Current developments in employee benefits.

• Author: Walker, Deborah
• Position: Part 2

Distribution Rule Changes; Nondiscrimination Rules; and ESOPs

This three-part article provides an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and employee benefits. Part I, published in November, focused on executive compensation and employee benefits, including changes not only under the Code, but also various other Federal laws, most notably the Employee Retirement Income Security Act of 1974 (ERISA) and the Age Discrimination in Employment Act (ADEA). Part II, below, will focus on current developments affecting qualified retirement plans, including recently enacted rules facilitating retirement plan rollovers and imposing a 20% withholding tax on certain qualified plan distributions; changes to the qualified plan nondiscrimination rules and transition rules for easing compliance with such rules; and additional IRS guidance on employee stock ownership plans (ESOPs). Part III, to be published in January, will focus on judicial consideration of the prohibited transaction and minimum funding rules; IRS liberalization of the distribution rules for plans whose assets are held in receivership; IRS guidance on early retirement windows; and the Supreme Court's determination that certain retirement assets are protected from an individual's bankruptcy creditors. Many of these developments indicate a growing awareness that retirement savings should be conserved for retirement and employers should be aided in offering such benefits to employees.

Legislative Changes To Distribution Rules

On July 2, 1992, Congress passed legislation(65) to extend unemployment benefits, and President Bush later signed the bill into law. As part of the financing of that law, Congress also adopted changes to the qualified plan rules governing the treatment of distributions from qualified plans or tax-deferred annuities. The changes require that after Dec. 31, 1992, most distributions from qualified plans that are not directly transferred into an individual retirement account (IRA), IRA annuity, Sec. 403(a) annuity, or another qualified plan accepting such transfers, will be subject to tax withholding of 20% by the plan sponsor.

The good news is that the treatment of distributions is greatly simplified. Any distribution after 1992 from a qualified plan, other than (1) a required minimum distribution, (2) distributions over life expectancy or (3) distributions over a specified period of 10 or more years, can be rolled over into an IRA or other qualified plan or annuity. Under a transition rule, a partial distribution made before 1993 will not be considered one of a series of payments if the payment is not substantially equal in amount to other payments in the series.(66) Unfortunately, this rule will be of little relief to the taxpayer who was properly advised that such distributions could not be rolled over and whose 60-day rollover period has expired.

On Oct. 20, 1992, the IRS issued temporary regulations on the changes to the distribution rules.(67) Highlights of the temporary regulations include: * A de minimis exception, at the employer's discretion, under which the direct rollover/withholding rules do not apply for annual distributions of less than $200. * An exception for distributions of excess contributions or deferrals under Sec. 401(k) plans, deemed distributions of P.S. 58 costs, and deemed distributions for employee plan loan defaults. * A provision that penalties for failure to withhold on lump-sum distributions made after Dec. 31, 1992 and before July 1, 1993 will be abated if the payor or plan administrator acted in good faith. * A provision that direct rollovers may be made by giving the employee a check if made payable only to the recipient plan. * A requirement that the Sec. 402(f) notice of the tax treatment of distributions must be given to distributees within a reasonable time before the distribution, defined as no more than 90 days nor less than 30 days before, for distributions requiring spousal consent, and generally 30 days for others; however, this 30-day period may be waived for employees affirmatively electing to make or not make a direct rollover.

The choice between a mandatory transfer of retirement plan benefits by the employer or withholding is thought by some to be good retirement policy. ff employees are discouraged from actually getting access to the qualified plan savings money directly, they will be less likely to spend their retirement savings when they change jobs. Unfortunately, this change does place an additional burden on the employer to either withhold 20% in taxes from the distribution or arrange a direct transfer to an account chosen by the employee.

Fortunately, the changes do not require employer plans to accept transfers. However, employers will need to amend their plans to provide for the direct rollover of eligible rollover distributions.

Other Distribution Rule Changes

A number of IRS rulings and judicial decisions clarify certain rules regarding special averaging and rollovers of retirement plan distributions. * Substantially equal periodic payments In Letter Ruling 9221052,(68) the IRS allowed a participant receiving substantially equal periodic payments from a terminating qualified money purchase plan to roll over the assets and continue receiving payments from an IRA without incurring ring a Sec. 72(t)(1) early withdrawal penalty. The IRS ruled that continuing to receive substantially equal periodic payments from the IRA will not constitute a change in substantially equal periodic payments within the meaning of Sec. 72(t)(4).

Company maintained a qualified money purchase pension plan (the Plan) for its employees. Taxpayer, a former employee of Company, accrued benefits under the plan before retiring. After separating from service, Taxpayer began receiving substantially equal periodic payments annually from the Plan in accordance with Sec. 72(t)(2)(A)(iv).

Company is currently in the process of terminating the Plan and all plan assets are being distributed. Taxpayer will receive a single sum distribution of his entire account balance and will roll over the assets into an IRA within 60 days of receipt. Taxpayer wants to continue receiving substantially equal periodic payments annually from the IRA in the same manner as payments were received under the Plan.

Sec. 72(t) provides that any taxpayer receiving a distribution from a retirement plan prior to attaining age 59 1/2 will pay an additional 10% tax on the distribution. Sec. 72(t)(2) provides exceptions to this general rule, including one for distributions received that are part of a "series of substantially equal periodic payments."

A distribution may be part of a series of substantially equal periodic payments if it is - a distribution that is received from a retirement plan; - payable at least annually; and - paid for the life of the employee or the joint lives of the employee and his designated beneficiary. Notice 89-25(69) provides guidance on how to calculate substantially equal periodic payments for this purpose.

Sec. 72(t)(4) provides that if the series of substantially equal periodic payments is modified, for reasons other than death or disability, before the later of the taxpayer attaining age 59 1/2 or the close of a five-year period, the additional 10% tax will be applied to all distributions received from the plan. In other words, if the substantially equal periodic payments are changed within five years, or, if later, age 59 1/2, the exception to the 10% additional tax does not apply to any of the substantially equal periodic payments received.

The IRS concluded that if Taxpayer continued to receive a series of distributions from an IRA that are the same as the series of substantially equal periodic payments currently being made under the Plan, this would not constitute a modification under Sec. 72(t)(4). Hence, based on this ruling, a taxpayer receiving substantially equal periodic payments from one retirement plan may terminate this plan and roll over the assets into another plan, then continue the periodic payments without incurring the 10% additional tax on early withdrawals, provided the payments are made on the same basis. * Lump: sum distribution treatment

The IRS has issued Letter Ruling 9139031(70) revoking an earlier letter ruling that held that a distribution of a participant's remaining account balance, after a portion of the plan's assets was transferred to another plan, is a qualified total distribution and a lump-sum distribution if the participant was over age 59 1/2.

Company N and Company M merged. Both companies had maintained profit-sharing retirement plans with a cash or deferred arrangement (CODA). To simplify administrative costs, the CODA portion of Company N's profit-sharing plan was transferred to Company M's profit-sharing plan. The Company N profit-sharing plan was then terminated and the remaining assets were distributed to the plan's participants. Company N requested rulings on whether the distribution of plan assets would be a qualified total distribution or a lump-sum distribution for participants age 59 1/2 at the date of distribution.

The IRS did not consider Rev. Rul. 72-242(71) in its original ruling. There the IRS concluded that a participant receiving a total distribution of plan assets immediately following a transfer of 50% of a participant's account balance to another qualified plan does not constitute a total distribution of a participant's account balance. The ruling provided that a participant's accumulated account balance prior to separation from service is unchanged by the transfer of assets immediately before retirement. Therefore, participants receiving their entire posttransfer account balances in the plan will not be treated as having received a total distribution of plan assets.

The IRS's current position, as stated in Letter Ruling 9139031, is that a participant's accumulated account...