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Revenue Reconciliation Act of 1993; Voluntary Compliance Resolution program; fiduciary responsibilities; distribution rules; excise taxes.

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part 1, below, will focus on current developments affecting qualified retirement plans, including the effect of the Revenue Reconciliation Act of 1993 (RRA) on qualified plans, the Voluntary Compliance Resolution program and other plan qualification issues, fiduciary responsibilities, including the Department of Labor (DOL) regulations under Section 404(c) of the Employee Retirement Income Security Act of 1974, (ERISA), and distribution rules. Part II, to be published in December, will focus on executive compensation and employee benefits issues, including the impact of the RRA, DOL and ERISA developments, and the Family and Medical Leave Act.

The Revenue Reconciliation Act of 1993

Under pre-RRA Sec. 401(a)(17), compensation in excess of $200,000 annually (indexed for inflation; the 1993 limit is $235,840) could not be considered when calculating the level of retirement benefit that may be paid to an employee or the level of contribution that may be made to an employee's retirement plan. As amended, this limit is reduced to $150,000 for plan years beginning after 1993.(1) Previously accrued benefits are not affected.(2)

The $150,000 limit will be indexed for inflation in years after 1994, but only when the indexed limit reaches an increment of $10,000 in excess of $150,000. Transition rules are provided for certain participants in retirement plans of state and local governments, and for certain collectively bargained plans.

The reduction in this limitation will create or aggravate problems for Sec. 401(k) plans that struggle to pass their actual deferral percentage (ADP.) and actual contribution percentage (ACP) tests under Secs. 401 (k) and 401 (m). By decreasing the denominator for the highly compensated employees (HCEs), the deferral percentage for the HCEs will increase and the ability of HCEs to defer funds into the Sec. 401 (k) plan will decrease. Due to the mechanics of the testing, it will typically be the mid-level executives, whose contributions represent a higher percentage of their total compensation, rather than the executives whose compensation exceeds $150,000, whose ability to defer compensation will be cut back the most.

The $150,000 ceiling will markedly increase the use of excess benefit plans and similar nonqualified deferred compensation vehicles in order to provide retirement incentives for employees whose qualified plan benefits are being curtailed. The increase in the top marginal individual income tax rates to 36% and 39.6%, versus the maximum 35% corporate rate, also improves the attractiveness of nonqualified deferred compensation.(3) While there are various qualified plan design features that could be implemented (e.g., using an age weighted or cross-testing allocation formula, or integrating the plan with social security), many employers will find these more costly and confusing to employees than the increased retirement benefit realized by the HCEs. Employees who currently contribute 15% of compensation to a profit-sharing plan may find that the new limit decreases the allowable contribution below the $30,000 limit of Sec. 415(c)(1). If employees are in this position, employers should consider adoption of a money purchase pension plan to limit the effect of this negative result.

Qualification Issues

* Voluntary Compliance Resolution program

In Rev. Proc. 92-89,(4) the IRS unveiled its Voluntary Compliance Resolution (VCR) program. Originally scheduled to expire on Dec. 31, 1993, the program has been modified and extended through Dec. 31, 1994 by Rev. Proc. 93-36.(5) In addition, this announcement expanded the types of defects that can be corrected under VCR; provided additional guidance on plans that should use the remedial amendment period rather than the VCR program; outlined general principles that should be followed in suggesting acceptable corrections; and established a new "Standardized VCR Procedure" (SVP) applicable for certain limited defects.

The program is administered by the IRS National Office, and is available only for plans with determination letters under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the Deficit Reduction Act of 1984 (DRA) and the Retirement Equity Act of 1984 (REA). Plans under examination or plans that have received written or oral notice of examination are not eligible for the VCR program; however, if a plan sponsor has some plans under examination, other plans of that sponsor may be eligible. Under the VCR program as originally announced, a plan that is aggregated for nondiscrimination purposes with a plan under examination was not eligible for the VCR program. Rev. Proc. 93-36 modified that standard to permit a plan that is aggregated with a plan under examination to use the VCR program for defects not related to provisions for which the plans are aggregated.

To qualify for the VCR program, plan sponsors have to identify qualified plan defects, propose to the IRS a plan for full correction of the defects and pay a fixed compliance fee. The IRS will rely on the plan sponsor's statements in identifying, the plan's operational defects and will not conduct a plan examination to find other defects. The plan sponsor receives a compliance statement describing the terms of full correction. After the sponsor implements the corrections and procedures set out by the IRS, the IRS reserves the right to require verification that the corrections have been made and the procedures implemented. However, information given by the plan sponsor under the program will not be used as the basis of an IRS employee plans examination. The compliance fees range from $500 for plans with less than $500,000 in assets and no more than 1,000 participants to $10,000 for plans with more than 10,000 participants.

Only operational defects are eligible for the VCR program. Exclusive benefit violations relating to the misuse or diversion of plan assets, egregious violations or operational defects creating income or excise tax issues, such as funding deficiencies or prohibited transactions, are not eligible for resolution under the program.

Rev. Proc. 93-36 provides examples of egregious violations, such as those involving consistent and improper coverage of only HCEs or self-employed plan contributions several times greater than the Sec. 415 dollar limit. If a plan requesting a VCR compliance statement is found to have egregious violations, the request will be sent to the appropriate Key District Office for processing under the Closing Agreement Program (CAP).

Rev. Proc. 93-36 outlines general principles for plan sponsors suggesting correction methods. The correction should restore active and former employees to the benefit levels they would have had if the defect had not occurred. Former employees should be sought out, including through the use of the IRS forwarding service. The correction should restore the plan to the position it would have been in had the defect not occurred. The correction should not violate another Sec. 401(a) requirement. The correction method should, if possible, resemble one already provided in the Code, regulations or other publications. The correction should keep the assets in the plan, except to the extent the Code, regulations or other publications already provide for distribution. Corrective allocations to a defined contribution plan must be adjusted for earnings and forfeitures that would have been allocated during the applicable period. Corrective contributions should come only from employer contributions, including forfeitures, if the plan permits. A corrective contribution to a participant's account because of failure to allocate the contribution in a proper limitation year will be considered an annual addition for the limitation year to which it relates, not the limitation year in which it is actually made.

The SVP program is available for a limited class of defects using the specified correction methods. The fee for the SVP is $350, regardless of the number of participants involved. The types of defects eligible to use the SVP program are failures to provide the minimum top-heavy benefit under Sec. 416, failures to satisfy the ADP tests for Sec. 401(k), ACP tests for Sec. 401(m) or the multiple use test under Sec. 401(m)(9), failures to distribute deferrals exceeding the Sec. 402(g) limit, or the exclusion of an eligible employee from plan participation.

Rev. Proc. 93-36 outlines the procedure for submitting an SVP notification letter and general principles for using the SVP approach. Excise taxes due, if any, must be paid. Contributions must include any earnings that would have been applicable. The plan may have to be amended to permit the correction method. Even though the defect may be eligible for the SVP, the ordinary VCR program process may be used as well.

* Failure to amend

The Tax Court issued decisions in Hamlin Development Co.(6) and Mills, Mitchell & Turner(7) upholding plan disqualifications and determination letter revocations for failure to timely amend qualified plans that had previously received determination letters.

The Hamlin Development Co. established a defined benefit plan in 1980, and the plan received a favorable determination letter in 1983. Hamlin was owned by Charles Faulkender, the sole shareholder and the plan's trustee. In October 1988, the IRS informed the plan of the examination of the plan's Form 5500-R, Registration Statement of Employee Benefit Plans, and asked for evidence showing plan amendments under the TEFRA, DRA and REA. Hamlin did not provide any documentation of the amendments. In December 1988, all assets of the plan were distributed, with over $200,000 going to Faulkender and the remaining approximately $12,000 in assets going to six other participants. In 1989, the IRS notified the plan of its intention to disqualify the plan for plan years ending after Mar. 31, 1985, and of the plan's right to seek an administrative appeal. Hamlin did not appeal. Only after the IRS issued a final revocation letter did Hamlin take any action.

Hamlin petitioned the Tax Court, claiming that the plan had operated in compliance with the TEFRA, DRA and REA, and therefore should not be disqualified because of violations of form. Hamlin also urged mitigating circumstances, citing Faulkender's serious illness, which began in 1986.

The court rejected both of these arguments in a lengthy opinion, noting:

Although the changes included in the Acts could be construed by some employers, such as petitioner, to be voluminous and unnecessary for their particular plan, Congress has decided that these changes are necessary in the retirement plan area and we do not second guess its wisdom.(8)

The court dismissed the mitigating factor of Faulkender's illness, saying that the plan was on notice of the need to amend long before the illness. In addition, even after the illness, the actuaries continued to provide actuarial reports, giving evidence of the fact the plan had the "resources and ability to timely amend the Plan to make it consistent with the Acts."

In Mills, Mitchell & Turner, the court rejected a law partnership's arguments that its amendments met the requirements of the Sec. 401(b) remedial period. The firm had adopted a defined benefit plan in 1984, and received a favorable determination letter in 1985. The letter reserved determination on whether the plan met the requirements of the DRA and REA. In 1988, the firm submitted a request on the amended plan. In December 1988, the IRS issued a favorable determination letter for years beginning after Dec. 31, 1987--but it also proposed to revoke the 1985 letter and to disqualify the plan for the 1985, 1986 and 1987 plan years because the plan was not amended to comply with the DRA and REA in a timely manner.

The firm argued that its amendments were retroactively effective to meet the applicable deadlines. In rejecting this argument, the court found the remedial provisions of Sec. 401(b) would not cover the firm's failure to amend for the DRA and REA. The court also found that the firm failed to demonstrate reasonable diligence. Finally, the court rejected the firm's argument that the IRS should be equitably estopped from retroactively disqualifying the plan.

While these decisions are a correct interpretation of the law, they appear to exalt form over substance. In neither case were arguments presented that the plan sponsors acted in bad faith or that plan participants were harmed. Notwithstanding this, taxpayers should be aware there is no judicial precedent that ignores the sanction of plan disqualification. Negotiation with the IRS, either through the CAP or VCR program, is a taxpayer's only practical alternative.

* Examination guidelines

As announced last year, the IRS has moved forward with its enforcement program for qualified plans. It has issued a series of announcements detailing guidelines for employee plans examiners. Ann. 92-182(9) included guidelines for examining prohibited transactions in defined contribution plans and the valuation of assets. Ann. 93-9(10) provided examination guidelines for plans terminating without a determination letter. The most recent action was the release of Ann. 93-105,(11) covering examinations of Sec. 401(k) plans, Sec. 401(m) employer contributions, lump-sum distributions from defined benefit plans, and joint and survivor annuity provisions.

In each case, the IRS cautioned that the guidelines are not meant to be all inclusive, are not a precedent or comprehensive statement of the IRS'slegal position on the issues, and cannot be relied on or cited as authority.

The prohibited transaction guidelines focus on defined contribution plans, other than employee stock ownership plans (ESOPs), that acquire or hold employer securities or employer real property. The plan asset valuation guidelines apply to all plans. These guidelines specifically state that the valuation division of an accounting firm used for tax and audit services by an employer sponsoring an ESOP may still be an "independent appraiser" for purposes of valuing ESOP stock so long as the valuation division does a majority of its appraisals for entities unrelated to the employer maintaining the ESOP.

The guidelines for terminated plans specifically address terminated plans' compliance with Secs. 410(b) 401(a)(26), 401(a)(17), 401(l), 401(a)(4), 415, 401(a)(11) and 417. The guidelines also cover partial terminations and employer reversions.

Examples of instructions in the guidelines include asking for substantiation for Sec. 410(b) coverage for plans using the line of business, aggregation, restructuring or average benefits tests to meet coverage. The guidelines also require a schedule of information to back up Sec. 415 compliance. Examiners are instructed to determine if each participant received the necessary notices under the qualified joint and survivor annuity rules for payouts other than in an annuity form.

The Sec. 401(k) guidelines support the earlier IRS position that plan restructuring was permissible for Sec. 401(k) and 401(m) tests for plan years 1989, 1990 and 1991, but not for other plan years. The guidelines recommend that examiners verify that any methods used to correct excess contributions are specified in the plan document, and establish whether corrections were made in a timely manner and included any gains or losses if necessary. The guidelines also recommend that examiners determine whether the employer ties any benefits other than matching contributions to making contributions and that they ask whether employees who make elective contributions get any special treatment from the employer.

The guidelines provide a few hints on the nature of the description of "hardship" for those plans that do not use the deemed hardship distribution rules. The guidelines also note that the employer may rely on the employee's representations of hardship unless the employer has actual knowledge to the contrary.

Guidelines on lump-sum distributions from defined benefit plans or other benefits subject to Sec. 417(e) focus on specific requirements under that section. Collateral issues are also discussed, including whether the plan benefits are definitely determinable, the actuarial equivalency requirements for different forms of distributions and the related compliance with Sec. 411(d).

The guidelines for examining the qualified joint and survivor rules set out the historical background of the requirements, address which plans are covered by the survivor annuity requirements, and focus on the notice, election and consent requirements. After determining that the plan is in fact subject to Sec. 412 (minimum funding standards) and, hence, joint and survivor rules, examiners are instructed to determine whether the plan provides for a qualified joint and survivor annuity or a preretirement survivor annuity. If the required survivor annuity language is not found, the plan is disqualified.

Plan administrators and their advisers should focus on these guidelines and weaknesses in their plan operations to determine whether an audit would likely reveal plan disqualification issues.

Fiduciary Responsibilities

* Participant directed accounts

The DOL regulations effectuating the limited fiduciary liability provided by ERISA Section 404(c) for retirement plans having individual accounts and permitting a participant or beneficiary to exercise control over the assets in those accounts generally will be effective for the second plan year beginning after Oct. 13, 1992.(12) While compliance with the regulations is optional, compliance will protect plan fiduciaries from liabilities as a result of a participant's investment direction. Many believe that one should comply with the regulations so that the fiduciary is protected against an argument that the regulations could have been complied with, but were not.

Under the final ERISA Section 404(c) regulations; a plan participant will be considered to exercise control over the individual account only in those plans providing at least three diversified investment options, permitting transfers among those options at least quarterly and providing investment information on all investment options. Once the plan satisfies these exercise-of-control regulations, two narrow limits on ordinary ERISA fiduciary liability are available. First, the plan participant or beneficiary will not be treated as a fiduciary of the plan simply because he exercises control over the individual account. Second, no other plan fiduciaries will be liable for breaches of fiduciary duties or losses resulting from the actions of the participant or beneficiary.

Although plan fiduciaries covered by ERISA Section 404(c) are not liable for the actions of plan participants exercising control of participant accounts under ERISA's fiduciary duties, plan fiduciaries may still be liable for other fiduciary breaches under other parts of ERISA or under the tax laws. All fiduciary provisions of ERISA apply to the initial designation of the investment alternatives and investment managers and the ongoing determination that such alternatives and managers remain suitable and prudent. Fiduciary duties under the Sec. 4975 prohibited transaction provisions or other parts of ERISA are also not affected.

To be qualified as "an ERISA section 404(c) plan" under the regulations, the plan must be an individual account plan in which the participant both (1) has an opportunity to exercise control of the assets in his individual account and (2) chooses from a broad range of investments.(13)

The participant has an opportunity to exercise control only if he has an opportunity to give an identified plan fiduciary investment instructions and obtain confirmation in writing, and if he has the opportunity to obtain sufficient information from an identified plan fiduciary to make informed decisions on investment alternatives and on the ownership rights to such investments. Participants must be provided with certain information automatically--not just offered that information. This includes an explanation that the plan is intended to be an ERISA Section 404(c) plan, and, as such, fiduciaries of the plan are relieved of liability for participant choices and actions. Participants must also be given descriptions of investment alternatives, including objectives, risk and return; explanations of how and what investment directions may be given; and the name of the fiduciary charged with providing information.

The regulations cite three specific types of restrictions a plan may apply that will not constitute a failure to exercise control.(14) First, the plan may impose charges for reasonable expenses. Second, a fiduciary may refuse to implement instructions that would violate the provisions or the ordinary operating procedures of the plan or would jeopardize the tax status of the plan. Finally, the plan may impose reasonable restrictions on the frequency of investment instructions.

To constitute the "broad range of investment alternatives" required by the regulations, the available investment alternatives must provide a participant with reasonable opportunity to materially affect the potential return and risk of his account by being able to choose from at least three alternatives, each of which is diversified; each of which has materially different risk and return characteristics that in the aggregate permit a participant to choose a portfolio with risk and returns appropriate for the participant; and which, when combined with other alternatives, tends to minimize risk through diversity.(15)

As the ERISA Section 404(c) regulations become effective, it will be important for plan fiduciaries and their advisers to review plan operations to determine if minor modifications will enhance compliance. Those choosing not to comply should do so with an understanding of the risks they are accepting.

* Who is a plan fiduciary?

In a decision applicable to all professionals who render services to plans, the Supreme Court ruled in Mertens v. Hewitt Associates(16) that a nonfiduciary who knowingly participates in the breach of an Erisa-mandated fiduciary duty is not liable for losses to an employee benefit plan because of the breach. In this case participants sued Hewitt Associates, the consultants performing actuarial work for the defined benefit plan, because benefits were underfunded as a result of inappropriate actuarial assumptions. Hewitt had delegated to the employer the responsibility for selecting actuarial assumptions.

The participants essentially argued three independent claims under ERISA: a claim for breach of fiduciary duty; a claim for knowing participation in a breach of fiduciary duty; and a claim for nonfiduciary breach of actuarial duties. The District Court dismissed all the participants' ERISA and state law claims and ruled in favor of Hewitt. The Ninth Circuit affirmed the District Court on the ERISA issues, but reversed and remanded to the lower court the state claims issues.

In addressing the fiduciary claims, the Ninth Circuit reviewed the statute and the case history, noting that an ERISA fiduciary includes anyone who exercises discretionary authority over the plan's management, anyone who exercises authority over the management of the plan's assets and anyone having discretionary authority or responsibility in the plan's administration.(17) The court relied heavily on its earlier finding in Nieto v. Ecker,(18) holding that a party rendering professional services to a plan is not a fiduciary if he does not exercise any authority over the plan other than by the usual professional functions.

In addressing the participants' argument that Hewitt was still liable under ERISA if it knowingly participated in another's breach of fiduciary duty, the Ninth Circuit relied on its earlier judgment in Nieto that ERISA Section 409(a) "limits its coverage to fiduciaries, and nothing in the statute provides any support for holding others liable under that section," and thus rejected the argument that a nonfiduciary could be liable under that section for knowing participation in a breach of fiduciary duty. The court also rejected the participants' argument that amendments to ERISA subsequent to Nieto expanded Section 409(a). In fact, the court noted that Congress had specifically considered overruling Nieto but refused to do so.

The court gave short shrift to the participants' claim under ERISA Section 502(a)(3), which provides that plan participants may seek equitable relief to redress violations of ERISA, seeking a recovery of money from Hewitt for alleged improper acts. The court found no unjust enrichment on Hewitt's part.

The Supreme Court upheld the Ninth Circuit's decision, and held that the participants were seeking compensatory damages, not a traditional equitable-type remedy such as restitution or injunction.

The dissenters in this 5-4 decision argued that "appropriate equitable relief" could be interpreted as relief that was available in the courts of equity under a breach of trust, which included compensatory damages against both trustees and nonfiduciaries. They argued further that ERISA codified common law. In their view, the majority opinion leaves those that Congress intended to protect with less protection than they had under pre-ERISA law.

Excise Taxes

* Prohibited transactions

With one dissenting vote, the Supreme Court held in Keystone Consolidated Industries, Inc.(19) that a disqualified person's transfer of unencumbered property to a defined benefit plan is a prohibited transaction when the transfer is in satisfaction of the minimum funding requirements. The Court's holding overturned the Fifth Circuit's decision, which had upheld the Tax Court's conclusion that such a transfer does not violate the prohibited transaction rules.

In 1983, Keystone contributed five truck terminals to defined benefit plans and credited the fair market value (FMV) of those terminals against its minimum funding obligation for its tax years ending in 1982 and 1983. In 1984, Keystone contributed some real property to the trust and credited the FMV of that property against its minimum funding obligation for its tax year ending in 1984. At the time of the contributions, neither the real property nor the terminals were subject to any encumbrances.

Keystone deducted the FMV of these properties on its 1982, 1983 and 1984 tax returns as contributions to its pension plans, and reported the difference between its basis in the properties and their FMV as taxable capital gain. The IRS determined that the contributions were prohibited transactions and issued Keystone a deficiency notice imposing excise taxes under Sec. 4975(a).

Sec. 4975(a) imposes an excise tax on a disqualified person who engages in a prohibited transaction. The sale or exchange of property between a qualified plan and a disqualified person (e.g., the employer) generally constitutes a prohibited transaction. Further, Sec. 4975(f)(3) provides that the transfer of encumbered property by a disqualified person to a plan is treated as a sale or exchange if the plan assumes the debt or if the encumbrance was placed on the property by the disqualified person within the 10-year period ending on the date of the transfer. ERISA contains a parallel set of rules at Sections 406(a)(1)(A) and 406(c).

The IRS's position was that a transfer of encumbered property is not the only type of property transfer that is treated as a sale or exchange under the prohibited transaction rules. Involuntary transfers--i.e., transfers to satisfy the minimum funding requirements--are to be treated as a sale or exchange regardless of whether they involve encumbered property, under the income tax principle that a transfer in satisfaction of a debt is treated as a sale or exchange.

In the majority opinion, the Supreme Court called the IRS's interpretation of Sec. 4975 "a sensible one." According to the Court, the logic behind treating a transfer of property in satisfaction of a debt as a sale or exchange is equally applicable in prohibited transaction cases as in income tax cases--and Congress was presumably aware when it enacted Sec. 4975 that the phrase "sale or exchange" had consistently been construed to include transfers of property in satisfaction of a debt. Unlike the Fifth Circuit, the Supreme Court did not view Sec. 4975(f)(3) as limiting the meaning of "sale or exchange." Rather, the Court agreed with the IRS's position that Congress intended Sec. 4975(f)(3) to expand the scope of the prohibited transaction rules: It extended the reach of "sale or exchange" in Sec. 4975(c)(1)(A) to include contributions of encumbered property that were not made in satisfaction of funding obligations.

According to the Court, Congress's goal in enacting Sec. 4975 was to bar transactions that are likely to injure pension plans, such as a sponsor's sale of property to the plan at an inflated price, or the sponsor's satisfying a funding obligation by contributing property that is overvalued or nonliquid. Concerns about overvaluation, liquidity and the need to maintain an independent investment policy characterize any contribution of property that satisfies a funding obligation--whether or not the property is encumbered. When a plan gives up an account receivable in exchange for property, it runs the risk of giving up more than it is getting in return if the property is either less valuable or more burdensome than a cash contribution would have been.

While ruling against the taxpayer, the Supreme Court, in a footnote to the opinion, did imply that if the plan did not have a required contribution (e.g., a profit-sharing plan), the contribution would not be a sale or exchange. Thus, employers without available cash should be able to contribute property to a profit-sharing plan without fear that this would be an indirect sale.

Transfer of Liabilities Between Defined Benefit Plans

IRS Letter Ruling 9318035(20) strongly implies that it is permissible to transfer accrued benefits and no assets from an underfunded defined benefit plan to an overfunded defined benefit plan maintained by the same employer, provided that after the transfer the transferee plan is still overfunded on a termination basis.

The employer maintained two qualified defined benefit pension plans. Plan A, originally established for the employer's salaried employees, was overfunded on a termination basis; Plan B, originally established for the employer's nonsalaried employees, was underfunded on a termination basis. In 1989, as a result of plan amendments made to comply with the Tax Reform Act of 1986 (TRA), approximately 330 employees who had been participants in Plan B ceased accruing benefits under Plan B and instead became participants in Plan A.

The employer wanted to transfer from Plan B to Plan A all the liabilities of those employees who were previously covered by Plan B, but who were either currently accruing benefits under Plan A or had accrued benefits under Plan A but had since terminated employment. Plan A would continue to be overfunded after the transfer. The employer requested rulings that it would not recognize income or be subject to the reversion excise tax as a result of the transfer, and that the transfer would not violate the exclusive benefit rule of Sec. 401(a)(2) or the merger/consolidation rule of Sec. 414(l). The IRS refused to rule on the two qualification issues, but it issued favorable rulings on the two tax issues.

Under the "inclusionary" portion of the tax benefit rule' as formulated by the Supreme Court in Hillsboro National Bank,(21) a taxpayer generally has income when an event occurs in a subsequent year that is fundamentally inconsistent with a deduction taken in an earlier year. The determination that must be made under this test is whether the subsequent event would have foreclosed the earlier deduction had the subsequent event and the event that gave rise to the deduction occurred in the same year. Here, the IRS found that the transfer of liabilities from Plan B to Plan A was consistent with the earlier deduction, in that the liabilities were attributable to accrued benefits of employees previously covered under Plan B but now covered under Plan A. As such, the IRS ruled that the transfer would not cause the employer to recognize income.

For purposes of the Sec. 4980 excise tax on employer reversions from qualified plans, "employer reversion" means the amount of cash and the FMV of other property received, directly or indirectly, by an employer from a qualified plan. The IRS concluded that, for the same reasons that the transfer of liabilities would not cause the employer to recognize income for income tax purposes, the transfer would not give rise to an excise tax under Sec. 4980.

Although the IRS did not address the qualification issues, it seems unlikely that the IRS would issue the two favorable tax rulings unless it also believed the transaction would pass muster under Sec. 401(a). This can be a useful way to control funding costs for a defined benefit plan. If an employer has two plans, it is important to evaluate carefully whether assets in an overfunded plan can be used to decrease a funding liability in an underfunded plan.

Distribution Rules

The IRS issued two notices that provide additional guidance on the rollover and withholding provisions amended by the Unemployment Compensation Amendments of 1992 (UCA), and the proposed and temporary regulations implementing these provisions, effective Jan. 1, 1993.

Notice 93-3(22) provided guidance on the direct rollover, 60-day rollover and 20% income tax withholding provisions. The notice addressed the treatment of distributions attributable to qualified plan loans, the treatment of payments required under Sec. 401(a)(9) and the application of withholding to net unrealized appreciation from employer securities.

The notice divided distributions attributable to qualified plan loans into two categories: "deemed distributions," occurring when Sec. 72(p)(2) is not satisfied, and "offset distributions," occurring when the participant's accrued benefit is reduced to repay the loan. "Deemed distributions" cannot be "eligible rollover distributions," but offset distributions will be treated as eligible rollover distributions. A plan need not provide for a direct rollover option for offset distributions. The notice specifically provided that an offset amount is treated the same way as employer securities for purposes of withholding. The offset amount must be included in the amount multiplied by 20% to calculate the withholding, but the total amount required to be withheld from an eligible rollover distribution should not exceed the amount of cash and the FMV of the property the participant receives in the distribution, excluding the offset amount and employer securities.

Under the notice, the entire amount of any distributions from defined benefit or insurance company annuities paid to an employee after January 1 of the year the employee attained age 70 1/2 is ineligible for treatment as an eligible rollover distribution. Any such annuity payment or distribution from an individual account paid before january 1 of the year in which the employee attained age 70 1/2 is eligible to be treated as an eligible rollover distribution if the distribution meets the other requirements of that term's definition.

If net unrealized appreciation (NUA) from employer securities is excluded from income under Sec. 402(e)(4), the NUA is excluded from the amount of the eligible rollover distribution subject to 20% withholding. Such NUA is not a "designated distribution" under Sec. 3405(e)(1)(B), and thus is not subject to withholding under that section.

In Notice 93-26,(23) the IRS provided additional guidance on the UCA changes and on the consent requirements under Sec. 411(a)(11). This new guidance permits a plan participant who has received the tax-treatment notice required by Sec. 402(f) to waive the 30-day waiting period before his qualified plan benefit can be distributed or rolled over. The changes also specifically state that payments from an annuity contract that has been distributed to a participant may qualify for the Sec. 402(c) rollover rules if the payments otherwise fit those rules. For example, if a participant receives the annuity contract and then surrenders it for a single cash payment, that payment would be eligible for rollover treatment and would be subject to mandatory withholding if the amount were not rolled over.

In order to accept a waiver of the 30-day waiting period, the plan administrator must observe two requirements. First, the participant must be given the opportunity to take at least 30 days to make his distribution decision. Second, the participant must receive information that clearly indicates the right to this 30-day time period. The IRS suggests this information could be added to the standard Sec. 402(f) notice, though the plan administrator can use any other reasonable method of notice. The 90-day period is not changed for either Sec. 402(f) or Sec. 411(a)(11). Thus, the notice of rights of distribution under both those sections cannot be given to participants more than 90 days before the actual distribution. Presumably the idea of simply making a Sec. 402(f) notice available, for example, in a summary plan description, continues to be unacceptable because such a notice would be provided more than 90 days before the distribution date.

These changes do not affect the timing of the notice regarding qualified joint and survivor annuity (QJSA) options under Secs. 401 (a)(11) and 417 and the regulations for those sections. The 30/90-day rule applied by those sections requires that a written explanation of the QJSA options be provided no less than 30 days or more than 90 days before the annuity starting date. Thus, a 30-day waiting period running from the delivery of the QJSA explanation to the distribution date may be required for distributions from such plans.

These changes are effective for distributions on or after Jan. 1, 1994; however, parties may rely on this guidance as though it were provided in the temporary UCA regulations and the final regulations under Sec. 411(a)(11).

Corrections of Excess Annual Additions

Rev. Proc. 92-93(24) provided guidance on the proper reporting of distributions of deferrals or employee contributions that have caused a violation of Sec. 415(c). Sec. 415(c) limits "annual additions," including employer contributions, employee contributions and deferrals, and allocations of forfeitures, to the lesser of (1) 25% of compensation or (2) $30,000. Sec. 415(c) violations commonly arise when additions exceed the 25%-of-compensation limit because contributions or deferrals were calculated on gross salary (before subtracting reductions in salary for contributions to cafeteria plans, Sec. 401(k) plans, etc.), rather than on "compensation included in gross income."

Amounts in excess of the limits may be handled under Regs. Sec. 1.415-6(b)(6) by reallocating excess amounts, placing excess amounts in a suspense account or distributing such amounts. When the amounts are distributed, Rev. Proc. 92-93 says that such distributions are "corrective disbursements," rather than distributions of accrued benefits.

Corrective distributions of both elective deferrals and employee contributions are not subject to the early withdrawal tax under Sec. 72; are not treated as distributions subject to excise tax under Sec. 4980A; are not wages subject to FICA or FUTA; do not require spousal notice or consent under Sec. 411(a)(11) or 417; are subject to withholding under Sec. 3405; cannot be treated as minimum distributions under Sec. 401(a)(9); and are not eligible for rollover to an IRA or qualified plan under Sec. 402(c)(4).

In addition, corrective distributions of elective deferrals are included in income in the year distributed; may not be treated as a return of investment under Sec. 72; and may be made without regard to the restrictions of Sec. 401(k)(2)(B)(i). Corrective distributions of employee contributions are not includible in income or in the employee's investment in the contract. Gains allocated to such contributions are included in income and are not included as employee investment in the contract.

Corrective distributions of employee contributions and their allocable gains and elective deferrals are to be reported on a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. These distributions may be reported on the same Form 1099-R, but no other distributions may be reported on a Form 1099-R that reports corrective distributions. Rev. Proc. 92-93 is effective for distributions after Jan. 1, 1993. For distributions before that date, the payor may rely on any reasonable good faith interpretation of the applicable statutes and regulations.

ESOP Loans

The IRS has ruled in Letter Ruling (TAM) 9304003(25) that a corporation could not deduct an "extraordinary" dividend paid as part of a redemption and used to pay off an exempt ESOP loan. According to the IRS, the dividend was not deductible because the dividend rate was not "reasonable"; it was not a rate normally paid in the ordinary course of business.

A corporation set up a qualified leveraged ESOP in 1986, using back-to-back loans from a bank to the corporation and then from the corporation to the ESOP. The ESOP used the loan proceeds to buy, at $10 a share, 30% of the corporation's stock from the seller, who had previously owned all of the corporation's stock. After the sale, the ESOP owned 150,000 shares and the seller owned the remaining 350,000. In 1988, an unrelated corporation bought 35,000 of the seller's 350,000 shares; the corporation redeemed the seller's remaining 315,000 shares at their current FMV of $12 a share; the corporation redeemed 135,000 of the ESOP's 150,000 shares at $12 a share; and the ESOP used part of the redemption proceeds to pay off the exempt loan.

On completion of these transactions, the ESOP continued to own 30% of the corporation, but the number of shares it held was reduced by 90%, from 150,000 shares to 15,000. In a 1991 technical advice memorandum, the IRS ruled that the redemption proceeds the ESOP received constituted a dividend. The corporation claimed a deduction under Sec. 404(k) for that part of the dividend the ESOP used to pay off the exempt loan'

Sec. 404(k)(2)(A)(iii) allows a deduction for dividends paid on stock held by an ESOP and used to make payments on an ESOP loan. Sec. 404(k)(5)(A) and the TRA Conference Report permit the Treasury to disallow the deduction for any dividend paid on stock held by an ESOP if the dividend constitutes, in substance, the evasion of taxation. The Conference Report further stated that "[t]he conferees intend that the deduction is to be allowed only with respect to reasonable dividends."(26)

According to the IRS, if the ESOP and the other shareholders hold only common stock, a "reasonable" dividend on that stock would not generally include an "unusually large" or "extraordinary" dividend used to repay an ESOP loan if the dividend greatly exceeds the dividend the sponsor can reasonably be expected to pay on a recurring basis. "Reasonable" under Sec. 404(k) contemplates a dividend rate that is normally paid in the ordinary course of business.

The IRS recognized that there are several approaches that can be, used to calculate a dividend rate to determine whether the rate is reasonable. But even using the approach that would result in the lowest dividend rate (dividing the claimed dividend by the value of all the shares held by the ESOP), the IRS calculated a dividend rate of 63.4%. According to the IRS, a 63.4% dividend rate is substantially higher than the rate the corporation could reasonably be expected to pay on its common stock on a recurring or continuing basis. Thus, the 63.4% rate was "extraordinary," especially when compared to the 7% dividend paid in the preceding plan year. Consequently, the IRS concluded that the dividends used to pay off the ESOP loan were not deductible under Sec. 404(k). (1) RRA Section 13212(a)(1). (2) RRA Section 13212(d). (3) RRA Section 13201(a). (4) Rev. Proc. 92-89, IRB 1992-46, 27. (5) Rev. Proc. 93-36, IRB 1993-29, 73. (6) Hamlin Development Co., TC Memo 1993-89. (7) Mills, Mitchell & Turner, TC Memo 1993-99. (8) Hamlin, note 6, at 93-410. (9) Ann. 92-182, IRB 1992-52, 45. (10) Ann. 93-9, IRB 1993-3, 62. (11) Ann. 93-105, IRB 1993-27,15. (12) DOL Regs. Section 2550.404c-1(g). (13) DOL Regs. Section 2550.404c-1(b). (14) DOL Regs. Section 2550.404c-1(b)(2)(ii). (15) DOL Regs. Section 2550.404c-l(b)(3). (16) Mertens v. Hewitt Associates, 113 Sup. Ct. 2063 (1993), aff'g 948 F2d 607 (9th Cir. 1991), aff'g and rem'g N.D. Cal. (17) Citing ERISA Section 3(21)(A) and Credit Managers Ass'n v. Kennesaw Life & Accident Insurance Co., 809 F2d 617 (9th Cir. 1987). (18) Nieto v. Ecker, 845 F2d 868 (9th Cir. 1988). (19) Keystone Consolidated Industries, Inc. 113 Sup. Ct. 2006 (1993)(71 AFTR2d 93-1809, 93-1 USTC [paragraph]50,298), rev'g 951 F2d 76 (5th Cir. 1992)(69 AFTR2d 92-517, 92-1 USTC [paragraph]50,045), aff'g TC Memo 1990-628. (20) IRS Letter Ruling 9318035 (2/10/93). (21) Hillsboro National Bank, 460 US 370 (1983)(51 AFTR2d 83-874, 83-1 USTC [paragraph]9229). (22) Notice 93-3, IRB 1993-3, 11. (23) Notice 93-26, IRB 1993-18, 11. (24) Rev. Proc. 92-93, IRB 1992-47,13. (25) IRS Letter Ruling (TAM) 9304003 (9/30/92). (26) H. Rep. No. 99-841, 99th Cong., 2d Sess., II-852 (1986).
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Title Annotation:Current Developments in Employee Benefits, part 1
Author:Walker, Deborah
Publication:The Tax Adviser
Date:Nov 1, 1993
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