Current developments.

• Author: Walker, Deborah
• Position: Part 2 - Retirement plan developments

This two-part article provides an overview of current developments in employee benefits. Part II focuses on significant retirement plan developments, including proposed and final regulations and revenue and letter rulings.

Part I of this two-part article, published in the Nov. 2003 issue, focused on recent developments in executive compensation and welfare plans. Part 11, below, highlights last year's most significant retirement plan developments, including both IRS and Department of Labor (DOL) guidance.

Qualified Plans

Proposed Regulations

In July 2003, the IRS published proposed regulations (33) on cash-or-deferred arrangements (CODAs) and employee and matching contributions. When published as final regulations, these rules will completely overhaul existing Sec. 401 (k) and (m) regulations, incorporating all of the statutory amendments and administrative guidance accumulated since the 1991 regulations. The proposed regulations eliminate the ability to accelerate deductions, restrict the use of "bottom up" qualified nonelective contributions (QNECs) as a way to pass the discrimination tests with minimal contributions and reflect a decade of statutory changes. While many provisions are not new, the following important changes were made:

* Undoing Notice 2002-48, (34) the proposal would prohibit employers from prefunding elective deferrals or matching contributions, a practice that the preamble notes is inconsistent with Sec. 401 (k) and (m).The proposed regulations do not distinguish transfers from terminating Sec. 4980(d) defined benefit (DB) plans, the use of forfeitures to offset elective or matching contributions or allocations of matches from employee stock ownership plan (ESOP) suspense accounts. The IRS has informally stated that these amounts will be exempt from the rule.

* The proposal noted that year-to-year changes in actual deferral percentage/ actual contribution percentage (ADP/ ACP) testing methods may arouse IRS suspicion. Thus, employers must not continually manipulate testing to significantly increase the permitted ADP or ACP for highly compensated employees (HCEs). However, plans would be allowed to perform the ADP test on a prior-year basis and the ACP test on a current-year basis (or vice versa); movement of contributions from one test to another will be prohibited.

* A favorable change eliminated separate ADP/ACP testing of the ESOP and non-ESOP portions of a plan and allows permissive aggregation of ESOPs and non-ESOPs for testing purposes. This change accommodates the many Sec. 401 (k) plans that have created component ESOPs to take advantage of the expanded deduction opportunities under Sec. 404(k). However, the group of employees eligible for the ESOP still must satisfy Sec. 410(b). Thus, a plan could not take advantage of this relaxation to limit participation in its ESOP component to a predominantly highly compensated group.

* The rules for sole proprietors' plans provided another favorable change, permitting all of their compensation to accrue on the last day of their tax year and allowing a deferral election to the end of that year.

* The proposal clarified that elective contributions, qualified matching contributions (QMACs) and QNECs received in a trustee-to-trustee transfer (other than a direct rollover) from another plan remain subject to the Sec. 401(k) (2) 03) distribution restrictions. The transferor plan has an obligation to ensure that the transferee plan will observe this requirement.

* Under the proposal, a participant's QNEC or QMAC cannot be taken into account for the ADP or ACP test to the extent that it exceeds the greater of 5% of compensation or twice the plan's "representative" nonhighly compensated employee (NHCE) ADP or ACP, which is the median (not average) ADP or ACP of the NHCE participants.

* Finally, plans that require employment on the last day of the year as a condition for receiving matching contributions will not be able to use the Sec. 401(m)(11) ACP safe harbor. However, their eligibility to use the Sec. 401 (k)(12) ADP safe harbor is not jeopardized.

The proposed regulations would become effective no earlier than the first plan year beginning at least 12 months after their adoption in final form. Until then, taxpayers need to adhere to the existing final regulations.

Catch-Up Contributions

Final regulations (35) relaxed the "universal availability" requirement, under which a controlled group cannot pick and choose which of its plans will allow catch-up contributions. The option must either be available under all plans that permit elective deferrals, or under none of them. Under the final regulations, collective bargaining employees and nonresident aliens without U.S.-source income may be ignored. Plans may also limit deferrals (including catch-ups) to (1) 75% of compensation or (2) the cash available after all required withholding front the participants' paychecks. A transition rule modeled on Sec. 410(b)(6)(C) is provided for mergers, spinoffs and acquisitions. Separately from these exemptions, Notice 2002-4 (36) offered relief to employers that maintain plans qualified under Puerto Rico law, which has no provision for catch-ups.

In addition, the final regulations noted that the identification of catch-ups is made annually. Plans can choose whether to offer matching contributions for catch-up deferrals without any "nondiscrimination" implications. Individuals participating in two or more plans of unrelated employers may take the catch-up rules into account in determining whether the Sec. 402(g) limit has been exceeded, regardless of whether the plans allow catch-up contributions.

The regulations apply to plan years beginning after 2003 and may be relied on immediately.

Restorative Payments

Two letter rulings illustrated when the IRS...