IRS Shuts the Door on ESOPs Only in Form. In a new revenue ruling, the Internal Revenue Service (IRS) attacked three types of situations in which individuals used a complex set of entities—professional services corporations, employee stock ownership plans (ESOPs), S corporations, qualified S subsidiaries (QSUBs) and stock options. The basic design resulted in virtually all profits of the businesses being moved away from ESOPs so that rank and file employees received no benefits from the arrangement. The ruling is designed to shut down transactions that move profits of an S corporation away from an ESOP and to prohibit use of stock options in a subsidiary to drain value out of the ESOP. The IRS not only held these situations would not produce the desired tax results for the ESOPs, but also that they would be “listed transactions,” subject to heavy reporting and disclosure requirements and possibly tax shelter registration and list maintenance requirements. (Rev. Rul. 2004-4, Feb. 9, 2004.)

IRS Allows Many Electronic Payee Statements, Makes Other Technical Changes. The IRS now allows payee statements (basically Form 1099s and Form 5498) to be sent electronically to recipients by sponsors or administrators of retirement plans or qualified tuition programs. Effective after 2003, electronic payee statements may be sent by trustees, custodians or issuers of individual retirement accounts (IRAs), Roth IRAs, Coverdell Education Savings Accounts or Archer Medical Savings Accounts. Consent, format, posting and notification are required; see part H of the 2003 General Instructions for Forms 1099, 1098, 5498, and W-2G. (http://www.irs.gov/pub/irs-pdf/i1099gi.pdf.) (Notice 2004-10, Feb. 9, 2004.)

In Announcement 2004-3, the IRS corrected the codes that must be used in Form 1099-R for distributions from Roth IRAs. (Jan. 12, 2004.) In Announcement 2004-2, it announced a new reporting Code W, to report employer contributions to an employee health savings account. (Jan. 15, 2004.) Finally, the IRS performed its annual update of the revenue procedures that govern the procedures for issuing and obtaining revenue rulings, information letters, technical advice and other guidance for employee plans and exempt organizations. Many of the changes simply reorganize the materials and update references. (Rev. Procs. 2004-1 through 2004-8, Jan. 5, 2004. For copies http://www.irs.gov/pub/irs-irbs/irb04-01.pdf.)

Cases

Gains and Setbacks for Domestic Partner Benefits. Benefits for same-sex couples continue to make news in Canada and the United States. Under the New Jersey Domestic Partnership Act (DPA), signed by the governor on January 12, 2004, domestic partners in New Jersey will soon enjoy a host of new legal rights and benefits. (P.L. 2003, c. 246.) Same-sex couples over the age of 18 who maintain a common residence and can demonstrate joint responsibility for each other’s welfare may establish a domestic partnership under the DPA by filing an Affidavit of Domestic Partnership with a local registrar. Same-sex domestic partners of state employees will be eligible for dependent retirement and health benefits on the same basis as spouses. Other public employers and all private employers have the option of extending benefits to domestic partners but are not required to do so by the DPA. In recognition of the financial and pension-related penalties that sometimes discourage marriage among older couples, unmarried same-sex couples over 61 also may receive certain benefits and protections under the law by registering as domestic partners, including hospital visitation and health care decision-making rights and state income and inheritance tax relief.

Meanwhile, the Canadian government recently announced it will appeal a December 2003 ruling by an Ontario court that granted retroactive survivor benefits under the Canada Pension Plan to same-sex domestic partners of individuals who died before 1998. (Hislop v. Attorney General of Canada (Ontario Sup. Ct. of Justice 2003).) We reported on this case in the last issue of Employee Benefits Developments. Estimates of the cost to the government, if the court’s ruling is upheld, run as high as Can$400 million, plus interest.

ERISA Decisions Left Standing by Supreme Court. The United States Supreme Court recently declined to review a number of federal appeals court decisions in cases brought under the Employee Retirement Income Security Act of 1974 (ERISA). Left standing, for example, was a Second Circuit decision holding a summary plan description (SPD) violated ERISA by failing to adequately inform plan participants that they must file an affidavit, as required by the plan document, if they want their domestic partners to receive pre-retirement survivor benefits. The appeals court had ruled, where the plan and the SPD are in conflict, the SPD must control. (Kodak Retirement Income Plan v. Burke, cert. denied, Jan. 12, 2004). The court also left standing a Fifth Circuit decision finding a grocery store and its owner violated ERISA when the store eliminated a grocery voucher program for its retirees. The program was determined to be an ERISA plan, despite the lack of a written plan document or a source of funding. (Schwegmann Giant Super Markets Inc. v. Musmeci, cert. denied, Jan. 12, 2004.)

Beneficiary Designation Dilemma. Beneficiary designations that are never changed to reflect the terms of marital property settlements continue to cause headaches for insurance companies and plan administrators, as demonstrated in a case recently decided by the Michigan Court of Appeals. Joe Dee MacInnes waived in a 1995 divorce judgment all rights to his former wife’s life insurance policy, which was provided through an ERISA-governed employee welfare benefit plan. When MacInnes’s former wife, Cheryl Rowley, died in 2000, it was discovered that MacInnes was still listed as the designated beneficiary on Rowley’s life insurance policy. The plan paid the $95,000 life insurance proceeds to MacInnes in accordance with the plan document, and Rowley’s estate sued to recover the proceeds. The trial court held, and the state appeals court agreed, that the language in the divorce judgment constituted an effective waiver of MacInnes’s rights to the proceeds of the policy. The court rejected MacInnes’s argument that ERISA preempted the provision of the divorce judgment purporting to alter the beneficiary designation of an ERISA insurance plan. Luckily for the plan, the proceeds had been placed in escrow pending appeal; so the plan was not faced with the possibility of having to pay twice. (Estate of Rowley v. MacInnes, (Mich. Ct. App., 2004).)

DOL Continues Pressing Directors’ Fiduciary Duties. The Department of Labor (DOL) filed an amicus (“friend of the court”) brief in In re WorldCom, Inc. ERISA Litigation (S.D.N.Y. (brief filed Jan. 16, 2004)). The DOL, in asking the federal court to deny the directors’ motion to dismiss the lawsuit filed by plan participants, asserted the directors had a continuing duty to monitor the individuals they had appointed as fiduciaries under the Internal Revenue Code (IRC) § 401(k) plan, and, therefore, the fiduciaries may be sued as fiduciaries for losses incurred by the plan. The brief said the directors are not required to “second-guess” every decision by a fiduciary but they must have “procedures in place so that on an on-going basis they may review and evaluate whether investment fiduciaries are doing an adequate job.” The position by the DOL challenges the federal district court decision in In re Williams Cos. ERISA Litigation. In the Williams case, an Oklahoma federal district court said in a footnote it rejected the DOL position on the directors’ on-going duty to monitor the actions of the Retirement Plan Committee. This “up-the-chain” element of fiduciary responsibility should concern directors. The DOL does not appear to be moderating its position.

No Exception to 10% Early Distribution Penalty for Medical Expenses Paid in Year After Distribution. Jeanette Kimball took an early distribution in 2000 from her company’s retirement plan to pay medical expenses she began incurring in that year, but she paid her bills in 2001. Kimball had been told by the plan administrator the 10% early distribution penalty under IRC § 72(t) would not apply, because of the medical exception. The plan sponsor also did not report the distribution as subject to the 10% tax, because of the apparent exception. The IRS found the medical exception was not available because the distribution was not “for amounts paid during the taxable year” of the distribution, as required under IRC § 72(t)(2)(B). The Tax Court, in a summary opinion, agreed with the IRS. The court also pointed out only part of the distribution would have been free of the penalty tax in any case, because only the amount of deductible expenses (over the floor of 7.5% of adjusted gross income) could be excepted from the tax, whether or not the employee deducted her medical expenses. An issue left open is whether Kimball might sue her employer for the bad advice. (Kimball v. Commissioner, T.C. Summary Opinion 2004-2.)

IRC § 403(b) Plan Assets May Not Be Excludable in Bankruptcy. Raymond Adams, an employee of the United Negro College Fund, and his wife, Janet, an employee of an Ohio hospital, amassed their retirement assets, like most employees of not-for-profit employers, in IRC § 403(b) tax-sheltered annuities. A Sixth Circuit bankruptcy panel recently held those assets might not get protection from the couple’s bankruptcy estate, because IRC § 403(b) annuities are not “trusts” under the Bankruptcy Code. Both of the Adamses’ IRC § 403(b) annuities were held by insurance companies in custodial accounts rather than in trusts. The federal appellate court bankruptcy panel reversed the federal district court and a federal bankruptcy court, as well as disagreeing with at least one other appeals court, in concluding these assets might have to be brought back into the bankruptcy estate. The case was sent back to the lower court to determine if other exceptions might apply. (In re Adams, (6th Cir. 2003).)

Disability Plan Still Subject to ERISA After Changing to Employee Pay All. An employer who wanted to insulate a voluntary insurance arrangement from ERISA changed it after six years so that employees pay the full premiums with after-tax dollars. The employer then, for the next nine years, was merely an administrative conduit between the employees and the insurance company. The federal district court here concluded the arrangement continued to be subject to ERISA because it had been “established or maintained” under ERISA. The court said the case law suggests “once ERISA, always ERISA.” In this case, the result was that the federal court retained jurisdiction, to the plaintiff doctor’s dismay, over his disability claim, rather than allowing the controversy to be sent back to state court. (Stern v. Provident Life & Accident Ins. Co., (M.D. FL. 2003).)

Other News

IRC § 401(k) Plans Affected by Scandals. Almost half of IRC § 401(k) plans are affected by mutual fund scandals. In a survey by Financial Executives International, 47% of corporate chief financial officers say the IRC § 401(k) plans at their companies include funds tainted by the scandals. Among those 47%, 75% already have made or may make changes in their plans in response to the scandals. All companies in the survey have made or are considering making changes. The most common change is to add new providers to the fund line-up. (http://www.fei.org/news/cfo_survey.cfm.)

PBGC Posts Record $11.2 Billion Deficit. The Pension Benefit Guaranty Corporation (PBGC) has reported its fiscal 2003 results: a $7.6 billion net loss in this year alone for employer sponsored plans the PBGC has taken over. This loss was sustained despite investment income of $3.3 billion. The two largest factors were a $5.4 billion loss from taking over pension plans and a $4.3 billion loss due to declining interest rates. (http://www.pbgc.gov/news/press_releases/2004/pr04_20.htm.)