April 2006 Vol. IX, No. 1
ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER

This past year has been busy indeed with respect to tax and ERISA law changes affecting every type of tax-qualified, executive compensation and welfare benefit arrangement. This Newsletter highlights the salient issues of which you should be aware. This Newsletter also contains a table with new cost of living adjustments affecting tax-qualified plans.

The Newsletter is not intended as, and cannot be considered to constitute, specific legal advice, as each individual circumstance is unique. However, we are prepared to assist our clients and business associates in reviewing their employee benefit programs and in making any necessary or desirable revisions to take into account changes in the law.

Since our last Newsletter, Marcia S. Wagner has continued to lecture and write extensively, and has received recognition in "The Best Lawyers in America" and "Massachusetts Super Lawyers". She has also been quoted in several major news publications, and has provided numerous seminars for the American Bar Association, Department of Labor, Internal Revenue Service and others. Marcia has also co-authored a Quick Reference to HIPAA Compliance, for Aspen Publishers and two BNA Tax Management Portfolios entitled "ERISA Litigation, Procedure, Preemption and Other Title I Issues" and "EPCRS Plan Correction and Disqualification". Marcia has also received the prestigious AV Peer Review Rating by LexisNexis Martindale-Hubbell for very high to preeminent legal ability and integrity, and has received two Who's Who honors. Ari J. Sonneberg continues his work at the Tax Section Council of the Massachusetts Bar Association. Debra Dyleski-Najjar has received recognition in three Who's Who publications, was named by Boston Women's Business Journal as one of Boston's top-ten women attorneys, completed the prestigious "Leadership New Hampshire" program and was recognized in Chambers U.S. Guide to Leading Lawyers in America. Diane Goulder Cohen has received "The Best Lawyers in America" honor in the ERISA/Employee Benefits field. To learn more about our team and practice, please visit our web site at www.erisa-lawyers.com.

In the event you desire legal advice or consultation, please feel free to contact Marcia S. Wagner, Christopher J. Sowden, John R. Keegan, Diane Goulder Cohen, Stephen J. Migausky, Ari J. Sonneberg, Jon C. Schultze, Jaime A. Dansa or Virginia S. Peabody.

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TABLE OF CONTENTS
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I COST OF LIVING ADJUSTMENTS

II. DEFINED CONTRIBUTION PLANS

A. Roth 401(k) Plans

B. Final 401(k) Plan Regulations

C. New 403(b) Regulations

D. Temporary Rules Expand FICA Taxation of 403(b) Contributions under Salary Reduction Agreements

E. Deemed IRAs in Qualified Plans

F. S Corp/ESOP Abuses

G. Proposed Rules Finalized for Eliminating Forms of Distribution

H. EBSA Issues Guidance on Distributions to Missing Participants from Terminated DC Plans

I. EBSA Proposed Regulations Provide Termination Instructions for Service Providers of Abandoned Plans

III. DEFINED BENEFIT PLANS

A. Phased Retirement Distributions from Pension Plans

B. Cash Balance Plans

C. IRS Issued Proposed and Final Regulations on Anti-Cutback Rules

D. Regulations on QJSAs and QPSAs Cover Information that Participants Must Receive to Compare Distribution Forms

E. IRS Cracks Down on "Abusive" Life Insurance Policies in 412(i) Plans

F. Deficit Reduction Act

G. IRS Proposes Shift to New Mortality Tables for Computation of Employee Plan Liabilities


IV. ALL TAX-QUALIFIED PLANS

A. Fees for Plan Rulings Increase Sharply

B. Hurricane Katrina Statutory and Administrative Relief

C. IRS Overhauls Rules on Remedial Plan Amendments

D. Bankruptcy Issues

E. Labor Department Issues Safe Harbors for Automatic Rollovers of Plan Distributions

F. IRS Issues Comprehensive Guidance on Plan Limits on Benefits and Contributions

G. EBSA Overhauls Voluntary Fiduciary Correction Program and Proposes Amendment to Related Class Exemption

H. IRS Changes Policy on Part-Time Employees and Qualified Plans

V. WELFARE BENEFIT PLANS

A. Comparison of Health Savings Accounts, Health Reimbursement Arrangements and Flexible Spending Accounts

B. Definition of Dependent

C. Modification of the Application of the "Use-it-or-Lost-it" Rule

D. HIPAA Update

E. Medicare Prescription Drug Benefits Impact on Employer-Sponsored Plans

F. Final COBRA Regulations Require Major Overhaul to COBRA Notices and Procedures

G. Parking, T-Pass and Vanpool Fringe Benefits IRC Section 132(f)

VI. NEW NONQUALIFIED DEFERRED COMPENSATION RULES UNDER CODE SECTION 409A

A. IRS Guidance on New Nonqualified Deferred Compensation Rules Explains Key Terms and Exceptions

B. IRS Provides Deferred Compensation Relief for Stock Options and SARs

C. Elections as to Deferrals and Distributions

D. Restrictions on Distributions

E. Effective Dates and Reliance

VII. MISCELLANEOUS

A. IRS Circular 230 Rules Seek to Rein in Tax Shelter Activity

B. Proposed Regulations Tighten Private-Purpose Prohibition for Section 501(c)(3) Exempt Status

C. IRS Issues Guidance on Determining Automatic Excess Benefit Transactions


 


I. COST OF LIVING ADJUSTMENTS


   2005 2006
 Maximum annual payout from a defined benefit plan
at or after age 62 (Plan Year ending in stated Plan Year)
 $170,000*  $175,000*
 Maximum annual contribution to an individual's defined contribution account (Plan Year beginning in stated year)  $42,000 **  $44,000 **
Maximum Section 401(k), 403(b) and 457(b) elective deferrals  $14,000 ***   $15,000 ***
Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older  $4,000***   $5,000***
 Maximum amount of annual compensation that can be taken into account for determining benefits or contributions under
a qualified plan
 $210,000 $220,000
 Test to identify highly compensated employees, based on
compensation in preceding year
 $95,000 $100,000
Wage Base: For Social Security Tax  $90,000  $94,200
 For Medicare  No Limit  No Limit
Amount of compensation to be a key employee $135,000
$140,000

* There are late-retirement adjustments for benefits starting after age 65.
** Plus "catch-up" contributions.
*** These are calendar year limitations.
**** For example, if looking back to 2005 to identify highly compensated employees in 2006, use the $95,000 limit; if looking back to 2006 to identify highly compensated employees in 2007, use the $100,000 limit.


II. DEFINED CONTRIBUTION PLANS

A. Roth 401(k) Plans

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") amended the Internal Revenue Code of 1986 (the "Code") to add Section 402A which permits Code Section 401(k) and 403(b) plans to allow participants to elect that a portion or all of their contributions to such plans be designated as Roth contributions for plan years beginning on or after January 1, 2006. Roth contributions are not tax deductible.

Roth contributions to Code Section 401(k) and 403(b) plans are likely to be attractive to many participants. The primary advantage of Roth contributions is that the earnings thereon are not taxed. This feature may be particularly advantageous to younger, lower-paid participants who have a longer time to retirement and for whom the benefit of a tax-free distribution at retirement will outweigh the current tax costs. Higher income employees have not had the right to use Roth IRAs because of the Roth IRA income limits. However, under Roth 401(k) and 403(b) plans, highly compensated employees will be able to save up to $15,000 after tax per year (in 2006, subject to an inflation adjustment in future years) without future income tax liability on the earnings on these Roth contributions. Further, there is a significant benefit to both lower income and higher income employees: contributions to a Roth 401(k) or 403(b), unlike Roth IRAs, may be matched by a participant's employer on a pre-tax basis, like matching contributions on non-Roth 401(k) or 403(b) elective deferrals.

Plan sponsors considering whether to implement Roth contributions in their 401(k) or 403(b) should tread carefully, as there are a number of legal and administrative issues that could add confusion, expense, or legal exposure for plan sponsors, their employees, and service providers.

1. Background

The general rule under Code Section 402A is that any contribution designated by a participant as a "designated Roth contribution" to a "qualified Roth contribution program" will be treated the same as an elective deferral. Except for rollover contributions from other Roth accounts, Roth contributions are aggregated with non-Roth elective deferrals and are subject to the elective deferral limits under Code Section 402(g) ($15,000 in 2006 for 401(k) or 403(b) plans; $20,000 for Code Section 414(v) catch-up eligible participants)).

A "qualified Roth contribution program" must satisfy two basic requirements. First, a participant must be able to designate that some or all of his or her elective deferrals will be Roth contributions. Second, Roth contributions must be recorded in a separate account with applicable earnings and losses allocated to the Roth account.

For a distribution from a designated Roth account to be tax-free, it must be a "qualified distribution." In general, a "qualified distribution" is a distribution (i) that is made after a participant reaches age 59-1/2, dies, or becomes disabled, and (ii) that is not made within five years of a participant's first Roth contribution to the applicable plan or a predecessor plan to which Roth contributions were also made. If Roth contributions result in excess deferrals under Code Section 402(g), the excess deferrals must be distributed by April 15 of the year following the year of contribution to avoid taxation even though the distribution is not a qualified distribution.

2. Proposed and Final Regulations

On March 2, 2005, the IRS issued proposed regulations providing guidance on Roth contributions, and recently, on January 3, 2006, the IRS issued final regulations. The regulations are written as additional language that is intended to supplement the recently effective comprehensive final regulations under Code Sections 401(k) and 401(m) (See Section II.B of this Newsletter).

a. Contribution Elections. An employee must irrevocably designate his or her contributions as Roth contributions at the time of his or her cash or deferred election and designate that the Roth contributions are being made in lieu of all or a portion of the pre-tax elective deferrals the participant is otherwise eligible to make, and Roth contributions must be included in income and subject to withholding at the time the employee contributes such amounts.

b. Separate Accounting. Roth contributions, earnings, and distributions must be tracked in a separate account. Gains, losses, and other credits or charges must be allocated to a Roth account and other plan accounts on a reasonable and consistent basis. Furthermore, forfeitures may not be allocated to a Roth account.

c. Compliance With Elective Deferral Requirements. Roth contributions must satisfy the requirements applicable to elective deferrals made under a cash or deferred arrangement or 401(k) plan. Therefore, Roth contributions must: (i) be nonforfeitable, (ii) follow the distribution-timing rules applicable to elective deferrals, and (iii) be treated as elective deferrals for most purposes (including nondiscrimination testing under Code Section 401(k) and (m)). Also, Roth accounts, unlike Roth IRAs, are subject to the minimum required distribution rules during a participant's lifetime (i.e., at the later of age 70-1/2 or retirement).

d. 401(k) and (m) Nondiscrimination Testing. A plan may permit an employee to designate whether excess contributions (as determined after ADP and ACP testing) are attributable to his pre-tax or Roth contributions.

e. Elective Deferral Requirement. In order to provide for designated Roth contributions, a qualified cash or deferred arrangement also must offer pre-tax elective deferrals.

f. Automatic Enrollment or Negative Elections. Plans can use automatic enrollment in conjunction with Roth contributions, but in doing so must set forth the extent to which default contributions are pre-tax elective contributions or designated Roth contributions. Wage laws of certain states may require that any deduction from wages be authorized by the employee in writing. Employers should check state law before using negative elections.

The IRS issued additional proposed regulations on the taxation of distributions from Roth contribution accounts under a 401(k) plan or 403(b) annuity on January 26, 2006. These regulations provide much-needed guidance and fill in gaps left from previous guidance.

a. Non-qualified Distributions. A "non-qualified distribution" will be subject to income taxation based on a pro-rata allocation of the income earned in the account to the contributions made to the account.

b. Partial Distributions. If a participant receives a partial distribution from a plan with both Roth and pre-tax accounts, either the participant or the plan can specify from which account the distribution is paid. A partial distribution from a Roth account must include a pro-rata distribution of income.

c. Rollovers. A participant can elect a direct plan-to-plan rollover of a Roth distribution from one 401(k) plan to another 401(k) plan, or from a Roth 403(b) plan to another Roth 403(b) plan. A participant also can elect a plan-to-plan or 60-day rollover of a distribution from a Roth plan to a Roth IRA (even if the participant would otherwise be barred from making a Roth IRA contribution). A participant cannot transfer any amount from a Roth IRA to a 401(k) or 403(b) plan even if the only amount in the IRA is a rollover distribution from a Roth 401(k) or 403(b) plan.

If a participant elects a direct plan-to-plan rollover of a Roth distribution, the five-year tracking period begins on the first day for which the employee first had Roth contributions made to the other plan, if earlier. In a plan-to-plan rollover from one Roth plan to another Roth plan, the distributing plan must inform the recipient plan, within 30 days, either: (1) that the distribution is a qualified distribution; or (2) the amount of the participant's basis and the year the participant's 5-year clock started to run. If a Roth plan distributes the amount to the participant, the participant can request a similar written statement.

d. Hardship distributions. The taxation of a hardship distribution to a participant from a 401(k) plan will depend on the portion of the participant's elective deferrals that is distributed from his Roth and pre-tax accounts (reduced by prior hardship distributions and excluding income on deferrals, QNECs, and QMACs).

e. Participant Loans. Loans may be paid from a participant's pre-tax account, Roth account, or both, and repayments must be allocated to each account, as applicable. If a participant defaults and a deemed distribution occurs, the Roth portion would be a nonqualified distribution, regardless of the 5-year clock or the participant's age.

f. Excess deferrals. Roth contributions that are excess deferrals and that are not corrected before April 15th of the following year are includible in gross income (with no exclusion from income for amounts attributable to basis) and are not eligible for rollover.

3. Open Issues

A number of questions remain to be addressed, including the following:

a. Automatic Rollover Rules. As discussed in Section IV. E of this Newsletter, effective March 28, 2005, mandatory cashouts of amounts between $1,000 and $5,000 became subject to the mandatory rollover rules. Because Roth contributions are treated as elective deferrals, Roth accounts may be subject to the mandatory rollover rules. As such, plans providing for mandatory cashouts of amounts between $1,000 and $5,000 may need to work with their service providers to provide default rollover Roth IRA accounts for Roth contributions.

b. Fiduciary Issues. There are certain unsolved fiduciary questions as well, for example: To what extent is the employer obliged to provide assistance to employees in deciding which type of contribution to make? Will general written materials suffice to meet any such obligation if these materials include a suggestion that the employee consult with a tax adviser, even though many employees may not have a tax adviser or are unwilling to hire one? If such assistance is provided by a person (including the employer) who is a fiduciary under the Employee Retirement Income Security Act of 1974 ("ERISA"), could this person be subject to claims of breach of fiduciary responsibility by plan participants asserting that such assistance was insufficient, misleading, or wrong?

Comment: Sunset After December 31, 2010. As is the case with many Code provisions added by EGTRRA, Roth contributions are due to sunset after December 31, 2010. It is expected that Roth contributions will result in a long-term reduction in revenue received by the Treasury due to the tax-free distribution of Roth accounts. As such, it is unclear whether there is sufficient political support for enacting legislation permitting Roth contributions after 2010. Employers should not shy away from offering Roth 401(k)s and 403(b)s because they might not be permanent. It is important to recognize that participants have a planning opportunity right now.

Comment: Plan Amendment. If you are considering adding a Roth contribution feature to your tax-qualified plan, please call us for assistance and advice; also, your plan document will need to be amended, and new summary plan descriptions or summaries of material modifications and enrollment forms will have to be distributed to your employees. Administratively, employers will need to ensure that new or upgraded recordkeeping systems are in place to maintain and track Roth contribution accounts. Additionally, changes to the payroll systems are needed to withhold taxes on Roth contributions and to include Roth contributions in income on an employee's Form W-2.

B. Final 401(k) Plan Regulations

The IRS has issued a huge set of comprehensive final regulations setting out the nondiscrimination and other requirements for Code Section 401(k) cash or deferred arrangements, and for matching contributions and employee contributions under Code Section 401(m). The 228 pages of regulations reflect the relevant tax law changes and IRS rulings that have come into effect since 1994, and modify and finalize the proposed regulations that were issued in 2003.

1. Prohibition of Pre-Funded Contributions

Contributions are treated as made pursuant to a cash or deferred election only if they are made after the employee's performance of services which relate to the compensation that would have been paid to the employee absent the election. Amounts contributed in anticipation of the future performance of services are not treated as elective contributions. Thus, employers may not pre-fund elective contributions in order to accelerate the deduction for elective contributions.

Employers are also prohibited from pre-funding matching contributions to accelerate the deduction for contributions. Thus, a matching contribution could not be made before the employee's performance of services with respect to which the elective deferral was made or before the employee's contribution.


2. Mandatory Disaggregation of ESOP and 401(k) Features of Plan

An ESOP may be incorporated into a 401(k) plan if the applicable qualification requirements are satisfied. Under an earlier iteration of the regulations, the ESOP and 401(k) components of the plan had to be tested separately for purposes of compliance with the coverage and nondiscrimination rules. Thus, in applying the coverage test and the ADP and ACP tests, the ESOP and 401(k) features of the plan were tested separately.

Acknowledging both the expense and administrative burden imposed on plan sponsors by the requirement of applying two separate nondiscrimination tests and the increased use of ESOPs as the employer stock fund under 401(k) plans, the final rules eliminate the mandatory disaggregation of the ESOP and non-ESOP portion for ADP and ACP testing.

Comment: Mandatory disaggregation continues to apply for purposes of the Code Section 410(b) coverage rules. Therefore, the group of eligible employees under the ESOP and non-ESOP portions of the plan would still be required to separately satisfy the nondiscrimination tests of Code Section 401(a)(4) and the coverage test of Code Section 410(b).


3. Distributions Upon Severance from Employment

401(k) plan participants may receive distributions in the event they continue on the same job for a different employer following a liquidation, merger, consolidation, or other corporate transaction. However, an employee will not be treated as having experienced a severance from employment, and therefore may not receive distributions, if the employee's new employer maintains the 401(k) plan in which the employee participates (e.g., by continuing to sponsor the plan or by accepting a transfer of plan assets and liabilities).

The final rules do not authorize a distribution to an individual whose employment status has changed from that of common law employee to leased employee, as that would not constitute a severance from employment.

4. Hardship Distributions

The final rules clarify the changes to the hardship distribution rules implemented by EGTRRA, including a 6-month suspension of elective deferrals following a hardship distribution. In addition, the final rules permit an employer to rely on a written representation by an employee in support of a claim that a distribution is necessary to satisfy an immediate and heavy financial need (including funeral expenses and the cost of repairs to a principal residence) to establish that the need cannot reasonably be relieved by any available distribution or nontaxable plan loan. However, an employee would not be required to take a commercial loan if a loan sufficient to meet the employee's need would not be available on reasonable commercial terms. In order to qualify for a hardship distribution, a participant must obtain all distributions currently available under all qualified plans of the employer.

The final rules also add two additional deemed hardship reasons: (1) funeral expenses and (2) expenses related to the repair of damage to an employer's principal residence. The final rules also modify existing hardship reasons to disregard the meaning of the definition of "dependent" in Code Section 152 by the working families Tax Relief Act of 2004 (see Section V.B of this Newsletter) and to expand the class of children whose medical expenses can result in hardship distribution to include a non-custodial child.

5. Specify Nondiscrimination Method

The final rules require plans to specify the nondiscrimination testing method and the optional choices being used under that method. For example, a plan must specify whether the current year or prior year ADP testing method is being used. A plan that uses the safe harbor method must specify whether the safe harbor contribution will be the nonelective safe harbor contribution or the matching safe harbor contribution. Once elected, a plan cannot switch from the safe harbor method to a non-safe harbor method during the plan year.


6. Disregarding Early Participants in ADP Test

Nonhighly compensated employees ("NHCE") who do not meet the Code Section 410(a) minimum age and service requirements may be disregarded for purposes of the ADP test (and the ACP test). This option is "permissive" and plans may continue to use the testing option under which a plan that benefits otherwise excludable employees is disaggregated and the ADP test (or ACP test) is separately performed for eligible and excludable employees.

7. Calculating the ADR of HCEs in Multiple Plans

The actual deferral ratio ("ADR") of a highly compensated employee ("HCE") who is eligible to participate in two or more CODAs or 401(k) plans of the same employer is determined by treating all of the plans in which the employee is eligible to participate as one CODA or 401(k) plan. Prior final rules had required aggregation of the elective deferrals for the HCEs for all plan years that end with or within the calendar year. The rules, however, produced inappropriate results because more than 12 months of elective deferrals could be included in an employee's ADR. Accordingly, the final rules, effective beginning in 2006, require the ADR for each HCE participating in more than one CODA to be determined by aggregating the elective contributions of the HCE that are made within the plan year of the CODA being tested. The modification is designed to ensure that each of the employer's CODAs will use 12 months of elective contributions and 12 months of compensation in determining the ADR for an HCE who participates in multiple plans, even if the plans have different plan years.

Similar rules apply to the determination of the actual contribution ratio under the ACP test for an HCE who receives matching contributions on employee contributions under two or more plans.

8. Restrictions on "Bottom Up" QNECs

The final rules continue to allow plans, subject to specified conditions, to correct failures of the ADP test by making qualified nonelective contributions ("QNEC") or qualified matching contributions ("QMAC"). The final rules add a new condition that limits the use of the bottom-up leveling technique, pursuant to which employers attempt to pass the ADP test by targeting high percentage QNECs to a small number of part-time, terminated, or other short-service NHCEs with the lowest compensation during the year (raising that NHCEs' ADR), rather than providing contributions to a broad group of NHCEs. The bottom-up leveling method enables an employer to pass the ADP test by contributing a small amount of money to select NHCEs which, because the ADP test is based on the unweighted average of ADRs, has the effect of increasing the average contribution for NHCEs.

Generally, under the new rules, a plan would be treated as providing an impermissibly targeted QNEC if less than one-half of all NHCEs receive QNECs or if the QNEC exceeds 5% of the NHCE's compensation and is more than twice the QNEC that other NHCEs receive, when expressed as a percentage of compensation. Specifically, QNECs that exceed 5% of compensation could be taken into account for ADP testing purposes only if the contribution, when expressed as a percentage of compensation, does not exceed two times the plan's "representative contribution rate." The plan's representative contribution rate is the greater of: (1) the lowest contribution rate of any eligible NHCE among a group of eligible NHCEs that consists of one-half of all eligible NHCEs for the plan, or (2) the lowest contribution rate among all eligible NHCEs under the arrangement who are employed on the last day of the year. The applicable contribution rate for an eligible NHCE would be the sum of the QMACs taken into account under the ADP test for the eligible NHCE for the plan year and the QNECs made for that NHCE for the plan year, divided by the NHCE's compensation for the same period.

Parallel restrictions would apply to QNECs taken into account in ACP testing. However, the contribution percentage made in determining the lowest contribution percentage would be based on the sum of the QNECs and those matching contributions taken into account under the ACP test.

With respect to QNECs made in connection with an employer's obligation to pay a prevailing wage under the Davis-Bacon Act, the final rules allow a QNEC of up to 10% of compensation to be taken into account under the ADP test.

In order to prevent employers from using targeted matching contributions to avoid the restrictions on targeted QNECs, the final rules do not allow matching contributions to be taken into account under the ACP test if the matching rate for the contribution exceeds the greater of 100% or two times the representative matching rate.

9. Apportioning Corrective Distributions to HCEs in Multiple Plans

The final rules provide a special rule for correcting excess contributions for HCEs who participate in multiple 401(k) plans. Specifically, in determining the HCE who will be apportioned a share of the total excess contribution to be distributed for the plan, all contributions in CODAs in which the HCE participates are aggregated and the HCE with the highest dollar amount of contributions is apportioned excess contributions first. However, distributions would be limited to actual contributions under the plan undergoing correction, rather than all of the contributions considered in calculating the employee's ADR. If additional corrections are needed, the HCEs with the next highest dollar amount of contributions are apportioned the remaining excess contributions, until the excess contributions are completely apportioned.

The final rules further clarify that gap period income (i.e., income for the period after the plan year) needs to be included only to the extent that the employee is or would be credited with allocable gain or loss on those excess contributions for that period, if the total account were to be distributed. In addition, a distribution of excess contributions is not required to include the income allocable to the excess contributions for a period that is no more than 7 days before the distribution.

10. Safe Harbor 401(k) Plans

A 401(k) safe harbor plan, a design-based plan that meets certain contribution and notice requirements, generally must be adopted before the beginning of the plan year, and must be maintained throughout a full 12-month plan year. The final regulations adopt the exceptions to
this 12-month rule that were included in the proposed regulations. Thus, a safe harbor plan generally can have a short plan year:

a. When a plan terminates, if the plan termination is in connection with a merger or acquisition involving the employer, or the employer incurs a substantial business hardship;

b. When a plan terminates, provided the employer makes safe harbor contributions for the short year, employees are provided notice of the change, and the plan passes the ADP test; or

c. Where a plan changes its plan year and, thus, has a short plan year, provided the plan was a safe harbor plan for the preceding plan year and the short plan year, and the short plan year is followed by a plan year (or 12-month period if the following plan year is a short plan year during which the plan is a safe harbor plan).

Comment: Although the regulations permit some provisions to be incorporated by reference, it is likely that most 401(k) plans will have to be amended to reflect the new regulations.

C. New 403(b) Regulations

1. Regulatory Background

The IRS has issued long awaited proposed regulations governing 403(b) plans. The proposed rules, which may not be relied upon until finalized, update final regulations issued in 1964, which predate ERISA. The proposed rules effectively consolidate legislative and regulatory developments released over the last 40 years that have significantly eroded the differences between 403(b) plans and other salary reduction arrangements, such as 401(k) plans and 457(b) plans. The new regulations generally codify existing rules and adopt standard administrative practices, but also impose documentation requirements that may subject employers to ERISA Title I coverage; eliminate good faith compliance with the nondiscrimination requirements applicable to nonelective deferrals; condition satisfaction of universal availability on an employee's effective opportunity to make deferrals; and clarify application of controlled group rules (including a new permissive aggregation option) to tax-exempt entities.

2. Statutory Background

Code Section 403(b) provides an exclusion from an employee's gross income for contributions made by an eligible employer to a Code Section 403(b) plan for the employee's benefit. A Code Section 403(b) plan may be funded in one of three ways:

a. Through annuity contracts, each of which is issued by an insurance company, and is purchased for an employee by his or her employer.

b. Through custodial accounts, each of which covers an employee, that meets the requirements of Code Section 401(f)(2), and is invested solely in mutual funds.

c. If the employer is a church, through retirement income accounts, each of which covers a church employee.

The exclusion from gross income generally will not apply unless the plan satisfies: (i) a nonforfeitability requirement, (ii) certain availability, nondiscrimination, and coverage requirements, and (iii) certain limitations on any salary reduction contributions.

3. Fully Vested and Nonforfeitable Right to Benefits

An employee's right to elective deferrals under a 403(b) plan must be nonforfeitable, unless there has been a failure to pay premiums or any annuity contracts. Accordingly, an employee's rights to elective deferrals under the plan may not be conditioned upon a subsequent event, subsequent performance, or subsequent forbearance, which will cause a loss of the right. In addition, an employee's rights may not be conditioned upon a sufficiency of assets in the event of plan termination.

4. Taxation of Excess Annual Additions

Annual additions to a 403(b) plan may not exceed the limits specified under Code Section 415(c), treating contributions as annual additions. Under the proposed rules, only the excess annual additions to a 403(b) plan will be subject to tax (i.e., amounts in excess of $44,000 for 2006, as indexed). However, in order for this treatment to apply, the issuer of the contract must maintain separate accounts for the portion that includes the excess annual additions and the portion of the arrangement that includes the amount not in excess of the 415 limits.

5. Plan Document Required

The prerequisite conditions for the exclusion from an employee's gross income for 403(b) contributions must be satisfied in form and operation in the 403(b) contract. The proposed rules would require the 403(b) contract to be maintained pursuant to a written plan that must include all material provisions relating to eligibility, benefits, applicable limits, contracts available under the plan, and the time and form under which benefits could be distributed. For example, the 403(b) plan must expressly include the Code Section 402(g) deferral limit. The written document requirement would generally not apply to church plans or to defined benefit plans (in effect on the date the regulations are finalized) that have complied with the requirements of Code Section 403(b).

Comment: The requirement of a written plan document is a significant change from current practice, in which, the employer may act merely as a conduit for the payment of elective deferrals to a custodian pursuant to a contract, but does not maintain a plan document.

6. ERISA Title I Coverage

ERISA Regulations Section 2510.3-2(f) provides that a salary reduction 403(b) arrangement will not be considered an employee benefit pension plan subject to Title I if, among numerous factors, participation is voluntary for employees; all rights under the contract are enforceable only by the employee; the employer's involvement in the plan is limited to such matters as selecting an annuity provider and placing limits on the number of available annuity providers; and the employer receives no compensation other than reasonable compensation to cover expenses incurred in the performance of duties pursuant to the salary reduction agreement. Employer contributions (e.g., profit sharing and matching contributions) to the plans generally trigger ERISA Title I coverage. In addition, ERISA Title I will apply if the plan authorizes the employer to make determinations regarding an employee's eligibility for hardship, disability or in-service distributions even if the employer makes no contributions to the plan.

The requirement under the proposed rules that a 403(b) program be maintained pursuant to a written plan, raises the issue of whether all Tax Sheltered Annuities ("TSAs") will now be subject to the requirements and standards of ERISA Title I (e.g., the coverage, reporting and disclosure, summary plan description, summary annual report, and joint and survivor annuity rules of ERISA). Currently, not all TSAs are subject to ERISA Title I as discussed below. Plans maintained by governmental employers and non-electing church plans are currently, and remain, exempt from ERISA Title I.

7. Distinguishing Between 403(b) and 401(k) Deferrals

The proposed regulations apply the rules governing cash or deferred elections under a 401(k) plan to elective deferrals under 403(b) plans. Therefore, elective deferrals would be limited to contributions made pursuant to a cash or deferred election and other benefits could not be contingent on an election to defer. However, the proposed rules would not eliminate all of the differences between 403(b) and 401(k) plans. Thus, among other differences: 403(b) plans may only be sponsored by specified tax-exempt employers; 403(b) contributions may only be made to an insurance annuity contract, a custodial account that is limited to mutual fund shares, or a church retirement account, and not to a trust or custodial account that fails to satisfy the custodial account rules of Code Section 403(b)(7) or the retirement income account rules of Code Section 403(b)(9) for churches; and 403(b) elective deferrals are subject to universal availability rules, rather than the ADP test and the 410(b) minimum coverage test applicable to 401(k) plans.

8. Coordination and Ordering of Catch-Up Contributions

A special catch-up election under Code Section 402(g)(7) allows employees who have completed 15 or more years of service with a qualified employer (e.g., an educational organization or hospital) to make a catch-up contribution to a 403(b) plan in excess of the generally applicable dollar limit. In addition, employees who will attain age 50 by the end of the tax year and for whom no other elective deferrals may otherwise be made to the plan for the year because of the deferral limits or any other comparable plan limits may, under Code Section 414(v), make additional catch-up contributions, up to a special limit ($5,000 for 2006), to the 403(b) plan.

Regulations issued under Code Section 414(v) have clarified that a 403(b) plan participant who qualifies for the special Code Section 402(g)(7) election may also make a catch-up contribution. The proposed rules include a similar provision and specify an ordering rule, under which any catch-up contribution for an employee who is eligible for both an age 50 Code Section 414(v) catch-up contribution and the special 403(b) catch-up under Code Section 402(g)(7) is treated first as a special 403(b) catch-up and then as an amount contributed as an age 50 catch-up (to the extent that an age 50 catch-up amount exceeds the maximum special 403(b) catch-up).

9. Years of Service

An employee's number of years of service, for purposes of determining a participant's includible compensation and years of service (applicable in determining the special 403(b) catch-up contribution and employer contributions for former employees), includes each full year during which an individual is a full-time employee of the eligible employer, plus a fraction of a year for each part of a year during which the individual is a full-time or part-time employee of the eligible employer.

A year of service would be based on the employer's annual work period and not the employer's tax year. For example, in determining whether a university professor is employed full time, the annual work period would be the school's academic year. In addition, the determination of whether an individual is a full-time employee would be made by comparing the amount of work performed with the amount of work that is normally required of individuals performing similar services from which substantially all of their compensation is derived. The amount of work performed would generally be determined based on an individual's hours of service. However, a plan may measure the work of a university professor by the number of courses taught during an annual work period, if the individual's work assignment is generally based on a specified number of courses to be taught.

10. Nonelective Employer Contributions for Former Employees

Code Section 403(b)(3), as amended by the Job Creation and Worker Assistance Act of 2002, allows contributions to be made for an employee up to five years after retirement, based on includible compensation for the last year of service before retirement. A former employee is deemed to have monthly includible compensation for the period through the end of the tax year of the employee in which he or she ceases to be an employee and through the end of each of the next five years. Under the proposed regulations, the amount of the monthly includible compensation is 1/12 of the former employee's includible compensation during the former employee's most recent year of service. The proposed regulations specifically authorize a plan to continue nonelective employer contributions for a former employee for up to five years, in an amount up to the lesser of the Code Section 415(c) dollar limit or the former employee's annual includible compensation (based on the former employee's compensation during the most recent year of service).

11. "Good Faith" Would Not Satisfy Nondiscrimination Requirements for Nonelective Contributions

Employer contributions and employee after-tax contributions (but not pre-tax elective deferrals) under a 403(b) contract are subject to nondiscrimination rules, including restrictions on contributions, benefits, coverage and annual compensation. The IRS had provided in Notice 89-23 that the nondiscrimination requirements could be met through a reasonable good faith interpretation of the rules under Code Section 403(b)(12). In requiring adherence to specified nondiscrimination rules, including those under Code Section 401(a)(4) and (17) and 401(m), the IRS would officially abandon the good faith standard articulated in Notice 89-23.

12. Universal Availability Would Require "Effective Opportunity" to Make Deferral Election

Under the universal availability rule of Code Section 403(b)(12)(A)(ii), an eligible employer that authorizes any employee to make elective deferrals pursuant to a 403(b) plan must allow all employees to make a 403(b) deferral election. The proposed rules expressly require that the contribution be made pursuant to a plan, and the plan must permit elective deferrals (including catch-up contributions) that satisfy universal availability. Specifically, the plan must provide an employee with an "effective opportunity" to make or change a cash or deferred election at least once during each plan year.

Comment: In complying with the requirement to provide employees with an effective opportunity to make elective deferrals, employers will need to focus on affirmatively and effectively communicating the availability of election opportunities to employees.

A 403(b) plan may cover employees of more than one 501(c)(3) organization. Under the proposed rules, the universal availability requirement would be applied separately to each common law entity (i.e., 501(c)(3) organization). With respect to a 403(b) plan that covers the employees of more than one entity, universal availability would be applied separately to each entity that is not part of a common payroll. In addition, an employer may require an employee to make elective deferrals of more than $200 a year.

The proposed rules provide exceptions to the universal availability requirement that would allow a plan to exclude: employees eligible to participate (i.e., make elective deferrals) in a 457(b) plan or a 401(k) plan; non-resident aliens; students performing services for a school; and employees who normally work less than 20 hours per week (generally less than 1,000 hours of service for the 12-month period beginning on the anniversaries of the date the employee's employment began). Employers should be aware that, if an excludable employee is allowed under the plan to make elective deferrals, the proposed rules would prevent any other comparably situated employee from being excluded. For example, if one non-resident alien or one student performing services for a school is allowed to participate in the plan, then all non-resident aliens and all such students would have the right to make elective deferrals under the arrangement.

13. Distributions From the Plan

The proposed regulations contain guidance regarding the timing of distributions from, and the benefits that may be provided under, a 403(b) plan.

A 403(b) plan may not distribute benefits to an employee prior to the earlier of the employee's severance from employment or the occurrence of a specified event, such as the passage of a fixed number of years, the attainment of a stated age, disability, death, hardship or attainment of age 59-1/2.

Any amounts transferred out of a custodial account that funds a Code Section 403(b) plan to an annuity contract or retirement income account that funds a Code Section 403(b) plan, including earnings on such amounts, continue to be subject to the foregoing rules after the transfer.

For these purposes, a "severance from employment" occurs on any date on which an employee ceases to be an employee of the eligible employer maintaining the Code Section 403(b) plan. A severance from employment will occur, even though the employee may continue to work for another entity treated, under the controlled group rules, as the same employer as the one maintaining the plan, if either (i) that other entity is not an eligible employer (e.g., where the employer maintaining the plan is a Code Section 501(c)(3) organization and the new employer is a for-profit subsidiary of a Code Section 501(c)(3) organization), or (ii) the employee is working in a capacity that is not treated as employment with an eligible employer (e.g., the employee ceases to be an employee performing services for a public school but continues to work for the same state employer).

In addition, for these purposes, the definition of "hardship" (and the circumstances under which amounts attributable to salary reduction contributions may be distributed if a hardship occurs) are determined in accordance with Regulations Section 1.401(k)-1(d)(3) (including the rule under which the amount of the hardship distribution is limited to the amount necessary to satisfy the hardship). Also, the amount of a hardship distribution is limited to the aggregate dollar amount of the salary reduction contributions held by the Code Section 403(b) plan (excluding earnings).

The foregoing restrictions on distributions do not apply to amounts attributable to rollover contributions held in a separate account under the Code Section 403(b) plan.

Finally, the proposed rules confirm the application of QDRO rules to 403(b) contracts, thereby authorizing distributions to a participant's former spouse pursuant to a QDRO.

14. Required Minimum Distribution Rules

The proposed rules, with minor modifications, incorporate provisions under existing regulations applying the required minimum distribution requirements of Code Section 401(a)(9) to 403(b) plans. Under the proposed rules, 403(b) contracts are treated as IRAs. However, distributions from 403(b) contracts do not satisfy the minimum distribution requirements for IRAs nor do distributions from IRAs satisfy the minimum distribution requirements for 403(b) contracts.

15. Time Frame in which to Transfer Elective Deferrals to Annuity Contracts

The proposed rules would require that contributions to 403(b) plans be transferred to the insurance company issuing the annuity contract (or the entity holding assets of any custodial or retirement income account that is treated as an annuity contract) within a period that is no longer than reasonable for the proper administration of the plan. The proposed rules would allow a plan to require the transfer of elective deferrals to an annuity contract as soon as reasonably practicable but in no event no later than 15 business days following the month in which the amounts would have been paid to the participant.

16. Controlled Group Rules for Tax-Exempt Organizations

The employer for a plan maintained by a tax-exempt organization includes the organization whose employees participate in the plan and other organizations with which it is under common control. The common control rules, which must be considered when applying the nondiscrimination requirements, 415 limits and required minimum distribution rules, would generally not apply to church entities or public schools.

Common control would generally exist between exempt organizations if at least 80% of directors or trustees of one organization are representatives of, or directly controlled by, the other organization. However, in addition to such mandatory aggregation, the proposed rules would, for the first time, allow for permissive aggregation, under which exempt organizations that maintain a single plan covering one or more employees from each organization may treat themselves as under common control if the organizations regularly coordinate their day-to-day exempt activities. The proposed rules would further authorize permissive disaggregation, under which a church plan to which contributions are made by more than one common law entity, could disaggregate church controlled organizations from other non-church entities. Finally, the proposed rules would empower the IRS to treat a tax-exempt entity and a non tax-exempt entity as being under common control if the entities are structured to avoid or evade the common control rules or other requirements under Code Section 401(a), 403(b) or 457(b).

17. Distribution of Accumulated Benefits on Plan Termination

The proposed regulations provide rules under which an employer may amend a 403(b) plan to limit future contributions for existing participants or to limit participation to existing participants and employees. A plan would be allowed to authorize termination and the subsequent distribution of accumulated benefits. However, the distribution of accumulated benefits incident to plan termination would generally be allowed only if the employer (taking into account all the controlled group entities) did not make contributions to an alternative 403(b) contract during the 12-month period beginning on the date of plan termination and ending 12 months after the distribution of all assets from the terminated plan.

18. Exchanges and Transfers Among 403(b) Plans

The proposed regulations would allow a 403(b) contract to be exchanged for another 403(b) contract held by the same 403(b) plan if, among other conditions, the participant or beneficiary has an accumulated benefit immediately after the exchange at least equal to the benefit before the exchange. A 403(b) contract also could be transferred to another 403(b) plan if, among other conditions, the receiving plan provides for receipt of the transfer and the accumulated benefit of the participant or beneficiary whose assets are being transferred are, after the transfer, at least equal to the benefit before the transfer.

19. Effective Date

The proposed rules may not be relied on until finalized. In addition, under transition relief, the rules would not apply to plans maintained under an existing collective bargaining agreement ("CBA") until the termination of the CBA. Although originally effective for tax years beginning in 2006, the proposed 403(b) regulations are expected to be made effective for tax years beginning on or after January 1, 2007.

D. Temporary Rules Expand FICA Taxation of 403(b) Contributions under Salary Reduction Agreements

The IRS has issued temporary regulations that, effective November 16, 2004, define salary reduction agreements in a manner that expands the FICA tax treatment of 403(b) contributions. By expanding the definition of 403(b) salary reduction agreements beyond the definition of elective deferrals that applies for income tax purposes, the temporary rules effectively subject a wider variety of 403(b) contributions to FICA tax.

The temporary rules define a salary reduction agreement as including a plan or arrangement whereby a payment will be made if the employee elects to reduce his compensation pursuant to a cash or deferred election. However, in going beyond the definition of an elective deferral, the temporary rules clarify that a salary reduction agreement also includes a plan or arrangement under which a payment will be made if the employee elects to reduce compensation pursuant to a one-time irrevocable election made at or before the time of initial eligibility to participate in the plan or arrangement. In addition, the temporary regulations provide that a salary reduction agreement will include a plan under which payments will be made if the employee agrees, as a condition of employment, to make a contribution that reduces the employee's compensation.

The temporary regulation is effective November 16, 2004. However, the regulation is scheduled to expire on or before November 16, 2007.

E. Deemed IRAs in Qualified Plans

1. Background

The IRS has issued proposed temporary and final regulations relating to deemed individual retirement accounts for tax-qualified retirement plans under Code Section 408(q). The rules implement an EGTRRA provision that allows employees to contribute to an account or annuity within a qualified pension plan that is treated like an IRA.

Deemed IRAs allow an employer to offer employees the ability to keep their IRA assets in the employer's retirement plan as a separate IRA account within the plan.

For plan years beginning on or after January 1, 2003, an employer maintaining a qualified plan, qualified 403(a) annuity, tax-sheltered annuity plan or governmental eligible deferred compensation plan may allow employees to make voluntary employee contributions to a separate IRA or annuity established under the plan. Contributions to a deemed IRA are treated as contributions to the employee's deemed IRA, rather than to the employer plan.

2. Separate Trust Requirement

Under prior proposed regulations, a trust holding deemed IRA assets had to be separate from a trust holding assets of a qualified employer plan. The separate trust rule was intended to ensure better compliance with IRA requirements and limit confusion of assets. The IRS has eliminated the separate trust requirement for deemed IRA account assets, as long as a separate account is maintained for each deemed IRA and the employer plan. The final regulations also allow deemed Roth IRAs and deemed IRAs to be held in a single trust, as long as separate accounts are maintained and clearly designated.

3. Disqualification Clarified

Failure of either the employer plan or the deemed IRA portions of a program to satisfy the qualification rules will not automatically disqualify the other portion. This rule applies, however, only if the deemed IRA portion and employer plan portion are maintained as separate trusts (or separate annuity contracts).

F. S Corp/ESOP Abuses

Continuing its crackdown on tax evasion, the IRS recently issued proposed and temporary regulations to curb abuses involving employee stock ownership plans ("ESOP") holding stock in S corps.

1. Background

An ESOP is permitted to hold stock in an S corporation, provided that the ESOP benefits rank-and-file employees. However, accruals or allocations are prohibited if the S corp is used to pass corporate income to a tax-exempt ESOP and ESOP benefits are concentrated in a small number of persons, such as upper management or family members. In some abusive situations, the only participants in the ESOP are the owners of the business and rank-and-file employees are excluded.

2. New Terms

The regulations provide two new terms: "impermissible accrual" and "impermissible allocation." An impermissible accrual occurs if S corporation stock is owned and held by an ESOP for the benefit of a disqualified person during a nonallocation year. A "disqualified person" is a person deemed to own at least 10% of the ESOP's shares individually or least 20% of the ESOP's shares with family members. A "nonallocation year" is any plan year in which the ownership of the S corporation is concentrated among disqualified persons. An impermissible allocation is defined as any allocation for a disqualified person under any qualified plan or ESOP during a nonallocation year.

If an impermissible accrual or allocation occurs, the fair market value of the disqualified person's ESOP account is included in his gross income.

G. Proposed Rules Finalized for Eliminating Forms of Distribution

The IRS has issued final regulations that modify how certain forms of distributions in defined contribution plans can be eliminated without violating the anti-cutback rules under Code Section 411(d)(6).

The regulations contain amendments that were added as new Code Section 411(d)(6)(E) by EGTRRA and became effective January 25, 2005. As noted in the final rules, the new Code section provides that, generally, a defined contribution plan is not treated as reducing a plan participant's accrued benefit when a plan amendment eliminates a form of distribution that was previously available, as long as it is replaced with a lump sum distribution.

In a previous regulation, plan sponsors were allowed to change the available forms of distribution provided that each participant was given 90 days' advance notice; the final regulations do not require a 90-day advance notice period.

The final regulations clarify that amendments that terminate an annuity option can apply only to distributions with annuity starting dates after the amendment is adopted and, therefore, cannot apply to distributions that have already commenced. This change does not, however, allow for the elimination of annuity distributions with respect to that portion of plan attributable to transfer from a money purchase pension plan.

Comment: The reasoning behind the guidance is to simplify the choices offered to participants under the defined contribution plans without really reducing their options for distribution and because benefits can be rolled-over to IRAs offering a wide variety of distribution options. Money purchase plans remain subject to the qualified joint and survivor annuity requirements and thus cannot eliminate annuity options required to satisfy these rules.

H. EBSA Issues Guidance on Distributions to Missing Participants from Terminated DC Plans

In Field Assistance Bulletin 2004-02, the Department of Labor's Employee Benefits Security Administration ("EBSA") issued guidance for fiduciaries that wish to make final distributions from terminated defined contribution plans that have missing participants. To comply with the Code's requirements for termination of a qualified plan, a plan's assets must all be effectively distributed as soon as is administratively feasible following a plan termination. EBSA has issued this latest guidance in response to concerns of plan administrators that are unable to obtain a response from, or that cannot locate, defined contribution plan participants for instructions regarding the final distributions of their benefits.

The guidance details acceptable methods for distributing missing participants' benefits. These distribution methods may only be used, however, if plan fiduciaries have used specified search methods, in addition to using first class mail or electronic notification. The four search methods provided in the guidance are: (i) using certified mail, (ii) checking records of related plans through both the missing participant's employer and the related plans' administrators, (iii) contacting designated beneficiaries to see if they can provide updated information with regard to the missing participant's location, and (iv) using either the IRS's or the Social Security Administration's letter-forwarding service. EBSA states that plan fiduciaries may use additional search methods, but the cost of those additional methods should be taken into account if they will be charged to the missing participant's account balance.

1. Individual Retirement Plan is Preferred Distribution Option

If participants cannot be located after using the search methods described above, EBSA has advised that it prefers the transfer of the participants' benefits to individual retirement plans over all other distribution options. Specifically, EBSA has stated that "plan fiduciaries must always consider distributing missing participant benefits into individual retirement plans (i.e., an individual retirement account or annuity)." EBSA states that it prefers individual retirement plans because they preserve retirement assets. An eligible rollover distribution from a qualified plan, performed as a trustee-to-trustee transfer into an individual retirement plan, is not subject to immediate income tax, the 20% mandatory income tax withholding requirement, or the 10% additional tax for premature distributions.

EBSA cautions that the choice of an individual retirement plan trustee, custodian, or issuer, as well as the choice of an individual retirement plan to receive the missing participant's distribution raises fiduciary concerns. EBSA has referred plan fiduciaries to previously-issued regulations that provided a safe harbor for fiduciaries engaged in the automatic rollover of mandatory individual retirement plans (see Section IV. E of this Newsletter). EBSA states that defined contribution plan fiduciaries that comply with the relevant requirements of the automatic rollover safe harbor regulations (without regard to the amount involved in the distribution) and then choose investment products designed to preserve the missing participant's plan principal will be treated as satisfying their fiduciary duties in connection with distributions made from terminated plans on behalf of missing participants.

2. EBSA Addresses Other Distribution Options

EBSA has provided two alternative distribution methods that plan fiduciaries may use if they are unable to locate an individual plan provider that will accept a rollover distribution on behalf of a missing participant. Plan fiduciaries may use either an interest bearing federally insured bank account in the name of the missing participant, or may transfer a missing participant's account balance to a state unclaimed property fund in the state of the participant's last known residence or work location.

EBSA has warned that it would view plan fiduciaries that effectively transfer a missing participant's benefits to the IRS by imposing 100% income tax withholding as violating ERISA's fiduciary requirements. EBSA explains that the IRS has advised that the withheld amounts would not necessarily be matched or applied to the missing participant's income tax liabilities.

I. EBSA Proposed Regulations Provide Termination Instructions for Service Providers of Abandoned Plans

EBSA has issued for comment three proposed rules to facilitate the termination of individual account (i.e., defined contribution) plans, and the distribution of benefits where the plans have been abandoned by their sponsoring employers. EBSA has also issued notice of a proposed prohibited transaction class exemption that would permit a "qualified termination administrator" ("QTA") of an abandoned individual account plan to select and pay fees to itself or to an affiliate for performing termination-related services to the plan.

1. Determination of "Abandoned Plan" by QTA

Under the proposed regulations, an individual account plan would be considered abandoned when there have been neither contributions to nor distributions from the plan for a continuous 12-month period, or where such facts and circumstances as a plan sponsor's bankruptcy suggest that the plan may become abandoned. The QTA must make reasonable efforts to locate or communicate with the known plan sponsor, furnishing the sponsor with notice of the QTA's intent to terminate the individual account plan or plans and distribute benefits. An appendix to the proposed regulations contains a model notice which QTAs may use to comply with this notification requirement. For the plan to be considered abandoned, the QTA must, following the attempt at notification, determine that the plan sponsor either no longer exists, cannot be located, or is unable to maintain the plan.

Once a QTA finds that a plan has been abandoned, the plan would be deemed, under the proposed regulations, to be terminated on the 90th day following the date on which the QTA provides notice of its determination and its election to serve as a QTA to the EBSA. EBSA would have discretion to waive this 90-day waiting period if the facts of a particular case of abandonment are not complicated, and if it is apparent that the proposed termination would not put participants' assets at risk. A model notice for notifying EBSA of plan abandonment has also been included in an appendix to the proposed regulations.

2. Guidelines Given for Winding Up Plans

To both clarify and limit QTAs' responsibilities and liabilities in connection with terminating abandoned plans, EBSA has provided guidance in the proposed regulations for winding up a plan's affairs. EBSA states that QTAs should make reasonable and diligent efforts to locate and update plan records necessary to determine benefits payable under the plan. If a QTA determines that updating the records is either impossible or excessively costly to the plan in relation to the plan's total assets, EBSA explains that it would not consider the QTA to have acted in less than good faith if the QTA uses reasonable care in calculating benefits payable based on the plan records already assembled. The proposed regulations also provide that reasonable expenses may be incurred and paid from plan assets to engage service providers as necessary to terminate a plan and wind up its affairs. Expenses will be considered reasonable if they are consistent with industry rates for such services and are not in excess of rates charged by the QTA or its affiliates to other customers for the same services.

QTAs would be required to furnish a notice of the termination to the last known address of participants and beneficiaries. The proposed regulations also include a model notice that may be provided to participants and beneficiaries that allows for inclusion of plan-specified information, including the process for electing a form of distribution. If a participant or beneficiary fails to elect a form of benefit distribution, the QTA would be required to roll over that person's benefits into an individual retirement plan.

3. Safe Harbor Requirements

To alleviate apprehension on the part of QTAs about the fiduciary consequences of such a rollover, EBSA has included in the proposed regulations a fiduciary safe harbor, under which the QTA would be deemed to have satisfied the fiduciary requirements of ERISA Section 404(a). To obtain the safe harbor protection: (i) each distribution must be rolled over into an individual retirement plan; (ii) the QTA and the individual retirement plan provider must enter into a written agreement that provides that: (a) rolled-over funds must be invested in an investment product designed to preserve principal and provide a reasonable rate of return, whether or not such return is guaranteed, consistent with liquidity; (b) the investment product selected for the rolled-over funds seeks to maintain a stable dollar value equal to the amount invested in the product by the individual retirement plan; (c) fees and expenses attendant to the individual retirement plan, including investments of such plan, do not exceed certain limits; and (d) the participant or beneficiary on whose behalf the QTA makes a direct rollover should have the right to enforce the terms of the contractual agreement establishing the individual retirement plan, with regard to his or her rolled-over funds, against the individual retirement plan or other account provider; and (iii) the self-designation of the QTA as the transferee of rollover proceeds is exempt from the restriction imposed by ERISA Section 406 (see the next section for an explanation of this restriction).


4. EBSA Proposes Exemption Relief for QTAs of Abandoned Plans

EBSA has issued a proposed class exemption in conjunction with the proposed regulations that would permit the QTA of an abandoned individual account plan to select itself or one of its affiliates to provide plan termination services to the plan and to pay itself or the affiliates for those services. ERISA Section 406 generally prohibits a plan fiduciary from, among other acts, causing a plan to engage in a transaction that constitutes the furnishing of goods, services, or facilities between the plan and a party in interest, or a transfer to, or use by or for the benefit of, a party in interest of any plan assets. ERISA also prohibits a plan fiduciary from dealing with the plan's assets in his own interest and from acting in any capacity in any transaction involving the plan on behalf of a party whose interests are adverse to the plan's interests, or to that of the plan's participants or beneficiaries.

Therefore, a QTA that determines to pay itself for services rendered to an abandoned plan from the plan's assets, that designates itself as the provider of an individual retirement plan established on behalf of an abandoned plan's participants who fail to elect a form of benefit distribution, or that invests a rollover distribution in the QTA's own proprietary investment product may commit a prohibited transaction. The proposed class exemption would provide conditional relief, so that a QTA of an abandoned individual account plan could select itself to provide termination services and pay itself for services rendered, subject to certain conditions.

The QTA would only be able to obtain the exemption if its fees and expenses are consistent with industry rates for similar services and the fees and expenses are not in excess of rates charged by the QTA for the same or similar services provided to customers that are not individual account plans terminated pursuant to the proposed regulations, if the QTA provides such services to other customers. The QTA would also be required to notify participants and beneficiaries of the abandoned plan that, absent the participant's or beneficiary's election within 30 days from receipt of the notice, the QTA will roll over the participant's or beneficiary's account balance to an individual retirement plan or other account offered by the QTA or one of the QTA's affiliates. The QTA would further be required to notify participants and beneficiaries that the account balance may be invested in the QTA's own proprietary investment product. The QTA's investment product would need to preserve principal and provide a reasonable rate of return and liquidity.

Furthermore, the QTA must maintain sufficient records to permit persons (e.g., IRS, EBSA, or the account holder) to determine if the QTA has met the conditions of the class exemption.

III. DEFINED BENEFIT PLANS

A. Phased Retirement Distributions from Pension Plans

1. Background

The IRS has issued proposed regulations that would permit distributions to be made from a pension plan under a phased retirement program, if the program meets specific requirements. Under this approach, a plan could allow employees who phase in their retirement by working fewer hours to receive a portion of their pension benefits while still working.

Some employers offer employees who are eligible to retire the opportunity for a reduced schedule or workload. Such a phased retirement provides the employee with a smoother transition from full-time employment to retirement, and allows the employer to retain the services of an experienced employee.

2. Phased Retirement Distributions

The proposed regulations would permit a pro rata share of an employee's accrued benefit to be paid under a bona fide phased retirement program. The pro rata share would be based on the extent to which the employee reduced his working hours.

A bona fide phased retirement program would be a written, employer-adopted program under which employees could reduce the number of hours they customarily work beginning on or after a retirement date specified in the program (but not before age 59-1/2), and a phased retirement benefit would be permitted only if the program met certain conditions. For example, employee participation would have to be voluntary and there would have to be an expectation that the employee would reduce, by 20% or more, the number of hours worked during the phased retirement period.

The maximum payment would be limited to the portion of the employee's accrued benefit equal to the product of his total accrued benefit on the date he commences phased retirement and his reduction in work. All early retirement benefits, retirement-type subsidies, and optional forms of benefit that would be available upon full retirement would have to be available with respect to the phased retirement accrued benefit. However, in order to prevent the premature distribution of retirement benefits, a plan could not permit payment in the form of a single-sum distribution (or other eligible rollover distribution).

3. Accruals During Phased Retirement

During the phased retirement period, in addition to being entitled to the phased retirement benefit, the employee generally would have to be entitled to: (i) participate in the plan in the same manner as if he were still maintaining a full-time work schedule (including calculation of average earnings), and (ii) to the same benefits (including early retirement benefits, retirement-type subsidies, and optional forms of benefits) upon full retirement as a similarly situated employee who has not elected phased retirement. However, the years of service for any plan year during the phased retirement period would be multiplied by the ratio of the employee's actual hours of service during the year to the employee's full-time work schedule, or by the ratio of his compensation to the compensation that would be paid for full-time work. Thus, for example, under a plan with an 1,000 hours of service requirement to accrue a benefit, an employee participating in a phased retirement program would accrue proportionate additional benefits, even if the employee worked fewer than 1,000 hours.

An employee who was a highly compensated employee before commencing phased retirement would have to be treated as a highly compensated employee during phased retirement.

The employee's final retirement benefit would be comprised of the phased retirement benefit and the balance of the employee's accrued benefit under the plan (i.e., the excess of the total plan formula benefit over the portion of the accrued benefit paid as a phased retirement benefit).

4. Application of Phased Retirement Rules

The new rules for phased retirement distributions would apply to pension plans, i.e., defined benefit plans and money purchase plans. The proposed regulations would apply for plan years beginning on or after the date the regulations are finalized.

B. Cash Balance Plans

The Treasury Department announced the withdrawal of controversial proposed regulations that provided conditions under which cash balance pension plans could meet age discrimination requirements. In Announcement 2004-57, the Internal Revenue Service said the move would "provide Congress an opportunity to review and consider the Administration's legislative proposal and to address cash balance and other hybrid plan issues through legislation."

Cash balance plans are defined benefit plans that mimic defined contribution plans like 401(k) plans, generally defining a participant's benefit in terms of a hypothetical account balance, credited each year with a pay credit and interest credit, and including an annuity conversion factor. They generally result from conversions from traditional defined benefit plans, which guarantee a promised amount at retirement.

The announcement said Treasury and IRS will not publish new age discrimination guidance for cash balance plans or other hybrid plans while these issues are under consideration by Congress. The IRS also does not intend to process determination letter requests for cash balance plan conversions while cash balance plans and cash balance conversion issues are under consideration by Congress. Hundreds of requests have been on hold since a 1999 moratorium on determination letters for cash balance plan conversions.

C. IRS Issues Proposed and Final Regulations on Anti-Cutback Rules

1. Background

The IRS has issued proposed and final regulations that provide guidance on amendments under Code Sections 411(a)(3) and 411(d)(6) dealing with protected benefits under qualified retirement plans, and also take into account recent judicial decisions.

These regulations allow defined benefit plan sponsors to streamline administration by reducing the number of distribution and early retirement benefit offerings under certain circumstances. The rules generally permit plans to eliminate optional forms of benefit that are not "core" options and are "redundant" to retained forms of benefit within certain designated "families." Plans also may eliminate "noncore" optional forms of benefit if "core" benefit options are provided. The regulations do not permit the elimination of a lump-sum payment option.

The U.S. Supreme Court case Central Laborers' Pension Fund v. Heinz (541 U.S. 739 (2004)) and EGTRRA prompted the guidance. In its decision, the Supreme Court ruled that plan sponsors are prohibited from expanding postretirement categories of jobs in ways that would result in the suspension of payments of early retirement benefits that retirees already had accrued. The final rules are intended to reflect the holding in Heinz by providing a utilization test under which a plan amendment is permitted in certain circumstances to eliminate or reduce an early retirement benefit, a retirement-type subsidy, or an optional form of benefit that is not widely utilized.

2. Conditions Allowing Reduced Benefits

The new regulations replace provisions in former Treasury Regulation Section 1.411(d)-3 by setting forth conditions under which a plan amendment is permitted to eliminate an optional form of benefit and to eliminate or reduce an early retirement benefit or a retirement-type subsidy that creates significant burdens or complexities for the plan and its participants.

The final regulations provide two permitted methods for eliminating or reducing protected benefits: (i) elimination of redundant optional forms of benefit, and (ii) elimination of noncore optional forms of benefits where core benefits are offered.

Under the regulations, a plan amendment may eliminate one or more optional forms of benefit if each eliminated optional form satisfies the redundancy and/or the core option rule:

a. Redundancy. Plans may eliminate an optional benefit form that is not "core" (as described below) and is redundant to another retained form of benefit within one of six designated "families" of optional forms (i.e., the 50% or more joint and contingent family; the below 50% joint and contingent family; the 10 years or less term certain and life annuity family; the greater than 10 years term certain and life annuity family; the 10 years or less level installment family; and the greater than 10 years level installment family). The plan amendment must not apply to any optional form of benefit with an annuity starting date less than 90 days after the adoption of the amendment, and the annuity starting date of the retained option must be within six months of the eliminated option. The actuarial present value of the eliminated option must not exceed that of the retained option by more than a de minimis amount.

b. Provision of Core Options. A noncore optional form of benefit may be eliminated if the plan, after amendment, offers "core" options ( i.e., straight life annuity; a 75% joint and contingent annuity; a 10-year certain and life annuity; and the most valuable option for a participant with a short life expectancy). The plan amendment must not apply to any optional form of benefit with an annuity starting date not more than 90 days after the adoption of the amendment, and the annuity starting date and the actuarial present value of the retained option must be the same as those of the eliminated optional form of benefit.

c. Special Rule. Where the retained option has a different annuity starting date or is of a lesser actuarial value than the option being eliminated:

(i) the eliminated option must be "burdensome"; and

(ii) the elimination must not effect participants in more than a
de minimis manner.

If these requirements are satisfied, the plan may eliminate an optional form of benefit even if it has the effect of eliminating an early retirement benefit or reducing a retirement-type subsidy.

3. Issues Addressed in Proposed Form

Under the proposed regulations, a plan may be amended to eliminate optional forms of benefit that comprise a "generalized optional form" for a participant with respect to benefits accrued before the applicable amendment date if certain requirements relating to the use, or rather non-use, of the generalized optional form are satisfied. Generalized optional forms of benefit are all optional forms in the plan that are the same form of benefit, with the exception of their actuarial factors and annuity starting dates. For example, benefits in the form of lump-sum distributions, but which use different actuarial factors for converting from an annuity, may be a generalized optional form.

The utilization test used to determine whether a plan has a sufficient number of eligible participants to eliminate an optional form is based on the forms of benefit that are not chosen within a specified period. To pass the utilization test, a generalized optional form of benefit must have been made available to at least 100 eligible participants in the last two years without having been chosen.

The utilization test cannot be used to eliminate core benefits, nor can it be applied to an annuity commencement date within 90 days of the adoption of the amendment eliminating the optional form.

If the optional forms are offered to fewer than 100 participants in two years, the plan then can go back three, four, or at the most, five years. The use of the longer lookback period may prove useful for smaller employers that may have too few employees eligible to take the benefit, usually through termination, or to employers that only offer the optional benefits to a limited group of eligible participants.

Certain participants do not count toward the pool of eligibility for purposes of the utilization test. Eligible participants who would be excluded from the utilization test include those who, in the two to five-year lookback period: (i) did not elect any optional form of benefit with an annuity commencement date during the relevant period, (ii) elected a lump-sum distribution in lieu of an annuity for at least 25% of the distribution that was due to them, (iii) elected an enhanced benefit that was available during a limited time period, and (iv) elected to start receiving their benefit with an annuity commencement date of more than 10 years before their normal retirement age.

The utilization test is proposed to become effective for plan years beginning in 2007.

D. Regulations on QJSAs and QPSAs Cover Information That Participants Must Receive to Compare Distribution Forms

In 2003, the IRS issued final regulations that: (i) consolidate the content requirements applicable to explanations of qualified joint and survivor annuities ("QJSAs") and qualified preretirement survivor annuities ("QPSAs") payable under certain retirement plans, and (ii) specify requirements for disclosing the relative values of optional forms of benefit that are payable from certain retirement plans in lieu of a QJSA.

In 2005, the IRS issued proposed regulations (on which taxpayers may rely) that revise final regulations that set forth the information required to be explained to pension plan participants regarding optional forms of benefit offered. The changes relate to the final regulations' effective date, notice requirements, and valuation of a QJSA.

The proposed regulations modify the 2003 regulations to provide that the 2003 regulations are generally effective for QJSA explanations provided with respect to annuity starting dates beginning on or after February 1, 2006.

1. Background

A defined benefit or money purchase pension plan must pay a participant's retirement benefit under the plan in the form of a QJSA. A QJSA for a married participant generally must be the actuarial equivalent of the single life annuity benefit payable for the life of the participant. However, a plan is permitted to subsidize the QJSA for a married participant. If a plan fully subsidizes the QJSA for a married participant, so that failure to waive the QJSA would not result in reduced payments over the life of the participant compared to the single life annuity benefit, then the plan need not provide an election to waive the QJSA (Code Section 417(a)(5)).

If a plan provides a subsidy for one optional form of benefit (i.e., the payments under an optional form of benefit have an actuarial present value that is greater than the actuarial present value of the accrued benefit), there is no requirement to extend a similar subsidy (or any subsidy) to every other optional form of benefit. Thus, for example, a participant might be entitled to receive a single-sum distribution on early retirement that does not reflect any early retirement subsidy in lieu of a QJSA that reflects a substantial early retirement subsidy.

A plan must provide to each participant, within a reasonable period before the annuity starting date: (i) a written explanation of the terms and conditions of the QJSA, (ii) the participant's right to make, and the effect of, an election to waive the QJSA form of benefit, (iii) the rights of the participant's spouse, and (iv) the right to revoke (and the effect of the revocation of) an election to waive the QJSA form of benefit.

The regulations provide rules for satisfying the Code Section 417(a)(3) written explanation requirement. For example, under one rule, sufficient information must be provided to explain the relative values of the optional forms of benefit available under a plan (e.g., the extent to which optional forms are subsidized relative to the normal form of benefit, or the interest rates used to calculate the optional forms). Under another rule, a written explanation must contain a general explanation of the relative financial effect of a participant's election on the participant's annuity.

2. Uniform Explanation for Both Married and Unmarried Individuals Permitted Where the Benefit Options are the Same

The final regulations require that the description of the relative value of an optional form of benefit compared to the value of the QJSA be expressed in a manner that provides a meaningful comparison of the relative economic values of the two forms of benefit, without the participant having to make calculations using interest or mortality assumptions.

Under the final regulations, the disclosure method may be either: (i) "participant-specific," or (ii) a "generalized notice." Under the participant-specific method, a plan must provide information on the relative value and financial effect of each optional form of benefit, and the plan is permitted to use reasonable estimates for this purpose.

Under the generalized notice method, a plan discloses the amount of the participant's benefit payable in the normal form of benefit and provides additional information that is not participant-specific. The additional information may be disclosed in the form of a chart based on computations for hypothetical participants that shows the financial effect of generally available optional forms of benefit, and the relative values of those optional forms.

The final regulations permit a plan to use a uniform basis of comparison of relative value for both married and unmarried participants, if the benefit options are the same for the married and unmarried participants. Thus, in a plan in which the applicable QJSA form for unmarried participants is a straight life annuity and the applicable QJSA form for married participants is a 50% joint and contingent annuity (and each of these forms of distribution is available to all participants on the same terms), the plan may choose to: (i) compare the relative values of the plan's optional forms of benefit to the value of the straight life annuity with respect to the required disclosure for all participants, or (ii) compare the relative values of the plan's optional forms of benefit to the value of the 50% joint and contingent annuity with respect to the required disclosure for all participants (Regulations Section 1.417(a)(3)-1(c)(2)(ii)).

3. Grouping Optional Forms of Benefit to Provide Simplified
Disclosure of Relative Value

The final regulations provide for certain simplifications in the disclosure to plan participants. The final regulations permit a plan that is comparing the relative value of each optional form to the value of the QJSA for a married participant to treat each presently available optional form of benefit that has an actuarial present value of at least 95% of the actuarial present value of the QJSA as having approximately the same value as the QJSA.

In addition, for a plan that is comparing the relative value of each optional form to the value of the single life annuity, if all of the optional forms of benefit presently available have actuarial present values that are at least 95%, but not greater than 102.5%, of the actuarial present value of the presently available single life annuity, the plan is permitted to treat all the presently available forms of distribution as approximately equal in value.

4. Offer to Provide Actuarial Assumptions

The final regulations require that information be made available upon request about what actuarial assumptions were used when the plan estimated relative value, if this information is not already provided in the notice to participants.

E. IRS Cracks Down on "Abusive" Life Insurance Policies in 412(i) Plans

The IRS issued regulations that constitute a broad-based attack aimed at shutting down "abusive" transactions involving specially designed life insurance policies in Code Section 412(i) plans. The regulations generally provide that life insurance contracts transferred to an employee must be taxed at their full fair market value ("FMV"), and a revenue procedure provides a temporary safe harbor for determining FMV. A new ruling concludes that an employer cannot buy excessive life insurance in order to claim large tax deductions and generally categorizes these arrangements as listed transactions. Finally, another ruling states that a Code Section 412(i) plan cannot use differences in life insurance contracts to discriminate in favor of highly paid employees.

1. Background

An individual insurance contract plan is exempt from the Code Section 412 minimum funding requirements for a plan year if the plan satisfies the following six requirements:

a. The plan is funded exclusively by the purchase from a licensed life insurance company of individual annuity or individual insurance contracts, or a combination of such contracts. The purchase may be made either directly by the employer or through the use of a custodial account or trust.

b. The contracts provide for level annual, or more frequent, premium payments.

c. Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by a licensed insurance carrier to the extent premiums have been paid.

d. Premiums payable for the plan year and all earlier plan years under the contracts have been paid before lapse or there is reinstatement of the policy. If a lapse has occurred during the plan year, the requirement is met if reinstatement of the insurance policy under which the individual insurance contracts are issued occurs during the year of lapse and before distribution is made or benefits commence to any participant whose benefits are reduced because of the lapse.

e. No rights under the contracts have been subject to a security interest at any time during the plan year.

f. No policy loans are outstanding at any time during the plan year.

The employer may claim tax deductions for contributions that are used by the plan to pay premiums on the insurance contract covering an employee, but not in excess of the Code Section 404(a)(1) deduction limit. Contributions exceeding that limit may be carried over to future years and deducted in those years to the extent the deduction ceiling for a later year is not exhausted by contributions for that later year. The plan may hold the contract until the employee dies, or it may distribute or sell the contract to the employee at a specific point, such as when the employee retires.

IRS's regulations contain two differing provisions that describe the amount includible in income under (Code Section 72 annuity rules) when a qualified plan distributes a life insurance contract. Under Regulations Section 1.402(a)-1(a)(1)(iii), the "fair market value" of the property distributed is includible, while under Regulations Section 1.402(a)-1(a)(2) the "entire cash value" of the life insurance contract distributed is includible. The IRS said that its regulations do not conclusively define "fair market value" or "entire cash value" or indicate which applies in determining the income consequences of a distribution. Cash surrender value and the value of a contract's reserves have been used as the value of a life insurance contract for purposes of determining the amount includible in income when the contract is distributed.

2. Reason for Crackdown

The IRS has become aware of abusive arrangements that purportedly enable businesses to generate large tax-deductible contributions to plans and tax-free retirement distributions and death benefits. For example, special policies are made available only to highly compensated employees. The insurance contract is designed so that the cash surrender value is temporarily depressed, making it significantly below the premiums paid. The contract is distributed or sold to the employee for the amount of the current cash surrender value during the period the cash surrender value is depressed. However, the contract is structured so that the cash surrender value increases significantly after it is transferred to the employee. Use of this "springing cash value" life insurance gives employers tax deductions that far exceed what the employee recognizes in income.

3. Proposed Reliance Regulations

New proposed regulations aim to prevent taxpayers from using artificial devices to understate the value of the life insurance contract. They provide that where a qualified plan distributes a life insurance, retirement income, endowment, or other contact providing life insurance protection, the FMV of the contract (i.e., value of all rights under the contract, including any supplemental agreements, and whether or not guaranteed) is generally included in the distributee's income, and not merely the entire cash value of the contracts. The proposed regulations also provide that, if a qualified plan transfers property to a plan participant or beneficiary for consideration that is less than the FMV of the property, the transfer will be treated as a distribution by the plan to the participant or beneficiary to the extent the FMV of the distributed property exceeds the amount received in exchange.

4. Fair Market Value Defined

Revenue Procedure 2004-16 provides interim rules under which the cash value (without reduction for surrender charges) of a life insurance contract distributed from a qualified plan may be treated as the FMV of that contract. These interim rules also apply for purposes of determining the value of insurance contracts under Code Section 79 and Code Section 83. Cash value (without reduction for surrender charges) may be treated as the FMV of a contract, as of a determination date, provided the cash value is at least as large as the aggregate of:

a. premiums paid from the date of issue through the date of determination, plus

b. any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise), minus

c. reasonable mortality charges and reasonable charges, but only if those charges are actually charged on or before the date of determination and are expected to be paid.

5. Plan Qualification Issues

Under the proposed regulations, the amount of a plan's distribution of a life insurance contract must be taken into account in determining the plan's qualified status. For example, the FMV of a distributed life insurance contract must be considered in determining whether the insured participant has received benefits in excess of the Code Section 415 limits.

6. Excess Life Coverage Not Deductible

Revenue Ruling 2004-20 holds that a qualified pension plan cannot be a Code Section 412(i) plan if it holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of his benefits at normal retirement age under the plan's terms. Employer contributions under a qualified defined benefit plan used to buy life insurance coverage for a participant in excess of the death benefit provided under the plan are not fully deductible when contributed. Rather, they must be carried over as contributions in future years and deducted in future years when other plan contributions that are taken into account for the tax year are less than the maximum amount deductible under Code Section 404.

Revenue Ruling 2004-20 provides that the purchase of excessive life insurance (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee's beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment) to claim large tax deductions is a listed transaction for tax-shelter reporting purposes. However, the listed transaction label applies only if the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000.

7. Nondiscrimination

In Revenue Ruling 2004-21, the IRS notes that Code Section 401(a)(4) provides that a qualified plan cannot discriminate in favor of highly compensated employees concerning contributions to or benefits accrued under the plan. Further, all benefits, rights and features provided under a qualified plan must be made available to participants in a nondiscriminatory manner. The ability of a plan participant to purchase a life insurance policy from a qualified plan before distribution of retirement benefits is a right that must be made available on a nondiscriminatory basis.

In the ruling, IRS described a plan where the features of the life insurance contracts covering the lives of highly compensated employees are different from the features of the contracts covering nonhighly compensated employees. Because of this difference, the purchase rights of nonhighly compensated are not of inherently equal or greater value than the purchase rights of the highly compensated. Thus, a plan that is funded partially or completely with life insurance contracts does not satisfy the Code Section 401(a)(4) nondiscrimination rules if: (i) it allows highly compensated employees to buy those life insurance contracts before distribution of retirement benefits; and (ii) rights under the plan for nonhighly compensated employees to buy life insurance contracts from the plan before distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees.

F. Deficit Reduction Act

On February 8, 2006, President Bush signed the Deficit Reduction Act of 2005 which increases Pension Benefit Guaranty Corporation ("PBGC") premiums for both single employer and multiemployer defined benefit plans, starting with the 2006 plan year.


1. Flat-Rate Premiums

Effective for plan years beginning in 2006, the annual flat-rate premium payable by all PBGC-covered single employer plans increases from $19 to $30, and the annual flat-rate premium for multiemployer plans increases from $2.60 to $8.00. For 2007 and subsequent years, it will be indexed for inflation, using the same wage-based index that is currently used for Social Security indexing. According to a statement issued by the PBGC, large plans that have already filed their estimated premiums using the old rate will have to submit an amended filing with the new rate. The amended filing must be submitted by the estimated premium due date.

2. Bankruptcy Exit Premium

A special premium will be assessed in the case of a distress termination of an underfunded single employer plan, unless the employer is liquidated. This special assessment applies to plan terminations in bankruptcy proceedings filed on or after October 18, 2005. The charge is $1,250 per participant (as of the day before the termination). To avoid a direct conflict with the bankruptcy laws, if the employer is in a bankruptcy reorganization, the special premium does not become payable until the bankruptcy proceeding is concluded. The premium is payable annually for each of the three years following the termination date or, if later, the employer's exit from bankruptcy. This special assessment will not apply to terminations that take place after December 31, 2010, unless Congress extends this provision.

G. IRS Proposes Shift to New Mortality Tables for Computation of Employee
Plan Liabilities

The IRS has issued proposed regulations that would provide guidance for updating mortality tables used in determining current liability for participants and beneficiaries of employee plans.

The proposal would update the methodology for generating mortality tables used under Code Section 412(l)(7)(C)(ii) and ERISA Section 302(d)(7)(C)(ii). The proposed rules would apply to plan years beginning on or after January 1, 2007.

The regulations would change the mortality tables used to determine current liability from tables based on the 1983 Group Annuity Mortality Table to updated tables based on the RP-2000 mortality tables, which were created by the Society of Actuaries.

The Service believes the 1983 GAM is no longer appropriate for determining current liability. By way of example, it said that:

a. Comparing the RP-2000 Combined Healthy Mortality Table for males projected to 2007 with the 1983 GAM shows that a current mortality table reflects a 52 percent decrease in the number of expected deaths at age 50, a 26 percent decrease at 65, and an 19 percent decrease at age 80.

b. Comparing annuity values derived under the RP-2000 Combined Healthy Mortality Table for males with annuity values determined under the 1983 GAM shows an increase in present value of 12% for a 35-year-old male with a deferred annuity payable at age 65, a 5% increase for a 55-year-old male with an immediate annuity, and a 7% increase for a 75-year-old male with an immediate annuity, when calculated at a 6% interest rate.

c. For females, the number of expected deaths decreased by 10% at age 50, but increased by 33% at age 65 and increased by 2% at age 80.

d. Comparing annuity values derived under the RP-2000 mortality rates with annuity values determined under the 1983 GAM shows a decrease in present value of 3% for a 35-year-old female with a deferred annuity payable at age 65, a 2% decrease for a 55-year-old female with an immediate annuity, and a 2% decrease for a 75-year-old female with an immediate annuity.

IV. ALL TAX-QUALFIED PLANS

A. Fees for Plan Rulings Increase Sharply

The IRS is implementing a new user fee schedule for 2006, including some sharply increased fees for employee plans private letter rulings and determination letters. New letter ruling fees increased from $95 - $5,415 to $200 - $14,500, effective February 1, 2006. New fees under the revised and centralized determination letter program take effect July 1, 2006.

In many instances, the fees jump to more than double the amount under the former fee structure. Compliance fees and compliance correction fees under the Employee Plans Compliance Resolution System ("EPCRS") remain at current levels.

According to the IRS, the increased user fees are a response to an Office of Management and Budget directive to charge user fees reflecting the full cost of providing goods or services when the benefits to the recipient otherwise exceed those received by the general public. The new fee structure is designed to more accurately reflect the resources that the IRS expends in processing the ruling request.

B. Hurricane Katrina Statutory and Administrative Relief

In response to the devastation caused in the Gulf Coast region by Hurricane Katrina, Congress, the Department of the Treasury (the IRS) and the Department of Labor (EBSA) took swift action to provide various measures of relief to affected individuals and entities with respect to their employee benefit plans.


1. Statutory Relief

On September 23, 2005, President Bush signed into law the Katrina Emergency Tax Relief Act of 2005 ("KETRA"). KETRA provides relief to Hurricane Katrina victims in the form of relaxed rules related to plan distributions and loans as follows:

a. KETRA provides for exemption from the 10% penalty tax under Section 72(t) of the Code for any distribution (up to $100,000) from an eligible retirement plan (i.e., 401(a), 403(a), 403(b) and 457(b) plans, and IRAs) made on or after August 25, 2005, and before January 1, 2007, to an individual whose principal abode on August 28, 2005, was located in an area declared a disaster area by the President before September 14, 2005, as a result of Hurricane Katrina and who has suffered economic loss as a result of the hurricane (a "Qualified Individual").

b. KETRA permits repayment of a distribution described above (a "Qualified Hurricane Katrina Distribution"), not to exceed the aggregate amount of such distribution, to any eligible retirement plan to which a rollover can be made at any time during the three-year period beginning on the day after the date on which the distribution was received. The repayment will be deemed an eligible rollover distribution.

c. Any amount that would be required to be included in a Qualified Individual's gross income for a taxable year as a result of a Qualified Hurricane Katrina Distribution, unless otherwise elected by the taxpayer, may be included on a prorated basis over the period of three taxable years beginning with such taxable year.

d. KETRA exempts Qualified Hurricane Katrina Distributions from the rollover rules under Section 401(a)(31) of the Code, from the rule concerning the special tax notice regarding plan payments under Section 402(f) of the Code, and from the mandatory 20% withholding under Section 3405 of the Code.

e. A Qualified Hurricane Katrina Distribution will be deemed to have met all plan distribution requirements.

f. The loan amount that a Qualified Individual may take from a plan pursuant to Section 72(p)(2) of the Code is raised to the lesser of $100,000 (reduced by the excess of outstanding loans) or 100% of the nonforfeitable accrued benefit of the employee under the plan.

g. KETRA provides for a one-year delay for plan loan repayment due dates occurring during the period from August 25, 2005, to December 31, 2006, for any loan made to a Qualified Individual who had an outstanding plan loan on or after August 25, 2005. Any subsequent repayment will be adjusted to reflect the delayed repayment due date and any interest accruing during the delay. The one-year delay period will be disregarded for purposes of the five-year repayment rule under Section 72(p)(2) of the Code.

h. A plan may be amended, no later than January 1, 2007 (or a later date if the IRS so permits), to include KETRA's provisions if the plan operates as if the amendment were in effect during the period from the amendment's effective date until the amendment is adopted.

2. Administrative Relief

On September 15, 2005, the IRS published Announcement 2005-70 (the "Announcement") which provides relief to Hurricane Katrina victims with respect to loans and hardship distributions, as follows:

a. A plan may make a loan or hardship distribution for a need resulting from Hurricane Katrina to an employee or former employee whose principal residence on August 29, 2005, was located in one of the areas in Louisiana, Mississippi or Alabama that have been or are later designated a disaster area eligible for individual assistance by FEMA as a result of Hurricane Katrina, or whose place of employment was located in one of those areas.

b. Plan administrators may rely on representations made by the individual with respect to the need for and amount of a hardship distribution unless they have actual knowledge to the contrary.

c. Hardship distributions may be made from profit sharing or stock bonus plans that currently do not provide for hardship distributions, except such distributions may not be made from qualified nonelective contributions ("QNECs") and qualified matching contributions ("QMACs") or from earnings on elective contributions.

d. Defined benefit plans and money purchase pension plans may only permit hardship distributions from any employee contributions or rollover contributions.

e. Hardships for which distributions are available under the Announcement are not limited to the hardships enumerated in the 401(k) plan regulations.

f. No post-hardship distribution contribution restrictions are required for hardship distributions made pursuant to the Announcement.

g. A plan that does not provide for hardship distributions or loans, but does permit such distributions pursuant to the Announcement, must be amended to so provide no later than the end of the first plan year beginning after December 31, 2005.

h. Plan loans made pursuant to the Announcement must satisfy the requirements under Section 72(p) of the Code (i.e., dollar amount limitations, timing limitations and level amortization requirement).

i. Any hardship distributions made under the Announcement must be made on or after August 29, 2005, and no later than March 31, 2006.

j. A plan's failure to comply with its procedural requirements with respect to loans and distributions made during the period beginning on August 29, 2005, and ending on March 31, 2006, to individuals eligible under the Announcement will be excused as long as the plan administrator makes a good faith effort under the circumstances to comply with those requirements. The plan administrator must make a reasonable effort to assemble any foregone documentation (e.g., spousal consent) as soon as practicable.

The Department of Labor issued a news release stating that it will not treat anyone as having violated the provisions of Title I of ERISA (e.g. reporting and disclosure and fiduciary obligations) as a result of complying with the Announcement.

On September 21, 2005, the Department of the Treasury and the Department of Labor jointly issued the Extension of Certain Time Frames for Employee Benefit Plans Affected by Hurricane Katrina; Final Rule, which extends time frames related to the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"), the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") and employee benefit plan claims procedure deadlines, as follows:

a. Relief applies to participants, beneficiaries, qualified beneficiaries and claimants who resided, lived or worked in, at the time of Hurricane Katrina, one of the areas designated a disaster area eligible for Individual Assistance by FEMA as a result of Hurricane Katrina. The rules also apply to any employee benefit plan that: (i) is maintained by an employer having a principal place of business in an area described above at the time of the Hurricane, or (ii) has its office or the office of the plan administrator or primary recordkeeper in an area described above at the time of the Hurricane.

b. The period from August 29, 2005, through January 3, 2006, must be disregarded when determining certain time periods under COBRA and HIPAA and for filing claims under a plan covered by ERISA.

c. The 60-day period to elect COBRA coverage is extended so that a qualified beneficiary who receives a COBRA election notice during the period from August 29, 2005, through January 3, 2006, will have until March 4, 2006, to elect COBRA continuation coverage.

d. The period from August 29, 2005, through January 3, 2006, is disregarded for a qualified beneficiary who received a COBRA election notice less than 60 days prior to August 29, 2005. For example, an individual who was given a COBRA notice on August 14, 2005 (having 45 days remaining in their COBRA election period on August 29, 2005), must be allowed to make the election until February 18, 2006.

e. COBRA premium payment deadlines are extended. A qualified beneficiary who was receiving COBRA coverage and who made a timely payment for August 2005 must have until February 2, 2006, to make COBRA premium payments for September, October, November and December 2005 and January 2006. If the individual only makes the equivalent of two monthly premium payments by February 2, 2006, then such amounts will be applied to the first two eligible months (i.e., September and October).

f. The period for a qualified beneficiary to inform the plan administrator of a qualifying event (e.g., divorce, adoption, loss of dependent status) that occurred in the period from August 29, 2005, through January 3, 2006, is extended until March 4, 2006. The period from August 29, 2005, through January 3, 2006, is disregarded for a qualified beneficiary whose 60-day notice obligation arose before August 29, 2005, but extended beyond such date.

g. A group health plan participant whose last day of coverage was August 29, 2005, will not be considered to have had a 63-day break in creditable coverage until 63 days after January 3, 2006, which was March 7, 2006.

h. The last day for requesting special enrollment under HIPAA as a result of a loss in eligibility for health care coverage due to Hurricane Katrina was February 2, 2006 (30 days after January 3, 2006). This also applies to an individual who acquired a new dependent during the period from August 29, 2005, through January 3, 2006. If the event qualifying an individual for special enrollment occurred less than 30 days before August 29, 2005, the period from August 29, 2005, through January 3, 2006, is disregarded in determining the individual's eligibility period for special enrollment.

i. The period from August 29, 2005, through January 3, 2006, is disregarded with respect to the deadline by which an affected individual has to file a benefit claim under any employee benefit plan.

j. The period from August 29, 2005, through January 3, 2006, is disregarded with respect to the deadline for an affected individual to file an appeal of an adverse benefit determination.

k. An affected employer required to provide notice to an individual of COBRA eligibility during the period from August 29, 2005, through January 3, 2006, will had until February 16, 2006 (44 days) to issue such COBRA notice. An employer that would have been required to issue a COBRA election notice to an individual during the 44-day period that extended beyond August 29, 2005, may disregard the period from August 29, 2005, to January 3, 2006, with respect to the required COBRA notice period. This same rule is applied for notices of creditable coverage required under HIPAA.

3. Conclusion

Congress, the IRS and EBSA have provided much needed relief for victims of the devastation caused in the Gulf Coast region by Hurricane Katrina with respect to their employee benefit plans. This relief will provide affected individuals with the flexibility that is needed so that they may use retirement plan funds to begin rebuilding their homes and their lives without adverse tax consequences, as well as to maintain their health coverage and claims. Although victims of future disasters or outside of the specified areas affected by Hurricane Katrina will not automatically receive similar relief, general guidelines have now been established that may provide a foundation should the need again arise.

C. IRS Overhauls Rules on Remedial Plan Amendments

1. Introduction

The IRS has issued Revenue Procedure 2005-66, a sweeping revenue procedure that creates fixed, regular cycles for the adoption of remedial plan amendments, and the submission of determination, opinion, and advisory letter applications. The procedure establishes a system of staggered five-year remedial amendment cycles for individually-designed plans, and a system of six-year amendment/approval cycles for pre-approved plans (M&P and volume submitter plans), while extending a plan's remedial amendment period to reflect the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA").

2. Remedial Amendment Periods

The IRS established remedial amendment periods to provide an extended period of time for plan sponsors to amend their plans to comply with legislative changes. Plans must be amended within the applicable remedial amendment period in a timely manner in order to reflect the new qualification requirements. Failure to amend a plan within the remedial amendment period can disqualify a plan for those plan years.

Example: GUST Remedial Amendment Period. GUST amendments are a series of required amendments that qualified plans were required to adopt in order to maintain their qualified status. For individually-designed plans, the GUST remedial amendment period ended on the later of February 28, 2002, or the end of the 2001 plan year. If a plan sponsor failed to amend its plan within the GUST remedial amendment period, the plan is disqualified.

Comment: Even though a plan does not need to be amended or restated until the end of a remedial amendment period, it must operate in compliance with any applicable legislative changes.

3. Cyclical Remedial Amendment Periods

Using a single remedial amendment period that applied to all qualified plans resulted in significant backlogs in the IRS opinion and determination letter programs. As a result, the IRS recently announced cyclical remedial amendment periods. Under this system, individually-designed plans have a regular five year remedial amendment cycle. The cycles are staggered over five year periods (i.e., different plans have different remedial amendment period cycles depending on the last digit of the plan sponsor's employer identification number ("EIN")). Pre-approved plans (i.e., VS and M&P plans) generally have a regular six-year remedial amendment cycle. As a result, prototype sponsors, practitioners, and adopters of pre-approved plans generally need to apply for new opinion, advisory or determination letters once every six years. Pre-approved defined contribution plans and defined benefit plans have different six-year cycles. A table showing the different cycles appears at the end of this section.

A plan must file a determination letter application during the last twelve months of its remedial amendment cycle (i.e., between February 1 and January 31 of the last year of the cycle). Determination letters issued to individually-designed plans may not be relied on after the expiration date (i.e., the end of the plan's first five-year remedial amendment cycle that ends more than twelve months after the application was received).

Example: Cyclical Remedial Amendment Period. Marshland Inc. is a C corporation, and the last digit of its EIN is 7. Marshland Inc. adopts a new 401(k) plan on January 1, 2006. The remedial amendment cycle for the 401(k) plan is Cycle B. Since the employer timely adopted the plan in good faith with the intent of sponsoring a qualified plan, the initial remedial amendment period for the 401(k) plan ends on January 31, 2008. Any remedial amendment required for the 401(k) plan to correct a disqualifying provision must be adopted by January 31, 2008, unless an application for a determination letter is submitted by that date. The 401(k) plan amendment would then be retroactively effective to its effective date in 2006. The subsequent five-year remedial amendment periods end on January 31, 2013, then January 31, 2018, etc.

4. Special Rules for Controlled Groups and Affiliated Service Groups

If a plan benefits the employees of a controlled group or an affiliated service group, the remedial amendment period is determined using the last digit of the EIN used on the Form 5500. If the controlled group or affiliated service group maintains more than one plan, the group may elect to use Cycle A for all plans maintained by the group (other than multiemployer plans or multiple employer plans). All members of the group must make the election jointly.

If more than one plan is maintained by a parent-subsidiary controlled group, the remedial amendment period cycle may be determined using the last digit of the parent's EIN. The parent of the controlled group makes the election. An election must:

a. Be made by the end of the earliest cycle for which a determination letter application would have been required to be submitted;

b. List all of the group members, including their EINs, and all plans maintained by each group member (other than multiemployer and multiple employer plans); and

c. Be filed with the first determination letter application for any plan maintained by any group member (other than multiemployer and multiple employer plans).

Once filed, an election may not be modified or revoked except in the event of a merger, acquisition, change in plan sponsorship or spin-off.

5. Special Rules In the Event of a Merger, Acquisition, Change in Plan Sponsorship or Spin-off

If plans with different five-year cycles are merged, then the remedial amendment cycle for the merged plan is determined on the basis of the EIN and the controlled group or affiliated service group status of the employer that maintains the merged plan.

If one employer acquires another employer and maintains the acquired employer's plan, then the five-year remedial amendment cycle of the acquired plan is determined on the basis of the EIN or controlled group or affiliated service group status of the employer that maintains the acquired plan.

If there is a change in the EIN, controlled group or affiliated service group status of the employer that maintains the plan, the remedial amendment cycle is determined on the basis of the changed EIN or the controlled group or affiliated service group status of the employer that maintains the plan.

If a portion of the plan is spun-off, the remedial amendment cycle of the spun-off plan is determined on the basis of the changed EIN or controlled group or affiliated service group status of the employer that maintains the spun-off plan.

In the case of a self-employed person without any employees who sponsors a plan, the employer may submit a determination letter application based upon the last digit of the individual's Social Security number ("SSN"). However, subsequent five-year remedial amendment cycles will be determined based upon the last digit of the employer's EIN (if any).

6. Terminating Plans

The termination of a plan ends the plan's remedial amendment period. As a result, any retroactive remedial plan amendments or other required plan amendments must be adopted in connection with the plan termination.

Remedial Amendment Period Cycle for Pre-Approved Plans



 Extension of the EGTRRA Remedial Amendment Period and Schedule of
Next Six-Year Remedial Amendment Cycle
If the plan is a:  The last day of the initial cycle (i.e., EGTRRA remedial amendment period) is: The next six-year remedial amendment cycle ends on:
 Defined contribution plan   January 31, 2011   January 31, 2017
 Defined benefit plan  January 31, 2013   January 31, 2019

 


Remedial Amendment Period Cycle for Individually-Designed Plans

 Extension of the EGTRRA Remedial Amendment Period and Schedule of
Next Five-Year Remedial Amendment Cycle
 If the Employer's EIN ends in: The plan's cycle is:  The last day of the initial cycle (i.e., EGTRRA remedial amendment period) is: The next five-year remedial amendment cycle ends on:
 1 or 6  Cycle A  January 31, 2007  January 31, 2012
 2 or 7  Cycle B  January 31, 2008  January 31, 2013
 3 or 8  Cycle C  January 31, 2009 January 31, 2014 
 4 or 9  Cycle D  January 31, 2010  January 31, 2015
 5 or 0  Cycle E  January 31, 2011 January 31, 2016 



Remedial Amendment Period Cycle for Multiple Employer Plans, Governmental Plans and Multiemployer Plans

 Extension of the EGTRRA Remedial Amendment Period and Schedule of
Next Five-Year Remedial Amendment Cycle
 If the plan is a:  The plan's cycle is:  The last day of the initial cycle (i.e., EGTRRA remedial amendment period) is: The next five-year remedial amendment cycle ends on:
 Multiple employer plan   Cycle B  January 31, 2008   January 31, 2013
 Governmental plan   Cycle C  January 31, 2009   January 31, 2014
Multiemployer plan    Cycle D January 31, 2010    January 31, 2015

Comment: Plan sponsors of individually-designed plans this firm maintains will receive correspondence from us concerning their applicable cycles.


D.
Bankruptcy Issues

1. Impact of Bankruptcy Legislation on IRAs

This section provides an update on the protection of an individual retirement account ("IRA") from creditors after the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act"). In general, the Act, which took effect on October 17, 2005, expands the bankruptcy protections previously available for a debtor's "ERISA-qualified" retirement funds.

In a bankruptcy proceeding, a bankruptcy estate is created to collect funds for the payment of the debtor's debts. The bankruptcy estate consists of all of the debtor's legal and equitable property interests. The debtor can seek to protect his retirement funds from creditors by claiming either an exclusion from the bankruptcy estate or an exemption. Historically, there were limitations on the effectiveness of both kinds of protection with respect to IRAs.

The Act adds a new exemption to Section 522 of the Bankruptcy Code for "retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under Section 401, 403, 408, 408A, 414, 457, or 501(a) of the Code." The reference to Sections 408 and 408A indicates that the exemption applies to traditional IRAs as well as Roth IRAs. The exemption for funds held in an IRA, calculated without regard to rollover contributions or the earnings thereon, is limited to $1 million.

Comment: It is a rare IRA account that will have accumulated $1 million from the modest contributions permitted to IRAs; thus, this is an unlimited exemption for all practical purposes.

The limit apparently does not apply to simple retirement accounts or to simplified employee pensions ("SEPs"). In addition, it will be adjusted for inflation and can be increased by a court "if the interests of justice so require."

The Act also provides for a limited exclusion from the bankruptcy estate for amounts contributed to Section 529 plans and Section 530 (Coverdell) education savings accounts. The beneficiary must be a child, stepchild, grandchild, or step grandchild in the taxable year for which the funds were contributed. Deposits within one year of the bankruptcy filing are not protected on the theory that recent deposits are a form of preference better devoted to creditors. Deposits made within the period beginning 720 days before filing and ending 365 days before filing which exceed $5,000 for any one beneficiary are also unprotected.

Outside of bankruptcy, IRAs are not protected by ERISA's prohibition on the assignment or alienation of benefits, and judgment creditors in some jurisdictions have had little trouble in attaching IRA assets. The self-settled nature of an IRA trust or custodial account and the fact that the IRA owner has the ability to revoke the agreement and recover the funds at any time make the enforcement of a "spendthrift" restriction problematic. Nevertheless, many states have enacted statutory protections for IRAs, in effect treating them as spendthrift trusts by legislative fiat.

It should be noted that the IRS can levy on the assets of an IRA under Section 506(a) of the Bankruptcy Code, although it has indicated that it will do so only when the taxpayer flagrantly disregards requests for payment.

2. Sole Owner Entitled as "Participant" to Protect Plan Assets from Bankruptcy Creditors under ERISA

The working owner of a business may qualify as a "participant" in an ERISA-covered pension plan and shield assets under the plan's anti-alienation provision from bankruptcy creditors, the U.S. Supreme Court unanimously ruled in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon K. Reversing the Sixth Circuit Court of Appeals, the Supreme Court ruled that some small business owners may be considered to be employees as well as employers for ERISA retirement plan purposes. Thus, these working owners are entitled to all the rights and protections of ERISA, including protecting benefits from the reach of creditors. The plan must cover the owner and one or more employees other than the owner's spouse. If it covers only the sole shareholder, or the sole shareholder and spouse, he or she is not a participant under ERISA, and not entitled to protections under ERISA.

E. Labor Department Issues Safe Harbors for Automatic Rollovers
of Plan Distributions

EBSA released a rule that provides guidance on how employers and financial institutions can implement the new requirement that retirement plan distributions between $1,000 and $5,000 be automatically rolled over into an individual retirement plan, unless the participant directs otherwise.

The rule protects retirement plan fiduciaries from liability under ERISA by providing a safe harbor in connection with two aspects of the automatic rollover process: (i) the selection of an institution to provide the individual retirement plans, and (ii) the selection of investments for such plans.

In order to obtain relief under the safe harbor, plan fiduciaries must satisfy certain conditions. These conditions relate to the amount of mandatory distributions, qualifications for an individual retirement plan, permissible investment products, permissible fees and expenses, required disclosures to participants and beneficiaries, and prohibited transactions.

The Department of Labor also released concurrently a class exemption that enables certain plan sponsors to use their own services and products in connection with rollovers from their own retirement plans.

1. EGTRRA Requirements

Pursuant to EGTRRA, Code Section 401(a)(31) was amended to require that, absent an affirmative election by the participant, certain mandatory distributions from a tax-qualified retirement plan must be directly transferred to an individual retirement plan or a designated trustee or issuer.

EGTRRA requires that certain distributions of retirement plan benefits of between $1,000 and $5,000 be automatically rolled over into an individual retirement plan when a participant fails to elect a distribution method.

EGTRRA directed the DOL to issue regulations providing safe harbors under which a plan administrator's designation of an institution to receive the automatic rollover and the initial investment choice for the rolled over funds would be deemed to satisfy the fiduciary responsibility provisions of Section 404(a) of ERISA.

2. Present Value of Benefits

For purposes of determining the present value of benefits, in general, if the present value of any nonforfeitable accrued benefit exceeds $5,000, such benefit may not be immediately distributed without the consent of the participant. However, a special rule permits plans to disregard that portion of a nonforfeitable accrued benefit that is attributable to amounts rolled over from other plans and the earnings thereon in determining the $5,000 limit.

3. Reasonable Rate of Return

The rule provides for the investment of mandatory distributions in investment products designed to preserve principal and provide a reasonable rate of return, whether or not such return is guaranteed, consistent with liquidity, and taking into account the extent to which charges can be assessed against an individual plan. Such products include money market funds, interest-bearing savings accounts, and certificates of deposit.

For this purpose, the product would have to be offered by a state or federally regulated financial institution, and seek to maintain a stable dollar value equal to the amount invested in the product by the individual retirement plan.

Comment: In effect, this requirement means that rolled-over funds will most likely be invested in certificates of deposit (and other time deposits) or other stable value investments, such as guaranteed investment contracts (GICs). These are typically low-risk, low-yield investments.

4. Fees May Not Exceed Comparability Standard

Fees and expenses attendant to an individual retirement plan, including investments of such plan, may not exceed the fees and expenses charged by the provider for comparable individual retirement plans established for rollover distributions that are not subject to the automatic provision.

5. Required Disclosure

The rule requires disclosure to participants and beneficiaries of the plan's procedures governing automatic rollovers, including an explanation about the nature of the investment product in which the mandatory distribution will be invested, and how fees and expenses will be allocated. In addition, the disclosure must identify a plan contact for further information concerning the plan's procedures, the individual retirement plan provider, and the fees and expenses associated with the individual retirement plan. The rule conditions safe harbor relief on the furnishing of this information to the plan's participants and beneficiaries in a summary plan description or a summary of material modifications in advance of an automatic rollover.

6. Written Agreement Requirement

The final regulations require that, when rolling over funds to an IRA, the plan fiduciary enter into a written agreement with an IRA provider that specifically addresses the investment of the rolled-over funds and fees and expenses assessed under the IRA.

7. Prohibited Transaction and Class Exemption

The safe harbor relief provided for in the rule is conditioned on the plan fiduciary not engaging in prohibited transactions in connection with the selection of an individual retirement plan provider or investment product, unless such actions are covered by a statutory or administrative exemption issued under ERISA.

In this regard, the DOL published a class exemption that is intended to deal with prohibited transactions resulting from an individual retirement plan provider's selection of itself as the provider of an individual retirement plan and/or issuer of an investment held by such plan in connection with mandatory distributions from the provider's own pension plan.

The exemption is intended to permit a bank or other regulated financial institution to select itself or an affiliate as the individual retirement plan trustee, custodian, or issuer to receive automatic rollovers from its own plan and select its own funds or investment products for automatic rollovers from its own plan.

F. IRS Issues Comprehensive Guidance on Plan Limits on
Benefits and Contributions

The IRS has issued proposed regulations under Code Section 415, generally effective for plan limitation years beginning on or after January 1, 2007, on the limits applicable to benefits and contributions under qualified plans that would consolidate miscellaneous guidance that has appeared since 1981, when the last set of final regulations was issued. The proposed regulations also specifically allow National Guard and Reserve members to contribute to their employers' plans while on active duty.

1. Background

Code Section 415 provides a series of limits on benefits under defined benefit plans, and contributions and other additions under defined contribution plans. By extension, these limits also apply to other arrangements, such as Code Section 403(b) annuity contracts and simplified employee pension ("SEPs"). Under Code Section 404(j), the Code Section 415 limits also act as a limit on the deduction for employer contributions. Further, the definition of compensation that is used for Code Section 415 purposes also is used for a number of other purposes under the Code.

2. Past Guidance Incorporated with Changes

IRS has reflected its past guidance in the proposed regulations with some modifications. Further, the proposed regulations reflect other statutory changes not previously addressed by guidance, and include some other changes and clarifications to the existing final regulations.

3. Statutory Changes

Some of the statutory changes that have been made since 1981 that are reflected in the proposed regulations are:

a. current statutory limits applicable for defined benefit and defined contribution plans, as most recently amended by EGTRRA;

b. changes to the rules for age adjustments to the applicable limits under defined benefit plans, under which the dollar limit is adjusted for commencement before age 62 or after age 65;

c. changes to the rules for benefit adjustments under defined benefit plans. The proposed regulations also specify the parameters under which a benefit payable in a form other than a straight life annuity is adjusted in order to determine the actuarially equivalent annual benefit that is subject to the limits;

d. phase-in of the defined benefit plan dollar limit over 10 years of participation under Code Section 415(b)(5);

e. addition of the limit on compensation that is permitted to be taken into account in determining plan benefits under Code Section 401(a)(17), and the interaction of this requirement with the other benefit and contribution limits;

f. exceptions to the compensation-based limit under Code Section 415(b)(1)(B) for governmental plans, multiemployer plans, and certain other collectively bargained plans;

g. changes to the aggregation rules under which multiemployer plans are not aggregated with single-employer plans for purposes of applying the compensation-based limit of Code Section 415(b)(1)(B) to a single-employer plan;

h. repeal of the limit on the combination of a defined benefit plan and a defined contribution plan;

i. changes made in conjunction with EGTRRA's repeal of the maximum exclusion allowance under Code Section 403(b)(2);

j. current rounding and base period rules for annual cost-of-living adjustments ("COLAs") under Code Section 415(d), most recently amended in EGTRRA and the Working Families Tax Relief Act of 2004;

k. changes under which certain types of arrangements are no longer subject to the defined contribution plan limit (e.g., individual retirement accounts other than SEPs), and other types of arrangements have become subject to those limits (e.g., certain individual medical accounts); and

l. inclusion in compensation (for limited purposes) of certain salary reduction amounts not included in gross income.

4. Break for Those in Military Service

Under the proposed regulations, payments received after severance from employment are generally not treated as compensation for plan limit purposes. However, payments to an individual who does not currently perform services for the employer because of qualified military service (defined in Code Section 414(u)(5)) are exempt from this rule to the extent that those payments do not exceed the amounts the individual would have received if the individual had continued to perform services for the employer, rather than entering qualified military service. Thus, National Guard and Reserve members may continue to contribute to their employer's retirement plans, including 403(b) and 457 plans, while on active duty. To encourage plan administrators to adopt these rules as soon as possible, IRS has carved out an exception to the general effective date for the proposed regulations (see below), and taxpayers may rely on these changes immediately.

5. Other Significant Changes

a. Multiple Annuity Starting Dates. The proposed regulations contain new rules for determining the annual benefit under a defined benefit plan where there has been more than one annuity starting date (e.g., where benefits under a plan are aggregated with benefits under another plan under which distributions have already started). The new rules resolve the many issues that have arisen in determining the annual benefit under a plan where the application of the defined benefit limits must take into account both earlier distributions and currently starting distributions.

b. Amounts Received Following Severance from Employment. The proposed regulations provide specific rules to determine when amounts received following severance from employment are considered compensation for plan limit purposes, and when these amounts may be deferred under Code Section 401(k), Code Section 403(b), or Code Section 457(b). The proposed regulations generally provide, with the exception for military service described above, that amounts received following severance from employment are not considered compensation for purposes of the Code Section 415 limits, but provide exceptions for certain payments made within 2-1/2 months after severance from employment. These exceptions apply to payments (such as regular compensation, and overtime, commissions, and bonuses) that would have been payable if employment had not terminated, and to payments for accrued bona fide sick, vacation, or other leave that would have been available for use if employment had not terminated.

c. Proposed Effective Date. The regulations are proposed to apply to limitation years beginning on or after January 1, 2007. Taxpayers may immediately rely on modifications in the proposed regulations regarding: (i) post-severance compensation payments and compensation timing rules (including the rules applicable to those in military service); (ii) Proposed Regulations Section 1.401(a)(9)-6, regarding certain changes in form of payment; and (iii) the corrective and clarifying changes made to the regulations under Code Section 457.

The proposed regulations do not provide rules for the application of the EGTRRA sunset provision, under which the provisions of EGTRRA do not apply to taxable, plan, or limitation years beginning after December 31, 2010.

G. EBSA Overhauls Voluntary Fiduciary Correction Program and
Proposes Amendment to Related Class Exemption

EBSA has expanded and simplified its Voluntary Fiduciary Correction ("VFC") program that was first adopted on a permanent basis in March 2002. The expanded VFC program contains three new eligible transactions dealing with: delinquent participant loan repayments, illiquid plan assets sold to interested parties, and participant loans that violate certain plan restrictions. The simplifications include an on-line calculator for determining the amount to be restored to plans, as well as streamlined documentation and clarified eligibility requirements. A proposed amendment to the existing VFC class exemption (PTE 2002-51) would cover transactions involving illiquid plan assets. The changes to the VFC program are effective as of April 6, 2005.

Comment: EBSA is focusing its efforts on fiduciary responsibilities. The revision of the VFC program is part of an overall effort by the EBSA to help fiduciaries understand and address their responsibilities and prevent fiduciary violations. A fiduciary manual can be an important tool to protect fiduciaries in the event of a violation or alleged violation in a court of law. For additional information about fiduciary manuals, please do not hesitate to contact us.

1. Overview of VFC Program

Under the VFC program, plan fiduciaries (and others) can avoid potential civil actions and the assessment of civil penalties under ERISA Section 502(l) for breaches of fiduciary duties by self-correcting the breaches and reporting them to EBSA. The VFC program describes: how to apply for relief; the specific transactions covered; acceptable methods for correcting violations; and examples of potential violations and corrective actions. Applicants under the VFC program must fully correct any violations, restore to the plan any losses or profits with interest, and distribute any supplemental benefits owed to eligible participants and beneficiaries. Eligible applicants that satisfy the terms and conditions of the VFC program receive a "no-action letter" from EBSA and are not subject to civil monetary penalties. The VFC program was first implemented on an interim basis on April 14, 2000. It was amended and adopted on a permanent basis on March 28, 2002.

In 2002, the original VFC program also was expanded to include a class exemption. PTE 2002-51 provided excise tax relief for four specific VFC program transactions: (i) delinquent remission of participant funds; (ii) loans by a plan to a party of interest; (iii) purchase, sale, and exchange of assets between a plan and a party in interest; and (iv) the sale and leaseback of real property between a plan and a party in interest.

2. New Covered Transaction Involving Illiquid Assets

The revised VFC program allows a plan to sell an illiquid asset (e.g., restricted and thinly traded stock, limited partnership interest, real estate, or collectibles) to a party in interest where the plan fiduciary has determined that continued holding of such asset is not in the best interest of the plan or the plan's participants and beneficiaries, and following reasonable efforts to dispose of the asset, the only available purchaser is the party in interest. Specifically, the revised VFC program covers the following three situations:

a. a plan holds an asset previously purchased from a party in interest with respect to the plan at no greater than fair market value ("FMV");

b. the plan holds an asset previously purchased from a person who was not a party in interest with respect to the plan in an acquisition in which a plan fiduciary failed to appropriately discharge his fiduciary duties; and

c. the plan holds an asset that was purchased from a person who was not a party in interest with respect to the plan in an acquisition in which a plan fiduciary appropriately discharged his fiduciary duties.

If the plan fiduciary concludes that the continued holding of the asset is not in the interest of the plan, the plan fiduciary may correct the transaction under the revised VFC program. To correct the transaction, the revised VFC program requires the fiduciary to classify the asset as illiquid by determining that: (i) the asset has failed to appreciate, failed to provide a reasonable rate of return, or has caused a loss to the plan; (ii) the sale of the asset is in the best interest of the plan; and (iii) following reasonable efforts to sell the asset to a non-party in interest, the asset cannot immediately be sold for its original purchase price, or its current FMV, if greater.

Under the VFC program, the transaction may be corrected by the sale of the illiquid asset to a party in interest, provided the plan receives the higher of: (i) the FMV of the asset on the date of the correction, or (ii) its original purchase price, plus incidental costs.

3. New Covered Transactions Involving Participant Loans

The new transactions described in the revised VFC program cover the following loans that fail to qualify for the statutory exemption in ERISA Section 408(b)(1) because they were not made in accordance with the following specific plan provisions:

a. a plan extends a loan to a participant who is a party in interest with respect to the plan based solely on his status as an employee; and

b. a plan extends a loan where either the amount or duration of the loan exceeds limitations of Code Section 72(p).

Correction of a loan that exceeded the amount limitation under the VFC program requires that (i) the participant pay back to the plan the excess amount of the loan; (ii) plan officials reform the loan to amortize the remaining principal balance as of the date of correction over the remaining duration of the original loan, making any required adjustments to the monthly repayment amount; and (iii) plan officials otherwise continue to enforce all other terms of the original loan agreement.

To correct a loan that exceeded the duration limitation under the VFC program, plan officials must reform the duration of the loan to complete repayment within the maximum term permitted under the plan loan provisions.

Example: A loan should have been for a term of five years, but the participant erroneously received a loan with scheduled repayments over ten years, and plan officials must reform the loan. The reformed loan must be paid back within five years from the date of loan origination, and plan officials must make any necessary changes to the monthly repayment amount. If more than five years has passed since the date of loan origination, then this correction is not available.

Comment: Plan loan transactions that fail to meet the statutory requirements generally require income tax reporting as a deemed distribution by the plan fiduciaries, which triggers income tax liabilities for participants. EBSA and IRS intend to coordinate corrections to alleviate certain tax consequences for these plan loans by revising the Employee Plans Compliance Resolution System.

4. New Model Application Form

EBSA has provided a new model VFC program application form in Appendix E to the EBSA notice as well as on the EBSA website (www.dol.gov/ebsa). The model form outlines the information and supplemental documentation that an applicant must include with a correct and complete application. The model form includes the VFC program's mandatory checklist.

5. Reduced Documentation

Under the revised VFC program, the documentation requirements for two items are reduced as follows: (i) the requirement that applicants provide certain information relating to the plan's fidelity bond has been eliminated from the application procedures; and (ii) applicants correcting breaches with respect to delinquent participant contributions or loan payments under the VFC program may provide summary documentation (instead of detailed records) for transactions that involve either (a) amounts below $50,000, or (b) amounts greater than $50,000 that were remitted within 180 calendar days after receipt by the employer.

6. Simplified Calculation of Correction Amount

The revised VFC program provides a simplified method of calculating the correction amount that must be restored to a plan. In general, plan officials determine the correction amount to be restored to the plan based on either the losses to the plan resulting from a breach, or the profits gained from improper use of plan assets, as required by ERISA Section 409. The correction amount generally consists of two components: (i) the principal amount (i.e., the amount of plan assets that would have been available to the plan if the breach had not occurred), and (ii) lost earnings or restoration of profits.

Under the revised VFC program, plan officials would be able to calculate the lost earnings (and interest, if any) and restoration of profits components of the correction amount using the factors provided under Revenue Procedure 95-17. The factors also are displayed on EBSA's website in a tabular format and incorporate daily compounding of an interest rate over a set period of time. Applicants may use either the online calculator (described below) to facilitate the calculation of the lost earnings and restoration of profits amounts, or perform the calculations manually. In either case, information sufficient to verify the correctness of the amounts to be paid to the plan must be included as part of the VFC program application.

As part of the revised VFC program, EBSA provides an on-line calculator on its website that may be used by applicants to calculate lost earnings and interest, if any, and the interest amount for restoration of profits. After an applicant inputs the appropriate data, the on-line calculator references the underpayment rates over the relevant time period, selects the applicable factors under Revenue Procedure 95-17, and automatically applies the factors to provide applicants with either the amount of lost earnings and interest, if any, that must be paid to the plan or the interest amount on the profit that must be paid to the plan.

7. Modification of Scope of Term "Under Investigation"

Eligibility to participate in the revised VFC program is conditioned on neither the plan nor the applicant being "Under Investigation" as defined in the VFC program. EBSA has expanded this definition to include investigations or examinations by other federal agencies, whether of a criminal or civil nature, as well as notice of a federal agency's intent to conduct an investigation well in advance of the beginning of the actual investigation. However, the applicant or plan sponsor will be considered "Under Investigation" only if the investigation or examination at issue is in connection with an act or transaction involving the plan.

8. Actions by Parties Other than DOL

Full correction under the VFC program does not preclude any other person or governmental agency, including IRS, from exercising any rights it may have with respect to the transactions that are the subject of the application. However, IRS has indicated that, except in those instances where the fiduciary breach or its correction involves a tax abuse, a correction under the VFC program for a breach that constitutes a prohibited transaction under Code Section 4975 generally will constitute correction for purposes of Code Section 4975, and a correction under the VFC program for a breach that also constitutes an operational plan qualification failure generally will constitute correction for purposes of the EPCRS program.

9. Proposed Amendment to VFC Class Exemption

Simultaneously with the EBSA notice regarding the amendments to the VFC program, EBSA has proposed an amendment to the VFC class exemption, PTE 2002-51, that would exempt the sale of illiquid assets. Specifically, the amended exemption would cover the purchase of an asset by a plan where the asset has been determined to be illiquid (as described in the revised VFC program, above), including real property, from a party in interest at no greater than FMV at that time, and/or the later sale of the asset to a party in interest provided that the plan receives the correction amount as described in the revised VFC program. The plan would pay no brokerage fees or commissions in connection with the sale of the asset to the party in interest.


H. IRS Changes Policy on Part-Time Employees and Qualified Plans

IRS has long taken the position that a plan that excludes from participation, regardless of the number of hours of service actually worked, any employee who is classified as a part-time employee or a seasonal employee does not satisfy the Code requirement that an employee may not be required to complete more than one year of service (1,000 hours of service, generally measured from the employee's date of hire) as a condition of plan participation.

While the IRS's interpretation of the Code has remained constant for the last 10 years, the manner in which it applies this position to plans that are submitted for IRS determination letters has changed over the years. Prior to 2000, the IRS would challenge service-based exclusions from plan participation. Then, during late 2000 and part of 2001, determination letters contained a caveat if a plan included eligibility exclusions based upon an indirect service requirement that could exceed one year. Starting in mid-2001, this caveat no longer appeared in determination letters, but was included in the IRS publication that the IRS enclosed with each determination letter. It stated that "[a] determination may not be relied upon with respect to whether a plan's exclusion classifications, if any, violate the minimum age or service requirements of [Code] section 410 by indirectly imposing an impermissible age or service requirement."

In 2002, the IRS directed its reviewers not to request plan sponsors to remove or clarify plan language relating to part-time employees or other exclusions (such as seasonal employees) with indirect service-related conditions. Rather, the IRS policy was to challenge such inclusions on plan examination, but not in the determination letter process.

Now, in internal guidance that appeared very recently (February 14, 2006) on the IRS's web site, the IRS has changed its policy yet again. Reviewers are once again instructed to request that plan sponsors remove or clarify plan language if a plan includes a provision that defines an exclusion classification by reference to service and the plan provision could result in the exclusion, by reason of a minimum service requirement, of an employee who has completed a year of service. If the plan's exclusion is defined in a way that does not refer to service, the plan's exclusion classification will not be challenged during the determination letter process. It could, however, be subject to challenge upon IRS audit if its effect is to exclude employees based solely upon a service requirement.

V. WELFARE BENEFIT PLANS

A. Comparison of Health Savings Accounts, Health Reimbursement
Arrangements and Flexible Spending Accounts

There have been many changes recently in the way that employers may offer health insurance to their employees. Much of this change is a direct result of the fact that health care costs are spiraling practically out of control; there has been double digit inflation in premiums for several years, which will likely continue unabated into the foreseeable future. As a result, two relatively new vehicles, Health Reimbursement Arrangements ("HRAs") and Health Savings Accounts ("HSAs"), have been introduced as part of the "ownership society", whereby employees have an incentive, by virtue of saving and accumulating assets in tax deferred accounts, to shop for reasonably-priced medical services. Flexible Spending Accounts ("FSAs") also provide similar incentives to employees. Perhaps as a result of the similar acronyms HSA, HRA and FSA, there has been much confusion as to what these programs require and what are
their salient terms and conditions.

The following table is intended to assist in understanding these vehicles:

  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
 Overview  A tax-exempt trust or custodial account established by an eligible individual or an employer for eligible individuals to pay for qualified medical expenses in coordination with a high-deductible plan.





Allows for portability, and liberalized funding.
A benefit plan funded solely by the employer, and not through salary reduction that reimburses the employee for qualified medical expenses.






Allows carryover and accumulation. No portability.
 A benefit plan typically funded with employee pre-tax dollars that reimburses the employee for qualified medical expenses incurred during the plan year and while a participant. Unused amounts are forfeited at the end of the plan year, or 2-1/2 months thereafter.

No carryover, accumulation or portability.



  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
 Eligibility  With respect to any month, an individual covered under a high deductible plan on the first day of the month. Individual may not be (1) covered under any other health plan as individual, spouse or dependent that is not a high-deductible plan except for certain exempted Limited Coverage and other Permitted Insurance, (2) enrolled in Medicare, or (3) claimed as a dependent on another's tax return. Eligibility rules apply separately to spouses unless special rules apply in the event either spouse has family coverage.

An employee must satisfy the eligibility requirements established by the employer, subject to nondiscrimination rules.

Self-employed individuals are not eligible.

An employee must satisfy the eligibility requirements established by the employer, subject to nondiscrimination rules.

Employee must elect to contribute.

Coverage Under the Plan  Amounts may be used to pay or reimburse qualified medical expenses incurred on behalf of an employee, former employee (even if COBRA not elected), spouse, and dependents.  Amounts may be used to pay for qualified medical expenses incurred on behalf of an employee, former employee (even if COBRA not elected), spouse, and dependents. Amounts may be used to pay for qualified medical expenses incurred on behalf of an employee, former employee (if COBRA elected), spouse, and dependents.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Limited Coverage and Permitted Insurance Limited coverage means coverage for accidents, disability, dental care, vision care, or long-term care. Permitted insurance includes all insurance where substantially all of the coverage relates to liabilities from workers' compensation, torts, ownership or use of property, insurance for a specified disease or illness, or insurance paying a fixed amount for hospitalization per day. Permitted insurance does not include prescription drug benefits.
N/A
N/A


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
High Deductible Plan Requirements

For individual coverage, a high-deductible health plan has an annual deductible of at least $1,050 and annual out-of-pocket not to exceed $5,250 (does not include premiums).

For family coverage, a high deductible plan has an annual deductible of at least $2,100 and an annual out-of-pocket not to exceed $10,500.

A high deductible plan may waive the deductible or have a lower deductible for preventative care. A high deductible plan may not pay benefits until the deductible has been met. With respect to family coverage, a plan is only a high deductible plan if amounts are not payable before the family deductible has been met.

N/A
N/A
 Account Requirements An account must be established pursuant to a trust, and the trustee must be either a bank (including a similar financial institution as defined in Code Section 408) or an insurance company.  Accounts are generally bookkeeping accounts and benefits are paid from the employer's general assets.  Accounts are generally bookkeeping accounts and benefits are paid from the employer's general assets.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Account Status/Ownership Tax-exempt funded trust or custodial account established for the benefit of an individual is owned by that individual. A bookkeeping account. Participant's rights are those of an unsecured general creditor, and limited by the terms of the plan. A bookkeeping account. Participant's rights are those of an unsecured general creditor and limited by the terms of the plan.
 Funding

An employee and/or an employer may contribute to an HSA.

Employers must make comparable contributions to all participating employees for that calendar year (i.e., same amount or same percentage of the deductible).

Contributions for the taxable year can be made in one or more payments at any time prior to the filing for the individual's tax return (without extensions), but not before the beginning of the year.

Amounts contributed must be paid by the employer and cannot be paid through salary reduction (either directly or indirectly). Amounts are usually (but not necessarily) contributed by the participant on a pre-tax basis pursuant to a salary reduction agreement.
 Use of Cafeteria Plan  HSAs and high deductible plans may be offered as part of a cafeteria plan. Employer contributions to an HRA may not be attributable to a cafeteria plan or through salary reduction (either directly or indirectly).  FSAs are cafeteria plans.



  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Contribution Limits

Maximum monthly amount for eligible individual coverage is 1/12 of the lesser of 100% of the annual deductible (minimum $1,050) or $2,700. Maximum monthly amount for eligible individuals with family coverage is 1/12 of the lesser of the annual deductible (minimum $2,100) or $5,450. All HSA contributions for or on behalf of an eligible individual must be aggregated. The same limit applies whether contributions are made by the employer, an employee and/or a family member.


Deduction limits under Code Section 419 do not apply.

NOTE: Because coverage under a high-deductible plan can permit up to $5,250/$10,500 out-of-pocket exposure, there can be a gap in funding medical expenses. HSAs may be paired with HRAs or FSAs in limited circumstances (e.g., access to HRA or FSA available only after required minimum deductible for high deductible plan is met).

There is no statutorily prescribed limit.
HRA contributions to a separate fund may be subject to the deduction limits of Section 419 of the Code.
There is no statutorily prescribed limit. However, employers frequently place limits to minimize risk. Typically the dollar limit is set between $2,500 and $5,000.
Amounts may be limited by the nondiscrimination rules under Code Section 125.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Catch-up Contributions For eligible individuals and their spouses between 55 and 65 who are not enrolled in Medicare the annual contribution limit is increased by $600 (applied monthly). This catch-up amount will increases by $100 annually until it reaches $1,000 in 2009.
N/A
N/A
Excess Contributions Employer contributions in excess of the limits or on behalf of an individual who is not eligible are included in the individual's gross income, and subject to a 6% excise tax.
N/A
N/A
Tax-treatment of Employee Contributions  Contributions are deductible in computing adjusted gross income regardless of whether the individual itemized the deductions.
N/A
Pre-tax contributions are not subject to tax.
Reimbursements are excludable from income under Code Sections 105 and 106.
Tax-treatment of Employer Contributions Contributions are excluded from gross income under Code Section 106 (including pre-tax contributions through a cafeteria plan), and are not subject to withholding or subject to FICA or FUTA. Employer contributions and reimbursements are excluded from gross income under Code Sections 105 and 106, and are not subject to withholding.  Employer contributions and reimbursements are excluded from gross income under Code Sections 105 and 106, and are not subject to withholding.

Typically, employers do not contribute to FSAs.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Coordination of Contribution Limits with Other Accounts or Arrangements Maximum contributions allowed to an HSA for any given year are reduced by any contributions made to an Archer MSA in the same year. If amounts are eligible for payment from an HRA and an FSA then amounts under the HRA must be exhausted first, unless the HRA states before the beginning of the plan year that payments must be made from the FSA first. Amounts may not be paid from an FSA if the expense has been reimbursed or is reimbursable from another accident or health plan.
Nondiscrimination Employer contributions for any employee must be comparable to those for any other employee participating in the plan (i. e., the contributions must be the same dollar amount or the same percentage of the deductible).

Part-time employees (i.e., those who normally work less than 30 hours per week) are tested separately.

Failure to satisfy the comparability rule will result in a 35% excise tax imposed on the employer based on the aggregate amount contributed by the employer for that period.
HRAs must meet the non-discrimination rules under Code Section 105 for self-insured plans which prohibit discrimination in favor of highly compensated employees with respect to eligibility and benefits. FSAs must meet the non-discrimination rules under Section 105 of the Code for self-insured plans which prohibit discrimination in favor of highly compensated employees with respect to eligibility and benefits, and the non-discrimination rules applicable to cafeteria plans.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Qualified Medical Expenses Qualified medical benefits are expenses for the individual's (spouse's or dependent's) medical care as defined under Code Section 213 (including over-the-counter drugs) if not covered by insurance or otherwise. Expenses must be incurred after the HSA is established.
Qualified medical expenses do not include amounts for health insurance (other than COBRA, qualified long-term care insurance, and health insurance while unemployed). It does not include premiums for a Medi-gap policy.

For individuals over 65, qualified medical expenses include premiums for Medicare Part A and/or B, Medicare HMO, and the employee-share of premiums for employer-sponsored health plan (other than a Medigap plan).

Plan may reimburse qualified medical benefits under Code Section 213 (including over-the-counter drugs) incurred after the employee becomes a participant for the covered employee, spouse and qualifying dependents. Qualified expenses include amounts paid for premiums for accident or health coverage for current employees, retirees, and COBRA qualified beneficiaries. If the HRA is an FSA it may not include expenses for qualified long-term care services.

Eligible expenses do not include expenses attributable to a deduction allowed under Code Section 213 for any prior taxable year.

Plan may reimburse qualified medical benefits under Code Section 213 (including over-the-counter drugs) incurred while a participant during the plan year for the covered employee, spouse and qualifying dependents. Eligible expenses do not include health insurance premiums or long-term care expenses.
An FSA may not permit cash out credits or use credits for other benefits.

Generally, expenses must have been incurred during the plan year while a participant. However, if a participant has unused funds on the last day of the plan year, the expenses incurred during the 2_ month period immediately following the end of the plan year may be applied to the unused funds. Furthermore, the maximum amount of reimbursement (less amounts already paid for the plan year) must be available at all times during the plan year.



  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Rollovers From Other Accounts or Arrangements

Amounts may be rolled over from an Archer MSA or another HSA.

Rollovers from HRAs or FSAs are not permitted.

N/A
N/A
 Tax Treatment of Distributions

 Distributions used exclusively for qualified medical expenses are not included in gross income even if the individual is not currently eligible for contributions.

Employers are not required to determine if amounts are used exclusively for qualified medical expenses. Individuals must maintain their own records to show that amounts were paid for qualified medical expenses and should not be included in gross income.

Distributions for amounts that are not exclusively qualified medical expenses are permitted, but are included in gross income and subject to a 10% penalty tax unless the distribution is made after the eligible individual's death, disability, or attainment of age 65.

Distributions for qualified medical expenses are not taxable. If any person has the right to receive (directly or indirectly) cash or any other taxable benefit or non-taxable benefit other than the reimbursement of qualified medical expenses, all distributions to all persons in the current tax year are included in gross income even if used to pay for qualified medical expenses. Distributions for qualified medical expenses are not taxable. The plan may not reimburse participants for non-qualified expenses or any other expenses.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Portability/Carryover of Funds


HSAs belong to the individual and are portable between jobs.

Amounts not distributed at the end of the taxable year may be carried over to the next year.

Any unused portion of the maximum dollar amounts at the end of the coverage period may be used to increase the maximum reimbursement amount for subsequent coverage periods. Amounts contributed to an FSA that are not used during the coverage period or 2 and one half months thereafter are forfeited, and may not be carried over to any subsequent period (or during the 2 and one half month grace period.
 Death   If the account holder's spouse is the beneficiary, then upon the account holder's death the HSA becomes the spouse's HSA and is subject to income tax only if amounts are not used for qualified medical expenses. If the spouse is not the named beneficiary, then the account is no longer an HSA and the fair market value as of the date of death must be included in gross income. The fair market value is reduced by any payments after the decedent's death for his qualified medical expenses if paid within one year of death.
No special rules for death.
No special rules for death.
 COBRA COBRA does not apply to HSAs.  HRAs must comply with COBRA continuation coverage rules by providing for continuation of the maximum reimbursement amount and increasing the maximum amount at the same time and in the same manner as other similarly situated employees.  FSAs are subject to the COBRA continuation coverage rules. Special rules apply to salary reduction only FSAs.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
Administration
HSAs are assets held by a qualified trustee or custodian, but the account holder may direct distributions and, if applicable, investments.
The trustee or custodian is not necessarily the provider of the high deductible plan. The trustee or custodian may request proof of an individual's eligibility.
HRAs are generally administered by the employer or its agent and subject to the terms of the plan document. FSAs are generally administered by the employer or its agent and subject to the terms of the plan document.
 Substantiation  No substantiation is required before benefits are paid (unless requested by IRS of account holder). Debit cards or credit cards may be used to effectuate distributions.

Each medical expense must be substantiated prior to payment.

Special rules apply for debit cards and credit cards.

Each medical expense must be substantiated prior to payment.

Special rules apply for debit cards and credit cards.

 Information Reporting Employer contributions are reported on an employee's Form W-2. Also new Form 8889 for HSAs will likely be required to be filed with an employee's Form 1040 to report contributions and distributions.  HRAs must file a Form 5500 with the Department of Labor. FSAs must file a Form 5500 with the Department of Labor.
 ERISA  HSAs are generally not considered ERISA ­ covered plans if employer involvement is limited. However, the related high deductible plan may be ERISA ­ covered.   HRAs are ERISA-covered plans.  FSAs are ERISA-covered plans.


  Health Savings Accounts (HSAs)  Health Reimbursement Arrangement (HRAs)  Flexible Spending Account (FSAs)
 HIPAA HSAs are health plans for purposes of the HIPAA privacy rules. However, because HSAs are not ERISA-covered plans, they are not subject to HIPAA nondiscrimination rules. HRAs are subject to the HIPAA nondiscrimination rules, must provide certificates of creditable coverage and must comply with the privacy rules. FSAs are subject to HIPAA privacy rules.
Most FSAs are not subject to the HIPAA nondiscrimination rules and do not need to provide certificates of creditable coverage.



B. Definition of Dependent

The Working Families Tax Relief Act of 2004 ("WFTRA") changed the definition of dependent under Code Section 152 effective January 1, 2005, and this has had a significant impact on some employee benefit plans. The new definition of dependent means either a "qualifying child" or a "qualifying relative."

A "qualifying child" is a daughter, son, stepchild, sibling, stepbrother or sister, or any descendent of these individuals if such child has the same principal place of abode for more than one-half of the taxable year and who (other than in the case of disability) has not attained age 19 as of the end of the taxable year (age 24 for students). The age limit does not apply to individuals who are totally and permanently disabled at any time during the year.

A "qualifying relative" is a person other than a qualifying child who has the same principal place of abode for more than one-half of the taxable year, receives more than one-half of his support from the taxpayer and does not have gross income in excess of the Code Section 151(d) exemption amount ($3,300 in 2006). Please note that under this definition, a domestic partner or same-sex spouse who earns more than the deduction limit would not be considered a dependent.

1. Group Health Plans

There should not be any impact on group health plans and medical reimbursement plans because IRS Notice 2004-79 eliminates the gross income limit for a "qualifying relative." Plan sponsors should, however, review their plan documents to ensure that the definition of dependent is not impacted by the change to the new statutory definition. For example, if a plan simply references Code Section 152, then the plan sponsor would need to amend the plan to include a statement that the gross income limit does not apply. Furthermore, employers should consider requesting an affidavit to establish dependent status for "qualifying relatives."

2. Dependent Care Assistance Plans

Benefits paid under a dependent care plan are pre-tax only if the individual is a "qualifying child" or a "qualifying relative." Plans documents, forms and procedures should be reviewed to ensure that the income limit is applied to "qualifying relatives."

3. 401(k) Plans

A 401(k) plan may permit hardship distributions to pay for medical expenses incurred by a participant's dependent as defined under Code Section 152. Plan sponsors should review plan procedures to ensure that distributions are only made for a "qualifying child" or a "qualifying relative."

4. 457(b) Plans

A 457(b) plan may permit a distribution for an unforeseeable emergency with respect to a dependent as defined under Code Section 152. Plan sponsors should review plan procedures to ensure that hardship distributions are only made for a "qualifying child" or a "qualifying relative."

5. Non-Qualified Deferred Compensation Plans

The American Jobs Creation Act limits distributions from non-qualified deferred compensation plans. A distribution paid due to an unforeseeable emergency is limited in the same manner as 457(b) distributions for unforeseeable emergencies. Plan sponsors should review plan procedures to ensure that hardship distributions are only made for a "qualifying child" or a "qualifying relative."

C. Modification of the Application of the "Use-it-or-Lose-it" Rule

The IRS released Notice 2005-42 which modifies the "use-it-or-lose-it" rule that applies to flexible spending accounts by allowing participants to take advantage of a 2-1/2 month grace period following the end of the plan year to spend any unused amounts that remain in their accounts on the last day of the plan year.

Under the existing rule, only expenses incurred during the 12-month plan year could be reimbursed from a participant's account balance for such plan year. Any amounts remaining in the account on the last day of the plan year are forfeited.

Under the new rule, participants may be reimbursed for expenses incurred during the
2-1/2 month period following the end of the plan year from any balance remaining in the account on the last day of the plan year which would otherwise be forfeited.

Example: A participant has an account balance of $200 as of December 31, 2005 (the last day of the plan year). During the grace period from January 1, 2006 through March 15, 2006, the participant incurs $300 of additional medical expenses. The unused balance of $200 from the 2005 plan year is used to reimburse the participant for $200 of the $300 of medical expenses incurred during the grace period. The participant, therefore, will not forfeit any benefits as of December 31, 2005. The remaining $100 will be reimbursed using amounts contributed for 2006.

To take advantage of the new rule, plan sponsors must amend their plan documents. For the current plan year, documents must be amended before the end of the plan year. Please note that the grace period must apply to all plan participants.

Under Notice 2005-61, the IRS provided guidance regarding how dependent care assistance plan ("DCAP") benefits are reported on Form W-2. Employers are required to report DCAP benefits provided during the calendar year to an employee in Box 10 of Form W-2. Under an IRS Notice 89-111, an employer may report a reasonable estimate of cash reimbursement provided to an employee if the employer does not know the actual total cash reimbursement amount when the Form W-2 is prepared. Under this Notice the amount of an employee's DCAP salary reductions for the year under the cafeteria plan may be used and will be considered a reasonable estimate.

This 2-1/2 month grace period created a problem regarding the reporting of DCAP benefits. Under Notice 2005-61, employers may still rely on Notice 89-111 for DCAP reporting on Forms W-2 and report the amount of DCAP salary reductions during the plan year and not benefits received under the plan even if the employer amends its DCAP plan to provide a 2-1/2 month grace period into the following year.

D. HIPAA Update

1. The Security Rule

We would like to bring to your attention to the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") Security Rule (the "Security Rule") which applies to protected health information that a group health plan creates, receives, maintains or transmits in electronic form ("ePHI"). The Security Rule is intended to provide standards to assure the confidentiality, integrity, and limited availability of ePHI. These standards generally require covered entities (e.g., group health plans) to take steps to safeguard ePHI when it is stored and transmitted.

The Security Rule imposes the following requirements on group health plans: (i) a group health plan must ensure the confidentiality, integrity and availability of all ePHI that it creates, receives, maintains or transmits; (ii) a group health plan must protect against any reasonably anticipated threats or hazards to the security or integrity of the ePHI; (iii) a group health plan must protect against any reasonably anticipated uses or disclosures that are not permitted or required under the Security Rule; and (iv) the plan sponsor of a group health plan must ensure that its workforce complies with the Security Rule.

To comply with the Security Rule, plan sponsors must take the following steps: (i) appoint a Security Officer; (ii) conduct a risk analysis; (iii) amend its group health plans; (iv) amend its business associate agreements; (v) adopt written polices and procedures; and (vi) train its workforce to comply with the Security Rule.

A group health plan amendment must provide that the plan sponsor will reasonably and appropriately safeguard all ePHI created, received, maintained or transmitted to or by the plan sponsor on behalf of the group health plan. For purposes of the Security Rule, the term group health plan includes a medical flexible spending account plan.

Business associate agreements must be updated to require the business associate to: (i) implement administrative, physical and technical safeguards that reasonably and appropriately protect the confidentiality, integrity and availability of the ePHI that it creates, receives, maintains or transmits on behalf of the group health plan; (ii) ensure that any agent or subcontractor to whom it provides ePHI agrees to implement reasonable and appropriate safeguards to protect such ePHI; (iii) report to the group health plan any security incident of which it becomes aware; and (iv) authorize the termination of the contract by the plan sponsor on behalf of the group health plan if the plan sponsor determines that the business associate has violated a material term of the business associate agreement.

The Security Rule generally took effect on April 21, 2005 for large health plans (plans with annual receipts of $5 million or more). Small group health plans (plans with less than $5 million in annual receipts) have a delayed effective date and do not need to comply until April 21, 2006. For insured plans, receipts means annual premiums, and for self-insured plans, receipts means claims reported on the plan's annual report (excluding stop-loss premiums).

Comment: Plan documents must be amended and revised business associate agreements must be executed to comply with the Security Rule no later than April 21, 2006. Please contact us if you require additional assistance.

2. Final and Proposed IRS, DOL and HHS HIPAA Portability Regulations

Initially issued in 1997, health coverage portability regulations under The Health Insurance Portability and Accountability Act ("HIPAA") have been issued for plan years beginning on or after July 1, 2005. After seven years of interim rules, the three agencies enforcing HIPAA (the IRS, the DOL and the Department of Health and Human Services) have clarified several issues as well as proposed additional regulations.

a. Final Regulations. The final regulations modify the current HIPAA provisions in the following ways:

(i) Model Certificate of Creditable Coverage. This document has been changed to include wording to educate the recipient about pre-existing conditions clauses, his rights under special enrollment periods and individual health coverage parameters. The new model certificate can be obtained on the DOL website.

(ii) Creditable Coverage. The final regulations add two new types of health insurance coverage that qualify as "creditable coverage" for anyone seeking to eliminate or reduce a preexisting conditions clause. Coverage under (1) a state children's health plan; or (2) a foreign national health program will now be considered "creditable coverage."

b. Special Enrollment Rights:

(i) Reacquiring Rights. Under HIPAA, employees who initially waive their right to enroll in group health coverage due to other coverage they have are able to join the plan in the event that they later lose that coverage.

(ii) Lifetime Maximum. Reaching a lifetime maximum under a health insurance policy qualifies as "losing eligibility," thereby providing access to another group health plan that the employee may be eligible for under special enrollment rights.

(iii) HMO Service Area. Relocating from an HMO in a service area without access to another plan would qualify as "losing eligibility" thereby providing access to another group health plan that the employee may be eligible for under special enrollment rights.

(iv) Changing Benefit Options. An employee participating in an employer's health plan will be allowed to change among benefit options provided by his employer if his dependent under the plan experiences a loss of other health coverage and is granted special enrollment rights.

(v) Excepted Plans and Benefits. Limited scope dental and vision benefits are not subject to HIPAA.

c. Proposed Regulations. The additional proposed regulations can be summarized as follows:

(i) Break in Coverage. A 12-month pre-existing conditions clause is reduced by any amount of time attributable to "creditable health care coverage". However, health coverage that existed prior to a 63-day break in coverage does not have to be counted. One of the proposed regulations would extend the allowable break in coverage for an additional 44 days for any period that a Certificate of Creditable Coverage is not provided. The 44 days time period is meant to coincide with COBRA regulations requiring election forms be sent during the same time period.

(ii) FMLA. In instances where employees voluntarily drop health care coverage during an FMLA leave, the proposed regulations would consider the entire FMLA leave as creditable coverage for purposes of calculating the 63-day break in coverage period. If the employee does not receive a Certificate of Creditable Coverage from the plan administrator and does not reinstate group health coverage, the 63-day break in coverage period is calculated beginning on the date the certificate is received. The proposal also contains an addendum to the Model Notice of a Certificate of Creditable Coverage describing how FMLA leave affects the 63-day break in coverage calculation.

(iii) Special Enrollment. Under HIPAA currently there is a special enrollment period for individuals who experience certain events during the plan year. One such event is the dependent's loss of health plan coverage. If a Certificate of Creditable Coverage is not readily generated, the proposed rules call for the 30-day enrollment period to begin at the earlier of the date that the Certificate of Creditable Coverage is provided, or 44 days after the other coverage ceases. The proposed rules also specify that although a request for special enrollment must be made either orally or in writing within 30 days, employers cannot require as a condition of enrollment that the full paperwork be completed within that time frame but reasonably thereafter. Extended deadlines for required receipt of a newborn's Social Security number are also proposed.

(iv) Employers with Multiple Medical Plans. The proposed regulations clarify that an employee changing between medical plans offered by the same employer need not generate a Certificate of Creditable Coverage. All plans offered by the same employer are to be seen as "one plan" for purposes of HIPAA.

Comment: It is suggested that employers confirm that their medical plan administrators are in compliance with the final HIPAA regulations.


E. Medicare Prescription Drug Benefits Impact on Employer-Sponsored Plans

The Medicare Prescription Drug Improvements and Modernization Act of 2003 ("MMA") added a prescription drug benefit to Medicare effective as of January 1, 2006, for individuals who are eligible for Medicare Part A or enrolled in Medicare Part B. This is optional coverage, and is available through Medicare Part D. In little noticed provisions, the new law also imposes certain obligations on employers who sponsor group health plans that provide prescription drug benefits, and offers potential federal subsidies for employers that sponsor certain retiree medical plans that provide prescription drug benefits.

The major requirements of the new law affecting employers who sponsor group health plans that provide prescription drug benefits include the following:

a. Any group health plan that provides prescription drug benefits to Medicare Part D eligible individuals enrolled or seeking to enroll in the plan must disclose to such individuals and the Centers for Medicare and Medicaid Services ("CMS") whether that coverage is considered "creditable coverage."

b. Group health plans must provide the Notice of Creditable Coverage in certain circumstances.

c. Some employers are considering "wrap plans" for Medicare Part D eligible retirees to "fill the donut" in prescription coverage benefits for these retirees.

d. Employers who maintain a group health plan for retirees that provides a prescription drug benefit that is the actuarial equivalent or better of a standard Medicare Part D Plan may be eligible for a 28% federal subsidy.

Each of these points is more fully discussed below.

1. Overview of Medicare Part D

Medicare Part D is not available through the federal government in the same manner as Medicare Parts A and B which provide hospitalization and major medical benefits. Instead, eligible individuals will be able to purchase benefits through prescription drug plans ("PDPs") approved by the Centers for Medicare and Medicaid Services ("CMS") or through Medicare Advantage plans.

Individuals are eligible for Medicare Part D if they:

a. Are eligible to enroll in Medicare Part A or enrolled in Medicare Part B;
b. Live in the PDP's service area; and
c. Are not enrolled in another Medicare Part D plan.

Eligible individuals who enroll in a Standard Medicare Part D Plan must pay a monthly premium (the estimated premium for 2006 is $37 per month). A Standard Medicare Part D Plan has an annual deductible ($250 for 2006, indexed), and 25% coinsurance on the next $2,000 (indexed). Medicare does not cover expenses in excess of the annual coverage limit ($2,250 for 2006, indexed) until expenses meet the catastrophic threshold limit. The catastrophic threshold limit is the annual coverage limit plus the annual out-of-pocket limit ($3,600 for 2006, indexed) less the individual's "true-out-of-pocket" expenses to date (i.e., $250 deductible and 25% of $2,000, or $750 total).

In 2006, the catastrophic threshold is $5,100 ($2,250 + $3,600 - $750). A Standard Medicare Part D Plan will pay any expenses in excess of the catastrophic threshold subject to a co-payment which is the greater of (i) $2 for a generic drug or $5 for any other drug and (ii) 5% of the cost of the drug. This means, practically, there is a gap in coverage between $2,250 and $5,100. This gap is called the "donut." The diagram below illustrates the different Medicare Part D thresholds.

 The first $250 paid by individual
 Medicare pays 75% of the next $2,000  Individual pays 25% of the next $2,000

 Individual pays the next $2,850 of "true-out-of-pocket" expenses
 Medicare generally pays 95% of amounts in excess of $5,100  Individual generally pays 5% of amounts in excess of $5,100

Please note that Medicare Part D premiums do not count as expenses. Therefore, the individual would have to pay $4,020 before reaching the "true-out-of-pocket" threshold.

True-out-of-pocket ("TrOOP") expenses are those amounts actually paid by the beneficiary, another person on behalf of the beneficiary, or a qualified State Pharmaceutical Assistance Program ("SPAP") which are not reimbursed by a third-party (e.g., a supplemental insurance plan sponsored by a former employer). Amounts paid by a third party do not count toward the TrOOP threshold that determines the start of the catastrophic coverage. Amounts paid through a Health Reimbursement Account would not count toward TrOOP expenses. However, amounts paid through a health savings account ("HSA"), a flexible spending account ("FSA"), or an Archer Medical Savings Account ("Archer MSA") would count as TrOOP expenses.

PDPs and Medicare Advantage Plans provide benefits that equal or exceed prescription drug coverage available through a Standard Medicare Part D Plan. Employers do not need to provide prescription drug benefits through a PDP or Medicare Advantage Plan. In their discretion, employers may adopt "wrap" or "supplemental" plans that coordinate with a PDP or Medicare Advantage Plan. For example, a supplemental plan could cover expenses not covered under a standard Medicare Part D plan (e.g., the donut). Amounts paid by a supplemental plan would not count as TrOOP expenses. As a result, participation in a wrap plan could increase the amount an individual would need to pay before reaching the annual out-of-pocket limit.

2. Covered Expenses

Generally, a Medicare Part D prescription drug is any drug that is only available by prescription, approved by the Food and Drug Administration ("FDA"), used and sold in the United States, and used for a medically accepted indication (e.g., prescription drugs, biological products, insulin, vaccines, and certain medical supplies associated with the injection of insulin (syringes, needles, alcohol swabs, and gauze)).

Medicare Part D prescription drugs do not include: (1) drugs used for anorexia, weight loss, or weight gain; (2) drugs used to promote fertility; (3) drugs used for cosmetic purposes or hair growth; (4) drugs used for the symptomatic relief of cough and colds; (5) prescription vitamins and mineral products, except prenatal vitamins and fluoride preparations; (6) nonprescription drugs; (7) outpatient drugs for which the manufacturer seeks to require that associated tests or monitoring services be purchased exclusively from the manufacturer as a condition of sale; (8) barbiturates; and (9) benzodiazepines.

A drug cannot be covered under Medicare Part D if payment for that drug, as it is prescribed and dispensed or administered to an individual, is available under Medicare Parts A or B.

Beyond this definition, individual plans will construct formularies to determine what drugs are covered under their plan. Plans are required to include at least two drugs in every therapeutic category and class on their formularies, and CMS will review the formularies to make sure they are adequate and do not discriminate against any group of beneficiaries.

3. Enrolling in Medicare Part D

An individual's initial enrollment period for Medicare Part D is the period that:

a. Begins on November 15, 2005 and ends on May 15, 2006 (for individuals who first become eligible before January 3, 2006 or who become eligible during February 2006); or

b. Is the individual's enrollment period for Medicare Part B (for those who become eligible for Medicare Part D in March 2006 or any subsequent month).

Eligible individuals may also enroll during the annual enrollment period (i.e., from November 15 through May 15 for 2006, and from November 15 through December 31 for 2007 and subsequent years).

Late enrollees must pay a late penalty which is the greater of: (i) an amount that the CMS determines is actuarially sound, or (ii) 1% of the base premium for each uncovered month. CMS has indicated that it will set the penalty for the first few years at one percent of the average drug premium for each uncovered month. For example, if the penalty amount is $0.367 for each uncovered month in 2006 and the individual delays enrolling in a Part D plan for 12 months, then the individual would pay an additional $4.40 ($0.367 x 12) per month in 2007. In subsequent years, the amount of the penalty would increase with the growth in the base Medicare Part D premium. The penalty applies for as long as the individual is enrolled in Medicare Part D.

A late enrollee is an individual who enrolls 63 days or more after the end of such individual's initial enrollment period during which all of the following apply:

a. The individual was eligible to enroll in Medicare Part D;

b. The individual was not covered under a PDP that provides creditable coverage; and

c. The individual was not enrolled in a Medicare Part D plan.

"Creditable coverage" means coverage provided by a group health plan, if the actuarial value of the group health plan's coverage equals or exceeds the actuarial value of the Standard Medicare Part D Plan. Please note that coverage made available through a supplemental prescription drug plan would not be considered creditable coverage.

4. Notice of Creditable Coverage

Any group health plan that provides prescription drug benefits to Medicare Part D eligible individuals enrolled or seeking to enroll in the plan must disclose to such individuals and the CMS whether that coverage is considered "creditable coverage." Group health plans must provide the Notice of Creditable Coverage to covered individuals:

a. Before November 15 of each calendar year (the individual's initial Medicare Part D enrollment period);

b. Before the effective date of the enrollment in the group health plan;

c. Before any changes that affect whether the coverage is creditable coverage; and

d. Upon the covered individual's request.

The first Notice of Creditable Coverage must have been provided before November 15, 2005. CMS has stated that the notice may be combined with other notices or materials that the plan sponsor provides (e.g., open enrollment materials). The Notices must be in writing, not electronic. The distribution method should ensure that the notice is delivered to all covered individuals who are eligible for Medicare Part D. Presumably, handing the notice to the employee who has a dependent eligible for Medicare Part D would not be considered adequate notice.

For purposes of this notice requirement, "individual" means plan participants, their spouses and dependents. For example, a notice must be sent to any covered employees age 65 or older, COBRA beneficiaries entitled to Medicare, or spouses or dependents eligible for Medicare Part D on the basis of disability. Plan sponsors may need to modify their systems in order to easily identify those individuals who must receive a Notice of Creditable Coverage.

If the group health plan prescription drug coverage is not creditable coverage, then the group health plan must provide a written disclosure to all Medicare Part D eligible individuals
who are enrolling or seeking to enroll in the plan providing that:

a. The coverage is not creditable coverage;

b. The individual may only enroll in a Medicare Part D Plan during specific enrollment periods during the year; and

c. The individual may be subject to a late enrollment penalty if he does not enroll within the required period.

Group health plans must notify CMS electronically. The first electronic filing is due by March 31, 2006. Subsequent filings are due no later than 60 days after the first day of the plan year. Plan sponsors must also provide creditable coverage disclosures within 30 days of a change in creditable status. A copy of the electronic disclosure form is available at http://www.cms.hhs.gov/apps/ccdisclosure/default.asp.

5. Group Health Plan Subsidy for Employers That Sponsor Retiree Plans

The Medicare Part D subsidy is designed to encourage plan sponsors to continue retiree health coverage. Plan sponsors who maintain a group health plan for retirees that provides a prescription drug benefit that is the actuarial equivalent of a standard Medicare Part D Plan may be eligible for a 28% federal subsidy. The subsidy pays plan sponsors 28% of a retiree's drug costs between $250 and $5,000 in 2006 for each "qualified covered retiree" who participates in a "qualified retirement prescription drug plan." The subsidy is not included in the plan sponsor's gross income.

A "qualified retirement prescription drug plan" is a group health plan that:

a. Provides an actuarial attestation certifying that the plan provides a prescription drug benefit that is at least the actuarial equivalent of a Standard Medicare Part D Plan;

b. Provides the Notice of Creditable coverage to all eligible individuals; and

c. Maintains records which are made available for audit.

A "qualified covered retiree" is the participant (or spouse or dependent of a participant) eligible for Medicare Part A or has enrolled in Medicare Part B who is covered under a qualified retirement prescription drug plan but has not enrolled in Medicare Part D or a Medicare Advantage Plan.

Plan sponsors apply for the subsidy by submitting an application with CMS signed by an authorized representative. The application must have been submitted in the form and manner required by CMS. For 2006, the application must be submitted no later than September 30, 2005 unless an extension was filed and approved. For subsequent years, the application must be filed at least 90 days before the beginning of the plan year unless an extension has been filed and approved.

The application which must be filed annually must contain the following information:

a. Employer tax identification number;

b. Plan sponsor's name and address;

c. Contact name and e-mail address;

d. Actuarial attestation;

e. A list of all the individuals the plan sponsor believes are qualifying covered retirees. The list must include full name, health insurance claim number or Social Security number, birth date, gender, and relationship to the retired employee;

f. A signed plan sponsor agreement; and

g. Any other information required by CMS.

Instead of providing a list of all individuals who are qualifying covered retirees, the plan sponsor may enter into a voluntary data sharing program with CMS. For some employers, this program may be more convenient.

6. Actuarial Equivalence

The test for actuarial equivalence is a two-prong test: the first prong tests the value of the coverage and the second prong determines the net value of the benefit. A plan sponsor must first test whether the gross value of the prescription drug coverage for the plan year is at least equal to the gross value for a Standard Medicare Part D Plan. Then the plan sponsor must test whether the net value is at least equal to the net value of a Standard Medicare Part D Plan.

7. Conclusion

Plan sponsors should analyze their group health plans to determine if they provide creditable coverage to retirees. If they do provide creditable coverage, the sponsors should consider applying for the federal subsidy. Plan sponsors that apply for the subsidy should start taking steps to identify all of those individuals who must be reported on the application and obtain an actuarial attestation.

In some cases, plan sponsors should consider reviewing their plan designs in light of the Medicare Part D changes (e.g., is a supplemental program appropriate?). Finally, plan sponsors must make arrangements with that group health providers to ensure that appropriate notification regarding Medicare Part D is timely made.

F. Final COBRA Regulations Require Major Overhaul to COBRA Notices
and Procedures

Effective January 1, 2005, the DOL issued final rules governing the notice requirements applicable to health care continuation coverage ("COBRA"), that make dramatic changes to some common COBRA administrative practices. Although the final rules are not substantially different than those previously proposed, these new rules require most health plan sponsors to: substantially revise their COBRA notices (including adding two new notices), revamp their COBRA procedures, and update their health plan summary plan descriptions ("SPDs").

Comment: If you have been using the same COBRA notices since the 1990s, you are already out of compliance, and the COBRA forms and procedures should be immediately updated or you risk incurring penalties.

1. General Notice Requirements

a. Delivery Method. The regulations specify how health plan administrators must furnish the general notice of COBRA continuation rights to employees and their spouses when they first become covered by the plan. A single notice to the covered employee and his or her spouse sent to their home address will satisfy the delivery rules with respect to the employee and all his or her covered dependents, but only if the employee and spouse reside at the same address. If the general notice is handed to the covered employee at the workplace, a separate general notice must be sent to his or her spouse. The plan administrator may also e-mail the general notice to the covered employee and his or her spouse, provided the DOL's electronic delivery rules are followed.

b. 90-Day Rule for Delivery. The general notice must be provided to the employee within 90 days after the employee's plan coverage begins and to the spouse within 90 days after the spouse's plan coverage begins. In other words, subject to the delivery rules described above, one general notice will suffice if the employee and spouse enroll in the plan at the same time, but two are required if the spouse enrolls more than 90 days after the employee. If a COBRA election notice (see below) must be provided within the initial 90-day period, the plan administrator may send an election notice instead of the general notice.

c. Inclusion in Summary Plan Description. As an alternative to providing the general notice to the employee and his or her covered spouse, the plan administrator may provide the required COBRA information in an SPD, provided the distribution of the SPD meets the delivery method requirements and the 90-day rule for delivery for both the employee and covered spouse.

d. Content. The DOL rules prescribe what information must be included in the general notice or SPD. The plan administrator must provide: a basic overview of COBRA rights and how they are exercised; the name, address and telephone number of the party who can provide additional information about the plan and COBRA procedures; procedures a covered individual must follow to advise the plan administrator of certain events giving rise to COBRA rights (i.e., a divorce or legal separation, a child ceasing to be a dependent under the terms of the plan, or a Social Security determination that a COBRA beneficiary is disabled); an explanation of the importance of keeping the administrator informed of the current addresses of all participants and beneficiaries who may become qualified beneficiaries; and a statement that the notice does not fully describe the COBRA rights or other rights under the plan and that more complete information is available from the plan administrator or in the SPD. The DOL provides a new model notice that may be used and is deemed to satisfy the content requirements, provided it is adapted for the specific plan.

2. Covered Employee/Qualified Beneficiary Notices to the Plan Administrator of Events that Affect COBRA Coverage

a. Timing of Employee/Qualified Beneficiary Notices. The DOL's rules place a premium on properly advising covered employees and spouses, in the general notices, of: (i) their responsibility to notify the health plan administrator within 60 days when they divorce or legally separate, when a child ceases to be eligible under plan terms, or when a Social Security disability determination or second qualifying event extends their rights to COBRA coverage from 18 to 29 or 36 months and (ii) the plan's procedures for exercising that responsibility.

The DOL rules provide that the 60-day period for the covered employee/qualified beneficiary notice generally begins on the later of: (i) the date of the qualifying event, (ii) the date coverage would end, or (iii) the date the qualifying beneficiary is told in the SPD or general notice of his or her obligation to provide such notice. For disability determinations, the beginning date generally is the date of the determination, but the plan can require notification to be made by the end of the first 18 months of COBRA coverage. However, the notice period cannot begin until the covered employee and qualified beneficiary are properly advised of their notification responsibilities and the notification procedures they must follow.

b. Reasonable Notice Procedures. A health plan must establish reasonable notice procedures for employees and qualified beneficiaries to follow when fulfilling their notice responsibilities. To be reasonable, the procedures must be fully described in the SPD. In addition, they must specify the individual or entity to receive the notice, specify how notice must be provided, and describe the information needed for the plan to provide COBRA coverage. A plan may require use of a specific form, as long as the form is reasonably available, without cost, to covered employees and qualified beneficiaries. A plan may also specify the content of the notice but cannot refuse to provide COBRA coverage just because the notice provided by the covered employee or qualified beneficiary does not provide all the required information, as long as the covered employee or qualified beneficiary supplements the notice at the plan administrator's request.

c. Failure to Establish Reasonable Notice Procedures. If a plan fails to establish reasonable notice procedures, the covered employee or qualified beneficiary may fulfill his or her notice obligation by any written or oral communication identifying the qualifying event to whichever person or unit within an organization ordinarily handles health plan administration.

3. COBRA Election Notices

a. Delivery Method. COBRA requires the plan administrator to furnish a COBRA election notice to each qualified beneficiary following a qualifying event. As with the general notice, a single notice may be provided to all qualified beneficiaries entitled to make a COBRA election who reside at the same address. The notice may be sent by e-mail, provided the DOL's rules for electronic delivery are followed. A separate notice is required for each qualified beneficiary who is a spouse or dependent child residing at a different address.

b. Content Requirement. The COBRA election notice must be in writing and include 14 specific items of information, including: the name of the plan and the party responsible for COBRA administration; the qualifying event; who is eligible to elect COBRA continuation coverage (either by status or name) and when they will lose coverage if they fail to make a COBRA election; an explanation of each qualified beneficiary's independent right to elect COBRA continuation coverage and who may exercise that right; the plan's election procedures and applicable election periods; the consequences of failing to elect COBRA and how to revoke an earlier waiver of COBRA; a description of the continuation coverage that is available and when it will begin; the maximum COBRA continuation period and events that may result in earlier termination; any circumstances that may extend the maximum coverage period, such as a second qualifying event or disability determination; the procedures for qualified beneficiaries to notify the plan administrator of a second qualifying event or Social Security determination of disability (or cessation of disability), including the time limits on providing such notices and the failure to provide notice; the cost of continuation coverage; when premiums are due and the consequences of delayed payment or non-payment; the importance of updating the plan administrator on address changes; and a statement that the notice does not fully describe all COBRA continuation or other rights under the plan and how to obtain that information.

While most COBRA administrators have included the listed items, the final rules expand on the information required to be included. For example, the explanation of the consequences of failing to elect COBRA must include a description of the ramifications under the Health Insurance Portability and Accountability Act ("HIPAA"), including the potential for losing protection from another plan's preexisting condition exclusions (if COBRA is declined and coverage lapses) and special enrollment rights under HIPAA's portability rules (if COBRA is elected but coverage terminated before the end of the maximum COBRA coverage period), as well as information about how a qualified beneficiary can get additional information about his or her HIPAA rights. The description of COBRA coverage that is available may be made by reference to the plan's SPD. As part of the information concerning premium due dates, the notice must advise the qualified beneficiary of the grace periods applicable to delayed payments.

The rules include a new model election notice that illustrates the new content requirements. Administrators who appropriately modify and supplement the model notice included in the final regulations are deemed to be in compliance with the content requirements.

c. Timing of Election Notices. Plan administrators have 14 days after receiving notice of a qualifying event from the employer or covered employee/qualified beneficiary to notify qualified beneficiaries of their COBRA election rights. For events like employment termination, where the employer has 30 days to provide notice of the qualifying event to the plan administrator, and the employer and plan administrator are the same, the DOL rules clarify that the employer/plan administrator has 44 days to provide a COBRA election notice to COBRA-eligible beneficiaries, not 14 days.

4. New COBRA Notices

a. Notice of Unavailability of COBRA Coverage. If a plan administrator receives notice of a qualifying event from a covered employee or dependent and determines that an individual covered by the notice is not entitled to elect COBRA coverage, the administrator must notify the individual that COBRA is not available and why, within the 14-day period applicable to COBRA election notices.

b. Notice of Early Termination of COBRA Coverage. If COBRA coverage ends before the maximum 18 or 36-month coverage period, the plan administrator must notify the affected qualified beneficiary of why coverage will terminate early and when it will terminate. The notice must explain any alternate coverage rights the qualified beneficiary may have under the plan or applicable law. Notice must be furnished as soon as practicable after the administrator determines that coverage will end.

Comment: Substantial effort will be required to comply with the extensive changes to the COBRA notices, procedures, and SPDs. While employers who use COBRA administrators may be able to have these administrators assume responsibility for most of the changes, the notices and procedures do have to be customized to the employer and the plan. Employers with multi-state locations may have customize notices depending on location, as some states, like California, provide additional rights that may have to be disclosed to qualified beneficiaries under these new rules.

G. Parking, T-Pass and Vanpool Fringe Benefits Under Code Section 132(f)

A federal and Massachusetts income-tax exclusion is allowed for employer-provided parking, transit passes and vanpool benefits (i.e., qualified transportation benefits), subject to monthly maximums. However, federal legislation effective January 1, 1998, created differences between the Massachusetts and federal exclusion amounts. Massachusetts did not adopt the federal exclusion for transit pass and employer-provided vanpool benefits if the employer offered the benefit as a reduction in salary and the employee chose the benefit in lieu of salary. As a result, the federal and Massachusetts exclusion amounts have not been the same.

Periodically, the Massachusetts Legislature adopts a more recent version of the federal Internal Revenue Code ("Code Update"), resulting in a number of changes to the Massachusetts personal income tax provisions. On December 8, 2005, the Massachusetts Legislature enacted a Code Update which incorporated into Massachusetts personal income tax law the Internal Revenue Code as amended and in effect on January 1, 2005.

As a result of the Code Update, for tax years starting on or after January 1, 2005, Massachusetts adopts the federal exclusion without any differences in exclusion amounts or allowed benefits. Therefore, the federal and Massachusetts exclusion amounts for tax year 2006 are $205 per month for employer-provided parking and $105 per month for employer-provided vanpool and transit pass benefits combined, including transit pass and employer-provided vanpool benefits that are purchase pre-tax through a reduction in salary.

VI. NEW NONQUALIFIED DEFERRED COMPENSATION RULES
UNDER CODE SECTION 409A

A. IRS Guidance on New Nonqualified Deferred Compensation Rules Explains Key Terms and Exceptions

On September 29, 2005, the IRS issued long-awaited proposed regulations regarding the treatment of nonqualified deferred compensation ("NQDC") under Internal Revenue Code Section 409A. Enacted in 2004, Section 409A, for the first time, provides statutory rules governing the tax treatment of NQDC. The proposed regulations expand in detail the guidance initially provided in Notice 2005-1, with the most notable change being a one-year extension (until December 31, 2006) of the time for employers to amend their nonqualified plans to comply with the new law. Until then, the operation of a plan which provides NQDC must conform to a good faith interpretation of the Section 409A rules.

The new guidance, which is discussed below, concentrates on practical aspects of the new rules such as the definition of a NQDC plan as well as the types of compensation arrangements that are beyond the reach and scope of Code Section 409A. The proposed regulations also provide detail with respect to deferral elections, the time and manner of distributions, and the prohibition on the acceleration of payments.

1. Background

Under Code Section 409A, unless certain requirements are satisfied, all amounts deferred under a NQDC plan for all tax years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. If the requirements of Section 409A are not satisfied, the deferrals will also be subject to an additional tax equal to 20% of the compensation required to be included in income. The tax due would be further increased by interest at the underpayment rate plus 1% from the year in which the amount was first deferred (or no longer subject to a substantial risk of forfeiture, if later) to the year in which it is included in income.

Where Section 409A applies, the consequences noted above will be imposed unless a NQDC plan meets requirements relating to the timing and manner of elections with respect to deferrals and distributions, permissible distribution events, restrictions on the acceleration of benefits, and certain funding limitations.

 

2. When is Code Section 409A Effective?

Code Section 409A generally applies to:

(i) amounts deferred in tax years beginning after December 31, 2004; and

(ii) amounts deferred in tax years beginning before 2005 if the NQDC plan is materially modified after October 3, 2004.

The new rules apply to earnings on amounts deferred only to the extent that Code Section 409A applies to the amounts deferred. Thus, earnings on amounts deferred before January 1, 2005 are not affected unless Code Section 409A applies to the amounts deferred.

An amount is treated as deferred before 2005 if:

(i) the employee had a legally binding right to be paid the amount by the end of 2004; and

(ii) the right to the amount was earned and vested by the end of 2004 (i.e., the amount was not subject to either a substantial risk of forfeiture or a requirement to perform further service).

Under the proposed regulations, an amount will not be considered deferred before January 1, 2005, if the service recipient retained discretion to reduce the amount of the payment. However, stock options, stock appreciation rights, and similar compensation are treated as earned and vested if they were exercisable for cash on or before December 31, 2004, even if the right of exercise would terminate upon the cessation of services.

 

3. Compensation Deferred Before 2005

Determining the amount deferred before 2005 (which would generally be exempt from the new rules) depends on the type of NQDC plan:

a. For a nonaccount balance plan (i.e., a defined benefit type plan), it is the present value (arrived at by using "reasonable" actuarial assumptions) as of December 31, 2004 of the amount to which the participant would be entitled if he voluntarily terminated services without cause on that date and received full payment of benefits from the plan (based on the maximum value available under the plan) on the earliest possible date allowed following termination, to the extent the right to the benefit is earned and vested as of that date. The grandfathered amount may increase due to the impact of certain factors on the present value of the benefit, such as changes in applicable limits under the Internal Revenue Code or an election by the participant as to the time or form of payment, but without regard to the rendering of further services or other events affecting the amount or entitlement to the benefit. A great deal of uncertainty remains as to how the grandfathered amount should be calculated under a nonaccount balance plan.

b. For an account balance plan (i.e., defined contribution type plan), the grandfathered amount is the portion of the participant's account balance as of December 31, 2004 that is earned and vested on that date.

c. For an equity-based compensation plan, the grandfathered amount is the amount found by applying the account balance rules in (b), above, except that the account balance is treated as the payment amount available to the participant on December 31, 2004 (or that would be available to him if the right were immediately exercisable), the right to which is earned and vested on that date. The payment available to the participant excludes any exercise price or other amount which he must pay.

4. Material Modification

Amounts deferred before 2005 are subject to Code Section 409A if the NQDC plan is materially modified after October 3, 2004. A material modification occurs if a benefit or right existing as of October 3, 2004, is materially enhanced, or a new material benefit or right is added, and the enhancement or addition affects amounts earned and vested before January 1, 2005. A benefit enhancement or addition is a material modification without regard to whether it occurs as a result of an amendment or the service recipient's exercise of discretion under the terms of the plan. The proposed regulations make it clear that amending a plan to bring it into compliance with the new rules will not be treated as a material modification, but that an amendment or exercise of discretion that materially enhances an existing benefit or right or adds a new one that is material will be treated as a material modification even if the enhancement or addition would be permitted under Section 409A. For example, adding a right to a payment upon an unforeseeable emergency would be a material modification. However, the reduction of an existing benefit (e.g., removal of a "haircut" provision, which permits accelerated payouts if a small penalty is paid) is not a material modification.

Adopting a new arrangement or granting an additional benefit under an existing arrangement after October 3, 2004 is presumed to be a material modification, unless it can be demonstrated that the adoption or grant is consistent with the service recipient's historical compensation practices (e.g., grant of a discounted stock option on November 1, 2004 is not a material modification if the grant is consistent with the historic practice of granting substantially similar stock appreciation rights, both as to terms and amounts, each November for a significant number of years). However, granting an additional benefit under an existing arrangement that consists solely of a deferral of additional compensation not otherwise provided under the plan on October 3, 2004 is a material modification only as to the additional deferral of compensation, provided that the plan (i) explicitly identifies the additional deferral of compensation, and (ii) provides that the additional deferral of compensation is subject to Code Section 409A.

5. Freezing or Shutting Down a Noncompliant Plan

The amendment of an existing plan to stop further deferrals after December 31, 2004 is not treated as a material modification. Notice 2005-1 had allowed participants to terminate plan participation or cancel existing deferrals during 2005, provided that distributions were taken into income by the participants in 2005 or the later taxable year in which the amounts were earned and vested. This transition rule has not been extended under the proposed regulations.

Similarly, under the notice, amending a plan before 2006 to shut it down and distribute all the deferred compensation was not treated as a material modification, if all amounts deferred under the plan were included in income in the year of termination, which in almost all cases would have been 2005. The proposed regulations do not extend this treatment to 2006 and later years so that, generally speaking, distributions cannot be made from a terminated plan after 2005 (other than pursuant to the original distribution schedule) without violating the prohibition on the acceleration of benefits. However, there are three circumstances under which distributions can be made as a result of the termination of a NQDC plan:

(i) When an employer or service recipient eliminates all plans of a similar type such as all account balance plans, all non-account balance plans, all equity-based plans, etc. In this type of plan termination, no distributions, except for distributions to participants already in pay status, may be made for at least 12 months following the termination, but all distributions must be made within 24 months of the termination, and the employer may not establish another plan of the same type within 5 years of the termination.

(ii) When a plan termination is within 12 months of a change in control.

(iii) When a plan termination is due to corporate dissolution or bankruptcy.

6. Short-Term Deferral Rule

Under the short-term deferral rule, which was first enunciated in Notice 2005-1, a deferral of compensation subject to Code Section 409A is deemed not to occur if at all times the terms of the plan require payment by, or an amount is actually or constructively received by the employee by, the later of:

(i) 2-1/2 months from the end of the employee's taxable year in which the amount became nonforfeitable, or

(ii) 2-1/2 months from the end of the employer's fiscal year in which the amount became nonforfeitable.

Where an amount is never subject to a substantial risk of forfeiture, it is treated as becoming nonforfeitable on the date that the employee first has a legally binding right to the amount.

The proposed regulations retain the 2_ month rule and significantly elaborate on it to protect against inadvertent violations of the rule. Thus, if no payment date is specified in a written document and payment is actually made outside of the 2_ month period, the payment will result in the automatic violation of Section 409A. However, if a payment date is specified in a written plan or agreement, the proposed regulations would allow payments actually made in the same calendar year as the fixed payment date to remain exempt from Section 409A, thereby preventing participants from incurring penalties. It follows that bonus programs intended to make payments within the short-term deferral period should be reviewed to determine whether they should specify a payment date in writing.

7. Separation Pay

Notice 2005-1 provided limited relief for severance pay that did not apply in many situations. The proposed regulations generally exempt severance arrangements (including early retirement windows) from the need to comply with Section 409A when the amount of payment does not exceed the lesser of two times an employee's annual compensation or two times the compensation limit under Code Section 401(a)(17), the latter limit being $220,000 for 2006. The payments must be completed by the end of the second calendar year in which an employee separates from service. One effect of this rule is that public companies will be able to make qualifying severance payments to key employees without waiting until six months after separation as would otherwise be required by Section 409A.

The proposed regulations also provide that where separation pay due to an involuntary termination has been the subject of bona fide, arm's length negotiations, an election as to the time and form of payment of any severance that does not qualify for the exception described above may be made on or before the date an employee obtains a legally binding right to the payment.

8. Restricted Property

Notice 2005-1 and the proposed regulations make clear that transfers of restricted property are generally regulated under Code Section 83 instead of Code Section 409A. Thus, an employee who receives restricted property (e.g., employer stock) in connection with the performance of services may not have current income by reason of the application of Code Section 83, because the property is nontransferable and is subject to a substantial risk of forfeiture.

9. Information Reporting Reprieve

Pursuant to other statutory changes enacted at the same time as Section 409A, all deferrals for the year under a NQDC plan must be separately reported in box 15a of Form 1099 (Miscellaneous Income) or box 12 of Form W-2 (Wage and Tax Statement). These rules apply to amounts actually deferred (and income, actual or notional, attributable to these amounts) in calendar years beginning after 2004. Annual reporting of all compensation deferred under the plan for a year is required regardless of whether the compensation is includible in gross income. For purposes of these rules, amounts are considered actually deferred when the employee has a legally binding right to the compensation.

In December of 2005, the IRS issued Notice 2005-94 which suspended the reporting requirements with respect to deferrals for calendar year 2005. It also suspended employers' and payers' reporting and wage withholding requirements with respect to amounts includible in gross income under Section 409A in 2005 that an employee or other service provider has neither actually nor constructively received. However future guidance may require such an employer or other payer to file a corrected information return and to furnish a corrected payee statement for 2005 reporting any previously unreported amounts. Notwithstanding the relaxation of employers' and payers' reporting obligations, service providers must include amounts includible in gross income under Section 409A in 2005 on their 2005 tax returns. The IRS has indicated that late payment of such taxes due to the inability to determine the correct amount and proper timing of amounts includible under Section 409A will not be subject to penalties (although interest will be due), provided that a service provider reports and pays such taxes in accordance with guidance expected to be published by July of 2006.

B. IRS Provides Deferred Compensation Relief for Stock Options and SARs

Code Section 409A does not apply to stock options and stock appreciation rights ("stock rights"), provided that the stock rights are issued with an exercise price that can never be less than the underlying stock's fair market value ("FMV") at the time they are granted. Exemption from the Section 409A regime also requires that the number of shares subject to the stock right be fixed on the date of grant and that a stock right possess no additional deferral features. Further, the proposed regulations (unlike Notice 2005-1) limit the exemption to stock rights based on common stock that has no preference features or special lapse rights with respect to puts and calls. In further contrast to Notice 2005-1, the proposed regulations allow plans maintained by public or private companies to provide for cash as well as stock settlements of stock rights.

In the case of publicly traded stock, compliance with the fair market rule will not be difficult. For a non-public company the regulations require a "reasonable application of a reasonable valuation method," taking into account all relevant factors. Factors to be considered in valuing such stock include asset values, future cash flows, objectively-determined values of similar entities, control premiums or discounts for lack of marketability, and whether the valuation method is used for other material purposes. An independent appraisal that complies with rules set forth in the Code for employee stock ownership plan valuations will be presumed to be reasonable, provided the value is measured not more than 12 months before the relevant grant date. Certain valuation formulae (e.g., book value) will be deemed to be reasonable, provided that they govern all subsequent transfer of company stock and are used for all compensatory and non-compensatory valuations of the stock, including regulatory filings, loan covenants and transactions involving the issuance or repurchase of the stock. Temporary valuation formulae or temporary restrictions on stock values (so called "lapse restrictions") may not be considered for valuation purposes.

Many employers with non-publicly-traded stock have complained that the valuation rules used to qualify for the stock-rights exception are too difficult to follow without further guidance. In response, in Notice 2006-4, the IRS announced postponements, in the form of two "good faith" exceptions, to applying the strict valuation rules found in the proposed regulations. One exception applies to stock rights issued before January 1, 2005; the other to those issued after December 31, 2004 and before final regulations are published, as discussed below:

1. Rights Issued Before January 1, 2005

The IRS will exempt stock rights issued before January 1, 2005 from Code Section 409A based on the standard in Code Section 422 for incentive stock options. Option price requirements are met if the employer makes a good-faith attempt to set the option price at fair market value. Good faith is determined based on the facts and circumstances.

2. Rights Issued On or After January 1, 2005

For stock rights issued on or after January 1, 2005 and before the effective date of final regulations, the IRS will exempt such rights from the reach of Section 409A if it can be demonstrated that the exercise price of the stock right was intended to be at least equal to the stock's FMV at the date of grant, and that the value of the stock right was determined using a reasonable valuation method without regard to the valuation standard contained in the proposed regulations.

C. Elections as to Deferrals and Distributions

1. Time for Making Deferral Elections

Elections to defer compensation as well as elections as to the time and form of payment must be made and become irrevocable no later than the close of the preceding year before the amounts will be earned. Generally speaking, elections made in the same year that amounts are earned will not be treated as deferring those amounts.

Evergreen deferral elections (i.e., elections that remain in place until changed by the employee) are effective provided that they become irrevocable each December 31 for compensation payable in the immediately following year.

Nonelective arrangements, such as a SERP, must designate the time and form of the payment up front.

2. Performance Based Compensation

A promise to pay a bonus in the future based on measures of the company's or the individual's performance is treated as NQDC. However, if the bonus or other performance based NQDC will be based on services performed over a 12-month period or longer, the employee may elect to defer income up to six months before the end of the performance period, provided that the amount of the payment remains unknown or the employer's liability for the payment remains uncertain.

Example: Employee will earn a bonus on her performance over a three-year period ending December 31, 2009. Employee may elect up to June 30, 2009 to defer any bonus eventually earned.

The proposed regulations define performance based compensation which is entitled to the relaxed rule as to the timing of deferral elections as payments contingent on the satisfaction of preestablished organizational or individual performance criteria. The new regulations allow the performance criteria to be established up to 90 days after the commencement of the performance period to which they relate, provided that the outcome is not substantially certain at that time. Performance based compensation may include payments based on subjective performance criteria and can also be based on an increase in the value of an employer or service provider for whom the services are performed.

3. Ad Hoc Awards

The proposed regulations establish a new rule for "ad hoc" awards that occur in the middle of the tax year and are often unforeseeable by an employee. Under such circumstances, an initial deferral election could not be made by the employee during the taxable year before the year in which the award was granted unless the employee had the foresight to request such an election. To address this situation, the proposed regulations provide that an initial deferral election can be made after the award has been granted, provided that it is made no later than 30 days after the date of the grant and at least 12 months in advance of the end of the service period. For practical purposes, the 12 month rule limits the usefulness of the special provision for ad hoc awards to situations in which an award is made contingent on the performance of additional service or the satisfaction of other conditions.

4. Changes as to Elections on the Time and Form of Payment

Under Section 409A, any subsequent change in the time or form of payment must be elected by a participant at least 12 months in advance of the originally scheduled payment date, and the new payment date must be at least five years after the originally scheduled payment date. The proposed regulations allow participants until the end of 2006 to revise the time and form of their distribution elections without having to comply with otherwise applicable rules regarding such changes. This special transitional rule as to election changes is available only if the revised elections are permitted by the plan. In addition, such a revised election may not accelerate payments into 2006 or defer amounts that would otherwise have been payable in 2006.

D. Restrictions on Distributions

1. New Guidance on Distributions

If an employee receives part or all of his benefits before the payment date elected or designated under the plan, the participant's entire deferred amount becomes subject to the sanctions of Section 409A. Thus, any remaining deferrals will become taxable and Section 409A's 20% penalty tax and interest charges will apply on the theory that the plan, as a whole, violated the statute.

Under Code Section 409A, payments must be made on a fixed date or pursuant to a fixed schedule, or upon one of the following events: separation from service, death, disability, change in control of the employer, or an unforeseeable emergency including severe financial hardships. The proposed regulations permit a plan to provide that payments may be made upon the earlier of, or the later of, two or more specified payment events or times. For example, payment could be triggered on the earlier of separation from service or a change in control of the employer.

In addition, a plan may provide that a different form of payment may be elected for each potential payment event. Thus, a plan could provide for payment in installments upon retirement at or after age 65 but in a lump sum on any earlier termination.

A payment will be treated as having been made on a designated date if it is made by the later of the first date it is administratively feasible on or after the designated date or the end of the calendar year containing the designated date. For an NQDC plan that designates only the year in which payment is to be made, the first scheduled payment is deemed to become due as of January 1 of such year.

2. Distributions Linked to Qualified Plan Distributions

Many nonqualified plans provide that NQDC distributions start at the same time that a participant begins receiving distributions from a related qualified plan. Although such provisions must eventually be eliminated, Notice 2005-1 allowed such practices to continue in 2005. The proposed regulations extend this relief through the end of 2006.

3. Anti-Acceleration Rules

Section 409A prohibits the acceleration of the payment of NQDC but leaves it up to the IRS to provide exceptions to the rule. One exception permitted by Notice 2005-1 was an acceleration due to a domestic relations order. Another limited exception which was added by the proposed regulations consists of the payment rules, discussed above, which apply when a plan is terminated.

E. Effective Dates and Reliance

As discussed above, Section 409A is generally effective for NQDC deferred, or previously deferred and first becoming vested, after December 31, 2004. Notice 2005-1 and the proposed regulations provide transition rules permitting plans to be amended before 2007 in order to bring them into compliance with Section 409A. The proposed regulations require that NQDC arrangements governed by Section 409A be in writing so that the deadline for amending plans is also the deadline for reducing unwritten deferral arrangements to written form.

The transition rules provided by Notice 2005-1 and the proposed regulations protect a plan from a violation of Section 409A before it has been amended to comply with the statute if the plan is operated in good faith compliance with the notice or the regulations. Therefore, although the regulations are proposed to be effective January 1, 2007, and a plan is not required to comply with the regulations until that date, employers and other service recipients have an incentive to operate their NQDC plans and arrangements according to the regulations in order to qualify for good faith compliance. Where the regulations are inconsistent with Notice 2005-1, a plan can satisfy the good faith compliance requirement before 2007 by compliance with either.

VII. MISCELLANEOUS

A. IRS Circular 230 Rules Seek to Rein in Tax Shelter Activity

As part of its ongoing campaign to curb abusive tax shelters, the IRS has issued final Circular 230 regulations imposing strict standards on attorneys, accountants and other professionals who give tax shelter opinions.

The Circular 230 standards apply to "covered opinions," that is, written advice (including e-mails) on a tax issue involving: (i) abusive ("listed") tax shelter transactions identified by the IRS; (ii) an entity or arrangement created for the principal purpose of avoiding or evading taxes; or (iii) an entity or arrangement that has a principal purpose of avoiding or evading tax, if the opinion is a reliance, marketed or confidential opinion, or includes contractual protection.

Practitioners who issue tax shelter opinions must use reasonable efforts to identify all relevant facts, discuss the applicable law, evaluate the significant tax issues, and give an opinion on "significant" tax issues that could jeopardize the transaction's tax benefits. The IRS also requires tax supervisors to ensure their firm's compliance with the shelter opinion rules.

The regulations require practitioners to inform investors of any referral or compensation arrangement with a transaction's promoter and to disclose that their opinion may not protect the client from penalties.

The final regulations apply to opinions issued after June 20, 2005.

Comment: As a result of Circular 230, clients will have seen a change in certain written communications from us, including e-mail. Although the scope of Circular 230 is extremely broad, and its application in many circumstances is unclear, as a general rule, if prescribed disclaimers are included in a written communication, the more onerous requirements set out in the Circular will not apply. We have therefore made a determination to include these disclaimers routinely in e-mail and other written communications, recognizing that in many cases the disclaimers may not be relevant. This approach will enable us to meet the requirements of Circular 230 in most cases at no extra cost to our clients. We believe that most other law firms have adopted a similar approach.

B. Proposed Regulations Tighten Private-Purpose Prohibition for Code
Section 501(c)(3) Exempt Status

As a result of IRS enforcement directed toward abuses in the use of tax-exempt entities, the regulations governing Code Section 501(c) organizations, in place since 1959, are getting a makeover to reflect changing circumstances. New proposed regulations clarify application of the Code Section 501(c)(3) prohibition against private benefit and the impact of the excess-benefit excise tax upon enforcement of the rules.

1. Underlying Rules

To qualify for tax-exempt status under Code Section 501(c)(3), an organization must exist and be operated only for charitable, religious, educational or scientific purposes. The tax-exempt entity may not have as a principal purpose the influence of legislation or interference with political campaigns. The organization also may not benefit any individual or private interest, such as the organization's creator or family, from any of its transactions or earnings.

Code Section 4958 authorizes the IRS to levy a 25% excise tax on disqualified persons who receive an excess benefit from a transaction with an exempt organization. A "disqualified individual" is an individual with the power to influence the affairs of a tax-exempt organization. Other individuals associated with the tax-exempt organization may be subject to a 10% excise tax if they knowingly participate in an excess benefit transaction. Code Section 4958 also gives the IRS authority to revoke an organization's exempt status.

2. Facts and Circumstances Test

Under the proposed regulations, an individual's private benefit from a Code Section 501(c)(3) organization's transaction may jeopardize the organization's tax-exempt status, regardless of whether the benefits derived are economic, or the extent to which the private interest is served. The regulations explain that the imposition of the excise taxes on the individual for the violation does not preclude the IRS from revoking tax-exempt status.

The regulations further explain that each case will be considered on its facts and circumstances to make an individual determination. The IRS provided a list of factors it will consider, including: (i) the size and scope of the offending transaction; (ii) whether the organization has been involved with such violations in the past, and the nature of those violations; (iii) whether the organization has implemented safeguards that are reasonably expected to prevent future violations; and (iv) whether the violation has been corrected, or whether the organization is making a good faith effort to ensure its correction from the individual or individuals deriving the benefit.

C. IRS Issues Guidance on Determining Automatic Excess Benefit Transactions

The IRS has issued guidance to help its agents determine when compensation received by a disqualified person from a tax-exempt organization should be considered an "automatic" excess benefit transaction under Code Section 4958. The guidance came in the form of a continuing professional education article intended for training purposes but not meant to be used as legal precedent. If the benefit is considered compensation under Code Section 4958, IRS said agents should include it in looking at whether aggregate compensation was reasonable. The exempt group must be able to provide written proof of reasonableness that is contemporaneous with the transfer of the particular benefit. Thus, it must contemporaneously prove that: (i) the economic benefit is reasonable; (ii) any other compensation the disqualified person may have received is reasonable; and (iii) the aggregate of the economic benefit and any other compensation the disqualified person may have received is reasonable.

The article sets out what the IRS considers timely written contemporaneous substantiation, including: (i) an approved, written employment contract executed on or before the date of transfer; (ii) documentation proving an authorized body approved the transfer as compensation for services on or before the date of the transfer; and (iii) written evidence, existing on or before the due date of the appropriate federal information or tax return, of a reasonable belief by the exempt organization that the benefit was excludable from the disqualified person's gross income.