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Employee Benefits Developments September 2006

RULINGS, OPINIONS, ETC.

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Update: 409A transition relief extended
The IRS announced on October 4 that it is extending through 2007 most of the existing transition relief for nonqualified deferred compensation arrangements subject to IRC Section 409A (Section 409A). Notice 2006-79 extends to December 31, 2007 the deadline for full compliance with the requirements of Section 409A. This means that plan sponsors now have until the end of 2007 to formally amend their plans to comply with Section 409A and the final regulations. However, nonqualified deferred compensation arrangements must continue to be operated in good faith compliance with the statute and existing guidance in the interim. Many of the existing transition rules, such as the ability to make new payment elections, have also been extended through 2007. According to the Notice, the IRS still intends to issue the final Section 409A regulations by the end of 2006.

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Regulatory update
Governmental agencies have been busily issuing regulatory guidance affecting compensation and benefits. The following regulatory items of interest were recently published:

The Securities and Exchange Commission (SEC) has formally published its final rules governing disclosure of executive compensation for publicly traded companies (71 Fed. Reg. 53,158 (September 8, 2006)). Companies must comply with the new disclosure rules for Form 10-K filings for fiscal years ending after December 14, 2006 and for Form 8-K triggering events that occur after November 6, 2006. The final rules are intended to provide investors with a more complete picture of the compensation of principal officers and directors. The new rules require proxy statements to include a new section, entitled the Compensation Discussion and Analysis (CD&A). The CD&A must include a discussion and analysis of material factors underlying the compensation policies and awards made by the company. The new CD&A is substantially different from the previous Compensation Committee Report, and will require input from management, compensation committee members, and, quite often, outside compensation consultants so that the new CD&A is prepared properly. Because of all the new information and disclosures required, a company that is subject to the reporting requirements should take steps to record compensation-related decisions throughout the course of the year.

As we reported in the September 2005 edition of our Employee Benefits Developments newsletter, the Internal Revenue Service (IRS) issued proposed regulations that provide guidance on the anti-cutback benefit rules of Internal Revenue Code (IRC) § 411(d)(6), including a new utilization test under which a plan may be amended to eliminate an optional form of benefit that has not been utilized during a look-back period. The 2005 proposed regulations also included new rules reflecting the Supreme Court decision in Central Laborers’ Pension Fund v. Heinz, which make it impermissible to impose new restrictions or conditions on a participant’s right to a protected benefit after the benefit is accrued. In August, those regulations were published in final form with some modification. The Heinz regulations generally take effect July 7, 2004. The utilization test rules are effective for amendments adopted after 2006. The regulations are published at 71 Fed. Reg. 45379.

As sponsors of IRC § 403(b) plans are already aware, the IRS has been considering a 2004 set of proposed regulations that, for the first time in decades, would provide comprehensive guidance for the operation of 403(b) plans. Those regulations still have not been finalized, but the publication of final IRC § 403(b) regulations is rumored to be close at hand. In anticipation of the publication of final regulations, the IRS announced that it will delay the effective date of those new regulations until at least January 1, 2008. The delayed effective date will give 403(b) plan sponsors more time to prepare for the changes needed to implement regulation changes. (IRS News Release 2006-136.)

The IRS and the Treasury Department released the final rules (T.D. 9282) on redemption payments of employer securities held by an employee stock ownership plan (ESOP). The final rules adopt, without material change, the proposed regulations released last January. The final rules state the following:

Payments made to reacquire stock held by an ESOP are not deductible under IRC § 404(k) because such payments are not applicable dividends under § 404(k)(2), and a deduction for such payments would constitute, in substance, an avoidance or evasion of taxation within the meaning of § 404(k)(5).

Section 162(k) disallows any deduction, including any deduction under § 404(k), for amounts paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in § 465(b)(3)(C)).

Amounts paid or incurred in connection with the reacquisition of stock include amounts paid by a corporation to reacquire its stock from an ESOP that are then distributed by the ESOP to its participants (or their beneficiaries) or otherwise used in a manner described in § 404(k)(2)(A).

Tax-free medical benefits must exclude unrelated beneficiaries
In a ruling with a prospective effective date for existing plans, the IRS has ruled that an employer’s accident and health plan will be fully taxable to an employee if any benefits from the plan can go to a designated individual who is not a spouse or dependent. The ruling involves a reimbursement plan that pays for uninsured medical expenses of an employee, spouse, or dependent. The plan carries over unused amounts to future years and permits the employee to name a designated beneficiary if there is any unused amount after the death of the employee, spouse, and dependents. Based on its interpretation of the IRC provisions that make benefits under employer-sponsored medical plans tax-free to employees, spouses, and dependents, the IRS concluded that by including other designated beneficiaries, the whole plan becomes taxable. If a plan that allowed for medical benefits to impermissible beneficiaries was in existence on August 14, 2006, this ruling will not apply until plan years beginning after 2008. (Rev. Rul. 2006-36.)

Federal rule blocks state taxation of nonresident partner benefits
A new federal law retroactively precludes states from taxing nonresident retired partners on retirement income from nonqualified partnership arrangements. The law is retroactive to 1996, when Congress first prohibited states from imposing income taxes on nonresidents who earned retirement benefits in qualified plans, IRAs, and certain nonqualified plans in one state before retiring to another state. The 1996 law, for example, prohibits New York from imposing its state income tax on an individual who earned a retirement benefit working as an employee in New York, moved to Florida in retirement, and collected the retirement benefit as a Florida resident. Since 1996, New York has taken the position that partners who earned a nonqualified retirement benefit while working in New York are not covered by the 1996 law and thus remain subject to New York taxes on nonqualified benefits earned in New York even if the partner later moves out of state. The new law retroactively puts an end to such “long arm” income tax rules. (P.L. 109-264.)

CASES

Eighth Circuit “pushing the envelope” on evidence of mailing COBRA notice
The United States Court of Appeals for the Eighth Circuit reversed a district court’s decision that granted summary judgment to a plan administrator who claimed to have issued a Consolidated Omnibus Budget Reconciliation Act (COBRA) notice to a former employee within the required statutory time limit. In reversing the lower court, the Eighth Circuit stated that, although the administrator offered proof that the COBRA notice had been generated, the administrator failed to prove that the COBRA notice was actually mailed. The federal appellate court further stated that because the administrator failed to carry its burden of proof, summary judgment instead should be granted to the former employee. This ruling may be interpreted as heightening the standard required for the administration of COBRA notices.

In 1993, Big D Oil Company terminated one of its employees. Dakotacare administered the group health insurance plan for Big D. The employee’s termination was a qualifying event that required Dakotacare to notify her of her right to continue her health coverage. The employee claimed, however, that she was not notified of her rights and that the first time she learned of the option to continue her benefits was when Dakotacare sent her a letter telling her that the period for exercising the option had expired.

This case hinged on whether Dakotacare presented sufficient evidence to show it had complied with the notice requirement. In its favor, Dakotacare produced an audit report showing that its tracking system generated a COBRA notice letter to the employee around the date of her termination. Dakotacare also presented testimony from an employee about the company’s normal procedure for mailing notification letters. Nevertheless, the Eighth Circuit stated that although only “a good faith attempt to comply with a reasonable interpretation of the statute is sufficient,” the administrator must offer evidence that the notice was in fact mailed. Citing other cases, the federal appellate court provided examples of sufficient proof of mailing, including a photocopy of the envelope addressed to the recipient; a report generated by the plan administrator, stamped with the date the notice was mailed; and an affidavit from an employee who remembered mailing the notice to the recipient.

In light of the specific type of proof required in this case, employers should review their COBRA administration policies and make certain to include not only evidence of the production of the notice but also evidence that the notice is actually mailed. (Crotty v. Dakotacare Administrative Services Inc., 8th Cir., 2006.)

Seventh Circuit rules in favor of cash balance plan designs
In reversing a lower court decision (See Employee Benefits Developments, July 28 to August 8, 2003) that held that the IBM Personal Pension Plan, a cash-balance defined benefit plan, violated the age discrimination rules, the United States Court of Appeals for the Seventh Circuit provided an analysis favorable to common cash-balance plan designs. The IBM Plan provides pay credits of five percent of a participant’s compensation and interest credits at one percent above one-year treasury bill rates. In this case, the plaintiffs had argued, and the federal district court agreed, that the pay credits, when compounded for interest over time, favored younger employees because they provided for a greater benefit to be paid out at the time of normal retirement age. The Seventh Circuit rejected the analysis of looking at the benefit at retirement and accepted that, for purposes of the relevant provisions of the Employee Retirement Income Security Act of 1974 (ERISA), benefit accrual is determined by the current input to the retirement benefit. On this basis, IBM’s hypothetical contribution of five percent of compensation was clearly non-age discriminatory. The Seventh Circuit found there was nothing in ERISA that required a finding that what is clearly non-age discriminatory in a defined contribution plan would become age-discriminatory because the plan was a defined benefit plan. (Cooper v. IBM Personal Pension Plan, 7th Cir., 2006.)

Fiduciaries did not use employee contributions for improper purposes
In an unpublished opinion, the United States Court of Appeals for the Fourth Circuit held an employer and its officers did not violate ERISA, even though employee contributions to the employer’s self-insured medical plan were not promptly used to pay claims or administrative expenses.

CT Enterprises, Inc. (CT) maintained a self-insured health plan for its employees. CT paid claims as they came due by contributing the necessary funds (consisting of employer and employee contributions) to an account established by the claims administrator. In July 2000, CT began to experience financial difficulties and failed to contribute the funds necessary to pay all claims. Until July 2000, all employee contributions had been submitted to the plan on a weekly basis. After that point, employee contributions were submitted at less frequent intervals but within 90 days of each weekly paycheck. In November 2000, CT terminated the plan, leaving a number of claims unpaid. Twenty-two employees then filed suit against CT and its officers, alleging, among other things, that the company and its officers failed to hold employee contributions in trust and, moreover, to use them for the exclusive purpose of paying benefits and plan administrative expenses as required by ERISA.

Under a Department of Labor (DOL) regulation, payroll deduction contributions to a welfare plan (insured or self-insured) become plan assets as of the earlier of

the earliest date on which the contributions can reasonably be segregated from the employer’s general assets, or

the 91st day after the date the contributions are withheld from the employee’s paycheck.

Under ERISA, once employee contributions become plan assets, they must be held in trust and used for the exclusive purpose of paying benefits and plan administrative expenses. In ERISA Technical Release 92-01, the DOL stated it would not assert a violation of the trust requirement where the participant contributions either

are made under a cafeteria plan, or

are applied only to the payment of insurance premiums, but only if the employee contributions are used within three months of receipt to pay the insurance premiums.

Citing the technical release, the Fourth Circuit in Phelps found the trust requirement did not apply because the employee contributions were paid under the terms of a cafeteria plan. More importantly, the federal appellate court found CT had submitted undisputed evidence that all employee contributions were ultimately used to pay plan administrative expenses and that no part of the money was used for general corporate purposes. Thus, even though employee contributions arguably were held by CT beyond the earliest date on which those contributions could be segregated (thereby becoming plan assets), no ERISA violation occurred because the employee contributions were, in fact, used for plan purposes and not corporate purposes (e.g., funding payroll).

In this case, the plan sponsor and its officers were able to demonstrate that the participant contributions were used for a permitted purpose (i.e., the payment of legitimate plan administration expenses). To reduce the risk of liability, employers should implement payroll and accounting procedures in the event it becomes necessary to prove prompt and proper use of welfare plan participant contributions. (Phelps v. CT Enterprises, Inc., 4th Cir. 2006.)

Improper notarization invalidates spousal waiver
A widow who had signed a spousal consent waiving all rights to her husband’s pension benefits was nevertheless awarded survivor benefits because the spousal waiver had been improperly notarized in her absence. On retirement at age 62, a New York Times employee began receiving pension benefits from his company’s pension plan. The employee died less than two months later, leaving his widow as beneficiary. When his widow inquired about survivor benefits, she discovered that the plan had on file a signed spousal consent waiving her right to her husband’s benefits. She sued the plan, claiming she had never signed the waiver. Relying in part on the testimony of a handwriting expert, the United States District Court for the Eastern District of New York found the signature on the spousal waiver was in fact the widow’s signature. The federal district court also found, however, that the waiver had not been signed in the presence of the notary public who notarized the document. Rather, after securing his wife’s signature on the waiver, the plan participant had taken the waiver to the New York Times’ office and had asked the notary to notarize the document. The notary, who worked for the company, accommodated the request and notarized the form in the wife’s absence, signing and stamping the waiver with his notary stamp. Significantly, the usual notary statement affirming that the spouse had signed the document in the notary’s presence was missing from the form. Finding that the consent was witnessed by neither a plan representative nor a notary public, as required by ERISA, the court held there was no valid spousal consent by the surviving spouse. The fact that the notary worked for the company was not a determining factor in the decision, as the court found the notary had no personal or financial interest in the husband’s pension benefits. (Alfieri v. Guild Times Pension Plan, E.D.N.Y. 2006.)