Section 403(b) Regulations Issued
In the words of the Internal Revenue Service (IRS), “welcome to a new world for 403(b).” For the first time in 43 years, the IRS has issued regulations covering 403(b) plans. These plans, sometimes referred to as “tax-sheltered annuities” or “TSAs,” are 401(k)-like arrangements for employees of tax-exempt organizations, schools and universities. While a 403(b) plan is not a “qualified plan” as we describe 401(k) plans, the statutory rules have brought 401(k) and 403(b) closer together over the years. The new regulations provide the most comprehensive guidance on 403(b) plans issued since the passage of Employee Retirement Income Security Act (ERISA) in 1974.

In general, the effective date of the regulations is in 2009, but a number of the provisions apply earlier. All tax-exempt employers maintaining 403(b) plans will need to review their plans and policies over the coming year. This summary cannot touch on all the provisions of the new regulations.

The highlights include:

• A requirement that all 403(b) plans be maintained pursuant to a written plan document. This rule will impose a responsibility on employers to establish a written plan, if one does not presently exist, and to maintain it.
• Distribution restrictions similar to those for 401(k) plans will apply. Hardship distribution rules for 403(b) plans will follow those used for 401(k).
• “Meaningful notice” must be provided to all employees eligible for salary deferral in order to satisfy the “universal availability” requirement.
• Post-severance contributions may be made by an employer on a nonelective basis for up to five years following severance.
• Catch-up rules for employees after age 50 apply after the special 403(b) catch-up rules are applied.
• Elective salary reduction deferrals will follow the cash or deferred rules of 401(k).
• Incidental life insurance is not permitted in a 403(b) plan except for certain grandfathered contracts.
• Rules are adopted to cover plan termination, termination distributions, rollovers and plan-to-plan transfers.
• New nondiscrimination rules for employer contributions are adopted.

In addition to these comprehensive rules governing the establishment and operation of 403(b) plans, the regulations issued by the IRS include new rules dealing with the treatment of related tax-exempt entities as a single employer under the “controlled group” rules. Under these rules, common control exists between two organizations if at least 80% of the directors or trustees of one organization are either representatives of or are controlled by the other organization.

Employers maintaining 403(b) plans will be required to learn much more about these final regulations before they go into effect in 2009. The IRS has set up a portion of its website covering 403(b) plans in the “Retirement Plan Community” section of its website at www.irs.ustreas.gov/retirement/ article/0,,id=172430,00.html. (Treasury Decision 9340).

DOL Bulletin Issued on ERISA Coverage for 403(b) Plans
The U.S. Department of Labor (DOL) has issued a field assistance bulletin addressing the question of whether an employer has “established or maintained” a plan under ERISA where the arrangement is a tax-sheltered annuity plan under Section 403(b) that consists solely of salary deferral contributions made by employees. An exemption from the ERISA rules is important in these circumstances because an employer would not be required to fulfill the ERISA reporting and disclosure requirements or fiduciary responsibility rules with respect to a plan that it does not establish or maintain. It should be noted that the ERISA exemption applies only to those circumstances where tax-sheltered annuity programs or 403(b) plans are funded solely by salary deferrals and not by employer contributions. This bulletin was issued following the publication of the Internal Revenue Service (IRS) final regulations for 403(b) plans. The DOL concludes that its prior principles applicable in determining ERISA coverage have not been changed by the IRS regulations. Thus, the existing regulations in this area continue to apply. Generally, a plan is exempt where participation is completely voluntary for employees and the employer’s involvement with permitting salary deferrals is basically limited to permitting annuity providers to make the accounts available without endorsement from the employer and without receiving any direct or indirect consideration in the process. In any case where a tax-exempt entity intends to avoid the ERISA requirements under these rules, this bulletin, the previously issued regulations and the new IRS regulations on 403(b) plans should be reviewed to determine that the employer has not crossed a line that will mandate ERISA reporting and disclosure and other obligations (DOL Field Assistance Bulletin 2007-02).

IRS Eliminates Form 5500 Schedule P
In 2006, the Department of Labor (DOL) announced rules mandating electronic filings of the Form 5500. In anticipation of the transition to a wholly electronic filing environment under the ERISA Filing Acceptance System (EFAST), the Internal Revenue Service (IRS) has determined that the continued use of a Schedule P, Annual Return of Fiduciary Benefit Trust, in connection with the filing of a plan’s Form 5500 is no longer necessary for the efficient administration of the Internal Revenue laws. The elimination of Schedule P is effective for the 2005 and later plan years for Form 5500-EZ filers. For all other Form 5500 series filers, the elimination of Schedule P is effective for the 2006 and later plan years. For plan years in which the Schedule P is eliminated, the IRS will treat the plan’s filing of a return from the applicable Form 5500 series as if the filing constitutes a return of the plan’s employee benefit trust, and will treat the filing of a complete Form 5500 return as the commencement of the running of the trust’s statute of limitations (IRS Announcement 2007-63, 6/29/2007).

Discounted Options Violate 409A
An advice letter issued by the Internal Revenue Service Office of Chief Counsel has addressed the permissible good faith interpretation of Internal Revenue Code (IRC) §409A to discounted stock options. A discounted stock option is an option where the exercise price is less than the fair market value (FMV) of the stock at time of grant. In the fact pattern set out in the letter, two employees were granted options in July 2003 with an exercise price of $1 at a time when FMV of the stock was $2. The options were not exercisable until July 2005 and would expire at the earlier of July 2013 or 90 days after termination of employment. Employee A terminated employment in February 2006 and Employee B continued in employment. Both Employee A and B exercised the options in February 2006. Because these events all occurred prior to the date the final regulations under IRC §409A became applicable, good faith interpretations of the requirements can be applied. The letter holds that, even under a good faith interpretation of IRC §409A, the discounted stock options represent deferred compensation plans for purposes of IRC §409A. The ability to exercise a discounted stock option at any time during the option term, where the term extends over more than one tax year, violates the requirements of IRC §409A. Employee B’s exercise of the option was therefore a violation of IRC §409A. Employee A’s exercise was held not to be a violation because the exercise within 90 days of termination of employment was determined, under a reasonable good faith interpretation of IRC §409A in 2006, to be payment of deferred compensation at the time of an otherwise permissible distribution event under IRC §409A (separation from service) (CCA 200728042).

In a related item, the IRS has identified backdated stock options (which usually involve a discounted option price) for the highest level of enforcement within the Large and Mid-Size Business Divisions of the IRS. For any taxpayer with backdated options, agents are required to examine all tax issues that may arise under IRC §409A, non-deductible compensation under IRC §162(m), and improper classification as incentive stock options under IRC §422.

IRS Announces Plans to Issue § 457 Guidance
The Internal Revenue Service recently announced in Notice 2007-62 its plans to issue guidance under Internal Revenue Code (IRC) §457 concerning the definitions of a bona fide severance pay plan and a substantial risk of forfeiture. Describing the anticipated guidance, the notice states that, in many respects, it would be similar to the rules described in the final regulations under IRC §409A.

Section 457 generally applies to nonqualified deferred compensation plans established by state and local government and tax-exempt employers. Certain types of plans, such as bona fide severance pay plans, however, are exempt from coverage under §457. According to the notice, the anticipated guidance will provide that an arrangement is a bona fide severance pay plan under §457(e)(11) and is not subject to the requirements of §457 if (1) the benefit is payable only on an involuntary severance from employment, (2) the amount payable does not exceed two times the employee’s annual rate of pay, and (3) the plan provides that all payments must be completed by the end of the second calendar year following the year of separation. Exceptions are also expected for window programs, collectively bargained plans, and certain reimbursement or in-kind benefit arrangements.

IRC §457(f)(1) provides that compensation under a nonqualified deferred compensation plan subject to §457(f) is included in a participant’s gross income for the first taxable year in which there is no substantial risk of forfeiture. As under the §409A final regulations, the §457(f) guidance is expected to define a substantial risk of forfeiture as an amount conditioned on the performance of substantial future services or on the occurrence of a condition related to a purpose of the compensation where the possibility of a forfeiture is substantial. As the notice also points out, under the §409A final regulations, the extension of a period during which compensation is subject to a risk of forfeiture (known as a “rolling risk of forfeiture”) is generally disregarded for purposes of determining whether a substantial risk of forfeiture exists under §409A. Rolling risks of forfeiture have been used in many existing §457(f) plans and continued use of this feature may be precluded in the future. The notice also briefly addresses the anticipated interaction of §§409A and 457. If the §409A standard for a substantial risk of forfeiture is adopted, then if an amount is included in income under §457(f) when it is no longer subject to a substantial risk of forfeiture, the amount generally would be exempt from §409A under the short-term deferral rule.

The guidance described in the notice is expected to be prospective only. However, pending the issuance of further guidance, taxpayers may rely on the definition of a bona fide severance pay plan for purposes of §457(e)(11)(A)(i) and on the rules regarding a substantial risk of forfeiture under 457(f).

Taxation of Nonexempt Employees’ Trust
Using an extended example, the Internal Revenue Service (IRS) explained in a July revenue ruling the tax consequences of a nonexempt employees’ trust established to fund a deferred compensation plan for a group of highly compensated employees. The revenue ruling describes the tax consequences of contributions, income and distributions to the employer, the employee and the trust. Under the scenario described, employer contributions to the nonexempt employee’s trust are included as compensation in an employee’s gross income when the contribution is vested. The employer is entitled to a deduction in the year in which amounts are includible in the employee’s income, provided that separate accounts are maintained for each employee in the trust. For purposes of withholding, contributions treated as wages for employment tax (FICA and FUTA) purposes are considered paid on the date a participant’s interest vests. The participant’s vested accrued benefit is included in his or her gross income as of the last day of the taxable year of the trust and are treated as paid for Federal income tax withholding purposes on that same date. Additional timing and withholding requirements are addressed in the ruling (Revenue Ruling 2007-48).

CASES

Court Rules Employer Failed to Provide Notice of Severance Plan Amendment Within a “Reasonable Amount of Time.”
A lawsuit was brought by 90 individuals (“Plaintiffs”) to recover severance benefits allegedly owed them by their former employer under the terms of the employer’s Severance Pay Plan (the “Plan”). The employer sold the business unit that employed Plaintiffs which resulted in the elimination of Plaintiffs’ job positions. Approximately seven months before the sale of the business unit, the employer amended the Plan to eliminate Plaintiffs’ eligibility for severance benefits (the “Amendment”). Among other things, Plaintiffs contend they were wrongfully denied severance benefits because they were not provided notice of the Amendment within a “reasonable amount of time,” as required by the Plan’s summary plan description (“SPD”).

The employer argued that a plan sponsor choosing to make a material modification to its welfare plan is generally obligated under ERISA to notify plan participants of the change within 210 days of the end of the year in which the change is adopted. The parties in this case agreed that the employer ultimately did provide a summary of material modification (SMM) within 210 days of the end of the year in which the Amendment was adopted. However, Plaintiffs argued that the employer was subject to its own notice timing provision which was included as part of the Plan documents. According to its terms, the SPD specifically states that employees “will be notified of any material changes to [the Plan] within a reasonable amount of time.” Plaintiffs argue that delivery of the SMM seven months after the Amendment was adopted was not adequate. The court agreed, noting that the employer “promised its employees something more – notice of any material changes ‘within a reasonable amount of time.’” In dismissing the employer’s motion for summary judgment, the court ruled that by any objective understanding of the employer’s promise to timely notify its employees of material changes to the benefits plans, it was unreasonable for the employer to knowingly wait to tell Plaintiffs of the Amendment disqualifying them from severance benefits until almost seven months after the Amendment took effect, and four days before each was terminated from employment.

While it has not yet been determined whether Plaintiffs will ultimately collect their severance benefits, this case serves as a reminder to plan sponsors that plan operations not only need to comply with statutory requirements, but must also comply with more stringent requirements that may be imposed by the terms of the plan documents (Rosenberg v. CNA Financial Corp., N.D. Ill. 2007).

Cattle Ranch is Liable for Trucking Company’s Withdrawal Liability
In lieu of establishing their own retirement plans, employers often agree to provide pension benefits to their collectively bargained employees by joining multiemployer pension funds. An employer’s ongoing contribution to such a fund is usually determined by reference to a flat dollar amount for each hour of covered work. However, an employer which joins a multiemployer pension fund should understand that its financial commitment to the fund can sometimes far exceed the required contributions. Under federal law, if a contributing employer “withdraws” from a multiemployer pension plan (e.g., the employer ceases to have an obligation to contribute), it generally must, upon withdrawal, contribute a share of the plan’s unfunded vested benefits (withdrawal liability). This withdrawal liability extends to each “trade or business” (e.g. partnership, sole proprietorship and trust) which is under common control with the withdrawing employer even if the related organization is engaged in a trade or business that is entirely unrelated (other than from an ownership perspective) to the business of the withdrawing employer.

A recent court case illustrates the broad application of these principles. In McDougal v. Pioneer Ranch Limited Partnership, an individual and his wife owned and controlled a trucking company which was obligated to make contributions to a multiemployer pension fund. The individual and his wife also owned a family limited partnership which held property used, in part, as vacation property and, in part, to farm and raise cattle. When the trucking company became bankrupt and ceased making contributions (i.e., it had “withdrawn” from the fund), the pension fund assessed a substantial withdrawal liability ($3.7 million) on the trucking company, but could not collect any of the amount owed. The pension fund then sued the limited partnership for the withdrawal liability on the theory that the limited partnership was a “trade or business” which was under common control with the trucking company. The court agreed with the fund and ruled that the limited partnership, as a related trade or business, was liable for the trucking company’s withdrawal liability (McDougal v. Pioneer Ranch Limited Partnership, 7th Cir. 2007).

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