Employee Benefits

Employee Benefits Developments September 2005

Rulings, Opinions, Etc.

Determination Letter Deadlines for Individually Designed, Pre-Approved Plans Announced. A qualified retirement plan is required to contain specific provisions to comply with Internal Revenue Code (IRC) § 401(a) requirements. On August 26, the Internal Revenue Service (IRS) issued Revenue Procedure 2005-66 which establishes a system of cyclical remedial amendment periods for individually designed and pre-approved plans (master and prototype and volume submitter) and the deadlines for submitting these plans to the IRS. Under the new procedures, individually designed plans will follow a staggered, five-year remedial amendment cycle, and pre-approved plans will follow a six-year amendment/approval cycle. The effect of this new system “is that a sponsor generally won’t have to apply for a new opinion, advisory, or determination letter more than once during any remedial amendment cycle.”

Under the new system, the staggered, five-year amendment cycles for individually designed plans are determined according to the last digit of the sponsoring employer’s taxpayer identification number (TIN) (see chart below).

If employer's TIN ends in	The plan's cycle is	Last day of the EGTRRA remedial amendment period (i.e., the first cycle) is
1 or 6	Cycle A	January 31, 2007
2 or 7	Cycle B	January 31, 2008
3 or 8	Cycle C	January 31, 2009
4 or 9	Cycle D	January 31, 2010
5 or 0	Cycle E	January 31, 2011

On February 1, 2006, the IRS will begin to accept determination letter applications for individually designed plans that fall in the first remedial amendment cycle (see above Cycle A ). Plan sponsors must apply for a new determination letter within the last 12 months of a plan’s Economic Growth and Tax Relief Reconciliation Act (EGTRRA) remedial amendment cycle. In other words, for Cycle A plans, a determination letter request must be filed within the period beginning February 1, 2006 and ending January 31, 2007. Included with the determination letter will be a statement by the IRS that the determination letter may not be relied on after the end of the plan’s first five-year remedial amendment cycle and will include a specific expiration date.

An application for a determination letter may be submitted early, or “off cycle.” However, to continue to be able to rely on the determination letter, the plan sponsor must submit an additional application in compliance with its regularly scheduled remedial amendment cycle.

The six-year remedial amendment/approval cycles for pre-approved plans differ depending on whether the plan is a defined contribution pre-approved plan or a defined benefit pre-approved plan. If the plan is a defined contribution plan, the last day of the EGTRRA remedial amendment period (i.e., the first cycle) is January 31, 2011. If the plan is a defined benefit plan, the last day of the EGTRRA remedial amendment period (i.e., the first cycle) is January 31, 2013.

IRS Publishes Final and Proposed Anti-Cutback Rules. On August 12, the IRS issued final regulations on the anti-cutback rules of IRC § 411(d)(6), which generally protect accrued benefits, early retirement benefits, retirement-type subsidies, and optional forms of benefit under qualified retirement plans. (T.D. 9219) The final regulations adopt, with minor revisions, proposed IRC § 411(d)(6) regulations published in March 2004 (see Employee Benefits Developments, March 22 to April 2, 2004). The IRS simultaneously published a set of proposed regulations (REG-156518-04) that include a new utilization test under which a plan may be amended to eliminate an optional form of benefit that has not been utilized during a look-back period. The utilization test would provide that the optional form being eliminated must have been available to at least 100 participants who are taken into account during the look-back period. The look-back period under the utilization test in the proposed regulations generally is the two-plan year period immediately preceding the plan year in which the plan amendment eliminating the optional form of benefit is adopted. The rules relating to the utilization test are proposed to be effective for amendments adopted after 2006.

Option Exercise Is Taxable, Despite Restrictions on Sale of Stock. Under a ruling issued August 2, employees who exercise nonqualified stock options during a “lock-up period” are subject to taxation at the time of exercise, even if the employees’ sale of the stock is restricted under insider trading rules. Revenue Ruling 2005-48 describes an employee who is granted a nonqualified option to purchase shares of employer stock. The employer then engages in an initial public offering. Under an underwriting agreement, the employee agrees not to sell any shares or options until the end of a five-month lock-up period. The company also adopts an insider trading compliance program under which the employee may trade company shares only during a 25-day “trading window” in November. During the lock-up period and outside the trading window, the employee exercises the option and receives shares of company stock. As of the date of exercise, the employee possesses material nonpublic information concerning the company that temporarily prohibits him from selling the shares under Rule 10b-5 of the Securities Exchange Act of 1934 (the Securities Act).

The IRS held any compensation income attributable to the option exercise is includable in the employee’s income at the time of exercise, despite the restrictions on selling the shares. The IRS distinguished the restrictions from those imposed under § 16(b) of the Securities Act. The employee’s shares would be treated as unvested if selling the shares within six months of purchase could subject the employee to a lawsuit under § 16(b). In this case, however, the IRS noted the six-month window of risk for a § 16(b) lawsuit begins when an option is granted, not when it is exercised. Consequently, the window of risk had already closed for the employee described in the ruling. The IRS also held the amount of compensation income that must be included is determined without regard to the share transfer restrictions imposed by either the underwriter’s agreement or the insider trading rules, because the restrictions did not subject the shares to a substantial risk of forfeiture.

IRS Guidance on Employee Tool Allowance Program Provides Useful Reminders. In Revenue Ruling 2005-52, the IRS reviewed the operation of an employee tool allowance program for an employer operating an automobile repair business. While the particular revenue ruling addressed the issues for employee tool allowances, employers should review all allowance programs to determine if the requirements of an accountable plan are met. If the requirements are not met, all amounts are includable in the employee’s income and the employer must withhold applicable income and other wage withholding amounts. Under the tool allowance program, service technicians were required to provide and maintain various tools they use in performing their services. The employer paid each employee a set amount each hour worked as a tool allowance to cover the cost the employee incurs for acquiring and maintaining the tools. Under the program, the technicians were not required to provide any substantiation of the expenses actually incurred for tools and the employer did not require the employees to return any portion of the tool allowance exceeding the expense actually incurred. Under IRS regulations an arrangement meets these requirements only if

it provides advances, allowances or reimbursements for business expenses that are allowable as deductions,

the employee must substantiate the amount expended, and

the employee must return all amounts in excess of the substantiated expenses.

In the revenue ruling, the IRS held the program does not meet the requirements to be an accountable plan for the amounts to be excluded from the employee’s gross income.

5500 Electronic Filing May Be Required in 2008. The Department of Labor (DOL) published proposed regulations that would require electronic filing of Form 5500 for plan years beginning in 2007. Currently, a Form 5500, filed for welfare plans with 100 or more participants and all pension/401(k) plans, may be filed on paper or may be filed electronically. The DOL proposal is intended to increase the efficiency of annual report filing and data analysis for both filers and the government. In the preamble to the regulation, the DOL discussed its analysis of an exception to electronic filing for small plans. As proposed, however, all plans regardless of size will be required to use the electronic filing system. Further information on DOL compliance may be found at: www.dol.gov/compliance. Comments on the electronic filing proposal should be received by the DOL by October 31. (DOL Prop. Reg. 2520.104 a-2; 70 Fed. Reg. 51,541).

Beware Undervalued Life Insurance Policies. Following earlier pronouncements on the use and valuation of cash-value life insurance policies that carry temporarily low cash surrender values, the IRS has issued final regulations on tax values to be used when a qualified retirement plan distributes a life insurance policy. The new regulations, as well as Revenue Procedure 2005-25 and earlier guidance on the valuation of life insurance policies in qualified plans, reiterate that fair market value is the taxable benefit received upon the distribution of a life insurance policy. The guidance was issued in response to promoters who designed transactions with life insurance policies where the plan accounts for its cost in purchasing a policy based on the premium paid and a plan participant, upon receiving the policy in a distribution, pays taxes only on a temporarily low cash surrender value. These arrangements and the resulting tax accounting are considered “abusive” tax shelter schemes by the IRS. Transactions involving the purchase and distribution of life insurance policies by qualified plans should be considered in light of these regulations. (T.D. 9223, issued Aug. 26, 2005).

CASES

Ninth Circuit Finds Implicit Duty Under ERISA to Provide Timely Notice of Plan Termination. The U.S. Court of Appeals for the Ninth Circuit recently ruled an employer that satisfied the explicit reporting and disclosure provisions of the Employee Retirement Income Security Act of 1974 (ERISA) when a long-term disability (LTD) plan was cancelled, nevertheless breached its ERISA fiduciary duties by failing to notify employees of the cancellation until three months after the plan had been terminated. Following a serious car accident in October 2000, Carmen Peralta filed for disability benefits under the LTD plan of her employer, Hispanic Business, Inc. (HBI), believing she was covered by the policy. Unfortunately, the policy was no longer in effect, even though the employees were not notified of the cancellation of coverage until after Peralta’s accident, some three months after the policy was cancelled. Peralta filed suit, claiming she had relied on HBI’s policy and alleging HBI had a fiduciary duty under ERISA to provide notice of the discontinuation of coverage. The federal district court granted summary judgment for HBI, and Peralta appealed.

In this case, the Ninth Circuit conceded the employer satisfied the explicit statutory disclosure provisions of ERISA. However, the court found that a separate notification duty exists, concluding that, although ERISA does not expressly require timely notice of plan termination, “more must be required of an administrator than mere compliance with ERISA’s express reporting and disclosure provisions.” The court found, “although the statute does not expressly require timely notice of plan termination, such a requirement is implicit in the purpose and structure of ERISA.” Although the court held notification three months after the plan’s cancellation does not constitute timely notification, the court nevertheless found no remedy was available to Peralta. Because the company’s LTD plan was no longer in effect, the only relief possible would be compensatory in nature and thus outside the scope of remedies available under ERISA. Peralta v. Hispanic Business, Inc., (9th Cir. 2005).

Fiduciaries In Distress (Along With Their Defined Benefit Plans). In Harpster v. AARQUE Management Corp., the U.S. District Court for the Northern District of Ohio was presented with a fact pattern that is becoming all too familiar: an employer unable to make the required contributions to its defined benefit pension plan. In Harpster, former members of the plan sponsor’s board of directors were sued on the grounds they had breached their fiduciary duties under ERISA by failing to protect (or at least attempting to protect) the interests of plan participants when it became clear that the worsening financial circumstances of the plan sponsor placed future contributions to the company’s defined benefit plan in jeopardy. In this case, the company negotiated financing with a lender who agreed to the loan only if the company went into a bankruptcy proceeding. As a result of the bankruptcy filing, the company did not make a known required contribution that would not have been due until eight months after the date of the bankruptcy filing. As a general rule, the obligation to make annual required contributions to a defined benefit plan is not a fiduciary obligation because, absent employee contributions, it does not involve the management or administration of the plan or its assets. Accordingly, the decision whether or not to commit corporate assets (as opposed to plan assets such as employee contributions) to the plan or to some business purpose (e.g., to appease an important creditor) is a decision the plan sponsor can make without giving paramount consideration to the interests of the plan’s participants. While the court did not hold the fiduciaries had, in fact, breached their fiduciary duties, it did find the defendants may have had a fiduciary duty under the circumstances to investigate the relevant facts and explore alternative courses of action. Harpster v. AARQUE Management Corp., (N.D. Ohio, 2005).

Court Assesses Employer With Penalty for Not Providing Requested Plan Information. An employer was fined for its failure to respond within 30 days to its employee’s request for long-term disability benefits information, even though the employee had previously been provided with the information. In this case, the employee’s first written request was made on July 5, 2002, and Pharmacia Corporation did not respond until August 29, 2002. The U.S. District Court of the District of Puerto Rico fined Pharmacia $2,500; $100 per day that the corporation exceeded the 30-day deadline.

The federal district court found it irrelevant that Pharmacia had already provided its employee with information explaining long-term disability benefits on October 21, 1999. “Providing a summary plan description several years before the request for information does not excuse the [defendant] from its duty to respond fully and accurately to later inquires regarding benefits.” The lesson for plan administrators is clear: Promptly respond to written requests for plan information. Otero-Carrasquillo v. Pharmacia, (D. P.R., 2005).

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