Current developments in employee benefits and pensions.

• Author: Walker, Deborah
• Position: Part 2

EXECUTIVE SUMMARY

* Rev. Proc. 2008-50 updated the rules for the Employee Plans Compliance Resolution System (EPCRS), under which qualified plan sponsors correct plan qualification failures and avoid plan disqualification.

* The IRS issued proposed regulations dealing with automatic enrollment arrangements, employer stock diversification, and cash balance and other hybrid plans.

* In Notice 2008-30, the IRS provided guidance on changes, including ones made by the Pension Protection Act of 2006, affecting qualified plan distributions.

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This two-part article provides an overview of current developments in employee benefits, including executive compensation, welfare benefits, and qualified plans. Part I, in the November issue, focused on executive compensation and benefits. Part II focuses on new guidance regarding qualified retirement plans.

EPCRS Update

The IRS published the first update to the Employee Plans Compliance Resolution System (EPCRS) in over two years on September 2, 2008. EPCRS allows plan sponsors to correct plan qualification failures without suffering the severe consequences of plan disqualification. Rev. Proc. 2008-50 (44) retains the basic structure and operation of EPCRS but adds several new correction methods for common plan qualification failures and makes numerous, mostly liberalizing, technical and procedural changes. These changes are effective January 1, 2009, but may be relied upon voluntarily beginning September 2, 2008.

Guidance for Failure to Implement an Employee's Deferral Election

Appendix A and Appendix B (45) in Rev. Proc. 2008-50 specify that, where an employee makes a 401(k) elective deferral and that election is not honored, the missed deferral is based on the deferral percentage that the employee attempted to elect, rather than on the average for his or her group.

Guidance for Correcting Catch-Up Contribution Exclusions

Another new method of correction provided in Appendix A involves a failure to provide catch-up contributions. To the extent an employee is improperly excluded from making a catch-up contribution, the correction is a qualified nonelective contribution (QNEC) equal to 50% of the missed deferral, but for this purpose the missed deferral is defined as one-half of the catch-up contribution limit in effect for the year of failure.

To illustrate, if an employee is excluded from the ability to make catch-up contributions during 2007 (when the catch-up contribution limit was $5,000), the missed deferral is equal to $2,500 and the missed deferral opportunity (and therefore the required QNEC) is $1,250. The QNEC must be adjusted for earnings through the date of correction.

Various Modified Correction Rules for Improper Exclusions from 401(k) Plans

Rev. Proc. 2006-27, (46) the last update of EPCRS, specifically stated that the method for correcting the failure to include an otherwise eligible employee in a 401(k) plan did not apply to a plan that allowed participants to make designated Roth contributions. Rev. Proc. 2008-50 now allows the same correction method to be used regardless of whether Roth contributions are available. The corrective QNEC, however, does not enjoy the benefits of a Roth contribution. Instead, it is excluded from income, and distributions are taxable.

Rev. Proc. 2008-50 retains the principle that an actual deferral percentage (ADP) test failure must be corrected before the correction of improper exclusions, but it clarifies that the ADP test is performed without considering the improperly omitted participants. The test results (reflecting any required corrections) are then used to calculate the excluded individual's missed deferrals. After that, the test is not run again. The same rule applies if the employee's deferral election was not honored.

New Guidance on Participant Loan Corrections

Rev. Proc. 2008-50 allows a defaulted loan that originally had a shorter term than the maximum permitted by Sec. 72(p) (five years except in the case of a loan whose proceeds are used to acquire a principal place of residence) to be reamortized over the longest period for which it could have been taken. Hence, in the case of the typical participant loan with a maximum term of five years, the loan may be reamortized over any term that ends no later than five years from the date of original issuance.

In addition, loans made by a plan that lacks Sec. 72(p) language (or even without any provision for loans at all) may now be corrected under EPCRS, although, as Rev. Proc. 2008-50 observes, they may result in fiduciary violations or prohibited transactions that will have to be dealt with separately under the rules established by the Department of Labor (DOL).

Rev. Proc. 2008-50 also states that the maximum payment amount (the basis for negotiating sanctions under the Audit Closing Agreement Program (Audit CAP)) will now include the amount of income tax that will be due under Sec. 72(p) if a loan failure is discovered upon examination and corrected through the Audit CAP process. While not stated explicitly, because Audit CAP sanctions are paid exclusively by the employer, this presumably means that the participant will be excused from the income tax consequences normally associated with loan failures.

Guidance for Correcting Sec. 415 Failures

Rev. Proc. 2008-50 revised the guidance for correcting Sec. 415(c) failures in defined contribution plans. The revised guidance reflects the new final regulations under Sec. 415, which eliminated provisions for correcting excess annual additions through their allocation to a suspense account or the refund of elective deferrals. (47) Instead, the regulations stated that Sec. 415 violations would be addressed through EPCRS. Previous EPCRS correction guidance for Sec. 415 failures specifically referenced the suspense account rules. For years prior to 2009, the guidance is the same as under Rev. Proc. 2006-27, which simply followed the prior regulations. For failures in years beginning in 2009 or later, the guidance is as follows:

1. If the excess is solely attributable to nonelective employer contributions, then:

   1. If the plan contains a rule under which the excess can be reallocated to other participants' accounts, it must be reallocated.

   2. If there is no reallocation provision (e.g., if the plan specifies a flat percentage rate of contribution or if every participant is at the Sec. 415(c) limit), the excess must be removed from the participant's account and applied to reduce future employer contributions. (It may not be returned to the employer.)

2. To the extent the excess is solely attributable to elective deferrals or employee after-tax contributions, it must be returned to the participants, with attributable earnings. If the plan provides for both types of contribution, after-tax contributions are returned first.

3. If the plan provides for matching contributions, unmatched after-tax contributions and elective deferrals are returned first. If returning unmatched after-tax contributions and deferrals is insufficient to correct the violation, the remaining excess must be apportioned between the deferrals or after-tax contributions and the match (based on the match formula). The deferrals and after-tax contributions are returned, and the attributable match is forfeited and used to reduce future employer contributions.

   New Definitions for Overpayment, Excess Allocation, and Excess Amount

   Rev. Proc. 2008-50 revises the definitions of the key terms "excess amount" and "overpayment" and coins a new term, "excess allocation."

   An excess amount includes any allocation in a defined contribution plan that exceeds either (1) a specific statutory limit or (2) the amount that can be allocated to a participant's account under the terms of the plan. The revised definition specifically excludes defined benefit plans (except for allocations of after-tax contributions to a separate account under such a plan) and, unlike the prior definition, does not include overpayments.

   An excess allocation is an excess amount for which the Code and regulations do not provide a specific correction mechanism. For example, an allocation to a participant that exceeds the amount permitted under the plan's terms is both an excess amount and an excess allocation, but elective deferrals in excess of the limits under Sec. 402(g) would only be an excess amount (because the Code permits these deferrals to be corrected by distributing them to the participant).

   If there is an excess allocation to a participant's account under a plan, it is to be corrected in the same manner as a Sec. 415 violation, as described above.

   An overpayment is any distribution that exceeds the amount payable to a participant or beneficiary under the terms of the plan or that exceeds a statutory limit. Thus, a distribution from a defined contribution plan that includes an excess amount, or from a defined benefit plan that is greater than the recipient is entitled to under the terms of the plan, is an overpayment. An improper in-service distribution (such as a purported hardship distribution that does not meet the conditions of Sec. 401(k)(2)) is also an overpayment, although this conclusion is not stated clearly and must be inferred from the discussion of correction methods.

   To correct an overpayment, the employer must take reasonable steps to recover it from the participant and must notify him or her that the overpayment is not eligible for favorable tax treatment. If the participant does not repay, the employer is required to reimburse the plan for the un-recovered amount, which is then allocated to other participants or applied to reduce future employer contributions. Presumably, no reimbursement is necessary if the overpayment results from a premature in-service distribution because the plan suffers no loss in that case. Rev. Proc. 200850 does not, however, address that point.

   Relief from Additional Excise Taxes

   Rev. Proc. 2008-50 expands the...