Current developments in employee benefits.

• Author: Kundin, Elizabeth A.
• Position: Part 2

Sec. 403(b) Plans; Accounting for Stock Compensation; Delinquent Filer Voluntary Compliance Program; Executive Compensation; Business Expenses; Judicial Developments

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part 1, published in November, focused on current developments affecting qualified retirement plans, including pension provisions within the General Agreement on Tariffs and Trade and the Uniformed Services Employment and Reemployment Rights Act of 1994, Employee Retirement Income Security Act of 1974 (ERISA) issues, and various IRS releases that provide guidance on qualified plan design. Part II, below, focuses on IRS initiatives on Sec. 403(b) plan compliance, the Financial Accounting Standards Board's (FASB) Statement on stock compensation, the Department of Labor's (DOL) Delinquent Filer Voluntary Compliance (DFVC) Program, the taxation of property transfers and other executive compensation issues new rules for substantiating business expenses and recent court decisions and related legislation.

Sec. 403(b) Plans

* Tax Sheltered Annuity Voluntary Correction program

Nonprofit organizations and public educational institutions that sponsor Sec. 403(b) retirement plans now can voluntarily correct plan problems with a procedure similar to the IRS's Voluntary Compliance Resolution (VCR) program for qualified retirement plans. The IRS has unveiled a Tax Sheltered Annuity Voluntary Correction (TVC) program, allowing employers that legitimately sponsor Sec. 403(b) plans to voluntarily identify and correct certain plan defects.(37) The TVC program is effective from May 1, 1995 through Oct. 31, 1996. Plan sponsors that request consideration under the TVC program agree to correct the identified defects and pay a sanction amount, and receive in return written assurance that the violations will not result in revocation of the income tax exclusion.

The TVC program is available only to employers eligible to offer Sec. 403(b) plans. The IRS has discovered a number of Sec. 403(b) plans sponsored by nonprofit organizations that are not Sec. 501(c)(3) organizations, including business leagues, boards of trade and recreational clubs, and is negotiating settlements for ineligible Sec. 403(b] plans on a case-by-case basis.

Under the TVC program, eligible Sec. 403(b) plan sponsors identify plan defects, propose a plan for full correction, describe any needed improvements in plan administration and pay both a correction fee and a negotiated sanction. Plans under examination or that have received written or oral notice of examination are not eligible for the program. A plan will not be selected for IRS examination while it is in the TVC program. If the employer anticipates that the corrections will require the cooperation of other parties (e.g., the insurance company issuing the annuity contracts), it must obtain assurance that those parties are willing to cooperate in correcting the defects.

The correction fees range from $500 for employers with fewer than 25 employees to $10,000 for employers with 10,000 or"more employees. Unlike the VCR program for qualified plans, the TVC program also requires payment of a "sanction" negotiated by the plan sponsor and the IRS, which will not exceed 40% of the "total sanction amount" (TSA), the tax the IRS could assess for the defects. The correction fee will be applied to reduce the TSA. The TSA is contingent on whether the defects are of a type that would cause the plan to lose its Sec. 403(b) status, or only cause contributions to certain contracts to lose their Sec. 403(b) status. The actual sanction imposed will be based on the severity of the defect' the number and type of employees affected by them, the cost of correction, the extent to which employees would be hurt if the income exclusion were lost and the extent to which the errors were found through the employer's own procedures.

The IRS will rely on the plan sponsor's statements identifying the plan's operational defects. The employer must correct identified defects for all years in which they existed, even closed tax years. The correction statement will only address the issues raised by the employer, related issues, and other issues presented by the employer in written or oral statements; however, if the IRS discovers unrelated violations while considering the TVC request, these defects will generally be added to the correction statement.

An employer can request a TVC correction for the following defects:

[] Violation of Sec. 403(b)(12) nondiscrimination requirements, including violations regarding matching contributions and failure to offer salary reduction opportunities on a universal basis.

[] Violation of distribution requirements (e.g., improper hardship distributions and improper withdrawal of salary reduction contributions).

[] Violation of the rules limiting death benefits under the plan to benefits that are "incidental."

[] Failure to pay minimum required distributions after participants reach age 70 1/2.

[] Failure to give employees the right to elect a direct rollover, including failure to give employees an information notice.

[] Violation of salary reduction limits, such as treating amounts as a one-time irrevocable election and then permitting revocation.

[] Contributions in excess of the Sec. 403(b)(2) exclusion allowance.

[] Failure to satisfy applicable nontransferability requirements for the annuity.

[] Failure to satisfy the Regs. Sec. 1.403(b)-l(b)(3) requirements that salary reduction agreements apply only to salary earned after the agreement is made, be made only once in any tax year and be legally binding.

[] Violation of the Sec. 415 limits prohibiting annual contributions of more than $30,000 or 25% of compensation or improperly applying special alternative limits to certain Sec. 403(b) plans.

Items not eligible for resolution under the TVC program include:

[] Defects relating to the misuse or diversion of plan assets.

[] Plans for which the employer does not have sufficient information to determine the nature or the extent of the defect, or to effect reasonable correction.

[] Plans that purchased annuity contracts from an entity other than an insurance company.

[] Plans that did not purchase annuity contracts or invest contributions in a proper custodial account.

[] Annuity contracts purchased or custodial accounts established on behalf of ineligible employees or independent contractors.

[] Plans with egregious defects.

[] Defects subject to an excise tax, penalty or additional income tax as a result of improper loans or early distributions.

The TVC program will not be available to waive or reduce any applicable excise taxes, nor does the program alter an employer's obligation to satisfy any applicable FICA and FUTA tax requirements. The IRS must be assured that the employer has or will initiate procedures to pay the appropriate employment taxes.

At the favorable completion of the TVC process, the plan sponsor will receive a correction statement and acknowledgment letter from the IRS. The correction statement will fully describe the defects, the required corrections, the sanction, the time frame in which corrections must be implemented and any revisions to the administrative procedures or employment tax procedures on which the statement is conditioned.

Acknowledging that data for Sec. 403(b) plans frequently is nonexistent, the IRS has indicated that, on a case-by-case basis, it will allow"a plan correction based on data estimated by the employer or will issue a correction statement covering only years for which data is available.

* Examination guidelines

The IRS subsequently issued proposed guidelines for employee plan examiners to use when examining Sec. 403(b) plans.(38) The IRS cautioned that the guidelines are not meant to be all-inclusive, are not a precedential or comprehensive statement of the IRS'S legal position on the issues, and cannot be relied on or cited as authority.

Agents are advised to determine whether the employer is eligible to maintain a Sec. 403(b) plan. Generally, only public education organizations described in Sec. 170(b)(1)(a)(ii) and nonprofit organizations described in Sec. 501(c)(3) are eligible. If the employer is not eligible, the plan most likely includes taxable annuities for employees and the agent is to consider collecting income and employment taxes for all open years.

The guidelines categorize Sec. 403(b) violations as either plan defects or annuity contract defects. In general, plan defects result in a loss of Sec. 403(b) status for the entire plan, while annuity contract defects affect only the annuity contract with the defect. Some defects may fall into either category, depending on the facts and circumstances. All defects that generate addition,al income will result in additional employment taxes and/or withholding requirements.

Annuity contract defects may be further broken down into defects that affect only a portion of a participant's annuity contract and those that adversely affect the status of the participant's annuity contract as a Sec. 403(b) contract. When only a portion of the annuity contract is affected, the tainted portion of the contract is includible in gross income and/or subject to excise tax in the tax year. Such defects include the following:

[] Contributions in excess of the exclusion allowance.

[] Excess Sec. 415 amounts.

[] Excess deferrals that do not cause a loss of Sec. 403(b) status.

[] Certain loans.

[] Isolated instances of failure to satisfy minimum distribution requirements.

[] More than one salary reduction agreement in a single tax year.

[] Salary reduction agreements that apply to prior earnings.

The following defects cause a participant's entire annuity contract to fail under Sec. 403(b):

[] An inadequate salary reduction agreement (e.g., existence of nonsalary reduction contributions).

[] An annuity contract not...