Current developments.

EXECUTIVE SUMMARY

* Rev. Proc. 98-22 combined a number of the IRS's qualified plan correction programs.

* QNECs contributed for HCEs (rare) are counted as elective contributions for the year in which contributed; QNECs for NHCEs are counted in the year for which contributed.

* Rev. Rul. 98-1 provides questions and answers that reflect the changes made to the Sec. 415 rules by the SBJPA, after the technical correction made by the TRA '97.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I focuses on recent developments (including those involving the Taxpayer Relief Act of 1997, the Small Business Job Protection Act of 1996 and the Internal Revenue Service Restructuring and Reform Act of 1998) affecting qualified retirement plans, employee stock ownership plans and individual retirement accounts.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, below, focuses on recent developments (including those involving the Taxpayer Relief Act of 1997 (TRA `97), the Small Business Job Protection Act of 1996 (SBJPA) and the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA `98)) affecting qualified retirement plans, employee stock ownership plans (ESOPs) and individual retirement accounts (IRAs). While this article does not provide a comprehensive examination of the specific provisions of the TRA `97, SBJPA and IRSIKRA `98, it does address certain regulatory developments in each. Part II, in the December 1998 issue, will focus on recent developments in welfare benefits, nonqualified retirement plans and executive compensation.

IRS Qualified Plan Guidance

VCR Programs Combined

Rev. Proc. 98-22(1) combined the Administrative Policy Regarding Self-Correction (APRSC) and the Voluntary Compliance Resolution (VCR), the Walk-in Closing Agreement (Walk-in CAP), and the Audit Closing Agreement (Audit CAP) programs. The IRS refers to these coordinated programs as the Employee Plans Compliance Resolution System (EPICS). The EPICS provisions were generally effective Sept. 1, 1998; however, plan sponsors were allowed to use them as of March 9, 1998.

The Tax Sheltered Annuity Voluntary Correction program, affecting Sec. 403(b) plans, was not included in the procedure; the procedure states there will be changes to that program as well.

Overall program changes: Relatively few changes were made to the programs. Rev. Proc. 98-22 made the following changes, which affect all of the programs comprising EPICS:

* Provided a uniform set of correction principles.

* Clarified that there may be more than one appropriate method of correcting qualification failures.

Permitted (in appropriate circumstances) the use of reasonable adjustments in making corrections.

* Permitted taxpayers to rely on the availability of EPICS in correcting qualification failures.

APRSC changes: APRSC enables a qualified plan or Sec. 403(b) plan sponsor to self-correct operational failures it discovers in its plans. The provisions of APRSC were modified and restated to:

* Incorporate the recent extension of the period for correcting significant operational failures from the end of the first plan year following the plan year in which the failure occurred, to the end of the second plan year following the plan year in which it occurred, as set forth in Ann. 97-121.(2)

* Clarify that, for purposes of correcting a failure to satisfy the actual deferral percentage (ADP) or actual contribution percentage (CAP) test, the two-year correction period begins after the expiration of the statutory correction period.

* Permit correction of an operational failure to be completed after the end of the correction period if correction was substantially completed by the end of the correction period. Two important items have not been changed. First, Rev. Proc. 98-22 did not modify the narrow position taken for Sec. 403(b) defects, thus keeping many of such defects out of APRSC. Second, it did not modify the "plan year" rule that permits correction of years not Under examination under the significant defect portion of APRSC.

Changes to VCR: The VCR program enables a qualified plan sponsor to voluntarily disclose to the IRS operational failures it has discovered in its plans and to pay a fixed fee to the IRS. The provisions of VCR were : modified to:

* Reduce the specificity required in the calculations supporting plan sponsors' proposed correction methods.

* Change the circumstances under which closing agreements will be entered into for the Sec. 4974 excise tax (applicable to the failure to satisfy the Sec. 401(a)(9) minimum distribution requirements).

* Extend the period within which corrections are to be made to 150 days.

* Clarify and simplify permissible correction methods under the standardized VCR procedure (SAP) listed in Appendix A of the procedure.

* Provide a checklist for use by plan sponsors in preparing VCR and SAP requests (contained in Appendix B of the procedure).

Changes to Walk-in CAP: The Walk-in CAP enables a qualified plan sponsor to voluntarily disclose to the IRS qualification failures it has discovered in its plans and to pay a compliance correction fee. The provisions of Walk-in CAP were modified to:

* Discontinue the use of 40% (or any other percentage) of the maximum payment amount as the basis for calculating sanctions (except for egregious failures).

* Provide for greater predictability and consistency, by replacing the prior sanction structure with a limited range of compliance correction fees, with the lowest fees provided for small plans using the IRS's chart (provided below).

Walk-in CAP Compliance Correction Fees

Number of               Fee            Presumptive
participants           range             amount

10 or fewer    VCR fee(*) to $ 4,000   $ 2,000
11 to 50       VCR fee(*) to $ 8,000   $ 4,000
51 to 100      VCR fee(*) to $12,000   $ 6,000
101 to 300     VCR fee(*) to $16,000   $ 8,000
301 to 1,000   VCR fee(*) to $30,000   $15,000
over 1,000     VCR fee(*) to $70,000   $35,000

(*) Asterisks refer to the applicable VCR fee amount had the plan been submitted under the VCR program.

* Provide a checklist for use by plan sponsors in preparing Walk-in CAP requests (contained in Appendix B).

Changes to Audit CAP: Audit CAP, a program established in the key district offices and available on examination of a qualified plan, enables the plan sponsor to negotiate a monetary sanction. The provisions of Audit CAP were modified and restated to:

* Clarify that the sanction imposed under Audit CAP will not be excessive and will bear a reasonable relationship to the nature, extent and severity of the failure.

* Provide assurance that correction made before audit (even for failures corrected outside of the APRSC, VCR and Walk-in CAP programs) will be an important factor in reducing the potential sanction under Audit CAP.

Miscellaneous: Rev. Proc. 98-22's Appendix B includes a 26-item checklist to review the completeness of any VCR/SVP/Walk-in CAP submission. Not every item applies to every program.

Because plans under examination are not eligible for VCR/SVP/Walkin CAP, terminating plans will want to do a thorough diagnostic check before submitting Form 5310, Determination Letter Regarding Plan Termination. The procedure included in its definition of "under examination" notification from the district office that such an application may have termination problems.

The correction principles clarified that correction of an ADP failure after the one-year statutory period will typically include contributions to, not just distributions to, highly compensated employees (HCEs).

The procedure formalized a $20 de minimis correction level. Thus, if the total to be distributed to an employee as a correction allocation is $15, the distribution does not need to be made.

The procedure precludes negotiation of the minimum required distribution excise tax. If the employer wants to deal with the tax, the entire amount (i.e., 100%) must be paid.

Eliminating Age 70 1/2 In-Service Distributions

The IRS released final regulations(3) permitting qualified plans to eliminate distributions to certain currently employed workers after age 70 1/2. In general, the final regulations, which apply to plan amendments adopted and effective after June 5, 1998, retained the structure and substance of the proposed regulations issued in July 1997, with only a few changes and clarifications. Thus, the conditions for such amendments are:

* The amendment eliminating this payment option applies only to employees who attain age 70 1/2 in or after a calendar year that begins after the later of Dec. 31, 1998 or the amendment's adoption date.

* Amendments must not eliminate any payment option for those retiring after age 70 1/2 that would have been available had the individual retired at age 70 1/2.

* Any amendment to the plan to eliminate the in-service distribution to those age 70 1/2 must be made by the end of the remedial amendment period that applies to the plan for changes under the SBJPA. For plans maintained under one or more collective bargaining agreements ratified before Sept. 3, 1998, the amendment deadline is extended to the last day of the twelfth month beginning after the date on which the last of such collective bargaining agreements terminates (determined without regard to any extensions after Sept. 2, 1998), if later than the last day of the plan's remedial amendment period for SBJPA changes.

A problem arose under Sec. 411(d)(6) when SBJPA Section 1404 repealed the requirement under Sec. 401(a)(9) that mandatory minimum distributions be paid from qualified retirement plans once an individual reached age 70 1/2, even though that individual was still working for the plan sponsor. This repeal, effective beginning in 1997, led plan sponsors to believe they could eliminate such in-service distributions for any employee who reached age 70 1/2 and was not a 5% owner.

The IRS recognized that doing so would violate the Sec. 411(d)(6) anti-cutback rule, which prohibits a plan sponsor from eliminating optional forms of benefits, including the right to commence benefit payments, for benefits already accrued. Amending the plan to cease distributions to employees over age 70 1/2 for the part of the benefit that accrued after amending the plan would only increase the complexity of administering payments to those workers. Plan sponsors complained that this was not simplification and sought relief from the IRS through regulations. The IRS issued these regulations to help achieve the SBJPA legislative intent of simplifying distributions.

Many employers will not need relief under Sec. 411(d)(6) to implement the SBJPA change, Regs. Sec. 1.411 (d)-4, Q&A-10(d), Example 3, describes a profit-sharing plan that allows a participant to elect distribution after age 59 1/2, and includes a Sec. 401(a)(9) override provision requiring that the plan make minimum required distributions starting at age 70 1/2 if the participant does not elect an amount at least equal to the amount necessary to satisfy Sec. 401(a)(9). This plan maybe amended to implement the SBJPA change without violating Sec. 411(d)(6), because the amendment would not eliminate an optional form of benefit.

Sec. 72(p) Loan Guidance

The IRS issued additional proposed regulations(4) under Sec. 72(p) on qualified retirement plan loans to participants, effective for loans made on or after the first January 1 that is at least six months after the date the final regulations are published. The new proposed regulations provide useful guidance on the treatment of loan repayment after a deemed distribution has occurred and on interest that accrues while the loan is in default. These open issues have been the subject of much concern from plan administrators and record-keepers.

Plan basis: Under the 1995 proposed regulations, if a plan declares a loan to be in default and issues a Form 1099-R, Statement for Recipients of Total Distributions from Profit-Sharing, Retirement Plans, Individual Retirement Arrangements, Insurance Contracts, etc., on the loan, it is a taxable deemed distribution but, generally, not an actual distribution. For example, Sec. 401(k) and money-purchase plans cannot permit in-service distributions, and therefore cannot permit distributions simply because the participant fails to repay a loan. Actual distribution will occur once the participant takes a distribution. However, as an obligation from the participant-to the plan, the loan should be repaid even after being taxed, and the plan administrator should generally be trying to collect on the outstanding balance. Prop. Regs. Sec. 1.72(p)-1, Q&A-20(a), notes that repayments after the deemed distribution will be counted as basis in the plan. Thus, the repayments will be treated for this purpose as after-tax contributions and will not be subject to tax again when distributed. The repayments will not be considered after-tax contributions for purposes of Sec. 415 or 401(m).

Prop. Regs. Sec. 1.72(p)-1, Q&A-20(a) notes that certain plans have immediately counted a deemed distribution as plan basis, but provides that basis does not arise until repayment is made.

Interest on defaulted loan: If a person takes a loan from a bank and does not make payments on it, the bank will eventually collect the outstanding balance, plus any accrued interest not yet paid. Because a plan loan is really an interest-bearing note (and a plan asset), many employers and recordkeepers have wondered how to treat the interest that accrues on the note when the loan goes into default and a-Form 1099-R is issued. The informal IRS answer over the years has been that the accrued interest must be counted and reported. Last year, the IRS suggested that the accrued interest could be counted up over the years and reported at distribution, rather than each year.

Prop. Regs. Sec. 1.72(p)-1, Q&A-19(a) states that the accrued interest continues to accrue and is counted in determining the amount available to the participant for a loan.

Example: P took a $42,000 loan (for a home) in 1990, but defaulted after paying back $2,000. The plan reported a $40,000 deemed distribution. Between 1990 and 1997, accrued interest on the loan grew to approximately $18,000. The outstanding balance and the accrued interest on the loan are added together in determining whether the participant can take another loan. Even if the plan permits a second loan while there is an outstanding loan (many do not), the total $58,000 outstanding balance precludes further loans.

However, the loan ceases to be an outstanding loan for Sec. 72 purposes and the accrued interest is disregarded once the loan has been reported as a deemed distribution. Thus, it appears that the plan ignores the accrued interest for distribution purposes. This is a major change that is very favorable to the defaulting taxpayer, because it appears the employee will never have to pay (and will never will be taxed on) the interest due.

Transition rules: Prop. Regs. Sec. 1.72(p)-1, Q&A-21(c)(3) provides three examples of how to calculate the basis and distribution once a distributable event occurs. The examples focus on how the employer has treated the defaulted loans in previous years, and what the plan has to do to comply with the proposed regulations.

Payroll withholding: The preamble to the proposed regulations includes an interesting hint from the IRS. It mentions using payroll withholding to pay back the loans, suggesting that any other method would likely result in defaults. Footnote 3 reassures employers with Sec. 403(b) plans that payroll deposit repayment is quite acceptable in such a plan, even under the Department of Labor's (DOL's) rules.(5)

ADP Testing

The IRS issued Notice 98-16 to offer guidance on several testing issues for Sec. 401(k) and (m) plans. The notice also asks for comments.

The IRS introduced three concepts: "testing year," "current year" and "prior year." The "testing year" is the year for which the Sec. 401(k) plan is being tested. The plan year ending Dec. 31, 1997, is the testing year when running the 1997 ADP test. The "prior year" is the year just before the testing year. Thus, for the 1997 calendar plan year, the 1996 calendar year is the prior year for testing and HCE purposes. Finally, if a plan uses "current year" data, it is using the testing-year's, rather than the prior-year's, data (e.g., the 1997 data rather than the 1996 data).

Prior-year vs. current-year testing methods: Under SBJPA Section 1433(c), a plan can use either prior-year or current-year data in the ADP test. This means an employer can use the 1996 nonhighly compensated employees' (NHCEs') ADP in place of the current-year (1997) NHCE ADP in satisfying the 1997 ADP test.

Under Sec. 401(k) and (m), an employer must notify the IRS if it wants to change from the prior-year data testing method to the current-year data testing method. Notice 97-27 gave employers a choice for the 1997 plan year, but suggested that changes from one method to the other in subsequent years would require employer action. Notice 98-1 provides that the IRS does not need notification from employers that want to change from the prior-year to the current-year data testing method. However, the IRS has required that the plan state which method it will use; thus, the employer would be required to amend the plan to change from one testing method to the other. In addition, Notice 98-1 prohibits aggregating Sec. 401(k) plans that use different testing methods.

Prior-year testing with QNECs: A concern after the SBJPA was whether qualified nonelective contributions (QNECs) made to fix an ADP failure could be counted as prior-year contributions for purposes of the prior-year testing method. For example, if a plan failed the ADP test in 1996 and corrected it by adding QNECs in 1997 (for the 1996 year), could the corrected NHCE ADP numbers be used as the basis for the 1997 prior-year data? According to Notice 98-1, yes. The IRS notes that:

* QNECs must be allocated to the testing year and must be contributed by the end of the following year.

* QNECs contributed after the Sec. 404(a)(6) date are counted as contributions for the following year for

* other purposes, such as Secs. 404 and 415 (most employers do not want to make contributions that late, because they must pay a 10% excise tax on excess contributions not corrected by two and one-half months after the end of the testing year).

* QNECs contributed for HCEs (rare) are counted as elective contributions for the year in which contributed;

* QNECs for NHCEs are counted in the year for which contributed. Thus, they may be counted in different years.

Prior-year data in year one: A new plan does not have prior-year NHCE numbers; thus, Sec. 401(k)(3)(E) provides a 3% NHCE ADP assumption for the first year. Alternatively, the employer can use the current-year data for the preliminary year. The plan is still testing using prior-year data, because that includes the first year's data. The same rule is used in the first year that a plan has a Sec. 401(k) or (m) feature. However, the IRS has provided some exceptions to this rule:

* If a new plan is aggregated with another Sec. 401(k) plan, it has prior-year data that it must use if the plan indicates the use of prior-year data.

* If the plan is a successor plan, it must use prior-year data. For this purpose, a successor plan is any plan in which 50% or more of the employees eligible for the previous plan are eligible for the new plan; thus, plans after a merger are probably "successor" plans.

Changes in the NHCE group: Employers have been concerned about using prior-year data (i.e., the NHCE ADP for the prior year) when there has been a change in the employee population or when employees who were not eligible in the prior year are now eligible. Notice 98-1 suggests that these changes can be ignored, unless there is a "plan coverage change." If so, the employer must use a weighted average of each subgroup of NHCEs.

Generally, a "plan coverage change" means a change in the group(s) of eligible employees because of a plan amendment, merger, spinoff, change in aggregation, etc. Thus, mere changes in day-to-day personnel can be ignored, but changes to the entire plan cannot. If there has been a plan coverage change, but 90% or more of the prior-year NHCEs are from the same "subgroup" of employees, the employer can use the ADP from that subgroup.

Change from current-year to prior-year testing method: Notice 98-1 observes that Sec. 401(k)(3)(A) and (m)(2)(A) provide an assumption that employers will choose a testing method and stay with it. Plans can change from the prior-year to the current-year testing method without noticing the IRS. However, plans can change from the current-year to the prior-year testing method only if any of the following occurs:

* The current-year testing method was used for each of the previous five plan years (or the total number of plan years, if less).

* A merger, acquisition or other business transaction occurs (as described in Sec. 410(b)(6)(C)(i)), as a result of which the employer has a plan that uses prior-year testing and a plan that uses current-year testing.

* The change occurs during the SBJPA remedial amendment period (which generally ends at the end of the 1999 plan year).

Notice 98-1 provides that an employer cannot "double count" QNECs for NHCEs when there is a change in testing method. Thus, QNECs used to satisfy the ADP test in 2000 cannot be counted in 2001 if there is a change in testing methods in 2001. The notice provides several examples of double counting. However, the double-counting rule is not in effect for plan years beginning before 1999.

Plan amendment rules: A plan must provide that the ADP and CAP tests will be satisfied. When amended, the plan can incorporate parts of Sec. 401(k) and (m) by reference (if the plan so states), but must state which testing method is being used and the first-year testing method used (i.e., 3% or first-year data).

While plans are not required to be amended for the SBJPA changes until the last day of the first plan year beginning after 1998, the plan must be operated in accordance with the changes; any retroactive amendment must reflect the choice made in operation and the date the choice (and the change) was made. Written plan procedures should be changed to reflect the choice made and the procedures should note that the plan will be timely amended to reflect this change.

Anti-abuse rule: The notice also states that "a plan will not be treated as satisfying the ADP or ACP test if there are repeated changes in plan testing procedures or plan provisions that have the effect of distorting ... [these] tests so as to increase significantly the permitted ADP or ACP for the HCEs and if a principal purpose of the changes was to achieve such a result."

Automatic Deferrals Permitted

The IRS has confirmed in Rev. Rul. 98-30(8) that when an employee has an effective opportunity to elect to receive cash or have that amount contributed by the employer to a profit-sharing plan, contributions made on the employee's behalf may be considered elective contributions under Regs. Sec. 1.401(k)-1(g)(3) under a qualified Sec. 401(k) cash or deferred arrangement, even though the employee does not make an affirmative election to defer.

Under the ruling, new employees are immediately eligible to participate in Plan A, a profit-sharing plan with both a Sec. 401(k) feature and an employer matching contribution under Sec. 401(m). When hired, an employee receives a notice explaining Plan A'S automatic 3% compensation-reduction election and the employee's right to elect to have no such contributions made to the plan or to choose an amount other than the automatic 3%. The notice also includes procedures for making the election and explains when the election takes effect. The employee is notified annually of his compensation-reduction percentage and his right to change the percentage (including the right to make no deferral). In arriving at its conclusion, the IRS reasoned:

The definition of a cash or deferred election in [Regs. Sec.] 1.401(k)-1(a)(3)(i) requires that the employee have an election between the employer paying cash (or some other taxable benefit) to the employee or making a contribution to a trust on behalf of the employee. The regulation does not require that the employee receive an amount in cash in any case in which the employee does not make an affirmative election to have that amount contributed to the trust.

If a participant has made no investment election, Plan A invests the amounts in a balanced fund that includes both diversified equity and fixed income investments. Footnote 1 of the ruling includes a warning that the DOL's position is that a participant or beneficiary will not be considered to exercise "control" (as that term is used in Employee Retirement Income Security Act of 1974 (ERISA) Section 404(c) and its regulations) when the participant or beneficiary is merely apprised of the investments that will be made on his behalf in the absence of instructions to the contrary.

Plan A does not permit after-tax contributions. However, the IRS noted that if Plan A were to permit them, amounts contributed to Plan A would have to be designated or treated, at the time of the contribution, as pre-tax compensation-reduction contributions or after-tax employee contributions.

Post-SBJPA Sec. 415 Benefit Limit

The IRS issued guidance on the limits on benefits payable from a defined benefit plan under Sec. 415. Rev. Rul. 98-19 provides questions and answers that reflect the changes made to the Sec. 415 rules by the SBJPA, after the technical correction made by the TRA '97. The ruling does not address the changes to the defined contribution Sec. 415 definition of compensation.

Under Sec. 415(b)(1)(A) and (B), annual benefits are limited to the lesser of $90,000, as adjusted ($130,000 for 1998), or 100% of a participant's average compensation for the participant's highest three consecutive years. Benefits payable other than as an annual straight-life annuity must be actuarially adjusted to an equivalent straight-life annuity, under Sec. 415(b)(2)(B). If benefits are payable at an age other than a participant's Social Security retirement age (SSRA), the dollar limit must be actuarially adjusted so that it is actuarially equivalent to the dollar limit at the participant's SSRA, under Sec. 415(b)(2)(C) and (D).

The actuarial assumptions used in making the adjustments required under Sec. 415(b)(2)(B), (C) and (D) are governed by Sec. 415(b)(2)(E). The interest rate used to adjust benefits payable in a form other than an annual straight-life annuity and the limit for benefits payable before a participant's SSRA generally cannot be less than the greater of 5% or the rate specified in the plan. Conversely, the interest rate used to adjust the limit for payments beginning after the SSRA generally cannot be greater than the lesser of 5% or the rate specified in the plan.

Sec. 415(e)(3) provides rules on the actuarial assumptions used in determining the present value of lump-sum payments.

The Retirement Protection Act of 1994 (RPA '94), part of the Uruguay Round Agreements Act (GATT), made various amendments to Sec. 415. First, RPA '94 Section 767 provided a special mortality table and changed the applicable interest rate used to determine the present value of a benefit subject to Sec. 417(e)(3). Second, it added new Sec. 415(b)(2)(E)(ii) , which requires that the interest rate used for adjusting a benefit or limit under Sec. 415(e)(3) equal the rate on 30-year Treasury securities, rather than the 5% rate specified in Sec. 415(b)(2)(E)(i). Finally, RPA '94 prescribed the mortality table to be used when adjusting any benefit or limit under Sec. 415(b)(2). These changes were generally effective for limitation years beginning after 1994, but plans were permitted to elect to use their old assumptions to calculate the present value of lump-sum distributions under Sec. 417(e)(3) until plan years beginning after 1999.

Rev. Rul. 95-29(10) provided guidance on the modifications to the benefit limits under Sec. 415 made by the RPA '94. These changes were subsequently modified by the SBJPA. Under the SBJPA, a plan that was in effect before Dec. 7, 1994 need not use the RPA '94 interest and mortality assumptions to calculate Sec. 415 limits before the earlier of (1) the date a plan amendment applying the new assumptions is adopted or made effective (whichever is later) or (2) the first day of the first limitation year beginning after 1999. To the extent that plan amendments had been adopted or made effective before the SBJPA enactment date, sponsors were allowed one year from Aug. 20, 1996 to amend the plan to retroactively reverse the new assumptions amendment.

SBJPA Section 1449 repealed the requirement that the interest rate to be used to reduce the dollar limit on lump-sum benefits under Sec. 415 could not be less than the greater of the rate on 30-year Treasury securities or the rate specified in the plan. Thus, under current law, the interest rate used to reduce the Sec. 415(b) dollar limit for benefits payable before age 62 will not change based on the form in which the benefit is paid. The SBJPA changes to Sec. 415 are effective as if they were enacted under the RPA '94.

As a result, Rev. Rul. 98-1 modifies the questions and answers in Rev. Rul. 95-29 and provides additional ones on the Sec. 415 limits. The ruling lists the benefits subject to the special interest rate under Sec. 415(b)(2)(E) (ii); shows how to determine the applicable interest rate; provides the effective dates for the changes to Sec. 415; addresses coordinating plan amendments required to apply Sec. 415 changes to actual plan operation; and provides numerous examples.

Defined Benefit Plan Distribution Valuation

The IRS has released final and temporary regulations(11) on interest and mortality assumptions required to calculate present values for defined benefit plan distributions under Sec. 417(e)(3). The regulations were effective April 7, 1998, and generally apply to plan years beginning after 1994. However, plans in effect before Dec. 8, 1994, may continue using the plan provisions in effect as of Dec. 7, 1994 (if they met Sec. 417(e)(3) at that time) until the first plan year beginning after 1999.

Assumptions: The assumptions in the present value calculations under Sec. 417(e)(3) are used for three separate Code requirements imposed on defined benefit plans:

* Calculating the present value of lump-sum cashouts of a participant's defined benefit plan amount under Sec. 417(e).

* Determining whether the lump-sump value exceeds the $5,000 cap on mandatory cashouts under Sec. 411(a)(11).

* Calculating the permissible maximum equivalent benefits payable under Sec. 415(b) when such benefits are not paid as an annual benefit.

Background: As discussed above, the RPA '94 provides that present value amounts calculated under Sec. 417(e) must not be less than the amount derived using (1) an applicable mortality table prescribed by the Treasury and based on the insurance commissioners' standard tables and (2) annual interest rates of 30-year Treasury bonds for the month prior to the distribution of the amount (or such other time as Treasury shall prescribe). Prior to the RPA '94, Sec. 417(e) did not specify requirements for mortality assumptions and permitted plans to use interest rates based on the Pension Benefit Guaranty Corporation's interest rate used to determine lump-sum present values in plan terminations. The IRS released proposed regulations implementing these changes on April 5, 1995. The final regulations generally follow the proposals, with some changes.

Mortality table: Regs. Sec. 1.417(e)-1(d)(2) provides that the IRS will prescribe the mortality table in a notice, revenue ruling or other guidance. The mortality table is currently set out in Rev. Rul. 95-6,(12) and is based on a fixed blend of 50% of the male mortality rates and 50% of the female mortality rates from the 1983 Group Annuity Mortality Table.

Interest rates: Given that Sec. 417(e) permits the IRS to prescribe interest rates other than the 30-year Treasury bond rate for the month before the distribution of the amount, the IRS has provided a number of alternatives. In addition to the "stability periods" outlined in the proposed regulations (which can be a plan quarter or plan year during which the interest rate remains stable), Regs. Sec. 1.417(e)-1(d)(4) also permits "stability periods" based on the calendar year or quarter. These rates can also be based on an average of two or more consecutive months in the five months before the beginning of the period.

When Sec. 417(0 inapplicable: Sec. 417(e)(3) and Regs. Sec. 1.417(e)-1(d)(6) do not apply to a distribution paid in the form of an annual benefit that (1) does not decrease during the participant's life (or, in the case of a qualified pre-retirement survivor annuity, the life of the participant's spouse) or (2) decreases during the participant's life merely because of the (i) death of the survivor annuitant (but only if the reduction is to a level not below 50% of the annual benefit payable before the death of the survivor annuitant) or (ii) cessation or reduction of Social Security supplements or qualified disability benefits.

Sec. 411(d)(6) anti-cutback rule: Regs. Sec. 1.417(e)-1(d)(10) provides limited Sec. 411 (d)(6) relief for certain plan amendments that change the time for determining the applicable interest rate and provides several examples on these protections.

New Determination Letter Procedures and User Fees

Two revenue procedures update the rules for IRS employee plan letters and rulings. Rev. Proc. 98-6(13) revises the employee plan determination letter procedures, effective Jan. 5, 1998. According to the IRS, Rev. Proc. 98-6 is a general update of Rev. Proc. 97-6,(14) which contains the IRS's general procedures for employee plan determination letter requests. Most of the changes to Rev. Proc. 97-6 involve minor revisions, such as updating citations to other procedures.

Plan transfers: The one substantive change in Rev. Proc. 98-6 is to the "no determination letter" list in Section 3.02, expanding the types of plans the IRS will consider. Rev. Proc. 98-6 removes from the no-determination list the issues of transfers of excess assets from ongoing defined benefit plans to defined contribution plans or transfers in connection with amending a defined benefit plan to create a floor offset arrangement with a defined contribution plan, including transactions resulting in a Sec. 414(k) plan (a defined benefit plan with benefits based partly on a participant's separate account).

Plan Amendments After New Laws

As of April 27, 1998, the IRS will consider plan changes required by the TRA '97 and GATT, and those changes effective before the first day of the first plan year beginning after 1998 required by the SBJPA and the Uniformed Services Employment and Reemployment Rights Act.

Rev. Proc. 98-14(15) announced the opening of the determination letter process for plan amendments required by these new laws. However, there are a few exceptions to the plans and amendments the IRS will consider:

* In issuing determination letters, the IRS will not rule on changes involving master or prototype plans and regional prototype plans not yet amended to comply with GATT, the SBJPA or the TRA '97, unless such plans are terminating plans.

* The IRS review for determination letters will not consider SBJPA changes for provisions effective for plan years beginning after 1998 (e.g., Sec. 401(k) nondiscrimination safe harbors).

Avoiding Sec. 411(d)(6): Under TRA '97 Section 1541, a plan will be considered to operate pursuant to its terms and not to violate the Sec. 411 (d)(6) anti-cutback provisions if the following conditions are met:

* The plan amendment is adopted before the first day of the first plan year beginning after 1998 (after 2000 in the case of a government plan).

* The plan is operated in accordance with the amendment on the date the statutory change takes effect (or if the amendment is not required by the statute, on the effective date of the amendment).

* The amendment is effective retroactively.

Government plans: The remedial period for government plan amendments for GATT, SBJPA and TRA '97 purposes is extended to the later of (1) the last day of the last plan year beginning before 2001 or (2) the last day of the first plan year beginning on or after the 1999 legislative date.

Family aggregation rules: The procedure notes that if the plan continues to apply the Secs. 414(q)(6) and 401(a) (17) (A) family aggregation rules after 1996, it will not be able to use the safe-harbor nondiscrimination rules under Regs. Secs. 1.401 (a)(4)-2(b) and 1.401(a)(4)-3(b), because such plans may discriminate against NHCEs. In filing for a determination letter after April 26,1998, such plans may not designate their status as a safe-harbor plan. Plans wishing to continue safe-harbor status must operate the plan and amend it during the remedial period without regard to the family aggregation rules.

Avoiding confusion: Rev. Proc. 98-14, which was released before Rev. Proc 98-6, provides that as of April 27, 1998, the IRS will consider most amendments required by the recent law changes in the SBJPA, GATT and the TRA '97. Rev. Proc. 98-6 states that these items will not be considered until further notice (Rev. Proc. 98-14 is further notice).

User fees: Rev. Proc. 98-8,(16) effective Jan. 5,1998, adjusts user fees for various ruling letters, determination letters and other employee plan and exempt organization matters. Fees for individual determination letters, SVP and VCR are generally unchanged.

Simplified Method for Taxing Qualified Plan Annuities

Notice 98-2(17) describes the new simplified method required under Sec. 72(d) for determining the taxable and nontaxable portions of annuity payments made from Sec. 401(a) qualified plans and Sec. 403(a) and (b) annuities. Notice 98-2 replaces Notice 88-118,(18) which had provided an optional simplified method for determining the taxable and nontaxable portions of such payments. The new method generally applies to any annuity with a starting date after Nov. 18, 1996.

Effect on employers: Payors must use this method to report the taxable portion of annuity payments on Form 1099-R; distributees must use this method to comply with Sec. 72(d). (The method does not apply if the annuitant is over age 75 and there are five or more years of guaranteed payments under the annuity.)

How it works: Under the new method, the portion of each annuity payment a distributee excludes from income is a level dollar amount determined by dividing (1) the investment in the contract by (2) the expected number of annuity payments listed in the appropriate table in the notice.

Pre-1998 starting dates: For annuity starting dates after Nov. 18, 1996 and before 1998, the expected number of payments is taken from Table I:

Table I

     Age of         Expected number
primary annuitant     of payments

55 and under              360
56-60                     310
61-65                     260
66-70                     210
71 and over               160

Post-1997 starting dates: For annuity starting dates beginning after 1997, the table used to determine the expected number of payments depends on whether the payments are based on the life of more than one individual.

Life of one individual: If the annuity is based on the life of only one individual, the expected number of payments is the same as under Table I, above, based on the annuitant's age (rather than the age of the primary annuitant) at the annuity starting date. An annuity payable over the life of one annuitant with a term certain feature is an annuity based on the life of that individual. Also, an annuity payable over the life of one annuitant, with a temporary annuity payable to the annuitant's child until the child reaches an age specified in the plan (not more than age 25), is an annuity based on the life of that individual.

Life of more than one individual: If the annuity is based on the life of more than one individual, the expected number of payments is taken from Table II, and is based on the annuitants' combined ages at the annuity starting date.

Table II

Combined ages   Expected number
of annuitants     of payments

110 and under         410
111-120               360
121-130               310
131-140               260
141 and over          210

If the annuity is payable to a primary annuitant and more than one survivor annuitant, the combined ages is the sum of the ages of the primary annuitant and the youngest survivor annuitant. If it is payable to more than one survivor annuitant but there is no primary annuitant, the combined ages is the sum of the ages of the oldest survivor annuitant and the youngest survivor annuitant. Any survivor annuitant whose entitlement to payments is contingent on an event other than the death of the primary annuitant is disregarded.

Term certain without life contingencies: For an annuity that does not depend on the life expectancy of one or more individuals, the expected number of payments is the number of monthly annuity payments under the contract.

Investment in the contract: The investment in the contract is the aggregate premiums or other consideration paid (generally, the aggregate after-tax contributions made to the plan), reduced by amounts received before the annuity starting date that were excluded from income. The investment is determined without regard to the adjustment for any refund feature described in Sec. 72(c)(2).

Because the death benefit exclusion under Sec. 101(b) was repealed by SBJPA Section 1402 for decedents dying after Aug. 20, 1996, surviving beneficiaries of such decedents may no longer increase the investment in the contract by the death benefit exclusion.

Excluded amount: The excludable dollar amount determined under these rules will be excluded from each monthly payment, even if the amount of the annuity payments changes. For example, the excluded amount remains constant even if the annuity payments increase due to cost-of-living increases, or if they decrease as a result of a reduced survivor annuity after the death of one of the annuitants.

If the amount to be excluded from each payment exceeds the amount of the annuity payment (e.g., because of decreased survivor benefits), each payment will be completely excluded until the entire investment is recovered. For annuity starting dates after 1986, annuity payments received after the investment is recovered (generally, after the expected number of payments has been received) are fully taxable. If annuity payments stop because of death, a deduction for the unrecovered investment is allowed on the decedent's final return. If two or more annuitants are receiving payments simultaneously, each will exclude a pro rata portion of the excludable amount.

Nonmonthly payments: An adjustment is necessary when annuity payments are not made on a monthly basis. One method is to determine the number of expected payments by dividing the applicable expected number of months in the applicable table by the number of months in each period. Another way is to determine the tax-free portion of a monthly payment using the applicable expected number of months from the applicable table and then multiply the resulting monthly dollar amount by the number of months in each period.

Transition rule: For annuities with starting dates after Nov. 18, 1996 and before 1997, pre-SBJPA law (including the optional simplified method under Notice 88-118) may be used to determine the taxable and nontaxable portions of annuity payments received in 1996 and 1997. Thus, payors will not need to re-issue Forms 1099-R for 1996 and 1997 (if applicable), and distributees will not need to file amended returns for those years, solely because they failed to take into account the SBJPA changes.

Under this transition rule, a payor who reports the taxable portion on Form 1099-R must determine the taxable and nontaxable portion of annuity payments made after 1997 under the "transition method." (Payors may choose to apply the transition method for payments made on an earlier date, e.g., payments made after 1996.) Under the transition method, the nontaxable portion of each payment made on or after the transition date is determined by dividing the remaining investment in the contract by the remaining number of expected payments.

For this purpose, the "remaining investment in the contract" is the distributee's original investment as of the annuity starting date, less the amount of the investment treated as recovered after the annuity starting date and before the transition date. The "remaining number of expected payments" is the total number of expected monthly payments on the annuity starting date, less the number of payments made before the transition date.

If the payor does not report the taxable portion of annuity payments on Form 1099-R, a distributee who uses the transition rule must determine the taxable and nontaxable portions using the transition method.

ESOPs

S Corporations

The TRA '97 included several provisions that will encourage the use of ESOPs by S corporations. By far, the greatest incentive created by the new law is the exemption of ESOPs from unrelated business income tax with respect to employer securities they hold; S income allocable to employer securities held by the ESOP will not be subject to Federal income taxation until it is distributed to the ESOP participants as a plan distribution. In some cases, this treatment may even favor a switch from C to S status.

Background: Before the SBJPA, neither tax-exempt Sec. 401(a) qualified plan trusts nor Sec. 501(c)(3) tax-exempt organizations could be S shareholders; exempt organizations could be partners in a partnership. If the partnership carried on an unrelated trade or business with respect to the tax-exempt partner, the latter had to include as unrelated business taxable income (UBTI) its distributive share of income from that trade or business, under Sec. 512(c).

SBJPA Section 1316(a) amended Sec. 512(c) to allow Sec. 401(a) trusts and Sec. 501(c)(3) organizations to be S shareholders, effective for tax years beginning after 1997. However, consistent with the underlying premise of subchapter S--that all income of the S corporation be subject to a shareholder-level income tax--SBJPA Section 1316(c) amended Sec. 512(e)(1) to treat all income flowing through to a tax-exempt shareholder as UBTI, regardless of its source or nature. Thus, for example, even S investment income would flow through to a qualified tax-exempt shareholder as UBTI. Gains and losses from the disposition of the S stock would also be treated as UBTI. This treatment applies to tax years beginning after 1997.

New ESOP exception: The TRA '97 carved out an exception to the SBJPA's UBTI rule for ESOPs, effective for tax years beginning after 1997. Sec. 512(e)(3), as amended by TRA '97 Section 1523(a), provides that an S corporation's income or loss generated by employer securities (as defined in Sec. 409(1)) held by an-ESOP maintained by the S corporation will not be taxed as UBTI.

This apparently is the result Congress intended, even though it seems to create an almost startling advantage for S corporations that sponsor ESOPs. Amended Sec. 512(e) will make ESOPs much more attractive to S corporations, and may create a powerful incentive for certain C corporations to convert to S status. The tax savings (i.e., the ability to defer from tax for an extended period of time some or all of an S corporation's income) potential is significant. The participants will pay tax on gains from the sale of the securities when they are distributed from the ESOP.

Cash distributions allowed: ESOPs are generally required by Secs. 409(h)(1)(A) and 4975(e)(7) to make distributions in the form of employer securities. If the employer securities are not readily tradable, the employee must have the right to require the employer to buy the securities. If the employer's bylaws or charter restricts ownership of substantially all employer securities to employees or a pension plan, the plan may provide that benefits will be distributed in the form of cash.

S corporations can have no more than 75 shareholders, under Sec. 1361(b) (1) (A) . Thus, an S corporation could lose its S status if the ESOP is required to give stock to plan participants, rather than cash equal to the stock's value. To reduce this possibility, Sec. 409(h)(2)(B), as amended by TRA '97 Section 1506(a), effective for tax years beginning after 1997, provides that an S ESOP does not have to give employees the right to demand employer securities on distribution, as long as they have the right to receive their distributions in cash equal to the stock's fair market value. Such an ESOP may distribute employer securities if the participant is allowed to resell them to the employer.

Stock sales to ESOPs: ESOPs are subject to prohibited transaction rules under the Code and ERISA, which generally prohibit certain transactions between the plan and certain persons close to the plan. Although a number of exceptions exist under Sec. 4975(d)(1)-(15), prior to the TRA '97 these exceptions did not apply to any transaction in which a plan, directly or indirectly:

* Lent any part of the plan assets to,

* Paid any compensation for personal services rendered to the plan to,

* Acquired for the plan any property from, or sold any property to, an S shareholder-employee, a family member of such shareholder-employee or a corporation controlled by the shareholder-employee.

Under TRA '97 Section 1506(b)(1), amending Sec. 4975(f)(6) effective for tax years beginning after 1997, the statutory exceptions to the prohibited transaction rules will be available for such transactions. For this purpose, Sec. 4975(f)(6)(C) defines a shareholder-employee as an S employee or officer who owns (after applying attribution rules) more than 5% of the corporation's outstanding stock during the corporation's tax year.

Cash Distributions Not Annual Additions

In Letter Ruling 9736018,(19) the IRS held that a distribution of cash to all shareholders, including an ESOP, would not be deemed Sec. 415 annual additions to the ESOP, nor would the amount distributed to the ESOP be deductible under Sec. 404(a).

In the ruling, a holding company was created to purchase all of a bank's capital stock when the bank was converted from a mutual savings and loan association to a stock savings bank. To raise money for the acquisition, the holding company sold shares of stock to the public. The holding company raised enough money to purchase all the bank's shares, retain some money for operations, and lend money to the holding company's newly created ESOP. The holding company raised more money than it needed and proposed to distribute the excess amount to its shareholders, including the ESOP.

According to the provisions of the ESOP, as amended, it must differentiate, with respect to the distribution, between shares allocated to the accounts of ESOP participants and shares held unallocated as security for the ESOP loan. The portion of the distribution not paid from the holding company's earnings and profits (E&P) (return-of-capital distribution) attributable to shares allocated to the ESOP participants' accounts is to be paid to such accounts. The portion of the return-of-capital distribution attributable to shares held in the ESOP suspense account is to be paid to the suspense account. The return-of-capital distribution in the suspense account and participants' accounts, including earnings while held in such accounts, will be reinvested in employer securities (as defined in Sec. 4975(e)(7)) as soon as administratively feasible without materially affecting the value of the securities based on applicable market conditions.

IRS holding: Without ruling on how much of the distribution might be return of capital and how much might be E&P (and hence, a dividend), the IRS addressed how the distribution would be treated for purposes of Sec. 415 limits, deductibility under Sec. 404(a) and the ESOP loan's continued qualification.

As to the Sec. 415 limits, the IRS found that because the return-of-capital portion of the distribution would not be used to repay the loan, there would be no release of shares from the suspense account (hence, no annual additions resulting from the allocation of released shares). The return-of-capital distribution also is not an annual addition for Sec. 415 purposes, because it is not an employer contribution, employee contribution or forfeiture; rather, it represents a return of a portion of the value of shares previously held by the ESOP (if allocated to the participants' accounts, it was previously taken into account under Sec. 415; if held under the suspense account, it will not be taken into account until released as a result of employer contributions applied to loan repayment).

A return of capital is also not an employer contribution deductible under Sec. 404(a). Thus, to the extent the distribution is other than a dividend, the distribution is not an employer contribution and is not deductible.

The IRS also sketched out the required treatment of the distribution needed to preserve the ESOP loan's exempt status:

The status of the ESOP loan as an exempt loan within the meaning of [Regs. Sec.] 54.4975-7(b)(1)(iii) will not be adversely affected if (a) the portion of the return of capital distribution that is attributable to employer securities held by the ESOP suspense account (and any earnings on such portion while held by the suspense account prior to the reinvestment of such portion and earnings thereon in employer securities) is held as collateral for the ESOP's exempt loan, subsequently released from collateral as the loan is repaid, and allocated to the accounts of ESOP participants and/or (b) the portion of the distribution that constitutes a dividend within the meaning of [Sec.[ 316(a) that is attributable to employer securities held by the ESOP suspense account (and any earnings on such portion while held by the suspense account) is treated for all purposes under the ESOP with respect to the requirements of [Secs.] 401 and 4975 in the same manner as ordinary dividends on employer securities are treated under the terms of the ESOP.

Finally, the IRS approved the holding of the returned capital distribution in the ESOP until the funds could be used to purchase employer securities and the purchase could be accomplished "without materially affecting the value of the securities based on applicable market conditions." This "grace period" could be critical in protecting both the ESOP and the company.

ESOP Stock Voting Rights

In Grindstaft v. Green,(20) the Sixth Circuit ruled that the voting rights for stock in an ESOP are not "plan assets" Consequently, the ESOP committee, which was appointed by the employer's board of directors, did not violate its fiduciary duties or commit a prohibited transaction by voting the ESOP shares for members of the board.

Facts: North American Rayon Corporation (NAR), a subsidiary of North American Corporation (NAC), has an ESOP containing 85% of NAC stock. The NAC board appoints the three-member NAR ESOP administrative committee that controls the ESOP's administration and operation. One member of the ESOP committee is recommended by the union. The union had held an unsuccessful strike to gain passthrough voting of the ESOP's stock. After the union ended the strike, Karl Grindstaff, the union-recommended member of the ESOP committee, filed a suit claiming that ESOP committee members Green (NAC's President) and Butts (NAC's Vice President) violated ERISA Section 404(a)'s exclusive benefit rule and committed an ERISA Section 406(b) prohibited transaction by voting the ESOP's stock for their own election to the board, knowing the board would appoint them to the ESOP committee.

Analysis: Grindstaff argued that the defendants violated ERISA Section 404(a)'s exclusive benefit rule and ERISA Section 406(b), which prohibits a plan fiduciary from dealing with plan assets for his own interest. He contended that the ESOP stock voting rights were plan assets and the use of such assets in furtherance of their election as directors violated their ERISA fiduciary duties.

According to the court, the first issue was whether the right to vote ESOP shares in a regular annual election of the board of directors for the purpose of electing plan fiduciaries to the board constituted a "plan asset" under ERISA. The second issue was whether, when acting in their capacity as members of the NAC board of directors, the defendant ESOP committee members violated their ERISA Section 404 fiduciary duties in voting against the passthrough voting proposal.

The court began its analysis with the fact the Congress, in drafting ERISA, specifically provided that corporate executives could also be plan fiduciaries. The court cited Moench v. Robertson,(21) which outlines the reasons for exempting ESOPs from ERISA's strict prohibitions against self-dealing. These reasons are based on the distinctive dual nature and purpose of ESOPs as both a retirement plan and a means of corporate finance.

In the court's view, the plaintiffs were alleging as a violation of ERISA a form of "management entrenchment" by which management controls employee pension assets. The court concluded that, as to ESOPs, management "entrenchment" is actually the rule rather than the exception, and that Congress has recognized and approved this.

The court acknowledged that two lower courts had treated ESOP voting rights as plan assets, in O'Neill v. Davis(22) and Newton v. Van Otterloo.(23) However, in both of those cases, while management entrenchment was an issue, the events complained of went beyond entrenchment to involve ESOP stock voted to fire an employee in a management dispute and the failure to vote a large block of ESOP stock to re-elect a board.

The court also relied on Kuper v. Iovenko,(24) which held that a key exception carved out by Congress for ESOPs is the fiduciary's relief from ERISA's "strict prohibitions against self-dealing," i.e., dealing with plan assets in his own interest or for his own account. The court concluded that a violation of fiduciary duty required an abuse or breach of fiduciary duties other than establishing or maintaining a corporate structure clearly envisioned and authorized by Congress.

The court rejected the DOL's amicus brief urging that in all circumstances ERISA stock voting rights are plan assets. The court concluded that the right to vote, or direct the voting of, an ESOP's shares, even when used to perpetrate one's own incumbency, does not, by itself, constitute a plan asset. The court also affirmed the dismissal of the claim against the ESOP trustee, First American National Bank; as a directed trustee, the bank had no fiduciary duties.

Securities Distributed From Employer Plans

The IRS released Notice 98-24,(25) clarifying certain rules involving net unrealized appreciation (NUA) in employer securities. The notice provides that the NUA in employer securities distributed from employer plans at the time of a lump-sum distribution is gain from an asset held more than 18 months when realized in a subsequent sale.

For purposes of a sale or other disposition of such employer securities occurring after May 6,1997, the period the employer securities were held by the plan need not be calculated. The holding period will be deemed to be 18 months, hence qualifying the NUA for the 20% capital gains rate (10% if the gain would otherwise be taxed at 15%). However, the actual holding period in the distributee's hands determines the tax rate that will apply to the NUA occurring after distribution from the plan.

This notice resolves an important question for participants who received employer plan lump-sum distributions (including employer securities in 1997) and subsequently sold the securities. Returns can now be filed applying the 20% (or 10%) rate for these assets.

Rev. Rul. 81-122(26) stated that NUA at the time of distribution would be treated as gain from assets held for more than one year. When that ruling was issued, the long-term capital gains rate applied for assets held for more than one year.

Notice 98-24 applies to sales occurring before the later of Jan. 1, 2000 or until further guidance is issued.

IRAs

Roth IRA Guidance

In the past year, the IRS provided substantive Roth IRA guidance in the form of Ann. 97-122,(27) Notice 98-49,(28) proposed regulations under Sec. 408A(29) and model agreements. Congress provided technical corrections for Roth IRAs in the IRSRRA '98.

Ann. 97-122: This announcement clarifies that Roth IRA contributions must be maintained separately--i.e., as a separate trust, custodial account or annuity--from regular IRA contributions. Separate accounting within the same trust, custodial account or annuity is not allowed.

The IRS will permit prototype sponsors to combine a Roth IRA and a regular IRA in the same document, provided (1) the separate trust requirement is met and (2) the completed document dearly indicates whether it is to be used as a regular IRA or a Roth IRA. This must be done in a way that makes clear that the designation as one type of IRA precludes designation as the other type.

The IRS is not currently accepting opinion letter requests on prototype IRAs; however, it does intend to issue procedures for requesting opinion letters in the future.

Transition relief: The IRS will provide transition relief for Roth IRA sponsors and customers similar to the relief provided in Rev. Proc. 97-29(30) for those who set up savings incentive match plans for employees (SIMPLE) IRAs with documents that were not IRS-pre-approved. The SIMPLE IRA transition relief was conditioned on the prototype sponsor's subsequently obtaining IRS approval of the documents and meeting certain other requirements. Transition relief for Roth IRAs will also be conditioned on the document's clearly designating the trust, custodial account or annuity as a Roth IRA at the time of creation.

Notice 98-49: This notice provides guidance, in question-and-answer form, on certain Roth IRA administrative issues. Of particular interest is the guidance on reporting requirements for trustees in the case of a recharacterization of IRA contributions, and the effect recharacterization has on the rules governing the nontaxable return of basis in the case of traditional IRA distributions.

The general reporting requirements for Roth IRAs are described in recently issued proposed regulations (discussed below). Notice 98-49 provides reporting requirements that apply to trustees of the "First IRA" and the "Second IRA" when the owner elects to treat a contribution as having been made to the latter and not to the former, under Prop. Regs. Sec. 1.408A-5. To the extent the instructions for 1998 Form 1099-R and 1998 Form 5498, IRA Contribution Information, are inconsistent with the instructions in Notice 98-49, trustees must follow the guidance in the notice. Notice 98-49 also modifies the rules for calculating the nontaxable return of basis in distributions set out in Notice 87-16(31) as they will apply to First and Second IRAs.

Sec. 408A: The proposed regulations provide guidance for:

* Establishing a Roth IRA (Prop. Regs. Sec. 1.408A-2).

* Making contributions (Prop. Regs. Sec. 1.408A-3).

* Converting to a Roth IRA (Prop. Regs. Sec. 1.408A-4).

* Recharacterizing contributions (Prop. Regs. Sec. 1.408A-5).

* Distributions (Prop. Regs. Sec. 1.408A-6).

* Required reporting (Prop. Regs. Sec. 1.408A-7).

A general overview of the Roth IRA (Prop. Regs. Sec. 1.408A-1), a definitions section (Prop. Regs. Sec. 1.408A-8) and the effective date (Prop. Regs. Sec. 1.408A-9) are also provided.

The most significant clarifications and additions involve the conversion process, taxing distributions and recharacterizing contributions from a Roth IRA to a traditional IRA. Recharacterization was added by IRSRRA '98 Section 6005(b) to help individuals who thought they were eligible for conversion to a Roth IRA (i.e., adjusted gross incomes (AGI) of $100,000 or less), but who later discovered otherwise.

IRSRRA '98: Many technical clarifications to the Roth IRA were provided by IRSRRA '98 Section 6005 (b), including the following:

* Clarification of the limit for Roth IRA and traditional IRA contributions as $2,000 per year.

* Clarification of the phaseout range for married individuals filing separately as $0-$10,000.

* Clarification that AGI is determined for the year of the conversion without regard to the amount taxable because of the conversion.

* The required five-year holding period begins with the first tax year a contribution is made to the Roth IRA.

* An election to include a 1998 conversion to a Roth IRA in income in 1998 or ratably over the four-year period ending in 2001.

* If the owner dies during the four-year period, the remaining untaxed portion will be included on his final return, unless his surviving spouse who is the sole beneficiary elects to continue the deferral over the remaining years.

* An erroneous conversion to a Roth IRA may be corrected without penalty.

* Distributions from a conversion not held for the required five-year period may be subject to a 10% penalty under Sec. 72(t).

Model Roth IRA agreements: The IRS issued Form 5305-R, Roth Individual Retirement Trust Account, and Form 5305-RA, Roth Individual Retirement Custodial Account. These forms constitute model Roth IRA agreements that meet the requirements of Sec. 408A.

A Roth IRA is considered established after the appropriate form is fully executed by both the individual and the trustee or custodian. These forms can be downloaded from the IRS's homepage (http://www.irs.ustreas.gov); neither form is to be fried with the IRS.

Authors' note: The authors acknowledge the significant assistance of Gary Cvach, Karen Field, Martha Priddy Patterson and Denis Yurkovic of KPMG Peat Marwick LLP's Washington National Tax Compensation and Benefits Practice in compiling information for this article.

(1) Rev. Proc. 98-22, IRB 1998-12, 11.

(2) Ann. 97-121, RIB 1997-50, 62.

(3) TD 8769 (6/5/98).

(4) REG-209476-82 (1/2/98).

(5) See DOL Reg. at 29 CFR 2510.3-2(f).

(6) Notice 98-1, IRB 1998-3, 42, supplementing Notice 97-2, IRB 1997-2, 22.

(7) Id.

(8) Rev. Rul. 98-30, IRB 1998-24, 8.

(9) Rev. Rul. 98-1, IRB 1998-2, 1, modifying and superseding Rev. Rul. 95-29, 1995-1 CB 81.

(10) Id.

(11) TD 8768(4/7/98).

(12) Rev. Rul. 95-6, 1995-1 CB 80.

(13) Rev. Proc. 98-6, IRB 1998-1, 183, superseding Rev. Proc. 97-6, 1997-1 CB 576.

(14) Id.

(15) Rev. Proc. 98-14, IRB 1998-4, 22.

(16) Rev. Proc. 98-8, IRB 1998-1,225, superseding Rev. Proc. 97-8, 1997-1 CB 610.

(17) Notice 98-2, IRB 1998-2, 22, obsoleting Notice 88-118, 1988-2 CB 450.

(18) Id.

(19) IRS Letter Ruling 9736018 (6/15/97).

(20) Karl Grindstaff v. Charles Green, 133 F3d 416 (6th Cir. 1998), aff'g 946 F Supp 540 (E.D. Tenn. 1996).

(21) Charles Moench v. Joseph Robertson, 62 F3d 553 (3d Cir. 1995).

(22) Thomas O'Neill v. DeForest Davis, 721 F Supp 1013 (N.D. Ill. 1989).

(23) Robert Newton v. John Van Otterloo, 756 F Supp 1121 (N.D. Ind. 1991).

(24) Glenn Kuper v. Michael Iovenko, 66 F3d 1447 (6th Cir. 1995).

(25) Notice 98-24, IRB 1998-17, 5.

(26) Rev. Rul. 81-122, 1981-1 CB 202.

(27) Ann. 97-122, IRB 1997-50, 63.

(28) Notice 98-49, IRB 1998-38, 5.

(29) REG-115393-98 (9/3/98).

(30) Rev. Proc. 97-29, IRB 1997-24, 9.

(31) Notice 87-16, 1987-1 CB 446.

Peter I. Elinsky, Esq.
Partner
KPMG Peat Marwick LLP
Washington, D.C.

Terrance E Richardson, Esq.
Manager
KPMG Peat Marwick LLP
Arlington, VA

Eugene M. Holmes, Esq.
Tax Specialist
KPMG Peat Marwick LLP
Arlington, VA