AMERICAN BAR ASSOCIATION SECTION OF LABOR AND EMPLOYMENT LAW COMMITTEE ON EMPLOYEE BENEFITS SUBCOMMITTEE ON

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1 AMERICAN BAR ASSOCIATION SECTION OF LABOR AND EMPLOYMENT LAW COMMITTEE ON EMPLOYEE BENEFITS SUBCOMMITTEE ON REGULATION OF SPECIALIZED TYPES OF RETIREMENT INCOME PLANS (CHAPTER 6) 2011 MID-WINTER MEETING SAVANNAH, GEORGIA FEBRUARY 16-19, 2011 Submitted by: Brian J. Dougherty, Employer Co-Chair Philadelphia, Pennsylvania Jonathan E. Hyun, Employer Co-Chair Chicago, Illinois Ginger B. LaChapelle, Union Co-Chair Latham, New York David Weingarten, Neutral Co-Chair Washington, D.C. DB1/

2 I. EMPLOYEE STOCK OWNERSHIP PLANS A. Statutory Requirements 4. Special ESOP Distribution Requirements ESOP Dollar Limitations for Tax Year 2010 The IRS announced cost-of-living adjustments applicable to dollar limitations for pension plans and other retirement-related items for tax year 2011, published in IR (Oct. 28, 2010). The dollar amount under section 409(o)(1)(C)(ii) of the Internal Revenue Code of 1986, as amended (the Code ), for determining the maximum account balance in an ESOP subject to a 5-year distribution period remains unchanged at $985,000, while the dollar amount used to determine the lengthening of the 5-year distribution period also remains unchanged at $195, Diversification Election Final Regulations under Code section 401(a)(35) In May 2010, the IRS issued final regulations under Code section 401(a)(35) relating to diversification requirements for certain defined contribution plans holding publicly traded employer stock. 1 The final regulations mostly incorporate the proposed regulations that were promulgated in January with a few changes and clarifications. Section 901 of the Pension Protection Act of 2006 ( PPA ) 3 added Code section 401(a)(35) which generally requires a defined contribution plan that offers employer stock as an investment option to provide diversification rights for amounts invested in employer stock. An ESOP is exempt from these diversification requirements if it is a stand-alone plan (i.e., not integrated or combined with any other defined contribution plan or defined contribution feature) 1 75 Fed. Reg (May 19, 2010) Fed. Reg. 412 (Jan. 3, 2008). 3 Pub. L. No , 120 Stat. 780 (Aug. 17, 2006). DB1/

3 and does not hold contributions that are subject to Code section 401(k) or (m) (i.e., employee elective deferrals, employee after-tax contributions or employer matching contributions). An ESOP will not lose its exempt status because it receives rollover contributions of amounts from another plan that are held in a separate account, even if such amounts were contributions subject to Code section 401(k) or (m). Prior to the enactment of PPA, ESOPs were required to allow participants who were at least age fifty-five (55) and completed ten (10) years of participation in the ESOP to diversify a certain percentage of the employer stock in their accounts in assets other than employer stock. This requirement may be met by permitting distribution of the amount subject to diversification. Closely held companies continue to be subject to this rule. The final regulations, however, clarify that an ESOP holding publicly traded employer stock that has been satisfying this rule, whether by diversification or distribution, does not thereby satisfy the new diversification requirements, if otherwise required to do so. An ESOP subject to the new diversification requirements must allow each participant to direct the ESOP to divest employer stock allocated to his or her account that is attributable to elective deferrals or employee contributions (e.g., after-tax or rollover contributions) and reinvest an equivalent amount in other investment options. With respect to employer stock allocated to the participant s account that is attributable to employer contributions, the same diversification rights must be provided to a participant (or the individual s beneficiary) who has completed at least three (3) years of service. The new diversification rules also provide that a plan may not impose restrictions or conditions with respect to the reinvestment in employer stock of amounts attributable to diversified employer stock investments, where those restrictions or conditions are not imposed on the investment of other assets of the plan (other than those required by securities laws). A DB1/

4 plan is permitted to prohibit investments in frozen employer stock funds, however, but only if no additional contributions or further investments in employer stock are allowed. The final regulations provide a transitional rule for certain leveraged ESOPs for this exemption for frozen funds, because leveraged ESOPs cannot cease allocations of employer stock held in a suspense account without significant effect on the company s debt management. An employer stock fund will not fail to be a frozen fund because of the allocation of employer stock that is released to the fund as matching contributions from the ESOP s suspense account that holds employer stock acquired with an exempt loan. This transition rule only applies to employer stock that was acquired in a plan year beginning prior to January 1, 2007 with the proceeds of an exempt loan which is not refinanced after the end of the last plan year beginning before January 1, The final regulations are effective May 19, 2010 and apply for plan years beginning on or after January 1, C. Benefits of Satisfying the ESOP Requirements 1. Tax Free Release Private Letter Ruling (June 18, 2010) A taxpayer sold shares of company stock to an ESOP, made a timely election under Code section 1042 for deferral treatment of the gain on the sale and timely acquired qualified replacement property ( QRP ) with the proceeds from the sale. The taxpayer requested a ruling that a transfer of the QRP to his spouse as part of a divorce settlement be treated as a gift under Code section 1042(e)(3)(C) because the transfer is treated as a gift to the spouse under Code section 1041(b)(1), and would not thereby trigger gain on the transfer. Under Code section 1042, a taxpayer may elect to defer the long-term capital gain on the sale of shares to an ESOP if certain requirements are satisfied, including: (1) the shares sold are DB1/

5 qualified securities within the meaning of Code section 1042(c)(1); 4 (2) the taxpayer has held the qualified securities for at least three (3) years prior to the sale; (3) immediately after the sale, the ESOP owns at least 30 percent of either (a) each class of outstanding stock of the corporation or (b) the total value of all outstanding stock of the corporation; and (4) the taxpayer uses the proceeds from the sale to purchase QRP as defined in Code section 1042(c)(4) 5 within the replacement period of Code section 1042(c)(3). 6 Code section 1042(e)(1), however, provides that the deferred gain will be recognized if the taxpayer disposes of any QRP, unless one of the exceptions in Code section 1042(e)(3) applies. A gift is excepted under Code section 1042(e)(3)(C), but neither the statute nor the regulations define the term gift for this purpose. Code section 1041(b) provides that, in the case of any transfer of property described in Code section 1041(a) between spouses in a divorce, the property is treated as if acquired by the transferee by gift. The IRS noted that although Code section 1041(b) refers only to the transferee s treatment of the transfer of property as a gift, the legislative history under Code section 1041 provides that transfers will be treated in the same manner as a gift. Thus, the IRS noted that treating the transferor as having made a gift for purposes of Code section 1042(e)(3)(C) is consistent with Code section 1041 and its legislative history. Further, since the transferee is treated as having received a gift under Code section 1041(b), it follows that the transferor should be treated as making a gift. 4 Qualified securities generally means employer securities (as defined in Code section 409(l)) issued by a domestic C corporation that has no stock outstanding that are readily tradable on an established securities market. 5 Qualified replacement property generally means any security of a domestic operating corporation that does not have substantial passive income. 6 Replacement period means the 15-month period which begins 3 months before the sale of qualified securities to the ESOP and ends 12 months after such sale. DB1/

6 Therefore, the IRS ruled that a transfer of the QRP by the taxpayer to his spouse will be treated as a gift under Code section 1042(e)(3)(C) and will not cause him to recapture deferred gain on the QRP under Code section 1042(e)(1). II. SECTION 401(k) PLANS B. Special Rules Applicable to 401(k) Plans 2. Contributions a. Elective Deferral Contributions i. General In Notice , the IRS provided guidance on the treatment of differential wage payments under the HEART Act. See IV.A.2, infra. ii. Limitations The maximum amount of elective deferrals remains unchanged for 2011 at $16,500 plus an additional 5,500 in catch-up contributions if the employee is 50 years or older as of the end of the year Distributions a. General On December 6, 2010, the U.S. District Court for the Eastern District of California held that a participant must receive a distribution of $700,000 of elective deferrals made to his employer s 401(k) plan, but not $50,000-$100,000 of employer contributions made to his account. 8 The participant had been accused of a variety of acts of financial wrongdoing with the employer, and, as a result, the plan trustee refused to distribute the participant s account, arguing 7 IRS Notice , I.R.B. 848 (December 14, 2009) and IRS News Release IR (October 28, 2010). 8 Anderson v. Strauss Neibauer & Anderson APC Profit Sharing 401(k) Plan, E.D. Calif., No. 1:09-cv OWW DLB. DB1/

7 that if the employer had known of the participant s wrongdoing, it would have terminated him, and contributions would never have been made to the plan. In reviewing the facts, the court determined that the participant s contributions to the plan must be distributed based on section 206(d)(1) of ERISA, which provides that plan benefits may not be assigned or alienated. With regard to the employer contributions, the court determined that the plan trustee did not abuse his discretion in refusing to distribute these contributions, because of the plan language permitting the employer to recoup mistaken contributions and section 403(c) of ERISA, which permits employers to recover contributions made under a mistake of fact. In Notice , the IRS provided guidance on distributions to participants on active military duty. See IV.A.3, infra. d. In-Plan Roth Rollover Conversions [New Topic] Section 2112 of the Small Business Jobs Act of 2010 ( SBJA ), P.L , added section 402A(c)(4) to the Code, which permits participants in 401(k) or 403(b) plans with designated Roth options to complete in-plan rollovers to the Roth components within these plans effective for distributions made after September 27, For taxable years beginning after 2010, section 2111 of the SBJA also permits governmental section 457(b) plans to include designated Roth accounts. Section 402A(c)(4)(A) of the Code provides that any distribution described in section 402A(c)(4) is included in gross income. However, for in-plan conversions completed in 2010, the taxable amount of the distribution is includible half in the taxable year beginning in 2011 and half in the taxable year beginning in 2012, unless the individual elects to include the entire amount in the 2010 taxable year. In order to be eligible for the two-year income deferral, the conversion must be made no later than December 31, 2010, and, at the time of the conversion to the designated Roth account, the plan must have a qualified Roth contribution program in place. DB1/

8 IRS Notice provides extensive guidance regarding new Code section 402A(c)(4). 9 Pursuant to this guidance, an in-plan Roth conversion may be accomplished as a direct rollover, or as a distribution that is rolled back into the Roth account within 60 days of receipt. Further, only amounts that satisfy the rules for distributions under the plan and the Code and that are eligible rollover distributions under Code section 402(c)(4) may be converted. This means that unless the plan allows for non-hardship in-service distributions, participants may only complete in-plan Roth conversions if they are over age 59 1/2, have become disabled, have separated from service, or have received a qualified reservist distribution as defined in 72(t)(2)(G)(iii) (assuming the plan itself allows distributions for all of these events). The ability to complete an in-plan Roth rollover also extends to surviving spouse beneficiaries and alternate payees under qualified domestic relations orders. Finally, an in-plan Roth direct rollover is not treated as a distribution for purposes of Code section 72(p) (relating to plan loans), Code section 401(a)(11) (relating to spousal annuities), Code section 411(a)(11) (relating to participant consent prior to immediate distribution of an accrued benefit in excess of $5,000), or Code section 411(d)(6)(B)(ii) (relating to the elimination of optional forms of benefit). Moreover, an in-plan Roth direct rollover is not subject to the 20% mandatory withholding under Code section 3405(c). However, pursuant to Code sections 402A(c)(4)(D) and 408(A)(d)(3)(F), if an amount allocable to the taxable amount of an in-plan Roth conversion is distributed within the 5-taxableyear period beginning with the first day of the participant s taxable year in which the conversion was made, the amount distributed is treated as includible in gross income for purposes of 9 IRS Notice , I.R.B (December 20, 2010). DB1/

9 applying the 10% additional tax under Code section 72(t) to the distribution (unless an exception under section 72(t)(2) otherwise applies). The 5-taxable-year period ends on the last day of the participant s fifth taxable year in the period. The 401(k) plan amendment deadline for providing for in-plan Roth conversions is the later of the last day of plan year in which the amendment is effective or December 31, 2011, provided that the amendment is effective as of the date the plan first operates in accordance with the amendment. IV. INDIVIDUAL RETIREMENT ARRANGEMENTS A. Section 403(b) Tax Sheltered Annuities On February 17, 2010, the Department of Labor issued Field Assistance Bulletin No , providing guidance on annual reporting and ERISA coverage for 403(b) plans. FAB states that the Department will not reject annual reports filed for years after 2009 solely because the reports exclude certain annuity contracts and custodial accounts that are not treated as part of the plan or plan assets under FAB FAB provides that an employer that has a third-party administrator make discretionary decisions would lose its 403(b) plan s ERISA coverage safe harbor exemption. A safe harbor plan may provide that optional features, like loans, are available if the 403(b) plan provider is responsible for any discretionary determinations. Further, a safe harbor plan may provide that salary deferrals will no longer be sent to a provider if the provider does not comply with Internal Revenue Code rules. But a safe harbor plan may not provide that the employer can change 403(b) providers and unilaterally move employee money from one provider to another, although the employer can decide to limit the providers to which it will forward salary deferrals. DB1/

10 2. Contributions In Notice , the IRS provided guidance on certain provisions of the HEART Act. The IRS advised that differential wage payments made by an employer to an employee called to active duty are not required to be treated as compensation for determining contributions to a 403(b), 401(k) or 457(b) plan. However, differential wage payments must be included in compensation under the maximum limits on contributions under section 415 of the Code. 3. Distributions and Rollovers a. Distributions The IRS clarified in Notice that a 403(b), 401(k) or 457(b) plan is not required to permit a distribution upon a deemed severance from employment under section 414(u)(12)(B) of the Code. A 403(b), 401(k) or 457(b) plan that does permit such a distribution must provide for a 6-month suspension of salary deferrals and employee contributions. b. Rollovers Section 2112 of the Small Business Jobs Act of 2010 permits rollovers from 403(b) plans to designated Roth accounts in the same plan that are made after September 27, In Notice , the IRS issued guidance about these in-plan Roth rollovers. See II.B.3.d, supra. B. Individual Retirement Arrangement and Simplified Employee Pension Plans 1. Statutory Requirements of IRAs Revenue Procedure provides guidance for drafters and users of pre-approved IRAs. Prototype IRA sponsors are not required to amend the prototype IRA for law changes since A prototype IRA sponsor that amends its prototype IRA for these changes may continue to rely on the favorable opinion letter previously issued by the IRS. The sponsor may apply for a new IRS opinion letter using IRS Form A prototype IRA that is identified as a dual-purpose IRA on Form 5306 may be used as either a traditional IRA or a Roth IRA. DB1/

11 A model IRA is not required to be amended for changes in the law since The IRS expects to issue new model amendments for SIMPLE IRAs and traditional individual retirement annuities. IRS recommends that model IRA plan sponsors adopt the new model amendments. 2. Statutory Requirements of SEPs An employer maintaining a SEP-IRA must make contributions on behalf of each employee who is at least 21, performed services during at least three of the preceding five years, and, for 2011, earned at least $ Statutory Requirements of SIMPLE IRAs The limitations for salary reduction contributions to a SIMPLE IRA remains at $11,500 for IRA Contributions and Deductions The limit on deductible IRA contributions for 2011 remains at $5,000. In Notice , section VI, the IRS discusses contributions of military death gratuities to Roth IRAs as a result of section 109 of the HEART Act. That section amends section 408A(e) of the Code to include as a qualified rollover contribution exempt from the annual limits on Roth IRA contributions, a contribution to a Roth IRA of a military death gratuity to an eligible survivor of a service member or a Servicemembers Group Life Insurance (SGLI) program payment if the contribution is made within one year after the IRA beneficiary receives the military death gratuity or SGLI payment. Section 109 of the HEART Act is generally effective for deaths from injuries occurring on or after June 17, a. Deductible Traditional IRA Contributions If a taxpayer is an active participant in an employer sponsored retirement plan, the deductible amount of the taxpayer s traditional IRA contribution for the taxable year is phased out between certain modified adjusted gross income (MAGI) levels. The threshold phase-out DB1/

12 level for 2011 for single taxpayers remains at $56,000. The threshold phase-out level for married taxpayer filing jointly is increased to $90,000. A special phase-out level applies if the spouse is not an active participant in another plan. In that case, the combined phase-out threshold level is increased to $169,000. b. Nondeductible Contributions Nondeductible contributions generally may be made to a Roth IRA, subject to annual maximum and phase-out rules based on the taxpayer s MAGI, similar to the rules that apply to traditional IRAs. The threshold phase-out level for contributions to a Roth IRA for 2011 is increased to $107,000 for individual filers and is increased to $169,000 for married taxpayers filing jointly. V. DEFERRED COMPENSATION PLANS THAT ARE NOT QUALIFIED UNDER CODE SECTION 401 Notice A. Section 409A In Notice the IRS established procedures for correction of certain plan document failures to comply with section 409A. Specifically, the Notice prescribes permissible corrections for the following documentary failures: Application of section 409A to certain ambiguous plan terms; Correction of faulty distribution provisions; Correction of impermissible definitions of otherwise permissible payment events; Correction of impermissible payment periods following a permissible payment event; Correction of impermissible payment events and payment schedules; DB1/

13 Correction of failure to include 6-month delay of payment for specified employees; Correction of provisions for impermissible initial deferral elections; Correction of documentary failures following initial adoption of a plan. The Notice provided transition relief allowing corrections on or before December 31, 2010 without tax penalties. This relief is also available for corrections made on or before December 31, 2011, but only with respect to a very limited number of specified documentary failures. For later corrections, a number of the permitted corrections require each affected employee to include in income 50% of the amount deferred under the plan that was subject to the correction. In addition to the federal income tax on these amounts, several of the corrections also apply the 20% penalty tax under section 409A. In some cases, these taxes may not be applicable at the time of the correction but may apply in the following year because of the occurrence of subsequent events. Consistent with other correction guidance under section 409A, these correction procedures for documentary failures generally require that both the employer and all affected employees meet specified notice and reporting requirements. Specifically, supplemental information relating to the failure and the correction must be attached to employer and employee tax returns for the year of the correction and any subsequent year in which an employee is required to recognize taxable income. Notice This Notice liberalized certain of the section 409A correction procedures under Notice for operational failures and under Notice for documentary failures. Specifically, Notice : DB1/

14 Expands the types of plans eligible for relief for documentary failures under Notice to include a nonqualified plan linked to a qualified plan or another nonqualified plan, so long as the linkage does not affect the time or form of payments; Expands the types of plans eligible for relief for documentary failures under Notice to include certain stock rights that were intended to comply with section 409A, rather than to be exempt from section 409A; Provides an additional method of correction for documentary failures under Notice for certain failures relating to payments at separation from service that are subject to a requirement to execute a release of claims or a similar document, and provides transition relief allowing the correction of such failures that were in effect on or before December 31, 2010, including relief from reporting requirements for affected employees (i.e., supplemental information otherwise required to accompany the employee s Form 1040); Provides relief from information reporting requirements for correction of documentary failures under Notice by affected employees under transition relief ending December 31, 2010 (i.e., supplemental information otherwise required to accompany the employee s 2010 Form 1040); Provides relief from the requirement that employers provide certain information to affected employees relating to correction of operational failures under Notice where corrections are made in the same taxable year as the failure occurs. B. Section 457 Plans For State And Local Governments And Tax-Exempt Employers 2. Eligible Plans DB1/

15 b. Contributions In Notice , the IRS provided guidance on the treatment of differential wage payments under the HEART Act. See IV.A.2, supra. i. Basic Annual Limitation The annual limit on total deferred compensation under a 457(b) plan remains at $15,500 for ii. Catch-Up Contributions The annual limit on catch-up contributions by a participant age 50 or over to a 457(b) plan maintained by a governmental employer remains at $5,500 for c. Taxation Of Distributions And Rollovers In Notice , the IRS provided guidance on distributions to participants on active military duty. See IV.A.3, supra. i. Distributions For Unforeseeable Emergencies In Revenue Ruling , the IRS provided three examples to illustrate circumstances that do or do not qualify as unforeseeable emergencies for purposes of permitting a distribution from a section 457(b) plan. Specifically, the Service concluded that unforeseeable emergencies included (i) repairs to the participant s principal residence after significance water damage from a water leak and (ii) funeral expenses for the participant s adult son, who was not a dependent. Payment of accumulated credit card debt, however, was not an unforeseeable emergency where the debt was not due to extraordinary events or unforeseeable circumstances resulting from events beyond the participant s control. v. Rollovers. Section 2112 of the Small Business Jobs Act of 2010 permits rollovers from governmental 457(b) plans to designated Roth accounts in the same plan that are made after DB1/

16 2010. In Notice , the IRS issued guidance about these in-plan Roth rollovers. See II.B.3.d, supra. VI. MISCELLANEOUS A. Catch-Up Contributions The annual limit on catch-up contributions is $5,500 for B. Tax Credit for Qualified Retirement Savings Contributions The income limits for the credit rate for 2011 are as follows: AGI Joint Filers AGI Head of AGI All Other Filers Credit Rate Households $0-$34,000 $0-$25,500 $0-$17,000 50% $34,000-$36,500 $25,500-$27,375 $17,000-$18,250 20% $36,500-$56,500 $27,375-$42,375 $18,250-$28,250 10% Over $56,500 Over $42,375 Over $28,250 0% DB1/