Benefits Issues Under the American Jobs Creation Act of 2004. Dramatic changes to the rules for nonqualified deferred compensation under the American Jobs Creation Act of 2004 (Jobs Act), which was signed by President Bush on October 22, were addressed in our recent Hodgson Russ Deferred Compensation Alert. Although drawing less attention, a number of other provisions in the Act are also of interest from an employee benefits perspective. For example, in 2002, the Internal Revenue Service (IRS) announced it was imposing an indefinite moratorium on its position that income resulting from the exercise or disqualifying disposition of statutory stock options (i.e., incentive stock options (ISOs) and Internal Revenue Code (IRC) § 423 employee stock purchase plan (ESPP) options) must be included in wages for employment tax and income tax withholding purposes (IRS Notice 2002-47). The Jobs Act now codifies the exclusion from wages of any gains resulting from the exercise or disqualifying disposition of statutory options. Payroll taxes will not be imposed on the exercise of ISOs and ESPP options, and employers are not required to withhold federal income tax from a disqualifying disposition of stock or on any discount allowed under an ESPP.

The Jobs Act also increases the withholding rate for certain supplemental wage payments. Currently, employers may withhold income taxes on bonuses and other supplemental wage payments at a flat rate equal to the third lowest income tax rate under the IRC (currently 25 percent). Beginning in 2005, supplemental wage payments over $1 million will be subject to withholding at the top marginal rate for ordinary income (currently 35 percent). Supplemental wage payments from all members of a controlled group must be aggregated for purposes of determining if an employee has exceeded the $1 million limit.

Another provision in the Act will limit corporate deductions attributable to the personal use of certain goods, services or facilities to the amount included in the compensation of the individual incurring the use. This limitation on deductions generally applies only to certain officers, directors and 10 percent owners. The provision is intended in part to limit deductions taken by corporations that permit executives to use corporate-owned aircraft for personal purposes, yet include in the executive’s compensation only a fraction of the actual cost to the employer of the aircraft’s use.

Working Families Tax Relief Act of 2004. This is another tax act signed into law in October. It contains several benefit-related provisions.

The definition of “dependent” under IRC § 152 has been changed, with a new uniform definition of “qualifying child” and the addition of a new category of dependent—the “qualifying relative.”
Mental health “parity” rules applicable to health plans have been extended through 2005.
Interest rule relief, adopted in 2002, under Pension Benefit Guaranty Corporation (PBGC) rules was extended to notice and reporting rules for underfunded defined benefit plans.
The excise tax on non-deductible employer contributions was adjusted to eliminate IRC § 401(k) elective deferrals in determining the amount subject to tax.
Domestic workers’ wages may be treated as compensation for SIMPLE plans.

These and other fairly technical changes included in this Act have immediate effective dates.

RULINGS, OPINIONS, ETC.

Cost-of-Living Adjustments Announced for 2005. On October 20, the IRS announced annual cost-of-living adjustments applicable to dollar limitations on benefits and contributions in qualified retirement plans. Many of the limitations are increasing for 2005 because statutory thresholds were met, automatically triggering adjustments. Other limitations are set to increase January 1 under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Increases effective January 1, 2005 include the following:

The annual benefit limit under a defined benefit plan under IRC §415(b) increases from $165,000 to $170,000.
The defined contribution plan limit under IRC §415(c)(1)(A) increases from $41,000 to $42,000.
The annual compensation limit under IRC §§401(a)(17), 404(l), 408(k)(3)(C) and 408(k)(6)(D)(ii) increases from $205,000 to $210,000.
The dollar limitation under IRC §416(i)(1)(A)(i) that determines who is a key employee in a top-heavy plan increases from $130,000 to $135,000.
The limitation that determines highly compensated employees for nondiscrimination testing under IRC §414(q)(1)(B) increases from $90,000 to $95,000.
Elective deferrals under IRC §402(g)(1) for IRC §§ 401(k) and 457 plans increase from $13,000 to $14,000.
SIMPLE retirement account limits under IRC §408(p)(2)(E) increase from $9,000 to $10,000.
Catch-up contribution limitations for individuals age 50 and over increase from $1,500 to $2,000 for SIMPLE 401(k) and SIMPLE IRA plans, and from $3,000 to $4,000 for other applicable plans.

Still to be announced are possible increases in the dollar limitations under other types of benefit plans, such as qualified transportation fringe benefit programs. (News Release IR-2004-127)

New York State Pension Plan to Recognize Canadian Same-Sex Marriages. In a development that may have a ripple effect in New York State, the trustee of New York State’s public pension fund, State Comptroller Alan Hevesi, stated the fund will recognize Canadian marriages of same-sex couples in the same manner as marriages of opposite-sex couples. Same-sex spouses recognized by the retirement system will be entitled to the same treatment as opposite-sex spouses with respect to accidental death benefits and cost-of-living adjustments payable to surviving spouses.

Double Dipping in the Parking Lot. Many employers have taken advantage of the income tax exclusion available for “qualified transportation fringe benefits.” Under these arrangements, an employee may pay for parking or transit passes on a pretax basis. An employer may also reimburse these costs on a tax-free basis. Some “creative” tax thinkers came up with the idea of combining the pre-tax election and the employer reimbursement rules to overstep the bounds of this tax benefit. The IRS issued a ruling stating an employee who makes an election to pay for parking costs on a pre-tax basis (thus reducing taxable income, FICA tax liability and the amount of tax withholding) cannot be reimbursed on a tax-exempt basis by the employer. Promoters have set up plans of this nature that purport to provide employees with no change in net take home pay but a reduced level of taxable income, FICA taxes and income tax withholding. If an employee enters into a salary reduction arrangement whereby parking expenses are paid on a pre-tax basis, the cost of the parking is treated as if it were provided by the employer. An employer may not then “reimburse” this expense to the employee on a tax-free basis. A pre-tax parking program that costs employees nothing in take home pay and reduces FICA and income tax revenues, will not work under the IRS ruling. (Rev. Rul. 2004-98)

CASES

Shutdown Benefits Not Covered by PBGC Insurance. The U.S. Court of Appeals for the Sixth Circuit reversed a district court decision earlier reported in Employee Benefits Developments September 22, 2003 to October 3, 2003. The federal appellate court’s decision denies PBGC insurance coverage for shutdown benefits in four negotiated defined benefit plans. The plans covered employees of steelmaker Republic Technologies International (RTI). RTI had been in financial difficulty for a number of years, and avoided involuntary terminations of the plans by PBGC in the 1990s following an agreement between PBGC and RTI to increase pension contributions. After a Chapter 11 bankruptcy petition in 2001, RTI suspended pension contributions, and PBGC acted in June 2002 to initiate involuntary termination procedures. Acting under its statutory authority, PBGC issued Notices of Plan Termination on June 12, 2002 with an effective date of termination of June 14. At the same time, RTI had been negotiating a sale of assets. In August 2002, RTI shut down its facilities. In its attempt to increase PBGC insurance coverage for pension benefits, the union filed a lawsuit to have the August shutdown date declared as the plan termination date, with the intent of having PBGC cover shutdown benefits included in the plans. While the district court agreed with the union position, the federal appellate court found PBGC’s Notice of Plan Termination effectively terminated the plans, ceased benefit accruals and, as a result, provided no PBGC insurance for the shutdown benefits that had not yet arisen under the plans. (PBGC v. Republic Technologies International LLC, 6th Cir., 2004)

Benefit Plans Wholly Funded by School Districts Are Not Covered by ERISA. A recent decision of the U.S. Court of Appeals for the Second Circuit reminds us that an arrangement that is fully funded by a government entity or subdivision, such as a public school district, is a “government plan” and not covered by the Employee Retirement Income Security Act (ERISA). This federal appellate court decision affirmed a trial court dismissal of an ERISA claim brought by plan participants against a health reimbursement plan maintained by a public school district because the plan was funded solely with contributions from the school district. While benefit arrangements maintained by government agencies or subdivisions may be governed by ERISA, the Second Circuit has made it clear that where exclusive funding comes from the governmental entity, the plan is a government plan exempt from ERISA. (Gualandi v. Adams, 2d Cir., 2004)

Take Administrative Caution With Death Beneficiary Designations. An ERISA case decided in U.S. District Court for Massachusetts should stand as a reminder to plan administrators to exercise prudence when dealing with death beneficiary designations. In this case, the participant named his daughter as death beneficiary in a group term life plan following a divorce settlement where the participant agreed with his first wife to name their daughter as beneficiary until her 21st birthday. The participant remarried and named his second wife as the beneficiary under an accidental death and dismemberment policy. Shortly before his daughter turned 21, the participant contacted his human resource department to request a change of beneficiary form so that he could change the term life insurance designation to his new spouse. The participant allegedly was told that his new spouse was already his death beneficiary even though that was only true of the accidental death and dismemberment policy. The plan administrator sent out the change of beneficiary form. The participant allegedly relied on the incorrect information and took no further steps to change the beneficiary for the term life policy. When the participant died less than a year later, the daughter remained the named death beneficiary. Both the second spouse and the daughter made claims for the benefits. In awarding the benefits to the daughter, the court concluded a phone call about his beneficiary designation, even if it contained inaccurate information from the employer, was not a sufficient good faith attempt by the participant to change his beneficiary. The lesson for plan administrators? It is good practice to continuously make beneficiary designation forms available to plan participants. The administrator in this case acted prudently by sending out new designation forms to the inquiring participant even if the existing named beneficiary seemed to be the “right” person. A reminder to participants about updating death designations and making forms available can go a long way in protecting against lawsuits. (Prudential Insurance Co. of America v. Schmidt, D. Mass, 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.