Small Business Job Protection Act adds simplicity (and complexity.)

EXECUTIVE SUMMARY

* A plan can provide that participants can waive the 30-day QJSA notice period requirement, as long as the first distribution begins more than seven days after notice is provide.

* The SBJPA limited application of the minimum participation rule to defined benefit plans.

* Plan administrators may be able to avoid nondiscrimination ADP/ACP testing under new safe harbor contribution formulas established by SBJPA Section 1433(a).

The Small Business Job Protection Act of 1996 (SBJPA) made many changes in the employee benefits area, some of which aid employers in administering plans. While this is good news, the so-called simplification provisions also add complexity in terms of creating new tests and standards to apply. This article highlights some of the many changes made by the SBJPA and their implications for both employers and employees.

The Small Business Job Protection Act of 1996 (SBJPA), enacted Aug. 20, 1996, contained many pension "simplification" provisions. This article highlights and analyzes some of the amendments made to Sec. 401(k) plan and other qualified plan provisions.(1)

Definition of HCE

The correct determination of which employees are highly compensated employees (HCEs) is pivotal to plan qualification. Prior to the SBJPA, Sec. 414(q)(1) contained four different definitions of HCE. SBJPA Section 1431(a) simplified the definition of HCE to include only any employee who:

1. Was a 5% owner at any time during the year or the preceding year (Sec. 414(q)(1)(A)), or

2. For the preceding year, had compensation from the employer greater than $80,000, and, if the employer elects for that year, was in the top-paid group of employees (Sec. 414(q)(1)(B))

Sec. 414(q)(1), flush language, states that the $80,000 threshold is subject to cost-of-living adjustments. The top-paid group, according to Sec. 414(q)(3), is the top 20% of employees based on compensation. Other than for new shareholders acquiring a 5% interest during the year, plan administrators will now be able to determine the HCE group at the beginning of the year. Guidance on how and when to make the top-paid group election is needed. Narrowing or expanding the HCE group by making or forgoing the top-paid group election triggers interesting planning opportunities; for example, professional service firms with several HCEs may be able to forgo the election in order to target benefits to certain employee groups, and exclude lower-paid HCEs.

According to SBJPA Section 1431(d), the effective date of the new definition is years beginning after 1996, except that, in determining whether an employee is an HCE for years beginning in 1997, the amendments are treated as having been in effect for years beginning in 1996.

Family Aggregation Rules

SBJPA Section 1431(b)(1) repealed the family aggregation rules under Sec. 414(q)(6), effective for years beginning after 1996. Under pre-SBJPA Sec. 414(q)(6), if an employee was a family member of either (1) a 5% owner or (2) one of the top 10 HCEs (by compensation), any compensation paid to, and any contribution or benefit under the plan for, such employee was aggregated with that of his HCE relative. The family member and the employee were treated as a single HCE.

Recognizing the complexity of these rules and the importance of having adequate retirement benefits for all family members, Congress repealed Sec. 414(q)(6). Secs. 401(a)(17) (the $150,000 limit on compensation that a plan may take into account) and 404(1) (the qualified plan deduction) were correspondingly amended,by SBJPA Section 1431(b)(2) and (3).

The repeal applies to the treatment of an HCE, but does not affect the ownership attribution rules used in determining HCE status.

Example 1: H is a 100% shareholder in, and W, his spouse, is an HCE in, Z Corporation in 1997. H and W are considered separate HCEs; they are not combined into one HCE.

ADP/ACP Tests: Prior-Year Deferrals

Qualified cash or deferred arrangements (CODAs) are subject to a special nondiscrimination test under Sec. 401(k)(3)(A) for employee deferral contributions. A plan that would otherwise fail to meet the test is not treated as failing if the test is corrected by (1) additional employer contributions, (2) refunds of excess deferrals or (3) recharacterization of deferrals as employee after-tax contributions. Similar rules exist for employer matching and employee after-tax contributions under Sec. 401(m)(2). SBJPA Section 1433(c)(1) modified the Section 401(k)(3)(A) test by providing that the computation of the maximum permitted actual deferral percentage (ADP) for HCEs for the year is determined by reference to the ADP for non-HCEs for the preceding, rather than the current, year. Sec. 401(m)(2)(A) was similarly amended, by SBJPA Section 1433(c) (2), to provide for the use of prior-year data in determining the actual contribution percentage (ACP) of the non-HCEs.

These amendments are effective for years beginning after 1996. According to Notice 97.2,(2) employers using the look-back test for their 1997 year do not recalculate their non-HCEs for 1996 using the new definition of HCE in Sec. 414(q)(1).

Notice 97-2 states that employers may elect to use the current-year ADP/ACP results; this election, once made, will be difficult to revoke. Some transition relief is available; a plan that uses current-year data in determining the non-HCEs' ADP/ACP for the 1997 plan year can use prior-year data for the 1998 plan year without IRS approval. In the case of a new plan, the ADP/ACP for the non-HCEs is deemed to be 3% for the preceding plan year, under Sec. 401(k)(3)(E). Sec. 401(k)(3)(E)(ii) allows a new plan to use current-year non-HCE percentages for its initial ADP/ACP tests without losing the right to change to prior-year percentages thereafter.

Minimum Participation Rule

pre-SBJPA Sec. 401(a)(26)(A) required a qualified plan to benefit no fewer than the lesser of:

1. 50 employees, or

2. 40% of all employees of the employer (determined on a controlled-group basis).

Comparable plans could not be aggregated in meeting this test, but Sec. 401(a)(26)(G) allowed the test to be applied separately to separate lines of business (SLOBs).

The new law limits application of the minimum participation rule to defined benefit plans. Under Sec. 401(a)(26)(A), as amended by SBJPA Section 1432, the plan satisfies the rule if it benefits no fewer than the lesser of:

1. 50 employees, or

2. the greater of (a) 40% of all employees of the employer or (b) two employees (one employee if there is only one employee).

A defined benefit plan can satisfy the minimum participation requirement on a SLOB basis. Sec. 401(a)(26)(G) provides that a SLOB used for this purpose does not have to satisfy the general requirement that a qualified SLOB employ at least 50 employees on each day of the year.

According to SBJPA Section 1432(c), this provision is effective for years beginning after 1996.

Safe Harbor Rules for Qualified CODAs

Plan administrators may be able to avoid nondiscrimination ADP/ACP testing under new safe harbor contribution formulas established by SBJPA Section 1433(a). The two alternative safe harbors are effective for years beginning after 1998, according to SBJPA Section 1433(f)(1). The first safe harbor, Sec. 401(k)(12)(A) and (B) and (m)(11)(A) and (B), requires the sponsor to satisfy a matching contribution requirement. The second safe harbor, Sec. 401(k)(12)(C), mandates a minimum qualified nonelective contribution (QNEC).

First Safe Harbor

Under Sec. 401(k)(12)(A) and (B), the first safe harbor test is satisfied for the ADP/ACP tests if:

1. The employer makes a matching contribution for each non-HCE of:

(a) 100% of the non-HCE's elective contribution, up to 3% of compensation (Sec. 401(k)(12)(B)(i)(I) and (m)(11)(A)(i)) and

(b) 50% of the non-HCE's elective contribution from 3%-5% of compensation (Sec. 401(k)(12)(B)(i)(II) and (m)(11)(A)(i)), and

2. The matching contribution rate for any elective contribution made by a non-HCE at least equals the highest rate of match for elective contributions by HCEs (Sec. 401(k)(12)(B)(ii) and (m)(11)(A)(i)).

Sec. 401(k)(12)(B)(iii) allows alternative plan designs that do not meet these requirements to qualify if, in general, they use formulas that result in the same aggregate matching contributions being made. The employer's matching contribution rate, however, may not increase as an employee's rate of elective contributions increases.

Second Safe Harbor

According to Sec. 401(k)(12)(C), the second safe harbor is met for the ADP/ACP tests if the employer is required to make plan contributions of at least 3% of the compensation of all eligible non-HCEs (without regard to employee contributions). Plans designed to exclude employees (1) with fewer than 1,000 hours or (2) no longer employed on the last day of the plan year should not be required to make minimum contributions for such employees.

Notice Requirement

There is also a notice requirement under Sec. 401(k)(12)(D) and (m)(11)(A)(ii);each eligible employee must be provided written notice of his rights and obligations under the arrangement within a reasonable period before any year. The notice must be accurate, comprehensive and written to be understood by the average eligible employee.

Limit on Matching Contributions

In addition to the requirements enumerated above, Sec. 401(m)(11)(B)(i) provides that satisfying the ACP safe harbor also requires (among other things) that the employer not match employee contributions or elective deferrals in excess of 6% of compensation.

Under Sec. 401(k)(12)(E) and (m)(11)(A)(i), safe harbor contributions must be fully vested and subject to the in-service withdrawal restrictions that apply to employee elective Sec. 401(k) plan deferrals.

The safe harbors are minimum contributions; the employer may contribute more. According to Sec. 401 (m)(11)(B), for instance, matching contributions can be more generous than the specified rate, as long as that rate (1) is not higher for any HCE than for any non-HCE, (2) does not increase as elective contributions or deferrals increase and (3) is zero for elective deferrals or employee contributions in excess of 6% of compensation.

It is too early to predict whether these provisions will be adopted by employers. An analysis of the reduced cost of administration relative to the increased contributions will have to be made by each plan administrator and sponsor.

Distributions of Excess Contributions

A qualified CODA that would otherwise fail the ADP/ACP tests can satisfy them by timely returning excess contributions to HCEs. In the interest of equity (not simplification), refunds of excess contributions now go first to the HCEs with the largest contributions. Under pre-SBJPA Sec. 401(k)(8)(C), refunds were first allocated among HCEs with the highest contribution percentages, generally resulting in the lower-paid group of HCEs receiving the largest refunds. For these individuals, the deferral was being compared to a lesser compensation base. According to Sec. 401(k)(8)(C) and (m)(6)(C), as amended by SBJPA Section 1433(e), excess contributions are now attributed first to HCEs who made the greatest dollar amount of elective deferrals.(3)

Example 2: Employer X maintains a Sec. 401 (k) qualified CODA. The ADP for eligible non-HCEs is 2%. Eligible HCE deferrals are as follows:

                           Compensation     Percentage
Employee    Compensation      deferred       deferred

A             $150,000         $7,500           5%
B              150,000          7,500           5%
C               70,000          7,000          10%
D               70,000          4,900           7%
E               70,000          2,100           3%
F               10,000              0           0%
ADP                                             5%

The ADP for the non-HCEs is 2%; thus, under Sec. 401(k)(3)(A)(ii)(II), the HCEs' ADP cannot exceed 4% (two percentage points above the non-HCE rate, up to two times that rate). Correction of the ADP test failure is made by refunding excess contributions to HCEs. Under pre-SBJPA Sec. 401 (k)(8)(C) and (m)(6)(C), C and D would each have had their deferrals reduced (via refunds from the plan) to $3,850, to reduce the overall ADP for HCEs to 4%; C and D would have received the refunds because they have they highest deferral percentages. The total reduction would have been $4,200 ($3,150 for C and $1, 050 for D). After the SBJPA the deferrals are still reduced by $4,200 (calculated in the same manner as before the SBJPA), but the refunds are made to the HCEs with the highest deferral amounts, not the highest deferral percentages. Thus, the refunds are $1,566.57 to each of A and B, and $1,066.67 to C.

The refunds to these HCEs are determined by a "leveling" method similar to that which applied prior to the SBJPA. A and B receive refunds of $500 each (to be level with the next highest contribution, by C), and the remainder ($3,200) is refunded pro rata to A, B and

Notice 97-2 states that if those distributions are made, the plan is treated as meeting the Sec. 401(k)(3) nondiscrimination test, regardless of whether the ADP (if recalculated after the distributions) would satisfy that test. (The ADP test is not performed again after the refunds are made.) SBJPA Section 1433(f)(2) provided that these changes are effective for years beginning after 1996.

Elective Deferrals Includible as Compensation

SBJPA Section 1434(a) amended the definition of "compensation" for purposes of applying the Sec. 415 limits to electively include (or add back) certain amounts excluded from an employee's gross income. Pre-SBJPA Sec. 415(c)(3)(D) provided that these excluded amounts were: (1) CODAs; (2) simplified employee pensions; (3) tax-sheltered annuities; (4) cafeteria plans; and (5) Sec. 457(b) eligible deferred compensation plans of state and local governments and tax-exempt entities. Sec. 415(c)(3)(D) now includes employee pre-tax contributions to savings incentive match plans for employees.

Sec. 415(a)(1) annually limits contributions to a defined contribution plan and benefits from a defined benefit plan. The effect of the SBJPA is to allow a higher contribution to (or benefit from) a qualified plan, because additional compensation can be taken into consideration under the limits. Non-HCEs are expected to benefit the most.

All of the items listed in post-SBJPA Sec. 415(c)(3)(D) were already taken into account in determining HCE status, according to Temp. Regs. Sec. 1.414(q)-1T, Q&A-13(a), and continue to be included after the SBJPA, according to Sec. 414(q), as amended by SBJPA Section 1434(b)(1). In addition, the Sec. 414(s)(2) definition of compensation (for nondiscrimination purposes) was amended under SBJPA Section 1434(b)(2), unless the employer elects otherwise.

Under SBJPA Section 1434(c), these amendments are effective for years beginning after 1997.

Early Participation Nondiscrimination Rules

At the discretion of the plan sponsor, Sec. 410(a)(1)(a) permits a qualified plan to exclude from participation and the Sec. 410(b)(4)(B) minimum coverage tests employees who have not vet (11 reached age 21 or (21 completed one year of service. In addition to meeting the minimum coverage tests, Regs. Sec. 1.410(b)-6(b)(3) requires that Sec. 401(k) CODAs meet the special nondiscrimination test for elective deferrals and matching contributions under Sec. 401(k) and (m), respectively. A plan that permits employees to participate prior to meeting the minimum age and service requirements may be treated as two separate plans for testing purposes. The minimum coverage test (generally requiring at least 70% of non-HCE's (when compared to HCEs) to benefit under the plan) and the ADP/ACP tests may be applied separately to those otherwise excludible employees (not meeting the age or service requirements). Thus, the plan administrator has to perform two sets of ADP/ACP tests.

SBJPA Section 1459 did not change these rules; rather, it added a new alternative, permitting plans to perform one ADP and ACP test when early participation is permitted. New Sec. 401(k)(3)(F) and (m)(5)(C) allow an employer to (1) elect to satisfy the Sec. 410(b)(4)(B) minimum coverage tests separately for employees who have not met the minimum age and service requirements and (2) include only eligible employees who have met those requirements in the ADP and ACP tests. However, HCEs are includible in the tests, whether or not they have met the eligibility requirements. (It is unlikely that the HCE group will include new hires under age 21.) This "simplification" provision may actually add to complexity in situations in which the plan administrator may be performing three sets of tests (two under the current provisions still in effect and one under the alternative test) to maximize deferrals and matching contributions for HCEs.

According to SBJPA Section 1459(c), these changes are effective for plan years beginning after 1998.

Repeal of ESOP Loan Interest Exclusion

Pre-SBJPA Sec. 133 provided a 50% income exclusion for interest earned on "securities acquisition loans" (as defined by pre-SBJPA Sec. 133(b)); such loans are made either (1) directly to an employee stock ownership plan (ESOP) or (2) to the sponsor corporation, which then loans the funds to the ESOP. SBJPA Section 1602(a) repealed Sec. 133 for loans made after Aug. 20, 1996. Interest is still excludible for loans in existence before Aug. 21, 1996; also grandfathered, under SBJPA Section 1602(c), are loans made after Aug. 20, 1996 pursuant to a binding written contract in effect before June 10, 1996 (and at all times thereafter until such loan was made). Certain refinancings are not affected, if the refinanced loan (1) meets the Sec. 133 requirements as in effect prior to repeal; (2) does not increase the principal amount of the loan; and (3) does not extend the term of the original note.

Plan Distributions and QJSA Waivers

Plans subject to the Sec. 417(a)(3) qualified joint and survivor annuity (QJSA) requirements must provide participants with a written explanation of the QJSA (i.e., notice) no less than 30 (and no more than 90) days before the annuity starting date. Temp. Regs. Sec. 1.417(e)-1T(b)(3) provides that a participant may begin receiving distributions before the expiration of the 30-day period after notice was provided, if the plan has received an "affirmative distribution election" (with any applicable spousal consent) before the 30-day waiting period. However, the distribution could not commence less than eight days after notice was provided.

SBJPA Section 1451(a) codified this temporary regulation by adding Sec. 417(a)(7)(A), which permits a plan to allow a participant to elect to receive an annuity distribution before receipt of notice. The applicable election period for waiver of the QJSA will continue for 30 days after notice is provided. The plan can also provide that the participant can waive the 30-day notice period requirement if the distribution begins more than seven days after notice is provided.

The provision also allows for retroactive payment of benefits attributable to the period before notice was provided. This provision is effective for plan years beginning after 1996. SBJPA Section 1451 (b) adds a new parallel provision, Employee Retirement Income Security Act of 1974 Section 205(C)(8)

Example 3: G is married and decides to take early retirement. On Monday, July 21, 1997, she terminates employment and receives the required notice and an election form to waive the 30-day applicable election period. With the consent of her spouse, G elects a single-life annuity form of distribution and waives the 30-day applicable election period. G's benefit may start as early as Tuesday, July 29, 1997.

As a practical matter, many defined benefit plan administrators will have difficulty accelerating the distribution process. Daily processing in the defined contribution plan environment makes it possible to provide for these shorter distribution cycles.

Repeal of Combined Defined Contribution/Benefit Plan Limits

When an individual is a participant in both an employer's defined benefit and defined contribution plans, an overall "combined plan limit" applies to restrict contributions and benefits under each plan type. SBJPA Section 1452(a) repealed Sec. 415(e), eliminating the need to compute the complex combined plan limit fractions for both plan types. Congress perceived this computation to be complex and expensive to administer, thereby limiting the number of employers willing to adopt defined benefit plans in combination with defined contribution plans.(4) The repeal of the limit should permit HCEs to increase their benefits through a qualified plan arrangement.

Under SBJPA Section 1452(d)(1), this amendment applies to limitation years beginning after 1999. Sec. 416(h) was correspondingly deleted by SBJPA Section 1452(c)(7); it provided special limits on top-heavy plans (based on Sec. 415(e) computations).

Leased Employees

The Sec. 414(n) employee leasing provisions were added to the Code by the Tax Equity and Fiscal Responsibility Act of 1982. In general, Sec. 414(n)(3) treats a leased employee as the service recipient's employee in applying the various employee benefit qualification requirements. Contributions and benefits provided by the leasing company are treated as if provided by the service recipient. Pre-SBJPA Sec. 414(n) applied a three-part test to determine a leased employee; under pre-SBJPA Sec. 414(n)(2), a leased employee was an individual who performed services for the recipient if: (1) such services were provided pursuant to an agreement between the recipient and the leasing company; (2) these services were performed on a substantially full-time basis for at least a year; and (3) the services were of a type historically performed in the business field of the recipient by employees.

SBJPA Section 1454(a) amended Sec. 414(n)(2)(C) to change the "historically performed" test to a "primary direction or control" test. The House Reports states that the test was changed because, in many cases, the former test was overly broad and resulted in the unintended treatment of individuals as leased employees. One of the principal purposes for changing the leased employee rules is to relieve the unnecessary hardship and uncertainty created for employers in these circumstances. The House Report indicates that a person's common-law employee status is determined before determining whether the person is a leased employee. A person who is determined not to be a common-law employee may nevertheless be the service recipient's leased employee, but failing the primary direction or control test does not determine whether the individual is a common-law employee.(6)

Whether services are performed under the primary direction or control of the service recipient depends on the facts and circumstances. Factors relevant to this determination include:

1. Whether the individual is required to comply with the service recipient's instructions about when, where and how to perform the services.

2. Whether the services must be performed by a particular person.

3. Whether the individual is subject to the service recipient's supervision.

4. Whether the individual must perform services in the order or sequence set by the service recipient.

Factors that are not relevant include: 1. Whether the service recipient can hire or fire the individual.

2. Whether the individual works for others. The factors listed are not intended to be exclusive; the House Report provides examples for further guidance, involving the performance of services by outside factory work crews, professionals and clerical staff.(7) Direct supervision by the service recipient (as is generally the case in a clerical function, such as temporary secretaries and word processing personnel) would trigger the primary direction or control test. On the other hand, actual supervision of a work crew by an employee of the installation or repair company would defeat this test. The House Report states that the primary direction and control test is not intended to enable employers to engage in abusive practices.(8)

The character of the work force has changed since the original tests for leased employees were enacted. With the significant increase in co-sourcing and outsourcing, certainty in the application of the leasing rules is critical for employers and employees. This legislative change is intended to provide more certain standards.

According to SBJPA Section 1454(b), the new test is effective for years beginning after 1996, but does not apply to relationships that have been previously determined by an IRS ruling not to involve leased employees. If this grandfather provision applies, prior law governs the transaction.

Modification of GATT Interest and Mortality Rate Rules

Sec. 415 provides that benefits under a qualified defined benefit plan cannot exceed certain specified limits. Sec. 415(b)(2)(B) states that a benefit must be actuarially adjusted to an equivalent annual straight-life annuity if payable in a form other than that. For benefit payments beginning before age 62, Sec. 415(b)(2)(C) and (D) require that the Sec. 415(b)(1)(A) dollar limit ($120,000 for 1996) also be actuarially adjusted. The Retirement Protection Act of 1994 (RPA '94), part of the Uruguay Round Agreements Act (GATT), amended Sec. 417(e)(3) to allow defined benefit plans to increase the interest rate used to convert accrued benefits into lump-sum cashouts and specified the mortality table to be used for that purpose. Correlatively, RPA '94 Section 767(b) amended Sec. 415(b)(2)(E)(v) to provide that the interest rate assumption used to adjust the benefit under Sec. 415(b)(2)(B) or (C) could not be less than the greater of 5% or the plan rate.

For Sec. 417(e)(3) purposes, the GATT assumptions for calculating; lump-sum benefits were not effective until plans were actually amended to include them; until then, the pre-GATT assumptions, which produced larger lump sums, had to be used. The corresponding amendment to Sec. 415 was, however, effective for limitation years beginning after 1994. The discrepancy in effective dates had an anomalous result: the Sec. 415 limit applicable to lump-sum distributions was reduced immediately, whether or not the plan adopted the GATT assumptions for other purposes. Hence, some participants who received distributions in 1995 and 1996 got considerably less than would have been paid to them on the last day of 1994.

SBJPA Section 1449(b) amended Sec. 415(b)(2)(E), applying a 5% interest rate (or the plan rate, if greater) to all distributions before age 62, regardless of the form of the benefit. For lump-sum distributions subject to Sec. 417(e)(3) payable at or after age 62, the minimum interest rate for adjustment purposes remains the 30-year. Treasury security rate.

These provisions are retroactively effective Dec. 8, 1994. Transition relief is provided by SBJPA Section 1449(d); in general, it permits a plan to defer the interest and mortality rate assumptions until the first plan year beginning after 1999 if the plan was never amended to include the new rate. Until Aug. 20, 1997, plans amended for the RPA '94 can retroactively repeal the amendment to revert to pre-RPA '94 rates.

Guidance on the application of these provisions (specifically, the transition rules) is needed from the Service. For plans that have applied the Sec. 415 GATT limits to lump-sum distributions to 1995 and 1996 retirees, correction may be necessary in certain circumstances.

Conclusion

The changes herein discussed bring some simplification to an already complex Code, but also create alternatives that must be fully analyzed. Ultimately, this analysis, and implementation of the new rules, will serve to add complexity.

Editor's note: Mr. Schneider is a member of the AICPA Tax Division Employee Benefits Taxation Committee.

(1) The discussion omits numerous technical changes and Family Aggregation Rules

(2) Notice 97-2, IRB 1997-2, 22, Section II.

(3) See id.

(4) H. Rep. No. 104-586, 104th Cong., 2d Sess. 123 (1996).

(5) Id., p. 124.

(6) Id., p.125.

(7) Id., pp.125-126.

(8) Id., p.126.