Tax Notes—Deferred Compensation Plans-Internal Revenue Service Issues a Reprieve-But it is Only a 'Deferral'
‘‘Tax Notes’’ is prepared by the Taxation Section of the State Bar. Some items are of primary interest to tax practitioners; others will be useful to lawyers in general practice. Since one purpose of ‘‘Tax Notes’’ is to afford an exchange of tax-related ideas, problems, and experience among Michigan lawyers, readers are invited to submit material for publication. For a copy of the publication guidelines, please contact column editor Steven E. Grob, Dykema Gossett, 35th Floor, 400 Renaissance Center, Detroit, MI 48243.
The Internal Revenue Service recently published Rev. Proc. 99-23,1 which provides guidance for bringing employee benefit plans in compliance with recently passed legislation. While the revenue procedure addresses defined contribution plans, defined benefit plans, governmental plans, and nonelecting church plans, this article will be limited to the revenue procedure’s effect on defined contribution plans.
Congress is continually passing legislation requiring sponsors of employee benefit plans to amend them to conform with the latest legislative requirements. The last plan amendments required changes to conform to the Tax Reform Act of 1986, the Omnibus Budget Reconciliation Act of 1986, the Omnibus Budget Reconciliation Act of 1987, the Technical and Miscellaneous Revenue Act of 1988, and the Omnibus Budget Reconciliation Act of 1993. The latest set of legislative Acts is referred to as the GUST Plan qualification changes; GUST is the latest acronym, and it refers to the following legislation:
• Uruguay Round Agreements Act (GATT)2
• Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA)3
• Small Business Job Protection Act of 1996 (SBJPA)4
• Taxpayer Relief Act of 1997 (TRA97)5
• Internal Revenue Service Restructuring and Reform Act of 1998 (RRA)6
Effect of the Revenue Procedure
When an employee benefit plan receives a favorable determination letter from the Internal Revenue Service, the plan is entitled to depend on this letter, assuming the plan is administered in accordance with the current law, for a period referred to as the reliance period. Revenue Procedure 99-23 has extended the reliance period of a plan that has received a determination letter from the Internal Revenue Service under the Tax Reform Act of 1986 by one year. This means that the GUST amendment must be effective no later than the first day of the first plan year beginning on or after January 1, 2000, and no earlier than the first day of the plan year in which the plan was adopted. This extended period is known as the GUST remedial amendment period.
For example, if you have a calendar year plan, the GUST amendment must be signed prior to December 31, 2000 with an effective date of January 1, 2000. If you have a plan with a September fiscal year, the GUST amendment must be signed no later than September 30, 2001, with an effective date of October 1, 2000. Notwithstanding the effective date of the plan amendment, the effective dates of the individual plan provisions must reflect the various effective dates required in the statutes. Throughout the article, specific effective dates are cited. These must be reflected in the various provisions of the plan document.
Major Plan Changes
What follows is a list of the major plan changes necessary to update an existing plan or to include in a new plan.
• Qualified Military Service
Under USERRA, if an employee who is a participant in the plan leaves employment to serve under ‘‘qualified military service’’ (defined as service in the uniformed services of the United States of America) and is then re-employed, the employee will not be considered to have incurred a break in service for purposes of forfeitures of account balances. The SBJPA added that a plan must include ‘‘make-up’’ provisions that permit the employee to contribute elective deferrals, employee contributions, and matching employer contributions for the period of the qualified military service.7
Make-up payments are limited to the amount of payments that would have been made had the employee never left the plan, and must be contributed within certain time periods. The law also allows this make-up of contributions to be made without violating plan qualification requirements, such as the annual limitations under IRC Section 415. Finally, scheduled loan repayments can be suspended during military service, if the plan so provides, without violating the provisions of IRC 72(p). These provisions are effective for plan years starting after December 12, 1994.
• Deferral of Required Distribution Date
Prior law required employees to begin receiving their distributions on April 1 of the calendar year following the year that the participant reached the age of 70 1/2, regardless of whether the participant retired. SBJPA now provides that, as long as the participant is not a five percent or greater owner of the sponsoring employer of the plan, the employee may delay distribution of his or her account balance until the later of April 1 of the calendar year following the year of reaching 70 1/2 or the year the employee actually retires.8 This provision is effective for plan years starting after December 31, 1996.
• Waiver of Applicable Election Period
If a plan provided for a qualified joint and survivor annuity as a retirement option, the plan administrator must give the participant a written explanation no less than 30 days and no more than 90 days before the annuity starting date. Under the new law,9 the participant, with spousal consent, can waive this 30-day minimum waiting period, as long as the distribution does not start for at least eight days after the explanation was provided to the participant. The provision is effective for plan years starting after December 31, 1996.
• Highly Compensated Employee
The definition of highly compensated employee has been simplified.10 This definition is important since it affects top-heavy plan status. An employee is highly compensated if, at any time during the plan year or preceding plan year, he or she was a five percent owner of the sponsoring employer or for the prior year his or her compensation from the employer exceeded $80,000, which is subject to cost of living adjustments. The plan can also provide an optional definition; an employee is highly compensated if he or she is part of the top 20 percent of employees on the basis of compensation (the so-called ‘‘top-paid group’’).
This definition allows the determination of highly compensated status at the beginning of the plan year and the provision is effective for plan years starting after December 31, 1996. The prior definition required five percent owner status, being part of the top 20 percent of employees on the basis of compensation, being an officer of the sponsoring employer, and receipt of compensation in excess of a certain amount subject to cost of living adjustments.
• Repeal of Family Aggregation
Before the SBJPA, a highly compensated employee and his or her family were considered one employee for purposes of determining compensation, for plan contribution purposes, and for deduction of employer contributions. Family membership was defined, with respect to an employee, as a spouse or a lineal ascendant or descendant. For example, if a husband earned $150,000 and his wife earned $100,000 and the employer sponsored a 15 percent profit sharing with $150,000 as the compensation limit, the total contribution for both husband and wife would be limited to $22,500. The total contribution would be allocated by the respective salaries of the husband and wife so that the husband would receive a plan contribution of $13,500 and the wife would receive a plan contribution of $9,000.
The SBJPA,11 effective for plan years starting after December 31, 1996, eliminated the family aggregation rules so that in this example, the husband would have a plan contribution of $22,500 (15% x $150,000), assuming no increase in the compensation limitation, and the wife would have a plan contribution of $15,000 (15% x $100,000). This provision is significant for a family-owned business that employs multiple family members, since the compensation limit now is applied separately to each employee’s compensation.
• Combined Defined Contribution—Defined Benefit Plan Limits Repealed
If an employer sponsored both a defined contribution plan and a defined benefit plan, the traditional pension plan that guarantees a specific retirement benefit, current law places limitations on the account balance an employee can receive in a defined contribution plan and the accrued benefit the employee can receive in the defined benefit plan from the same plan sponsor. The law provided that some of the account balance and the accrued benefit could not exceed an amount that could be maintained if the plan sponsor had only one plan (the so-called 1.0 rule). The SBJPA has eliminated this rule12 by repealing IRC 415(e) effective for plan years starting after December 31, 1999.
In addition to the repeal of IRC 415(e), the Taxpayer Relief Act of 1997 repealed both the 15 percent excise tax on excess distributions received after December 31, 1996,13 and the 15 percent estate tax on excess retirement accumulations for estates of decedents dying after December 31, 1996.14 Prior law placed limits on distributions and accumulations from qualified retirement plans, individual retirement accounts, and tax-sheltered annuities.
Starting on January 1, 2000, plan sponsors may determine that it makes sense to rollover plan proceeds from a defined benefit plan into either a profit sharing or individual retirement account and start a new defined benefit plan in order to take advantage of the more generous provisions relating to funding plans without the risk of incurring an excise tax for excess distributions and retirement accumulations.
• New Definition For Leased Employees
Leased employees are counted as ‘‘employees’’ of the service recipient for purposes of employee benefit plan provisions such as vesting, participation, and contributions. Prior law looked at whether the person performing the services was of a type historically performed by the employees of the lessee. The SBJPA has replaced the historically performed test with a test of performance under the primary direction or control of the lessee.15 The House Committee Report states that ‘‘...primary direction and control means that the service recipient exercise the majority of direction and control over the individuals.’’ While the report lists factors to be considered, drafters of documents will want to be industry specific in drafting their definitions of leased employees. The new standard for defining leased employees is effective for plan years starting after December 31, 1996.
• Involuntary ‘‘Cash Out’’
To eliminate maintaining small account balances on the books and records of the plan, the law has permitted the closing of a former employee’s account balance without his or her consent, or in the case of a joint and survivor annuity benefit, without the consent of both the former employee and the spouse, if the present value does not exceed $3,500. Effective for plan years beginning after August 5, 1997,16 the law provides that this involuntary cash out is increased to $5,000, without an adjustment for inflation.
• Changes to Cash or Deferred Arrangements—401(k) Plans
There have been many changes to 401(k) plan provisions and a thorough explanation is beyond the scope and purpose of this summary. However, several important changes can be briefly highlighted.
Before the passage of the SBJPA, the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test were based on the current plan year. Effective for plan years after December 31, 1996, the SBJPA now provides testing for ADP and ACP using the prior year’s deferral and contributions.17 This change should reduce the amount of excess contributions returned to highly compensated employees.
Before the SBJPA, excess contributions were returned to highly compensated employees in order of the highest percentage rate of ADP until the appropriate test was satisfied. Effective for plan years after December 31, 1996, highly compensated employee contributions are reduced first on the basis of the actual amount of the deferral and not the percentage of compensation deferred.18
Finally, nondiscrimination safe harbor provisions,19 effective for plan years starting after December 31, 1998, will automatically satisfy ADP and ACP tests. These provisions require certain mandatory contributions. Since top-heavy plans already contribute three percent of compensation to the plan, the contribution part of safe harbor requirements will be less onerous for top-heavy plans.20 Problems arise because safe harbor provisions require, among other factors, immediate 100 percent vesting of employer contributions21 and prevent the employer from excluding employees who are not employed on the last day of the plan year.22 Employers may determine that these requirements offset the advantages the safe harbor provisions provide.
Submitting Plans to the Internal Revenue Service
The Internal Revenue Service has not set forth guidelines regarding the submission process for obtaining new approval letters for new or amended plans. In fact, in Announcement 99-50,23 the Internal Revenue Service has advised practitioners that it has temporarily discontinued accepting applications for approval of master, prototype, and regional prototype plans effective May 10, 1999. In conversations with an official in the Cincinnati office of the Employee Plan Group, the author has been able to get the following advice and guidance on submission of plans once the program is reopened in the context of submitting master, prototype or volume submitter plans:
• The processing fee for a law firm drafting a volume submitter plan will be $1,500 and the law firm will be able to submit the plan for approval without submitting an adopting employer.
• The Internal Revenue Service will require that employers submit a complete amendment of an existing plan. An amendment referencing only changes based on GUST will not be acceptable.
• Once the Internal Revenue Service issues an approval letter for a volume submitter plan, the law firm will be required to submit all adopting employer plans within one year of the date of the approval letter if the letter is issued after December 31, 1999. If the approval letter is dated before December 31, 1999, the law firm will have until December 31, 2000 to submit all the adopting employers to the Internal Revenue Service.
• Cross-tested plan provisions will now be included as a variable to the profit sharing volume submitter or prototype plan. Until recently, the Internal Revenue Service required that a plan with this type of allocation formula be submitted as an individually designed plan that required a more costly user fee. Now, the law firm drafting the prototype or volume submitter plan may pass the user fee cost savings to its clients.
Hopefully, in the next several months, the Internal Revenue Service will issue more guidelines to clarify the plan submission process.
11999-16 IRB, effective April 19, 1999.
2Pub L 103-464, effective Dec. 8, 1994, 108 Stat 4809.
3Pub L 103-353, Oct. 13, 1994, 108 Stat 3149, 38 USC 430, et seq.
4Pub L 104-188, 26, Aug. 20, 1996, 110 Stat 1755.
5Pub L 105-34, Aug. 5, 1997, 111 Stat 788.
6Pub L 105-206, July 22, 1998, 112 Stat 685.
7Pub L 104-188, § 1704(u), IRS 414(u).
8Pub L 104-188 § 1404(b), IRC 401(a)(9)(C).
9Pub L 104-188 § 1451(c), IRC 417(a)(7)(B).
10Pub L 104-188 § 1431(a), IRC 414(q)(1).
11Pub L 104-188 § 1431(b)(1).
12Pub L 104-188 § 1452(a), repealing IRC 415(e) effective December 31, 1999.
13Pub L 105-34 § 1073(c)(1).
14Pub L 105-34 § 1073(c)(2).
15Pub L 104-188 § 1454, IRC 414(n)(2)(C).
16Pub L 105-34, § 1071(a), IRC 411(a)(11)(A) and 417(e).
17Pub L 104-188, § 1433(c)(1); IRC 401(k)(3)(A)(ii); although the law allows an employer to elect the current plan year.
18Pub L 104-188, §1433(e)(1) & (2), IRC 401(k)(8)(C) and 401(m)(6)(c).
19Pub L 104-188, § 1433(a) & (f)(1), IRC 401(k)(12) and 401(m)(11), Notice 98-52, 1998-46 IRB 16 (11/16/98).
20A top-heavy employee benefit plan has allocated at least 60 percent of account balances to the highly compensated employees. The law requires this type of plan to contribute at least three percent to the accounts of non-highly compensated employees.
21Notice 98-52, 1998-46 IRB 16 (11/16/98), at IV H.
22Notice 98-52, 1998-46 IRB 16 (11/16/98), at V, example 4.
23Internal Revenue Bulletin 1999-19.