November 2003 Vol. VII, No. 1

This past year has been busy indeed as a result of numerous legal changes brought about by Congress (Sarbanes-Oxley Act and various ERISA and tax bills) and pronouncements by the Internal Revenue Service, Department of Labor and Pension Benefit Guaranty Corporation. For the benefit of our clients and business associates, this newsletter summarizes these important changes in the employee benefits area. 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. [1]

Since our last newsletter, Marcia S. Wagner has continued to lecture and write extensively, and has been named as one of the top ERISA/employee benefits attorneys in Massachusetts by the prestigious Corporate Counsel Journal. She has also been quoted in several major news publications, including Newsweek and Pension & Investments, and has provided numerous seminars for the American Bar Association, Society of Enrolled Actuaries, Internal Revenue Service and others. Marcia has also authored a well-received article for the Bureau of National Affairs Tax Management Compensation Planning Journal entitled "Managed Accounts: Are They the Answer?" She has also received the 2002 New England Employee Benefits Council "Best Practices" Award and has been appointed as a Delegate to Harvard Law School. Ari J. Sonneberg continues his work at the Tax Section Council of the Massachusetts Bar Association. John R. Keegan, Esq., Jon C. Schultze, Esq., Virginia Peabody and Rebecca Watson have joined the firm.

In the event you desire legal advice or consultation or wish to discuss the appropriate timing of necessary plan amendments or any other benefits issues, please feel free to contact Attorney Marcia S. Wagner, Attorney Christopher J. Sowden, Attorney John R. Keegan, Attorney Katharine Butler Nesta, Attorney Ari J. Sonneberg, or Attorney Jon C. Schultze.

Footnotes appear in [ ] at end of the article.





H. 401(K) PLANS


This newsletter reports the 2004 index limits for Social Security benefits, the Internal Revenue Service ("IRS") limits for qualified retirement plans, the Pension Benefit Guaranty Corporation ("PBGC") guarantee limit and the Medicare rates.

   2003 2004
 Maximum annual payout from a defined benefit plan
at or after age 62
 $160,000*   $165,000*
 Maximum annual contribution to an individual's defined contribution account  $40,000  $41,000
Maximum Section 401(k), 403(b) and 457(b) elective deferrals  $12,000**   $13,000**
Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older  $2,000**   $3,000**
 Maximum amount of annual compensation that can be taken into account for determining benefits or contributions under
a qualified plan
 $200,000 $205,000
 Test to identify highly compensated employees, based on
compensation in preceding year
 $90,000 $90,000
Wage Base: For Social Security Tax  $87,000  $87,900
 For Medicare  No Limit  No Limit
Maximum Social Security Benefit for a worker retiring at
age 65 and 2 months in 2003 or retiring at age 65 and
4 months in 2004
Earnings Test ­ Early Retirement (Age 62)
(amounts that can be earned before benefits are cut)***
$11,520/year***  $11,640/year***
PBGC Maximum Guarantee  $3,664.77/month $3,698.86/month

* There are late-retirement adjustments for benefits starting after reaching age 65.
** These are calendar year limitations.
*** Under the Senior Citizens' Freedom to Work Act of 2000, people who are covered by Social Security can receive their full benefits once they reach Social Security normal retirement age (age 65 and 2 months in 2003 and age 65 and 4 months in 2004) regardless of how much they work and earn.



A. Voluntary Fiduciary Correction Program

1. Voluntary Fiduciary Correction Program ­ In General.

Under the Voluntary Fiduciary Correction ("VFC") program, plan officials, sponsoring employers, and certain parties to eligible prohibited transactions may apply to the Department of Labor ("DOL") for relief in connection with their voluntary correction of specific violations of the law. Applicants must fully correct any prohibited transactions, calculate any losses, and restore those losses with interest or profits, and distribute any supplemental benefits owed to eligible participants and beneficiaries. If properly corrected, plan officials will receive a "no action" letter indicating there will be no further enforcement action by the Department on the corrected transaction.

In March 2000, the DOL instituted on an interim basis the VFC program, under which plan fiduciaries (and others) can avoid the assessment of civil penalties under ERISA Section 502(l) for breaches of fiduciary duties by self-correcting the breaches and reporting them to the DOL. The VFC program was adopted as final on March 28, 2002 (PWBA Notice RIN 1210-AA76, 67 Fed. Reg. 15062).

In response to the concern that participants in the VFC program might be held liable for the Internal Revenue Code (the "Code") Section 4975 excise taxes on prohibited transactions solely due to their participation in the VFC program, the DOL, when finalizing the VFC program, also issued a proposed Prohibited Transaction Class Exemption ("PTCE") that provides limited excise tax relief for the correction of certain transactions under the VFC program. The DOL has now granted the proposed PTCE (Prohibited Transaction Class Exemption 2002-51, 11/25/2002). This PTCE provides excise tax relief for the correction of the first four transactions listed below ((a)-(d)).

The list of fiduciary breaches that are eligible for correction under the VFC program are:

(a) Late payment of participant contributions to pension or welfare plans;
(b) Loans to or from parties-in-interest at below market interest rates;
(c) Purchase or sale of assets between a plan and a party-in-interest;
(d) Sale and leaseback of property to a sponsoring employer;
(e) Purchase or sale of assets between a plan and an unrelated party at below-market value;
(f) Under- or over-payment of benefits due to inaccurate valuation of plan assets;
(g) Payment of duplicate, excessive or unnecessary compensation; and
(h) Payment of dual compensation to a fiduciary.

2. Notice Requirements.

Although the interim VFC program's notice requirement (requiring that plan participants and other interested parties be notified of a plan's participation in the VFC program) was eliminated when the VFC program was adopted as final, an applicant taking advantage of the excise tax relief under PTCE 2002-51 must satisfy the exemption's notice provisions. These
provisions require that:

(a) written notice of the transactions that the applicant is seeking relief for under the VFC program and PTCE 2002-51, as well as the method of correcting the transactions, be given to interested persons within 60 calendar days following the date the VFC program application is submitted to the appropriate DOL regional office;

(b) the notice must include a description of the transaction and the steps taken to correct it. The notice must be written in a manner that can be reasonably understood by the average plan participant; and

(c) the notice must provide for a 30-day comment period, beginning on the date the notice is distributed, for interested persons to provide comments to the appropriate DOL regional office, and must include the address and telephone number of that office.

The notice may be given in any manner that is reasonably calculated to result in the interested parties receiving it. This includes posting, regular mail, or electronic mail, or any combination thereof.

Comment: In most cases, we strongly recommend that the VFC program be utilized to correct breaches of fiduciary duty.

B. DOL Simplifies DFVC Program; IRS And PBGC Waive Penalties

The DOL issued notice of modifications to its Delinquent Filer Voluntary Compliance ("DFVC") program providing reduced civil penalties under ERISA and simplified filing procedures for delinquent Form 5500 filers who voluntarily file late Forms 5500 under the program (67 Fed. Reg. 15052-15060 (2/28/2002). Simultaneously with that notice, the IRS in AdvNotice 2002-23, 2002-15 IRB, 4/15/2002 issued a separate notice of relief, waiving certain civil penalties normally assessed against delinquent Form 5500 filers if they comply with, and participate in, the revised DFVC program.

1. Chart of DOL Penalties.

To encourage participation in the DFVC program, the DOL modified the DFVC program penalty structure to offer reduced per-day penalties for all plans, a special penalty cap for "single" violations, and a per-plan cap for submissions reporting all annual reporting violations under a particular plan.

 Per day late filing penalty   $10
Maximum per 5500 penalty   Small plans -$750
Large plans - $2,000
Maximum per plan penalty Small plans - $1,500
Large plans - $4,000

2. IRS Notice 2002-23 and PBGC relief under the DFVC Program.

The IRS and PBGC have agreed to provide penalty relief for delinquent Form 5500 submissions made in conjunction with the DFVC program. Thus, plan administrators that participate in the revised DFVC program are eligible for waiver of the penalties assessed for certain Form 5500-related filing violations under the Internal Revenue Code (the "Code") and ERISA.

The PBGC is providing similar relief from the assessment of the penalty under ERISA Section 4071, which is imposed for late Form 5500 submissions.

Under Notice 2002-15, if a late filer satisfies the requirements of the revised DFVC program and pays the applicable penalty, the IRS will waive all penalties. The waivers will be automatic, without the need for any application for relief, and IRS will coordinate its waiver determinations with the DOL.

Note: The reduced DOL penalties and the IRS and PBGC relief are good news for those who have failed to timely file Form 5500s. This relief will be particularly useful for employers that acquire noncompliant plans as a result of a merger or acquisition, or who fail to file because they exceeded the 100 participant threshold for welfare plans and were not aware they needed to file.

C. Small Plan Audits

1. Department of Labor Proposes Annual Audits.

Under current law, any tax-qualified plan with 100 or more participants at the beginning of a plan year must obtain an annual audit of the plan and its operations from an independent qualified public accountant. Small plans (those with fewer than 100 workers) are exempt from this requirement.

Concerned about the vulnerability of small plans to asset misappropriation and other abuses, the DOL believes additional protection may be needed for the assets of those plans.

Under proposed regulations, generally a small plan must obtain an annual audit of the plan and its operations from an independent qualified public accountant. A small pension plan may claim an exemption from the audit requirement, if three conditions are satisfied:

(a) At least 95 percent of the plan's assets are qualifying plan assets ("QPA") (generally, assets that carry very little risk of loss due to fraud or dishonesty, such as publicly traded stocks, bonds and mutual funds) or any person who handles plan funds is bonded for at least the value of the assets that are not QPAs. (Note: This is more onerous than current bonding rules, which generally require the bond value to be only 10 percent of the funds handled);

(b) The summary annual report provided to plan participants contains additional information on the plan assets and entities holding the plan's assets; and

(c) The administrator makes available for examination a statement from any regulated financial institution holding the plan's assets and evidence of any bond required by regulation. This condition is met only if the plan administrator furnishes copies, free of charge, to any participant who requests this information.

2. Qualifying Plan Assets.

The new regulations classify plan assets as "qualifying plan assets," when the asset falls into any one of the following six categories: (i) qualifying employer securities as defined in ERISA Section 407(d)(5); (ii) a participant loan; (iii) assets that are held by any of the following institutions: (a) bank or similar financial institution; (b) insurance company; or (c) registered broker-dealer or any other organization authorized to act as trustee for individual retirement accounts under Code Section 408; (iv) shares issued by a registered investment company registered under the 1940 Act; (v) investment and annuity contracts issued by an insurance company; and (vi) assets in individual accounts of participants or beneficiaries over which the participants or beneficiaries have the opportunity to exercise control and where statements from a registered financial institution reflecting such assets are given to the participants or beneficiaries on an annual basis.

3. Summary Annual Report ("SAR") Rules.

Currently all plans are required to provide a summary of the financial information that is included in Form 5500 by preparing and distributing the SAR to each plan participant and beneficiary. Small plans that claim an exemption from the audit requirement will now have to include in the SAR additional information on the institutions holding qualifying plan assets, the name of the surety company issuing the ERISA bond and a notice on obtaining additional information on the plan assets and the ERISA bond.

D. IRS Modifies EPCRS Voluntary Plan Correction Program

1. Introduction.

The IRS has updated and streamlined its Employee Plans Compliance Resolution System ("EPCRS"), a comprehensive system of correction programs for sponsors of retirement plans that have not met the Code's qualification requirements (Rev. Proc. 2003-44, 2003-25 IRB; IR 2003-74, 6/4/2003 and Rev. Proc. 2002-47, IRB 2002-9). EPCRS permits plan sponsors to correct qualification failures, thereby continuing to provide participants with retirement benefits on a tax-favored basis.

2. Background.

In the early 1990s, the IRS introduced a number of pilot programs to encourage compliance among tax-qualified retirement plan sponsors by enabling them to correct plan defects without incurring harsh penalties.

Since its official introduction, EPCRS has been successful in promoting compliance among plan sponsors by giving them the ability to correct most defects in their plans, thus enabling plan sponsors to maintain the tax-qualified status of their plans. Due to the continued success of EPCRS, the IRS has sought to streamline and expand the program to accommodate a wide variety of plan sponsors and eliminate barriers that complicate compliance with applicable law.

Note: Marcia Wagner has been influential in the creation and development of EPCRS and this law firm sub-specializes in rectifying plan disqualification issues. Ms. Wagner has also authored a Bureau of National Affairs Tax Management Portfolio on EPCRS, and has lectured extensively on this topic.

EPCRS continues to be driven by three main components:

(a) Self-Correction Program ("SCP"). Employers or plan administrators identify operational and other failures and self-correct the problems pursuant to IRS guidelines without seeking IRS approval.

(b) Voluntary Correction Program ("VCP"). Plan sponsors submit proposed correction methods for all qualification failures (operational, plan document, demographic, and employer eligibility) to the IRS for approval, pay a compliance fee, and receive written assurance that the IRS has approved the correction methodology. Such submissions may be anonymous.

(c) Audit Closing Agreement Program ("Audit CAP"). Plan sponsors negotiate with the IRS about correcting defects discovered during an audit, and request a lesser sanction in lieu of disqualification.

3. Changes made to EPCRS by Rev. Proc. 2002-47.

Rev. Proc. 2002-47 retains the existing core structure of EPCRS, including its key components. Thus, the Rev. Proc. 2002-47 changes are consistent with the IRS's intention to periodically update and improve the EPCRS revenue procedure based on comments received and IRS experience in administering the program.

The Revenue Procedure:

(a) extends the duration of the self-correction period under SCP for correcting significant operational compliance failures where the plan sponsor assumes the plan in conjunction with a corporate merger, acquisition or similar transaction to the last day of the first plan year that begins after the corporate merger, acquisition or other similar employer transaction;

(b) extends the Anonymous Submission Procedure indefinitely;

(c) expands the Anonymous Submission Procedure to permit the submission of more types of plan failures;

(d) expands the Anonymous Submission Procedure to VCGroup and VCSEP submissions;

(e) expands "employer eligibility failure" to include the adoption of a 401(k) plan by any ineligible employer;

(f) broadens the VCGroup procedures to permit eligible organizations to submit operational and plan document failures in a single submission;

(g) increases the de minimis threshold amount from $20 to $50 for purposes of making any corrective distributions to make an affected participant or beneficiary whole (for example, a distribution to correct an earlier underpayment of a participant's benefit under a defined benefit plan);

(h) adds a de minimis rule for correcting certain overpayments ­ i.e., benefit payments in excess of the Code's limits ­ excusing a plan sponsor from correcting plan overpayment if the total amount of an overpayment to a participant or beneficiary does not exceed $100;

(i) clarifies that failures under a terminated plan are eligible for correction under VCP;

(j) clarifies what items may be excluded from the initial submission under the Anonymous Submission Procedure. Items that a plan sponsor may exclude from an initial submission under the Anonymous Submission Procedure are the name of the plan or plans and the name of the plan sponsor or sponsors (or other filer). The materials included in the submission package may have this information redacted, and the application need not include a power of attorney or a penalty of perjury statement;

Comment: Rev. Proc. 2002-47 clearly provides that, until a plan sponsor provides the identifying information to the IRS, the IRS is not precluded from beginning an examination of the plan or plan sponsor. If IRS were to begin an examination before entering an agreement with the plan sponsor and receiving the appropriate identifying information, the plan and plan sponsor lose eligibility for both the Anonymous Submission Procedure and VCP.

(k) updates the requirement that, if a plan must have received a favorable determination, opinion, or advisory letter for eligibility for a particular program, the plan must have received a letter or certification that considers GUST, [2] as well as earlier laws;

(l) clarifies the factors considered under Audit CAP in determining a sanction amount by focusing more specifically on the steps taken to prevent, identify, and halt the continued progression of any failures under the plan; and

(m) revises the VCP Checklist for assuring that a VCP application is complete, and which is submitted to IRS as part of a VCP submission, to include questions relating to the transfer of plan assets pursuant to a plan merger or similar transaction relating to a corporate business transaction, and the waiver of federal excise under Code Section 4974 (for excess accumulations because of a failure to comply with the minimum distribution requirements under Code Section 401(a)(9)).


4. Changes to EPCRS Made by Rev. Proc. 2003-44.

Rev. Proc. 2003-44 modifies and supersedes Rev. Proc. 2002-47, but maintains the basic structure and changes to EPCRS described above.

The Revenue Procedure contains the following modifications:

(a) EPCRS is now available for the correction of failures in SIMPLE IRA plans;

(b) Voluntary Compliance of Operational Failures Standardized procedure ("VCS") has been eliminated;

(c) VCP, which previously consisted of seven sub-programs categorized by type of failure, has now been consolidated into a single program;

(d) The payment structure for VCP has been simplified;

(e) SIMPLE IRAs and SEPs may utilize the Anonymous and Group Submission programs;

(f) Plans which have failed to adopt good faith amendments to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001 may use EPCRS to obtain approval of late amendments;

(g) A correction method for the failure to obtain spousal consent has been added: in the event that spousal consent cannot be obtained due to spousal refusal, failure to respond, or because the spouse cannot be located, the spouse is entitled to a benefit equal to the portion of the qualified joint and survivor annuity that would have been payable to the spouse upon the death of the participant had a qualified joint and survivor annuity been provided to the participant under the plan at his or her retirement;

(h) EPCRS was revised to clarify the special exception to full correction for imprecise or unavailable data: reasonable estimates can be used in calculating the appropriate correction where it is not possible to make precise calculations; and

(i) As in the previous version of EPCRS, a plan sponsor is not required to seek the return of a small overpayment (less than $100) from a beneficiary or participant, but now is required to notify the participant or beneficiary that the overpayment is not eligible for favorable tax treatment accorded to distributions from qualified plans.

E. Final 204(h) Notice Regulations

1. Background.

The IRS has issued final regulations under Section 204(h) of ERISA and Section 4980F of the Code concerning advance notice of a reduction in future pension benefits (Reg. Section 54.4980F-1). The final regulations, which are quite similar to the rules proposed last year, affect defined benefit and money purchase pension plans.

2. When Notice is Required.

The notice requirement is triggered by a plan amendment that may result in a significant reduction in either the rate of future benefit accruals or an early retirement benefit or
retirement-type subsidy. This includes:

(a) the dollar amount or percentage of compensation on which benefit accruals are based;

(b) the definition of service or compensation used in calculating benefit accruals;

(c) the method of determining compensation for calculating benefit accruals;

(d) the definition of normal retirement age in a defined benefit plan;

(e) benefit offset provisions; and

(f) minimum benefit provisions.

The final regulations add two new rules:

(a) A change in a document to which a plan refers in determining benefit amounts, such as a collective bargaining agreement, is considered a plan amendment for which notice must be given before the rate of benefit accrual can decline. Thus, if a multiemployer plan incorporates a collective bargaining agreement by reference, and if that collective bargaining agreement significantly reduces the rate of future benefit accruals, a 204(h) notice is required; and

(b) The conversion of a money purchase pension plan to a profit sharing plan is always considered an amendment reducing benefits, even if employer contributions are expected to stay at the same level.

Notices are not required for changes in plan features that are not protected from reduction by Code Section 411(d)(6) (e.g., provisions for plan loans and disability benefits).

3. Required Content.

The notice must give enough information to enable recipients to understand the effect of the change, including the scope of the possible benefit reduction.

(a) Accrual Rate Reduction. The notice must include a description of the benefit formula before and after the amendment, and the effective date of change. If the likely magnitude of the change is not reasonably apparent from that description, the notice must also include more detailed explanation, typically with examples; and

(b) Reduction in Early Retirement Benefit. The notice must include a description of how the benefit is calculated before and after the change, and its effective date. As with the notice for accrual rate reductions, more information is required if this description does not give a reasonable picture of the full impact of the change.

4. Delivery Deadline.

In general, notice must be given 45 days before the effective date of the amendment. However, small plans (i.e., those with fewer than 100 participants with accrued benefits on the amendment's effective date) only have to give notice 15 days in advance. Fifteen days is also the notice deadline for plan amendments reducing benefit accrual rates in connection with corporate mergers or spin-offs. For corporate transaction-related amendments that only reduce early retirement benefits or retirement type subsidiaries, not accrual rates, the deadline is 30 days after the effective date of the amendment.

If participants are given a choice between the old and new formulae, they must be provided with adequate information in order to make informed decisions early enough to allow for careful consideration of their choices.


5. Notice Delivery.

A Section 204(h) notice must be provided by first-class mail, hand delivery or approved electronic means. For electronic notices, participants must be alerted to the significance of the notice (e.g., by marking e-mail "urgent") and informed that they can receive a free paper copy upon request. Electronic notice standards are met for anyone who consents to, and provides an address for, electronic delivery, after having been informed that this consent can be withdrawn at any time.

6. Failure to Comply.

If the failure to give a required notice is "egregious," all participants whose benefits would be reduced significantly by the amendment are entitled to their benefit under the terms of the plan before the amendment, if that is higher than the revised benefit. An "egregious violation" is an intentional failure to provide the required notice, failure to provide most of the information to most of the people who should be receiving such information, or a failure to correct an unintentional violation once it is discovered. There is a $100 per day excise tax which will be waived if the IRS determines that the plan sponsor exercised "reasonable diligence" in arranging for distribution of the notice, did not know of the violation, and corrected the violation within 30 days after discovering the violation.

F. IRS Provides Waiver of 60-day Rollover Rule in Certain Cases

1. Background.

An individual can exclude from gross income in the year of receipt certain distributions from qualified plans and individual retirement accounts ("IRA") if the distribution is rolled over to another qualified plan or an IRA within 60 days of receipt of the distribution (the "60-day rule"). A distribution rolled over after the 60th day following the day on which the distributee receives the distribution does not qualify as a tax-free rollover.

EGTRRA amended the Code to allow the IRS to waive the 60-day rule if an individual suffers a casualty, disaster, or other event beyond his reasonable control, and not waiving the 60-day rule would be against equity or good conscience.

Under a newly-issued Revenue Procedure, the IRS will automatically waive the 60-day rollover rule if the failure to satisfy the rule is caused exclusively by bank error and certain other conditions are met. Otherwise, taxpayers may apply for a private letter ruling to obtain a hardship waiver (Rev. Proc. 2003-16, 2003-4 IRB).

2. Automatic Waiver for Failures caused by Bank Error.

Automatic approval of a waiver of the 60-day rule will be granted if a bank error caused the rollover to be untimely. That is, the waiver is available if the failure was due solely to
an error on the part of the financial institution. Thus, the automatic waiver will be granted only if:

(a) the financial institution received the funds prior to the expiration of the 60-day rollover period;

(b) the taxpayer followed all procedures required by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period (including giving instructions to deposit the funds into an eligible retirement plan); and

(c) there would have been a valid rollover, if the financial institution had deposited the funds as instructed.

Further, the funds must actually be deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period.

3. Private Letter Ruling Process for Obtaining Waiver of the 60-day Rule.

If the automatic approval procedure for obtaining a waiver of the 60-day rule is unavailable, taxpayers may still be able to obtain a waiver by applying for a private letter ruling. Under this process, IRS will waive the 60-day rule where failing to do so would be against equity or good conscience, including casualty, disaster or other events beyond the reasonable control of the taxpayer. More specifically, IRS will consider all relevant facts and circumstances, including:

(a) errors committed by a financial institution;

(b) the taxpayer's inability to complete a rollover due to death, disability, hospitalization, or incarceration;

(c) restrictions imposed by a foreign country;

(d) postal error;

(e) if and how the amount distributed was used (for example, in the case of payment by check, whether or not the check was cashed); and

(f) the time elapsed since the distribution occurred.

Taxpayers must apply to IRS for the hardship exception to the 60-day rule in accordance with the procedures for issuing letter rulings accompanied by the appropriate user fee.

G. ERISA's Fiduciary Standards for Selecting Annuity Providers

In an advisory opinion, the DOL stated that ERISA's fiduciary standards for selecting insurers for pension plan benefit distributions, as set forth in ERISA Interpretive Bulletin 95-1, apply to fiduciaries of defined contribution plans as well as to fiduciaries of defined benefit plans (ERISA Advisory Opinion Letter No. 2002-14A).

1. Background.

In 1995, the DOL issued ERISA Interpretive Bulletin 95-1, to address concerns about plan fiduciaries who had purchased benefit distribution annuities from insurers who had invested a substantial portion of their assets in high-yield securities, known as "junk bonds." Because of the greater risk of default presented by non-investment grade securities, these obligations offer higher rates of return than investment grade securities. Several insurers who had invested heavily in junk bonds, such as the Executive Life Insurance Company, were later forced out of business when the once booming market for junk bonds collapsed in the early 1990s.

2. ERISA Interpretive Bulletin 95-1.

ERISA Interpretive Bulletin 95-1 clarifies that the process of selecting an annuity provider for benefit distribution is a fiduciary act that is governed by the fiduciary standards of ERISA. This includes a fiduciary's duty to act prudently, and solely in the interest of the plan's participants and beneficiaries. The Interpretive Bulletin provides that plan fiduciaries must take steps that are designed to procure the safest annuity available, unless it would be in the interest of the participants and beneficiaries not to do so.

The Interpretive Bulletin also provides factors that should be considered when determining a provider's creditworthiness and claims paying ability, as follows:

(a) the quality and diversification of the annuity provider's investment portfolios;

(b) the size of the insurer relative to the proposed contract;

(c) the level of the insurer's capital and surplus;

(d) the lines of business of the annuity provider and other indications of an insurer's exposure to liability;

(e) the structure of the annuity contract and the guarantees supporting the annuities, such as the use of separate accounts; and

(f) the availability of additional protection through state guaranty associations and the extent of their guarantees.

If a fiduciary does not have the expertise required to evaluate these factors, the fiduciary must be advised by a qualified, independent expert.

The Interpretive Bulletin provides that there are situations where it may be in the interest of participants and beneficiaries to purchase an annuity other than the safest available one; for example, where one annuity is only marginally safer, but much more expensive than a competing annuity. However, increased costs or other considerations can never justify placing participants and beneficiaries at risk by purchasing an unsafe annuity.

3. Application to Defined Contribution Plans.

The Metropolitan Life Insurance Company ("MetLife") sought guidance from the DOL regarding the application of ERISA Interpretive Bulletin 95-1 to the selection of annuity providers for distributions from defined contribution plans.

In response to the questions raised by MetLife, the DOL stated that the fiduciary principles set out in ERISA Interpretive Bulletin 95-1 apply equally to defined benefit and defined contribution plans.

With regard to state guarantees, MetLife requested clarification as to the scope of a fiduciary's consideration. According to the DOL, plan fiduciaries should determine if the annuity provider and the annuity product are covered by state guarantees and the extent of those guarantees, in terms of amounts (e.g., percentage limits on guarantees) and individuals covered (e.g., coverage limited to state residents only).

MetLife expressed concern that fiduciaries should be able to evaluate annuity providers without having to hire an expert in annuity matters. According to the DOL, if the fiduciary who is responsible for selecting an annuity provider has, at the time of the selection, a sufficient level of expertise or knowledge to meaningfully evaluate the claims paying ability and creditworthiness of an annuity provider, the fiduciary would not be required to hire an independent expert.

MetLife also sought confirmation that, in evaluating competing annuity products, cost is an appropriate consideration for the fiduciary of a defined contribution plan where the participant would receive an increased benefit due to the reduced costs. While agreeing that it is appropriate for the fiduciary of a defined contribution plan to take into account the costs and benefits to the participant or beneficiary of competing annuity products, the DOL said that a lower cost cannot justify purchasing an unsafe annuity, even if that annuity would pay a higher benefit amount to the participant or beneficiary.

H. Job Creation and Worker Assistance Act of 2002

Numerous pension and benefit provisions are affected by the Job Creation and Worker Assistance Act of 2002 ("JCWAA"). JCWAA modifies the funding rules applicable to pension plans and makes several technical corrections to pension and benefit measures enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA").

1. Funding Changes.

In response to the increased funding requirements imposed on employers incident to the discontinuation of the 30-year Treasury bond, JCWAA authorizes a temporary increase in the maximum interest rate to be used in determining current liability from 105% to 120% of the weighted average interest rate of 30-year Treasury bonds for plan years beginning after December 31, 2001 and before January 1, 2004. Thus, for plan years beginning in 2002 and 2003, the permissible range of interest rates that may be used in determining the current liability component of the full funding limitation must be a rate that is not less than 90% or greater than 120% of the weighted average interest rate during the 4-year period prior to the beginning of the plan year.

Comment: The discontinuation of the 30-year Treasury bond, announced by the IRS in October 2001, had precipitated further erosion in yields on the bond, resulting in increased required plan contributions by employers, higher insurance premium payments to the PBGC, and larger lump-sum benefit payments to employees who had terminated employment. The higher interest rate in the expanded range reduces a plan's current liability and, thus, lessens the amount of any additional funding contributions that may be required.

2. Technical Corrections to EGTRRA.

The technical corrections include modifications to amendments enacted by EGTRRA that affect plan design and administration and employee retirement planning. In general, JCWAA:

(a) modifies the funding rules governing the use of prior year valuation dates;

(b) provides for the aggregation of plans for the purpose of determining the limit on 401(k) catch-up contributions that may be made by an eligible participant and makes other clarifying corrections;

(c) details the effect of distributions consisting of after-tax contributions on the amount of an individual's saver's credit under Code Section 25B;

(d) clarifies the timing of the employer deductions for ESOP dividends under Code Section 404(k);

(e) explains that after-tax contributions may only be rolled over to a qualified defined contribution plan or an IRA (not a defined benefit plan);

(f) provides ordering rules for the rollover of distributions of pre-tax and after-tax contributions;

(g) allows deemed IRAs to be established under qualified employer plans maintained by governmental employers;

(h) extends the application of the ERISA administration and enforcement rules to deemed IRAs;

(i) clarifies that distributions made upon "severance from employment" will be considered for only one year in determining a plan's top-heavy status;

(j) provides that the 25% deduction limit that generally applies when an employer maintains both a defined benefit plan and a defined contribution plan will not be imposed if the only contributions made to the defined contribution plan are elective deferrals;

(k) corrects the drafting oversight in EGTRRA that limited an employer's contribution to a SEP to 15%, rather than 25% of compensation;

(l) sets forth new rules under Code Section 415(c) for church plans;

(m) allows for the electronic delivery of Forms 1099-R and other information statements to taxpayers, with their consent.

3. JCWAA Subject to EGTRRA's Sunset Provisions.

The technical corrections implemented by JCWAA generally apply to years beginning after December 31, 2001, which is the effective date of most of the amendments enacted by EGTRRA. In addition, the technical corrections to EGTRRA implemented by JCWAA are subject to EGTRRA's sunset provision, pursuant to which all amendments enacted by EGTRRA cease to apply after December 31, 2010.

I. Remedial Amendment Periods

1. IRS Extends GUST Filing Deadline and Minimum Distribution Amendments.

The IRS has recently released Rev. Proc. 2003-72, extending the time for many retirement plans to submit GUST [3] plan amendments for determination letters. The new rules apply to "eligible plans," plans which have a GUST remedial amendment period ("RAP") deadline which generally expires as of September 30, 2003. This includes most prototype and volume submitter plans. The Rev. Proc. has no effect on a plan which had a GUST RAP expiring prior to September 30, 2003, such as an individually designed plan where the plan sponsor did not timely certify an intention to adopt a pre-approved plan.

Under the new Revenue Procedure:

(a) If the sponsor timely restates the plan to conform to GUST within the existing RAP (i.e., September 30, 2003 for most plans), and the sponsor submits a determination letter request by January 31, 2004, the request will be deemed to be within the plan's RAP;

(b) If the sponsor fails to adopt a "bona fide" GUST restatement prior to the end of the existing RAP, a determination letter request by January 31, 2004 will nonetheless be considered timely and entitled to the extension described in paragraph (a), provided the employer submits a $250 compliance fee, payable to the U.S. Treasury, with the determination letter request. This is to be in addition to (and a separate check from) the normal user fee; and

(c) A plan which is not timely amended and submitted, or which does not comply with the procedures in the Rev. Proc., is subject to the late amender rules under EPCRS.

The guidance defines a "timely" GUST plan amendment as an amendment prior to the end of the GUST RAP which is a "bona fide effort" to comply with the GUST requirements. The fact that the sponsor, or the IRS upon plan review, after the GUST RAP expires discovers the need for other amendments does not mean that the sponsor's "timely" GUST amendment did not represent a "bona fide effort" to amend for GUST.

If a plan is not entitled to reliance on an opinion or notification letter for a pre-approved plan (e.g., if a modification is made to a volume submitter specimen plan or prototype plan), the sponsor must timely apply for a determination letter in order to take advantage of the GUST RAP.

2. Minimum Required Distributions ­ Defined Contribution Plans.

Under Revenue Procedure 2003-72, the IRS also extended the deadline for defined contribution plans to amend to conform to the final Code Section 401(a)(9) regulations regarding minimum required distributions until the later of the last day of the plan year beginning in 2003 or the end of the GUST RAP. The Revenue Procedure does not, however, extend the December 31, 2003 deadline by which sponsors of pre-approved plans must amend their defined contribution plans to comply with the new 401(a)(9) rules, and in the case of master and prototype plans, to furnish copies of the amendments to adopting employers. (See Section I.K. of this Newsletter for details regarding the minimum required distribution rules.)

3. Minimum Required Distributions ­ Defined Benefit Plans.

The IRS has postponed the deadline by which defined benefit plans must be amended to comply with the final Code Section 401(a)(9) regulations regarding minimum required distributions. The compliance deadline is postponed until the end of the EGTRRA remedial amendment period, which ends "not prior to the last day of the first plan year beginning on or after January 1, 2005".

4. Updated Mortality Table Amendments.

In Revenue Ruling 2001-62, the IRS updates the mortality tables to be used by defined benefit plans to determine maximum benefit limitations and the present value of accrued benefits for certain purposes. The new mortality tables must be used for distributions with annuity starting dates beginning on or after December 31, 2002.

Plans that need to be amended to include the new mortality tables have until the last day of the plan year that contains the effective date (i.e., December 31, 2002 for calendar year plans) to make such amendments. The Revenue Ruling contains two model amendments that may be used under certain circumstances to adopt the new mortality tables. Plans that make a good faith amendment on a timely basis have the extended EGTRRA remedial amendment period to make corrections (i.e., until the end of the 2005 plan year).

J. IRS Clarifies Plan Qualification Notice Requirements

The IRS has issued final regulations eliminating the requirement that notice to interested parties concerning the filing of a determination application on the qualified status of a retirement plan be in writing.

Formerly, IRS Regulations Sections 7476-1(a)(1) and 7476-2(b) required that, in order to receive a determination on the qualified status of a retirement plan, an applicant had to provide evidence that individuals who qualify as interested parties receive written notice of the determination letter application. The final regulations provide for electronic notification, by stating that the notice may be provided by any method that reasonably ensures that all interested parties will receive it.

The final regulations contain a safe harbor under which plans will satisfy the notice requirement if: (i) the electronic medium is reasonably designed to provide the notice in a manner no less understandable to the distributee than a written paper document, and (ii) at the time the notice or summary is provided, the distributee is advised that he or she may receive a free written paper notice.

K. IRS Finalizes Minimum Required Distribution Rules

1. Introduction.

The IRS has issued long-awaited final regulations on required minimum distributions for qualified plans, 457 plans, tax-sheltered annuity plans and IRAs. In conjunction with the new rules, IRS Notice 2002-27 provides guidance on reports that trustees, custodians and issuers are required to make with respect to minimum distributions from IRAs.

The final regulations retain the simplified rules contained in the proposed regulations issued in 2001, including the uniform lifetime table for determining minimum distributions, but add new provisions relating to life expectancy and beneficiary designations.

2. Life Expectancy Tables.

EGTRRA instructed the Treasury Secretary to modify the life expectancy tables in Code Section 72 in order to reflect current life expectancy. Accordingly, the final regulations adopt new life expectancy tables taking into account increased longevity.

Comment: The new tables, by extending the period over which minimum distributions must be taken, allow employees and beneficiaries to spread out payments and effectively lessen their tax.

3. Determination of Designated Beneficiary.

The final regulations adjust the deadline for determining a designated beneficiary from December 31 of the plan participant's year of death to September 30 of the year following the plan participant's year of death.

4. Default Rule for Post-Death Distributions.

The 2001 proposed regulations and final regulations provide that where an employee who has a designated beneficiary dies before the required beginning date, the life expectancy rule, rather than the five-year rule, is the default distribution rule. Absent a plan provision or election of the five-year rule, the life expectancy rule will apply in all cases in which the employee has a designated beneficiary, and the five-year rule will apply if the employee does not have a designated beneficiary.

5. Annuity Payments.

The rules dealing with annuity payments have been substantially changed from the 2001 proposed regulations and have been issued as temporary and proposed regulations.

Under the temporary rules, annuity payments may be provided for a period certain that is as long as the period under the uniform lifetime table for the employee's age in the year in which the annuity starting date occurs, regardless of who is the employee's designated beneficiary. The same rule applies if the annuity also includes a life annuity or a joint and survivor annuity.

The temporary and proposed regulations also make a number of changes that expand the situations in which increasing annuity payments are permitted. The additional situations are generally only available to annuities purchased from insurance companies.

6. IRA Reporting Requirements.

In Notice 2002-27 the IRS requires trustees, custodians and issuers of IRAs to report the required minimum distribution amounts to the IRA owners, or to calculate it for the owners upon request, but will not require trustees to report the required distribution amount to the IRS. The first report will be due January 31, 2003, alerting IRA owners to the distribution they must take for 2003.

Beginning with required minimum distributions for 2004, the IRA trustee must identify to the IRS each IRA for which a minimum distribution is required for the year, but need not indicate the amount.

L. IRS Modifies Rules for Early Plan Distributions

1. Backround.

Code Section 72 prescribes certain rules for distributions from qualified retirement plans and IRAs. Generally, under these rules, distributions before age 59-1/2 are subject to a 10% excise tax in addition to the normal income tax, unless a distribution is on account of death or disability, or is in the form of substantially equal periodic payments. The periodic payments must be based on the recipient's life expectancy or on the joint life expectancy of the recipient and beneficiary.

Code Section 72 provides that if a recipient's periodic payment amount is modified before the later of age 59-1/2 or 5 years after payments begin, the recipient is subject to the 10% excise tax on payments received, plus interest from the original date to the modification date.

2. Prior Law.

In 1989, the IRS released Notice 89-25, which included three safe harbor methods for determining if payments are substantially equal periodic payments. Under the required minimum distribution method ("RMD") in Notice 89-25, the annual payment is determined by dividing the account balance (including investment gains and losses) by a number taken from a life expectancy table. The annual distribution is redetermined each year based on the remaining account balance and life expectancy. Under the fixed amortization and fixed annuitization safeharbor methods, a distribution amount is determined once in the first year of distribution and the amount remains the same thereafter.

The annual recalculation under the RMD method takes into account investment gains and losses. Under the other two methods, no adjustments are made to the amount initially determined. Therefore, if investment results are unfavorable, the account balance could be exhausted before the life or joint life expectancy of the recipient and/or beneficiary.

3. Revenue Ruling 2002-62.

The IRS provides relief for recipients of distributions from IRAs and tax qualified retirement plans who have elected a fixed method of substantially equal periodic payments. According to the ruling, such individuals have a one-time opportunity, if the plan permits, to switch to the RMD method and, at the same time, change the life expectancy table used. As noted above, the RMD method annually recalculates the distribution amounts based on the remaining life expectancy and account balance, which reflects investment gains or losses. Also, according to the ruling, once a change to the RMD method is elected, the method must be used for determining distributions in all subsequent years.

M. Enron Litigation

The DOL filed an amicus curiae brief in Tittle v. Enron, which argues that Enron executives may be held personally liable for retirement plan losses as a result of their breach of fiduciary duties.

The DOL's brief makes the following legal points:

1. Fiduciaries responsible for monitoring an administrative committee that directly manages a 401(k) plan have an affirmative duty under ERISA to ensure that the committee is properly performing its duties and that the committee has the tools and information necessary to do so.

2. Fiduciaries may not deceive plan participants or allow others to do so; fiduciaries have the obligation to take appropriate actions to carry out this responsibility. This may include investigating allegations of fraud, disclosing facts to participants, other fiduciaries or the public and stopping further investment in company stock.

3. Fiduciaries have an obligation to ensure that investments in employer stock in a 401(k) plan are prudent, notwithstanding the plan provisions that favor such investments.

4. Directed trustees cannot follow directions that they know or should know are imprudent or violate ERISA. In the Enron case, the plaintiffs allege that there were sufficient red flags suggesting the imprudence of the lockdown, such that the directed trustee may have had a duty to override the fiduciary's direction to freeze participants' accounts.

In its brief, the DOL went beyond the positions it has stated in the past. For example, with respect to the DOL's discussion of the duty to monitor a fiduciary, it is at best unclear what actions a company's board of directors should take with respect to supervising a plan fiduciary appointed by the board. Apparently, the DOL believes that the appointing fiduciary has a duty to disclose information to the appointed fiduciary that the appointed fiduciary may not be aware of and could affect the plan. This creates a slippery slope concerning the dissemination of sensitive corporate information.

In light of the brief, holding of employer stock in a tax-qualified plan has become somewhat riskier. The DOL brief assumes that the fiduciary knows that there is a cataclysmic event pending. However, fiduciaries may not know that the event is cataclysmic until it is too late. When viewed in hindsight, an event might be disastrous for the company, but while in the middle of the situation, it might not look so bad. It is unclear what standard will be used to judge a fiduciary's actions.

Furthermore, ERISA says that the fiduciaries must follow the terms of the plan document. For example, many plans provide that the employer match must be made in employer stock and that employees cannot diversify out of the employer stock. In this case, it would seem that the plan design would protect the fiduciaries, whereas the DOL appears to be saying that the fiduciaries may, in certain circumstances, have an affirmative duty to override the plan design.

In general, the DOL is of the view that the company owes a higher duty to disclose information to plan participants than it owes to its shareholders generally.

Comment: This brief could merely be an example of bad facts creating bad law, but plan sponsors should re-evaluate the holding of employer stock in their tax qualified plans and the conditions under which such employer stock will be held.

Comment: On September 30, a United States District Court issued the first substantive decision in the Enron ERISA litigation (Tittle v. Enron Corp., 2003 WL 22245394 (S.D. Tex. Sept. 30, 2003)). The court ruled that most of the fiduciary claims against Enron's officers, directors, and plan administrators could proceed. Although the decision does not resolve these claims, it adopts many of the theories of fiduciary liability that the Department of Labor had advanced in its brief.

We will follow this case development closely, as it could well portend the significant expansion of the boundaries of fiduciary liability for plans invested in employer stock.

N. Guidance on Claims Procedure Regulations Affects Pension Plans

The DOL issued guidance, in the form of frequently asked questions ("FAQs"), regarding its final regulations for claims procedures. Although the final regulations apply to all employee benefit plans subject to ERISA, the most significant changes apply to group health plans and plans providing disability benefits. Pension plans are generally still subject to the regulations issued in 1977.

The regulations contain minimal changes for pension plans, but the DOL's position in Q& A-9 of the FAQs, contrary to the position in final regulations, is that a disability benefit provided under a pension plan is subject to the disability benefit rules in the regulations. This is an important distinction because DOL Regulations Section 2560.503-1(d) provides specific requirements for the claims procedures for disability benefits that would not ordinarily apply to pension plans. These rules include: de novo review; a consultation requirement for medical determinations; limits on appeal levels; time limits for deciding disability claims; and disclosure requirements regarding extensions of time. Thus, a pension plan must then have a separate claims procedure for disability benefits.

The DOL explains that a pension plan may avoid the more stringent procedures for a disability benefit and the necessity of maintaining a separate claims procedure by having the participant's disability determination be made by a party other than the plan. Two examples of this type of independent determination are: a participant is considered disabled (i) by the Social Security Administration or (ii) under the employer's long-term disability plan.


A. Cash Balance Plans

1. Proposed Regulations.

In a positive development for cash balance plan sponsors, the IRS has issued long-awaited proposed regulations that confirm that the basic cash balance plan design does not discriminate on the basis of age. The proposed regulations also provide acceptable approaches for converting a traditional plan to a cash balance plan to avoid age discrimination. Cash balance plans are a type of "hybrid" defined benefit plan under which a "hypothetical account" for each employee is created and credited with hypothetical "pay credits" and "interest credits." The proposed regulations require that conversions must be age-neutral.

(a) The Issue. Employees enrolled in a cash balance plan receive benefits based on the status of their account balances. Unlike most traditional defined benefit plans, they are more likely to receive benefits in a lump sum.

When a traditional pension plan is converted to a cash balance plan, an employee's benefit under the old plan may exceed the amount determined to be his or her benefit under the cash balance plan. When this occurs, the employee may not earn any additional benefits until his or her benefit earned under the cash balance plan exceeds the benefit earned under the traditional defined benefit plan. This event is known as a "wear away" period and is at the heart of employee disenchantment with cash balance plans.

Older workers, who have been employed by the same company for many years, charge that wear away periods are a form of age discrimination because they produce a lower benefit accrual rate for older participants, since older, longtime employees have fewer years before retirement in which to accrue new benefits.

(b) The Solution. The proposed regulations require that conversions be age neutral. A converted plan must satisfy one of two alternative rules.

(i) The converted plan must determine each participant's benefit as not less than the sum of the participant's benefit accrued under the traditional defined benefit plan and the cash balance account.

(ii) The converted plan must establish each participant's opening account balance as an amount not less than the actuarial present value of the participant's accrued benefit under the traditional defined benefit plan.

A plan satisfying the first alternative will not have a wear away period for benefits accrued under the traditional plan. A plan satisfying the second alternative may have a wear away period.

Comment: The moratorium that the IRS presently has in place on approval of conversions will be lifted when final regulations are published. The IRS states that finalization of the regulations is a high priority.

(c) A Wrinkle. In Announcement 2003-32, the Treasury withdrew a portion of the proposed regulations governing disproportionate benefits to highly compensated employees under Code Section 401(a)(4). The proposed age-discrimination provisions in the regulations for cash balance plans or cash balance conversions remain unaffected by the withdrawal.

2. IBM and Xerox Cases.

Recent court decisions have added another degree of uncertainty to cash balance plans. In the cases of IBM and Xerox, the courts have ruled certain pension designs as being impermissibly age discriminatory, while such formulae would likely be acceptable to IRS and Treasury under the proposed regulations discussed above.

(a) IBM. In Cooper v. IBM Pers. Pension Plan, 2003 U.S. Dist. LEXIS 13223 (S.D. Ill, July 31, 2003), the U.S. District Court for the Southern District of Illinois held that the employer violated the age discrimination provisions of ERISA when it amended its traditional defined benefit plan in the 1990s, first by adopting a pension equity plan and then by converting it to a cash balance plan.

IBM initially amended its defined benefit plan by adopting a pension equity plan under which participants earned a specific number of base points determined by the employee's age in the year worked. Excess points could be earned if a participant's five year average earnings exceeded the social security wage base. Next, IBM converted the plan into a cash balance plan under which participants accumulated pay credits at a rate of five percent of salary and an interest credit at a rate of one percentage point higher than the rate of return on one-year Treasury securities.

The court held that both amendments violated ERISA. The benefit conversion factor contained in the pension equity plan violated ERISA Sections 204(b)(1)(G) and (H) because it reduced a participant's accrued benefit based solely on increases in age and service and the participant's rate of benefit accrual decreased because of the attainment of a certain age. The cash balance plan formula also violated Section 204(b)(1)(H) because the interest credits were more valuable for younger employees, which resulted in benefit accruals becoming progressively smaller as the participant grew older.

Comment: IBM recently released a statement indicating that it will appeal the ruling.

(b) Xerox. In Berger v. Xerox Corp. Ret. Income Guar. Plan, 2003 U.S. App. LEXIS 15427 (7th Cir., Aug. 1, 2003), the Seventh Circuit Court of Appeals upheld a class action judgment of $300 million against a cash balance plan in favor of participants because the plan's method of computing participants' lump-sum entitlements violated ERISA. The plan's cash balance benefit formula was substantially the same as the formula applied in the IBM case. However, the issue in Xerox concerned the appropriate method for calculating the amount of the distribution to which workers were entitled.

Under the terms of the cash balance plan, employees who left Xerox could elect to take a lump sum payment based on their hypothetical account balance or they could defer taking their pensions until they reached age 65. Employees who deferred their pensions continued to accrue future interest credits under the terms of the plan until age 65. However, in determining the amount of the lump sum distribution that employees opting for the current distribution were entitled to, the plan applied a discount rate prescribed by the Pension Benefit Guaranty Corporation ("PBGC").

The PBGC rate lowered the amount of the distribution that employees would receive, had the plan applied the future interest credits. In other words, employees who elected to take the lump sum payments did not receive the actuarial equivalent of what they would have received had they deferred receipt until age 65. The court held that ERISA requires that lump sum substitutes must represent the actuarial equivalent of the substituted benefit.

B. IRS Modifies Rules for Explaining Defined Benefit Distribution Options

The IRS issued final regulations that define the conditions under which a defined benefit plan may furnish an explanation concerning a participant's right to choose between a qualified joint and survivor annuity ("QJSA") and other forms of payment after the date that the annuity payments are to start ("annuity starting date"). The rule allowing for the provision of the explanation subsequent to the annuity starting date was created by the Small Business Job Protection Act of 1996. The final regulations are generally identical to previously-issued proposed regulations.

1. Background.

Generally, all distributions under a defined benefit plan must be made in the form of a QJSA. Code Section 417 provides an exception, whereby a participant may waive the QJSA, subject to spousal consent, in favor of another distribution method, such as a single life annuity or a lump sum. Plans generally must provide a QJSA explanation to each participant, within a reasonable time before the annuity starting date, describing the QJSA, the right to waive the QJSA, and the rights of the participant's spouse.

Pursuant to the Small Business Job Protection Act of 1996, QJSA explanations may be furnished after the annuity starting date if the applicable election period is extended for at least 30 days after the date on which the explanation is furnished. Since the annuity starting date may be earlier than the date on which the QJSA explanation is provided, retroactive benefit payments may be made which are attributable to the period before the QJSA explanation is provided.

The final regulations clarify the rules under which a defined benefit plan may send the QJSA explanation after the annuity starting date, creating a retroactive annuity starting date, and explain how payments are made when there is a retroactive annuity starting date, as well as providing other rules for the use of a retroactive annuity starting date. Generally, a retroactive annuity starting date may only be applied if the plan document permits it and if the participant affirmatively elects and the spouse consents to the use of the retroactive annuity starting date. If the participant elects a retroactive annuity starting date, the participant must be put in the same position he or she would have been in had benefits actually commenced on the retroactive annuity starting date.

C. IRS Clarifies Treatment of Defined Benefit Plan Annuity Overpayments

In Revenue Ruling 2002-84, the IRS clarifies how overpayments of annuity benefits from a defined benefit pension plan made in a single year, over several years, or as a lump-sum distribution can be corrected by the plan and taxed to the participant. The IRS states that, in the case of a miscalculation that results in an excess distribution to a participant in a single year, the following year's distributions can be reduced by the excess amount plus interest. If excess payments are distributed over several years, future payments to the participant may be reduced in a manner actuarially equivalent to the excess payments plus interest based on the plan's interest rate factors. Overpayment of a lump sum is properly included in gross income but is deductible when repaid.

D. Elimination of COLA Benefits for Retirees Does Not Violate Anti-Cutback Rules

In Board of Trustees of the Sheet Metal Workers' National Pension Fund (4th Cir., January 31, 2003), the Fourth Circuit held that a plan could abolish a cost of living adjustment ("COLA") for retirees without violating ERISA's anti-cutback rule which generally bars the reduction or elimination of accrued benefits. The court held the COLA for participants who had retired before it was added to the plan is a gratuitous benefit, which could be eliminated. In other words, for a benefit to be treated as an accrued benefit, it has to be earned during the time of the participant's employment.

Comment: This decision provides opportunities for plan sponsors, particularly those in distress, to reduce pension obligations attributable to COLAs for participants who retired before the COLA was adopted.


A. IRS Proposes Modifications to Optional Forms of Benefit Regulations to Conform to EGTRRA

The IRS has issued proposed regulations that modify final regulations concerning optional forms of benefit by changing the circumstances under which certain forms of distribution previously available to participants can be eliminated from qualified defined contribution plans (Proposed Regulations Section 1.411(d)-4, Q& A 2(e)).

1. Background.

Instead of requiring plans to continue to maintain nearly all existing alternative forms of payment (annuity, lump-sum, payment-in-kind, etc.), the optional form of benefit regulations (Regulations Section 1.411(d)-4) allow defined contribution plans to be amended to eliminate or restrict a participant's right to receive payment of accrued benefits under a particular optional form of benefit, without violating the Code Section 411(d)(6) anti-cutback rules, if:

(a) Once the plan amendment takes effect for a participant, the alternative forms of payment that remain available include payment in a lump sum that is "otherwise identical" (e.g., applicable to the same portion of the account balance, available in the same timeframes, etc.) to the eliminated or restricted optional form of benefit, and

(b) The amendment does not apply to a participant for any distribution with an annuity starting date before the earlier of: (i) the 90th day after the participant receives a summary that reflects the plan amendment; or (ii) the first day of the second plan year following the plan year in which the amendment is adopted.

2. EGTRRA Change.

EGTRRA amended Code Section 411(d)(6) to provide that a defined contribution plan is not treated as reducing a participant's accrued benefit where a plan amendment eliminates a form of distribution previously available under the plan, if:

(a) a lump sum distribution is available to the participant, and

(b) the lump sum distribution is based on the same or greater portion of the participant's account as the form of distribution eliminated by the amendment.

EGTRRA also instructed IRS to issue regulations, under both the Code and ERISA, implementing these changes.

3. Proposed Regulations.

To reflect the EGTRRA change, IRS has issued proposed regulations that would modify the existing final regulations by eliminating the 90 day advance notice rule discussed in Section III, A.1.(b) above.

B. DOL Guidance on Paying Expenses from Plan Assets

1. Background.

Under ERISA, assets of an employee benefit plan must be used exclusively to pay benefits to plan beneficiaries and, if the plan so provides, to defray reasonable expenses of administering the plan. According to the DOL, it is the responsibility of plan fiduciaries to determine whether a particular expense is a reasonable administrative expense under ERISA, which can be paid for with plan assets.

In a 1987 information letter (the "Maldonado Letter"), the DOL identified certain services that are provided by employers in connection with the establishment, termination and design of plans that are not services performed exclusively for the benefit of plan participants. The information letter went on to state that such functions (referred to as "settlor functions") were related to the business of the employer and, therefore, should not generally be paid from the assets of an employee benefit plan.

In response to a request for specific guidance on the payment of certain expenses incurred in seeking a determination letter upon a plan's termination, the DOL issued Advisory Opinion 97-03A, wherein the DOL stated its position that expenses related to settlor functions are not reasonable expenses of a plan that may be paid from plan assets. Further, it provided that a plan's tax-qualified status confers benefits on both a plan's participants and beneficiaries and the plan sponsor. Therefore, it concluded that only a portion of the expenses incurred in maintaining tax qualification are reasonable plan expenses that are payable from plan assets. This was interpreted to mean that the DOL required the apportionment between plan and sponsor of all tax qualification expenses. Moreover, some practitioners construed Advisory Opinion 97-03A to require that an independent fiduciary was needed to determine such apportionment.

In response to a request for clarification of its position on the payment of plan expenses from plan assets, the DOL issued Advisory Opinion 2001-01A, and recently Field Assistance Bulletin 2003-3.

2. Advisory Opinion 2001-01A.

In Advisory Opinion 2001-01A, the DOL indicates that it does not agree that Advisory Opinion 97-03A requires an apportionment of expenses between the plan and sponsor for all tax qualification-related expenses. However, DOL Advisory Opinion 2001-01A does not supersede Advisory Opinion 97-03A.

Advisory Opinion 2001-01A reconfirms the DOL's position that a wide range of expenses relating to plan formation, rather than plan management, are settlor functions that cannot reasonably be paid from a plan. Thus, the formation of a tax-qualified plan is a settlor activity, but the DOL opines that the implementation of this settlor decision may require plan fiduciaries to undertake activities relating to maintaining the plan's tax-qualified status that may be paid by the plan to the extent that they are reasonable in light of the services rendered. Examples of implementation activities include: drafting plan amendments required by changes in the tax law, nondiscrimination testing, and requesting IRS determination letters. However, expenses incurred in analyzing options for amending the plan would be settlor expenses.

The DOL restates that it is a plan fiduciary's obligation to determine whether certain plan-related functions are settlor or non-settlor expenses incurred in maintaining a plan. Importantly, the Advisory Opinion clarifies that the incidental benefit of having a tax-qualified plan should not be considered in determining whether plan-related costs are plan or sponsor expenses.

Whether certain other expenses (e.g., plan drafting and plan amendments) should be allocated depends on the particular facts and circumstances of the situation. According to the Advisory Opinion, costs associated with studies of compliance alternatives in response to required legal changes would not be payable from plan assets. An example in the Advisory Opinion clarifies that the cost of an amendment to comply with a board resolution, such as the addition of a loan feature, is a settlor expense payable by the plan sponsor. However, the maintenance costs of the loan feature (e.g., participant communications, processing loan applications) would be appropriate plan expenses that could be paid from plan assets.

3. DOL Hypothetical Fact Patterns.

The DOL issued six hypothetical fact patterns to illustrate its position on determining appropriate plan expenses, versus expenses incurred for settlor activities. In each case, the DOL confirms its position that, although settlor activities do not constitute reasonable plan expenses, expenses incurred in connection with the implementation of settlor decisions still may constitute reasonable expenses which the plan may pay.

(a) Plan Spinoff as Part of Sale of Business Unit. Expenses incurred in conducting a plan design study in connection with a plan spinoff are considered settlor expenses that cannot be paid by the plan. Expenses incurred in amending a plan to effect a plan spinoff as part of the sale of a business unit should be treated as settlor plan design expenses, since no implementation responsibilities exist under the plan until the plan actually is amended. However, expenses incurred in determining the amount of plan assets to be transferred from the seller's plan to the buyer's plan would be permissible plan expenses, if the expenses are incurred in implementing the seller's decision to spin off certain participants, versus assisting the seller in formulating the spinoff.

Expenses incurred in conducting any negotiations with any unions affected by the plan spinoff and sale would be settlor expenses that are not payable under the plan. The DOL notes that these types of union negotiations typically occur in advance of plan changes and that activities taking place in advance of, or in preparation for, a plan change nearly always constitute settlor ­ versus plan ­ activities.

(b) Reduction in Staff in Conjunction with Early Retirement Window. In analyzing a situation involving a company that decides to reduce its staff and implement an early retirement window to cut expenses, the DOL concludes that the expenses incurred fall within three basic categories: plan design, benefit computation, and communication expenses.

The DOL's position is that plan design expenses ­ which generally are incurred before the plan is adopted or amended ­ constitute settlor expenses that are not payable by the plan. The cost incurred in calculating the benefits to which a participant is entitled, however, is an administrative expense of the plan and accordingly is payable by the plan. Similarly, the communication of plan information to participants and beneficiaries is a plan activity that constitutes permissible plan expenses.

(c) Plan Amendments to Add Participant Loan Program and Early Retirement Window. Plan design activities involve settlor activities for which a plan cannot pay, but the expenses incurred in implementing the decision to maintain a tax-qualified plan might result in reasonable plan expenses. In applying that principle, the expenses incurred in amending the plan to comply with the applicable tax changes and to conduct routine nondiscrimination testing may constitute reasonable expenses of the plan. On the other hand, expenses incurred in connection with amending the plan to establish a participant loan program would be a plan design or settlor expense, since the plan fiduciaries have no implementation obligations under the plan until the plan is amended. Expenses incurred in operating the plan loan program, however, would be implementation expenses that are eligible for treatment as plan expenses. If a single expense is attributable to both plan design and settlor activities (e.g., amending the plan to establish an early retirement window) and implementation activities (e.g., obtaining an IRS determination letter), the plan must obtain from the service provider a determination of the specific expenses attributable to each for the plan to pay any portion of the expense as a plan implementation expense.

(d) Nondiscrimination Testing and Amendment of Plan for Law Changes. Expenses incurred in amending the plan to maintain the plan's tax-qualified status, submitting the plan for a determination letter, and performing any required nondiscrimination testing are considered plan maintenance expenses that are permissible plan expenses. Even if the nondiscrimination testing is required because of a union-negotiated plan amendment, the expense continues to be a permissible plan expense. On the other hand, if the expense was incurred as part of the union negotiations by the employer, in advance of the adoption of the plan amendment necessitating the testing, that expense is a settlor ­ not plan ­ expense. Similarly, consulting fees incurred in analyzing the sponsor's options for complying with changes in the law would be plan design or settlor expenses.

(e) Plan Disclosure Expenses ­ Preparation and Distribution of Plan Information to Participants. The DOL states that plans may pay expenses incurred in complying with ERISA's disclosure requirements. Thus, the expenses incurred in producing and distributing individual benefit statements to participants are permissible plan expenses. Also, expenses incurred in preparing the participant benefit books are permissible plan expenses. The plan sponsor should pay the portion of the booklet expenses relating to non-plan matters (for example, describing any employee fringe benefits such as company outings). The plan must pay only those reasonable expenses that relate to that particular plan, with each of the plans paying its proportionate share of the expenses.

(f) Outsourcing Benefit Administration ­ Start-up Fees and Research. To the extent that the services provided by an outside benefits administrator are necessary to the plan's administration, the start-up fee and ongoing administrative fees paid to that service provider may constitute reasonable plan expenses.

4. Field Assistance Bulletin 2003-3 - Expenses Attributable to Specific Plan Participants. The above discussion concerns plan-wide expenses that are borne by the plan as a whole (with respect to defined contribution plans, either pro rata on each account balance or from the forfeiture or suspense account). On May 19, 2003, the DOL issued a Field Assistance Bulletin (FAB 2003-3) that significantly changes the DOL's position on charging individual participant's accounts for certain plan-related expenses. The DOL's new position enables the plan to pass through certain charges relating to an individual participant to his or her account, rather than requiring allocation of such charges to all participants in proportion to account value.

In earlier guidance, the DOL stated than an individual participant's account could not be charged for expenses incurred as a result of exercising his or her rights under the law. As a result, costs associated with activities such as reviewing whether domestic relations orders constitute qualified domestic relations orders (which grant benefit rights to former spouses or dependent children) and processing distributions had to be charged to the plan overall, and not solely to the affected participant's account. On the other hand, the earlier guidance allowed a plan to charge an individual participant's account for privileges not guaranteed under ERISA, such as processing loans or directing investments.

In FAB 2003-3, the DOL, noting that some ERISA provisions specifically permit plans to charge an individual participant for certain expenses, such as obtaining copies of documents, concludes "except for the few instances in which ERISA specifically addresses the imposition of expenses on individual participants, [ERISA] places few constraints on how expenses are allocated among plan participants."

Under the DOL's new position, if a plan document specifically provides for an individual participant's account to be charged for certain expenses, the plan administrator and other fiduciaries must follow the document. If the document leaves the charging of expenses up to the plan administrator's (or other fiduciary's) discretion, the determination of whether to charge an individual participant's account or the plan as a whole is a fiduciary decision that is subject to ERISA's fiduciary standards ­ that is, the decision on how to allocate the expense must be made prudently and in the sole interests of plan participants and beneficiaries.

The DOL position, as currently set forth in the FAB, expressly permits the allocation of the following common expenses directly to an individual participant's account. These expenses include the costs to:

(a) Determine if domestic relations orders meet the requirements to be considered qualified domestic relations orders or qualified medical child support orders.

(b) Process hardship withdrawals. Presumably this would include fees involved both in determining if the requirements for a hardship are met and expenses involved in making the distribution.

(c) Process benefit distributions. This includes check writing fees.

(d) Maintain accounts for terminated vested participants. The DOL now specifically permits the sponsor or plan to pay the expenses to maintain accounts for active participants, while not paying for the costs for the accounts for participants who have left the company.

Comment: The IRS and the tax rules may make some of these charges impermissible. In particular, Treasury Regulations require that a consent to distribution (which is required if the amount being distributed is more than $5,000) is not valid if a significant detriment is imposed on a participant who does not consent to a distribution. If the charge to maintain the account is considered by the IRS to be a "significant detriment," it may be impermissible notwithstanding the DOL's position.

Comment: If plans are not amended to include guidance on allocating plan expenses, fiduciaries would be burdened with establishing guidelines for properly allocating expenses, which could lead to significant legal exposure. Therefore, if plan sponsors and fiduciaries determine to charge individual accounts for permissible expenses, they should review their methodology for allocating such expenses and amend the plan and summary plan documents in order to appropriately inform participants of fees that will be charged to accounts and how and when such fees will be charged.

C. IRS Guidance on Deemed IRAs

1. Background.

EGTRRA added Code Section 408(q) which permits employers to amend their qualified plans to allow for voluntary employee contributions to a separate account established under the plan. These accounts, called "deemed IRAs", must satisfy the requirements applicable to traditional or Roth IRAs. If these conditions are met, the accounts will be treated as IRAs, and not as part of the qualified plan. Also, deemed IRAs are not subject to Title I of ERISA other than those sections relating to the exclusive benefit rule and fiduciary and co-fiduciary responsibilities.

2. Revenue Procedure 2003-13.

The IRS issued Revenue Procedure 2003-13, which provides employers with an extended period of time to amend their plans to provide for deemed IRAs, provided the plan satisfies the EGTRRA remedial amendment period requirements.

Notwithstanding the general rule that deemed IRA provisions must be in place prior to accepting employee voluntary contributions, Revenue Procedure 2003-13 permits plan sponsors to adopt the necessary amendments after a plan begins accepting contributions for plan years beginning in 2003. Thus, plan sponsors have until the end of the 2003 plan year to adopt a deemed IRA plan provision even though contributions may be received by the plan from the beginning of that plan year.

3. Proposed Regulations.

The IRS issued proposed regulations on deemed IRAs that set forth the conditions, restrictions and requirements that must be satisfied for a qualified employer plan to
establish a deemed IRA, as follows:

(a) Eligible Plans. Qualified employer plans that may establish a deemed IRA include a Section 401(a) qualified plan, a Section 403(a) or 403(b) annuity or a governmental Section 457(b) plan.

(b) Eligible IRA. Only IRAs that meet the requirements of either a traditional or Roth IRA may be a deemed IRA. SEPs and SIMPLE IRAs are not eligible deemed IRA vehicles.

(c) Separate Entities. A deemed IRA must be a separate entity from the qualified employer plan under which it is maintained. The deemed IRA and the qualified employer plan generally must independently satisfy the rules applicable to each entity (e.g., eligibility, participation, disclosure, nondiscrimination, minimum distribution, maximum limits) and each must have a separate trust. Contributions to a deemed IRA, up to the limits permitted for a traditional or Roth IRA, will not be taken into account for purposes of a participant's elective deferral limit to a 401(k), 403(b) or governmental 457(b) plan or for purposes of Section 415 maximum limits because they are not treated as contributions to the qualified employer plan.

However, the proposed regulations contain an exception to the separate entity requirement with respect to the commingling of IRA assets with other plan assets. The exception permits the assets of a deemed IRA to be commingled for investment purposes with the assets of a qualified employer plan. However, separate accounts must be maintained for allocating gains and losses.

The regulations contain another exception to the separate entity rule, that is, if a deemed IRA fails to meet any of the requirements of a traditional or Roth IRA, then the qualified employer plan that elected to provide for voluntary employee contributions to a deemed IRA will fail to meet its qualification requirements. On the other hand, if a qualified employer plan fails to satisfy any qualification requirement, the account that was intended to be a deemed IRA may, nevertheless, be treated as a traditional or Roth IRA, provided it satisfies the requirements for these types of IRAs.

(d) Correction of Qualification Failures. A qualified plan or deemed IRA that fails to satisfy any applicable requirement may correct such failure through the Employee Plans Compliance Resolution System.

(e) Distributions. Distributions from deemed IRAs are treated independently from distributions under qualified plans. For example, withdrawals from a deemed IRA may be made before an individual is eligible to retire under the qualified plan. Similarly, minimum required distributions must be calculated separately for the deemed IRA and qualified plan. Minimum required distributions from the qualified employer plan, in general, would have to commence at the later of the April 1 following the attainment of age 70-1/2 or retirement of the employee. However, required minimum distributions from deemed IRAs would have to commence by the April 1 following the attainment of age 70-1/2 even if the employee is still working.

D. Final Regulations on Qualified Plan Loans Cover Maximum Term of Loans, Loans Made After a Deemed Distribution, Loan Refinancing, and Multiple Loans

1. Background.

Under Code Section 72(p), a loan from a qualified plan to a participant is treated as a taxable distribution unless certain conditions are satisfied. In general, the loan may not exceed the lesser of 50% of the participant's vested account balance or $50,000. The repayment term of the loan may not be more than 5 years unless it is for the purpose of acquiring a principal residence. Payments must be substantially level and must be made no less frequently than quarterly.

The IRS issued two sets of proposed regulations on these criteria in 1995 and 1998. In 2000, the IRS issued final regulations and also issued a new set of proposed regulations. The IRS has now finalized the 2000 proposed regulations. The final regulations provide guidance on the suspension of loan repayments during a military leave of absence, new loans following a deemed distribution of a prior loan, loan refinancing and multiple loans.

2. Military Leaves of Absence.

A suspension of loan payments while a participant is on a military leave of absence will not cause the loan to be deemed distributed, regardless of the length of the leave. For other unpaid leaves of absence, the suspension period may not exceed one year. In general, the loan must be reamortized over the remaining term plus the period of military leave either to provide for higher periodic payments, or to provide the same payments as before the leave but with a balloon payment at the end. As with other leaves of absence, the periodic repayment amount may not be less than it was before the military leave. Furthermore, the final regulations provide that loan repayments can be revised at the end of a military leave to extend the repayment schedule in the event the loan originally had a term of fewer than five years, but the extension may not exceed the period of the military leave.

Example: If the repayment period for a loan made before a participant's leave for military service was three years, the final regulations would allow the loan to be repaid by the end of five years (the latest permissible loan term absent a leave of absence) plus the period of military service.

Interest must continue to accrue during a military leave of absence. The final regulations clarify that the maximum interest rate that may be charged during a military leave is 6% per year as required by the Soldiers' and Sailors' Civil Relief Act of 1942.

3. Effect of Deemed Distribution on Subsequent Loans.

When a loan is deemed distributed, e.g., the participant has defaulted on the loan, it is treated as outstanding for purposes of determining whether additional loans can be made. No future payout made to the participant can be treated as a loan unless either of the following conditions is met with respect to the new loan:

(a) The repayments are made by payroll deduction; or

(b) The plan receives adequate security other than the participant's vested accrued benefit under the plan.

If the condition for allowing the subsequent loan ceases to be met (e.g., the participant revokes the payroll deduction agreement), the loan, unless repaid, will be deemed distributed.

Comment: Loans are deemed distributed when a participant loan goes into default status. The plan must issue a 1099-R for the amount of the defaulted loan. The loan balance cannot be distributed until the participant experiences a distributable event (e.g., termination of employment), and as a result the loan balance continues to accrue interest. This can cause a significant problem for multi-employer plans or other plans when loan repayments are not made by salary reduction.

4. Refinanced Loans.

If a loan is replaced by another loan (a replacement loan), and the term of the replacement loan ends after the latest permissible term of the loan it replaces, the final regulations treat both loans as outstanding on the date of the transaction. Thus, for example, if: (a) the term of the replacement loan ends after the latest permissible term of the replaced loan, and (b) the sum of the amount of the replacement loan and the amount of the replaced loan fails to satisfy the dollar limits on plan loans, then the replacement loan results in a deemed distribution in the amount by which this sum exceeds the dollar limit on plan loans.

However, the above rule will not apply to treat both the replacement loan and the original loan as outstanding, if the terms of the replacement loan would satisfy the regulations for Code Section 72(p)(2), applied as if the replacement loan consisted of two separate loans, to wit: (a) the replaced loan (amortized in substantially level payments over a period ending no later than the last day of the latest permissible term of the original replaced loan), and (b) a new loan in the amount by which the replacement loan exceeds the amount of the replaced loan (i.e., the lesser of one-half of a participant's vested account balance or $50,000 less the largest outstanding loan balance during the 1-year period preceding the refinance date), with the new loan amortized in substantially level payments over a period ending not later than the latest permissible term of the replacement loan.

Example: A participant whose vested account balance was $200,000 borrowed $30,000 on January 1, 2001 with loan payments to be made quarterly over a 5-year period. On January 1, 2002, the participant decided to refinance the remaining loan balance ($25,000) to take advantage of lower interest rates. That would not be a problem if payments under the refinanced loan were scheduled to end no later than 5 years after the original loan date. However, Code Section 72(p) would preclude the extension of the payment period to a new 5-year period without adverse tax consequences because the refinanced loan could not exceed $20,000 ($50,000 less the largest outstanding loan balance during the 1-year period preceding the refinancing date, or $30,000 in this example). Thus, an attempt to refinance the $25,000 over a new 5-year period would result in a taxable distribution of $5,000. If, however, the refinanced loan payment period were to end no later than December 31, 2005 (the end of the original loan period), the participant could borrow up to an additional $20,000 to be paid over a new 5-year period because the $25,000 refinanced loan would not be treated as a new loan.

5. Multiple Loans.

The final regulations do not restrict the number of loans a participant may take in a 12-month period. A plan, however, may restrict the number of loans a participant may have outstanding.

Comment: This provision accommodates so-called "credit card" plan loans.

E. IRS Lets Employee Leasing Groups Convert to Multiple Employer Plans

1. Background.

The IRS has provided a framework under which defined contribution plans sponsored by employee leasing organizations (referred to as professional employer organizations, or "PEOs") will not be disqualified for violating the exclusive benefit rule solely because those plans provide benefits to "worksite employees" who are not PEO employees. To obtain this relief, a PEO that maintains a defined contribution plan must either convert the plan into a multiple employer plan that benefits worksite employees, or terminate the plan before a specified date.

An employee leasing arrangement involves the interaction of three parties: the PEO, the client organization ("CO"), and worksite employees. Usually, a PEO enters into an agreement with a CO under which employees receive payment from a PEO for providing services to a CO under a service agreement between the PEO and the CO. The employees are referred to as "worksite employees".

If the PEO has a retirement plan, the issue is whether the worksite employees are employees of the PEO or the CO. A retirement plan that provides benefits for individuals who are not employees of the employer maintaining the plan violates the exclusive benefit rule. Thus, a retirement plan maintained by a PEO can be qualified only if it provides benefits exclusively for its own employees.

Whether a worker is an employee of a particular entity is generally based on which entity has the right to direct and control the individual performing the services. If it is found that the CO, and not the PEO, is the employer, then the plan maintained by the PEO that benefits worksite employees would fail the exclusive benefit rule.

A plan that would fail the exclusive benefit rule because it covers employees of employers other than the employer maintaining the plan can satisfy the exclusive benefit rule if it is a multiple employer plan (i.e., a plan maintained by more than one employer). In determining whether a multiple employer plan complies with the exclusive benefit rule, all participants are treated as employees of all employers who maintain the plan.

2. Relief from Disqualification.

If a PEO has a defined contribution plan that: (i) is in existence on May 13, 2002, (ii) benefits "worksite employees", and (iii) is intended to be qualified, the PEO plan will not be treated as disqualified solely on the grounds that the plan violates (or has violated) the exclusive benefit rule for plan years beginning before the "compliance date" (discussed below) by benefiting worksite employees who are not the PEO's employees, if a PEO satisfies the relief requirements described below.

To obtain relief from potential disqualification, the plan sponsor of the PEO plan must either (i) terminate the plan, or (ii) convert the plan into a multiple employer plan.

If, as of the compliance date, a PEO does not either terminate its plan covering worksite employees or convert the plan to a multiple employer plan, the relief from disqualification is not available. After the compliance date, a PEO may not rely on a determination letter for a plan that covers worksite employees performing services for COs, regardless of when the letter was issued.

3. Dates for Remedial Action.

Generally, all remedial actions and other relief requirements must be completed by the "compliance date"-i.e., the last day of the first plan year of the PEO's plan beginning on or after January 1, 2003. For a calendar year plan, the compliance date is December 31, 2003.

F. Money Purchase Pension Plan's Conversion or Merger into Profit Sharing Plan Not Partial Termination, but Requires Participant Notice

1. Background.

The IRS has ruled that a money purchase pension plan will not be treated as having been partially terminated because of its merger or conversion into a profit sharing plan. However, employees must be given formal ERISA Section 204(h) notice of the change (Rev. Rul. 2002-42, 2002-28 IRB).

Comment: With a money purchase pension plan, contributions must be made in accordance with a formula usually expressed as a percentage of the participant's compensation. By contrast, with a profit sharing plan, contributions generally vary with the fortunes of the employer, although contributions may continue to be made even in the absence of profits.

2. Plan Conversion or Merger.

The ruling addressed two situations in which an employer merges or converts a money purchase pension plan into a profit sharing plan. Employers X and Y each maintain a money purchase pension plan. Employer Y also maintains a profit sharing plan.

(1) Employer X converts its money purchase pension plan into a profit sharing plan covering the same employees as the money purchase pension plan and containing the same vesting schedule.

(2) Employer Y amends its money purchase pension plan to cease future employer contributions and merges it into its profit sharing plan in a transaction that satisfies the requirements of Code Section 414(l). Following the merger, the profit sharing plan covers the same employees and contains the same vesting schedule as the money purchase pension plan.

In both situations, assets and liabilities in the profit sharing plan that originated in the money purchase pension plan retain their money purchase pension plan attributes (e.g., amounts are still subject to the qualified joint and survivor rules) (in accordance with Rev. Rul. 94-76).

3. Notice Must be Provided.

To avoid the Code Section 4980F excise tax, and to satisfy ERISA Section 204(h), a plan amendment that provides for a significant reduction in the rate of future benefit accruals must be accompanied by a notice from the plan administrator describing the reduction to each affected individual whose benefit is adversely affected by the reduction, and to each employee organization representing these individuals. The IRS states that the conversion or merger of a money purchase pension plan into a profit sharing plan necessarily involves a significant reduction in the rate of future benefit accrual under the money purchase plan. Therefore, Employers X and Y must provide notice of the conversion or merger to affected employees under Code Section 4980F and ERISA Section 204(h).

4. Reasons to Convert to a Profit Sharing Plan.

Before EGTRRA, there was a 10-percentage point difference in the maximum deductible amount that could be contributed to a profit sharing plan (15% of compensation) as opposed to a money purchase pension plan (25% of compensation). Further, for purposes of determining an employer's maximum deductible contribution, elective deferrals to 401(k) plans were treated as employer contributions. EGTRRA raised the deductible contribution percentage to 25% for profit sharing plans, and eliminated the provision requiring that employee elective deferrals be treated as employer contributions for purposes of the deductible contribution limit.

Thus, employers may now make the same contributions to a profit sharing plan as to a money purchase pension plan, without incurring the obligation to so contribute inherent in money purchase pension plans.

G. Guidance on Restorative Payments

In Rev. Rul. 2002-45, the IRS provided guidance on whether an employer payment to a defined contribution plan to make up for substantial investment losses should be classified as a contribution or a restorative payment. This distinction is important because restorative payments (unlike plan contributions) are not subject to the various nondiscrimination requirements and deduction limits of the Code. [4]

In the two situations discussed in the ruling, the employer paid an amount to the plan to compensate for the loss of a significant amount of plan assets due to a high risk investment. The payment was allocated among the accounts of all participants and beneficiaries in proportion to each account's investment in the high risk asset. The only difference between the two situations is that, in one, the payment was made as part of a settlement due to a lawsuit filed by the plan participants against the employer alleging breach of fiduciary duty. In the other situation, no suit was filed, but the employer was aware that participants were concerned about the investment and were considering legal action. The IRS ruled that the payment to the plan in both situations was restorative rather than a contribution. While pointing out that a facts-and-circumstances test applies for characterizing restorative payments, the IRS nonetheless established two guidelines for determining if payments constitute restorative contributions: (i) the payment is made to restore losses resulting from the action or omission by a fiduciary for which there is a reasonable risk of liability for breach of fiduciary duty, and (ii) similarly situated plan participants are treated similarly with respect to the payment.

The IRS offered specific examples of what types of payments constitute restorative payments. Payments made pursuant to DOL or court-approved settlement are restorative payments, while payments required under the terms of a plan or necessary to comply with a Code requirement are not restorative payments, even if the payments are delayed contributions or are otherwise made in circumstances in which there has been a breach of fiduciary duty. Payments of delinquent Section 401(k) contributions under the Voluntary Fiduciary Correction Program are not restorative payments. However, payments under Employee Plans Compliance Resolution System of adjustments to reflect lost earnings are treated as restorative payments. Payments made to make up for losses due to market fluctuations and that are not attributable to a fiduciary breach are generally treated as contributions rather than restorative payments.

H. 401(k) Plans

1. 401(k) Proposed Rules Consolidate and Modify Existing Guidance.

The IRS has issued a comprehensive set of proposed regulations setting out the requirements for cash or deferred arrangements ("CODA") under Code Section 401(k) and for matching contributions and employee contributions under Code Section 401(m). The proposed regulations reflect the relevant tax law changes and IRS rulings that have come into effect since 1994.

(a) Introduction. The proposed rules implement modifications designed to simplify plan administration and ensure benefits for rank-and-file employees.

(b) Prohibition of Pre-Funded Contributions. The IRS has stated that prefunding elective and matching contributions is inconsistent with Code Sections 401(k) and 401(m). As a result, the proposed regulations would not allow an employer to prefund elective contributions to accelerate the deduction.

(c) Aggregation of Plans with ESOPs. The proposed regulations would change the treatment of a CODA under a plan that includes an ESOP. Current rules provide that the portion of a plan that is an employee stock ownership plan ("ESOP") and the portion that is not an ESOP are treated as separate plans for purposes of the Code Section 410(b) minimum coverage rules. Thus, these plans have to apply two separate actual deferral percentage ("ADP") tests: one test for elective contributions going into the ESOP (and invested in employer stock), and a second test for elective contributions going in the non-ESOP portion of the plan.

The proposed regulations would eliminate disaggregation of the ESOP and non-ESOP portion of a single plan for purposes of ADP testing. The same rule would apply for actual contribution percentage ("ACP") testing under Code Section 401(m). In addition, the proposed regulations would provide that, for purposes of applying the ADP test or the ACP test, an employer could permissively aggregate two plans, one that is an ESOP and one that is not.

(d) Distributions Upon Severance from Employment. EGTRRA repealed the same desk rule by allowing employers to amend their plans to authorize distributions attributable to elective deferrals to be made to participants upon severance from employment, rather than separation from service. Accordingly, 401(k) plan participants are no longer prohibited from receiving 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 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).

(e) Hardship Distributions. The proposed rules clarify the changes to the hardship distribution rules implemented by EGTRRA, including the six-month suspension of elective deferrals following a distribution. In addition, the proposed rules require a representation by an employee in support of a claim that a distribution is necessary to satisfy an immediate and heavy financial need 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 needs would not be available on reasonable commercial terms. If the plan has a loan provision, the participant must take loans from the plan before requesting a hardship distribution.

(f) Distribution Restrictions Under Transferee Plans. Plans that receive plan-to-plan transfers that include elective deferrals, QNECs or QMACs must contain the statutory withdrawal restrictions. The proposed rules would further require the transferor plan to "reasonably conclude" that the transferee plan provides for the applicable withdrawal restrictions.

(g) Specify Nondiscrimination Testing Method. The proposed rules require plans to specify the nondiscrimination testing method and the optional choices being used under that method. For example, a plan would need to specify whether the current year or prior year ADP testing method is used. In addition, the rules prohibit plans that use the safe harbor nondiscrimination method from reserving the right to use the ADP method in the event that the safe harbor conditions are not met.

(h) Disregarding Excludable Participants in ADP Test. The proposed rules reflect Code Section 401(k)(3)(F), as enacted by EGTRRA, pursuant to which nonhighly compensated employees who do not meet ERISA's minimum age and service requirements may be disregarded for purposes of the ADP and ACP tests. This option is "permissive" and plans may continue to use the existing testing option under which a plan is disaggregated and the ADP and ACP tests are separately performed for eligible and excludable employees.

(i) Calculating the ADR of HCEs in Multiple Plans. The proposed rules require the actual deferral ratio for each highly compensated employee ("HCE") participating in more than one CODA to be determined by aggregating the HCE's elective deferrals 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 deferrals 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 or makes employee contributions under two or more plans.

(j) Restrictions on "Bottom-Up" QNECs. The proposed rules would continue to allow plans, subject to conditions specified in the existing regulations, to correct failures of the ADP test by making QNECs. However, the proposed rules would add a new condition that would limit 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 each such NHCE's ADR), rather than providing contributions to a broad group of NHCEs. The bottom-up leveling method, which has become increasingly popular in the wake of EGTRRA's increase in Code Section 415 annual additions limit to 100% of a participant's compensation, 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 contributions for NHCEs.

Under the proposed rules, a plan would be treated as providing an impermissible targeted QNEC if less than one-half of all NHCEs are receiving QNECs or if the QNECs exceed 5% of the NHCE's compensation and is more than twice the QNEC that other NHCEs are receiving, 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."

Similar restrictions would apply to QNECs taken into account in ACP testing. In order to prevent employers from using targeted matching contributions to avoid the restrictions on targeted QNECs, the proposed rules would 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.

(k) Apportioning Corrective Distributions to HCEs in Multiple Plans. The proposed regulations 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 contributions to be distributed for the plan, all contributions in CODAs in which the HCE participants 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.

(l) Safe Harbor Rules. Code Section 401(k) provides a design-based safe harbor method under which a CODA is treated as satisfying the ADP test if the arrangement meets certain contribution and notice requirements. In addressing the requirement for safe harbor plans, the proposed regulations generally follow the rules established under Notice 98-52 and Notice 2000-3. Thus, a plan would satisfy the Code Section 401(k) safe harbor if it makes specified QMACs for all eligible NHCEs. The matching contributions could be provided using a basic matching formula that provides for QMACs equal to 100% of the first 3% of elective contributions and 50% of the next 2%, or using an enhanced matching formula that is at least as generous in the aggregate, provided the rate of matching contributions under the enhanced matching formula does not increase as the employee's rate of elective contributions increases. In lieu of QMACs, the plan is permitted to provide QNECs equal to 3% of compensation for all eligible NHCEs. In addition, notice must be provided to each eligible employee, within a reasonable time before the beginning of the year, of his or her right to defer under the plan.

The proposed regulations clarify that a Code Section 401(k) safe harbor plan must generally be adopted before the beginning of the plan year and be maintained throughout a full 12-month plan year, but would adopt the exception to this requirement that was provided in Notice 2000-3. Thus, under the proposed regulations, an employer is allowed to amend its safe harbor plan to eliminate matching contributions for future elective deferrals, provided that (i) the matching contributions are made with respect to pre-amendment elective deferrals, (ii) employees are provided with notice of the change and the opportunity to change their elections, and (iii) the plan satisfies the ADP or ACP test for the plan year using the current year testing method.

(m) Accounting for Elective Contributions in ACP Safe Harbor. Under the ACP safe harbor, an HCE may not have a higher rate of matching contributions than any NHCE. The proposed rules require any NHCE who is an eligible employee under a safe harbor CODA to be taken into account in making this determination, even if the NHCE is not eligible for a matching contribution. Thus, the IRS explains, a plan that limits matching contributions to employees who are employed on the last day of the plan year will not satisfy the ACP safe harbor.

2. Catch-Up Contributions: IRS Guidance and Technical Corrections.

Final regulations regarding catch-up contributions for employees aged 50 and older clarify and simplify the proposed regulations. The final rules apply to catch-up contributions made to 401(k) plans, SIMPLE-IRAs, simplified employee pensions or SEPs, Code Section 403(b) tax-sheltered annuity contracts, and Code Section 457 eligible governmental plans.

Comment: Federal law does not require a retirement plan to permit participants to make catch-up contributions. However, once a plan allows catch-up contributions it must comply with the applicable requirements.

(a) Background. Code Section 414(v), added by EGTRRA, permits individuals aged 50 and over to make additional elective contributions beginning in 2002. JCWAA added several technical corrections to clarify the coordination and operation of the catch-up rules. While the final regulations retain much of the structure of the proposed regulations, they incorporate the changes made by JCWAA and include simplifications. The final regulations contain comprehensive guidance on all of the administrative rules under Code Sections 414(v) and 402(g) that come into play when a plan sponsor makes catch-up contributions available.

(b) Eligibility. A participant is eligible to make catch-up contributions beginning on January 1 of the calendar year that includes the participant's 50th birthday.

(c) Catch-Up Contribution Limit. The catch-up contribution limit for a tax year is generally the applicable dollar catch-up limit for the year (as shown below).

The dollar limit is:

 Tax Year  General Catch-Up
 Catch-Up Amount:
 2003  $2,000  $1,000
 2004  $3,000  $1,500
 2005  $4,000  $2,000
 2006  $5,000  $2,500


After 2006, the limit on catch-up contributions will be adjusted for inflation in $500 increments.

(d) Applicable Limits. Elective deferrals made by an eligible participant are catch-up contributions if they exceed any otherwise applicable limit, to the extent they do not exceed the catch-up contribution limit.

Catch-up contributions are determined by reference to three types of limits: (1) statutory limits (e.g., Code Section 415), (2) document and other employer-provided limits, and (3) operational limits (e.g., the actual deferral percentage ("ADP") limit).

(e) Alternative Bases for Determining Employer-Provided Limit. The determination of whether elective deferrals are catch-up contributions is generally determined at the end of the plan year. However, the final regulations allow alternative methods for determining an employer-provided limit, as follows:

(i) Payroll-By-Payroll Basis. For a plan that provides separate employer-provided limits on elective deferrals for separate portions of plan compensation within the plan year, the applicable limit for the plan year is the sum of the dollar amounts of the limits for the separate portions. For example, if a plan sets a deferral percentage limit for each payroll period, the applicable limit for the plan year is the sum of the dollar amounts of the limits for all the payroll periods.

(ii) Time-Weighted Basis. If a plan limits elective deferrals for separate portions of the plan year, then solely for purposes of determining the amount that is in excess of an employer-provided limit, the plan is permitted to provide that the applicable limit for the plan year is the product of the employee's plan year compensation and the time-weighted average of the deferral percentage limits. Thus, for example, if a plan provides that deferrals for highly compensated employees are limited to 8% of compensation during the first half of the year, and 10% of compensation for the second half of the plan year, the plan is permitted to provide that the applicable limit for highly compensated employees is 9% of the employee's plan year compensation.

(f) Catch-Up Contributions' Effect on Plans. Catch-up contributions are not taken into account in applying the 415 or 402(g) limits.

Elective deferrals that are treated as catch-up contributions are disregarded, and thus are subtracted from the participant's elective deferrals for the plan year for purposes of determining the participant's actual deferral ratio ("ADR") or deferral percentage. This subtraction applies without regard to whether the participant is a highly compensated employee.

If a 401(k) plan must take corrective action under Code Section 401(k)(8), the plan must retain any elective deferrals that are treated as catch-up contributions because they exceed the ADP limit. Although these catch-up contributions are not distributed, they are still considered to be excess contributions, so that matching contributions made with respect to the catch-up contributions are permitted to be forfeited.

(g) Top-Heavy and Minimum Coverage Test. Catch-up contributions are not taken into account under the top-heavy rules. But catch-up contributions for prior years are taken into account for purposes of applying Code Section 416 for the current plan year's top-heavy test. A similar rule applies with respect to the application of the Code Section 410(b) minimum coverage test.

(h) Matching Contributions. Employers may provide matching contributions on catch-up contributions by specifying that such contributions will be matched.

(i) Universal Availability. In general, a plan that offers catch-up contributions must provide all eligible participants with the opportunity to make the same dollar amount of catch-up contributions.

The final regulations provide the following exceptions to the universal availability requirement:

(i) Collectively bargained employees do not have to be given the opportunity to make catch-up contributions.

(ii) A cash availability limit, which restricts elective deferrals to amounts available after withholding from the employee's pay (e.g., after deduction of all applicable income and employment taxes), will not violate the universal availability requirement. For this purpose, a limit of 75% of compensation or higher will be treated as limiting employees to amounts available after other withholdings.

(iii) The final regulations broaden the exception to the universal availability requirement during the acquisition or disposition transition period provided in Code Section 410(b)(6)(C). Under the final regulations, an employer plan that satisfies the universal availability requirement before an acquisition or disposition continues to be treated as satisfying the universal availability requirement through the end of the transition period described in Code Section 410(b)(6)(C).

(j) Participants in Multiple Plans. All plans of an employer, other than governmental Section 457 plans, are treated as one plan for purposes of determining the amount of catch-up contributions, and all governmental Section 457 plans of the same employer are treated as one plan for this purpose. However, employer-provided limits apply only to the plan that provides the limit, and the ADP limit applies only to 401(k) plans.

The final regulations allow a plan to permit a catch-up eligible participant to defer an amount in addition to the amount allowed under the employer-provided limit, without regard to whether the employee has already used his catch-up opportunity under another plan of the same employer. However, to the extent elective deferrals under another of the employer's plans have already been treated as catch-up contributions during the tax year, the elective deferrals under the plan may be treated as catch-up contributions only up to the amount remaining under the catch-up limit for the year. Any other elective deferrals that exceed the employer-provided limit may not be treated as catch-up contributions and must satisfy the otherwise applicable nondiscrimination rules. For example, the right to make contributions in excess of the employer-provided limits is an "other right or feature" which must satisfy Regulations Section 1.401(a)(4)-4 to the extent that the contributions are not catch-up contributions. Also, contributions in excess of the employer-provided limit that are not catch-up contributions are taken into account under the ADP test.

3. Vacation Pay Contributions to a Qualified Plan.

In PLR 200311043, the IRS ruled that an employer's vacation pay contributions made on behalf of its employees to its qualified plan do not constitute Section 401(k) cash or deferred elections and are not includible in income for federal income tax purposes or in the employees' gross wages for FICA purposes.

In PLR 200311043, the employer sponsored a defined contribution plan. The plan provided that the employer must contribute for each plan year the value of the employee's unused vacation pay that the employee elected to have contributed to the plan on his behalf for that plan year. The plan defined unused vacation pay as the vacation time that an employee would permanently forfeit if, during the plan year, the employee did not use all of his vacation time or elected to have the paid vacation time that would otherwise have been forfeited contributed to the defined contribution plan on his behalf. Vacation time that was accrued and unused could not be carried over to the next plan year and was forfeited. Additionally, the employee did not have the option of receiving cash in lieu of paid vacation time.

The IRS concluded that, because the employees did not have the option of receiving cash or any other taxable benefit in lieu of the additional employer contributions to the plan, the employees were not in constructive receipt; the employees' choice of options was not a cash or deferred arrangement; and the employer vacation pay benefit contributions would not be includible in the employees' income until they were distributed from the plan. Rather, the IRS stated that the contributions of unused paid vacation time were nonelective employer contributions to a qualified plan, and hence, were excludible from wages for purposes of FICA.

Comment: The employer could deduct the value of the unused vacation time that was contributed to the plan. If such amounts were merely forfeited, the employer would not have the benefit of this deduction. However, contributions of unused vacation time are subject to the nondiscrimination requirements applicable to employer contributions.

I. Prospectus Profile Complies with ERISA Section 404(c)

In an Advisory Opinion, the DOL stated that a defined contribution plan, in which participants self-direct their investments, could meet the requirements of ERISA Section 404(c) by providing participants with summaries of a prospectus, or "profiles," instead of providing a full prospectus. If requested by a participant, however, the plan would still have to provide a copy of the prospectus itself (ERISA Op Letter No 2003-11A).

ERISA Section 404(c) generally shields fiduciaries from claims arising from plan participants' losses where the plan participants themselves exercise control over the investments in their accounts. Among other requirements, Labor Regulation Section 2550.404c-1(b)(2)(i)(B) provides that a participant or beneficiary in a participant-directed plan must have access to sufficient information to make informed decisions with regard to the plan's investment alternatives. The regulations further provide that for any investment alternative that is subject to the Securities Act registration requirements, including mutual funds, a participant must be provided with a copy of the most recent prospectus for that investment that was provided to the plan, either immediately before or after the participant's or beneficiary's initial investment.

In 1998, the Securities and Exchange Commission ("SEC") adopted a rule that allows a dealer to provide a summary prospectus, or "profile," to investors in connection with an offer to purchase or sell mutual fund shares, in lieu of providing a copy of the full prospectus. Under the SEC rule, a profile must include, among other items, an explanation that the profile summarizes key information included in the prospectus; and instructions on how investors can get a copy of the prospectus. In its rule, the SEC stated that investors in participant-directed plans might find a profile useful in evaluating and comparing funds offered as investment alternatives in a plan.

In the facts of the Advisory Opinion letter, the Principal Financial Group ("Principal") provides investment products and administrative services to defined contribution plans. Principal sought the DOL's opinion as to whether it could provide mutual fund profiles, including profiles of its proprietary mutual funds, to participants of Code Section 401(k) plans that are designed to comply with the ERISA Section 404(c) regulations. According to Principal, providing a mutual fund profile would meet the prospectus requirement under the ERISA Section 404(c) regulations, and allow plans to avoid the additional expense of automatically providing a lengthy prospectus to Code Section 401(k) plan participants. Further, Principal stated that it would send the full prospectus to any Code Section 401(k) plan participant or beneficiary who requested it within three days.

According to the DOL, a profile that meets the requirements of the Securities Act would provide participants with the type of information that the DOL intended participants to receive. If, however, the participant specifically requests a prospectus, the most recent full prospectus must be provided.


A. Golden Parachute Proposed Regulations

1. Background.

A "golden parachute" is an arrangement between an employer and an employee providing payments to the employee following a corporate change in ownership or control. Code Section 280G provides that payments in excess of a calculated amount are not tax deductible by the employer. Furthermore, Code Section 4999 imposes on the affected executive a 20% excise tax on excess payments in addition to the ordinary income tax on these payments.

Payments to "disqualified individuals", which are created, vested or accelerated by a change in control, can be designated as "parachute payments." If the aggregate value of the parachute payments equals or exceeds three times a base amount that is related to the executive's earnings for a period, the parachute payments in excess of the base amount will be subject to the deduction disallowance of Section 280G and the excise tax of Section 4999.

In 1989, the IRS issued proposed regulations on golden parachute payments. However, the 1989 regulations did not address the treatment of statutory stock options and needed clarification in other areas. The IRS has issued revised, proposed regulations, which clarify many issues that were raised by the prior proposed regulations.

2. Limiting the Group of Disqualified Persons.

Only "disqualified persons" are subject to the golden parachute excise tax. The new proposed regulations change the definition of a disqualified person. The new definition of disqualified individuals includes employees or independent contractors who are officers, shareholders (who own more than 1% of the fair market value of outstanding shares) or highly compensated.

For purposes of determining who is a disqualified person, a highly compensated individual with respect to a corporation is one who is a member of the group consisting of the lesser of the highest paid 1% or the highest paid 250 employees ranked by pay (including the value of qualified and nonqualified stock options). For purposes of this ranking, a highly compensated disqualified person must earn at least $90,000.

3. Contingent on Change of Control.

A common parachute, found in employment contracts, provides that severance payments will not be made unless there is both a change of control and the dismissal or reduction in duties of the executive within a certain timeframe; this is called a "double trigger" parachute. The proposed regulations clarify that payments made after the occurrence of a double trigger will be treated as parachute payments.

4. Reasonable Compensation.

Payments made by an employer to a disqualified person for services rendered after a change in control would not have to be treated as parachute payments if they are reasonable. The regulations emphasize that payments for services which are the same as those performed prior to the change in control will only be deemed reasonable if the executive's duties have not changed. If the duties have changed, the reasonableness of the payment must be analyzed. Also, payments made pursuant to a covenant not to compete can be reasonable compensation, but only if the covenant substantially constrains the individual's ability to perform services and if there is a reasonable likelihood that the agreement will be enforced.

5. Stock Options.

The revised proposed regulations provide that statutory stock options arising out of an employment relationship are to be included in determining the amount of the parachute payment, and can be measured using the Black-Scholes model or any other method permissible under generally accepted accounting principles. In general, the spread between the stock value upon the change in control and the option's exercise price is often used to determine this value.

B. Revised Rules on Section 457 Plans

In a relatively short period of time, the IRS has issued proposed regulations, a Notice and final regulations concerning Code Section 457 plans.

1. Proposed Regulations.

Code Section 457 allows state and local governmental employers and tax-exempt employers to maintain eligible Section 457(b) or ineligible Section 457(f) deferred compensation plans for their employees. In 1982, the IRS issued final regulations on Section 457 deferred compensation plans. Since then, numerous amendments to Section 457 have been made by the Tax Reform Act of 1986, the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Job Creation and Worker Assistance Act of 2002. The proposed regulations reflect these changes.

(a) 457(b) Plans. An eligible Section 457(b) plan must be established in writing, include all the material terms for benefits under the plan, and must be operated in compliance with regulatory requirements.

Annual deferrals under an eligible Section 457(b) plan include voluntary salary reductions, mandatory employee contributions, nonelective employer contributions, employer matching contributions and all earnings thereon. In general, deferral contributions to Section 457(b) plans will be taken into account for taxation purposes together with earnings in the year in which distribution occurs.

An agreement to defer compensation is valid if it is made before the first day of the month in which compensation is paid or made available. In the case of new hires, an agreement that is entered into on the date of employment is valid on that date and effective for compensation earned thereafter. In addition, an eligible plan may provide that an agreement to make deferrals will remain in effect until the participant revokes or alters the terms of the agreement.

Under a Section 457(b) plan of a tax-exempt organization, a terminated participant or beneficiary may be permitted to make a second election, in addition to an initial election, to further defer receipt of benefits. However, the subsequent election must provide for a payment date that is later than the original payment date. In any event, the payment date may not violate the plan's provisions on required minimum distributions.

EGTRRA increased the maximum amount of deferrals that participants may contribute to an eligible Section 457(b) plan. In 2003, the limit or plan ceiling is the lesser of 100% of compensation or $12,000. The dollar amount increases annually in $1,000 increments until it reaches $15,000 in 2006. Thereafter, it will be adjusted for inflation. This brings the plan ceiling for Section 457(b) plans in line with maximum deferral limits under Section 401(k) and Section 403(b) plans.

Similar to qualified defined contribution plans and Section 403(b) plans that permit elective deferrals, eligible Section 457(b) deferred compensation plans of state and local governmental employers may permit participants aged 50 and older to make catch-up contributions.

In addition to the availability of the aged 50 catch-up contributions, Section 457(b) plans may permit participants to make a larger special catch-up contribution in the last three years ending before reaching their normal retirement age. The special catch-up contribution is the lesser of twice the basic annual limit or the basic annual limit plus the amount by which a participant has deferred less than the maximum in all prior years (i.e., the underutilized amount).

Beginning in 2002, EGTRRA made it possible for recipients of distributions from qualified plans, Section 403(b) plans and IRAs to roll over the distribution to an eligible Section 457(b) governmental plan that accepts such distributions and maintains the amounts in a separate account. The proposed regulations make it clear that rollovers will not be counted as annual deferrals for maximum deferral purposes under the eligible Section 457(b) plan but they will be counted as deferrals for payout purposes.

EGTRRA repealed the special minimum distribution rules applicable to eligible Section 457(b) plans. The regulations make reference to the Section 401(a)(9) required minimum distribution rules applicable to defined contribution plans which now apply to eligible Section 457(b) plans.

The Small Business Job Protection Act of 1996 created Section 457(g) which provides that eligible Section 457(b) plans maintained by state and local governmental employers must hold plan assets in a trust for the exclusive benefit of participants and beneficiaries. This requirement does not apply to eligible Section 457(b) plans of tax-exempt employers.

(b) Section 457(f) Plans. The proposed regulations provide limited yet significant guidance with respect to ineligible Section 457(f) plans. Section 457(f) provides that deferred compensation is includible in gross income when deferred or, if later, when the right to payment of the deferred compensation ceases to be subject to a substantial risk of forfeiture. According to the proposed regulations, Section 457(f) does not apply to the portion of any plan that consists of a transfer of property described in Code Section 83. Code Section 83 applies (and not Section 457(f)) if on the date property is transferred, there is no risk of forfeiture with respect to compensation deferred under the arrangement. Under Section 83 rules, property is subject to taxation when there is no longer a substantial risk of forfeiture (e.g., on the vesting date). On the other hand, Section 457(f) applies if the date on which there is no substantial risk of forfeiture precedes the date on which there is a transfer of property. For example, if under a plan, an employee is vested before the date the property (e.g., options) is transferred, Section 457(f) applies and the options are immediately taxable. If the vesting of options occurs after the date of grant, Section 83 applies and the options are taxable once the risk of forfeiture lapses.

Comment: This rule effectively ends option programs because the value of the options is includible in income once vested and will be taxed based on the excess of the options' fair market value over the amount, if any, paid for the options.

2. Notice 2003-20.

IRS Notice 2003-20 describes the withholding and reporting requirements applicable to 457(b) plans. The guidance addresses: (i) income tax withholding and reporting for annual deferrals made to 457(b) plans; (ii) income tax withholding and reporting for distributions from 457(b) plans; and (iii) Federal Insurance Contributions Act ("FICA") payment and reporting for annual deferrals.

Prior to EGTRRA, amounts deferred in 457(b) plans were included in income only for the tax year in which the amounts were paid or when the amounts were "otherwise made available" to the participant or other beneficiary. When taxable, annual deferrals were treated as wages for income tax withholding.

Post-EGTRRA, amounts deferred in governmental 457(b) plans are included in income only when the amounts are actually paid to the employee. However, the old rule remains unchanged for 457(b) plans sponsored by tax-exempt organizations, in which case deferred compensation is included in a participant's income when paid or made available.

For both governmental and tax-exempt 457(b) plans, annual deferrals are subject to FICA taxes to the extent the deferrals are vested.

Distributions from a 457(b) plan are treated differently depending on whether the plan is a governmental plan or a tax-exempt employer's plan. Distributions from a governmental 457(b) plan are subject to the income tax withholding rules applicable to qualified plans. Thus, the direct rollover and mandatory 20 percent withholding rules are extended to governmental 457(b) plan distributions that qualify as eligible rollover distributions. Distributions from a tax-exempt employer's 457(b) plan are subject to the income tax withholding rules applicable to the payment of wages.

3. Final Regulations.

The final regulations are substantially similar to the proposed regulations discussed above, with the following additional guidance:

(a) The self-correction provision for excess deferrals, under which an eligible governmental plan may self-correct and distribute excess deferrals and still satisfy Code Section 457(b) eligibility requirements, has been extended to eligible plans of tax-exempt employers. However, if an excess deferral is not corrected by distribution, the plan is ineligible and benefits are taxable in accordance with the ineligible plan rules; and

(b) An eligible plan may permit participants to elect to defer compensation only if an agreement that so provides is entered into before the beginning of the month in which the amounts would otherwise be paid or made available and the participant is an employee in that month. However, an election may be made for not-yet payable sick pay, vacation pay, or back pay for retiring or otherwise terminating employees.

C. Split-Dollar Regulations Finalized

On September 17, 2003, the IRS finalized regulations it had proposed regarding split-dollar life insurance arrangements. The regulations broadly define a split-dollar life insurance arrangement as any arrangement (that is not part of a group term insurance plan) between an owner of a life insurance contract and a nonowner under which either party pays directly or indirectly all or part of the premiums where the party paying the premiums is entitled to receive repayment of all or a portion of those premiums from the proceeds of the policy.

The regulations provide rules for determining the identity of the "owner" and the "nonowner" of the contract in a split-dollar arrangement. The owner is generally the person named as the policy owner. However, in situations in which the only benefit available under the split-dollar arrangement would be the value of current life insurance protection (that is, so-called nonequity arrangements), either the employer in a compensatory arrangement or the donor in a private split-dollar arrangement is treated as the owner of the contract. The nonowner is any person other than the owner having any direct or indirect interest in the contract.

The regulations provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements: the economic benefit regime and the loan regime.

1. Economic Benefit Regime.

Under the economic benefit regime, an owner is treated as providing economic benefits to a nonowner. The economic benefit regime will govern the taxation of traditional endorsement arrangements, any arrangements entered into for the performance of services where the employee is not the owner, and private split-dollar arrangements where the donor is deemed to own the policy.

In a plan subject to the economic benefit regime, the nonowner must report the value of the economic benefit the owner is providing. The value of the economic benefit, reduced by any consideration paid by the nonowner to the owner, is treated as transferred from the owner to the nonowner. The tax consequences of that transfer will depend on the relationship between the owner and the nonowner and thus may constitute compensation to an employee, a dividend to a shareholder, or a gift to a donee or trust.

The value of the economic benefit provided to the nonowner is the cost of any current life insurance protection, the amount of cash surrender value to which the nonowner has "current access," and the value of any other economic benefits provided. The latter two values are included only to the extent not taken into account in a prior taxable year. The regulations provide that the nonowner has "current access" to any portion of the cash value that is: (i) directly or indirectly accessible to the nonowner; (ii) inaccessible to the owner; and (iii) inaccessible to the owner's general creditors.

For this purpose, access includes any right to obtain, use, or realize potential economic value from the policy cash value (e.g., through a withdrawal, loan or surrender of the policy). The right to anticipate, assign, alienate, pledge, or encumber the cash value would also evidence accessibility.

Comment: On May 9, 2003, the Internal Revenue Service issued proposed regulations relating to the valuation of economic benefits under certain endorsement, equity split-dollar life insurance arrangements. These proposed regulations provided that a nonowner would, in certain situations, be currently taxed on the cash surrender value of a split-dollar life insurance policy even though the nonowner's right to borrow or withdraw the policy cash value did not exist until some time in the future, e.g., when the split-dollar life insurance arrangement terminated. Generally, taxing an individual currently on funds not currently available or accessible is contrary to longstanding principles of income taxation. As a result of the efforts of The Wagner Law Group, the Internal Revenue Service reversed its position. As discussed above, final regulations issued in September 2003 now provide that a nonowner will be currently taxed on the cash surrender value of an endorsement, equity split-dollar life insurance policy if, in general, the nonowner may currently borrow or withdraw the policy cash value.

2. Loan Regime.

The loan regime governs the taxation of collateral assignment compensatory arrangements or those private split-dollar arrangements designed so that the donor is not treated as the owner of the contract. Under the loan regime, the nonowner is treated as lending premium payments to the owner.

A payment made pursuant to a split-dollar arrangement is a split-dollar loan and the owner and nonowner are treated, respectively, as borrower and lender if: (i) the payment is made either directly or indirectly by the nonowner to the owner; (ii) the payment is a loan under general principles of federal tax law or, if not, a reasonable person would expect the payment to be repaid in full to the nonowner (with or without interest); and (iii) the repayment is to be made from, or is secured by, either the policy's death benefit proceeds or its cash surrender value.

The loan can be structured as either a demand loan or a term loan. If there is no interest charged on the loan, or if the interest is charged at a rate that is less than the appropriate applicable federal rate ("AFR"), Code Section 7872 applies. Under Section 7872, to the extent that the interest rate actually charged is less than the AFR, the difference is compensation income, dividend or gift, as the case may be.

Where the policy is owned by a third party such as an employee's irrevocable life insurance trust and the employer is lending the premiums, the transaction is deemed to comprise two loans. The first is a compensation-related loan between the employer and the employee, and the second is a gift loan between the employee and the third party (i.e., the trust).


A. Background

In July 2002, President Bush signed into law the "Sarbanes-Oxley Act of 2002" ("SOX"), which adopts provisions designed to deter and punish corporate and accounting fraud and corruption, and protect the interests of workers and shareholders.

SOX was in response to public outrage concerning the highly-publicized corporate scandals of the early 2000's, where plan participants lost vast sums of their retirement savings, while corporate insiders effectively looted their companies with the tacit acquiescence of companies' consultants, brokers, accountants and attorneys. SOX is intended to close that devastating chapter in corporate "governance". In doing so, SOX directly affects retirement plans and executive compensation.

B. DOL Final Regulations

1. Blackout Period.

The blackout period rules are intended to inform plan participants when they will not be able to access their retirement accounts; this is a significant issue in the Enron case where plan participants were not permitted to trade their employer stock due to a blackout period, just as the Enron stock plummeted in value.

The DOL regulations define a blackout period under a defined contribution plan as any period that lasts for more than three (3) consecutive business days during which normal plan transactions (e.g., loan requests, fund transfers) are restricted or suspended.

A blackout period does not include a suspension, limitation or restriction under a defined contribution plan that: (i) occurs by reason of the application of SEC rules; (ii) is a regularly scheduled suspension, limitation or restriction under the plan which is disclosed to affected participants and beneficiaries through a summary of material changes or other communication regarding plan investments; and (iii) applies only to an individual who is an alternate payee under a qualified domestic relations order.

2. Timing of Advance Notification.

Plan administrators must notify all affected plan participants and beneficiaries that their rights to enter into a plan transaction will be restricted during a blackout period. The notice must be provided at least 30 days and not more than 60 days before the last day that a right will be restricted.

The examples in the regulations indicate that a plan administrator must count back from the last day that affected participants and beneficiaries may engage in plan transactions to determine the start of a blackout period. In counting back from the last day of permissible transactions, all calendar days are taken into account (not just business days). The DOL regulations do not preclude an employer from providing a notification earlier than 60 days in advance of a blackout period, provided another notice that meets the 30/60 day rule also is distributed to affected participants and beneficiaries.

3. Content of Advance Notification.

The notice must be written in a manner calculated to be understood by the average plan participant and must include the reasons for the blackout period (e.g., changing recordkeepers), a description of the rights that will be temporarily restricted during the blackout period, the expected beginning and ending dates of the blackout period or a reference to the calendar weeks in which the blackout period is expected to begin and end. Also, the name, address and telephone number of the person responsible for answering questions about the blackout period must be included. Furthermore, a statement must be included advising participants and beneficiaries to evaluate the appropriateness of their investment decisions in light of their inability to direct or diversify their assets during the blackout period.

4. Exceptions to 30-Day Advance Notification Period.

The 30-day advance notice requirement may be waived if the plan administrator cannot provide the notice in that time period due to unforeseen circumstances or circumstances beyond its control. Also, the 30-day notice requirement does not have to be met if it would violate ERISA fiduciary requirements or if the only participants affected are those involved in a corporate transaction (e.g., merger). In such a situation, the notice must be distributed as soon as reasonably possible. The delayed notice must include a statement indicating that federal law requires a 30-day advance notice and the reasons why this period could not be met. Also, the plan fiduciary must sign and date the statement if the failure to give 30 days' advance notification is due to unforeseen circumstances or to a potential ERISA fiduciary violation.

5. Timing.

A blackout notice will be considered delivered on the date of mailing if sent by first class mail, certified mail or express mail. Further, it will be treated as delivered on the date it is transmitted to a private delivery service or on the date of transmission of an electronic communication.

If there is a change in the dates or length of the blackout period, the plan administrator must provide all affected participants and beneficiaries with an updated notice that explains the reason(s) for the change and identifies all material changes from the prior notice.

6. Model Notice.

As required by SOX, the DOL has included a model notice with its regulations that may be used to satisfy the blackout period notification requirements.

7. Penalties.

ERISA was amended by SOX to permit a penalty of up to a $100 per day per participant for failure to provide an advance notice. According to the DOL regulations, if more than one person is responsible for providing the notice, liability for the failure will be joint and several. Also, ERISA's criminal penalties for willful violations of its reporting and disclosure requirements (e.g., SPDs, SMMs, SARs, blackout period notices) have been increased from $5,000 and one-year imprisonment to $100,000 and 10-year imprisonment for individuals, and from $100,000 to $500,000 for corporations.

C. SEC Final Regulations

As required by SOX, the SEC issued final regulations on the insider blackout trading restrictions.

1. Prohibited Trading Transactions.

According to SOX, it is unlawful for a director or executive officer of a publicly-held company to directly or indirectly purchase, sell, acquire or transfer any securities of the issuer during a plan blackout period, if the director or executive officer acquired the securities in connection with his service as a director or executive officer.

Under the SEC final rules, the trading prohibition would apply to any equity security, including derivatives of the issuer. The rules would apply to direct and indirect transactions in which the officer or director has a "pecuniary interest". However, the final rules exempt: (i) acquisitions of equity securities under dividend or interest reinvestment plans; (ii) transactions that satisfy affirmative defense conditions of the Securities Exchange Act of 1934 (the "'34 Act"); (iii) purchases or sales of equity securities pursuant to certain employee benefit plans that meet the requirements for exemption from the insider trading rules under Section 16(b) of the '34 Act; and (iv) transactions resulting from a stock split, dividend or pro rata rights distribution.

2. SEC Blackout Period.

The SEC final rules coordinate with the DOL rules on SOX's advance notification of blackout periods under defined contribution plans. However, the SEC rules are triggered when the following two conditions are met: (i) a blackout period under a defined contribution plan that holds (or could hold) employer securities lasts for more than three consecutive business days; and (ii) at least 50% of the rank and file participants or beneficiaries under all defined contribution plans maintained by the employer on a controlled group basis are prohibited from engaging in transactions with respect to employer securities held in their accounts during the blackout period.

SOX exempts two categories of suspension periods from the SEC definition of a blackout period: (i) a regularly scheduled period during which participants and beneficiaries cannot purchase, sell, acquire, transfer, etc. any employer security, provided the period is incorporated into the plan and is timely disclosed to the participants, and (ii) any period during which plan transactions are suspended to accommodate the enrollment or disenrollment of individuals following a merger or similar transaction.

3. SEC Insiders.

SOX defines insiders as directors and executive officers. Under the '34 Act, executive officers include a company president, any vice president in charge of a principal business unit, division or function, any other officer who performs a policymaking function, or any other person who performs similar policymaking functions for the corporation.

4. Penalties for Noncompliance.

According to SOX, a violation of the blackout trading restrictions subjects the employer to possible enforcement action by the SEC. In addition, the employer or a shareholder may sue to recover any profit realized by a director or executive officer during a blackout period.

The SEC final regulations provide that violations of the statutory trading prohibition during a blackout period are subject to possible civil injunctive actions, cease-and-desist proceedings, civil penalties and any other remedy available to the SEC. Under certain circumstances, a director or executive officer also could be subject to criminal penalties.

5. Notice to Executives and Directors.

SOX requires publicly-held employers to timely notify their directors and executive officers of the imposition of any blackout period which will trigger the trading prohibitions.

The final SEC rules set forth the content requirements for the notice to corporate insiders. The notice must include: (i) the reason(s) for the blackout period; (ii) a description of plan transactions that will be suspended during the blackout period; (iii) a description of the class of equities subject to the blackout period; (iv) the actual or expected beginning and ending dates of the blackout period (or reference to the calendar weeks the blackout period is expected to begin and end); (v) the name, address and telephone number of a designated individual responsible for inquiries concerning the blackout period (or in the absence of such a designee, the issuer's human resources director or person who performs equivalent functions).

In general, the employer or issuer must provide a notice to its directors and officers at least 15 calendar days before the actual or expected beginning date of the blackout period. However, in the event of unforeseen circumstances or circumstances beyond the control of the employer, such as a major computer or other technical failure, it may not be possible to meet the 15-day advance requirement. The SEC rules provide that an employer in these circumstances would be excused if the employer makes a written determination indicating that circumstances preclude compliance with the 15-day rule and that directors and executive officers will be notified as soon as reasonably practicable.

6. Notice to SEC.

SOX requires that the publicly-held company notify the SEC, as well as directors and executive officers, of impending blackout periods. According to the final rules, the notice to the SEC is to be reported on Form 8-K on the same day notice of the blackout period is transmitted to directors and officers.

D. Executive Compensation Aspects of the Sarbanes-Oxley Act

1. Background.

This section describes some of the provisions of SOX that have the most direct impact on executive compensation paid by publicly-traded companies:

(a) SOX Section 403, Disclosures of Transactions Involving Management and Principal Stockholders (new two-day reporting requirement under Section 16 of the '34 Act);

(b) SOX Section 402, Enhanced Conflict of Interest Provisions (the prohibition on personal loans to directors and executive officers); and

(c) SOX Section 304, Forfeiture of Certain Bonuses and Profits (disgorgement triggered by restatements of financial reports).

2. SOX Section 403; Disclosures of Transactions.

SOX Section 403 amended Section 16(a) of the '34 Act to require reports of changes in ownership or purchases and sales of company securities or security-based swap agreements (Form 4):

(a) to be filed before the end of the second business day following the day on which the transaction is executed, unless the SEC determines that two-day reporting is "not feasible," and

(b) to be filed electronically and be available on company web sites no later than July 30, 2003.

Historically, the reporting and short-swing profit rules under Section 16 of the '34 Act required non-exempt purchases and sales to be reported on Form 4 on or before the 10th day following the close of the calendar month in which the transactions occurred. Most exempt transactions were reportable on Form 5 on or before the 45th day after the end of the fiscal year.

Section 403 of SOX and the SEC's revised Section 16 rules now require virtually all Forms 4 to be filed within two business days following the transaction and require Form 4 reporting for certain exempt transactions previously eligible for year-end reporting on Form 5.

3. SOX Section 402; Enhanced Conflict of Interest Provisions.

SOX Section 402 prohibits any issuer from directly or indirectly extending, maintaining, arranging or renewing a personal loan to or for a director or executive officer.

Under SOX, public companies are prohibited from directly lending or co-signing or otherwise guaranteeing or providing security for an insider's personal loan. But other common practices may or may not be prohibited, including such things as selecting a lending institution for an insider, making salary advances, awarding bonuses that are repayable in certain circumstances, using company funds to advance an insider's tax withholding obligations, certain broker-assisted cashless stock option exercises, and even advancement of litigation expenses.

(a) Cashless Exercise Programs. Many stock option arrangements provide for the exercise of an option through a broker-assisted cashless exercise. In a typical arrangement, the broker, upon receipt of exercise instructions, will sell a sufficient number of shares to remit the exercise price and applicable tax withholding amounts to the company, with the remaining shares or sales proceeds being delivered to the optionee (less applicable commissions).

If the broker pays the company the exercise price on the date of the exercise but does not receive the proceeds of the stock sale until the settlement date (typically on the third day following business day, or T+3), the company may be considered to have "arranged for" the broker's margin loan to the insider, particularly if the company required or encouraged the optionee to use that particular broker to effect the cashless exercise. Or, if the company releases the shares to the broker upon exercise but does not receive payment until the T+3 settlement date, the company may be considered to have provided a short-term loan of the shares to or for the insider. In either event, a potential Section 402 problem exists.

(b) Split-Dollar Life Insurance. As discussed in Part IV.C. of this Newsletter, split-dollar life insurance is generally a life insurance policy in which some of the ownership rights are divided between two or more parties. Under the recently finalized IRS regulations, the tax treatment of split-dollar arrangement depends on how they are structured (i.e., as collateral assignment or endorsement arrangements).

In a collateral assignment arrangement, the insured (typically the employee) owns the policy and has rights to the death benefit and potentially the cash-surrender value. Another party (typically the employer) pays the premiums, subject to a right to be reimbursed later from the policy proceeds. The policy is assigned to the employer as collateral for the repayment obligation. The employer essentially loans the premiums to the employee/owner of the policy. A collateral assignment policy is taxed as a loan under the finalized IRS regulations. Employer premium payments on an insider collateral assignment policy are prohibited under Section 402.

(c) 401(k) Plan Loans. Concern has been expressed as to whether Section 402 prohibits 401(k) plan loans to directors and executive officers.

A bona fide loan from a tax-qualified plan appears to be outside the scope of the intent of SOX for several reasons. First, a plan loan is adequately secured. Second, the principal amount of a plan loan cannot exceed $50,000. Third, a default of any such loan will not result in adverse consequences to shareholders. Fourth, the decision to permit a loan from a tax-qualified plan to an officer does not create a conflict of interest.

Nevertheless, based on the plain reading of the statute, it appears that plan loans are prohibited under SOX. That is, absent SEC guidance to the contrary, a plan loan constitutes an indirect extension of credit. Moreover, in Field Assistance Bulletin 2003-1, the DOL provided relief for fiduciaries of pension plans that deny officer loans on the basis of SOX, which relief was provided "in view of the uncertainty concerning the scope of Section 13(k) of the ['34 Act]." Although the DOL does not have rulemaking or interpretive authority under SOX, this pronouncement underscores the uncertainty surrounding the issue.

Comment: In light of the above, conservatively, employers should consider prohibiting loans from their tax-qualified plans to officers, pending further guidance.

4. SOX Section 304; Forfeiture of Certain Bonuses and Profits.

SOX Section 304 requires that if misconduct results in material non-compliance with SEC financial reporting requirements, and as a result of such non-compliance the company is required to restate its financial statements, then the Chief Executive Officer and Chief Financial Officer must disgorge: (i) any bonuses or other incentive-based or equity-based compensation that they received during the 12-month period following the first public issuance or filing (whichever is earlier) of a financial document embodying such financial reporting requirement, and (ii) profits on the sale of company securities during such 12-month period.

E. Independence Rules

SOX amended the SEC's criteria for ensuring that an auditor of a publicly-held company conducts an audit in an unbiased, independent manner.

The final SEC rules provide guidance on the nine nonaudit services that auditors may not provide to their clients that are publicly-held companies:

(i) bookkeeping or other services related to accounting records or financial statements;
(ii) financial information systems design and implementation consulting services;
(iii) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
(iv) actuarial services;
(v) internal audit services;
(vi) management or human resources functions;
(vii) broker, dealer, investment adviser or investment banking services;
(viii) legal services and expert services unrelated to the auditing service; and
(ix) any other service that the oversight board determines by regulation is impermissible.

According to the preamble to the final regulations, the prohibition on providing the enumerated nonaudit services is premised on the following three principles that could impair an auditor's impartiality. An auditor should not: (i) audit his or her own work, (ii) function as part of management or as an employee of the audit client, or (iii) act as an advocate for the audit client.

F. Registered Public Accounting Firms

SOX created "registered public accounting firms," that is, accounting firms that must register with and pay fees to the public accounting oversight board. Companies listed on a stock exchange will also pay fees to the oversight board. This will create for the first time a board that is not dependent on the auditors it is policing for its funding. Registration with the board is necessary in order for an accounting firm to prepare, issue or participate in the preparation or issuance of any audit report for a publicly-held company. Once registered, accounting firms will have to file periodic reports with the oversight board that, among other things, list the names of all their audit clients, the annual fees received for audit services and the names of accountants performing the audits. These reports will be available for public inspection.

A public company's audit committee must preapprove audit and non-audit services that are provided by a registered public accounting firm. Thus, audit committees of public firms will be responsible for approving or selecting the company's auditor. This is a departure from the common practice of CEOs selecting and engaging a corporation's accountants.

G. Enron and Similar Pension Litigation

A federal judge, U.S. District Judge Melinda Harmon in Houston, Texas, ruled that former Enron Chairman Kenneth Lay and Northern Trust Corp., trustee of Enron's 401(k) plan, can be sued under ERISA for failing to protect Enron employees. The ruling said Mr. Lay and Northern Trust, along with others who oversaw Enron's retirement programs, had a responsibility to ensure that the plan's investments were prudent. This responsibility extended to decisions about how much Enron stock employees held in their retirement accounts.

The Enron lawsuits, which have been consolidated, accuse the company, Mr. Lay, other Enron executives, the retirement plan administrators, Northern Trust and others of misleading Enron employees by encouraging and in some cases requiring them to hold Enron stock in their retirement accounts, at a time when the stock price plummeted from an artificially inflated level.

Comment: Plan fiduciaries should be cautious when dealing with employer stock in pension plans, as ERISA provides for personal, civil and criminal liability in certain cases of fiduciary breach.

The Enron litigation is discussed in more detail in Section I.M. of this Newsletter.


A. Open Enrollment Issues

For many employers, open enrollment periods are very stressful and can be legally problematic. Materials need to be developed and employee meetings designed that accurately and succinctly describe the benefits program. Unfortunately, problems can arise if communication materials and election forms are not carefully drafted.

Misunderstandings contribute to poor morale and in some cases lead to litigation and liability. Accurate communication materials are an essential component of any open enrollment. They can also help reduce administrative costs as less time is spent explaining changes or re-entering election forms completed incorrectly.

Comment: The Wagner Law Group can review a company's open enrollment materials to ensure that they are accurate, legally compliant and user friendly. Our staff may help prepare materials for, or help facilitate, employee meetings to explain benefit plan changes or the impact of recent regulations like HIPAA that impact how a plan functions. We can also act as a resource for benefits administrators.

B. IRS Overhauls Welfare Benefit Fund Rules to Curb Deduction Abuse

1. Background.

The IRS has tightened the rules for welfare benefit funds to combat their use as tax avoidance devices. In 2002, the IRS announced that it would revisit the rules governing multiple employer welfare plans. Welfare benefit funds typically provide bundled benefits such as life insurance, health insurance, severance benefits, and child care. The recently issued final regulations seek to preserve Congress' intent that employers who contribute to 10-or-more employer plans have no incentive to over-contribute.

In 1984, Congress limited the amount of deductions an employer may claim for contributions to a welfare benefit fund. Congress, however, made an exception for a welfare benefit fund that is part of a plan to which 10 or more employers contribute. Code Section 419A(f)(6) provides that the myriad deduction limits for welfare benefit funds under Sections 419 and 419A do not apply to welfare benefit funds that are part of a 10-or-more employer plan, to which, by definition, more than one employer contributes without any one employer contributing more than 10 percent of total contributions. However, there is an exception to the exception: if a 10-or-more employer plan maintains experience-rating arrangements with respect to individual employers, then it does not qualify for the exception and it is subject to general limits on employer deductions discussed in the first sentence of this paragraph. This is because, according to the IRS, experience-rating arrangements encourage excess contributions.

The factors disqualifying a plan from being treated as a 10-or-more employer plan because the plan provides experience rating for each participating employer include:

(i) assets allocated among participating employers through a separate accounting of contributions and expenditures for individual employees;

(ii) amounts charged under the plan differing among employers in a manner not reflective of differences in risk or rating factors commonly taken into account in manual rates used by insurers;

(iii) an absence of fixed welfare benefits for a fixed coverage period for a fixed price;

(iv) the plan charges participating employers an unreasonably high amount for covered risk; and

(v) payment of benefits triggered upon events other than illness, personal injury, death, or the employee's involuntary termination.

Comment: A disqualifying experience-rating arrangement under the new regulations is one that skews the economics of excess payments to insulate an employer to a significant extent from the experience of other participating employers.

C. COBRA Issues

1. DOL Issues Proposed Rules for Six COBRA Notices.

The DOL recently issued proposed rules concerning notification requirements under the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"). The proposed rules provide standards regarding the timing and content of notices relating to the implementation of COBRA for health plans. The rules address the four separate written notices already required by COBRA, and provide models for single employers for the initial notice and qualifying event notice. In addition, the proposed rules add two new written notice requirements: a notice of the unavailability of continuation coverage and a notice of the termination of continuation coverage.

The DOL recently stated that it intends to publish a final rule soon that will be effective six months after its adoption of final rules. In the meantime, the DOL states that plans are required to operate in good faith compliance with a reasonable interpretation of the COBRA notice rules.

(a) Initial Notice of COBRA Rights. Under the proposed regulations, the initial notice describing COBRA rights to employees and their covered spouses must be provided within 90 days of the date health coverage begins. The proposed regulations permit the plan to send a single initial COBRA notice addressed to both the covered employee and the employee's spouse at their place of residence if: (i) the most recent information available to the plan indicates that the covered employee and spouse reside at the same address; (ii) the spouse's coverage begins at the same time as that of the employee, or begins no more than 90 days after the employee's coverage begins.

The proposed regulations permit a plan to satisfy the initial notice requirement by including the required information in a summary plan description.

Comment: In light of the proposed rule giving a plan 90 days from the commencement of coverage in which to provide the initial COBRA notice (which is the same timeframe for furnishing a summary plan description to a participant), employers may choose to incorporate the notice in the SPD rather than provide a separate initial COBRA notice. However, there are some significant drawbacks to using an SPD when the covered employee is married. Because hand-delivery of an SPD to the covered employee will not satisfy the requirements with respect to the spouse, the SPD would have to be delivered to their residence.

The proposed regulations set out specific content requirements for the initial COBRA notices, including: (i) an explanation of a qualified beneficiary's obligation to notify the administrator of divorce, legal separation or loss of dependent status under the terms of the plan, including the plan's procedures for providing the notification; (ii) an explanation of a qualified beneficiary's obligation to notify the administrator of a second qualifying event that results in an extension of the maximum coverage period, including the plan's procedures for providing the notification; (iii) an explanation of the importance of keeping the administrator informed of the current addresses of all individuals who may become qualified beneficiaries; and if the notice is not being furnished through an SPD, a statement that the notice does not fully describe COBRA coverage or other rights under the plan and that more complete information is available from the plan administrator or in the SPD.

The proposed regulations contain a model initial COBRA notice that includes all of the new content requirements. The use of the model notice is not mandatory, but if used should be tailored to each employer's health plan arrangement.

(b) Employer Notice of Qualifying Events. An employer must notify the plan administrator of qualifying events involving an employee's termination of employment or reduction in hours, the employee's death, the employee's enrollment in Medicare or, in the case of a retiree, the commencement of the employer's bankruptcy proceedings. This notice must be provided within 30 days of the qualifying event, or if the plan provides that the maximum period of coverage begins on the date coverage is lost, notice may be provided within 30 days of the loss of coverage.

(c) Notice of Qualifying Event by Covered Employee or Qualified Beneficiary. A covered employee or qualified beneficiary is responsible for providing the plan administrator with the following notices: (i) notice of the initial qualifying events of divorce or legal separation of the employee from his or her spouse or a dependent's loss of eligibility status under the plan; (ii) notice of a second qualifying event that will extend the maximum COBRA coverage period from 18 months (or 29 months) to 36 months; (iii) notice of a determination of disability by the Social Security Administration that will extend the maximum COBRA coverage period from 18 months to 29 months; and (iv) notice of a determination that a qualified beneficiary who qualified for a disability extension is no longer disabled.

The COBRA statute prescribes time limits for providing these notices. The proposed regulations make it clear that these time limits are minimums and that a plan may establish more liberal notice requirements. The proposed regulations provide that a plan may enforce any deadlines for submitting notices only if such deadlines are previously communicated.

Under the proposed regulations, the qualified beneficiary must notify the plan administrator of an initial or second qualifying event no later than 60 days after the later of: (i) the date of the qualifying event; (ii) if the plan provides that the maximum period of coverage begins on the date coverage is lost, the date of the loss of coverage; and (iii) the date on which the qualified beneficiary is provided with a COBRA notice that describes the obligation to provide the notice and the procedures for doing so.

Similar rules apply with respect to disability determinations. A plan may require a qualified beneficiary to provide notice of disability within 60 days of the date of the Social Security Administration determination (and during the first 18 months of COBRA coverage). It may also require the qualified beneficiary to provide notice that he or she is no longer disabled within 30 days of the date of that determination.

(d) Notice Requirements for Plan Administrators. Plan administrators are subject to several notice requirements. The proposed regulations state that these notices may be provided in any manner consistent with the ERISA rules for furnishing notices, including the rules regarding electronic media. They also clarify that a single notice may be used for a covered employee and spouse if plan information indicates that they both live at the same address. Further, a notice may be furnished to a covered dependent by sending it to the covered employee or the covered employee's spouse if plan information indicates that the dependent resides at the same location as the individual receiving notice.

The plan administrator must provide qualified beneficiaries with notice of their right to elect COBRA continuation coverage within 14 days of receiving the notice of a qualifying event. The new rules clarify that a plan administrator who is also the employer has 44 days after a qualifying event in which to provide this notice. (This 44-day period represents the 30-day period that an employer has to notify the plan administrator of a qualifying event and the 14-day period for notifying qualified beneficiaries of their COBRA rights.) If the plan provides that the COBRA coverage period begins on the date of the loss of coverage, the 44-day period runs from the date of the loss of coverage.

The proposed regulations contain new content requirements for the COBRA election notice including:

(i) an explanation of the consequences of failing to elect or waiving COBRA coverage and a description of the procedures for revoking a waiver of coverage;

(ii) if the initial COBRA coverage period is 18 months, a description of the plan's requirements regarding notice of a second qualifying event or disability determination by the Social Security Administration;

(iii) an explanation of the responsibility to notify the plan that a disabled qualified beneficiary is no longer disabled;

(iv) a description of any other opportunity under the plan to obtain health coverage;

(v) an explanation of the importance of keeping the administrator informed of the current addresses of all individuals who are or may become qualified beneficiaries;

(vi) if the notice is not being furnished through an SPD, a statement that the notice does not fully describe COBRA coverage or other rights under the plan and that more complete information is available in the SPD or from the plan administrator; and

(vii) the availability of a second election period if the qualified beneficiary may be eligible for the tax credit under the Trade Act of 2002 (see paragraph (e) immediately below).

The proposed regulations impose a new notice requirement on plan administrators. Under the new rule, a plan administrator who receives notice of a qualifying event from an individual ineligible for COBRA coverage should notify that individual that COBRA coverage will not be offered. The notice must be provided within 14 days of the date notice of the qualifying event is received and must explain the reasons why the individual is not entitled to coverage.

Plan administrators will also be required to notify qualified beneficiaries when their COBRA coverage will terminate before the end of the applicable maximum coverage period due to non-payment of premiums, Medicare enrollment, other group coverage or any other reason. The notice must (i) be provided as soon as administratively practicable after the termination decision is made, (ii) explain why and when the continuation coverage will terminate, and (iii) describe any rights to other coverage that the affected qualified beneficiaries may have. The proposed regulations provide that this notice may be furnished with the certificate of creditable coverage.

(e) Rights Under the Trade Act of 2002. The Trade Act of 2002 amended COBRA to create a second 60-day COBRA election period for certain individuals who become eligible for trade adjustment assistance.

Comment: In the preamble to the proposed regulations, the DOL commented that information on the possible availability of a new second election period should be included in a group health plan's SPD as part of the discussion about COBRA continuation of health coverage. Virtually every group health plan SPD will have to be revised to include this information.

2. Divorced Spouse's COBRA Coverage Must be Available on the Date of the Divorce.

In Revenue Ruling 2002-88 the IRS states that if an employee eliminates the coverage of the employee's spouse under a group health plan in anticipation of divorce, the plan must nonetheless make COBRA coverage available as of the date of the divorce.

An individual generally is a qualified beneficiary if the individual is covered under a group health plan on the day before a qualifying event by virtue of being, that day, the spouse of a covered employee. A divorce or legal separation of a covered employee from the covered employee's spouse is a qualifying event if, under the terms of the plan, the divorce or legal separation causes the spouse to lose coverage under the plan. If coverage is eliminated in anticipation of a qualifying event, such as an employee's eliminating the coverage of the employee's spouse in anticipation of a divorce or legal separation, the elimination is disregarded in determining whether the qualifying event causes a loss of coverage.

If the elimination in anticipation of the divorce is ignored, the spouse would have remained covered until the divorce and then lose coverage because of the divorce. Consequently, the divorce is a qualifying event and the spouse is a qualified beneficiary.

COBRA continuation coverage must be provided for a period that begins on the date of the qualifying event. A plan generally has the obligation to make COBRA continuation coverage available to a qualified beneficiary in case of a divorce or legal separation for 36 months after the date of the divorce or legal separation. State law may impose additional requirements.

D. IRS Rules on Deductible Medical Expenses

1. Background.

Two new Revenue Rulings and a Private Letter Ruling address the deductibility of certain common medical expenses concerning when and whether (i) cosmetic surgery may be deductible, (ii) the cost of medical equipment when purchased upon a doctor's recommendation qualifies as a deductible medical expense, and (iii) egg donor fees and related expenses may be deductible.

2. Cosmetic Surgery.

Revenue Ruling 2003-57 provides that amounts paid for cosmetic surgery are not deductible unless the procedure is necessary to ameliorate a deformity relating to a congenital defect or personal injury from an accident, trauma or disease. In addition, to be deductible, the procedure must promote proper body function or prevent or treat illness or disease.

The ruling provides examples of cosmetic surgeries that are deductible. Breast reconstruction performed after a mastectomy to treat cancer is deductible because the reconstruction ameliorates a deformity directly related to a disease. Also, laser eye surgery, including corrective procedures is deductible because the procedure corrects a bodily dysfunction (although arguably at considerably more expense than a pair of glasses).

However, the IRS rules that teeth-whitening is not deductible, even though performed by a dentist, because it does not treat a disease or promote proper body function, but solely enhances appearance.

3. Equipment and Supplies.

Revenue Ruling 2003-58 provides amounts paid for drugs or medicines are deductible only if they are available through prescription. Over-the-counter drugs, even if recommended by a physician for the treatment of an injury, are not deductible because no prescription is required for their use.

However, the prescription rule does not apply to "over-the-counter" medical equipment, such as crutches, bandages or diagnostic devices, such a blood sugar kits. These items are deductible if they mitigate injury or aid in the diagnosis or treatment of a disease.

4. Egg Donor Fees and Expenses Deductible.

The IRS ruled, in PLR 200318017, that egg donor fees and expenses related to obtaining a willing donor are allowable as medical care expenses deductible under Code Section 213. Specifically, unreimbursed expenses for the egg donor fee, the agency fee, the donor's medical and psychological testing, the insurance for post-procedure donor assistance, and the legal fees for preparation of the contract, are allowable medical care expenses deductible under Code Section 213.

E. Cafeteria Plan and Flexible Spending Account Arrangements

1. Cafeteria Plan May Use Automatic Enrollment Process for Health Coverage.

(a) Automatic Enrollment. The IRS has ruled that contributions used to purchase group health coverage under a Code Section 125 cafeteria plan are not included in an employee's gross income solely because an automatic enrollment or negative election reduces the employee's salary each year to pay for part of the plan's group health coverage.

Comment: IRS reached a similar conclusion for contributions to Code Section 401(k) plans, Code Section 403(b) tax-sheltered annuity plans, and Code Section 457 plans.

The ruling is based on two situations:

Situation 1: An automatic enrollment health coverage feature in an employer's cafeteria plan does not cause pre-tax salary reduction contributions to be taxable to the employee as long as the employee is notified and given the opportunity to take a cash option in lieu of health insurance coverage.

Situation 2: An employee may not elect to receive cash and his salary will automatically be reduced to purchase health insurance when the employee is unable to certify that he or she has other health coverage.

Comment: The holding for Situation 1 does not change due to the twist in Situation 2 that requires employees to certify other health coverage in order to affirmatively elect to receive cash instead of health coverage.

(b) Compensation Definition. Salary reduction contributions under a Section 125 plan are treated as Section 415(c)(3) compensation for purposes of limitations on contributions and benefits under tax-qualified plans. In Situation 2 above, contributions for the employees who cannot certify other coverage and cannot receive cash do not qualify as Section 125 contributions. Thus, the contributions are not includible as compensation under Section 415(c)(3). However, the IRS said that an employer may treat the salary reduction contributions for those employees who cannot receive cash as "deemed Section 125 compensation" in certain circumstances (i.e., if the employer does not request or collect information regarding the employee's other health coverage as part of the enrollment process), and thus not adversely affect their compensation amount which determines their pension benefit.

The IRS says that in order to count these "salary reduction" contributions as "deemed Section 125 compensation," the pension plan must be amended to incorporate language that recognizes deemed Section 125 compensation for Section 415 compensation and benefit purposes. For a plan that has already been treating the contributions in this manner, the amendment should have been adopted by the end of the 2002 plan year and could have applied retroactively to plan years beginning in 1998. If a plan sponsor has not been treating these contributions as deemed Section 125 compensation, but wishes to do so, the plan may be amended prospectively for a plan year beginning on or after January 1, 2002, and the amendment must be adopted by the end of the plan year in which it is effective. The IRS has provided model amendment language that may be used for this purpose.

2. Transferred Employees in Asset Sale May Continue FSA Without Interruption.

In Revenue Ruling 2002-32, the IRS ruled that employees transferred pursuant to an asset sale may, in certain instances, continue to exclude from their gross income amounts deducted from their salary pursuant to an election under a health FSA under the seller's cafeteria plan. According to the IRS, the FSA benefits may continue without interruption and at the same coverage level either when: (i) the seller-employer agrees to continue its existing health FSAs for transferred employees, or (ii) the buyer-employer agrees to adopt a continuation of the seller-employer's health FSAs for the transferred employees.

3. IRS Allows Pre-Tax Flexible Spending Accounts to Cover Over-the-Counter Drugs.

In Revenue Ruling 2003-102, the IRS recently authorized health FSAs, health reimbursement arrangements ("HRAs") (discussed in part VI.H. below), and other employer arrangements to reimburse employees for over-the-counter medications. Pre-tax dollars in an FSA, HRA, or other arrangement can be used to purchase nonprescription drugs so long as the transactions are adequately substantiated.

Comment: The ruling does not change the deductibility of over-the-counter drugs for income tax purposes. Over-the-counter drugs are not deductible as an itemized medical expense because a different Internal Revenue Code Section applies in this situation.

In the Revenue Ruling, an employer sponsored a health FSA. Employees used FSAs to reimburse for medical expenses not covered by health insurance. An employee purchased four over-the-counter drugs (antacid, allergy medicine, pain reliever and cold medicine) from a pharmacy. She also purchased vitamins. The items were for herself, her spouse and dependents. The items did not require a prescription and were not covered by health insurance. The employee subsequently sought reimbursement for the expenses out of her FSA.

Generally, FSA reimbursements for medical care are excluded from an employee's income. Medical care includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease. Medicines and drugs are for medical care. Cosmetics, toiletries, vitamins, dietary supplements and sundry items that are merely beneficial to the general health of the individual have long been held not to be medicines and drugs. Expenditures for these items are not expenditures for medical care.

The IRS determined that under the rules for employer health plans, there is no requirement that only prescription drugs qualify for reimbursement. Thus, FSAs, HRAs, and other arrangements may also reimburse employees for out-of-pocket expenses for over-the-counter drugs (but not vitamins or dietary supplements), and such reimbursements may properly be excluded from employees' incomes.

4. IRS Sets Rules on Debit/Credit Card Use a Part of FSAs and HRAs.

In Revenue Ruling 2003-43, the IRS explained when employer-provided medical and dental expense reimbursements, made under health FSAs, HRAs, through debit or credit cards and other electronic media, would be excludable from an employee's gross income. The IRS provided three scenarios as guidance.

A credit or debit card reimbursement program is permitted if certain requirements are met. The basic structure is as follows:

When an employee enrolls in the FSA and/or HRA, he or she is issued a credit or debit card, and the employee must certify that the card will be used to pay only eligible medical care expenses and that the card will not be used for expenses reimbursed by another health plan. The employee agrees to acquire and retain receipts to document any expense paid with the card. The card self-cancels if the employee is terminated.

The card is subject to the maximum dollar amount of coverage elected by the employee. When the card is used, the full amount of the expense (up to the amount in the employee's account) is paid and the employee's FSA and/or HRA account balance is reduced. The card only works at certain pre-authorized locations, such as pharmacies, hospitals, doctors' offices, or other service and medical care providers, with specified codes that relate to the care provided.

Although the IRS has stated that payments through the use of these programs must be reported to the employee on a Form 1099-MISC (this requirement generally applies when payments of $600 or more are reimbursed to any single provider), that position is being reconsidered and the IRS may issue a clarification shortly exempting such reporting.

For expenses to be paid under a credit or debit card program and excluded from an employee's gross income, medical expense reimbursements must be substantiated as an eligible
medical expense under Code Section 213. This substantiation requirement may incorporate the following:

(a) Copayments: If a health care provider charges the same amount to the card as the copayment amount under the health plan, then the charge meets the substantiation requirements without need for further documentation (e.g., a physician's office charges $25 and the copay under the plan is $25).

(b) Recurring Expenses: Recurring expenses, i.e., expenses that match a previously approved expense with respect to amount, provider and time period, meet the substantiation requirements without need for additional documentation (e.g., prescription refills made regularly at the same pharmacy).

(c) Real-Time Substantiation: If information is provided to the employer at the time and place the expense is incurred that confirms that the charge is for an eligible medical expense, then the substantiation requirement is met without need for review (e.g., treatment codes at a doctor's office).

(d) Other Charges: The employer may require that all other charges be treated as conditional until the charge can be confirmed. Additional information that describes the charge, the date of the service, and the amount must be submitted for review and substantiation.

Employees may still submit claims for reimbursement under their FSAs or HRAs using traditional claim forms with the required documentation.

If a reimbursed claim is later determined to have been ineligible for reimbursement, the employer may require the employee to reimburse the health plan for the expense. If the employee does not repay the health plan, then the employer may withhold the amount from the employee's compensation (but only to the extent consistent with applicable law). The employer also may offset future claims by the amount owed until the ineligible claim has been repaid.

Comment: Revenue Ruling 2003-43 provides that debit cards can be used in a fairly easy-to-administer manner. Because the cards, which eliminate the need to submit claims, are very popular with employees, they may be viewed as low-cost benefit improvement. However, use of the cards with FSAs and HRAs which may now reimburse for over-the-counter drugs may be problematic.


1. HIPAA Privacy Regulations.

(a) Background. The HIPAA privacy requirements are effective for large group health plans (i.e., those with premiums of more than $5 million) on April 14, 2003 and April 14, 2004 for small health plans. Employers that sponsor group health plans will need to: (i) prepare and distribute a notice of privacy practices to health plan participants; (ii) amend group health plan documents; (iii) conduct HIPAA privacy training; and (iv) establish "firewalls" to prevent the unauthorized use of employees' protected health information ("PHI").

On December 28, 2000, the Department of Health and Human Services ("HHS") released "final regulations" (the "Regs"). HHS revised the Regs on March 27, 2002 (the "Revised Regs") and on August 14, 2002, HHS released "final revisions" to the regulations (the "Final Regs"). The Final Regs, which had a general effective date of October 15, 2002 (but which could have been delayed until October 16, 2003 by filing an extension request), follow the Revised Regs in many, but not all, respects. HHS issued guidance on the Final Regs in question-and-answer form in September and December 2002. As our March 2002 Newsletter described the Revised Regs, the following summarizes key differences between the Final Regs and the Revised Regs.

(b) Business Associates' Contracts. A covered entity (e.g., health plans, health care clearinghouses and certain health care providers) (a "CE") must have a written agreement with each business associate (third party administrator or actuarial, legal, or accounting firm that performs services involving disclosures of PHI). The contract must establish the permitted and required uses and disclosures of PHI by the business associate and contain other required provisions. The Final Regs include a transition rule whereby a CE that complies with certain conditions will be deemed to be in compliance with the Final Regs' business associate contract requirements until the earlier of the date on which any such contract is renewed or modified on or after April 14, 2003 or April 14, 2004 if: (i) the CE entered into and was operating under a written business associate contract prior to October 15, 2002; and (ii) such contract is not renewed or modified between October 15, 2002 and April 14, 2003.

Comment: Employers that sponsor group health plans must determine how many business associate contracts they have and the dates on which they expire.

(c) Authorizations. Each version of the HIPAA privacy regulations restricted a CE's ability to use or disclose PHI without written consent or authorization. A CE cannot use or disclose PHI without a written authorization except for treatment, payment or health care operations, or for limited purposes specified in the regulations, including public health activities, military or veterans' affairs, or judicial and administrative proceedings.

A valid authorization must be in plain language and meet the following content requirements: (i) a description of the information to be used or disclosed that identifies it in a "specific and meaningful" fashion; (ii) the name or other specific identification of the person authorized to make the requested use or disclosure; (iii) the name or specific identification of the person to whom the CE may make the requested use or disclosure; (iv) a description of each purpose of the requested use or disclosure; (v) an expiration date or event that relates to the individual or purpose of the use or disclosure; and (vi) the signature of the individual and date.

These statements must be adequate to place the individual on notice of all of the following: (i) the right to revoke the authorization in writing (or any exceptions to such right); (ii) the CE may not condition treatment, payment, enrollment, or eligibility for benefits on provision of an authorization by the individual; and (iii) the information disclosed pursuant to the authorizations may potentially be subject to redisclosure and no further HIPAA protection.

A health plan must comply with certain procedural requirements concerning authorizations. The plan must forward a copy of the signed authorization to the participant and keep a copy for six years under HIPAA's documentation requirements.

Comment: Employers or third party administrators must draft authorizations that contain the requirements set forth in the Final Regs, establish procedures for obtaining signed authorizations when necessary, and retain copies for six years.

(d) Limited Data Sets. A CE may use or disclose de-identified health information after removal of 18 identifiers, including names, addresses, URLs, and biometric identifiers. HHS added an exception that allows a CE to use or disclose a "limited data set," provided the CE enters into a "data use agreement." A "limited date set" is PHI that is missing 16 of 18 identifiers that have to be deleted in order to meet the safe harbor. Unlike de-identified information, a limited data set may include geographic identifiers (such as town, city, state, or zip code information) and dates such as birth dates, age, admission date, etc. (45 CFR § § 164.514(e)(2), 164.514(b)(2)).

A limited data set may be used or disclosed only for research, public health or health care operations. Additionally, a CE must enter into a "data use agreement" to ensure that the limited data set recipient will use or disclose the information for limited purposes.

An individual may request an accounting of disclosures of PHI made other than for purposes of treatment, payment or health care operations, authorized disclosures, and certain other disclosures. However, a CE does not have to account for disclosures that are part of a limited data set.

If a CE engages in "marketing," it must obtain an individual's written authorization before it discloses PHI. However, a CE's release of PHI does not require prior authorization for an activity that is treatment, payment or health care operations. The marketing definition has been changed in the follow respects:

(i) "Marketing" includes an arrangement between a CE and any other entity whereby the CE discloses PHI to such other entity, in exchange for direct or indirect remuneration, in order for the second entity or an affiliate to make a communication about its own product or services that encourages recipients to purchase or use that product or service.

(ii) "Marketing" excludes a communication made to describe a health-related product or service (or payment for such product or service) provided by or included in a plan of benefits of the CE making the communication, including communications about participating providers; replacement of, or enhancements to, a health plan; and health-related products or services available only to an enrollee that "add value" to, but are not part of, a plan of benefits.

Communications regarding disease management and wellness programs will generally not be considered "marketing." Consequently, health plans may promote their benefits, describe networks, and inform health plan participants about special programs without first obtaining individual authorization. In addition, the rules clarify that mailings about health fairs, SPDs, newsletters about health issues, reminders about physicals, mammograms, or new diagnostic tools, or mailings about enhanced health benefits are not marketing.

(e) Unemanicipated Minors. In general, a parent, guardian, or other person acting in loco parentis (a "parent") is a minor's personal representative for HIPAA privacy purposes. The Final Regs make the following changes concerning minors:

(i) HIPAA provides individuals a right of access to their PHI. A parent also has the right to access a minor's PHI to the extent permitted or required by state or other applicable law. If state or other applicable law prohibits disclosure to a parent, the parent may not access the minor's PHI.

(ii) A parent will not always be a minor's personal representative. If a parent is not the personal representative and there is no right of access under state or other law, a CE may provide or deny access to the parent if such action is consistent with state or other law and a licensed health care professional makes the decision.

(f) Hybrid Entities. Single legal entities that perform both covered and non-covered functions, such as an employer that maintains a health clinic that conducts EDI-covered transactions like billing or utilization review, may designate themselves as "hybrid entities." The covered healthcare component of a hybrid must be designated as such, and firewalls must be erected to ensure that health information is not used improperly by the entity.

2. HIPAA Final Security Rules.

Security rules were finalized on February 20, 2003. The rules are effective for large health plans on April 21, 2005; small health plans have an extra year to comply.

Generally, a CE must ensure the confidentiality, integrity and availability of electronic PHI it creates or maintains, and protect it from reasonably anticipated threats or improper use or disclosure.

The final rules are significantly different from the security rules proposed in 1998. The scope of the rules is limited to electronic PHI rather than to all electronic health information. In addition, the rules provide health plans with greater flexibility to determine which of many security standards they need for their plan. For example, rather than making encryption of data transmission mandatory, the rules allow plans to determine for themselves when encryption is reasonable and appropriate and, if it is not, what alternative security measures should be adopted. Plans must conduct a risk analysis and make documented determinations about whether certain security standards are applicable to their operations.

HHS has also clarified that HIPAA's security rules are closely linked with HIPAA's privacy rules, since PHI must be kept secure in order to remain private. HHS has emphasized, however, that there are some important distinctions between the security and privacy rules. While the privacy rules essentially deal with issues of control over information, how information is used, when it may be disclosed, and what rights healthcare patients may have in terms of information being revealed, the security rules speak to physical, administrative, and technical matters as means of protecting the integrity and availability and not only the privacy of information. In terms of scope, the privacy rules govern health information in all forms while the narrower security rules apply only to information that is kept electronically.

Comment: The final security rules require reasonable and appropriate workforce training.

G. Fringe Benefit Plans Relieved from Schedule F Reporting Requirement

Pursuant to Notice 2002-24, the IRS is indefinitely suspending the requirement for employers that maintain cafeteria plans under Code Section 125, educational assistance programs under Code Section 127, and adoption assistance programs under Code Section 137 to file annual information returns as Schedule F of Form 5500. Those plans had been required to file information returns under Code Section 6039D. Other fringe benefit plans, such as group-term life insurance plans under Code Section 79, accident and health plans under Code Sections 105 and 106, and dependent care assistance programs under Code Section 129, already were exempt pursuant to Notice 90-24. Thus, there is no longer any fringe benefit plan that has to file Schedule F which, as a practical matter, is now obsolete.

Comment: Fringe benefit plan sponsors who did not file required Schedule F, for plan years before 2001 should not seek relief under the Department of Labor's Delinquent Filer Voluntary Compliance Program and do not need to request relief from the IRS.

Caution: The suspension of the requirement to file Schedule F does not relieve plan administrators from complying with any requirement under Title I of ERISA to otherwise file Form 5500 or any of its other required schedules. Thus, plan sponsors must continue to file Forms 5500 with respect to their welfare benefit plans (e.g., health, life, disability, etc.).

H. Health Reimbursement Arrangements

1. Background.

Health reimbursement arrangements ("HRAs") are a new type of defined contribution health plan. HRAs provide a way to establish a health plan funded with employer contributions that grows tax-free and is tax-free upon distribution to employees. The IRS provided the following guidelines with respect to HRAs: in Revenue Ruling 2002-41, the IRS sets forth two factual situations in which HRAs will be permissible and in Notice 2002-45, the IRS provides general guidance on taxability and other issues with respect to HRAs.

Revenue Ruling 2002-41 addresses a typical situation where the plan sponsor maintains a high-deductible medical plan which is paid for in part through salary reduction under a Section 125 cafeteria plan. The high deductible plan is provided in conjunction with an HRA, which reimburses expenses that would be covered under the medical plan except for deductibles or other limitations. The unused amounts in the HRA are carried over each year for use in subsequent years. In the first situation, if the employee terminates employment or retires, the unused amounts in the HRA are no longer available to the former employee. An employee may then elect COBRA with respect to the HRA only if it is taken in conjunction with the high-deducible medical plan. In the second situation, the amounts in the HRA are available to the former employee after retirement or termination. Nonetheless, COBRA may be elected with respect to the HRA in order to receive further employer contributions.

The IRS said that in both situations, the amounts contributed by the employer and the amounts reimbursed from the HRAs would be excludable from the employee's income.

2. Eligibility.

All current and former employees, their respective spouses and dependents may be covered by an HRA. An HRA could continue to reimburse an employee, his or her spouse and dependents for medical expenses after the employee terminates employment or retires. An HRA must be provided in a non-discriminatory manner.

3. Contributions.

Only employer contributions may be made to an HRA. There may not be any type of employee contribution, salary reduction contribution, or choice between receiving cash or contributing forgone cash to the HRA. If at any point the HRA receives anything but employer contributions, any distributions from the HRA, even for the payment of medical expenses, will be included in the employee's gross income.

Contributions to an HRA may be made as an annual, lump sum contribution, or may be made periodically. Additionally, there is no dollar limit on the amount that may be contributed per year to an HRA, nor is there any requirement that the yearly contribution be available for immediate use. The HRA can be established such that an employee may only use the amount in his or her account as the account is periodically credited with contributions.

Finally, perhaps the most attractive aspect of an HRA, as well as one of the greatest distinctions between an HRA and other flexible spending arrangements, is that the unused amount in an HRA account at year end may be carried over from year to year. There is no forfeiture requirement in an HRA.

4. Covered Benefits.

An HRA may be used to pay for medical expenses as defined under Code Section 213 which includes accident and health insurance premiums, long-term care premiums, and general costs related to maintaining one's health or treating illness. An employee must substantiate all costs incurred for medical care by submitting receipts for such care to the plan administrator. Any expense incurred after the HRA is adopted and after the employee becomes enrolled in the HRA is eligible for reimbursement. There is no requirement that an expense must be incurred and reimbursed in the same plan year.

5. Establishment.

An HRA is an employee welfare benefit plan covered by ERISA. As such, it is subject to standard ERISA requirements including the adoption of a written plan document, providing participants with a summary plan description, and filing all applicable annual reports.


A. DOL Renames PWBA To Be The Employee Benefits Security Administration (EBSA)

The DOL has renamed the Pension and Welfare Benefits Administration ("PWBA") to the Employee Benefits Security Administration ("EBSA"). DOL has also redesignated the title and position of Assistant Secretary for Pension and Welfare Benefits as Assistant Secretary for Employee Benefits Security, and the Office of the Assistant Secretary for Pension and Welfare Benefits to the Office of the Assistant Secretary for Employee Benefits Security. According to the DOL, changing the agency's name to the Employee Benefits Security Administration more clearly communicates the agency's mission of protecting private sector employee benefits.

B. IRS Final Regulations Require Tax Shelter Disclosure Statements For Plans

The IRS issued final regulations requiring corporate taxpayers to file disclosure statements with their federal corporate income tax returns reporting certain tax avoidance transactions involving plan contributions attributable to compensation earned after the close of the tax year, as well as certain multiple employer welfare trust arrangements which are exempt from funding limitations.

Under the regulations, Form 8886 (Reportable Transaction Disclosure Statement) must be attached to the returns of corporate taxpayers, disclosing their participation in reportable transactions that have characteristics common to tax shelters. Reportable transactions include transactions such as those in which taxpayers claim deductions for contributions to qualified cash or deferred arrangements or matching contributions to a defined contribution plan where the contributions are attributable to compensation earned by plan participants after the end of the taxable year, as well as transactions involving certain trust arrangements purported to qualify as multiple employer welfare benefit funds exempt from the limits of Code Sections 419 and 419A.

C. Military Leave Obligations

Employers whose employees enter military service will have to review their obligations under federal law and in certain instances state law and determine how these employees should be treated under their employee benefit programs. What follows is a description of an employer's obligations under the Uniformed Services Employment and Reemployment Rights Act of 1994 ("USERRA"), and the Soldiers' and Sailors' Civil Relief Act of 1940 ("SSCRA").


USERRA's protection extends to any employee who leaves civilian employment for the uniformed services, except for those individuals who are employed in positions in which there is no reasonable expectation that employment will continue indefinitely or for a significant period.

Under USERRA, an employee called to serve in the armed forces is entitled to certain benefits during such service if the following conditions are met: (i) the employee gives the employer advance written or verbal notice of the service (advance notice is not required if giving the notice would be impossible or unreasonable, or is precluded by military necessity); and (ii) the employee has no more than five years of total absences from the employer for all military service.

2. Benefits During Military Service.

An employer must treat an individual who is absent from employment by reason of military service in the same manner as any other employee having similar seniority, status, or pay who is on an unpaid leave of absence. Although paid military leave is not required (assuming the employer does not provide paid leave for other types of leaves), the employer must allow employees to use any vacation or any other similar leave with pay that accrued before military service began.

3. Health Benefits.

USERRA requires that employees who leave employment for military service be given the opportunity to continue health coverage for themselves and for their dependents for up to 18 months. For periods of military service of up to 31 days, the employee may be charged no more than he would normally pay as an active employee. However, an employer can charge up to 102% of the full cost of coverage, similar to COBRA, for any longer periods of coverage.

Except in the case of non-payment of premiums, coverage provided under USERRA may be terminated before expiration of the 18-month period only if the individual fails to apply for, or return to a position of, employment within a prescribed period after military service ends.

A loss of coverage caused by an employee's leaving for military service is also a qualifying event under COBRA. The COBRA regulations indicate that coverage under USERRA and coverage under COBRA run concurrently.

4. Health Care Flexible Spending Accounts.

Many employees may have been participating in health FSAs at the time they are called up for military service. While it is not clear whether USERRA's health care continuation rules apply to FSAs, it is clear that under COBRA affected employees must be given the opportunity to continue their FSA participation for the remainder of the plan year. The means of paying for continued coverage should be no less favorable than the means made available to other employees.

Issue: However, at the end of the plan year, under current regulations, the soldier would forfeit any unused deferred amounts.

5. Plan Loans.

USERRA permits the suspension of an employee's obligation to repay a loan for the period during which the employee is performing military service. If loan payments are suspended during the period of military leave, the balance of the loan would either have to be reamortized upon return to employment or the period of the loan extended by the period of military service (so that payments remain the same).

SSCRA permits enlisted personnel and reservists on active duty to request that the interest rates they pay on particular loans during active duty be limited to 6% if the debts were incurred before the commencement of the period of military service.

6. State-Mandated Benefits.

USERRA does not preempt state laws that provide for greater benefits.

7. Benefits on Reemployment.

A veteran is entitled to certain benefits upon reemployment, provided the leave does not exceed five years and certain conditions are met.

(a) Seniority. An employee who returns to employment from military leave is entitled to the seniority and to those rights and benefits determined by seniority that he would have had if employment had not been interrupted by military service. For rights or benefits that are not based on seniority, the employee must be treated no less favorably than other employees who have been on an unpaid leave of absence.

(b) Health Coverage. Health coverage that was discontinued during military leave must be immediately reinstated without any pre-existing condition exclusion or waiting period.

(c) Retirement Benefits. USERRA provides that for purposes of calculating pension benefits, compensation during a period of military leave is to be determined as if the leave had not occurred. In the 401(k) context, this means that an employee can contribute a "make up" contribution over a period equal to three times the military leave or, if less, five years measured from the veteran's date of reemployment.

USERRA also provides that periods of military service cannot be treated as a break in service and must be counted as service with the employer for purposes of vesting and benefit accrual. Thus, the employer generally would have to fund any accruals to a defined benefit pension plan and make contributions to a defined contribution plan for a returning employee as if the employee had never taken a leave. An employee is entitled to accrued benefits that are contingent on or derived from employee contributions or salary reductions, such as matching contributions in a 401(k) plan, only to the extent that he makes up such contributions after returning to employment.

[1] This memorandum is provided for information purposes by The Wagner Law Group, a Professional Corporation to clients and others who may be interested in the subject matter. This material is not to be construed as legal advice or legal opinions on specific facts. Under the Rules of the Supreme Judicial Court of Massachusetts, this material may be considered advertising.

[2] GUST is an acronym that stands for the statutory changes made by the Uruguay Round Agreements Act (commonly referred to as GATT because the Act approved the trade agreements negotiated under the General Agreement on Tariffs and Trade), the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA), the Small Business Job Protection Act of 1996 (SBJPA), and the Taxpayer Relief Act (TRA) of 1997, plus the Internal Revenue Service Restructuring and Reform Act of 1998, and the Community Renewal Tax Relief Act of 2000 (CRA).

[3] GUST is an acronym that stands for the statutory changes made by the Uruguay Round Agreements Act (commonly referred to as GATT because the Act approved the trade agreements negotiated under the General Agreement on Tariffs and Trade), the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA), the Small Business Job Protection Act of 1996 (SBJPA), and the Taxpayer Relief Act (TRA) of 1997, plus the Internal Revenue Service Restructuring and Reform Act of 1998, and the Community Renewal Tax Relief Act of 2000 (CRA).

[4] The IRS has previously addressed this issue in private letter rulings (see, e.g., PLRs 200137064 and 200038051).