New Tax Law Significantly Improves Benefits of 401(k) and Other Qualified Plans
On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act"). Although the Act is perhaps best known for the lowering of tax rates and phase out of the estate tax, the Act has also made important changes to the rules governing all qualified plans, especially 401(k) plans. These changes generally increase the amount of contributions and/or benefits that can be provided under these plans and should encourage employers to establish new qualified plans and continue maintaining existing plans, as well as enable highly compensated individuals to utilize more fully the benefits associated with these plans.
Many of the Act's provisions affecting the operation of qualified plans are effective in 2002. Thus, employers should immediately review their benefit programs in order to determine the extent to which the new law may have an impact on their programs.
This article guides tax executives through the labyrinth of changes that the Act makes in the employee benefit provisions of the Internal Revenue Code (the "Code"). The following specific areas are addressed:
- 401(k) plans and other defined contribution plans
- Increase in contribution and benefit limits under qualified plans
- Expansion of rollover rules and related distribution changes
- Individual Retirement Accounts (IRAs)
- Employee stock ownership plans
- Other employee benefit and compensation changes
- Amendment requirements for qualified plans
401(k) Plans and Other Defined Contribution Plans
Increases in Dollar Limit on 401(k) Elective Deferrals
Current law limits the amount of the 401(k) elective deferrals that an individual can elect to have an employer contribute on his behalf to a 401(k) plan. For 2001, the maximum 401(k) elective deferral is $10,500. The Act raises the limit on annual 401(k) elective deferrals to $11,000 in 2002, increasing the limit in $1,000 annual increments thereafter until the limit reaches $15,000 in 2006, with future increases for cost of living to be made in $500 increments. Thus, the annual limits through 2006 will be $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006.
Increase in Compensation Limit
For purposes of applying annual deduction and contribution limits as well as for nondiscrimination testing purposes, current law limits the annual compensation of each participant that may be taken into account under a qualified plan to $170,000. For plan years beginning after December 31, 2001, the Act raises this limit to $200,000, indexed thereafter in $5,000 increments.
This increase should make it easier for 401(k) plans to satisfy the special nondiscrimination test applicable to elective deferrals (i.e., the "ADP Test", see below), because the test is based on the percentage of an employee's pay and a larger compensation base reduces the contribution percentages of certain highly compensated employees. In other words, $10,000 is approximately 5.9 percent of $170,000 but only 5.0 percent of $200,000.
In addition, by raising the compensation base, the Act allows employers to increase the contributions that can be made on behalf of highly compensated employees under a profit sharing plan. For example, where an employer contributes a uniform percentage of compensation to the profit sharing account of each employee, employees who earn in excess of the current compensation limit will now see the contribution to their accounts increase. For an employer who contributes a pool of money to be allocated among its employees, the increased limit will skew the contributions in favor of the higher compensated employees, enabling them to receive a larger portion of the profit sharing contribution.
Changes in Deduction Limits
Increase in 15 Percent of Compensation Limitation
Under current law, an employer may deduct contributions to a 401(k) plan (or any other profit sharing plan) for a taxable year up to a maximum of 15 percent of the aggregate compensation paid to employees covered by the plan for that year. Contributions in excess of this limit may be subject to a 10 percent excise tax. Where an employer sponsors both a defined benefit (or a money purchase plan) and a defined contribution plan, deductible contributions are generally limited to 25 percent of the aggregate compensation paid to covered employees during the taxable year. The current 15 percent limitation on deductible contributions to defined contribution plans has forced employers who want to provide contributions in excess of 15 percent of aggregate compensation to maintain a money purchase plan in addition to their profit-sharing or 401(k) plan so that they can deduct contributions up to the maximum limit of 25 percent.
Effective for taxable years beginning after 2001, the Act raises the limit on deductible employer contributions to a profit sharing plan to 25 percent of the compensation paid during the taxable year to plan participants. The Act also specifies that money purchase pension plans will be treated like profit sharing plans for deduction limitation purposes. Thus, it will no longer be necessary to maintain two plans in order to take advantage of the maximum 25 percent deductible contribution limitation.
Treatment of 401(k) Elective Deferrals for Deduction Purposes
For purposes of the deduction limitations, the employee compensation base upon which the maximum deductible employer contribution is calculated currently includes only taxable compensation and, as such, does not include salary reduction amounts such as elective deferrals to 401(k) plans or contributions to a Section 125 cafeteria plan. In addition, current law treats elective contributions deducted from employees' pay as employer contributions when applying the limits on deductible contributions.
Effective for years beginning after 2001, the Act substantially liberalizes these rules by (i) changing the definition of compensation for purposes of applying the deduction limits to include salary reduction amounts and (ii) excluding salary reduction amounts in applying the new 25 percent maximum deduction limitation on total employer contributions to defined contribution plans. Thus, the compensation base upon which the maximum permitted deductible contribution by the employer is calculated has been increased to include 401(k) elective deferrals, but these deferrals are no longer counted toward the 25 percent limitation on such contributions. Consequently, 401(k) elective deferral contributions will no longer need to be limited to ensure that employer deduction limits are not exceeded.
New Catch-up Contributions under 401(k) Plans
In an attempt to enable older workers to enhance their retirement benefits, the Act establishes special "catch-up" contribution provisions for employees who have attained age 50. Beginning in 2002, such an employee who has made the maximum permitted elective deferrals under a 401(k) plan, as determined under all applicable Code provisions (e.g., the annual limit on 401(k) elective deferrals) or under the plan, may make an additional elective contribution to the plan if the plan so permits. The maximum permitted catch-up contribution amount generally starts at $1,000 in 2002 and is increased in $1,000 annual increments until it reaches $5,000 in 2006, adjusted for inflation in $500 increments thereafter. The catch-up contribution provisions do not apply to after-tax employee contributions.
The IRS recently issued proposed regulations which provide that catch-up eligible participants are those employees who are projected to reach age 50 by the end of the calendar year. Thus, all employees who will be at least 50 years old by December 31st of a calendar year, are treated as if they are 50 as of January 1st of that year, regardless of whether they terminate employment or survive to their actual birthday.
Besides the annual maximum catch-up contribution limit itself, catch-up contributions are not subject to any other contribution limits nor are they taken into account in applying other contribution limits. In addition, catch-up contributions are not subject to the nondiscrimination rules otherwise applicable to 401(k) plans (i.e., the "ADP Test", see below). However, if a catch-up contribution feature is provided in a plan, the plan (and all similar plans within the employer's controlled group) must allow all participants to make the same election with respect to catch-up contributions. Lastly, an employer is permitted to make matching contributions with respect to catch-up contributions, but any such matching contributions are subject to all normally applicable limits and rules, including the nondiscrimination rules applicable to matching contributions (i.e., the "ACP Test", see below).
Two examples provided in the Act's legislative history are worth mentioning here: Example 1 describes a highly compensated 401(k) participant employee over age 50 whose maximum annual deferral of $15,000 for the year 2006 is reduced to $8,000 by the 401(k) nondiscrimination rules. Under the Act, the employee may make an additional elective catch up contribution of $5,000 (the maximum permitted catch up contribution for 2006). The employee in Example 2 is over age 50, earns $30,000 for the year 2006 and participates in the employer's 401(k) plan whose terms permit a maximum deferral of 10 percent of compensation. The employee's maximum permitted elective deferral is $8,000: $3,000 under the terms of the plan, plus an additional $5,000 under the catch-up provisions of the Act.
Faster Vesting of Employer Matching Contributions
Current law requires that employer matching contributions under a qualified plan vest at least as rapidly as under one of two alternative minimum vesting schedules: (1) five year cliff vesting which requires 100 percent vesting after five years of service or (2) seven year graded vesting, which requires 20 percent vesting after three years of service, with an additional 20 percent vesting each year until 100 percent is fully vested after seven years of service.
Under the Act, each of these matching vesting schedules is replaced by a new, faster schedule and matching contributions must vest under one of the following alternatives:
1. Three Year Cliff: After completion of three years of service, a participant must have a nonforfeitable right to 100 percent of employer matching contributions.
2. Six Year Graded: After completion of two years of service, a participant must have a nonforfeitable right to 20 percent of employer matching contributions and vest in an additional 20 percent with each additional year of service, reaching 100 percent vesting after six years of service.
Employer contributions that are not matching contributions may continue to be subject to the old (five year cliff or seven year graded) vesting schedules.
The new vesting rules for matching contributions are generally effective for contributions for plan years beginning after December 31, 2001. There are several important points with regard to this effective date. First, the provision does not apply to an employee until the employee has completed an hour of service after the effective date; thus, benefits for an employee who terminates employment prior to December 31, 2001 will be determined under the vesting schedule in effect on the termination date. There is also a delayed effective date for plans maintained under a collective bargaining agreement. Lastly, as described above, the provision is effective for contributions for plan years beginning after December 31, 2001. This is a departure from vesting rule changes under prior laws which historically applied to plan years after the effective date, thus affecting the vesting of current and prior year contributions. In contrast, the Act gives an employer the option of keeping the old (longer) vesting schedule for matching contributions made in pre-2002 years.
Repeal of Multiple Use Test
Current law requires that 401(k) plans satisfy two complex nondiscrimination tests generally designed to ensure that the plan does not significantly discriminate in favor of highly compensated employees. The first test relates to elective 401(k) deferrals and is commonly referred to as the "ADP Test." The second test, relating to employer matching contributions and after-tax employee contributions, is commonly referred to as the "ACP Test."
There are two means of satisfying each test: a 125 percent standard and a more lenient 200 percent standard (which also requires that the difference between the percentages deferred or contributed by the highly versus the nonhighly compensated employee group not be greater than 2 percent). However, if a plan needs to utilize the more lenient 200 percent standard to pass both the ADP and ACP tests, the Plan must also pass a special "multiple use" test.
The Act repeals the multiple use test so that, for years beginning after December 31, 2001, the 200 percent test can be used for both ADP and ACP testing purposes. The repeal of the multiple use test will not only substantially simplify 401(k) nondiscrimination testing, but will also make it easier for plans to pass the nondiscrimination requirements.
Exemption from Top-Heavy Status for "Safe Harbor" 401(k) Plans
Under current law, plans that meet the ADP and ACP nondiscrimination tests are nevertheless subject to additional minimum contributions and vesting standards if the plan primarily benefits key employees (i.e., if the plan is a "top-heavy" plan). Current law also provides that 401(k) plans that provide certain levels of fully vested employer contributions and satisfy a notice requirement are deemed to satisfy the ADP and ACP nondiscrimination tests (a "safe harbor" 401(k) plan).
Under the Act, a safe harbor 401(k) plan is automatically considered not to be top-heavy (even if it primarily benefits certain key employees) and, thus, will no longer be subject to the minimum contribution and vesting standards of top-heavy plans. This provision is effective for plan years beginning after December 31, 2001.
Elective deferrals to a 401(k) plan may be distributed only upon the occurrence of certain specified events. One such event is the financial hardship of the employee.
Modification of 12 Month Suspension Rule
Currently, a plan may make a financial hardship distribution only where it is necessary to meet an immediate and heavy financial need of the employee. The regulations offer a "safe harbor" under which a distribution is deemed necessary to meet the immediate and heavy financial need. One of the requirements of the safe harbor is that the employee be prohibited from making elective deferrals or employee contributions to any plan of the employer for twelve months after receipt of the hardship distribution.
The Act reduces the mandatory suspension period for elective deferrals and employee contributions after a hardship distribution from twelve months to six months. This change is effective for calendar years beginning after December 31, 2001, rather than only for distributions made after that date. Thus, a plan may permit an employee who receives a hardship distribution during 2001 to recommence elective deferrals after a six month suspension (or on January 1, 2002, if later). A plan has the option of retaining its existing twelve month suspension period for all hardship distributions after December 31, 2001. However, all safe harbor 401(k) plans must reduce their post-hardship distribution suspension period from twelve to six months in order to continue reliance on the safe harbor provisions, although such plans may provide that the shorter six month suspension is available only for distributions made after December 31, 2001.
Hardship Distributions No Longer Eligible for Rollover
Under current law, hardship distributions of an employee's 401(k) elective deferrals are not eligible to be rolled over to another qualified plan or IRA, whereas certain other hardship distributions, including distributions of employer matching contributions, are eligible to be rolled over. Further, distributions eligible for rollover that are not directly rolled over are subject to mandatory 20 percent withholding, whereas distributions that are not eligible for rollover are subject to elective withholding.
The Act provides that any distribution an account of financial hardship will no longer be eligible to be rolled over. Thus, after December 31, 2001, any amounts distributed to an employee on account of financial hardship, including amounts attributable to elective deferrals, matching contributions and nonelective employer contributions, are ineligible for rollover to another plan or IRA and, further, are no longer subject to the mandatory 20 percent withholding requirement.
Repeal of Same Desk Rule
Under current law, an employee who ceases to be employed by an employer that maintains a 401(k) plan (i.e., has experienced a "severance from employment") may not necessarily have experienced a "separation from service" needed to permit the distribution of the employee's 401(k) elective deferrals under the plan. A separation from service occurs only upon the death, retirement, resignation or discharge of the employee. Under the so called "same desk" rule, an employee who continues in the same job for a different employer following a liquidation, merger, or other corporate transaction, generally is not considered to have experienced a separation from service and may, therefore, not be eligible to receive a distribution of 401(k) elective deferrals. Current law provides certain narrow exceptions to this rule.
The Act repeals the same desk rule and provides that, after December 31, 2001, a plan may distribute 401(k) elective deferrals upon an employee's severance from employment (even if the severance occurred prior to that date) rather than upon the more restrictive separation from service standard. Thus, employees who experience a severance from employment due to a sale of assets, merger or other corporate transaction should be eligible to receive a distribution of 401(k) elective deferrals. The legislative history of these provisions, however, provides employers with the option of continuing to follow the old rules regarding separation from service, thereby continuing to disallow distributions that would have been prohibited under the same desk rule.
Increase in Contribution and Benefit Limits
Defined Contribution Plans
Under current law, the maximum amount of "annual additions" that may be credited to a participant's account under a defined contribution plan may not exceed the lesser of (i) 25 percent of the participant's compensation or (ii) $35,000 (for 2001). Annual additions are generally the sum of employer contributions (which includes 401(k) elective deferrals), employee contributions and forfeitures.
The Act increases the $35,000 dollar limitation on annual additions to $40,000 (indexed in $1,000 increments). Moreover, the Act increases the 25 percent of compensation limitation on annual additions to 100 percent. These changes are effective for limitation years beginning after December 31, 2001. Thus, beginning in 2002, the annual additions that may be credited to a participant's account under a defined contribution plan will be limited to the lesser of (i) 100 percent of the participant's compensation or (ii) $40,000.
Defined Benefit Plans
Increase in and Adjustments to Dollar Limitation
Under current law, the maximum annual benefit payable to a participant at retirement under a defined benefit plan generally may not exceed the lesser of (i) 100 percent of the participant's average compensation for the participant's highest three years or (ii) $140,000 (for 2001). The dollar limitation is adjusted for cost-of-living increases in $5,000 increments.
Further, in general, the dollar limitation on annual benefits is reduced if benefits under a defined benefit plan begin before the participant's social security retirement age (age 65, 66 or 67, depending on the year in which the participant was born) and increased if the benefits begin after the participant's social security retirement age.
The Act increases the $140,000 annual benefit dollar limitation from $140,000 to $160,000. Further, the Act provides that the annual benefit dollar limitation is reduced for benefits that commence before age 62 and increased for benefits that commence after age 65. Thus, if benefits under a defined benefit plan begin when a participant attains age 62, no adjustment to the maximum annual benefit dollar limitation is required under the Act.
The changes to the annual benefit dollar limitation for defined benefit plans are effective for limitation years ending after December 31, 2001. Consequently, the changes generally are already effective for plans with a non-calendar year limitation year. For example, if a plan has a July 1 - June 30 limitation year, the provisions of the Act were effective July 1, 2001.
Modification to Compensation Limitation for Multiemployer Plans
Under the Act, the 100 percent annual benefit compensation limitation does not apply to collectively bargained multiemployer defined benefit plans for limitation years beginning after December 31, 2001. Thus, beginning in 2002, the only annual benefit limitation that will apply to participants in a collectively bargained multiemployer defined benefit plan will be the annual benefit dollar limitation.
Expansion of Rollover Rules and Related Distribution Changes
Rollovers from IRAs to Qualified Plans
Under current law, an individual may roll over a distribution (other than a required minimum distribution) from an IRA only into another IRA, and generally, may not roll over such a distribution into a qualified plan. An exception exists, however, in the case of an individual who has rolled over a distribution from a qualified plan into a "conduit" IRA and has not made any other contributions to such conduit IRA. If the amounts in the conduit IRA are attributable solely to rollovers from qualified plans, a distribution from that conduit IRA may be rolled over into another qualified plan.
Under the Act, effective for distributions made after December 31, 2001, all distributions from IRAs (regardless of whether such IRA is a conduit IRA) generally are permitted to be rolled over into qualified plans. It is important to note that in certain limited cases, distributions from qualified plans are eligible for favorable capital gains treatment and income averaging. However, an individual's distribution from a qualified plan will not be eligible for such treatment if the plan has accepted a rollover by such individual that is not permitted under current law (e.g., a rollover from an IRA that is not a conduit IRA). Thus, to preserve capital gains and income averaging treatment for a qualified plan distribution that is rolled over, the rollover would have to be made to a conduit IRA as under current law, and then rolled back into a qualified plan.
Currently, similar restrictions apply to rollovers from Section 403(b) annuities to qualified plans. The Act also liberalizes the rules with respect to these rollovers. Thus, effective for distributions made after December 31, 2001, a distribution from a Section 403(b) annuity may generally be rolled over into a qualified plan, and a distribution from a qualified plan may generally be rolled over into a Section 403(b) annuity.
Rollovers of After-Tax Contributions
Under current law, an "eligible rollover distribution" is generally a distribution of all or a portion of an employee's benefit in a qualified plan that is includible in the employee's income other than (i) a distribution which is one of a series of distributions made over a period of 10 years or more, (ii) a required minimum distribution or (iii) a hardship withdrawal. Thus, an individual's after-tax contributions under a qualified plan may not be rolled over.
The Act provides that, effective for distributions made after December 31, 2001, after-tax contributions made under a qualified plan may be rolled over into another qualified plan (but only if such plan is a defined contribution plan) or an IRA. If such a rollover is being made from one qualified plan to another qualified plan, generally it must be accomplished only by way of a "direct rollover." Additionally, the qualified plan to which such amounts are being transferred must provide separate accounting for after-tax contributions and any earnings thereon. Rollovers of after-tax contributions may not be made from an IRA into a qualified plan.
Expansion of Spousal Rollovers
Under current law, an employee's surviving spouse who receives an eligible rollover distribution from a qualified plan on account of the employee's death may roll over such amounts into the surviving spouse's own IRA. The surviving spouse is, however, precluded under current law from rolling over such amounts into a qualified plan or Section 403(b) annuity.
Effective for distributions made after December 31, 2001, a surviving spouse may roll over such amounts into a qualified plan or a Section 403(b) annuity in which such surviving spouse is a participant in the same manner as if the spouse were the employee.
Waiver of 60-Day Rollover Period
Under current law, an eligible rollover distribution received from a qualified plan may be rolled over tax free so long as the rollover is made within 60 days of the distribution. The Secretary of the Treasury has no authority or discretion to extend the 60 day period, except in the case of military service in a combat zone or during a Presidentially declared disaster.
Effective for distributions made after December 31, 2001, the Secretary of the Treasury will have discretion to waive the 60-day period if the imposition of such a requirement would be against equity or good conscience; e.g., cases of casualty, disaster or other events beyond the reasonable control of the individual subject to the requirement. The legislative history of the Act indicates that in addition to these circumstances, a waiver of the 60 day rollover rule might be appropriate for errors committed by financial institutions, or in cases where the inability to complete a rollover is due to death, disability, hospitalization, incarceration, postal errors or restrictions imposed by a foreign country.
Disregard of Rollovers for $5,000 Cash-Out Purposes and Automatic Rollovers of Certain Involuntary Distributions
Currently, if an employee who participates in a qualified plan terminates employment and if the present value of such participant's accrued benefit (in the case of a defined benefit plan) or account balance (in the case of a defined contribution plan) is $5,000 or less, then the employer may distribute the vested portion of the participant's benefit under the plan without the participant's consent (or the consent of the participant's surviving spouse, if applicable). In determining the present value of the participant's accrued benefit or account balance under the plan, any rollover contributions made to the plan (and any earnings thereon) are included. A participant may elect to roll over an involuntary distribution to another qualified plan or IRA. Absent such an election, the involuntary distribution would be paid to the participant. The Act makes the following changes to these rules:
$5,000 Involuntary Cash-Out Rule
Effective for distributions made after December 31, 2001, an employer may disregard any rollover contributions made to the plan (and any earnings thereon) when determining the present value of the participant's accrued benefit or account balance for purposes of the involuntary cash-out rules.
Automatic Rollover of Certain Involuntary Distributions
Under the Act, a plan administrator is required to make a direct rollover of any involuntary distribution of between $1,000 and $5,000 (which is otherwise an eligible rollover distribution) to an IRA established by the administrator, unless the participant affirmatively elects to either roll over the distribution to a different IRA or a qualified plan or to receive it directly. The Act further requires that a written explanation be provided to the participant explaining that a direct rollover will be made unless the participant elects otherwise and that the distribution may be transferred by the participant without cost to another IRA.
The new rules with respect to automatic rollovers of involuntary distributions are effective for distributions that occur after the Department of Labor adopts final regulations implementing these rules. The Secretary of Labor is directed to adopt these final regulations not later than three years after the date of enactment of the Act (i.e., by June 7, 2004).
Individual Retirement Accounts (IRAs)
Increase in Annual Contribution Limits
Under current law, total annual contributions to an individual's traditional and Roth IRAs cannot exceed $2,000. In addition, the $2,000 limit is not indexed for inflation.
Under the Act, the annual IRA contribution limit is increased to $3,000 for the years 2002 through 2004, $4,000 for the years 2005 through 2007 and $5,000 thereafter. Further, the annual limit will be increased for inflation after 2008 in $500 increments.
Catch-up Contributions for Older Workers
The Act permits individuals who have attained 50 years of age by the end of the calendar year, to make an additional IRA contribution above the otherwise applicable dollar limit for that year. Such an individual may make an additional annual contribution of $500 during the years 2002 through 2005 and may contribute an additional $1000 in the year 2006 and for each year thereafter.
The Act provides that a qualified plan may permit employees to make voluntary contributions to a separate account established under the plan that will be treated like an IRA for all Code purposes, provided that each such account meets the requirements for either a traditional IRA or a Roth IRA, as applicable. These "deemed IRA" accounts will generally not be subject to the rules governing qualified plans, nor will contributions to such accounts be taken into account in applying the limits and nondiscrimination testing rules under the qualified plan. Rather, the deemed IRAs are generally subject to all applicable IRA rules and limitations so that, for example, an individual's contribution to his deemed IRA will count towards the maximum permitted annual contribution for all of his IRAs. The deemed IRA provisions are effective for plan years beginning after December 31, 2002.
Employee Stock Ownership Plans (ESOPs)
Deductions for Dividends Paid on Employer Securities
Under current law, corporations may not receive a deduction for dividends paid on employer securities held by an ESOP, if such dividends are reinvested in employer securities under the Plan.
Effective for tax years beginning after December 31, 2001, the Act expands the deduction for dividends paid on employer securities held by an ESOP so that now a deduction is available for dividends which, at the election of participants (or their beneficiaries) are either (1) paid to them in cash, (2) paid to the plan and distributed to them in cash within 90 days after the end of the plan year in which the dividend was paid, or (3) paid to the plan and reinvested in employer securities held by the ESOP. The new provisions under the Act will need to be clarified in order to determine the time at which a deduction may be taken with respect to reinvested dividends.
Since existing law had required ESOP dividends to be distributed in order to be deductible, the expansion of the dividend deduction rule to reinvested dividends should result in ESOPs being more beneficial to employers and participants.
New Restrictions Applicable to S Corporation ESOPs
Under current law, an ESOP may be an eligible shareholder of an S Corporation. In order to ensure that ESOPs that are established by S Corporations provide broad based coverage to employees rather than a limited group of individuals, the Act imposes new restrictions with respect to S Corporation stock held by an ESOP.
Under the Act, if an S Corporation maintains an ESOP, certain "disqualified persons" may not own (or be deemed to own) more than 50 percent of the stock of the S Corporation or receive allocations of S Corporation stock under the ESOP. The Act also limits "synthetic equity" (i.e., an interest that gives the holder a future right to acquire or receive stock of an S Corporation or which provides the holder with a right to a future cash payment based upon the value of or the appreciation in the value of the S Corporation stock) that may be owned by a disqualified person. If a disqualified person receives an impermissible allocation of stock, the amount allocated to such individual will be deemed to have been distributed and will be subject to taxation. In addition, the sponsor of the ESOP will generally have to pay a 50 percent excise tax on (i) the amount of any S Corporation stock that is impermissibly owned by a disqualified person or allocated to a disqualified person under the ESOP and (ii) the value of the underlying shares with respect to any synthetic equity that is treated as being owned by a disqualified person.
The rules regarding who is a disqualified person, the prohibited ownership and allocation of S Corporation stock and the prohibited ownership of synthetic equity in S Corporations are very complex and their application to any S Corporation ESOP needs to be analyzed on a case by case basis. These rules are generally applicable with respect to plan years beginning after December 31, 2004. However, the rules apply to plan years ending after March 14, 2001 with respect to any S Corporation ESOP that is first established after March 14, 2001 and to any ESOP established before that date if the employer maintaining the ESOP was not an S Corporation on March 14, 2001.
Other Employee Benefit and Compensation Changes
Loans to Owners/Partners
Current law prohibits certain transactions ("prohibited transactions") between a qualified plan and persons with a close relationship to the plan. Loans from the plan to plan participants are statutorily exempt from the prohibited transaction rules provided they comply with certain requirements. Not all loans are given this statutory exemption; specifically excluded are loans to owner-employees, which include a sole proprietor, a partner with a 10 percent interest in capital or profits, an S Corporation shareholder owning over 5 percent of its outstanding stock and the owner of an IRA.
Under the Act, loans to owner-employees (other than owners of IRAs) are given the same exemption from the prohibited transaction rules as loans to employees. Thus, except for the owner of an IRA, owner-employees may borrow from their plans under the same terms and conditions as other employees after December 31, 2001.
Changes to Top-Heavy Plan Rules
The Code provides that if a plan is "top-heavy" (i.e., primarily benefits certain "key employees") as of a determination date (generally, the last day of the plan year which immediately precedes the plan year for which the determination is being made), the plan must provide certain minimum benefits or contributions for non-key employees. In addition, a more liberal vesting schedule must apply to the benefits of non-key employees under the plan. Effective with respect to top-heavy determinations for plan years commencing on or after January 1, 2002 (which for calendar year plans will be based upon a December 31, 2001 determination date), the Act makes the following changes to the top heavy rules which should ease compliance by plan sponsors with the top-heavy requirements:
1. Under current law, an individual is a key employee of an employer if the individual is (i) an officer of the employer who received annual compensation in excess of $70,000, (ii) a five-percent owner of the employer, (iii) a one-percent owner of the employer with annual compensation in excess of $150,000 or (iv) one of the ten employees with the largest ownership interests in the employer and compensation in excess of $35,000. The Act eliminates the "top-ten employee owner" category from the key employee definition. The Act also provides that an officer is a key employee only if such officer received annual compensation from the employer in excess of $130,000 (indexed for inflation in $5,000 increments).
2. Under current law, in determining the present value of the accrued benefit or the account balance of any key employee, such employee's accrued benefit or account balance must be increased to reflect distributions made to the employee within the five-year period ending on the determination date. Also, under current law, if at any time during the five-year period ending on the determination date, a key employee has not performed services for the employer maintaining the plan, such employee's benefit or account is not taken into account for purposes of the top-heavy test.
The Act generally modifies both of these rules by replacing the five-year period with a one-year period ending on the applicable determination date. Thus, under the Act (i) distributions made to a key employee prior to the plan year which includes the determination date and (ii) benefits of any key employee who did not perform services for the employer during the plan year ending on the determination date, are not taken into account for purposes of determining whether the Plan is top-heavy. However, in-service distributions (i.e., distributions made other than on account of an employee's separation from service, death or disability) made to a key employee during the five-year period ending on the determination date must continue to be included in determining whether the plan is top heavy.
3. Under current law, matching contributions made to non-key employees under a top-heavy plan may be used to satisfy the minimum contribution requirements applicable to such employees. However, such matching contributions would then not be treated as matching contributions for purposes of satisfying the special nondiscrimination test applicable to matching contributions (i.e., the ACP Test) which in many instances may result in a plan's failure to satisfy such test. The Act changes this rule and provides that matching contributions that are used to satisfy the top-heavy minimum contribution requirement may also be treated as matching contributions for purposes of the ACP nondiscrimination test.
New Tax Credits
Nonrefundable Credit for Certain Contributions
In addition to any deduction or exclusion that otherwise applies, the Act establishes a new nonrefundable tax credit for certain 401(k) elective deferrals or IRA contributions made during the years 2002 through 2006. The maximum annual contribution eligible for the credit is $2,000, with the credit rate based on the filing status and adjusted gross income of the taxpayer, as follows:
Heads of Households
All Other Filers
$0 - $30,000
$0 - $22,500
$0 - $15,000
50 % of contribution
$30,000 - $32,500
$22,500 - $24,375
$15,000 - $16,250
20 % of contribution
$32,500 - $50,000
$24,375 - $37,500
$16,250 - $25,000
10 % of contribution
Note that the annual contribution eligible for the credit will be reduced by certain distributions from an IRA or qualified plan received by the taxpayer (or spouse). The credit is not available to those under age 18, full time students, or individuals who are claimed as a dependent on another's tax return.
This credit should encourage nonhighly compensated employees to make elective deferrals to their employer's 401(k) plan and thereby make it easier for the plan to satisfy applicable nondiscrimination tests. Consequently, although not required to do so, employers should consider informing their employees about this credit before the 2002 plan year.
Small Business Credit for New Plan Expenses
Current law generally permits an employer to deduct costs related to the establishment and maintenance of a retirement plan as ordinary and necessary business expenses.
The Act establishes a nonrefundable income tax credit for expenses incurred by certain small businesses that establish a new plan in taxable years beginning after December 31, 2001. The credit applies to 50 percent of the first $1,000 in administrative and retirement-education expenses for the plan for each of the first three years of the plan. The new plan must cover at least one nonhighly compensated employee and eligible small businesses can have no more than 100 employees who received annual compensation in excess of $5,000 in the preceding year.
Employer-Provided Retirement Advice Excluded from Tax
Under current law, certain employer provided fringe benefits are excludable from gross income of the employee, but at the present time, it is not clear to what extent retirement planning advice falls within any of these exclusions.
The Act provides that, effective after December 31, 2001, "qualified retirement planning services" provided to both an employee and his or her spouse will not be included in an employee's income. Overall retirement planning beyond qualified plan information falls within this exclusion, and, thus, for example, the exclusion applies to advice and information regarding retirement income planning for the individual and his or her spouse. However, the exclusion does not apply to tax preparation, accounting, legal or brokerage services related to retirement planning. Moreover, the provision of the retirement planning services may not discriminate in favor of highly compensated employees. Thus, such services generally may not be offered to highly compensated employees unless the services are offered to each member of the group of employees normally provided education and information regarding the employer's qualified plan.
Notice of Significant Reduction in Rate Of Future Benefit Accruals
Section 204(h) of ERISA currently provides that defined benefit and money purchase pension plans may not be amended to significantly reduce future benefit accruals, unless after adoption of the amendment and not less than 15 days before the effective date of the amendment, a written notice setting forth a summary of such amendment and its effective date is provided to participants.
The Act adds a provision to the Code (and makes corresponding changes to Section 204(h) of ERISA) which expands this notice requirement. Under the new Code provision, plan administrators of defined benefit and money purchase pension plans that are amended to provide for a significant reduction in the rate of future benefit accruals or the elimination or reduction of any early retirement benefit or retirement-type subsidy must, within a reasonable time before the effective date of any such amendment, furnish participants with a written notice explaining the amendment. The notice must be written in an understandable fashion and must be provided to each plan participant whose benefit may reasonably be expected to be significantly affected by the plan amendment. A failure by a plan sponsor to provide the notice to affected participants may result in an excise tax equal to $100 per day for each participant who did not receive the required notice, subject to certain maximums and exceptions. The Act authorizes the Secretary of the Treasury to provide simplified notice requirements or exemptions from the notice requirements if a plan has less than 100 participants with an accrued benefit or if participants are given the option to choose between a new benefit formula and the old benefit formula.
The new notice requirements are effective for plan amendments taking effect on or after June 7, 2001. Prior to the issuance of Treasury regulations, a plan will be treated as meeting the new notice requirements if the plan makes a good faith effort to comply with the requirements.
College Savings Plans
Under current law, Qualified State Tuition Programs ("QSTPs") offer a way to save for a child's or grandchild's college education on a tax deferred basis. Account earnings which are withdrawn for qualified higher education expenses are taxed for federal income purposes at the student's rate and, depending on the state, may be exempt from state income tax. Currently, there are two types of QSTPs: (1) prepaid tuition programs that permit the prepayment of credits based on the tuition rates in effect at the time of purchase, and (2) college savings programs, sponsored by a state, that allow a donor to make contributions to an account that can be used by the student to pay for qualified higher educational expenses.
In a significant improvement for taxpayers, the Act exempts from federal income tax most distributions taken from QSTPs after January 1, 2002 that are used to pay qualified higher education expenses. The Act also removes the 'state' from QSTPs (now QTPs), thereby allowing private educational institutions to establish prepaid tuition programs (but not savings programs), although withdrawals from such private programs are not tax free until January 1, 2004. Distributions from QTPs continue to be subject to the rules coordinating (and limiting) the use of QTPs simultaneous with funds from qualified scholarships, Educational IRAs, employer-provided educational assistance, Hope scholarships and Lifetime Learning credits.
Amendment Requirementsfor Qualified Plans
The IRS has issued guidance detailing how and when a qualified plan sponsor is required to amend a plan to comply with the Act. Pursuant to the IRS guidance, a qualified plan must adopt a "good faith" plan amendment for a plan year to comply with a provision under the Act that is effective for such plan year if (1) the plan is required to implement such provision under the Act for the year or, where the provision is not mandatory, the sponsor chooses to implement the provision under the Act for such year and (2) the plan language is not consistent with such provision of the Act. A good faith amendment is one that represents a reasonable effort to take into account all the requirements of the applicable Act provision, and is not an unreasonable or inconsistent interpretation of such provision. The IRS has recently provided sample amendments which, if adopted by a plan sponsor, are considered to satisfy the good faith requirements. Plans that are amended by a timely good faith amendment to comply with the Act or that automatically reflect a statutory change made by the Act, have until the end of the 2005 plan year to adopt any retroactive plan amendments required by the Act or by any IRS regulations or guidance that may be issued in connection with the Act's provisions.
As noted above, many provisions of the Act are effective in 2002. Some of these provisions are mandatory (e.g., faster vesting of matching contributions). Thus, plan sponsors must amend their plans prior to the end of the 2002 plan year to incorporate all mandatory provisions required by the Act that are effective for the 2002 plan year.
Further, many of the Act's provisions are optional; e.g., the increase in the 401(k) elective deferral limit to $11,000, the increase in the maximum compensation limit to $200,000, the ability of older employees to make special catch-up contributions and the other provisions that increase the various statutory limitations applicable to qualified plans. Plan sponsors will need to review their plans to decide (1) whether they wish to have the increased limitations and other optional provisions of the Act apply to their plans and (2) to what extent their plans need to be amended in 2002 in order to implement their decisions regarding these optional provisions. In this connection, it should be noted that where plans incorporate specific statutory limitations by reference, plan sponsors who do not want to utilize the optional increases in the limitations under the Act may need to amend their plans prior to the 2002 plan year in order to prevent the automatic application of such increases to their plans.