Current developments.

EXECUTIVE SUMMARY

* The Ninth and Tenth Circuits decided whether a corporation could deduct defined benefit plan contributions made after the end of the tax year but before the extended due date of that year's return.

* The IRS amended the Internal Revenue Manual to include a host of Sec. 403(b) plan examination guidelines.

* Final regulations allow S corporation ESOPs and other stock bonus plans to substitute cash distributions for stock distributions without violating the Sec. 411(d)(6) anti-cutback rules.

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 general developments in retirement plan qualification requirements and employee stock ownership plans.

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 general developments in retirement plan qualification requirements and employee stock ownership plans (ESOPs).

Qualified Plan Cases

Lucky Stores, Inc.

In May 1999, the U.S. Supreme Court declined to review a Ninth Circuit decision(1) denying Lucky Stores, Inc. a deduction for contributions to multiemployer defined benefit plans made after the tax year for which the deduction was taken.

Lucky Stores contributed monthly to several collectively bargained defined benefit plans. Before 1986, it deducted a total of 12 monthly contributions attributable to employee service during a particular tax year from its taxable income for that year. Although the twelfth payment was made after the end of the tax year, it was attributed to the previous year as a payment "on account of" that year under Sec. 404(a)(6). However, for its tax year ended Feb. 2, 1986, the taxpayer obtained an extension and fried in October 1986. On that return, it attributed to its tax year ended Feb. 2, 1986, all monthly contributions made during the extension period, claiming such payments were "on account of" the prior tax year. These deductions totaled $36,661,529, which the IRS disallowed; the Tax Court agreed with the Service.

Appeals court's analysis: Under Sec. 404(a)(1)(A), accrual- or cash-basis employers may deduct contributions to qualified pension plans in the tax year the contribution is actually paid. Additionally, Sec. 404(a)(6) deems a taxpayer to have made a payment on the last day of the preceding tax year if it is made (1) on account of such tax year and (2) not later than the extended due date of that year's return. The Ninth Circuit stated that the plain meaning of Sec. 404(a)(6) supported the Tax Court's decision, noting the seven or eight months of additional payments stemmed from 1987 employee service, not 1986.

The taxpayer relied on Rev. Rul. 76-28,(2) which permits deductions if the payment is treated by the plan in the same manner as it would have been if received on the last day of the preceding tax year. The taxpayer's defined benefit plans calculated a pension under a formula based on years worked and the highest salary maintained over a particular period; thus, the employer's contribution had no direct relation to the workers' benefits--the contributions were simply placed in one common pool to fund the entire plan. Because the plan treated all contributions similarly (no matter when received), the post-1986 contributions met Rev. Rul. 76-28's requirements and were deductible.

The appeals court dismissed this argument, noting that under the terms of the collective bargaining agreement, the taxpayer was required to make monthly payments to the plans, based on the hours or weeks of employee service in the immediately preceding month. Plan administrators treated each remittance as the fulfillment of the taxpayer's required contribution for a discrete month. Thus, the extra contributions were treated by the plans as meeting the taxpayer's 1987 obligations, which differed from the treatment than if they had been received in 1986. Thus, the taxpayer did not meet Rev. Rul. 76-28 or Sec. 404(a)(6). Further, the court ruled that plan administrators could not properly calculate meaningful contribution amounts if employers were allowed to count work performed after the plan year.

American Stores Co.

Similarly, in American Stores Co.,(3) the Tenth Circuit affirmed a Tax Court decision holding that an employer could not deduct more than 12 months' contributions to a qualified multiemployer defined benefit plan.

The accrual-basis taxpayer and its subsidiaries contributed to 39 qualified multiemployer defined benefit plans. Generally, at the end of each month, the various plan administrators sent bills to participating employers, who would calculate their required contributions by multiplying the units of service (e.g., hours or weeks) worked by covered employees by fixed dollar rates set by the applicable collective bargaining agreements. Contributions based on work performed within a particular month were due at the end of the following month.

For tax years before 1988, the taxpayer and its subsidiaries used one of two methods to calculate pension deductions. Some would deduct contributions actually paid during the tax year; others would deduct contributions corresponding to work done during the tax year, including one payment made after the close of the tax year, corresponding to work done in the last month. For the tax year ended Jan. 30, 1988, however, the taxpayer deducted the typical 12 payments, plus seven or eight additional payments made (and based on services performed) after the close of the tax year, but before the extended due date of that year's return. The IRS disallowed the deduction for the additional months' contributions; the Tax Court held for the Service.

Deduction rules: Sec. 413 contains special rules for collectively bargained plans. Under Sec. 413(b)(7), Sec. 404(a) deduction limits are determined on a plan-wide basis, as if all plan participants were employed by a single employer. At the beginning of the plan year, working from the terms of collective bargaining agreements and past contribution levels, the plan determines the "anticipated employer contributions" it will receive for that year. If such contributions for the plan year are within the plan-wide deduction limit, each participating employer may (without further determination and regardless of subsequent events) deduct all contributions-it makes for the portion of its tax year included within the plan year. Of course, employers will make only those contributions required by the plan, because their employees receive a predetermined level of benefits independent of the amounts contributed by a specific employer.

"On account of" previous tax year: On appeal, the taxpayer argued that deductibility of contributions under a multiemployer defined benefit plan is not tied to the concept of monthly obligations paid or accrued through the end of the year under the terms of a collective bargaining agreement. Rather, its payments during the Sec. 404(a)(6) "grace period" were "on account of" its 1988 tax year and, thus, deductible for that year. The taxpayer also contended that it met Rev. Rul. 76-28.

Rejecting these arguments, the Tenth Circuit stated that, because Sec. 413(b)(7) requires a multiemployer plan to calculate a plan-wide deduction limit in advance based on anticipated employer contributions, those contributions are effectively restricted by that limit only if the plan and the contributing employers use a common method for attributing payments to specific plan years and tax years. Thus, an employer's grace-period payment to a multiemployer plan is on account of its previous tax year only if a deduction for that year is consistent with the way the plan calculates anticipated employer contributions for Secs. 404(a) and 413(b)(7) purposes. Here, each of the plans was required to calculate anticipated employer contributions for the plan year by considering only contributions attributable to services performed during that year, consistent with the method used to determine each employer's contribution obligation. Thus, the taxpayer could deduct "on account of" its previous tax year only those grace-period contributions attributable to services performed during that year.

The court also concluded that Rev. Rul. 76-28 requires that, for an employer to deduct a payment on account of a previous tax year, the plan must have treated the payment as if made on the last day of the tax year. In the case of a multiemployer plan, the plan itself must have treated the payment as being made on the last day of the preceding tax year for purposes of calculating the plan-wide deduction limit under Sec. 413(b)(7). This requirement was not met, because the plan did not treat the disputed grace-period payments as being made on the last day of the taxpayer's 1988 tax year in calculating the plan-wide deduction limit under Sec. 413(b) (7).

Improper Termination

In Gant,(4) the Tax Court held that two retirement plans were improperly terminated; when the plans failed to meet employee participation requirements, the company president, a highly compensated employee (HCE), was required to include all his vested accrued benefits in gross income. While the Sec. 401(a)(26) participation requirements no longer apply to defined contribution plans, they still apply to defined benefit plans.

The taxpayer was the president and sole shareholder of a corporation with a defined benefit plan (pension plan) and a money-purchase plan. Both plans were intended to be Sec. 401(a) qualified plans. The taxpayer was each plan's trustee and fiduciary. In October 1987, the board of directors decided to terminate the plans; the taxpayer sent a letter to the plans' third-party administrator requesting that the plans be terminated. Neither the corporation nor the taxpayer gave written notice of this decision to plan participants or the Pension Benefit Guaranty Corporation (PBGC). In June 1988, the taxpayer, as trustee, purchased group annuity contracts for both plans' participants. One month later, the money-purchase plan was converted into a profit-sharing plan. In December 1988, the taxpayer distributed the annuity contracts to the participants. The corporation continued to distribute annual benefits statements to pension plan participants through the 1991 plan year. For plan years 1988-1990, the corporation stated on Form 5500, Annual Return/Report of Employee Benefit Plan (with 100 or more participants), that the pension plan had not been terminated.

The issue before the Tax Court was whether the taxpayer had to include in income for 1991-1993 his vested accrued benefits in the plans. Sec. 402(b)(4) provides that, if a trust is not exempt under Sec. 501(a) because it failed to meet the Sec. 401(a)(26) employee participation requirement or the Sec. 410(b) minimum coverage requirement, an HCE must include his vested accrued benefits in income. Thus, the Tax Court had to determine whether (1) both the pension and profit-sharing plans were ongoing plans, (2) the plans failed to meet Sec. 401(a)(26) or 410(b) and (3) the taxpayer was an HCE.

Plan termination: Pension plans are covered by Title IV of the Employee Retirement Income Security Act of 1974 (ERISA); single-employer plans must use the ERISA Section 4041(a) (1) termination rules. To effectively terminate a defined benefit plan under ERISA Section 4041(b) (2) (B) , the plan administrator must provide 60 days' advance notice to affected parties and notify the PBGC of its intent to terminate the plan. Further, plan participants or beneficiaries must be notified of the amount of their benefit at termination and how it was determined. The Tax Court ruled the corporation had not complied with these requirements; thus, it had not terminated the plans in 1988.

A plan not subject to ERISA Title IV (i.e., a profit-sharing plan) is terminated when an employer voluntarily terminates the plan and completely distributes plan assets. Rev. Rul. 89-87(5) states that the distribution must be made "as soon as administratively feasible"; a distribution more than one year after termination is presumed not to be as soon as administratively feasible. The corporation had stated on Form 5500 that the plan was not terminated for fiscal years 1989 and 1990. Further, the profit-sharing plan participants had accumulated vested account balances of $413,746, but the group annuity contract that had been purchased was valued at only $56,031. The Tax Court determined that this difference, and the Form 5500 statements, were inconsistent with an intent to terminate; thus, the profit-sharing plan was not terminated in 1988 and was an ongoing plan.

Employee participation and minimum coverage: The Tax Court next determined whether the plans met Secs. 401(a)(26) and 410(b). Under Sec. 401(a)(26) (which no longer applies to defined contribution plans), a plan must benefit the lesser of (1) 50 employees or (2) 40% of all employees. Only 15 employees participated out of 66 eligible. Because the plan failed this test, the court did not need to determine whether the Sec. 410(b) minimum coverage requirements were met.

HCE: When a plan does not meet the Sec. 401(a) (26) requirements, Sec. 402(b) requires that HCEs include their vested accrued benefits in income. Because the taxpayer was the corporation's sole shareholder, he was an HCE who had to include his vested accrued benefits for 1991-1993 in income.

Plan Administration Review Standard

The Sixth Circuit(6) held that, when the administrator of a stock bonus/profit-sharing plan was granted broad discretion to interpret and construe the plan, his determination that a partial termination had not occurred should be reviewed under a relatively undemanding "arbitrary and capricious" standard. The court rejected the position of several former employees that the issue of partial termination is a question of law subject to de novo review.

Remedial Amendment Period Extended

In Rev. Proc. 99-23,(7) the IRS extended the remedial amendment period for amending qualified plans under Sec. 401(a) or 403(a) to comply with recent law changes. Rev. Proc. 99-23 also applies the extended remedial amendment period to assorted deadlines for adopting plan amendments. The remedial amendment period for government plans remains unchanged at the last day of the first plan year beginning after 1999.

Under Rev. Proc. 99-23, the new deadline for amending Sec. 401(a) or 403(a) plans is the last day of the first plan year beginning after 1999. The extended remedial amendment period also applies to:

* All disqualifying provisions of new plans adopted or effective after Dec. 7, 1994.

* All disqualifying provisions of existing plans arising from plan amendments adopted after Dec. 7, 1994.

* The deadline for adopting Sec. 415(b)(2)(E) amendments.

* The deadline for adopting amendments of disqualifying provisions integral to a qualification requirement changed by the Small Business Job Protection Act of 1996 (SBJPA) that became effective on the first day of the first plan year beginning after 1998.

* The deadline for adopting amendments of disqualifying provisions integral to Sec. 401(a)(31) (as amended by the Internal Revenue Service Restructuring and Reform Act of 1998, Section 6005(c)(2)).

The procedure makes the following additional changes:

* Applies the extended remedial amendment period to any plan provision that causes a plan to meet the Code's qualification requirements because of the repeal of the Sec. 415(e) combined plan limit.

* Extends by one year the period of extended reliance for various plans that received favorable determination, opinion or notification letters under the Tax Reform Act of 1986 (TRA '86).

Sec. 403(b) Plans

During 1999, the IRS provided much-needed guidance to Sec. 403(b) plan sponsors. Rev. Proc. 99-13(8) described a new and improved Tax Sheltered Annuity Voluntary Correction (TVC) program that was incorporated into the Employee Plans Compliance Resolution System (EPCRS). The IRS also released revised Sec. 403(b) examination guidelines, including examples of violations, tips on common mistakes and how the IRS will look for mistakes.

Rev. Proc. 99-13

This procedure makes the TVC program significantly more attractive to plan sponsors and offers a solution to the longstanding problem of nonprofit, non-Sec. 501(c)(3) employers that adopted Sec. 403(b) plans despite ineligibility. Rev. Proc. 99-13 also discusses the Audit Closing Agreement Program (Audit CAP) for Sec. 403(b) plans, including the determination of sanctions. However, the procedure's true focus is on voluntary correction under the Administrative Policy Regarding Self-Correction (APRSC) and TVC.

Three critical terms are used throughout Rev. Proc. 99-13--eligibility failure, demographic failure and operational failure. The type of failure determines the corrections needed and the sanction amount.

Eligibility failure: Generally, "eligibility failure" means the employer was not eligible to maintain the plan or did not set it up properly. For example, Sec. 403(b) funds can generally be used only to purchase Sec. 403(b) annuity contracts or invest in a mutual fund; however, some employers failed to immediately segregate the funds or set them aside in savings accounts. Such a failure can also mean the purchase of an inappropriate annuity contract.

Demographic failure: "Demographic failure" means the plan does not satisfy either Sec. 401 (a) (4) (nondiscrimination) or Sec. 410(b) (coverage) for employer contributions. These are fairly major failures, and rather unusual. By contrast, failure to satisfy Sec. 401(m) (the actual contribution percentage (ACP) test) for matching and after-tax contributions does not fall into this category.

Operational failure: This catch-all category is defined to cover most or all of the typical defects found in Sec. 403 (b) plans, including:

* Failure to give employees the right to make elective deferrals (universal availability of salary reduction contributions).

* Failure to satisfy Sec. 401(m).

* Failure to satisfy Sec. 401(a)(17).

* Inappropriate distributions.

* Failure to give a direct rollover option under Sec. 403(b)(10).

* Failure to limit elective deferrals to the Sec. 402(g) limits.

* Excluding contributions in excess of the maximum exclusion allowance (MEA) or Sec. 415 limit.

APRSC: APRSC is available to correct Sec. 403(b) operational failures. To use APRSC, the plan must have in place practices and procedures "reasonably designed to facilitate overall compliance." While a plan document is not required under APRSC, such practices and procedures are. APRSC cannot be used if the defects are egregious or involve misuse of plan assets.

In a change from Rev. Proc. 98-22,(9) APRSC can be used to correct Sec. 415 and MEA defects. This is a very welcome change; until now, there was no practical way to correct MEA defects, outside the TVC program, other than by amending employees' Forms W-2. Under Rev. Proc. 99-13, MEA and Sec. 415 defects (excess amounts) and attributable earnings must be distributed and included in employees' income in the year of distribution. However, because Rev. Proc. 92-93(10) applies, the distribution is not subject to the 10% early retirement penalty, but must be reported on Form 1099-R. This suggests that larger amounts may need to be distributed, because the employer must correct all known excess amounts, rather than just amending Forms W-2 for the last three years. If the employer does not want to distribute these amounts, it can use the TVC program to correct such defects.

TVC program: An employer with eligibility, demographic and/or operational failures can work with the IRS to correct these defects. However, TVC is not available if the plan is already under IRS examination. The major change in the TVC program is that the sanction (i.e., correction fee) for operational failures is now a user fee (similar to the Voluntary Compliance Resolution (VCR) program for qualified plans). The correction fees for eligibility and demographic failures are set forth in a chart, with a presumed amount and a maximum amount (assuming the defect is not egregious).

An employer that chooses to correct excess amounts in the TVC program rather than distributing them will generally pay a correction fee and 2% of the excess amounts (adjusted for earnings through the date of the TVC filing) contributed in the calendar year of the application and in the three prior calendar years. Thus, an employer can distribute excess amounts and have employees pay tax on them, or pay an additional amount under the TVC program to keep them in the plan. If they are left in the plan, they must be counted as MEA or Sec. 415 excess amounts and will generally reduce future contributions. The employer cannot choose to distribute excess amounts for some employees and use the TVC program for others.

Audit CAP: A plan currently under IRS examination has fewer options. Depending on the type of defect uncovered on audit, the employer may be required to enter into a closing agreement; this usually includes payment of a sanction in addition to the required correction. However, Rev. Proc. 99-13 makes clear that sanctions are to be proportionate to defects.

Ineligible employers: After years of trying to balance statutory concerns with retirement policy and equity concerns, the IRS has crafted a solution for Sec. 403(b) plans established by ineligible employers. Typically, this has occurred when a trade association, chamber of commerce or other nonprofit, non-Sec. 501(c)(3) employer mistakenly purchased a Sec. 403(b) plan. The IRS correction is to freeze the plan (i.e., no additional contributions), but allow existing contributions to remain in the plan untaxed until distribution. The amounts are to be treated as Sec. 403(b) amounts, subject to such plans' distribution restrictions. More remarkably, employees will be permitted to roll over these amounts as if they actually were in Sec. 403(b) plans, if the plan is corrected under TVC and a (small) sanction paid.

Examination Guidelines

The IRS also released revised examination guidelines for Sec. 403(b) plans.(11) The guidelines are divided into several sections, each providing (1) a discussion of the technical requirements applicable to Sec. 403(b) plans and (2) examination steps relating to those requirements. The following summaries focus on the examination steps and the tax consequences of a defect in a particular area.

General requirements: The guidelines instruct agents to request all plan documents, including (to the extent applicable):

* Determination of the tax exemption.

* Basic plan document and any amendments.

* Summary plan descriptions (SPDs).

* Annuity contracts.

* Custodial account agreements.

* Salary reduction agreements.

* Employment contracts.

* Other communications with employees.

The guidelines note that although the Code does not require a basic plan document, faulty plan language may indicate defects in the plan's operation.

For corrections made under APRSC, agents are to verify that the method of correction was appropriate and timely. If the employer has a closing agreement through the TVC program, agents must (1) verify that the employer complied with the terms of the agreement and that the correction was properly and timely completed; (2) verify the accuracy of specific numbers; and (3) check to see if there are failures that fall outside the scope of the agreement.

Eligibility: The guidelines instruct agents to check whether the employer (1) is a public educational organization; (2) is a Sec. 501(c)(3) organization; or (3) has a closing agreement with the IRS covering the employer's ineligibility.

Agents are then instructed to consider the employer's relationship to participating employees. (Contributions made on behalf of an individual who is not an employee does not mean the plan is not a Sec. 403(b) plan, but the exclusion allowance is not available for that individual.) If the employer is not eligible, agents are instructed to consider a dosing agreement under the Audit CAP.

The guidelines note that, if the examination is conducted in connection with an Exempt Organizations (EO) audit, a loss of Sec. 501(c)(3) stares will automatically cause the plan to fail the Sec. 403(b) requirements for any plan year the employer was not eligible. Agents are again instructed to consider a closing agreement. If the examination is not inflated by EO, the guidelines suggest the agent may want to request EO's assistance on the issue of employer eligibility.

Salary reduction contributions: Agents are to check sample salary reduction election forms to determine whether the agreement applies to amounts not yet currently available to the employee at the time the agreement is effective.

Sec. 402(g) limit on elective deferrals: The guidelines state that the first step is to identify the elective deferrals under the employer's plan(s). In determining whether contributions are elective deferrals, agents are told to examine the substance of the arrangement, and not be misled by labels the employer attaches to the contributions (e.g., "employer," "employee" or "mandatory" contributions). Also, in determining whether deferrals are elective or nonelective, the guidelines suggest that agents consider:

* Plan operation (e.g., have any participants revoked their elections?).

* Employment contracts (i.e., is participation in the plan a condition of employment? If so, the contributions are not elective deferrals).

* All plan documents, including SPDs, funding vehicles and any memoranda or other communications to employees.

The guidelines suggest that, in certain cases, it may be appropriate to check for inconsistencies in the various documents.

If there are elective deferrals, the agent is instructed to check if the underlying annuity contracts (including custodial account agreements) specifically limit elective deferrals. The agent is urged to check for excess deferrals by requesting annual contribution records and/or salary reduction agreements.

If the employer has another plan covering the same employees (including a Sec. 403(b) plan with elective deferrals, or a Sec. 457 or 401(k) plan), the guidelines instruct the agent to ensure the combined amount of elective deferrals is within the Sec. 402(g) limit and the Sec. 457(c)(2) coordinated limit.

Agents are to check whether elective deferrals were reported on Form W-2, and on Form 1099-R (if distributed). If a participant had excess deferrals, the agent is to determine whether the excess was timely and properly corrected.

Sec. 415 limit: For the Sec. 415 limit, the guidelines instruct agents to check annual contributions to the Sec. 403(b) plan, specifically to see whether the amount deferred for any employee exceeds $30,000.

Agents are also instructed to check whether a participant has a practice (such as a medical clinic or consulting firm) that maintains a Keogh plan; Keogh contributions may have to be aggregated with Sec. 403(b) contributions.(12)

The guidelines instruct agents to check plan documents (including the basic plan document, SPDs and funding vehicles) to see whether contributions are properly limited by Sec. 415. Although specific plan language is not required, faulty plan language may indicate an operational defect.

If the employer has more than one Sec. 403(b) plan, agents are to see how the plans interrelate. If the employer also has a qualified plan, agents are to check that the combined contributions are within the Sec. 415 limit for participants who elected the C election limitation.

Exclusion allowance: The guidelines note that although neither a Sec. 403(b) plan document nor contract has to include the exclusion allowance or Sec. 415 limits, faulty plan language may indicate operational defects. Accordingly, the guidelines instruct agents to check if the plan and worksheets for employees properly limit contributions. A common error is disregarding prior contributions or benefits under qualified plans in calculating amounts previously excludible in later years, especially when state defined-benefit plans use pick-up arrangements.

Agents are advised to check whether there have been excess Sec. 415 amounts in a prior limitation year that resulted in contributions exceeding the exclusion allowance in a later year.

The guidelines caution agents that, because the exclusion allowance is cumulative and because of special elections, they may not be able to determine compliance solely on the basis of Forms W-2 or annual contribution records. According to the guidelines, there may be a problem if:

* The plan language does not satisfy Sec. 403(b) or 415.

* Prior contributions exceed the Sec. 415 limit.

* Contributions exceed 20% of compensation for long-term employees with large account balances.

* Compensation has declined.

* The employee participates in other plans that must be aggregated with the Sec. 403(b) plan.

The guidelines suggest obtaining employees' Social Security numbers, looking up prior-year Forms 1040 and test-checking the contributions using the formula provided (exclusion allowance = [20% x includible compensation x years of service] -- amounts previously excludible).

Excise tax: As to the 6% Sec. 4973 excise tax on excess contributions to a Sec. 403(b)(7) custodial account (or to a Sec. 403(b)(9) retirement income account to the extent funded through custodial accounts), the guidelines state that, if a plan has excess contributions, the agent should see whether and the extent to which the plan funds are invested through a custodial account. Agents are instructed to ask the employer for the actual amount contributed to the custodial account and to check salary reduction agreements and participants' annual compensation.

Nondiscrimination and coverage: In examining a Sec. 403(b) plan for nondiscrimination compliance, agents are to ask the employer for the number Of HCEs and non-HCEs, which of them participate (or are eligible to participate) in the Sec. 403(b) plan or other plans of the employer, and annual compensation and contribution records. Agents are told to check employment records to see (1) who can make salary reduction contributions (and when they can be made) and (2) whether salary reduction contributions are indeed available to all nonexcludible employees.

The guidelines caution that, because the definitions of "salary reduction contribution" and "elective deferral" are similar, agents should check whether contributions are elective or nonelective. The guidelines note that nondiscrimination requirements may be violated if the employer characterizes contributions improperly. Agents are also instructed to:

* Ask the employer which employees were excluded from participation, and the basis for their exclusion.

* Ascertain whether the employer aggregates plans to pass coverage under Secs. 403(b)(12) and 410(b), and which test the employer uses to pass coverage (ratio percentage or average benefits).

* Consider whether employer contributions satisfy the safe harbors; if not, see if there is another basis on which employer contributions satisfy good faith/reasonable interpretation.

* See whether matching contributions satisfy the ACP test.

Minimum distribution requirements: The guidelines instruct agents to check all documents concerning the required beginning date. Agents are to request data on the age of participants and former participants, and to determine whether distributions have begun timely.

Distribution restrictions: In examining a Sec. 403(b) plan as to the Code's restrictions on when amounts may be distributed, agents are to check the withdrawal provisions of the basic plan document (if any) and the funding vehicles. If withdrawals are permitted at any time and the plan provides for salary reduction contributions or is funded through a custodial account, agents are to check the plan's operation to see whether distributions have been made before a permitted "distribution event."

The guidelines refer agents to the Sec. 401(k) hardship distribution rules in determining an employee's eligibility for such a distribution. Agents are instructed to look at beginning and ending account balances and check Forms 1099-R to determine whether minimum distributions have been made.

Transfers and rollovers: The guidelines instruct agents to see whether transferred funds are accounted for separately and continue to be subject to at least as stringent early distribution restrictions.

Tax consequences of failure: The guidelines identify three general types of failures:

* Plan failures, which affect the plan as a whole and result in income inclusion as to all annuity ,contracts purchased under the plan.

* Annuity contract failures, which result in income inclusion as to the affected annuity contract.

* Transactional failures, which generally arise from a transaction in connection with an otherwise valid Sec. 403(b) plan or annuity contract, and result in income inclusion for a portion of contributions made to purchase the contract.

These failures also result in additional income tax withholding, FICA taxes and Federal unemployment taxes. If they are corrected under one of the IRS's correction programs, the IRS will not pursue income tax or withholding collection resulting from the failure. However, corrections of failures may have their own tax consequences.

Plan failures: Plan failures cause a plan not to be a Sec. 403(b) plan. For this purpose, the "plan" is the aggregate annuity contracts (including custodial accounts and retirement income accounts) established by an employer on behalf of its employees. Generally, the "employer" is the common-law employer and any related employer under Sec. 414(b), (c), (m) or (o).

For plan failures, all contributions made to the plan beginning in the tax year of the failure are includible in the participants' gross income. Typical plan failures include the following:

* Employer was ineligible. If the employer was never eligible to maintain a Sec. 403(b) plan, the plan was never a Sec. 403(b) plan and Sec. 403(c) or 83 governs. If the employer was a Sec. 501 (c)(3) organization but lost that status, the exclusion allowance is lost for any contributions made while the employer was ineligible.

* Annuity contracts not purchased until participants reach retirement age or status. In this case, the plan is intended to be funded through annuity contracts (not custodial accounts), but the employer fails to buy the annuity contracts until retirement age. In the absence of appropriate funding vehicles, the plan from its inception is not a Sec. 403 (b) plan.

* Discrimination with respect to nonsalary reduction (including matching and nonmatching) or salary reduction contributions. The Sec. 4979 excise tax may apply if the plan has excess aggregate contributions under Sec. 401 (m)(6).

* Failure to satisfy the minimum participation rules.

* Inadequate coverage.

Annuity contract failures: Following is a list of failures that generally pertain to an annuity contract. These failures cause a participant's annuity contract to fail to meet Sec. 403(b); thus, all contributions made under the annuity contract beginning in the tax year of the failure are includible in the participant's gross income (except contributions subject to a substantial risk of forfeiture). The earnings on premiums paid for the purchase of a Sec. 403(b)(1) annuity contract (and not custodial accounts) are not includible in gross income. (Annuity contract failures may also cause other problems; if the failure is systemic, the entire plan may be adversely affected.)

* Annuity contract not purchased from an insurance company or not a Sec. 403(b) annuity contract (e.g., the purchase of a life insurance contract).

* Custodial account not maintained by a bank or an approved nonbank trustee.

* Failure of custodial account to invest exclusively in regulated investment company stock.

* Violation of incidental death benefit requirements.

* Failure of annuity contract (and not a custodial account) to satisfy the Sec. 401 (g) nontransferability requirement (in either form or operation).

* Impermissible distribution under Sec. 403(b)(7) or (11).

* Failure to provide a direct rollover (in form or operation).

* Pattern of violating the minimum distribution rules.

* Uncorrected excess deferrals under Sec. 402(g).

* Failure of annuity contract to preclude excess deferrals. For plan years beginning after 1997, the exclusion allowance does not apply to contributions made to purchase a contract.

Transactional failures: Following is a list of failures that do not adversely affect the Sec. 403(b) status of the annuity contract or plan as a whole:

* Contributions in excess of the exclusion allowance.

* Excess Sec. 415 amounts.

* Certain loans. The amount of a loan that does not meet Sec. 72(p) requirements is a deemed distribution includible in gross income. (If the participant's account balance is reduced to satisfy the loan balance, there is an actual distribution that could violate Sec. 403(b)(7) and (11); the failure becomes an annuity contract failure.)

* Isolated failure to satisfy minimum distribution requirements.

* Salary reduction agreement not legally binding.

* Salary reduction agreement applies to amounts currently available to employee at the effective date of the agreement.

* Participation of nonemployee.

* Timely corrected excess deferrals.

Acceptable EPCRS Corrections

The IRS released Rev. Proc. 9-31,(13) containing examples of acceptable corrections to plan failures when using the various voluntary .programs under EPCRS. The procedure focuses primarily on common qualification defects and provides preferred methods and alternatives that may be used to correct them to maintain plan qualification. The procedure deems all standardized correction methods permitted under the Standardized VCR Procedure (SVP) reasonable and appropriate for these purposes. Other areas of correction discussed include:

* A "one-to-one" correction method for Sec. 401(k) and (m) failures that combines distribution of excess contributions to HCEs with an employer corrective contribution to non-HCEs.

* Reallocation of improper contributions to otherwise eligible employees impermissibly excluded from participation.

* Reallocation or corrective contribution to make up for amounts improperly forfeited under a defined contribution plan.

* Current repayment or an offset against future payments of distributions from a defined benefit plan that exceed the Sec. 415(b) limits.

* Additional corrections for excess annual additions and other contribution limits, using repayment, forfeiture or offset of future contributions.

* Violations of Sec. 401(a)(17) corrected by reallocating the excess to other participants or offsetting against future contributions.

* Correction of impermissible hardship distributions by plan amendment.

While the procedure offers numerous examples, it is not all-encompassing; various other reasonable and appropriate correction methods may be available to plan sponsors. Thus, the procedure still allows plan sponsors some flexibility, depending on the particular circumstances. Also, because many of the corrective methods require additional contributions, distributions or reallocations, the IRS requires earnings to be determined and paid along with the correction. The procedure offers several alternative methods for calculating those earnings.

Walk-In CAP

"Best Practices"

The IRS has released an outline(14) of procedures ("best practices") it will follow under its closing agreement and determination letter programs, including (1) in processing Walk-in Closing Agreement Program (Walk-in CAP) submissions; (2) in Walk-in CAP cases involving plan document failures; and (3) when a qualification failure for which no Walk-in CAP submission was received is discovered during the determination letter process. Several of the procedures are specifically intended to encourage voluntary compliance, including an instruction that IRS employees should not ask for copies of a plan sponsor's compliance audit report.

Processing Walk-in CAP submissions: Under the Walk-in CAP, qualified plan sponsors may voluntarily disclose certain qualification failures, pay a correction fee and correct the failures in accordance with an IRS closing agreement. The Walk-in CAP applies to plan document and demographic failures, and to operational failures not eligible for correction under the APRSC and the VCR programs.

The IRS lists the following "best practices" in controlling and processing Walk-in CAP cases:

* All cases should be controlled in a way that enables the district office to capture accomplishments and record cases for future reference.

* Before a Walk-in CAP case is processed, the district office is to ascertain whether the plan is under examination.

* Closing agreements should specifically describe all issues addressed in the case and their resolution.

* Except in "rare and unusual circumstances," the district office should verify the correction before signing a dosing agreement.

* Generally, neither a full nor limited-scope examination should be conducted in Walk-in CAP cases. (This practice recognizes that routine examinations of Walk-in CAP cases would have a negative effect on voluntary compliance.)

* Form 5500 series returns should be reviewed (not examined) to confirm there are no additional significant problems not identified in the submission.

* When a plan warrants an examination, it should be examined by the key district with examination jurisdiction.

Plan document failures: The following procedures are to be used for Walk-in CAP cases involving plan document failures (including failure to timely amend for the TRA '86, the Unemployment Compensation Act of 1992 and the Revenue Reconciliation Act of 1993).

* If the document failure cannot be corrected by adopting model amendments or a standardized master or prototype plan, the sponsor must submit a determination letter application with the appropriate user fee to the Employee Plans (EP) Specialist working the case. The EP Specialist will work the determination letter application and prepare the closing agreement addressing the plan document failure(s) and operational or demographic failures. When issued to the taxpayer, the closing agreement should be accompanied by the determination letter.

* If the sponsor refuses to submit a determination letter application (with the appropriate user fee), no closing agreement will be issued and plan examination should be considered. Failure discovered during determination letter process: If a qualification failure for which no Walk-in CAP submission was received is discovered during the determination letter process, the handling of the case will depend on how the failure is discovered. If it is discovered by an EP Specialist, it will be resolved as follows, using the Audit CAP guidelines:

* If the failure does not warrant an examination, the office working the determination letter application should resolve it and prepare any resulting closing agreement. The sanction structure of the Audit CAP (as provided in Rev. Proc. 98-22, section 15) will apply. But if the failure is minor, the sanction should be no higher than the Walk-in CAP "presumptive amount" (under Rev. Proc. 98-22, section 13.05). The determination letter is to be issued only after the closing agreement has been signed.

* If the failure warrants an examination, the case is to be transferred to the key district with examination jurisdiction. The closing agreement and determination letter should be issued only on "favorable resolution" of all issues raised during examination.

If the taxpayer identifies and voluntarily raises the failure, the IRS will give the taxpayer the opportunity to make a valid Walk-in CAP submission and have the issues resolved under that program. When issued, the determination letter should be accompanied by the Walk-in CAP closing agreement. If the taxpayer does not make a valid Walk-in CAP submission, the failure will be resolved under the Audit CAP rules.

Excise taxes: In Walk-in CAP and Audit CAP cases, an EP Specialist is to resolve excise taxes required to be reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, by obtaining a Form 5330 providing for 100% of the tax and interest outstanding, and' forwarding it (with or without the excise tax payment) to the appropriate Service Center. (The EP Specialist may recommend that the Service Center waive failure-to-file and/or failure-to-pay penalties under Sec. 6651.) The excise tax should not be resolved as part of the closing agreement document.

When a plan sponsor has used a voluntary correction program to correct a failure of the Sec. 401 (a) (9) minimum distribution requirements (except for failures involving owner-employees), the EP Specialist should routinely recommend waiver of the Sec. 4974 minimum distribution excise tax. In all other cases, the EP Specialist has discretion to recommend such a waiver.

ESOP Distributions

Anti-Cutback Rule

The IRS issued final regulations(15) allowing S corporation ESOPs and other stock bonus plans to substitute cash distributions for stock distributions without violating the Sec. 411 (d)(6) anti-cutback rules. The regulations also extend the time for Sec. 41 l(d)(6) relief for amendments made by Taxpayer Relief Act of 1997 (TRA '97) Section 1541 to the end of the remedial amendment period for such plan amendments (which, for nongovernmental plans, is the last day of the first plan year beginning after 1998).

Background: Before the SBJPA, an S corporation could not have an ESOP; tax-exempt Sec. 401 (a) qualified plan trusts could not be S shareholders. The SBJPA allowed Sec. 401(a) trusts and Sec. 501(c)(3) organizations to be S shareholders, effective for tax years beginning after 1997; however, the combination of the S rules and the ESOP and other stock bonus plan rules still made it difficult for S corporations to offer such plans. Under Sec. 409 (h) (1) (A) , an ESOP or other stock bonus plan generally must make distributions available in the form of employer securities. Because S corporations can have no more than 75 shareholders, satisfying the Sec. 409(h)(1)(A) stock distribution requirement could result in a loss of S status.

Additional changes made by the TRA '97 make it easier for S corporation employers to facilitate employee ownership of employer securities through qualified plans. Before its amendment by the TRA '97, Sec. 409(h)(2) provided an exception to the Sec. 409(h) (1) (A) stock distribution rule in the case of an employer whose charter or bylaws restricted the ownership of substantially all outstanding employer securities to employees or a Sec. 401(a) trust; in such cases, distributions could be made in cash instead of stock. The TRA '97 expanded that exception to cover employers that are S corporations. Thus, for tax years beginning after 1997, ESOPs and other stock bonus plans maintained by S corporations are not required to offer distributions in the form of employer stock, but may offer cash instead.

Exception expanded: Generally, Sec. 411(d)(6) provides that a plan will not meet Sec. 411 if a participant's accrued benefit is decreased by a plan amendment. A plan amendment that eliminates an optional form of benefit is treated as reducing accrued benefits to the extent the amendment applies to benefits accrued as of the later of the amendment's adoption date or effective date.

Prior regulations provided an exception to the anti-cutback rule for plan amendments that eliminate optional forms of benefit from an ESOP or other stock bonus plan by substituting cash distributions for distributions in the form of employer stock. That exception applied when the employer became substantially employee-owned, provided the employer otherwise met Sec. 409(h)(2) roles restricting the ownership of outstanding employer stock.

Uniform time to amend plans: TRA '97 Section 1541 includes provisions on plan amendments adopted as a result of changes made by the TRA '97. For nongovernmental plans, Rev. Proc. 98-14(16) extended the remedial amendment period for adopting plan amendments to which TRA '97 Section 1541 applies to the last day of the first plan year beginning after 1998. To provide a uniform time for plan amendment, final Regs. Sec. 1.411 (d)-4 provides a similar amendment period.

Settlement Payments

According to Letter Ruling 9913047,(17) amounts contributed to an ESOP as part of a settlement agreement of an agency challenge are not contributions under either Sec. 404 or 4972, do not adversely affect the plan's qualified status under either Sec. 401 (a) (4) or 415, are not taxable to plan participants and are deductible by the company under Sec. 162. The ruling is consistent with (if not a bit more generous than) similar rulings regarding other restoration payments.

Background: A company established an ESOP, the trustees of which included the company president, the chief financial officer and the corporate secretary. The company sold stock to the ESOP at a price below its professional appraised value. Nevertheless, an unspecified Federal agency (presumably, the Department of Labor) investigated and concluded that the ESOP overpaid for the stock; thus, the company and the trustees violated the ERISA Section 406 prohibited transaction rules. The agency had authority to charge both the company and the trustees; the company had a contractual obligation to indemnify the trustees for plan transactions.

After lengthy negotiations, during which the agency told the company's attorneys that the agency "would absolutely and immediately initiate legal proceedings absent" a settlement agreement, the company agreed to a settlement under which it was to make a "replacement payment" to the ESOP. This payment equaled the sum the agency alleged the company had overcharged the ESOP. The settlement agreement provided this amount "shall be credited to the accounts of the participants in the Plan on a pro rata basis consistent with the terms of the Plan."

The company represented that it entered into the settlement agreement and made the replacement payment to avoid litigation costs and resolve potential agency claims against the plan trustees. The company requested rulings that the replacement payment to the ESOP:

* Did not constitute a "contribution" or other payment subject to either Sec. 404 or 4972.

* Would not adversely affect the qualified status of the ESOP under either Sec. 401(a) (4) or 415.

* Would not, when made to the ESOP, result in taxable income to affected plan participants or beneficiaries.

* Would be deductible in full by the company under Sec. 162.

IRS analysis: Neither the Code nor the regulations provide guidance on whether the company's replacement payment should be treated as contributions. According to the IRS, the payment would ensure that the affected plan participants recovered a portion of their account balances and place them in a similar position as if the trustees had not allegedly overpaid for the stock. Thus, it was reasonable to characterize the payment as a replacement payment. Given that the payment was made in response to a complaint by the Federal government, the IRS concluded that the amounts were not contributions, would not affect the plan's qualified status and would not be treated as income to participants.

As to whether the amounts would be deductible under Sec. 162, the IRS noted that, in general, payments made in settlement of lawsuits or potential lawsuits are deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of the taxpayer's business. The IRS's position on the deductibility of payments made to resolve actual or potential claims of legal liability or to uphold business reputation, is consistent with numerous authorities cited in the ruling.

The ruling was based on the company's representations regarding the settlement, and that such representations were subject to verification by field service personnel. The ruling expressed no opinion on the tax treatment of the transaction under other Code provisions. Presumably, the company also paid tax under Sec. 4975, applying to prohibited transactions.

Similar cases: The IRS has ruled on several replacement payment situations regarding poor investments and other types of prohibited transactions. However, in most rulings, the restorations did not permit the accounts of those participants who had a role in the disputed transactions to receive payments. In Letter Ruling 9913047, there was no apparent prohibition against trustees, corporate officers (presumably, plan participants) receiving restoration payments to their accounts.

Conclusion

In the next issue, Part II of this article will focus on executive compensation, health and welfare, and fringe benefit issues.

Authors' note: The authors acknowledge the significant assistance of Gary Cvach, Karen Field, Martha Patterson, Denis Yurkovic, Tracey Schlabach, Terri Stecher, Donna M. Prestia and Pamela Hobbs, of KPMG LLP's Washington National Tax Compensation and Benefits Practice, in compiling information for this article.

(1) Lucky Stores, Inc.,153 F3d 964 (9th Cir. 1998)(82 AFTR2d 98-5815, 98-2 USTC [paragraph] 50,662), aff'g 107 TC 1 (1996); the Court also declined to review a similar case, Airborne Freight Corp., 153 F3d 967 (9th Cir. 1998)(82 AFTR2d 98-5835, 98-2 USTC [paragraph] 50,664).

(2) Rev. Rul. 76-28, 1976-1 CB 107.

(3) American Stores Co., 170 F3d 1267 (10th Cir. 1999)(83 AFTR2d 99-1337, 99-1 USTC [paragraph] 50,326), aff'g 108 TC 178 (1997).

(4) Frank Gant, TC Memo 1998-440.

(5) Rev. Rul. 89-87, 1989-2 CB 81.

(6) Sea Ray Employees' Stock Ownership and Profit-Sharing Plan v. Robinson, 164 F3d 981 (6th Cir. 1999); for a discussion, see Cvach and Yurkovic, Tax Clinic, "No Partial Termination of Plan," 30 The Tax Adviser 383 (June 1999).

(7) Rev. Proc. 99-23, IRB 1999-16, 5.

(8) Rev. Proc. 99-13, IRB 1999-5, 52.

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

(10) Rev. Proc. 92-93, 1992-2 CB 505.

(11) See generally, Internal Revenue Manual, Handbook No. 7.7.1, Employee Plans Examination Guidelines Handbook, Section (13) (amended 5/21/99).

(12) See Regs. Sec. 1.415-7(h) and -8(d).

(13) Rev. Proc. 99-31, IRB 1999-34, 280.

(14) Notice (2/19/99).

(15) TD 8806 (2/8/99).

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

(17) IRS Letter Ruling 9913047 (1/5/99).

Peter I. Elinsky, Esq.
Partner
KPMG LLP
Washington, DC

Terrance F. Richardson, Esq.
Manager
KPMG LLP
Arlington, VA

Eugene Holmes, Esq.
Tax Specialist
KPMG LLP
Arlington, VA