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Employee Benefits Developments June 2005

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RULINGS, OPINIONS, ETC.

Cafeteria Plans: The “Use-It-or-Lose-It” Rule Gets Some Added Flex. In May, the Treasury Department published Notice 2005-42, under which a cafeteria plan, at the employer’s option, may be amended to provide for a 2½-month grace period following the end of each plan year. If a cafeteria plan document is amended to include the new grace period, a participant who has unused qualified cafeteria plan benefits or contributions (particularly unused benefits or contributions in a medical or dependent care flexible spending account (FSA)) at the end of a plan year, and who incurs expenses for that same qualified benefit during the 2½-month grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred during the plan year. The effect of the grace period is that a participant will have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are “forfeited” under the “use-it-or-lose-it” rule. An employer may adopt a grace period as authorized in this notice for the current cafeteria plan year (and subsequent cafeteria plan years) by amending the cafeteria plan document before the end of the current plan year.

IRS Proposes New § 415 Regulations. The Internal Revenue Service has issued proposed Internal Revenue Code (IRC) § 415 Regulations (70 Fed. Reg. 31214, May 31, 2005) which, when finalized, are intended to provide a consolidation of rules currently found in existing regulations and a series of IRS pronouncements over the last 20 years. Generally, with one exception noted below, these proposed regulations will not be effective until finalized. Some highlights are:

Post-Severance Compensation. This clarifies the rule on what compensation paid after separation from service may be considered for purposes of IRC § 415. Amounts paid prior to separation from service would be counted. Amounts paid after separation from service would be counted if they are paid within 2 ½ months after separation from service, but only if the amounts would have been paid had the individual continued in employment or if the amounts represent bona fide sick, vacation, or other leave amounts. Payments of severance and other compensation after separation from service would not be § 415 compensation. Further, by conforming amendments to regulations under IRC §§ 401(k), 403(b), and 457, similar rules would apply for elective deferral contributions on these amounts. This rule is proposed to be effective for limitation years beginning after 2004 and taxpayers may rely on these proposed rules until final regulations are issued.

Military Differential Pay. The proposed regulation would allow individuals not currently performing service because of qualified military service to contribute to his or her employer’s retirement plan while on active duty.

Multiple Annuity Starting Dates. The proposed regulation includes explicit rules for determining the annual benefit where there has been more than one annuity starting date (e.g., where benefits under another plan have previously commenced).

Corrections. The IRS has indicated that the current correction mechanisms in the § 415 regulations will be moved to guidance under the Employee Plans Compliance Resolution System.

IRA Fee Offset Program Is OK Under Prohibited Transaction Rules. Country Trust Bank set up an individual retirement account (IRA) program called the Country Managed Portfolio Account Service (CoMPAS) that utilizes mutual funds for which the bank is the custodian and investment manager. Individuals participating in the CoMPAS program may establish an investment strategy to be carried out by the bank. In this process, the bank is a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA) and may be given discretionary authority by the IRA holder to make investment decisions and rebalance the account’s holdings. Under the program, the bank is paid an annual management fee of fixed percentages of the IRA’s assets. This fee is offset, however, by any management and custodial fees earned by the bank in the mutual funds used in the CoMPAS program. Thus, the bank cannot earn fees in excess of the IRA management fee through the use of its affiliated mutual funds. The bank initially asked the Department of Labor (DOL) for an exemption from the prohibited transaction rules for the CoMPAS program. The DOL responded with an advisory opinion that the program generally will not result in any prohibited transactions in the fee structure because the bank’s fee income will not be increased beyond the IRA management fee as a result of the Program. DOL Advisory Opinion 2005-10A (2005).

CASES

Unpaid Employer Contributions Do Not Render the Employer a Fiduciary. In a recently decided case, the U.S. Court of Appeals for the Tenth Circuit considered whether ERISA makes a bankrupt employer (Luna Steel Erectors, Inc., owned by members of the Luna family) a fiduciary with respect to its employees if it agrees to make regular employer contributions to an ERISA-covered employee benefit plan. To establish ERISA fiduciary status within the meaning of ERISA, the plaintiff (trustees of various multiemployer employee benefit plans to which the employer had a contractual obligation to make contributions) had to show that (1) the unpaid employer contributions were plan assets, and (2) the Lunas exercised authority and control over the management or disposition of these assets. The federal appellate court overruled the federal district court and ruled the contractual right to the unpaid employer contributions is an “asset” under ERISA. The Tenth Circuit also held, however, that the Lunas were not fiduciaries under ERISA. In reaching the second holding, the court considered whether the Lunas exercised any authority or control respecting management or disposition of plan assets (i.e., the contractual right to the unpaid employer contributions), and found it is “the Trustees, not the Lunas, who control the contractual right to collect unpaid contributions from the Lunas.” The court concluded whether to enforce their contractual rights is entirely up to the Trustees; the Lunas, meanwhile, have no say over whether this right will be enforced or not. In the absence of any exercise of fiduciary authority, the Lunas were not fiduciaries with respect to the unpaid contributions which ultimately meant that the unpaid contributions could be discharged in bankruptcy. (Navarre v. Luna (In re Luna), 10th Cir. 2005).

“On the Verge of Retirement” Equals Retirement for Bankruptcy Law. General DataComm Industries Inc. (DataComm) filed for Chapter 11 bankruptcy relief. DataComm subsequently informed four long-time executives that their employment would be terminated in 11 days. On the day before their jobs were terminated, DataComm filed a motion in Bankruptcy Court rejecting certain retirement agreement contracts it had with the four executives. The four executives objected to the rejection of the contract, arguing that they were retirees under Bankruptcy Code § 1114, which provides that the debtor must continue to pay retiree benefits unless the Bankruptcy Court or Trustee and an authorized representative of the retirees have agreed to modify the benefits. DataComm argued the executives never retired, but were terminated as employees without cause. The U.S. Court of Appeals for the Third Circuit rejected that argument and held the “deliberate and involuntary termination of an employee on the verge of retirement, where the employee has otherwise met all qualifications for retirement, can not deprive such an employee of the procedural protections of § 1114.” (In re General DataComm Industries Inc., 3d Cir. 2005).

Ex-Spouse Properly Waived Benefits, But Not All Courts Would Agree. What happens when an ex-spouse waives his or her right to ERISA plan benefits in a divorce agreement, but the participant fails to change the beneficiary designation naming the ex-spouse? The Michigan Court of Appeals faced that question in Moore v. Moore (Mich. Ct. App. 2005). The court held Hetta Moore’s agreement to waive her interest in life insurance policies and pension plan benefits represented a knowing and voluntary waiver of her rights in her former husband’s group life insurance policy. Thus, the life insurance benefit is payable to Mr. Moore’s estate. In reaching this conclusion, the court followed a growing trend to apply federal common law principles to allow a beneficiary to waive rights to ERISA benefits. Other courts (including the Sixth Circuit) have refused to follow this common law doctrine of waiver. The U.S. Supreme Court was asked to review a Fifth Circuit federal appeals court decision (Finch v. Galaway, 5th Cir 2004), which held under federal common law a deceased participant’s estate was entitled to life insurance proceeds after the participant’s former spouse, who remained the main beneficiary, waived his or her rights to plan benefits in a divorce agreement. The Supreme Court, in refusing to hear this appeal (Finch v. Galaway, U.S. Cert. denied, 2005), leaves plan sponsors across the country with conflicting decisions. Until this split in opinions is resolved, plan sponsors will face difficult decisions and may continue to be involved in court actions to determine the proper recipient of plan benefits in these situations.

Banking Arrangement Causes TPA to Be an ERISA Fiduciary to Plan. The U.S. Court of Appeals for the Tenth Circuit held an accountant and his third-party administration firm were ERISA fiduciaries to the David P. Coldesina D.D.S., P.C. Employee Profit Sharing Plan & Trust (plan) because the accountant’s banking arrangement with the plan gave him control over the disbursement of plan assets. Gregg Simper, a general agent for Kansas City Life Insurance Company (KCL) and a broker-dealer, was hired to serve as an investment adviser to the plan. Simper encouraged the plan to hire Ted Madsen to serve as the plan administrator. To facilitate “better recordkeeping,” a banking arrangement was created where Dr. Coldesina would write checks from the plan payable to Madsen’s company, Flexible Benefit Administrators, Inc. (Flexible Benefit), and Madsxen would deposit the checks into his business account on which he was the only signatory. Madsen would then remit checks on behalf of the plan to KCL. Simper later directed Madsen to write checks on behalf of the plan payable to Simper’s company, Greystone Marketing, with the understanding that Simper would transfer the funds to KCL. Dr. Coldesina did not authorize this action and was unaware of the change.

After it was discovered, from a suicide note left by Simper, that Simper misappropriated over $600,000 in plan assets, the plan filed suit against Madsen and Flexible Benefit under ERISA. Madsen and Flexible Benefit argued they were not ERISA fiduciaries because they were “simply performing a ministerial check-writing service” and were not in control of the plan’s assets. The federal appellate court held although Madsen did not have any involvement in choosing the plan’s investments, he did assume control over the disposition of the plan’s funds by exercising his own judgment in writing checks to Greystone Marketing without Dr. Coldesina’s express authorization. Madsen argued he was not an ERISA fiduciary because he simply followed Simper’s instructions in writing checks for the plan. The federal appeals court rejected this argument because Madsen was hired by the plan, not by Simper, and was entrusted with the plan’s funds, not Simper’s funds. (David P. Coldesina D.D.S., P.C. Employee Profit Sharing Plan and Trust v. Estate of Simper,10th Cir. 2005).