- Defined-benefit plan distribution rules have been amended to facilitate phased retirement alternatives for workers.
- Regulations have been issued that clarify what are considered qualified distributions from Roth 401(k) accounts and the rules for rollover distributions from these accounts.
- New regulations update the regulations under Sec. 403(b) to reflect statutory changes and IRS rulings and include a new requirement that all 403(b) plans have a written plan.
- The IRS has issued several forms of guidance on the provisions of the Pension Protection Act of 2006.
This two-part article covers significant developments in late 2006 and 2007 in employee benefits, including executive compensation, welfare benefits, and qualified plans. Part II, below, focuses on updates and changes to the rules for qualified retirement plans. Part I, in the November issue, focused on new guidance regarding executive compensation and welfare benefits.
Qualified Retirement Plans
On May 22, 2007, the IRS issued final regulations on making in-service distributions from defined-benefit pension plans.28 The final regulations are part of an ongoing effort by the IRS, recently joined by Congress,29 to facilitate phased retirement alternatives for workers. Under these workplace alternatives, near-retirees may reduce their hours worked and use partial distributions from their pension plans to make up for their reduced wages. The final regulations,30 reflecting statutory changes, eliminate one primary obstacle to phased retirement arrangements by expanding the circumstances under which defined-benefit plans may make in-service distributions.
The final regulations amend Regs. Sec. 1.401(a)-1 to codify the two exceptions to the rule that defined-benefit plans may not begin paying benefits until after a participant’s severance from employment. The first is the long-established rule that distributions may begin at the plan’s “normal retirement age.” The second is new Sec. 401(a)(36), added by PPA ’06,31 which permits in-service distributions to participants age 62 or older. However, the regulations also limit the plan sponsor’s freedom to set the normal retirement age. It may not be earlier than the “typical retirement age” for the industry in which participants work. Age 62 or over is conclusively presumed to be acceptable. Ages between 55 and 61 must be reasonable under the facts and circumstances, but the IRS will generally defer to the sponsor’s good-faith determination. An age lower than 55 (50 for public service employees) is presumed to be unreasonably early absent facts and circumstances that demonstrate otherwise to the Commissioner.32
The final regulations were originally effective for plan years beginning May 22, 2007, with delayed effective dates for plans maintained under one or more collective bargaining agreements and governmental plans. The Service subsequently delayed the effective date to plan years beginning after June 30, 2008, except for plans with extremely low retirement ages (below age 40, or the earlier of a stated age and a period of service of less than 22 years).33
Plans that currently have normal retirement ages below 62 and permit in-service distributions may have to be amended to increase the normal retirement age and eliminate the right to begin receiving in-service distributions at ages before 62. These amendments will not be treated as improperly eliminating an optional form of distribution, in violation of the Sec. 411(d)(6) anti-cutback rule, if they are adopted by the end of the Sec. 401(b) remedial amendment period for the first plan year beginning after June 30, 2008. For a calendar-year plan with a calendar-year corporate sponsor that extends its income tax return, that deadline is September 15, 2010.34 To be eligible for the delayed effective date, plans with a normal retirement age of less than 55 will normally need to request approval from the Commissioner by June 30, 2008. Notice 2007-69 contains the procedures for applying for this determination.
Roth 401(k) Distributions
The IRS issued final regulations on the tax treatment of distributions from Roth 401(k) accounts and made two changes to the regulations concerning the tax qualification rules for Roth 401(k)s that it had published early in 2006.35 The final regulations apply to tax years beginning on or after January 1, 2007, with certain rules effective for tax years beginning on or after January 1, 2006, the statute’s effective date.
Qualified distributions: Only qualified distributions from Roth 401(k) accounts are eligible for tax-preferred treatment. A qualified distribution is one that is made (1) at least five full calendar years after the beginning of the year in which the participant first makes a Roth contribution to the plan and (2) either at or after age 59½ or on account of death or disability. The final regulations clarify that for distributions to an alternate payee or beneficiary, the participant’s age, disability status, or death determine whether the distribution is qualified (except where a spousal beneficiary rolls the distribution over to his or her own account, in which case his or her status is determinative).
The five-year qualifying period is determined independently for each plan. It begins on the first day of the calendar year in which the participant first makes designated Roth contributions to the plan and ends at the completion of five consecutive calendar years. The plan year is of no significance, nor are the same participant’s previous Roth contributions to IRAs or other plans. For example, if an individual contributed to a Roth IRA in 2005 and makes his first Roth contribution to his employer’s 401(k) plan on June 1, 2008, distributions from that plan cannot be qualified until January 1, 2013, at the earliest.
If contributions are transferred via a plan-to-plan transfer or direct rollover to another plan, the qualifying period is tacked. In our example, the participant could separate from service in 2010, make a direct rollover of his account balance to his new employer’s plan, and receive a qualifying distribution from the new plan in 2013 or later.
The regulations take a different approach in the case of a rollover from a Roth 401(k) to a Roth IRA. A similar five-year requirement applies to distributions from Roth IRAs, except that it begins with the first tax year for which the individual makes a contribution to any Roth IRA. Under the final regulations, contributions to a Roth 401(k) account do not count toward the five-year requirement for a Roth IRA. Hence, if the rollover is the taxpayer’s first Roth contribution to an IRA, the five-year period starts over again. If he has previous Roth IRA contributions, they are taken into account in determining the five-year period for the rollover IRA.
To continue our example, if the participant rolled his Roth 401(k) account into a Roth IRA on separation from service in 2010, he could receive qualifying distributions immediately (provided that the other conditions were satisfied), because his first Roth IRA contribution was in 2005, more than five years previously.
Rollovers: Distributions from Roth 401(k) accounts may be rolled over to Roth 401(k) accounts, Roth 403(b) accounts, or Roth IRAs. A rollover to a Roth 401(k) or 403(b) account must be made via direct rollover. If the participant receives the distribution himself, he can roll over only the taxable portion, if any. These restrictions do not apply to rollovers to Roth IRAs. The limitations on contributions to Roth IRAs, based on adjusted gross income (AGI), do not apply to rollovers.
Example: T, a participant who began contributing to a Roth 401(k) account in 2007, has no prior Roth IRA contributions and has AGI in excess of the Roth IRA limit. T separates from service in 2010. His Roth account balance is $75,000, of which $60,000 is his contributions and the remainder is earnings. He goes to work for a company that also allows Roth contributions to its 401(k) plan.
T has these rollover options:
- Make a direct rollover of the entire $75,000 account balance to his new employer’s plan or to a Roth IRA.
- Receive a $75,000 distribution and roll it into a Roth IRA within 60 days after receipt.
- Receive a $75,000 distribution and roll the taxable portion (the $15,000 in earnings) into a Roth account in his new employer’s plan within 60 days after receipt. There will be no tax on the other $60,000 because it represents the return of investment in the contract and thus is excluded from gross income by Sec. 72.
Excess elective deferrals: Designated Roth contributions are aggregated with pretax elective deferrals for the Sec. 402(g) limit on deferrals and for “nondiscrimination testing.” If an employee’s total elective deferrals and Roth contributions exceed the Sec. 402(g) limit for a year, the excess can be distributed by April 15 of the following year without adverse tax consequences. If the excess occurs under a single plan (or the plans of members of the same controlled group), the refund is mandatory on pain of plan disqualification (or correction and sanctions via the Employee Plans Compliance Resolution System). An individual covered by plans of unrelated employers, whose excess deferrals result from contributions to more than one employer’s plan, must ask for a refund. If no corrective distribution is made by April 15, any excess Roth contribution is includible in gross income for the year of the contribution and is also fully taxable when distributed. The participant does not get the benefit of the exclusion for qualifying Roth distributions or even for investment in the contract under Sec. 72.
Refunds to correct nondiscrimination violations are handled identically for elective deferrals and Roth contributions, except that only the income attributable to a refunded Roth contribution is subject to tax. A corrective refund is not entitled to exclusion as a qualified Roth distribution, no matter when it occurs.
Reporting and recordkeeping: In general, the same reporting requirements apply to a Roth 401(k) as apply to other plans. Contributions are included in the wages reported on Form W-2, Wage and Tax Statement. Distributions are reported on Form 1099-R, Distribu-tions from Pensions, Annuities, Re-tirement or Profit-Sharing Plans, IRAs, Insurance Contracts. Employees do not have any reporting obligations with respect to designated Roth contributions.
The regulations require plan administrators to track each participant’s designated Roth contributions and five-year qualifying period. In the case of direct rollovers, the plan administrator of the transferring plan must furnish to the transferee plan the data needed to determine when the qualifying period began and the amount of the participant’s Roth contributions. For nonqualifying distributions, the plan administrator must provide the recipient, on request, with a statement of the nontaxable portion. This information must be provided to the receiving plan or employee within a reasonable period of time, but not later than 30 days after the direct rollover or employee request.
Final Sec. 403(b) Regulations
On July 26, 2007, the IRS issued final regulations under Sec. 403(b).36 For most taxpayers, the new regulations will become effective for tax years beginning after December 31, 2008. Taxpayers may rely on the regulations immediately if done on a consistent and reasonable basis. Special transitional relief and effective dates are provided in various circumstances.
The final regulations update existing regulations that were finalized back in 1964. Since then, there have been many statutory changes and IRS rulings that significantly affect Sec. 403(b) arrangements. The new regulations incorporate the revisions, reflecting, in particular, the increasing similarities between 403(b) arrangements and Sec. 401(a) qualified plans (though there are still important distinctions between the two).
Key changes: Perhaps the most fundamental change is that the regulations require every 403(b) plan to have a written plan document that sets forth all of the provisions necessary for favorable tax treatment. In the past, precise and detailed documentation, of the sort that has long been the rule for qualified plans, has not been essential under Sec. 403(b), though plans have always had to operate in accordance with the statutory rules.
The plan document requirement will be a profound change for many eligible employers. While incorporation by reference of existing annuity contracts and custodial agreements is allowed, the preamble to the regulations cautions:
[A] plan may include a wide variety of documents, but it is important for the employer that adopts the plan to ensure that there is no conflict with other documents that are incorporated by reference. If a plan does incorporate other documents by reference, then, in the event of a conflict with another document, except in rare and unusual cases, the plan would govern. In the case of a plan that is funded through multiple issuers, it is expected that an employer would adopt a single plan document to coordinate administration among the issuers, rather than having a separate document for each issuer.
This is a greater burden than many plan sponsors currently assume. It is not uncommon for plan administration to be effectively in the hands of participants and investment providers, with minimal employer involvement.
Plan documents must be adopted or amended before the new regulations become effective. There is currently no remedial amendment period, determination letter program, or prototype program. IRS officials have indicated informally that they intend to fill those gaps. In the meantime, defective documents will be correctable through the Employee Plans Compliance Resolution System.
The regulations also provide guidance on the effect of a failure to satisfy Sec. 403(b) and, to some extent, on how failures can be corrected. Unlike violations that occur in a qualified plan, Sec. 403(b) problems ordinarily affect only the participants involved. For example, excess contributions to a participant’s account or improper distributions may result in the loss of 403(b) status for the participant’s own contracts but have no impact on anyone else. The major exceptions are discrimination in favor of highly compensated employees, the absence of a written plan satisfying all of the requirements of the section, and the employer’s ineligibility to maintain a 403(b) plan, all of which have plan-wide significance.
Department of Labor guidance: A Sec. 403(b) arrangement is exempt from the Employee Retirement Income Security Act of 1974 (ERISA) if all contributions are elective deferrals or Roth contributions and the employer has only minimal involvement with its operations.37 The new regulations, by significantly broadening employer responsibility, raised concerns about whether it would be practicable to rely on the exemption in the future. The Department of Labor (DOL) sought to allay those fears with Field Assistance Bulletin (FAB) No. 2007-02, which states that compliance with the written plan requirement and other aspects of the regulations generally will not subject a plan to ERISA coverage, although determinations are made on a case-by-case basis. Situations in which ERISA coverage is likely are those in which the employer has
responsibility for, or make[s], discretionary determinations in administering the program. Examples of such discretionary determinations are authorizing plan-to-plan transfers, processing distributions, satisfying applicable qualified joint and survivor annuity requirements, and making determinations regarding hardship distributions, qualified domestic relations orders (QDROs), and eligibility for or enforcement of loans. (FAB No. 2007-02)
This is a rather broad construction of “discretionary.” While some might believe that receiving an election form and instructing an annuity provider or custodian to make distributions in accordance with it, or determining whether a domestic relations order satisfies the requirements of Sec. 414(p), entails no real exercise of discretion, the prudent course is to avoid any of the activities that the DOL singles out.
Final Sec. 415 Regulations
On April 5, 2007, the IRS and Treasury issued final regulations under Sec. 415, which governs maximum contributions and benefits under qualified plans, 403(b) plans, and similar arrangements.38 To a large extent, the new regulations’ provisions reflect the many statutory changes since the last set of regulations appeared, including the following:
- Changes to the rules for adjusting the defined-benefit plan limitations to reflect payment in a form other than a straight life annuity beginning between ages 62 and 65;
- Guidance on the phase-in of the defined-benefit plan dollar limitation, which is reduced for participants who have fewer than 10 years of participation in the plan;
- The repeal of the Sec. 415(e) combined limitation on defined-benefit and defined-contribution plans;
- The inclusion in compensation (for purposes of Sec. 415) of certain salary reduction amounts not included in gross income: Secs. 401(k), 403(b), and 457 plan elective deferrals, Sec. 125 cafeteria plan pretax contributions, and Sec. 132(f)(4) qualified transportation fringe benefits;
- Reversal of the Service’s position that compensation for a period during which an individual was not a plan participant may not be taken into account in determining his or her three-year-high average compensation.
Change to compensation definition: Among the more significant elements of the regulations not prompted by statutory changes are three important modifications to the definition of “compensation.” Two address previously unresolved issues. The third is a reversal of the IRS’s previous position.
First, under the final regulations, Sec. 415 compensation does not include amounts received following severance from employment, unless the payment is made by the later of 2½ months following severance or the end of the year in which the severance occurs and represents compensation that would have been received in the ordinary course of employment, such as base compensation, overtime, bonuses un-related to severance, and cashouts of unused, bona fide paid time off. Thus, traditional severance payments due to the loss of employment are not includible in Sec. 415 compensation, unless they are paid before severance.
Second, the new regulations make it clear that foreign earned income, including that received by nonresident aliens without U.S.-source income, may be included in Sec. 415 compensation, though plans may exclude it if desired. This rule eases a number of problems encountered by plans of multinational companies that allow participation by non-U.S. employees.
Third, the new regulations apply the Sec. 401(a)(17) limit on compensation that may be taken into account for plan purposes to Sec. 415 compensation. This change will affect participants who work past normal retirement age, whose Sec. 415 dollar limitation may increase, as the result of age-related adjustments, to a higher level than the Sec. 401(a)(17) limit.
The regulations are generally effective for limitation years beginning on or after July 1, 2007, with a delayed effective date for governmental plans. To the extent that plans need to be amended, interim good-faith amendments must be adopted within the Sec. 401(b) remedial amendment period. For a calendar-year employer with a calendar-year plan, the deadline is the due date (including extensions) of its 2008 tax return.
Final Sec. 409(p) Regulations
The final Sec. 409(p) regulations,39 which are designed to prevent tax abuse in employee stock ownership plans (ESOPs) maintained by S corporations, became effective for plan years beginning on or after January 1, 2006. In general, this section imposes excise taxes on “disqualified persons” if they own, in the aggregate, 50% or more of the corporation’s stock and any stock is owned by an ESOP. A disqualified person is an individual whose ESOP account and holdings of restricted stock and other “synthetic equity” (stock options and similar instruments) equal at least 10% of the total equity and synthetic equity of the ESOP sponsor. The final regulations closed a loophole in the proposed regulations under which ownership percentages could be diluted through the creation of valueless synthetic equity. They also defined circumstances under which deferred-compensation arrangements that nominally involve no stock transfers may be a form of synthetic equity. Sec. 409(p) presents traps for the unwary and should be watched closely by all S corporations that sponsor ESOPs.
Amended Sec. 411(d)(6) Regulations: Vesting
The IRS finalized regulations under Sec. 411(d)(6) incorporating and expanding the Supreme Court’s decision in Central Laborers’ Pension Fund v. Heinz. 40 Heinz held that a plan amendment that altered the plan’s rules governing the suspension of benefits on reemployment violated the Sec. 411(d)(6) prohibition against retroactive reductions of accrued benefits. Suspension of benefits is a vesting concept, so the regulations generalize the conclusion to all changes in vesting provisions subject to Sec. 411(d)(6). As adopted, the regulation forbids amending a plan to make its benefit suspension or vesting rules more stringent, unless the amendment applies only to benefits accrued in the future. The sole exception is amendments changing vesting computation periods. The regulation was effective as of June 7, 2004 (the date of the Heinz decision), for plan amendments adding or altering suspension of benefits provisions, and as of August 9, 2006, for changes to plan vesting rules.
Amended Sec. 411(d)(6) Regulations: Elimination of Optional Forms of Benefit
Another amendment to the Sec. 411(d)(6) regulations makes it possible for defined-benefit plans to prune their optional forms of benefit by eliminating those that participants do not in fact elect. This method of eliminating options is in addition to the previously approved rules for eliminating non-core and redundant forms.
Effective January 1, 2007, a defined-benefit plan may be amended to eliminate any optional form of benefit that no participant has actually elected during a two-to-five-year lookback period, subject to the following rules and conditions:
- During the lookback period, at least 50 participants must have made benefit elections, not counting any who elected to have 25% or more of the value of their benefits paid as lump sums, were eligible for subsidized benefits under early retirement windows, or commenced distribution more than 10 years before the plan’s early retirement age. Participants who accept the plan’s default form count. As an exception, recipients of full or partial lump sums (other than those who are mandatorily cashed out) may be counted if the 50-participant threshold is increased to 1,000.
- An optional form, except for a “core” option, may be amended out of the plan if no participant elected it during the lookback period. The core forms are (1) a life annuity, (2) a joint-and-75% survivor annuity (in lieu of which a plan may offer both a joint-and-50% and a joint-and-100% option), (3) a 10-year-certain-and-life annuity, and (4) whichever of the plan’s existing forms is most valuable for a participant who dies shortly after commencing receipt of benefits (usually a lump-sum option).
- The plan sponsor may choose the lookback period, within certain para-meters. The lookback period must include at least the previous two, but not more than the previous five, full plan years and may not end earlier than the beginning of the second full calendar month before the date of adoption. For instance, an amendment to a calendar-year plan that was adopted on April 15, 2008, would have to include at least 2006, 2007, and the first month of 2008 in the lookback period. The period could, if desired, begin as early as January 1, 2003, and continue through the date of adoption. The motive for a longer period is, of course, to encompass enough benefit elections to meet the eligibility condition for utilizing the regulation.
- The amendment may apply only to benefits that commence at least 180 days after it is adopted.
Because of the required plan disclosures regarding relative value of different options, plan sponsors may want to carefully consider no longer offering distribution options that can be eliminated. The virtue of the utilization test is that, unlike other methods, it can eliminate subsidized optional forms without long delays or extensive recordkeeping. The downside is that not many plans have enough retirees over a five-year period to meet its conditions.
Guidance on PPA ’06
Notice 2007-741 furnished the first IRS guidance on PPA ’06 provisions. The principal focus was on those with immediate effective dates and those dealing with distributions. Topics included distributions on account of a beneficiary’s hardship, direct rollovers by nonspouse beneficiaries, tightened vesting requirements for defined-contribution plans, and changes in the due dates and content of distribution notices.
Hardship distributions for beneficiaries: PPA ’06 directed the IRS to revise its regulations in order to allow distributions in the case of hardships affecting participants’ beneficiaries. Notice 2007-7 responded with two provisions. First, 401(k) and 403(b) plans that use the safe-harbor definition of “hardship” may include financial needs resulting from a beneficiary’s medical, tuition, or funeral expenses. Second, nonqualified deferred compensation plans that are subject to Secs. 409A or 457(b) may consider the unforeseeable emergencies of designated beneficiaries on the same basis as those of spouses and dependents. In all cases, the other hardship or unforeseeable emergency conditions must exist (e.g., inability to relieve the hardship from other resources). “Beneficiary” is defined as “an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant’s account balance under the plan upon the death of the participant.” There is no requirement that the participant have any preexisting legal or moral obli-gation to pay the expenses on which the withdrawal is predicated.
These liberalizations are neither automatic nor mandatory. Qualified plans that begin following the new rules in operation do not need to be amended to reflect them until the 2009 plan year (the general deadline for the adoption of PPA ’06 amendments).
Rollovers by nonspouse beneficiaries: PPA ’06 gave nonspouse beneficiaries of participants in qualified, 403(b), and governmental 457(b) plans the right to roll over distributions received on the participant’s death. Only direct rollovers are allowed, and the transfer must be made to an IRA whose title identifies both the decedent and the beneficiary (“Jerry Smith as beneficiary of Will Smith” or the like). Sec. 401(a)(31) does not apply. Hence, the rollover does not have to be the plan’s default distribution option and need not be offered at all. (A pending technical correction, expected to be adopted, will require offering the option starting in 2008.)
The nonspouse’s IRA is classified as “inherited,” which means that either (1) distributions must begin in the year after the participant’s death and be made over the life expectancy of the beneficiary or (2) the account must be emptied by the end of the fifth calendar year after death. Which rule applies depends on the terms of the distributing plan, as Notice 2007-7 discusses in some detail. If the plan has no options for beneficiaries other than lump sums, the IRA will have to observe the five-year rule, which somewhat limits the value of the rollover. Note, too, that where the five-year rule is not used, a distribution—not eligible for rollover—must be made in the year of death to satisfy Sec. 401(a)(9).
Vesting schedules for defined-contribution plans: PPA ’06 shortened the minimum vesting schedule for nonelective contributions to defined-contribution plans. Contributions made on account of plan years beginning on or after January 1, 2007, must now vest as rapidly as matching contributions: either 100% after three years of service or 20% per year over two to six years. Separate schedules may be applied to pre-2007 and post-2006 contributions. Amendments to comply with the new law are subject to Sec. 411(a)(10). A plan could not, for instance, change from five-year cliff vesting to two-to-six-year graded vesting without letting participants with three years of service either choose between the schedules or have the benefit of the one that was more favorable at each point in time (resulting in a 0%-20%-40%-60%-100% schedule).
Notice of right to defer distribution: PPA ’06 requires that distribution election forms include information about a participant’s right to defer distributions until the plan’s normal retirement age and the effects of doing so. The new requirement is effective as of January 1, 2007; it does not apply if the participant received the election form in 2006 and elected benefit commencement in 2007. Pending the issuance of regulations, Notice 2007-7 states that plan administrators must make “a reasonable attempt to comply.” Participants in defined-benefit plans must be told how much larger their periodic benefits will be if distribution is deferred, while defined-contribution plans must describe the investment options available after separation from service, as well as any applicable fees. Defined-plan notices do not need to show the effect of deferral on benefit options other than the normal form, and it is apparently not necessary to explain that the present value of the benefit may be higher if it begins earlier.
Employer Stock Diversification Requirements
To address the risks associated with excessive concentration of an individual’s assets in stock of his or her employer, PPA ’06 added Sec. 401(a)(35) and ERISA §204(j), expanding participants’ diversification rights. Sec. 401(a)(35) requires defined-contribution plans (other than certain ESOPs) that hold publicly traded employer securities to permit participants to divest employer stock holdings attributable to elective deferrals and employee contributions at any time and to divest employer stock holdings attributable to employer contributions after completing three years of service. Participants must be able to exercise their diversification rights at least quarterly. They must also be given notice of those rights and information about the importance of diversifying investments. Pending the issuance of regulations, Notice 2006-10742 provides transitional guidance and a model disclosure notice.
For purposes of Sec. 401(a)(35), Notice 2006-107 indicates that a participant completes three years of service immediately after the end of the plan’s third vesting computation period under Sec. 411(a)(5). If the plan uses the elapsed-time method for crediting service for vesting purposes or provides for immediate vesting, then a participant completes three years of service on the third anniversary of his or her date of hire.
Cash Balance and Other Hybrid Plans
Notice 2007-643 announced that the IRS had resumed processing determination letter applications for conversions of traditional defined-benefit plans into cash balance or pension equity plans, lifting a moratorium that had been in effect since September 1999. It also provided some guidance on the interpretation of the PPA ’06 provisions relating to those plans.
Notice 2007-6 adds a new term, “statutory hybrid plan,” to the pension lexicon. It includes cash balance plans, pension equity plans, and plans that index accrued benefits before normal retirement age. Statutory hybrid plans are subject to the various benefits and burdens (faster vesting, conversion restrictions, distribution rules, etc.) enacted by PPA ’06 in response to the cash balance controversy.
Determination letters for plans subject to the moratorium will apply PPA ’06’s favorable age discrimination standards to all benefits accrued after conversion to hybrid form, whether before or after the PPA ’06 effective date. However, the letters will not consider whether conversions before June 30, 2005 (the effective date of the PPA ’06 conversion requirements), were age discriminatory. The Service thus does not address the question of whether it was proper under prior law to “wear away” preconversion accruals. The moratorium has not been lifted for plans that did not comply with Notice 96-8 by either utilizing safe-harbor interest crediting rates or performing whipsaw calculations for lump-sum distributions.
Plans that used the whipsaw method may eliminate it in operation by distributing a notice to participants at least 30 days in advance of the change. A formal plan amendment must then be adopted by the end of the first plan year beginning on or after January 1, 2009. Amendments that follow this procedure are exempt from the anti-cutback rule.
Notice 2007-6 also states that guidance defining “market rate of return” for cash balance plan purposes will be issued during 2007. In the meantime, long-term corporate bond rates, 30-year Treasury bond rates, or rates permitted by Notice 96-8 may be treated as safe harbors.
New Guidance on Partial Terminations
Sec. 411(d)(3) provides that participants affected by a partial plan termination must become 100% vested in their accrued benefits (to the extent funded in the case of a defined-benefit plan). “Partial termination” is not defined. The regulations say only that “whether or not a partial termination of a qualified plan occurs (and the time of such event) shall be determined ... with regard to all the facts and circumstances in a particular case.”44
Case law and rulings hold that a partial termination consists of a significant percentage reduction in the number of plan participants. A recent leading case endorsed the rule of thumb that a 20%-or-greater reduction should generally be presumed to be “significant.”45 Rev. Rul. 2007-4346 adopts that view and provides additional guidance on how the IRS believes Sec. 411(d)(3) issues should be analyzed.
The starting point is the plan’s turnover rate during the applicable period. The rate is determined by dividing the number of participants who left at the employer’s initiative by the total number of participants during the period (both those participating at the beginning of the period and new hires). Each plan year is normally looked at separately, but the period may be longer if there is a series of related severances from employment (e.g., a long-term reduction in force extending over several years). Short plan years are aggregated with the preceding year. No distinction is drawn between vested and nonvested participants. Participants whose benefits are transferred to a plan of an acquiring employer, where they can continue to vest, are treated as if they had not severed.
Though acknowledging that only employer-initiated severances count toward a partial termination, the ruling tries to keep the numerator as large as possible, stating:
Employer-initiated severance from employment generally includes any severance other than those on account of death, disability, or retirement on or after normal retirement age. An employee’s severance from employment is employer initiated even if caused by an event outside of the employer’s control, such as severance due to depressed economic conditions. In certain situations, the employer may be able to verify that an employee’s severance was not employer initiated. A claim that a severance from employment was purely voluntary can be supported through items such as information from personnel files, em-ployee statements, and other corporate records.
The courts have also excluded participants who were terminated for cause or who were rehired after a brief period.47
The ruling reiterates the IRS’s position that a partial termination need not be connected to any definable corporate event, such as a plant shutdown or a reduction in force. A steady decline in the employer’s business may result in a partial termination. However, high turnover is not in and of itself necessarily dispositive. If departing employees are replaced by new ones performing the same duties, there may be no partial termination even if the turnover rate is well over 20%, assuming that the number of plan participants has not shrunk. Case law generally regards that indicator as more significant than the bare turnover rate.
Limitations on Deductible Contributions
PPA ’06 amended Sec. 404(a)(1) to increase the maximum deductible contribution to a single-employer defined-benefit plan from 100% of unfunded current liability to the excess of 150% of current liability over the value of plan assets. The new limit applies only to 2006 and 2007, after which the new PPA ’06 funding and deduction rules become effective.
A second PPA ’06 amendment modified Sec. 404(a)(7), which imposes an overall limit on deductions when the employer contributes to both defined-benefit and defined-contribution plans, such that it applies only to the extent that contributions to defined-contribution plans exceed 6% of the compensation otherwise paid or accrued during the tax year to the beneficiaries under such plans.
Most practitioners interpreted this language to mean that the combined plan limit would not apply as long as the employer’s contributions to defined-contribution plans (disregarding 401(k) elective deferrals, which are not taken into account for Sec. 404(a)(7) purposes) did not exceed 6% of participants’ aggregate compensation. In Notice 2007-28,48 however, the IRS took the position that any employer contributions (other than elective deferrals alone) invoked the Sec. 404(a)(7) limit, which PPA ’06 neglected to amend to reflect the changes to Sec. 404(a)(1). The upshot was, in many cases, a dramatic reduction in the maximum deductible contribution.
Legislation pending in the House (H.R. 3361) and the Senate (S. 1974) rejects the IRS’s interpretation. In a September 13, 2007, letter to the chairmen and ranking members of the House and Senate tax-writing committees, Treasury and the IRS stated that “in anticipation of the enactment of this legislation,” the IRS will not follow Notice 2007-28. As a result, employers that contribute to both defined-benefit and defined-contribution plans now will be able to take advantage of the expanded defined-benefit plan deduction limit in 2006 and 2007, provided that they keep their nonelective deferral contributions to defined-contribution plans below 6% of the participants’ compensation.
Updated Determination Letter Procedure
Rev. Proc. 2007-4449 updated the rules governing determination letter applications, which were originally set forth in Rev. Proc. 2005-66.50 The main purpose of this guidance was to address various problems that have arisen in the course of implementing the new process, which drastically altered the traditional method of handling determinations. Rev. Proc. 2005-66’s key innovation was the introduction of a five-year staggered application cycle for individually designed tax-qualified retirement plans and a six-year cycle, based on somewhat different principles, for pre-approved plans. An individually designed plan may, as a general rule, apply for a determination letter only during a one-year window that opens every five years. Plans are assigned to cycles on the basis of the plan sponsor’s employer identification number. The new revenue procedure, effective as of June 13, 2007, makes this process more flexible by allowing more “off-cycle” filings. For example, a newly adopted plan whose normal cycle would begin more than two years in the future may file immediately. There are many other clarifications of details, although the basic structure remains intact.
PPA ’06 replaced the current minimum-funding rules for single-employer defined-benefit plans with new minimum-funding rules effective for plan years beginning on or after January 1, 2008. Briefly, under the new rules—which have been codified in Sec. 430—a plan sponsor’s minimum required contribution for a plan year is based on the plan’s funding target for that year. In general, a plan’s funding target for a plan year is the present value of all benefits accrued or earned under the plan as of the beginning of the plan year. Most plan sponsors will use the generally applicable mortality tables prescribed by the Secretary of the Treasury for purposes of this and other present-value calculations under Sec. 430. However, certain large plan sponsors may petition the Service to use substitute mortality tables based on their own plans’ actual experience. In addition, plan sponsors will have the option of using separate Treasury-prescribed mortality tables to value liabilities for individuals entitled to benefits on account of disability. On June 1, the IRS issued Rev. Proc. 2007-37,51 which provides specific procedures for plan sponsors to follow when petitioning the IRS to use substitute mortality tables.52
Department of Labor
Before PPA ’06 was enacted, employers wishing to implement automatic enrollment Sec. 401(k) or 403(b) plans were often concerned about increased fiduciary liability from choosing default investment options. PPA ’06 addressed these concerns by amending ERISA to add a default investment election safe harbor under ERISA §404(c). The DOL issued final regulations on October 24, 2007,53 providing that relief from fiduciary liability would be available if fiduciaries invested automatic enrollees’ assets in “qualified default investment alternatives.” Significantly, this special fiduciary relief relating to default investment elections for automatic enrollees is available regardless of whether the plan at issue satisfies all the requirements for protection under ERISA §404(c).
28 TD 9325 (5/22/07).
29 The Pension Protection Act of 2006, P.L. 109-280 (PPA ’06), established new Sec. 401(a)(36), which provides that a pension plan does not fail to satisfy the tax qualification rules solely because it permits distributions to employees who are at least 62 years old and still working. This provision is effective for plan years beginning after December 31, 2006.
30 The final regulations amend Regs. Sec. 1.401(a)-1 to incorporate the new Sec. 401(a)(36) rule permitting in-service distributions beginning at age 62 and to adopt the basic rule from the proposed regulations (REG-114726-04) permitting in-service distributions on attainment of the plan’s normal retirement age. The final regulations also establish rules for setting a plan’s normal retirement age.
31 Pension Protection Act of 2006, Section 905(b), P.L. 109-280 (2006).
32 Regs. Sec. 1.401(a)-1(b)(2).
33 Notice 2007-69, 2007-35 IRB 468.
34 Regs. Sec. 1.401(b)-1 and Notice 2007-69.
35 TD 9324 (4/30/07).
36 TD 9340 (7/26/07).
37 29 CFR §2510.3-2(f).
38 TD 9319 (4/5/07).
39 Regs. Sec. 1.409(p)-1.
40 Central Laborers’ Pension Fund v. Heinz, 541 US 739 (2004).
41 Notice 2007-7, 2007-5 IRB 395.
42 Notice 2006-107, 2006-51 IRB 114.
43 Notice 2007-6, 2007-3 IRB 272.
44 Regs. Sec. 1.411(d)-2(b)(1).
45 Matz v. Household Int’l Tax Reduction Inv. Plan, 388 F3d 570 (7th Cir. 2004), further proceedings, 232 FRD 593 (N.D. Ill. 2005), aff’d sub. nom. In re Household Int’l Tax Reduction Plan, 441 F3d 500 (7th Cir. 2006).
46 Rev. Rul. 2007-43, 2007-28 IRB 45.
47 Cf. Halliburton Co., 100 TC 216 (1993), aff’d per curiam, 25 F3d 1043 (5th Cir.), cert. den., 513 US 989 (1994).
48 Notice 2007-28, 2007-14 IRB 880.
49 Rev. Proc. 2007-44, 2007-28 IRB 54.
50 Rev. Proc. 2005-66, 2005-2 CB 509.
51 Rev. Proc. 2007-37, 2007-25 IRB 1433.
52 On February 1, 2007, the IRS issued final regulations to update the mortality tables that sponsors must use to determine current liability under the deficit reduction contribution requirements of Sec. 412(l) and ERISA §302(d) (TD 9310 (2/2/07)). However, the final regulations will be relevant to most single-employer plans only for the 2007 plan year because PPA ’06’s new minimum-funding requirements will begin taking effect in 2008.
53 72 Fed. Reg. 60452 (10/24/07).