Break for Tax-Exempt Employer in Controlled Group with 401(k) Plan. A nongovernmental tax-exempt employer that is part of a controlled group with a for-profit entity and that has both Internal Revenue Code (IRC) § 401(k) (or IRC § 401(m)—matching contributions) and IRC § 403(b) plans has faced the problem of providing dual coverage or having its 401(k) plan fail coverage testing under IRC § 410(b). The Internal Revenue Service (IRS) recently proposed regulations that would permit these employers to exclude employees eligible to make salary reduction contributions to 403(b) plans when testing their 401(k) plans or 401(m) plans. The issue arose after the change in laws that first prohibited employers exempt under IRC § 501(c)(3) from having 401(k) plans, and now permits them to have both 401(k) and 403(b) plans. Congress addressed the issue in 2001 laws and mandated that the IRS amend its regulations. Under the proposed regulations, an employer who wishes to exclude employees eligible to contribute to 403(b) plans from 401(k) plan or 401(m) testing must meet two thresholds: no employee of the exempt organization may be eligible to participate in the 401(k) or 401(m) plan and at least 95% of the employees of the employer who are not employees of the exempt organization must be eligible to participate in the 401(k) or 401(m) plan. Governmental employers still may not offer 401(k) plans. (Prop. Reg. § 1.410(b)-6(g))

Restorative Payments to Plan: Employer Contributions or Not? In two recent private letter rulings (PLRs), the IRS examined the effect of payments intended to compensate plans for surrender charges deducted from plan assets by an annuity issuer. In the first ruling (PLR 200337017), the plan sponsor sued the annuity company on behalf of the plan, arguing its contract did not contain surrender charges. The plan sponsor won and was awarded a sum equal to the amount of the surrender fee plus interest, which it deposited into the plan. (It also was awarded attorney’s fees.) The IRS ruled this payment would not be treated as an employer contribution for various purposes (IRC § 404, deductibility, IRC § 415, contribution limits), and that the contribution would not affect the plan’s discrimination testing (IRC § 401(a)(4)) or taxability of participants (IRC § 402(a)). In the ruling, the IRS provided guidance on the calculation of interest and allocation of the amounts into participant accounts. The IRS analysis in the ruling is that the replacement payment is a substitute for amounts wrongly deducted from the participant accounts and a substitute for earnings on contributions the plan would have earned on previously-made contributions to the plan.

In the second ruling (PLR 200317048), it was clear the plan owed the surrender charges. The plan had attempted to limit participant withdrawals by switching out of its annuity contracts, but it couldn’t stop them quickly enough to stay under the maximum withdrawal amount before the surrender charges were imposed under the contract (10% of the amount invested in the contracts in the year). The plan sponsor stated it had received inquiries and threats of litigation from participants’ attorneys alleging improper fiduciary conduct. The plan sponsor proposed a restorative payment to offset the surrender charges. Citing Rev. Rul. 2002-45, the IRS noted payments to defined contribution plans are not plan contributions if “made to restore losses to the plan resulting from actions by a fiduciary for which there is a reasonable risk of liability for breach of fiduciary duty.” The IRS ruled here, however, the facts “are not sufficient to demonstrate a reasonable risk of liability to the employer for breach of fiduciary duty.” It further stated the proposed payments would be subject to Code §§ 404, 415, and 4972 (the last, an excise tax on excess contributions). It’s a good thing the plan sponsor asked this question prospectively.

Note a private letter ruling is directed to the taxpayer who requested it and, says the IRS, cannot be used or cited by others as precedent.

CASES

Prudence Yes, Prescience No. Fiduciaries of a plan with employer stock investments can breathe easier because a federal appeals court found they acted appropriately in refusing a request to allow plan participants to sell a portion of their employer stock shortly after the employer merged with another firm. Oregon Metallurgical Corp. (Oremet) did not go bankrupt. However, there were fluctuations in its stock because of the merger. The Oremet plan was an employee stock ownership plan that had been amended to curtail diversification alternatives for the participants. Both the lower district court and the appellate court acknowledged these plans are exempt from the diversification requirement under the Employee Retirement Income Security Act of 1974, as amended (ERISA), but that fiduciaries still must act prudently. The participants, “with 20-20 hindsight,” argued the fiduciaries did not act prudently here. The courts found otherwise. The fiduciaries, the court said, are not required to “act in an extraordinarily prescient manner.” (Wright v. Oregon Metallurgical Corp., 9th Cir. 2004)

“The Dog Ate My Homework” Defense Rejected. “The dog ate my homework” is no excuse for a plan not providing requested documents to a claimant, at least not in the Seventh Circuit. Following his wife’s death in 1999, George Lowe was told he was not entitled to survivor benefits from his wife’s retirement plan, because the plan had a benefit election form on file indicating his wife had chosen to take her benefits as a single-life annuity. To be effective, the election of single-life annuity by a married participant requires a waiver of survivor benefits signed by the spouse, whose signature must be either witnessed by a plan representative or notarized. In this case, the waiver on file was signed by Lowe, but his signature was neither witnessed nor notarized. On discovering a different election form in his wife’s papers, Lowe wrote the plan administrator requesting relevant plan documents. Despite two requests, the intervention of the Department of Labor, and the filing of a lawsuit, the plan did not provide the documents until two years later. At that time, the plan also acknowledged Lowe’s right to survivor benefits, because of the ineffective waiver.

In March 2003, the trial court awarded Lowe more than $19,000 in attorney’s fees and $30,050 in penalties ($50 per day for 701 days) for the plan’s failure to provide the requested documents in a timely fashion. In upholding the award on appeal, the federal appeals court rejected the plan’s plea for leniency on the grounds that its records were “in disarray” at the time of Lowe’s request due to a plan merger and that the plan employee who handled the request for documents thought the other required signatures “might be on another page that had gotten lost in the shuffle.” Characterizing the plan’s argument as a “the dog ate my homework” defense, the court noted “the only basis the plan had for refusing to pay survivor’s benefits was that Lowe’s signature might have been notarized on a sheet of paper that has vanished.” The court concluded the plan should consider itself lucky that only $50 a day in penalties was awarded, rather than the maximum $100 a day (now $110). (Lowe v. McGraw-Hill Cos., 7th Cir. 2004)

Waiver in Divorce Decree Overrides Beneficiary Designation for Welfare Plan. Courts in several federal appellate circuits continue to rule ERISA welfare plans are subject to qualified domestic relations orders (QDROs), despite strong legal arguments that QDRO rules apply only to pension plans. The practical problem for plan administrators is that courts also may find a divorce decree constitutes a QDRO, even if there are deficiencies in the order, and that a decree not previously filed with the plan overrides a beneficiary designation on file with the plan. This dilemma is illustrated by a decision recently upheld by the Court of Appeals for the Sixth Circuit in which the estate of a deceased employee was entitled to the employee’s life insurance benefits, even though his former wife was still the named beneficiary of the policy.

In a classic scenario, Carl Johnson named his then-wife, Antoinette Seaman, as the beneficiary of his group term life insurance policy with his employer. When Johnson and Seaman divorced in 1976, their divorce decree substituted the couple’s two minor children as beneficiaries until they reached the age of majority. The divorce decree also specified Seaman would have no further interest in the policy. However, Johnson never changed the beneficiary designation of his policy. At the time of Johnson’s death, the children were no longer minors entitled to be the named beneficiaries, and both Johnson’s current wife and former wife claimed the proceeds of his policy.

The trial court held the divorce decree effectively trumped the beneficiary designation filed with the plan because it was specific enough, despite its deficiencies, to constitute a QDRO. The Sixth Circuit agreed. According to both courts, the divorce decree effectively erased the beneficiary designation of the former spouse and replaced it with the children. The designation of the children then “expired by its terms” once the children reached the age of majority, leaving no beneficiary. Under the terms of the plan, the insurance benefits passed to the estate by default. The terms of the divorce decree thus nullified the beneficiary designation on file with the plan. This case illustrates once again that plan administrators are well advised to periodically remind participants to make sure all their beneficiary designations are up-to-date. (Seaman v. Johnson, 6th Cir. 2004)

Rolling QDRO Overpayment into IRA Creates no Safe Haven. The Texas Court of Appeals ruled February 26 that a retirement plan was entitled to recover $415,540 in funds mistakenly paid to a former wife under a QDRO, even though she had rolled some of the money into individual retirement accounts (IRAs). Under Texas law, IRAs are normally exempt from turnover proceedings. On her divorce from Leslie Jones in 1995, Sharon Jones obtained a QDRO awarding her a share of her ex-husband’s pension funds in the American Airlines, Inc. Retirement Benefit Program. Following payment of the funds, Mr. Jones filed suit in federal court against the plan, asserting the plan had misconstrued the QDRO and overpaid his former wife. The plan settled with Mr. Jones and sued Mrs. Jones to recover the overpayment.

The court awarded the plan the full amount of the overpayment plus interest. The plan then learned Mrs. Jones had converted the plan funds into cash and deposited them in several accounts shortly before the federal trial, eventually depositing some of the funds in IRAs. On Mrs. Jones’s failure to pay, the plan instituted turnover proceedings in state court. Rejecting Mrs. Jones’s claim that the funds were exempt from turnover because they were in IRAs, the court signed a turnover order for the overpayment, plus interest.

On appeal, the state appeals court held that, although retirement funds in IRAs are normally exempt from the claims of judgment creditors, the exemption does not apply where a debtor transfers funds to a retirement plan in an attempt to defraud creditors. The court agreed with the plan that Mrs. Jones did not have a legal right to the pension funds mistakenly paid to her. Holding that Mrs. Jones cannot claim as exempt benefits to which she has no legal right, the court also determined the mistaken distribution did not qualify as an eligible rollover distribution. Rather, it was an excess rollover contribution. As a result, Mrs. Jones’s accounts did not qualify as IRAs under IRC § 408(a). The court affirmed the lower court decision to award turnover relief and attorneys’ fees to the plan. (Jones v. American Airlines, Inc., Texas Ct. App. 2004)

Plan Document Controls over Conflicting SPD. Courts routinely hold a summary plan description (SPD) controls over a plan document with conflicting terms when the terms of the SPD are more favorable to employees. Faced with a complex set of facts covering multiple plans and opposing summary judgment motions, the federal district court for the Southern District of New York recently ruled on a variation of this familiar scenario, holding a plan’s formal documents will control over an SPD when the terms of the SPD are less favorable to employees. In this case, plan administrator Janet Stoner relied on the language in the plans’ SPDs when she determined a group of leased employees was not entitled to benefits under Texaco’s employee benefit plans. However, the SPD language conflicted with language on the eligibility of leased workers in the plans’ official documents.

In rejecting Stoner’s contention the SPDs should govern, the court said, “to hold categorically that an SPD which may well narrow the plans’ original participation provisions supersedes the official plan text to the extent there is a conflict would be to permit plan sponsors and fiduciaries to escape obligations undertaken in duly adopted plans by the simple expedient of disseminating more restrictive SPDs.” As the court concluded, that result would be inconsistent with ERISA’s requirements that an SPD be accurate and that plans be administered in accordance with their terms. Denying motions for summary judgment by both Stoner and the workers, the court remanded the case to the current plan administrator to determine if the workers were entitled to benefits under the plans’ formal documents, rather than under the SPDs. (Schultz v. Stoner, SDNY 2004)

This newsletter is a periodic publication of Hodgson Russ LLP and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your own situation and any specific legal questions you may have.