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Current developments in employee benefits.

Sec. 403(b) Plans; Accounting for Stock Compensation; Delinquent Filer Voluntary Compliance Program; Executive Compensation; Business Expenses; Judicial Developments

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part 1, published in November, focused on current developments affecting qualified retirement plans, including pension provisions within the General Agreement on Tariffs and Trade and the Uniformed Services Employment and Reemployment Rights Act of 1994, Employee Retirement Income Security Act of 1974 (ERISA) issues, and various IRS releases that provide guidance on qualified plan design. Part II, below, focuses on IRS initiatives on Sec. 403(b) plan compliance, the Financial Accounting Standards Board's (FASB) Statement on stock compensation, the Department of Labor's (DOL) Delinquent Filer Voluntary Compliance (DFVC) Program, the taxation of property transfers and other executive compensation issues new rules for substantiating business expenses and recent court decisions and related legislation.

Sec. 403(b) Plans

* Tax Sheltered Annuity Voluntary Correction program

Nonprofit organizations and public educational institutions that sponsor Sec. 403(b) retirement plans now can voluntarily correct plan problems with a procedure similar to the IRS's Voluntary Compliance Resolution (VCR) program for qualified retirement plans. The IRS has unveiled a Tax Sheltered Annuity Voluntary Correction (TVC) program, allowing employers that legitimately sponsor Sec. 403(b) plans to voluntarily identify and correct certain plan defects.(37) The TVC program is effective from May 1, 1995 through Oct. 31, 1996. Plan sponsors that request consideration under the TVC program agree to correct the identified defects and pay a sanction amount, and receive in return written assurance that the violations will not result in revocation of the income tax exclusion.

The TVC program is available only to employers eligible to offer Sec. 403(b) plans. The IRS has discovered a number of Sec. 403(b) plans sponsored by nonprofit organizations that are not Sec. 501(c)(3) organizations, including business leagues, boards of trade and recreational clubs, and is negotiating settlements for ineligible Sec. 403(b] plans on a case-by-case basis.

Under the TVC program, eligible Sec. 403(b) plan sponsors identify plan defects, propose a plan for full correction, describe any needed improvements in plan administration and pay both a correction fee and a negotiated sanction. Plans under examination or that have received written or oral notice of examination are not eligible for the program. A plan will not be selected for IRS examination while it is in the TVC program. If the employer anticipates that the corrections will require the cooperation of other parties (e.g., the insurance company issuing the annuity contracts), it must obtain assurance that those parties are willing to cooperate in correcting the defects.

The correction fees range from $500 for employers with fewer than 25 employees to $10,000 for employers with 10,000 or"more employees. Unlike the VCR program for qualified plans, the TVC program also requires payment of a "sanction" negotiated by the plan sponsor and the IRS, which will not exceed 40% of the "total sanction amount" (TSA), the tax the IRS could assess for the defects. The correction fee will be applied to reduce the TSA. The TSA is contingent on whether the defects are of a type that would cause the plan to lose its Sec. 403(b) status, or only cause contributions to certain contracts to lose their Sec. 403(b) status. The actual sanction imposed will be based on the severity of the defect' the number and type of employees affected by them, the cost of correction, the extent to which employees would be hurt if the income exclusion were lost and the extent to which the errors were found through the employer's own procedures.

The IRS will rely on the plan sponsor's statements identifying the plan's operational defects. The employer must correct identified defects for all years in which they existed, even closed tax years. The correction statement will only address the issues raised by the employer, related issues, and other issues presented by the employer in written or oral statements; however, if the IRS discovers unrelated violations while considering the TVC request, these defects will generally be added to the correction statement.

An employer can request a TVC correction for the following defects:

[] Violation of Sec. 403(b)(12) nondiscrimination requirements, including violations regarding matching contributions and failure to offer salary reduction opportunities on a universal basis.

[] Violation of distribution requirements (e.g., improper hardship distributions and improper withdrawal of salary reduction contributions).

[] Violation of the rules limiting death benefits under the plan to benefits that are "incidental."

[] Failure to pay minimum required distributions after participants reach age 70 1/2.

[] Failure to give employees the right to elect a direct rollover, including failure to give employees an information notice.

[] Violation of salary reduction limits, such as treating amounts as a one-time irrevocable election and then permitting revocation.

[] Contributions in excess of the Sec. 403(b)(2) exclusion allowance.

[] Failure to satisfy applicable nontransferability requirements for the annuity.

[] Failure to satisfy the Regs. Sec. 1.403(b)-l(b)(3) requirements that salary reduction agreements apply only to salary earned after the agreement is made, be made only once in any tax year and be legally binding.

[] Violation of the Sec. 415 limits prohibiting annual contributions of more than $30,000 or 25% of compensation or improperly applying special alternative limits to certain Sec. 403(b) plans.

Items not eligible for resolution under the TVC program include:

[] Defects relating to the misuse or diversion of plan assets.

[] Plans for which the employer does not have sufficient information to determine the nature or the extent of the defect, or to effect reasonable correction.

[] Plans that purchased annuity contracts from an entity other than an insurance company.

[] Plans that did not purchase annuity contracts or invest contributions in a proper custodial account.

[] Annuity contracts purchased or custodial accounts established on behalf of ineligible employees or independent contractors.

[] Plans with egregious defects.

[] Defects subject to an excise tax, penalty or additional income tax as a result of improper loans or early distributions.

The TVC program will not be available to waive or reduce any applicable excise taxes, nor does the program alter an employer's obligation to satisfy any applicable FICA and FUTA tax requirements. The IRS must be assured that the employer has or will initiate procedures to pay the appropriate employment taxes.

At the favorable completion of the TVC process, the plan sponsor will receive a correction statement and acknowledgment letter from the IRS. The correction statement will fully describe the defects, the required corrections, the sanction, the time frame in which corrections must be implemented and any revisions to the administrative procedures or employment tax procedures on which the statement is conditioned.

Acknowledging that data for Sec. 403(b) plans frequently is nonexistent, the IRS has indicated that, on a case-by-case basis, it will allow"a plan correction based on data estimated by the employer or will issue a correction statement covering only years for which data is available.

* Examination guidelines

The IRS subsequently issued proposed guidelines for employee plan examiners to use when examining Sec. 403(b) plans.(38) The IRS cautioned that the guidelines are not meant to be all-inclusive, are not a precedential or comprehensive statement of the IRS'S legal position on the issues, and cannot be relied on or cited as authority.

Agents are advised to determine whether the employer is eligible to maintain a Sec. 403(b) plan. Generally, only public education organizations described in Sec. 170(b)(1)(a)(ii) and nonprofit organizations described in Sec. 501(c)(3) are eligible. If the employer is not eligible, the plan most likely includes taxable annuities for employees and the agent is to consider collecting income and employment taxes for all open years.

The guidelines categorize Sec. 403(b) violations as either plan defects or annuity contract defects. In general, plan defects result in a loss of Sec. 403(b) status for the entire plan, while annuity contract defects affect only the annuity contract with the defect. Some defects may fall into either category, depending on the facts and circumstances. All defects that generate addition,al income will result in additional employment taxes and/or withholding requirements.

Annuity contract defects may be further broken down into defects that affect only a portion of a participant's annuity contract and those that adversely affect the status of the participant's annuity contract as a Sec. 403(b) contract. When only a portion of the annuity contract is affected, the tainted portion of the contract is includible in gross income and/or subject to excise tax in the tax year. Such defects include the following:

[] Contributions in excess of the exclusion allowance.

[] Excess Sec. 415 amounts.

[] Excess deferrals that do not cause a loss of Sec. 403(b) status.

[] Certain loans.

[] Isolated instances of failure to satisfy minimum distribution requirements.

[] More than one salary reduction agreement in a single tax year.

[] Salary reduction agreements that apply to prior earnings.

The following defects cause a participant's entire annuity contract to fail under Sec. 403(b):

[] An inadequate salary reduction agreement (e.g., existence of nonsalary reduction contributions).

[] An annuity contract not purchased from an insurance company.

[] A custodial account not maintained by a bank or an approved nonbank trustee.

[] Failure of a custodial account to invest exclusively in regulated investment company stock.

[] Violation of incidental death benefit requirements.

[] Inclusion of ineligible employees.

[] Failure of an annuity contract to satisfy the Sec. 401 (g) no transferability requirement in either form or operation.

[] Impermissible distribution under Sec. 403(b)(7) or (b)(1 1), including an improper transfer or a disguised loan.

[] Failure to provide a direct rollover.

[] A pattern of violating the minimum distribution rules.

All contributions made into an annuity contract containing any of the previously listed defects are includible in the participant's gross income, except contributions subject to a substantial risk of forfeiture. These defects may also cause other plan problems. For example, if some annuity contracts are not See. 403(b) annuity contracts, the plan may fail to satisfy coverage or nondiscrimination rules, thereby causing a loss of Sec. 403(b) status for the entire plan.

Finally, the guidelines list plan defects that cause loss of Sec. 403(b) status. For these defects, all contributions made to the plan in the first tax year of the defect and subsequent years until the defect is corrected are includible in the participants' gross income. Plan defects that cause a loss of Sec. 403(b) status include:

[] A failure by the plan to purchase Sec. 403(b)(1) annuity contracts until participants reach retirement age or status.

[] Discrimination with respect to nonsalary reduction (e.g., matching and nonmatching) or salary reduction contributions.

[] Failure to satisfy minimum participation rules.

[] Inadequate coverage.

[] Excess deferrals that cause the plan to lose its Sec. 403(b) status.

If the employer was never eligible to maintain a Sec. 403(b) plan, the plan was never a Sec. 403(b) plan; therefore, Sec. 403(c) or 83 governs, depending on the funding vehicle being used. If the employer was a Sec. 501(c)(3) organization but lost such status, the exclusion allowance is lost for any contributions made while the employer is ineligible.

Accounting for Stock Compensation,

On Dec. 14, 1994, the FASB voted not to require the recognition of expense stemming from employee stock options. In so doing, the FASB effectively repealed its exposure draft, Accounting for Stock-based Compensation, issued on june 30, 1993 amid significant publicity and controversy.

In October 1995, the FASB released Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (Statement). The Statement is effective for transactions entered into in fiscal years beginning after Dec. 15, 1995. For entities remaining on APB Opinion No. 25, Accounting for Stock Issued to Employees, new disclosures will be required for fiscal years beginning after Dec. 15, 1995.

The Statement encourages companies to use the fair value based method of accounting for stock option and similar equity instruments, which accounts for stock compensation awards based on estimated fair value at the grant date. Companies would be permitted, however, to continue using the intrinsic value based methodology in APB No. 25, with expanded disclosure in notes to financial statements of the pro forma effects on net income and earnings per share assuming the application of the new accounting method.

If the new method is chosen, compensation cost arising from both fixed and performance stock compensation plans should be measured at the fair value of the award on the grant date, with subsequent adjustments for actual experience for performance-related factors i"modified grant date" method). This method "freezes" the stock price at the grant date, thereby eliminating the difference between "fixed" and "variable" awards that currently result under APB No. 25. In most cases, the value of the options would not subsequently be adjusted.

The fair value of an option issued by a public company should be estimated using an option-pricing model that takes into account the exercise price, the expected term of the option, the stock's current price, expected dividends, expected volatility and the expected risk-free rate of return during the option term. The Statement provides specific guidance on the definition of volatility and the selection of assumptions used in option-pricing models, including the use of a low end of a range of estimates. The fair value of an option issued by a nonpublic company can be estimated using a method that does not take into account the stock's expected volatility.

A prepaid compensation asset is not recognized at the grant. date. The fair value of the option is recognized ratably over the employee service period by a charge to compensation cost and a corresponding credit to paid-in capital. If the option is for past services, the entire fair value is charged to compensation cost and credited to paid-in capital when granted. Only options that result in a current employer tax deduction will receive "net-of-tax" recognition.

The new provisions may be adopted immediately and must be applied to all awards granted after the beginning of the fiscal year in which first applied. The provisions cannot be applied to awards granted before the year of initial adoption, except to the extent that prior years' awards are modified or settled in cash after the entity adopts the provisions.

The disclosure requirements included in the Statement apply both to entities that adopt the new method and those that use APB No. 25. Entities remaining on the latter method will be required to disclose the pro forma effect on net income and earnings per share data of applying the fair value model.

Required disclosures include:

[] A description of the stock-based compensation plans, including the general terms of awards, vesting requirements, etc., and the term of significant modifications to outstanding options.

[] The number and weighted-average exercise prices of options outstanding at the beginning and end of the year, the number of options exercisable at those dates, and the number of options granted, exercised, forfeited or expired during the year.

[] The weighted-average fair values of options granted during the year, with separate disclosures for options with an exercise price less than, equal to or exceeding the market price of the stock on the grant date.

[] A description of the method and significant assumptions used to estimate the fair value of the options.

[] The assumptions used to determine the expected lives of options, including the number of nonexercisable options that are time- and performance-based, and the range of exercise prices and weighted-average remaining lives for options outstanding at the latest balance sheet date.

[] The total compensation cost recognized for stock-based compensation awards.

Pro forma disclosures will include the effects of all a"wards granted in fiscal years beginning after Dec. 15, 1994. Although pro forma disclosures need not be presented in financial statements for the first fiscal year beginning after Dec. 15, 1994, they must be subsequently presented whenever financial statements for that fiscal year are presented for comparative purposes.

DFVC Program

On Apr. 27, 1995, the DOL released its long-awaited DFVC Program, providing for reduced penalties for plan sponsors who voluntarily file late Forms 5500, Annual Return/report of Employee Benefit Plan (with 100 or more participants), for plan years beginning after 1987.(39) The DOL anticipates the DFVC Program will be permanent, subject to periodic review. The program is not available for filers currently subject to a DOL "Notice of Intent to Assess a Penalty" due to a delinquent filing.

The DOL has statutory authority to levy penalties for late Forms 5500 of up to $1,000 per day; the agency had previously announced that the ordinary penalty for late filings would be $300 per day (up to $30,000 per year) until the form was filed. Under the DFVC program, reduced penalties apply. The penalty for a Form 5500 less than 12 months late is $50 per day up to $2,500 ($1,000 for a Form 5500-C/R, Annual Return/report of Employee Benefit Plan (with fewer than 100 participants)). A Form 5500 more than 12 months late is subject to a $5,000 penalty ($2,000 for a Form 5500-C/R).

Special rules apply for top hat and apprentice plans. The DFVC allows sponsors of such plans who failed to take advantage of the special provisions to elect out of annual reporting to make that election. Plan sponsors with more than one plan are not required to file a separate statement for each. Regardless of the number of top hat or apprenticeship plans or the number of participants in such plans, the maximum penalty will be $2,500 under this program.

The program announcement notes that because the plan administrator is personally liable for civil penalties under ERISA Section 502(c)(2), DFVC penalties may not be paid from plan assets. In addition, IRS penalties for Forms 5500 filed late may still apply; however, the IRS has the discretion to abate such penalties for reasonable cause.

Executive Compensation

* Taxation of property transfers

The IRS has finalized Regs. Sec. 1.83-6.(40) Regs. Sec. 1.83-6(a)(2) no longer requires an employer to deduct and withhold income tax as a prerequisite for claiming a deduction for property transferred to an employee in connection with the performance of services. Under proposed and prior final regulations, employers were denied a deduction for failure to withhold, even when the employee had reported the income and paid the tax.

Sec. 83(h) provides that in the case of a transfer of property to which Sec. 83(a) applies, the service recipient can take a deduction equal to the amount included in the service provider's gross income. In light of the difficulty a service recipient may have in demonstrating that an amount was actually included in gross income, Regs. Sec. 1.83-6(a)(1) permitted a deduction for the amount "includible" in gross income. Thus, the IRS allowed the deduction to the service recipient even if the service provider did not properly report the includible amount.

If the service provider is an employee of the service recipient, prior Regs. Sec. 1.83-6(a)(2) allowed a deduction only if the service recipient deducted and withheld income tax under Sec. 3402. This special rule was designed to ensure that the service recipient's deduction had been offset by a corresponding inclusion in the service provider's gross income. The rule was limited to employer-employee situations, because in other situations there was no underlying withholding requirement on which the deduction could be conditioned.

Under Regs. Sec. 1.83-6(a)(1), as amended; the service recipient is allowed a deduction for the amount "included" in gross income. The amount can be reported on an original or amended return or included in gross income as a result of an audit. Regs. Sec. 1.83-6(a)(2) provides that if the service recipient timely complies with applicable Form W-2 or Form 1099 reporting requirements, the service provider is deemed to have included the amount in gross income. If a transfer satisfied the exemption from reporting requirements for payments aggregating less than $600 in any tax year, or was eligible for another reporting exemption, the service recipient is deemed to have complied with the inclusion rule.

Although the withholding requirement is eliminated as a prerequisite for claiming a deduction, the final regulations do not relieve the service recipient from any applicable withholding requirements of subtitle C or from the statutorily prescribed penalties or additions to tax for noncompliance with payroll or information reporting requirements.

The regulations are effective for deductions allowable for tax years beginning after 1994. However, a taxpayer may rely on the final regulations when claiming a deduction for any year not closed by the statute of limitations.

* Deduction for deferred compensation

On rehearing in Albertson's, Inc.,[41] the Ninth Circuit reversed its earlier decision as to whether an accrual-basis employer was entitled to a current interest expense deduction for certain "additional amounts" paid to participants under a nonqualified deferred compensation plan. The circuit court's decision affirmed the Tax Court's holding that the additional amounts cannot be deducted currently.

Albertson's, Inc. had several agreements in which recipients agreed to receive in the future deferred compensation plus an additional amount calculated via a predetermined formula. In 1982, Albertson's requested IRS consent to deduct currently the additional amounts (but not the deferred compensation) instead of waiting until the end of the deferral period. In 1983, the IRS granted Albertson's request, and it claimed deductions for the additional amounts that had been accrued. In 1987, the IRS sought a deficiency for those amounts. A divided Tax Court ruled that the amounts could not be currently deducted.

In 1993, the Ninth Circuit reversed the Tax Court's decision, holding that the additional amounts were interest that could be deducted as accrued regardless of the timing restrictions of Sec. 404. On rehearing in 1994, the Ninth Circuit found that Congress's intention in providing the timing restrictions of Sec. 404 was to ensure matching of income inclusion and deduction between employee and employer under nonqualified plans. This created a tax incentive for adopting qualified plans not governed by the matching principle. Holding that the additional amounts in the Albertson's deferred compensation agreements were currently deductible as interest would undermine the matching principle and create a tax incentive for employers to establish nonqualified plans. Thus, the court held that Albertson's could not deduct the additional amounts until they were paid to the participants.

Albertson's request for review by the Supreme Court was denied Oct. 2, 1995, thus affirming the Ninth Circuit's decision.

* Payroll taxes on deferred compensation

Notice 94-96[42] states that until regulations are issued interpreting Secs. 3121 (v)(2) and 3306(r)(2), covering FICA and FUTA taxes on nonqualified deferred compensation (NDC), the IRS will not challenge FICA and FUTA tax liability determinations by an employer whose determinations are based on a reasonable, good faith interpretation of those sections.

Secs. 3121(v)(2) and 3306(r)(2) apply FICA and FUTA tax liability to amounts earned under NDC plans on the later of when services are performed or the amounts are no longer subject to a substantial risk of forfeiture. Although these provisions have been on the books for some years, they were relatively unimportant prior to 1994; employees earning NDC are typically highly paid, exceeding the wage base for FICA and FUTA before counting the deferred compensation. However, Revenue Reconciliation Act of 1993 (RRA '93) Section 13207 repealed the dollar limit on wages subject to hospital insurance tax (2.9%) under Secs. 3101 (b) and 3 1 1 1 (b), extending the tax, to all wages, causing all employees with deferred compensation to be affected by these provisions. There is no IRS guidance, however, on a number of issues involved in applying these sections, such as valuing the deferred compensation or determining exactly when services are performed.

According to the notice, whether an employer has made a reasonable, good faith interpretation of Secs. 3121(v)(2) and 3306(r)(2) will be determined based on all relevant facts and circumstances, including consistency of treatment by the employer. The IRS is adamant that treating deferred compensation as earned for FICA and FUTA tax purposes before an NDC plan is adopted will not be a reasonable interpretation. The IRS also cautions that an employer's reasonable, good faith treatment of an amount as deferred compensation subject to FICA and FUTA for periods preceding the effective date of the promised regulations may not be determinative of FICA and FUTA liabilities for periods after the effective date of such regulations. Thus, the regulations could determine the amount to be taken into account as FICA and FUTA wages for periods after their effective date, independent of the amount (if any) that the employer took into account as FICA or FUTA wages for periods preceding the effective date under the employer's reasonable, good faith interpretation. In such situations, the IRS anticipates that a taxpayer would not be required to pay more tax than would have been payable had the regulations been in effect since the effective dates of Secs. 3121 (v)(2) and 3306(r)(2).

Business Expenditures

* Substantiation

Effective for expenses incurred after Sept. 30, 1995, the IRS will require receipts for business travel and entertainment under Sec. 274(d) only when the expense is $75 or more.[43] Previously, the IRS had required receipts when expenses were $25 or more, a threshold in effect since 1962.

Employers are likely to want receipts from employees for expenses of less than $75, but the IRS's announcement eliminates the employers' need to retain the records for open tax years, thus reducing the time and expense of organizing, storing and maintaining such records.

The IRS is also reviewing the "adequate accounting" rules of Temp. Regs. Sec. 1.274-5T(f), which require substantiation of business expenses with documentary evidence, including receipts establishing each element of the expense and retention of such evidence, to determine whether alternative means of substantiation might be available to satisfy Sec. 274(d).

* Consequences to employees

The IRS has proposed regulations[44] addressing the income tax consequences to employees when the employer's deduction for club dues, meals, entertainment or spousal travel expenses has been disallowed as a result of the changes made by the RRA '93.

RRA '93 Section 13209 amended Sec. 274 to disallow deductions for 50% of business meal and entertainment expenses. According to the preamble to the proposed regulations, the legislative history to the RRA '93 indicates that Congress did not intend such disallowance to result in income to employees. Prop. Regs. Sec. 1.62-2(h)(1) provides that if a portion of a reimbursement or advance for business meal or entertainment expenses is treated as paid under a nonaccountable plan solely because of the 50% disallowance rule, that portion will not be considered wages subject to withholding and employment taxes.

RRA '93 Sections 13210 and 13272 amended Sec. 274 to disallow a deduction for amounts paid or incurred for (1) membership in any club organized for business, pleasure, recreation or other social purpose and (2) spousal travel expenses. Prop. Regs. Sec. 1.132-5(s)(1) and (t) provide that the denial of a deduction to the employer for the payment of an employee's membership in a club, or for the payment of an employee's spousal travel expenses, does not preclude those items from qualifying as working condition fringe benefits. These amounts may so qualify to the extent that the employer has not treated them as compensation under Sec. 274(e)(2), the employee substantiates the expenses, and the amounts would otherwise be deductible under Sec. 162 (without regard to Sec. 274(a) and (m)(3)). In the case of spousal travel, employees would have to show that the accompanying individual's presence on the business trip had a bona fide business purpose.

Court Decisions and Legislation

* Vesting

Notwithstanding a retiree medical plan document's clear reservation of the employer's right to terminate or amend medical benefits, the Eighth Circuit held that an employer could not terminate or change medical benefits for certain retirees because it had intended to vest such benefits.[45] The employer's intent was in part established by the testimony of the former chief executive officer (Ceo),pnd the former benefits manager.

SIPCO established a medical benefit plan for salaried pensioners, funded a trust for the benefits and created new plans for prospective retirees. SIPCO was acquired; subsequently, the acquirer's president announced to management that the retiree plan would be eliminated for future retirees. New summary plan descriptions (SPDs) for certain plans covering former retirees stated that the plan and trust documents were the controlling legal documents, and that the company reserved the right to terminate, discontinue, alter, modify or change the plan or any provision at any time.

In April 1989, eligible retirees received an SPD for a new plan covering salaried employees who retired between Jan. 1 and Mar. 1, 1989. This SPD disclosed benefit changes and stated that the "employer reserves the right to charge the employee/retiree a premium for this coverage...." A group of retirees sought an injunction in district court to require SIPCO to provide benefits as they were prior to the issuance of the new SPD (i.e., for life at no charge). The Eighth Circuit affirmed, stating that the only issue was whether the benefits were vested. The court acknowledged that ERISA does not require vesting of welfare benefits and that such rights become vested only through some employer action.

The court stated that because ERISA required employee benefit plans to be established by a written instrument, any promise to provide vested benefits had to be incorporated into the formal written plan. Thus, the inquiry had to begin with the written plan documents, including the SPDs. However, the court also noted that in interpreting ERISA documents, trust law governs. The terms of trusts created by written instruments are "determined by the provisions of the instrument as interpreted in light of all the circumstances and such other evidence of the intention of the settlor with respect to the trust as is not inadmissible."[46]

Because the employer's intent is important, the court stated that evidence outside the written documents would be considered. While SIPCO relied heavily on the actual plan language reserving the right to change, both its benefits manager and former CEO stated unequivocally that vesting had always been intended and that is what employees considering retirement were always told.

The Eighth Circuit agreed with the district court that SIPCO intended that retirement medical benefits for salaried employees would vest when those employees retired. The court stated that either the reservation-of-rights provisions in the plan documents must be construed as conferring only a power to modify plan benefits prospectively (for employees not yet retired), or SIPCO relinquished the broader power to modify benefits for those already retired. In most ERISA welfare benefit plans, a reservation-of-rights provision would reflect the employer's intent to make plan benefits nonvested. In this case, the provisions were not free of ambiguity, and the plaintiffs proved that SIPCO, in creating the plans, did not have such intent.

* Plan amendments

The Supreme Court, unanimously reversing the Third Circuit, has held in Curtiss-Wright Corp. v. Schoonejongen[47] that a retiree medical plan included a valid amendment procedure that satisfied ERISA Section 402(b)(3) requirements. The Court then remanded to the Third Circuit the question of whether the plan was properly amended. This case has been watched closely, because many ERISA plans include the same amendment procedure language as was included in the Curtiss-Wright Plan.

Curtiss-Wright voluntarily maintained a post-retirement health plan for employees who had worked at certain Curtiss-wright facilities. The plan's terms were chiefly found in the plan constitution and the SPD, both of which primarily covered active employee health benefits. In 1983, a revised SPD was issued, stating that health care benefits would cease for retirees and their dependents on the termination of business operations of the facility from which they retired. Later that year, Curtiss-Wright announced that the Woodridge, New Jersey, facility would close and the Woodridge retirees were informed by letter that their post-retirement health benefits were being terminated.

The retirees sued Curtiss-Wright for terminating their benefits. The district court rejected most of the claims, including the claim that Curtiss-Wright had contractually bound itself to provide health benefits to the retirees for life. However, the district court ruled that the new SPD provision effected a significant change in the plan's terms and thus constituted a plan amendment, that the plan documents nowhere contained a valid amendment procedure, as required by ERISA Section 402(b)(3), and that the proper remedy for such violation was to declare the new SPD provision void ab initio. The court also ordered Curtiss-Wright to pay the retirees back benefits.

On appeal, Curtiss-Wright claimed that the plan documents did include an amendment procedure -- the standard reservation clause ("the Company reserves the right at any time and from time to time to modify or amend, in whole or in part, any or all of the provisions of the Plan"). According to Curtiss-Wright, this clause established an amendment procedure under ERISA, because it provided that the plan could be amended by "the Company." Rejecting this argument, the Third Circuit affirmed the district court's decision.

Granting certiorari, the Supreme Court agreed that employers or other plan sponsors generally are free under ERISA, for any reason at any time, to adopt, modify or terminate welfare plans. Nor does ERISA establish any minimum participation, vesting or funding requirements for welfare plans as it does for pension plans. Therefore, the fact that Curtiss-Wright amended its plan to deprive the retirees of health benefits was not a cognizable complaint under ERISA. Rather, the only cognizable claim was that the company did not do so in a permissible manner.

The Supreme Court stated that ERISA Section 402(b)(3) requires a procedure for amending the plan and for identifying the persons who have authority to amend it. It noted that, with regard to the second requirement, the ERISA definition of the term "person" includes companies, and consequently, the Curtiss-Wright reservation clause appeared to satisfy ERISA's identification requirement by naming the Company as the person with amendment authority. The Court added that a plan that simply identifies the persons outright necessarily indicates a procedure for identifying the persons as well.

The Court agreed with the retirees that one of ERISA's central goals is to enable plan beneficiaries to learn their rights and obligations at any time. The Court said since ERISA's reporting and disclosure requirements are thorough but not foolproof, Congress devised the elaborate scheme for participants and beneficiaries to learn about their rights and obligations through written documents. Congress did not intend employee rights and obligations to be hidden in a document that employees would never practically see.

In remanding, the Court stated that the Third Circuit will have to decide whether Curtiss-Wright's valid amendment procedure was complied with. The Court warned that companies maintaining plans with the standard reservation clause may want to provide greater specificity to their amendment procedures to avoid such costly litigation.

* Pension Annuitants Protection Act

The Pension Annuitants Protection Act of 1994 (PAPA) gives annuitants the right to sue and take other enforcement action under ERISA against their former pension plans. The act grew out of cases such as Mertens v. Hewitt Associates,[48] which refused to permit ERISA suits by individuals who were participants or beneficiaries under their plans when the alleged breaches of fiduciary duty or violations of the plans or ERISA occurred, but, because of intervening plan terminations, were not plan participants at the time they brought suit.

PAPA clarifies existing law. In Congress's view, court decisions have incorrectly held that annuitants are not plan participants and thus, lack standing to sue under ERISA.

PAPA applies to any legal proceeding pending, or brought, after May 30, 1993. It amends ERISA Section 502(a), giving individuals, the DOL or plan fiduciaries the right to sue if a purchase of an insurance contract or insurance annuity in connection with termination of an individual's status as a participant covered under a pension. plan occurs. This right is extended to all or any portion of the participant's pension benefit affected by a violation of the trust and fiduciary duties under ERISA Sections 401 through 414 or a violation of the plan rules. The individual must have been a participant in the plan at the time of the alleged violation. Appropriate relief in such cases can include the posting of security by the defendant to ensure the participant or beneficiary receives amounts granted by the annuity or insurance contract, plus reasonable prejudgment interest on such amounts.

Recently, DOL officials have indicated that because PAPA does not go far enough in redressing ERISA remedies, the DOL's Pension and Welfare Benefit Administration will seek legislation to overturn Mertens.

* Insurance agent as fiduciary

In Reich v. Lancaster,[49] the Fifth Circuit upheld a district court's finding that an insurance salesman/adviser was "transformed" into an ERISA fiduciary by effectively exercising discretionary authority over a welfare plan to which he was providing services.

Insurance agent Jerry Lancaster was the sole owner and chairman of Jerry D. Lancaster and Associates, Inc. (JDL), which owned Diversified Consultants, Inc. (DCI). In 1983, the trustees of the Plumbers & Pipefitters Local 454 Health Welfare Fund (the Fund) hired Lancaster, JDL and DCI to provide insurance services. In 1983, Lancaster proposed, and the trustees approved, that the Fund buy individual $10,000 whole life policies from Guaranty Income Life Insurance Company (GILICO) and that the Fund prepay three years of premiums to qualify for a discount on the second- and third-year premiums. By persuading the Fund to prepay, Lancaster and JDL were entitled to commissions of 85% of the first year's premiums, 55% of the second year's, and 10% of the third year's. Lancaster neither disclosed to the trustees the amount of his fees and commissions, nor revealed that JDL was regional manager for GILICO and subject to a $500,000 production goal on first-year life insurance premiums.

In 1984, Lancaster proposed, and the trustees approved, the purchase of an additional $10,000 whole life policy from GILICO for each participant. Again JDL received substantial commissions. Lancaster also bought stop loss, group-term life, and accidental death and dismemberment insurance on the Fund's behalf and billed the Fund higher premiums than he remitted to the insurance companies. Lancaster kept these "premium differentials," which were in addition to the commissions and fees the Fund paid.

In 1985, the trustees canceled the Fund's GILICO policies and requested a refund of the policies' cash values and the unearned and prepaid premiums. The Fund then bought a $25,000 universal life policy from American General Life Insurance Company (AGLIC) for each participant. AGLIC, in turn, paid commissions to JDL and Lancaster's sons, who were employees, officers and directors of JDL and DCI. By the end of 1985, the Fund had spent nearly $1 million on life insurance premiums, and Lancaster and his companies had received more than $550,000 in commissions.

The DOL brought suit against Lancaster, JDL and DCI, alleging various ERISA fiduciary violations. The district court found that the defendants violated multiple ERISA provisions. The court entered judgment against Lancaster and JDL, ordering them to pay the Fund for losses incurred from the purchase of whole life policies instead of group-term life insurance, for commissions received by the defendants and Lancaster's sons, and for excessive and unreasonable compensation in the form of consulting fees, commissions and premium differentials. The court also enjoined the defendants from serving as fiduciaries or service providers to any ERISA plan.

On appeal, Lancaster and JDL challenged all of the district court's findings, the money judgment and the injunction. The threshold issue was the district court's finding that the defendants were Fund fiduciaries. The defendants argued that Lancaster was merely a consultant and salesman, that a professional does not become a fiduciary merely by giving professional advice, and that Lancaster and JDL did not cause the Fund trustees (who were responsible for the Fund's decision making and operations) to give up their independent discretion. Further, the defendants argued that JDL was merely a claims-paying administrator who performed the "ministerial" duty of processing and paying claims.

The Fifth Circuit examined first the district court's finding that JDL had sufficient discretionary authority in managing or administering the Fund to be a fiduciary. The administrative services agreement between JDL and the Fund specified not only that JDL would provide claims services, but also that it would perform administrative, actuarial and consulting services. Administrative services included providing advice and assistance on the plan and subsequent revisions and conferring with the trustees on tax, insurance and other issues that might affect Fund administration. Consulting services included advice and recommendations on proposed plan changes and costs, and analysis and recommendations on bid specifications, insurance company proposals and alternative funding methods. Further, JDL had the authority and obligation to investigate, process and approve claims, compute and determine benefits, maintain claim files, and draw checks on an account to pay plan benefits.

The court recognized that a third-party administrator who merely performs ministerial duties or processes claims is not a fiduciary; however, it also noted that having discretionary authority to approve or deny claims may make one a fiduciary. The court concluded that, given the breadth of JDL's discretion in managing and administering the Fund the district court had not clearly erred in elevating JDL to the status of fiduciary.

As to Lancaster's status, the court noted that discretion is the benchmark for fiduciary status under ERISA, and in some situations, an adviser's influence may become so great it confers effective discretionary authority. Here, the Fund was managed by a group of trustees who had no experience or expertise in insurance matters. The trustees accepted every recommendation Lancaster made regarding health insurance, life insurance and Fund investments. According to the court, the record supported the determination that Lancaster usurped the trustees' independent discretion and effectively exercised authority and control over management and administration of the plan with respect to the insurance policies. Thus, the district court did not clearly err in finding that Lancaster was the decision maker (and a fiduciary) when it came to insurance purchases and the payment of compensation to those who procured it on the Fund's behalf.

This case sounds a warning to service providers who are heavily relied on by a plan's "real" fiduciaries. In dealing with inexperienced or unsophisticated clients, service providers must avoid decision making responsibility, so as to avoid fiduciary responsibility.

* Amendment procedures on plan termination

The Third Circuit, in Ackerman v. Warnaco Inc.,[50] concluded that a welfare benefit plan termination gives rise to ERISA Section 402(b)(3) amendment procedures, a position conflicting with the Eleventh Circuit's decision in Aldridge v. Lily-Tulip, Inc.[51]

Warnaco's 1988 employee handbook outlined the circumstances under which it would pay a "termination allowance" to terminated employees. In a December 1990 memorandum, a Warnaco officer stated that the termination allowance program was being eliminated, and directed that meetings be held to inform all employees of the change. In january 1991, Warnaco's president sent a letter to all employees advising them about unfavorable economic conditions, and making a general reference to "changes in our severance policy." Later that year, the company published a revised employee handbook reflecting the program's elimination.

Employees at Warnaco's Altoona, Pennsylvania, plant were never invited to a meeting notifying them of the program's elimination, and never received the revised handbook. Rather, the Altoona employees first heard of the program's termination at a january 1992 meeting held to discuss the Altoona plant closing. Employees asked at that meeting if they would be receiving severance benefits under Warnaco's termination allowance program and were told that the program had been terminated.

A number of the Altoona employees terminated due to the plant closing sued Warnaco in district court, contending that the elimination of the termination allowance program was void because Warnaco had failed to comply with ERISA Section 402(b)(3) amendment procedures. They argued that even if the rescission of the program was properly adopted, it was void with respect to Altoona employees who did not receive adequate notice of the change. The district court granted Warnaco summary judgment, concluding that a complete rescission of a welfare benefit plan does not implicate the amendment procedures required by ERISA Section 402(b)(3). Whether or not the employees received adequate notice of the program's elimination, their claim for benefits was barred because a procedural defect, like defective notice, does not give rise to a substantive remedy under ERISA; further, no genuine issue of material fact existed as to whether Warnaco intentionally misled Altoona employees by not timely disclosing the program elimination. ERISA Section 402(b)(3) requires an employee benefit plan to include a procedure for amending the plan and for identifying the person(s) authorized to amend it. On appeal, the Third Circuit found it "anomalous" to suggest that ERISA offers employees protection from mere changes in employee benefit plans, but does not afford protection against wholesale elimination of benefits. Recognizing the Eleventh Circuit's differing view in Lily-Tulip, the Third Circuit concluded that

ERISA Section 402(b)(3)'s requirements apply to plan terminations as well as to plan amendments, and remanded the case to the district court for further proceedings. The issue to be determined on remand is whether Warnaco complied with its plan amendment procedure. According to the Third Circuit, the answer will depend on a fact-intensive inquiry into whether Warnaco's management actually approved the new plan provision eliminating the termination allowance program.

Citing a string of earlier decisions, the Third Circuit stated that under ordinary circumstances defects in fulfilling ERISA's reporting and disclosure requirements generally do not give rise to a substantive remedy. Thus, the court stated it could not void the elimination of the termination allowance program even if, as a result of Warnaco's negligence, it failed to notify the Altoona employees of the program's termination within 210 days after the end of the plan year in which the change was adopted (as required by ERISA Section 104(b)(1)), or failed to make available for examination at the plan administrator's principal office a copy of governing plan documents, including any bona fide plan amendments (as required by ERISA Section 104(b)(2)).

The Third Circuit then noted that the remedy sought -- voiding the change -- might be appropriate if the plaintiffs could demonstrate the presence of "extraordinary circumstances." The court rejected the district court's finding that there were no extraordinary circumstances. According to the Third Circuit, one could reasonably infer from the facts that Warnaco had actively concealed its changed severance policy to prevent Altoona plant employees from leaving. In that court's view, if such concealment is found, it would be inappropriate to deprive the plaintiffs of the remedy of voiding Warnaco's rescission of the termination allowance policy. The Third Circuit thus reversed the district court's grant of summary judgment on this issue and remanded to determine if Warnaco had actively concealed the change.

(37) Rev. Proc. 95-24, IRB 1995-18, 7. (38) Ann. 95-33, IRB 1995-19, 14. (39) 60 Fed. Reg. 20874 11995). (40) TD 8599 (7/18/95). (41) Albertson's, Inc., TC Memo 1988-582, aff'd, 95 TC 415 (1990), rev'd, 12 F3d 1529 (9th Cir. 1993)(73 AFTR2d 94-558, 94-1 USTC [paragraph]50,016), reh'g granted, 38 F3d 1046 (9th Cir. 1993)(73 AFTR2d 94-1721, 94-1 USTC [paragraph]50,016), vac'd and aff'd in part, 42 F3d 537 (9th Cir. 1994)(74 AFTR2d 94-7072, 94-2 USTC [paragraph]50,619), cert. denied. (42) Notice 94-96, 1994-2 CB 564. (43) Notice 95-50, IRB 1995-42, 1; IR 95-56 (9/29/95). (44) IA-17-94, EE-36-94 (12/16/94); Prop. Regs. Secs. 1.132-5 and 1.62-2. (45) Fred G. Jensen v. SIPCO, Inc., 38 F3d 945 (8th Cir. 1994). (46) Citing Firestone Tire & Rubber Co. v. Bruch, 489 US 101, 112 (1989), citing Restatement (Second) of Trusts, [sections]4, Comment d (1959). (47) Curtiss-Wright Corp. v. Frank C. Schoonejongen, 115 Sup. Ct. 1223 (1995). (48) Mertens v. Hewitt Associates, 113 Sup. Ct. 2063 (1993). (49) Robert Reich v. Ferry D. Lancaster, 55 F3d 1034 (5th Cir. 1995). (50) Valerie J. Ackerman v. Warnaco, Inc., 55 F3d 117 (3d Cir. 1995). (51) Allan C. Aldridge v. Lily-Tulip, Inc., 40 F3d 1202 (11th Cir. 1994).

Authors'note: The authors gratefully acknowledge the contribution to this article of Amy L. Miller, of KPMG Peat Marwick's Compensation Benefits Practice in Baltimore, Md.
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Title Annotation:part 2
Author:Walker, Deborah
Publication:The Tax Adviser
Date:Dec 1, 1995
Previous Article:Significant recent developments in estate planning.
Next Article:Technology is an invaluable tool in the tax practice.

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