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Employee Benefits

Employee Benefits Developments November 2007

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RULINGS, OPINIONS, ETC.

409A Transition Relief and Compliance Deadline Extended
Responding to concerns of practitioners and employers, on October 22, 2007, the IRS formally extended the transition relief for bringing deferred compensation arrangements into compliance with the final regulations under Section 409A of the Internal Revenue Code (IRC). With the earlier release of Notice 2007-78, the IRS had already extended to December 31, 2008 the deadline for documentary compliance with Section 409A. Although appreciative of the limited relief, commentators had expressed concern that it did not adequately address the need for additional time for employers to analyze all of their plans and make informed decisions regarding the changes that would be necessary to bring existing plans into compliance with the final regulations. Now, with the issuance of Notice 2007-86, the IRS has generally extended to December 31, 2008 the transition relief that was currently scheduled to expire at the end of 2007. Under Notice 2007-86, compliance with the final regulations is not required before 2009. If a plan is operated in compliance with the provisions of the statue, Notice 2005-1, and other applicable guidance through 2008, and the plan is amended before 2009 in accordance with the final regulations, the plan will not be treated as violating Section 409A. New payment elections with respect to time and form of payment may now be permitted until the end of 2008, provided the rules restricting current-year elections are observed. For example, an election made in 2008 to change a time and form of payment may not apply to an amount that would otherwise be payable in 2008 or cause an amount to be paid in 2008 that would not otherwise be payable in 2008. Transition rules permitting the replacement of discounted stock options and stock appreciation rights are also extended through the end of 2008, except for awards granted to certain executives of publicly traded companies.

2008 Benefit Limits Announced
The Internal Revenue Service (IRS) and Social Security Administration (SSA) have announced the cost-of-living adjusted dollar limits applicable to benefit plans for 2008. A listing of key limits is set out below:

Cafeteria Plans: New Items on the Menu
On August 6, 2007, the IRS issued proposed cafeteria plan regulations, bringing clarity to a number of important issues and adding some new rules. The regulations are generally effective for plan years beginning on and after January 1, 2009. The following are some of the highlights of the new regulations:

• Cafeteria plans must be maintained in writing, and the documents must reflect a number of statutory and regulatory requirements. If there is no plan document or the plan document fails to incorporate all necessary requirements, the plan is “disqualified,” and employee pre-tax salary reduction contributions and cashable employer flex credits are subject to income and payroll taxes.

• A cafeteria plan may allow an employee to purchase health plan coverage for a nondependent (e.g., a domestic partner or nondependent child) with pre-tax cafeteria plan dollars, provided the employer imputes income to the employee equal to the value of the nondependent coverage. Employers do not have to require premiums associated with nondependent coverage to be paid with after-tax salary reduction contributions.

• A cafeteria plan may offer employee group term life insurance on a pre-tax basis up to $50,000.  Before the new regulations, employees were taxed on the greater of either the cafeteria plan contributions for coverage in excess of $50,000 or the Table I rates for the excess coverage.  The amount taxed to the employee is now based only on the cost of the excess coverage as determined under Table I, even if the actual premium cost is greater.  In most cases, this change will result in a tax savings for employees.

• A cafeteria plan (other than a health FSA) may reimburse individual accident and health insurance premiums, provided the plan substantiates the expense prior to reimbursement.  In this respect, the new regulations confirm a cafeteria-plan feature that had been in use for years.  However, employers should consider the compliance implications of this feature under other federal laws, such as ERISA and HIPAA.  An employer that wishes to extend this benefit to its employees must be sure the cafeteria plan document permits it.  Pending further guidance, employers should restrict this feature to individual policies covering employees; it is unclear whether a plan can reimburse premiums for policies covering only dependents.

• A cafeteria plan may reimburse an employee for COBRA premiums under the employer’s group health plan (e.g., an employee shifts from full to part-time status and loses coverage) or under a plan maintained by the employee’s prior employer (e.g., a new hire who has COBRA coverage through his or her prior employer).  In addition, a cafeteria plan may permit a former employee to pay COBRA premiums under the employer’s plan with pre-tax deductions from severance pay.  An employer that wishes to extend this benefit to its employees must be sure the cafeteria plan document permits it.

• The new regulations prohibit discrimination in favor of highly compensated employees, a term that has a meaning similar to the definition used for qualified retirement plan testing.  Under the proposed regulations, a cafeteria plan must:

• Benefit a minimum percentage of an employer’s nonhighly compensated employees (i.e. the “eligibility test”) • Provide each similarly situated employee with the same opportunity to elect cafeteria plan benefits
• Not be used by highly compensated employees to purchase non-taxable benefits to an extent that is disproportionately greater than the extent to which nonhighly compensated employees purchase nontaxable benefits
• Not permit non-taxable benefits for “key” employees to exceed 25 percent of the aggregate nontaxable benefits for all participants The following plan designs can be problematic under the new rules:
• Exclusion of one or more classes of employees from cafeteria plan participation (e.g., “part-time” employees, hourly employees, employees of specific company divisions or lines of business)
• Shorter waiting period for salaried employees versus hourly employees
• Different benefits (e.g., flex credits, component benefits, premium cost-sharing) based on employee classification
• Different benefits for the employees of various employers within a company’s controlled group

These are a few of the highlights of the new regulations. While the regulations are not effective until January 1, 2009, it is not too early for employers to begin a comprehensive review of their cafeteria plans. With the increased IRS attention to cafeteria plan discrimination issues, employers must now test their plans more rigorously than in the past. Employers should test their plans in 2009 (based on 2008 demographics) to see how they would fare under the new nondiscrimination rules. (IRS Prop. Reg. §1.125, 72 Fed. Reg. 43938)

409A Rules Do Not Affect Teacher Salaries for the Upcoming School Year
Under the Internal Revenue Code Section 409A (409A) rules regulating deferred compensation, when a teacher is allowed to choose between being paid only during the school year and being paid over a 12-month period and then chooses the 12-month pay period, that teacher technically is deferring part of his or her pay from one year to the next. For example, a teacher who chooses to get paid over a 12-month period running from September 1, 2007 through August 31, 2008, rather than the 10-month period running from September 1, 2007 through June 30, 2008, is effectively deferring until 2008 some of the dollars he or she would have received in 2007. Although schools are not required to offer teachers a so-called annualization election, those schools that choose to offer such an election may have to make some changes in their procedures to comply with the new 409A rules. The IRS, however, has announced that the new 409A rules will not be applied to annualization elections for school years beginning before January 1, 2008, so school districts will have time to make any procedural changes needed to comply with 409A. (IR-2007-142; see also Frequently Asked Questions: Sec. 409A and Deferred Compensation at www.irs.gov/newsroom/article/0,,id=172883,00.html)

DOL Publishes Civil Penalty Rules for Failure to Provide Stock Diversification Notice
The Pension Protection Act of 2006 (PPA) enacted rules giving certain plan participants and beneficiaries the right to sell the employer stock in their accounts and reinvest the proceeds into other investments available under a plan. PPA requires plan administrators to notify participants and beneficiaries of this new right and of the importance of diversifying the investment of retirement account assets. Plan administrators must provide this notice not later than 30 days before the first date on which the individuals are eligible to exercise their stock diversification rights. Pursuant to authority granted under the PPA, the Department of Labor has published regulations under which it may assess civil monetary penalties up to $100 per day against plan administrators for each violation of the new stock diversification notice requirement. (72 Fed. Reg. 44970)

IRS Relief for Pension Plans Modifying Definition of Normal Retirement Age
As previously reported (see Employee Benefits Developments, July 2007), the IRS has adopted rules on the earliest a normal retirement age may be under a plan. Now, in Notice 2007-69, the IRS has provided two methods of relief to plans that may need to make changes in this area. Under the first form of relief, plans with a normal retirement age between 55 and 62 that cannot reasonably and in good faith determine that no amendment is necessary may adopt an amendment modifying normal retirement age effective no later than the first day of the first plan year beginning after June 30, 2008. The interim amendment would have to be adopted by the later of two dates, either the first day of the first plan year beginning after June 30, 2008, or the due date, including extensions, for filing the employer’s income tax return for the taxable year that includes the first day of the first plan year beginning after June 30, 2008. Under the second form of relief, plans with a normal retirement age lower than 55 will get the same presumption as plans with a normal retirement age between 55 and 62 if they submit a request for a letter ruling on whether the plan’s normal retirement age definition satisfies the new standards.

Medical Insurance Taxable if Paid by Pension Plan
The IRS issued proposed regulations addressing the payment of medical or accident insurance by a qualified pension plan to provide coverage for a participant. The regulations do not establish a new position, but rather reflect and clarify the IRS position that was articulated before ERISA in Revenue Rulings 61-164 and 73-501. The regulation basically provides that the payment of premiums from a qualified pension, profit sharing, 401(k), or stock bonus plan for accident or health insurance, including long-term care insurance, constitutes a distribution to the participant against whose benefit the premium is charged. The amount of the distribution equals the amount of the premium paid under the plan. In the case of an individual account plan, if a premium is paid from a current-year contribution or forfeiture before the contribution or forfeiture is allocated to participant accounts, then the amount of the premium paid for each participant is treated as if it is first allocated to the participant account and then distributed in a taxable distribution to the participant. Because of these tax rules, the use of qualified plan benefits to pay health insurance premiums normally does not provide any tax advantage. There are some exceptions to the rule recognized in the regulations. Special rules in IRC Section 401(h) permit the payment of medical benefits under certain pension plans pursuant to a set of rules and regulations that have allowed overfunded pension plans to utilize pension assets to provide retiree health accounts. There is also a special rule allowing the tax free payment of health and long-term care insurance benefits from governmental plans to retired public safety officers. The proposals affect several sections of the Treasury regulations. (Basic rules contained in Prop. Reg. § 1.402(a)-1(e). 72 Fed. Reg. 46421)

Regulations Issued on Restricted Benefits in Underfunded Pension Plans
The Pension Protection Act of 2006 (PPA) adopted a new IRC Section 430 in 2006, dealing with funding standards for single-employer defined benefit pension plans. These rules require a tremendous amount of actuarial review and analysis with respect to the funding of defined benefit plans. Coupled with IRC Section 430 is new IRC Section 436, which provides limits on benefits and benefit accruals for underfunded plans. Proposed regulations provide guidance on these benefit limitations. Compliance with the new limitations is an element of plan qualification, meaning that failure to follow the rules will disqualify a plan. The new statutory rules and accompanying regulations add a fair amount of complexity to the funding rules for defined benefit pension plans and will have considerable impact on plans that are underfunded. While there are a number of exceptions under the rules, particularly for newly adopted defined benefit plans, plan sponsors will be required to carefully monitor the funding status of a defined benefit plan. If a plan is less than 60 percent or 80 percent funded, these rules will impose restrictions on the employer’s ability to increase benefits or accelerate benefit payments. There are also limitations on “unpredictable contingent event benefits,” such as plant shutdown benefits, that will restrict the ability of the plan to pay these benefits if the plan is less than 60 percent funded. Other limitations are imposed on the ability of the plan sponsor to adopt an amendment that would increase benefit liabilities if the plan is less than 80 percent funded. The new rules are effective for plan years beginning after 2007. All plan sponsors of defined benefit plans should be reviewing these rules with the plan actuary and other plan advisors to make sure that all of the new rules are taken into account in funding decisions and that the plan retains its qualified status once the new rules are in effect. (Prop. Reg. §1.430(f)-1 & §1.436-1, published in 72 Fed. Reg. 50544)

CASES

Participants Not Entitled to Surplus Assets From Plan That Was Not Terminated
In December 2000, Moore Wallace North America Inc. (Moore Wallace) announced it would terminate its defined benefit/cash balance plan in favor of a defined contribution plan. An application was filed with the IRS for a determination letter on plan termination, and a standard termination notice was filed with the Pension Benefit Guaranty Corporation. In 2004, when the IRS had failed to provide a favorable determination letter (apparently because of the freeze on determination letters involving cash balance conversions), Moore Wallace decided not to terminate the plan. Former and current plan participants filed a class action law suit seeking a declaration that the plan had been terminated, entitling them to surplus assets of approximately $200 million. The Sixth Circuit, affirming the district court’s decision, found that Moore Wallace did not take one of the required steps under ERISA to terminate a plan. The requirement of ERISA Section 4041(b)(2)(D) requires final distribution of assets as part of the termination procedure. Because Moore Wallace did not satisfy this requirement, the plan had not terminated and the claims of current and former participants were dismissed. (Jensen v. Moore Wallace North America Inc., 6th Cir., 2007)

Sixth Circuit Joins Other Circuits Holding That Cash Balance Plans Are Non-Discriminatory
The Court of Appeals for the Sixth Circuit, relying on opinions in the Seventh and Third Circuits (see Employee Benefits Developments, September 2006 and March 2007), found that the better view in analyzing cash balance plan designs is that the “rate of benefit accrual” refers to an employer’s contributions to a plan, and any difference in output as a result of time and compounding of interest does not violate the requirements of ERISA. The Sixth Circuit refused to accept the positions taken in two district court cases in the Second Circuit (See Employee Benefits Developments, January 2007). (Drutis v. Rand McNally & Co., 6th Cir., 2007.)

This newsletter is a periodic publication of Hodgson Russ LLP. Its contents are intended for general informational purposes only and should not be construed as legal advice or legal opinion on any specific facts or circumstances. Information contained in the newsletter may be inappropriate to your particular facts or situation. Please consult an attorney for specific advice applicable to your situation. Hodgson Russ is not responsible for inadvertent errors in this publication.