Revenue Reconciliation Act of 1993; Voluntary Compliance Resolution program; fiduciary responsibilities; distribution rules; excise taxes.

• Author: Kundin, Elizabeth A.
• Position: Current Developments in Employee Benefits, part 1

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part 1, below, will focus on current developments affecting qualified retirement plans, including the effect of the Revenue Reconciliation Act of 1993 (RRA) on qualified plans, the Voluntary Compliance Resolution program and other plan qualification issues, fiduciary responsibilities, including the Department of Labor (DOL) regulations under Section 404(c) of the Employee Retirement Income Security Act of 1974, (ERISA), and distribution rules. Part II, to be published in December, will focus on executive compensation and employee benefits issues, including the impact of the RRA, DOL and ERISA developments, and the Family and Medical Leave Act.

The Revenue Reconciliation Act of 1993

Under pre-RRA Sec. 401(a)(17), compensation in excess of $200,000 annually (indexed for inflation; the 1993 limit is $235,840) could not be considered when calculating the level of retirement benefit that may be paid to an employee or the level of contribution that may be made to an employee's retirement plan. As amended, this limit is reduced to $150,000 for plan years beginning after 1993.(1) Previously accrued benefits are not affected.(2)

The $150,000 limit will be indexed for inflation in years after 1994, but only when the indexed limit reaches an increment of $10,000 in excess of $150,000. Transition rules are provided for certain participants in retirement plans of state and local governments, and for certain collectively bargained plans.

The reduction in this limitation will create or aggravate problems for Sec. 401(k) plans that struggle to pass their actual deferral percentage (ADP.) and actual contribution percentage (ACP) tests under Secs. 401 (k) and 401 (m). By decreasing the denominator for the highly compensated employees (HCEs), the deferral percentage for the HCEs will increase and the ability of HCEs to defer funds into the Sec. 401 (k) plan will decrease. Due to the mechanics of the testing, it will typically be the mid-level executives, whose contributions represent a higher percentage of their total compensation, rather than the executives whose compensation exceeds $150,000, whose ability to defer compensation will be cut back the most.

The $150,000 ceiling will markedly increase the use of excess benefit plans and similar nonqualified deferred compensation vehicles in order to provide retirement incentives for employees whose qualified plan benefits are being curtailed. The increase in the top marginal individual income tax rates to 36% and 39.6%, versus the maximum 35% corporate rate, also improves the attractiveness of nonqualified deferred compensation.(3) While there are various qualified plan design features that could be implemented (e.g., using an age weighted or cross-testing allocation formula, or integrating the plan with social security), many employers will find these more costly and confusing to employees than the increased retirement benefit realized by the HCEs. Employees who currently contribute 15% of compensation to a profit-sharing plan may find that the new limit decreases the allowable contribution below the $30,000 limit of Sec. 415(c)(1). If employees are in this position, employers should consider adoption of a money purchase pension plan to limit the effect of this negative result.

Qualification Issues

* Voluntary Compliance Resolution program

In Rev. Proc. 92-89,(4) the IRS unveiled its Voluntary Compliance Resolution (VCR) program. Originally scheduled to expire on Dec. 31, 1993, the program has been modified and extended through Dec. 31, 1994 by Rev. Proc. 93-36.(5) In addition, this announcement expanded the types of defects that can be corrected under VCR; provided additional guidance on plans that should use the remedial amendment period rather than the VCR program; outlined general principles that should be followed in suggesting acceptable corrections; and established a new "Standardized VCR Procedure" (SVP) applicable for certain limited defects.

The program is administered by the IRS National Office, and is available only for plans with determination letters under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the Deficit Reduction Act of 1984 (DRA) and the Retirement Equity Act of 1984 (REA). Plans under examination or plans that have received written or oral notice of examination are not eligible for the VCR program; however, if a plan sponsor has some plans under examination, other plans of that sponsor may be eligible. Under the VCR program as originally announced, a plan that is aggregated for nondiscrimination purposes with a plan under examination was not eligible for the VCR program. Rev. Proc. 93-36 modified that standard to permit a plan that is aggregated with a plan under examination to use the VCR program for defects not related to provisions for which the plans are aggregated.

To qualify for the VCR program, plan sponsors have to identify qualified plan defects, propose to the IRS a plan for full correction of the defects and pay a fixed compliance fee. The IRS will rely on the plan sponsor's statements in identifying, the plan's operational defects and will not conduct a plan examination to find other defects. The plan sponsor receives a compliance statement describing the terms of full correction. After the sponsor implements the corrections and procedures set out by the IRS, the IRS reserves the right to require verification that the corrections have been made and the procedures implemented. However, information given by the plan sponsor under the program will not be used as the basis of an IRS employee plans examination. The compliance fees range from $500 for plans with less than $500,000 in assets and no more than 1,000 participants to $10,000 for plans with more than 10,000 participants.

Only operational defects are eligible for the VCR program. Exclusive benefit violations relating to the misuse or diversion of plan assets, egregious violations or operational defects creating income or excise tax issues, such as funding deficiencies or prohibited transactions, are not eligible for resolution under the program.

Rev. Proc. 93-36 provides examples of egregious violations, such as those involving consistent and improper coverage of only HCEs or self-employed plan contributions several times greater than the Sec. 415 dollar limit. If a plan requesting a VCR compliance statement is found to have egregious violations, the request will be sent to the appropriate Key District Office for processing under the Closing Agreement Program (CAP).

Rev. Proc. 93-36 outlines general principles for plan sponsors suggesting correction methods. The correction should restore active and former employees to the benefit levels they would have had if the defect had not occurred. Former employees should be sought out, including through the use of the IRS forwarding service. The correction should restore the plan to the position it would have been in had the defect not occurred. The correction should not violate another Sec. 401(a) requirement. The correction method should, if possible, resemble one already provided in the Code, regulations or other publications. The correction should keep the assets in the plan, except to the extent the Code, regulations or other publications already provide for distribution. Corrective allocations to a defined contribution plan must be adjusted for earnings and forfeitures that would have been allocated during the applicable period. Corrective contributions should come only from employer contributions, including forfeitures, if the plan permits. A corrective contribution to a participant's account because of failure to allocate the contribution in a proper limitation year will be considered an annual addition for the limitation year to which it relates, not the limitation year in which it is actually made.

The SVP program is available for a limited class of defects using the specified correction methods. The fee for the SVP is $350, regardless of the number of participants involved. The types of defects eligible to use the SVP program are failures to provide the minimum top-heavy benefit under Sec. 416, failures to satisfy the ADP tests for Sec. 401(k), ACP tests for Sec. 401(m) or the multiple use test under Sec. 401(m)(9), failures to distribute deferrals exceeding the Sec. 402(g) limit, or the exclusion of an eligible employee from plan participation.

Rev. Proc. 93-36 outlines the procedure for submitting an SVP notification letter and general principles for using the SVP approach. Excise taxes due, if any, must be paid. Contributions must include any earnings that would have been applicable. The plan may have to be amended to permit the correction method. Even though the defect may be eligible for the SVP, the ordinary VCR program process may be used as well.

* Failure to amend

The Tax Court issued decisions in Hamlin Development Co.(6) and Mills, Mitchell & Turner(7) upholding plan disqualifications and determination letter revocations for failure to timely amend qualified plans that had previously received determination letters.

The Hamlin Development Co. established a defined benefit plan in 1980, and the plan received a favorable determination letter in 1983. Hamlin was owned by Charles Faulkender, the sole shareholder and the plan's trustee. In October 1988, the IRS informed the plan of the examination of the plan's Form 5500-R, Registration Statement of Employee Benefit Plans, and asked for evidence showing plan amendments under the TEFRA, DRA and REA. Hamlin did not...