The agencies were very active in the past two weeks, with the IRS alone issuing five sets of regulations and six published revenue rulings. This biweekly issue of Employee Benefits Developments, therefore, focuses on agency decisions, some of them reported only summarily, and gives only brief mention to interesting cases that came out in the period.

Code § 457 Plan Regulations. Regulations under Internal Revenue Code (“Code”) § 457 on deferred compensation plans of state and local governments and tax-exempts are finalized. The final regulations, issued July 11 by the IRS, liberalize the rules for 457 plans in many respects, including:

Sick, vacation, and back pay may be deferred prior to the time the amounts have not been paid (rather than earned).
Loan features are permitted and examples broaden the definition of unforeseen emergencies.
457 plans may comply with qualified domestic relations orders (QDROs) without jeopardizing their tax status.
Transfers between 457 plans are liberalized, including transfers between governmental plans in different states.
A 457 plan may be terminated.

In addition, these final regulations shut down a dubious (in our view) discounted stock option device designed to provide deferred compensation to executives of tax-exempt entities. Governmental and tax-exempt plan sponsors should review these regulations carefully and be attentive to plan document updating and effective dates (generally taxable years beginning after 2001, but good faith operational compliance with various laws, including the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), is permitted through the 2003 tax year). (Prop. Reg. §§ 1.457-1 through -12; 68 Fed. Reg. 41,230 (July 11, 2003); TD 9075.)

Final Regulations on Catch-Up Contributions. Final regulations issued July 6 provide guidance for 401(k) plans and other retirement plans that permit eligible participants age 50 and older to make catch-up contributions under Code § 414(v). The final rules generally follow the proposed regulations published in 2001, but offer a few clarifications and modifications. The IRS eased the rules for multiemployer plans, providing that employees covered by collective bargaining agreements are disregarded for purposes of determining whether an applicable employer plan complies with the universal availability requirement. The offer of catch-up contributions in a multiemployer plan will not trigger an obligation to offer catch-up contributions in an employer’s other plans. Special rules are provided for plans involved in acquisitions and mergers. (Treas. Reg. §§ 1.402(g)-2 and 1.414(v)-1; 68 Fed. Reg. 40,510 (July 8, 2003); TD 9072.)

COBRA’s Small Employer Exception: Stock and Asset Sales. In Revenue Ruling 2003-70 (July 1, 2003), the IRS addresses the impact of stock and asset sales on the small employer exception to COBRA coverage. Under the exception, an employer that normally employed fewer than 20 employees on a typical business day during the preceding calendar year is not subject to COBRA. The IRS ruled that stock sales would be treated differently from asset sales for purposes of the exception. In a stock sale, the buyer and seller are treated as a single employer. Employees of both entities are combined to determine if, together, the two employers normally employed at least 20 employees during the previous calendar year. If the combined number of employees is 20 or more, the combined entity becomes subject to COBRA as of the date of the stock transfer. In contrast, where one employer acquires substantially all the assets of another, the buyer and seller are not treated as a single employer. If the buyer employed fewer than 20 employees in the previous year, the buyer continues to qualify as a small employer until the January 1 following the year in which the buyer acquired the new business, regardless of the number of combined employees. (2003-29 IRB ___ (July 21, 2003).)

Curbs on Transfers of Compensatory Options to Related Persons. With the simultaneous publication of a notice and proposed and temporary regulations, the IRS launched a concerted attack against tax shelters designed to defer income and employment taxes on an employee’s nonstatutory compensatory stock options by the transfer of the options to related parties. Giving notice that it intends to challenge these arrangements on a number of grounds, the IRS observes that these transactions rarely, if ever, reflect terms that would be agreed to between unrelated parties dealing at arm’s length. (IRS Notice 2003-47 (July 1, 2003), 2003-30 IRB ___ (July 28, 2003); Treas Reg. § 1.83-7T; REG-116914-03, Prop. Reg. § 1.83-7.)

Other rulings and regulations:

Elimination of Determination Letter User Fees for Small Employers. Small employers (i.e., those with 100 or fewer employees and at least one non-highly compensated participant) will not have to pay user fees, under certain conditions, for determination letter requests after 2001. User fees range from $125 to $1,250, depending on the type of submission. The waiver of user fees generally applies to determination letters within a plan’s first five years of existence. This notice provides guidance for an employer to determine whether it is required to pay a user fee. Certain plans may be eligible for elimination of the user fees for their so-called GUST amendments. (IRS Notice 2003-49 (July 8, 2003), 2003-32 IRB ___ (August 11, 2003).)

Proposed Elimination of the 90-day Advance Notice When Cutting Back Plan Payment Options. A plan sponsor may eliminate options of payment under certain conditions (“anti-cutback” rules). EGTRRA removed a minimum 90-day advance notice requirement when a plan sponsor eliminates payment options under certain conditions. These proposed regulations would conform the anti cutback regulations to EGTRRA by replacing the advance notice requirement with a summary of material modifications (SMM) or a revised summary plan description (SPD). Plan sponsors should continue to issue the 90-day advance notice until these regulations are finalized. (Prop. Reg. § 1.411(d)-4, REG-112039-0368, Fed Reg. 40581 (July 8, 2003).)

Shareholder Approval Required for Most Equity Compensation Plans. The Securities and Exchange Commission approved new listing standards for the New York Stock Exchange and the Nasdaq Stock Market, generally requiring shareholder approval of the adoption or material amendment of all equity compensation plans, including stock option plans, unless an exemption applies. Among the plans that are exempt from the rules are qualified plans (e.g., ESOPs and 401(k) plans), Code § 423 employee stock purchase plans, and phantom stock plans that pay in cash. Individual arrangements, even if outside a formal plan, however, may be subject to the shareholder approval requirement. Material revisions to existing plans that require shareholder approval include any amendment permitting repricing of options, an expansion of the types of awards available under the plan, and a material extension of the term of the plan. The new rules are effective for plans adopted or materially revised by listed companies after June 30, 2003. (SEC Release No. 34-48108; File Nos. SR-NYSE-2002-46 and SR-NASD-2002-140 (June 30, 2003).)

Tax-free Exchanges of Annuity Contracts. Revenue Ruling 2003-76 confirms that direct transfers of a portion of a cash surrender value of an existing (nonqualified) annuity contract for a new contract issued by another insurance company are tax-free exchanges under Code § 1035. Basis is allocated pro rata between contracts if there is a partial transfer. (2003-__ IRB ___, ___, 2003.)

Guidance on Transfers from Defined Benefit to Defined Contribution Plans. The rules for special benefits (among them, a reduction in the excise tax on a reversion from 50% to 20%) for a defined benefit plan that terminates after transferring at least (rather than precisely) 25% of its assets to a defined contribution plan are described in this ruling on “qualified replacement plans.” (Revenue Ruling 2003-85, (July 1, 2003), 2003-32 IRB __, August 11, 2003.)

The IRS Shows Heart Allowing Extended Rollover Period for Taxpayers Whose IRA Funds Were Misappropriated. A taxpayer who takes a distribution from an IRA has up to 60 days to roll it into another IRA before being subject to income tax on the distribution. Relatively new Code § 408(d)(3)(1) allows the IRS to waive the 60-day requirement in certain hardship situations. As described in a recent private letter ruling, a fraudulent investment manager took distributions out of the taxpayers’ IRAs for his own use. By the time the taxpayers found out about the misappropriation, the 60-day period was long past. The taxpayers wanted to contribute the distributed amount to new IRAs. The IRS found this situation “demonstrates hardship” and permitted the rollover within 30 days from the issuance of the letter ruling. (Priv. Ltr. Rul. 200327064.)

CASES

ESOP Fiduciaries Finally Win One. ESOP fiduciaries obtained some relief at the federal district court level in a Textron case, concluding the ESOP did not breach its fiduciary duty by continuing to invest in company stock, even though that stock was falling in value. The judge referenced the “unique situation of having to facilitate the ESOP goal of employee ownership.” An appeal is expected. (Lalonde v. Textron Inc., D.R.I., No. 02-334s (June 24, 2003).)
Need to Disclose LTD Plan Requirements. The 10th Circuit Federal Appeals Court ruled Cendant breached its ERISA fiduciary duties when it failed to disclose its long-term disability (LTD) plan requirements to a vacationing employee who questioned whether it had an “actively at work” requirement in its LTD plan. The company was required by the court’s decision to cover the employee, who did not work a day for the sponsor after it merged with her employer, Avis Rent-A-Car. (Horn v. Cendant Operations, Inc. et al, 10th Cir. No. 01-5205 (July 3, 2003).)

Preemption Applied to Individual Disability Policies. State law claims against an insurer were dropped when a federal district court held individual disability policies constituted an ERISA plan. The court applied preemption to knock out state law claims relating to these supplemental individual policies purchased by doctors in a medical clinic. (Halprin v. Equitable Life Assurance Soc’y of the U.S., 2003 U.S. Dist. LEXIS 10299 (D. Colo. 2003).)

COBRA Notice Need Not be Sent to Employee at Hospital. An employer that sent a COBRA notice to a hospitalized employee’s home was let off the hook by a federal district court. The hospitalized employee’s mother did not open the envelope until after the employee’s death, two and a half months after he left his job. (Weeks v. Western Auto Supply, W.D. Va. No. 7:02cv00724, unpub. June 25, 2003.)