Pension Simplification Finally Arrives
The Small Business Job Protection Act of 1996(1) (the "Act"), which was signed by the President on August 20, 1996, eliminates some of the complexities and restrictions involved in maintaining and administering 401(k) and other qualified plans. This should encourage employers to establish new qualified plans and continue to maintain existing plans, as well as enable highly compensated individuals to utilize more fully the benefits associated with these plans.
Although some of the provisions affecting the operation of qualified plans have effective dates deferred until 1998 and 1999, many employee benefit provisions of the Act are effective beginning January 1, 1997. Thus, it is important that employers review their benefit programs at an early date in order to determine the extent to which the new law may have an impact on their programs.
The Act also contains important changes that are likely to affect the retirement and financial planning of executives. Most significantly, beginning in 1997, the Act creates a three-year window during which individuals with large accumulations in qualified plans and IRAs may receive distributions without having to pay the 15 percent excise tax on "excess distributions".
This article describes the significant changes made by the Act to the employee benefit provisions of the Internal Revenue Code of 1986, as amended (the "Code"); it is intended to provide a guide through the labyrinth of changes and to be a ready reference tool for the future.
401(k) PLANS - "CASH OR DEFERRED ARRANGEMENTS"
Under current law, elective deferrals under a qualified 401(k) plan must satisfy complex nondiscrimination requirements (commonly referred to as the "ADP Test") under which the elective deferrals of highly compensated employees generally may not exceed the elective deferrals of non-highly compensated employees by more than a specified percentage. Additionally, employer matching contributions and after-tax employee contributions under a qualified plan must satisfy similar nondiscrimination requirements (commonly referred to as the "ACP Test").
A. Safe Harbor Nondiscrimination Rules
1. The Elective Deferral Safe Harbors
The Act provides special safe harbor rules under which plan sponsors are given the option to avoid ADP testing if certain levels of employer contributions are provided. Under these special rules, if a 401(k) plan complies with one of the two safe harbors described below for a plan year, the ADP Test will automatically be satisfied for that plan year.
a. Nonelective Contribution Safe Harbor
A 401(k) plan satisfies the nonelective contribution safe harbor if the employer makes a nonelective contribution to the plan of at least 3 percent of compensation on behalf of each non-highly compensated employee ("Non-HCE") who is eligible to participate in the 401(k) plan, without regard to whether or not the Non-HCE makes elective deferrals to the plan.
b. Matching Contribution Safe Harbor
A 401(k) plan satisfies the matching contribution safe harbor if the employer makes a matching contribution on behalf of each Non-HCE equal to (i) 100 percent of each such Non-HCE's elective deferrals up to 3 percent of compensation and (ii) 50 percent of each such NHCE's elective deferrals from 3 to 5 percent of compensation. This safe harbor also requires that the rate of the matching contributions for any highly compensated employee ("HCE") not be greater than the rate of the matching contributions for any Non-HCE.
Alternatively, even if the rate of matching contributions does not satisfy the percentage requirements described above, this safe harbor will nevertheless be satisfied if (i) the matching contribution rate does not increase as the elective deferral rate increases and (ii) the aggregate amount of matching contributions equals at least the aggregate amount of matching contributions that would have been made if the matching contribution safe harbor percentage requirements were satisfied. It should be noted that unlike the nonelective contribution safe harbor which requires employer contributions for all eligible Non-HCEs without regard to whether they make elective deferrals to the plan, the matching contribution safe harbor requires employer contributions only for those Non-HCEs who actually make elective deferrals to the plan.
c. Requirements of Safe Harbors
All employer matching contributions and nonelective contributions that are used to satisfy the safe harbor rules must be nonforfeitable and subject to the restrictions on withdrawals and distributions that apply to an employee's elective deferrals under a 401(k) plan.(2) Further, under both the nonelective contribution and matching contribution safe harbors, each employee eligible to participate in the plan must be given written notice, within a reasonable period before any year, of the employee's rights and obligations under the plan.
2. The Matching Contribution Safe Harbor
The Act also provides a safe harbor method for satisfying the ACP Test applicable to employer matching contributions. A plan is treated as meeting the matching contribution safe harbor if (a) the plan meets the contribution and notice requirements applicable under the elective deferral safe harbor (described above) and (b) the plan meets a special limitation on matching contributions.
The special limitation on matching contributions is satisfied if (a) matching contributions are not made with respect to elective deferrals or after-tax employee contributions in excess of 6 percent of compensation, (b) the matching contribution rate does not increase as the elective deferral or employee contribution rate increases, and (c) the rate of matching contributions for any HCE is not greater than the rate of matching contributions for any Non-HCE.
3. Testing After-Tax Employee Contributions
No safe harbors apply to after-tax employee contributions made under a qualified plan. Therefore, such after-tax contributions will continue to be tested under the ACP Test. In performing the ACP Test, employer matching contributions and employer nonelective contributions used to satisfy the safe harbor rules may not be taken into account for purposes of the ACP Test; however, employer matching and nonelective contributions in excess of the amount required to satisfy the safe harbor rules may be taken into account for this purpose.
4. Effective Date
The new safe harbors for satisfaction of the nondiscrimination tests applicable to 401(k) plans are first effective for plan years commencing in 1999. Many employers will want to consider utilizing the new safe harbors when they become available. If utilized, these safe harbors will enable HCEs to benefit more fully from participation in a 401(k) plan without regard to the extent to which Non-HCEs participate in the plan.
B. Distribution of Excess Elective Deferrals
Under current law, the distribution of excess elective deferrals relating to a plan's ADP Test are made first to HCEs with the highest deferral rate expressed as a percentage of the HCE's compensation. This typically results in distributions being made to the lowest compensated employees of the HCE group.
Effective for plan years beginning in 1997, the Act provides that the distribution of excess deferrals are required to be made on the basis of the amount of contributions made by each HCE.(3) Thus, under the Act, excess deferrals are deemed attributable to those HCEs who have the greatest dollar amount of elective deferrals and accordingly the excess deferrals of those HCEs must be returned first.
C. Use of Prior Year Data
Beginning with the 1997 plan year, the Act modifies the ADP Test by providing that the limit on elective deferrals made by HCEs under a 401(k) plan may be based upon the elective deferrals made by Non-HCEs in the previous plan year, rather than the current plan year.(4) This change should simplify compliance with the nondiscrimination tests applicable to 401(k) plans, since employers will know at the beginning of a plan year the amounts that HCEs can defer without violating these rules.
An employer may instead elect to use the current plan year percentages. However, once such an election is made, it may be revoked only as provided under regulations to be issued by the Secretary of Treasury.
D. Alternative ADP and ACP Testing for Plans that Provide for Early Participation
A qualified plan may generally exclude employees who are under age 21 or who have not completed one year of service from plan participation. However, an employer may adopt a plan with less restrictive participation requirements.
Under current law, for purposes of the ADP and ACP Tests, an employer that maintains a 401(k) plan with less restrictive participation provisions may choose to undertake separate testing under which the ADP and ACP Tests are applied separately to (i) employees eligible to participate in the plan, excluding those employees who are either under age 21 or have not completed one year of service and (ii) employees eligible to participate in the plan who are either under age 21 or have completed less than one year of service (i.e., those excluded from the first group).
The Act modifies the nondiscrimination tests applicable to 401(k) plans by permitting plans to disregard employees who are under age 21 or have not completed one year of service. This modification, which is effective for plan years beginning in 1999, will generally enable employers to permit employees to participate in their 401(k) plans before completing a year of service without adversely affecting compliance with these nondiscrimination rules. It should be noted, however, that all employees who are under age 21 or have not completed one year of service continue to be separately subject to the minimum coverage requirements applicable to qualified plans.
E. Tax-Exempt Organizations Eligible to Maintain Section 401(k) Plans
Effective for plan years beginning in 1997, the Act permits tax-exempt organizations to establish 401(k) plans. However, state and local governments are still not allowed to establish such plans.
TREATMENT OF DISTRIBUTIONS FROM QUALIFIED PLANS
A. Repeal of Five-Year Forward Income Averaging
Under current law, an individual who receives a qualifying lump-sum distribution may elect to pay a tax on the lump-sum distribution that would approximate the tax that would be paid if the lump-sum distribution were received in 5 equal annual installments (5-year forward income averaging). Effective in the year 2000, the Act repeals 5-year forward income averaging. However, 10-year averaging and capital gains treatment for the pre-1974 portion of a lump-sum distribution remain available for certain individuals who attained age 50 prior to January 1, 1986.
B. Modification of Required Distribution Rules
Beginning in 1997, the Act allows participants in qualified plans (other than 5 percent owners) who continue to be employed by their employers after attaining age 70-1/2, to defer commencement of their distributions until April 1st of the calendar year following the calendar year in which they retire. This rule is an important change from current law under which participants who are still employed upon attaining age 70-1/2 must nevertheless commence receiving distributions. If a participant was receiving required minimum distributions prior to 1997, but under the Act is no longer required to receive such minimum distributions, the plan could (but is not required to) permit the participant to stop receiving distributions until distributions are required (i.e., upon retirement).
C. Recovery of Basis on Payments from Qualified Plans
The Act provides a new simplified method for determining the recovery of basis for distributions from qualified plans. Under the new method, the portion of each annuity payment that represents a return of basis equals the employee's total basis as of the annuity starting date, divided by the number of anticipated payments, which is now determined under a table based upon the employee's age as of the annuity starting date. This new method of calculating basis recovery is effective with respect to annuity starting dates beginning 90 days after August 20, 1996
TEMPORARY SUSPENSION OF EXCISE TAX ON EXCESS DISTRIBUTIONS
Current law imposes a 15 percent excise tax on "excess distributions" from qualified plans, tax sheltered annuities, and IRAs. The amount of the excess distribution is generally the amount of any distributions made during a calendar year in excess of $155,000 (in 1996) or in the case of a lump-sum distribution, $775,000 (in 1996). An additional 15 percent estate tax is also imposed on an individual's "excess accumulation" at death.
In a change which could significantly benefit highly compensated employees with large accumulations in qualified plans, tax sheltered annuities and IRAs, the Act temporarily suspends the 15 percent excise tax on excess distributions received in 1997, 1998 and 1999. This temporary suspension does not apply to the 15 percent additional estate tax imposed on excess accumulations at death. In addition, as previously discussed, beginning in the year 2000, the Act eliminates five-year income averaging for individuals who receive qualifying lump-sum distributions. Accordingly, individuals with substantial retirement accumulations may want to consider taking distributions between January 1, 1997 and December 31, 1999 in order to avoid the 15 percent additional excise tax and/or take advantage of the expiring five-year income averaging provision.
NONDISCRIMINATION REQUIREMENTS FOR QUALIFIED PLANS
A. Definition of Highly Compensated Employee
Beginning with the 1997 plan year, the Act eliminates the current complex definition of a highly compensated employee and replaces it with a substantially simplified definition. Under this simplified definition, an employee is an HCE only if such employee either (1) is a 5 percent owner of the employer at any time during the current or preceding plan year or (2) had compensation for the preceding plan year in excess of $80,000(5) (indexed for inflation). This change should simplify administration of 401(k) plans, as well as compliance with the nondiscrimination requirements for other qualified plans.
B. Repeal of Family Aggregation Rules
Under current law, if an employee is a member of the family of either a 5 percent owner or an individual who is one of the top ten most highly compensated employees, then such family member is not considered a separate employee and, for qualified plan purposes, any compensation, contribution or benefit paid to or on behalf of such family member is generally treated as if it were paid to or on behalf of the related HCE. Similar family aggregation rules apply with respect to the $150,000 limit on compensation that may be taken into account under a qualified plan and for compensation that is taken into account for deduction purposes.
Effective for plan years commencing in 1997, the Act repeals the family aggregation rules described above.
C. Modification of Minimum Participation Requirements
Effective for plan years commencing in 1997, the Act modifies the minimum participation rules so that such rules will apply only to defined benefit plans and will no longer apply to defined contribution plans. Under the Act, in order for a defined benefit plan to satisfy the minimum participation requirements, the plan must benefit no fewer than the lesser of (1) 50 employees, or (2) the greater of (a) 40 percent of all employees of the employer, or (b) two employees (one employee if an employer has only one employee).
MODIFICATIONS TO BENEFIT AND CONTRIBUTION LIMITATIONS UNDER QUALIFIED PLANS
A. Definition of Compensation for Purposes of the Annual Limitation on Contributions and Benefits
Effective for plan years commencing in 1998, the Act expands the definition of compensation for purposes of the annual limitation on contributions and benefits (Code Section 415). Under this change, compensation includes elective deferrals under 401(k) plans and similar arrangements, elective contributions to nonqualified deferred compensation plans of tax-exempt employers and state and local governments, and employee salary reduction contributions to a cafeteria plan. This expanded definition of compensation should result in fewer inadvertent violations of the annual contribution limitations for qualified plans.
B. Repeal of Combined Plan Limitation
Under current law, if an employee is a participant in both a defined contribution and a defined benefit plan maintained by the same employer, an overall limitation on contributions to and benefits from the combined plans applies with respect to such employee. Under the Act, effective with respect to limitation years beginning in the year 2000, this combined plan limitation is repealed.
C. Contributions on Behalf of Disabled Employees
Current law provides that an employer may elect to continue to make contributions to a defined contribution plan for the benefit of permanently and totally disabled non-highly compensated employees and that the compensation of any such disabled employee for purposes of determining the annual limitation on contributions is the annualized compensation of the employee prior to becoming disabled.
Effective for plan years commencing in 1997, the Act provides that if a plan so provides, an employer may make contributions to a defined contribution plan on behalf of all permanently and totally disabled employees (i.e., both non-highly and highly compensated employees) without making any specific election.
EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)
A. ESOP as S Corporation Shareholder
Under current law, an ESOP may not be a shareholder of an S Corporation. The Act provides that, effective for taxable years beginning in 1998, an ESOP may be an eligible shareholder of an S Corporation. However, many of the special tax incentives applicable to ESOPs will not be available to ESOPs that are shareholders of S Corporations.(6) Further, any income attributable to the S Corporation will be taxable to the ESOP as unrelated business taxable income.
B. Repeal of 50 Percent Interest Exclusion for ESOP Lenders
Under the law prior to the Act, a business actively engaged in lending could exclude from its gross income 50 percent of the interest it received on an ESOP loan, provided certain requirements were met.
Effective with respect to loans made after August 20, 1996, the Act repeals the 50 percent interest exclusion. The repeal of the exclusion does not apply, however, to the refinancing of ESOP loans made on or before August 20, 1996 which meet certain requirements.
MISCELLANEOUS PENSION AND EMPLOYEE BENEFIT CHANGES
A. Increase in Tax on Prohibited Transactions
A two level excise tax is imposed on certain prohibited transactions between a qualified plan and disqualified persons (e.g., a fiduciary or plan sponsor). Under the law prior to the Act, the initial level of tax was equal to 5 percent of the amount involved in the prohibited transaction. Under both prior law and the Act, a second level of tax, equal to 100 percent of the amount involved in the prohibited transaction, is imposed if the transaction is not corrected within a certain amount of time.
The Act provides that with respect to prohibited transactions occurring after August 20, 1996, the initial level of tax is increased from 5 percent to 10 percent.
B. Treatment of Leased Employees
If an individual is a "leased employee" of an employer, such employer may be required to treat the individual as his own employee for purposes of various employee benefit provisions (e.g., nondiscrimination testing).
Under current law, one of the requirements that must be satisfied in order for an individual to be considered as a leased employee is that the services performed by the individual for the service recipient are of a type "historically performed" by employees in the business field of the recipient. The Act revises this requirement by eliminating the historically performed test and replacing it with a "control" test. Thus, under the revised test, an individual is not considered a leased employee unless the individual's services are performed under the primary direction or control of the service recipient.(7)
The revised definition of a leased employee is effective for plan years commencing in 1997, except that it will not apply for relationships that the IRS has already determined not to involve leased employees.
C. Individual Retirement Accounts (IRAs)
Under current law, an eligible non-working spouse may not make a deductible IRA contribution of more than $250 for any year. Beginning in 1997, the Act provides that a deductible contribution of up to $2,000 may be made to an IRA for a nonworking spouse. Thus, if a married couple is eligible to make deductible contributions to an IRA, they may make a total deductible contribution of up to $4,000, even if one of the spouses does not have any compensation for the year of the contribution.
D. Elimination of Special Vesting Rule for Multiemployer Plans
Under current law, multiemployer plans may require participants to complete up to 10 years of service before becoming 100 percent vested. The Act repeals the special vesting rule for multiemployer plans and subjects such plans to the same vesting requirements as other qualified plans. This provision is effective for plan years beginning on or after the earlier of (1) the later of January 1, 1997, or the date on which the last collective bargaining agreement pursuant to which the plan is maintained terminates, or (2) January 1, 1999.
E. Simple Plans
Effective for plan years beginning in 1997, the Act also creates a new simplified retirement plan called the Savings Incentive Match Plan for Employees ("SIMPLE Plan"). Employers that employed 100 or fewer employees with at least $5,000 in compensation for the preceding plan year may maintain a SIMPLE Plan provided certain requirements are satisfied. This SIMPLE Plan may be maintained in either IRA form or as a 401(k) plan and the maximum annual amount that an employee may contribute on a pre-tax basis is $6,000 (indexed for inflation).
Each employee of an employer that received at least $5,000 in compensation from the employer during any prior two years and who is reasonably expected to receive at least $5,000 in compensation during the current year must generally be eligible to participate in a SIMPLE Plan. Employers must make contributions to a SIMPLE Plan in accordance with either a required matching contribution or nonelective contribution formula. Under the matching contribution formula, an employer is generally required to make a fully vested matching contribution with respect to an employee's elective contributions on a dollar-for-dollar basis up to 3 percent of the employee's compensation. Under the nonelective contribution formula, an employer must make a fully vested nonelective contribution equal to 2 percent of compensation (not taking into account compensation in excess of $150,000 as indexed) for each eligible employee with at least $5,000 in compensation for such year.
F. Employer Provided Educational Assistance
For taxable years beginning prior to January 1, 1995, an employee could exclude from gross income amounts of up to $5,250 paid by his employer pursuant to an educational assistance program, even if such education was not job related.(8) The exclusion expired on December 31, 1994; beginning January 1, 1995, payments for educational expenses were excluded from an employee's gross income only if it related to the employee's current job.
The Act extends the original exclusion to tax years beginning after December 31, 1994. However, the exclusion expires after May 31, 1997 and it does not apply to graduate school courses beginning after June 30, 1996. To the extent employers have previously filed Forms W-2 reporting the amount of educational assistance as taxable wages, they are generally required to file Forms W-2c (i.e., corrected Forms W-2) with the IRS and affected employees.(9)
G. Amendment Requirements for Qualified Plans
In general, plan amendments to incorporate the pension changes under the Act are not required to be made before the first plan year beginning on or after January 1, 1998. However, all plans must be operated in compliance with these changes when they first become effective.
1. Pub.L. No. 104-188, (August 20, 1996). Many of the pension simplification provisions contained in the Act were previously included as part of proposed tax legislation that was never enacted.
2. Elective deferrals under a 401(k) plan may generally be distributed only upon a participant's retirement, death, disability, separation from service, attainment of age 59-1/2 or upon the occurrence of a hardship.
3. This rule also applies with respect to excess matching and/or after-tax employee contributions of HCEs under the ACP Test.
4. A similar change is made with respect to the ACP Test.
5. As an alternative to the $80,000 test, an employer may elect a more limited definition of highly compensated employee by treating only those employees who had compensation for the preceding plan year in excess of $80,000 (indexed for inflation) and were in the top 20 percent of employees by compensation for such plan year as highly compensated employees.
6. The Act denies several benefits with respect to S corporation stock held by an ESOP. These benefits relate to liberalized limits on deductions for contributions to ESOPs and dividends on employer securities. In addition, gain on the sale of S corporation stock is not eligible for tax-deferred "rollover" treatment under Code Section 1042.
7. The legislative history of the Act indicates that whether services are performed by an individual under the primary direction or control of the service recipient depends on the facts and circumstances of the particular situation. The legislative history further provides that generally, if the service recipient exercises the majority of direction and control over an individual, the service recipient will be considered to have primary control over that individual.
8. Code Section 127.
9. IR 96-36 (8/23/96) provides a special procedure for employers and employees to obtain refunds as a result of this retroactive reinstatement of the tax-break for employer provided educational assistance.