing a deferral election to the end of that year.

* The proposal clarified that elective contributions, qualified matching contributions (QMACs) and QNECs received in a trustee-to-trustee transfer (other than a direct rollover) from another plan remain subject to the Sec. 401(k) (2) 03) distribution restrictions. The transferor plan has an obligation to ensure that the transferee plan will observe this requirement.

* Under the proposal, a participant's QNEC or QMAC cannot be taken into account for the ADP or ACP test to the extent that it exceeds the greater of 5% of compensation or twice the plan's "representative" nonhighly compensated employee (NHCE) ADP or ACP, which is the median (not average) ADP or ACP of the NHCE participants.

* Finally, plans that require employment on the last day of the year as a condition for receiving matching contributions will not be able to use the Sec. 401(m)(11) ACP safe harbor. However, their eligibility to use the Sec. 401 (k)(12) ADP safe harbor is not jeopardized.

The proposed regulations would become effective no earlier than the first plan year beginning at least 12 months after their adoption in final form. Until then, taxpayers need to adhere to the existing final regulations.

Catch-Up Contributions

Final regulations (35) relaxed the "universal availability" requirement, under which a controlled group cannot pick and choose which of its plans will allow catch-up contributions. The option must either be available under all plans that permit elective deferrals, or under none of them. Under the final regulations, collective bargaining employees and nonresident aliens without U.S.-source income may be ignored. Plans may also limit deferrals (including catch-ups) to (1) 75% of compensation or (2) the cash available after all required withholding front the participants' paychecks. A transition rule modeled on Sec. 410(b)(6)(C) is provided for mergers, spinoffs and acquisitions. Separately from these exemptions, Notice 2002-4 (36) offered relief to employers that maintain plans qualified under Puerto Rico law, which has no provision for catch-ups.

In addition, the final regulations noted that the identification of catch-ups is made annually. Plans can choose whether to offer matching contributions for catch-up deferrals without any "nondiscrimination" implications. Individuals participating in two or more plans of unrelated employers may take the catch-up rules into account in determining whether the Sec. 402(g) limit has been exceeded, regardless of whether the plans allow catch-up contributions.

The regulations apply to plan years beginning after 2003 and may be relied on immediately.

Restorative Payments

Two letter rulings illustrated when the IRS will treat a contribution as a deductible restorative payment under Sec. 162, rather than a contribution subject to normal allocation and deduction restrictions (applying tkev. Rul. 2002-45 (37)).

In Letter Ruling 200317050, (38) a defined contribution plan had incurred a large loss on a secured loan to an unrelated party. The employer agreed to restore the plan's loss and to reimburse part of its legal and accounting fees, to head off participant and DOL lawsuits. The IRS agreed that these payments fell within the purview of Rev. Rul. 2002-45. Thus, because they were a bona fide settlement of a potential fiduciary liability, they (1) were not treated as annual additions to participants' accounts, (2) did not have to satisfy "nondiscrimination" standards and (3) were fully deductible under Sec. 162, without regard to Sec. 404 limits.

In contrast, in Letter Ruling 200317048, (39) the IRS found no genuine apprehension of fiduciary liability when a plan incurred early withdrawal penalties on the withdrawal of deposits made under insurance company annuity contracts. The facts did not demonstrate a reasonable risk of liability to the employer for breach of fiduciary duty; the deposits were deductible plan contributions under Sec. 404 and subject to Sec. 415'S annual addition limits and Sec. 401 (a)(4)'s nondiscrimination rules.

Compensation Limit

Rev. Rul. 2003-11(40) allowed plans to increase retiree benefits by using the new, higher Sec. 401(a)(17) limit for past years. In the ruling, a plan amendment adopted in 2002, adjusted future benefit payments to retired participants to reflect compensation that could not be considered under prior Sec. 401(a)(17) limits. The IRS ruled that the amendment did not violate Sec. 401(a)(4), because the HCEs did not gain any benefit that they would not have had if the new provision had actually been in effect in earlier years, and the amendment's timing did not favor HCEs over NHCEs.

However, the ruling failed to address Sec. 401 (a) (26), which requires that a benefit structure in a qualified DB plan benefit the lesser of (1) 50 employees or (2) the greater of 40% of all employees or two employees. Any plan taking advantage of this ruling needs to be sure benefit increases do not violate Sec. 401(a)(26).

Prohibited Transaction Exemptions

In a move of interest to cash-strapped employers, the DOL wanted a prohibited transaction exemption (41) to allow Northwest Airlines to contribute stock of its Pinnacle Airlines subsidiary to one of its pension plans to satisfy the plan's minimum funding requirements. (42) The airline asked the DOL for an individual exemption, because the shares are not qualifying employer securities as defined in Employee Retirement Income Security Act of 1974 (ERISA) Section 407(d)(5), as they do not meet ERISA Section 407(f)(1)'s widely held requirement.

In addition to authorizing the contribution and allowing the plan to hold nonqualifying employer securities, the exemption requires the employer to offer the plan an option to resell the stock for the greater of fair market value or its value on the contribution date. By granting the exemption, the DOL is accepting the employer's arguments that the Pinnacle stock is a sound investment for the plan, especially in light of the put option protection, and that reducing the sponsor's cash-flow burdens is also beneficial to the plan and its participants. Other companies with valuable but illiquid investments may be able to obtain a similar exemption.

Sec. 72(t) Penalty Tax

One way to avoid the Sec. 72(t) 10% penalty tax on qualified plan and IRA distributions before age 59 1/2 is to establish a stream of "substantially equal periodic payments." Modifying the distribution schedule before age 59 1/2 (or the passage of five years, if payments began after age 54 1/2) leads to retroactive imposition of the penalty. Under Notice 89-25, (43) there are three permissible distribution methods, two of which mimic mortgage amortization or annuity payouts, thus producing equal distributions each year. The third method is used to calculate minimum required distributions under Sec. 401 (a)(9) and backloads the payment stream.

Prompted by the bear market, Rev. Rul. 2002-62 (44) relaxed Notice 89-25's principle that, once selected, the distribution method may not be changed. Distributees will henceforth be allowed to switch freely from the amortization or annuity method to a schedule that satisfies Sec. 401 (a)(9). Further, Sec. 401(a)(9) distribution schedules that began under the pre-2002 regulations may be modified by substituting the current mortality table for the one previously required. Hence, an IRA participant whose balance is being dissipated more rapidly than originally anticipated can slow distributions and preserve the IRA for a longer period. However, the converse is not true--a distributee whose IRA income is disappointingly low cannot increase distributions by switching from the Sec. 401(a)(9) method to another. Changes to the Sec. 401(a)(9) method cannot be rescinded if the market rises again.

Reversions

In Rev. Rul. 2003-85, (45) the IRS again reversed itself on more-than-2S% transfers by DB plans to qualified replacement plans. Under Sec. 4980(d)(2), the excise tax on employer reversions from a terminating DB plan is reduced from 50% to 20%, if 25% of the plan's residual assets are transferred to a replacement plan. The transferred amount is neither included in, nor deductible from, the employer's taxable income. A set of 1998 letter rulings (46) held that any portion of the transfer in excess of 25% was subject to the reversion excise tax, but was otherwise treated in the same manner as the qualifying portion of the transfer. Letter Ruling 200227041 (47) revoked those rulings, concluding that the "excess" transfer is includible in the employer's income, with an offsetting deduction to the extent allowable under Sec 404(a).A corollary is that the "excess" must be allocated in the year of transfer, whereas the "qualifying" portion is allocable over up to seven years.

Rev. Rul. 2003-85 returned to the 1998 view of the income tax consequences and is even more favorable on the excise tax. It considers a situation in which a terminating plan has $60x of residual assets, one-third of which ($20x) is transferred to a qualified replacement plan. The IRS ruled that only the $40x that the employer receives directly is subject to reversion tax and included in taxable income. By implication--the ruling does not address the issue--the entire transferred amount may be allocated to replacement plan accounts over a seven year period.

This result is difficult to reconcile with the statutory language, which on its face limits file favorable tax treatment to precisely 25% of the terminating plan's residual assets. However, taxpayers can rely on the latest ruling until it is modified or revoked.

Expense Allocations

The DOL has markedly eased the past formal and informal positions on the manner and extent to which plan expenses can be charged to participants, by stating that, "[i]f the plan document sets forth rules for allocating expenses among participants' accounts, those rules ... must be adhered to by the plan administrator." (48) In the absence of specific plan provisions, a plan's "overhead" expenses may be allocated pro rata, per capita or on any other basis, as long as the method bears a "reasonable relationship to the services furnished or available to an individual account." The plan administrator is not required to determine whether the method is equally favorable to all participants. Thus, the plan's fixed administrative expenses, such as record keeping, legal, auditing, annual reporting, claims processing and similar administrative expenses, can reasonably be allocated either pro rata or per capita; those that vary with the value of assets, such as investment management fees, should have a pro-rata allocation. Another alternative is allocation on the basis of use (e.g., the plan arranges for investment advisers to consult with participants).

Thus, specific charges may be allocated to specific accounts (e.g., costs associated with qualified domestic relations orders, hardship withdrawals, calculation of benefits payable under different distribution options and benefit distributions). In addition, accounts of separated participants can be charged a reasonable share of plan administrative expenses, even if the employer otherwise pays all plan costs.

ESOPs

SESOP Management Companies

Temp. Regs. Sec. 1.409(p)-1T (49) aimed to shut down S corporation/ ESOP management companies. Published as both temporary (for three years) and proposed regulations, the new regulations ensure that ESOP-owned S corporations (SESOPs) benefit more than a scant few individuals. Some SESOPs may unwillingly run afoul of the rule, with disastrous consequences.

The temporary regulations treat the executives' deferred compensation as "synthetic equity" a concept unique to Sec. 409(p). Under the statute, if "disqualified persons" own 50% or more of a SESOP's stock, including stock deemed to be held through the ESOP and synthetic equity (options, restricted stock, stock appreciation rights, etc.), the corporation is subject to Sec. 4979A excise tax and the individual is treated as having received a distribution. Ordinarily, persons with less-than-l0%-ownership interests are not disqualified persons, but the temporary regulations authorize the IRS to include anyone in that category to prevent Sec. 409(p) "avoidance" by ,groups of executives.

SESOPs that existed on March 14, 2001 are exempt from Sec. 409(p) until plan years beginning after 2004 and, thus, are not immediately affected. Otherwise, the temporary regulations are effective for plan years ending after Oct. 20, 2003, except that deferred compensation distributed by July 21,2004, will not be treated as synthetic equity.

SESOP Shells

Rev. Rul. 20(13-6 (50) aimed at a device marketed to postpone Sec. 409(p)'s effective date for newly established SESOPs. Sec. 409(p)'s effective date is plan years beginning after March 14, 2001, but ESOPs existing on that date are grandfathered until years beginning in 2005. Several consulting firms offered for sale SESOPs created before March 14, 2001 with only nominal business operations. Rev. Rul. 2003-6 holds that "an ESOP is not established until it is adopted by an employer for the purpose of enabling its employees to participate in a more than insubstantial manner in the ownership of the employer's business and to provide its employees with more than insubstantial benefits under the ESOR" Hence, ESOPs of shell corporations do not qualify.

Dividend Deductions

In Letter Ruling 200237026, (51) the IRS granted a U.S. subsidiary a deduction under Sec. 404(k) for dividends paid on the foreign parent's stock. A U.S. subsidiary of a foreign corporation established an ESOP to invest in the parent's publicly traded stock and offered participants an election to receive dividends. The letter ruling holds, routinely, that the parent's shares are qualifying employer securities and, less expectedly, that the subsidiary can deduct the dividends under Sec. 404(k), which grants the deduction to the issuer of the stock. One might think that the subsidiary has no deduction, while the parent has one that is probably useless.

To support letting a non-issuer take the deduction, the IRS revoked the Sec. 414(b) controlled-group rules, which treat all members of a group as a single employer for various purposes. That section makes only a limited reference to Sec. 404, however: "With respect to a plan adopted by more than one employer, the applicable limitations provided by [section] 404(a) shall be determined as if all such employers were a single employer...." Taxpayers should exercise caution in relying on Letter Ruling 200237026; the IRS is currently reviewing its position and determining whether it will issue additional rulings.

Basis

In Rev. Rul. 2003-27, (53) the IRS ruled that net unrealized appreciation (NUA) is reduced by undistributed income allocable to S stock held by a SESOP. SESOPs can own S stock but, unlike other S shareholders (including non-ESOP qualified plans), they pay no tax on their share of the corporation's income. Despite that exemption, Rev. Rul. 2003-27 held that the SESOP's basis in its stock is (like that of any other shareholder) increased by undistributed income allocable to the stock and decreased by return-of-capital distributions (miscalled "dividends" for the balance of this discussion to avoid confusion with SESOP distributions to participants).

Basis has no effect on the SESOP itself, but does affect the taxation of distributions. If a participant or beneficiary receives a lump-sum distribution of employer stock, he or she may elect, under Sec. 402(e)(4), to recognize ordinary income equal only to the plan's basis in the distributed shares. Any value beyond that (i.e., NUA) is taxed when the stock is sold at long-term capital gain rates, regardless of the length of the holding period. SESOPs are not required to make distributions available in the form of stock, but the possibility of deferring tax on NUA is an incentive to give participants that option, despite potential complications in complying with the 75-shareholder limit for S corporations.

By increasing basis and reducing NUA, Rev, Rul. 2003-27 makes stock distributions somewhat less attractive than they would be if the basis adjustment were not required. Although the IRS'S position may seem theoretically odd--the standard rationale for adjusting basis is that the shareholder has paid tax on undistributed income--it ensures consistency between SESOPs that do and do not pay "dividends." Without the adjustments, avoiding "dividends" would be advantageous to participants, because the stock's basis would remain low, while the retained cash increased NUA. "Dividends," by contrast, would both lower NUA and be taxed as ordinary income when ultimately distributed by the SESOP.

SESOP Rollovers

Rev. Proc. 2003-23 (53) provided that a SESOP may make a direct to[lover of stock to a participant's IRA, as long as the IRA immediately sells the shares back to the corporation. This ruling resolves a technical conflict between Sec. 401(a)(30) (which requires qualified plans to "allow participants to elect to have distributions rolled directly into IRAs) and the S corporation rules (which do not allow IRAs to hold S stock). Stock rollovers normally are not a problem, because most SESOPs use the special rule that lets them make distributions solely in cash.

See. 1042 Elections

A taxpayer who elects to use See. 1042 to defer gain recognition on stock sold to an ESOP must file a notarized statement with the IRS describing the qualified replacement property that he or she purchases with the sales proceeds. Temp. Regs. Sec. 1.1042-1T requires that the statement be notarized within 30 days after the purchase, a deadline that has led to the issuance of numerous letter rulings granting relief to tardy taxpayers. Recognizing a problem, the IRS published a proposed amendments (54) that extends the notarization deadline. Under the new rule (which taxpayers may rely on immediately for all open years), the statement covering qualified replacement property purchased up to the date on which the seller's return is filed for the year of the Sec. 1 (142 transaction must be notarized by the filing date (not the return due date). The statement covering any subsequent purchases must be notarized by the filing date of the following year's return.

IRAs

Excess Contributions

The IRS published final regulations (55) establishing a revised method of calculating income attributable to excess IRA contributions, as the only method beginning in 2004. This calculation needs to be made when excess contributions to a traditional IRA are returned under Sec. 408(d)(4) or contributions ,are recharacterized under Sec. 408A(d)(6).

The regulations bring to an end a revision process that began with Notice 2000-39, (56) which made the calculation of attributable income more realistic, by (1) basing it only on the period during which the IRA held the excess contribution and (2) allowing income to be negative as well as positive. Proposed regulations published in July 2002 made minor changes to the calculation method. Since the issuance of Notice 2000-39, IRA owners have been permitted, at their election, to follow either the notice or the prior regulations.

The final regulations adopt the proposed regulations' method without change. To calculate attributable income, the excess or recharacterized contribution is divided by the value of the IRA assets on the date made. The quotient is then multiplied by the difference between the closing balance (as of the date of distribution or recharacterization) and the opening balance. The opening balance is adjusted by adding any contributions or transfers received during the computation period; the closing balance by adding any distributions or outgoing transfers. There are special rules for dealing with assets whose value is not available on a daily basis.

IRAs may choose among the methods set forth in the old regulations, Notice 2000-39 or the new regulations, until the end of 2003. For distributions or recharacterizations after 2003, the new regulations are the sole alternative. None of these rules apply to attributable income calculations for qualified plans (e.g., for refunds to correct ADP/ACP violations). In general, the plan administrator may employ any reasonable calculation method in those situations.

Beneficiary Designations

Letter Ruling 200317041s7 high lighted a beneficiary designation trap for unwary IRAs. An IRA owner named a trust for his three children as the beneficiary of the account. The trust terms required the trustee to divide the trust into three subtrusts, one for each child, on the IRA owner's death .When the owner died before the Sec. 40] (a)(9) required beginning date, the trustee duly created the subtrusts, and the IRA was split into three corresponding IRAs. Nothing was distributed from the undivided IRA to the undivided trust.

One of the younger children asked the IRS to rule that distributions to the subtrust for his benefit could be made over his own life expectancy, rather than that of the oldest of his siblings. He argued that the decedent had, for practical purposes, set up three separate IRAs and that the measuring life for each account should be that of its own beneficiary. The IP, S disagreed; the regulations state that, when a trust is an IRA beneficiary, the longest possible distribution period is the oldest beneficiary's life expectancy. Applying that rule literally, the IRS viewed the undivided trust as the beneficiary, regardless of the later division of the trust and the IRA.

The moral is that, despite the eased distribution rules in the final Sec. 401(a)(9) regulations, estate planners must pay careful attention to details. In tiffs case, the IRA owner should have named separate trusts as beneficiaries, to ensure the maximum distribution period for each child.

EXECUTIVE SUMMARY

* Proposed regulations would completely overhaul existing regulations on CODAs and employee and matching contributions.

* Several SESOP rulings were issued.

* Final regulations establish a single revised method for calculating income from excess IRA contributions.

(33) Prop. Regs. Sec. 1.401(k)-1 and (m)-1, REG-108639-99 (7/17/03).

(34) Notice 2002-48, IRB 2002-29, 130.

(35) Regs. Secs. 1.414(v)-1 and 1.402(g)-2,TD 9072 (7/7/03).

(36) Notice 2002-4, IRB 2002-2,298.

(37) Rev. Rul. 2002 45, IRB 2002-29, 116.

(38) IRS Letter Ruling 200317050 (1/30/03).

(39) IRS Letter Ruling 200317048 (1/27/03).

(40) Rev. Rul. 2003 11, IRB 2003-3, 285.

(41) Prohibited Transaction Exemption 2003-26, 68 FR 49792.

(42) Without an exemption, contributing such shares would be a prohibited "sale" between the employer and the plan under Keystone Consolidated Industries, Inc., 508 US 152 (1993).

(43) Nonce 89 25, 1989-1 CB 662.

(44) Rev. Rul. 2002-62, 2002-2 CB 710.

(45) Rev. Rul. 2003 85, IRB 2003-32, 1.

(46) IRB Letter Rulings 9837036 (6/18/98) and 9839030 and 9839031 (both dated 6/29/98).

(47) IRS Letter Ruling 200227041 (7/5/02).

(48) DOL Field Assistance Bulletin 2003-03 (5/19/03).

(49) TD 9081, REG-129709-03 (7/21/03).

(50) Rev. Rul. 2003-6, IRB 2003-31, 286,

(51) IRS Letter Ruling 200237026 (9/13/02).

(52) Rev. Rul. 2003-27, IRB 2003-11, 597.

(53) Rev. Proc. 2003-23, IRB 2003-11, 599.

(54) Temp. Regs. Sec. 1.1042-1T, Q&A 3(b)(6), REG-121122-03 (7/10/03).

(55) Regs. Secs. 1.408-4,-11 and 1.408A-5,TD 9056 (5/2/03).

(56) Notice 2000-39, IRB 2000-2 CB 132.

(57) IRS Letter Ruling 200317041 (12/19/02).

For more information about this article, contact Ms. Walker at [e-mail] or Mr. Wagenbach at pwagenboch@ deloitte.com.

Deborah Walker, CPA 

Partner

Deloitte & Touche LLP 

Washington, DC

Paul Whgenbach, J.D., LL.M.

Manager

Deloitte & Touche LLP

Washington, DC