Employee Benefit Provisions of the Taxpayer Relief Act of 1997 and Implementation Guidance on Prior Legislation

On August 5, 1997, the President signed into law the Taxpayer Relief Act of 1997 ("TRA '97") which contains a wide variety of provisions affecting employee benefit plans. In addition, in the weeks following, the Internal Revenue Service released important guidance with respect to implementing employee benefit provisions modified by prior legislation, including modifications made by the Small Business Job Protection Act of 1996 ("SBJPA"), the Retirement Protection Act of 1994, enacted under the General Agreement on Tariffs and Trade ("GATT"), and the Uniformed Services Employment and Reemployment Rights Act of 1994 ("USERRA"). This guidance extends the deadlines for amending employee benefit plans to reflect the legislative modifications. The employee benefit provisions of TRA '97 and the subsequently released guidance from the Internal Revenue Service are summarized below.

A. EMPLOYEE BENEFIT PROVISIONS OF THE TAXPAYER RELIEF ACT OF 1997

1. Increase in Dollar Limitation for Cashouts of Accrued Benefits -$5,000 Cashouts

The dollar limit up to which qualified plans may involuntarily "cash out" the benefit of a terminated participant without the consent of the participant or, if applicable, the participant's spouse, is increased from $3,500 to $5,000. This provision applies to plan years beginning after August 5, 1997.

2. Diversification of 401(k) Plan Investments - Limit on Investments in Employer Stock under 401(k) Plans

TRA '97 provides that, if elective deferrals under a 401(k) plan equal to more than 1% of an employee's eligible compensation are required to be invested in employer securities and employer real property, no more than 10% of the plan's aggregate elective deferrals (and earnings thereon) may be invested in employer securities or real property.

* This provision does not apply to a plan for a plan year if, on the last day of the preceding plan year, the fair market value of the assets of all individual account plans maintained by the employer equals not more than 10% of the fair market value of the assets of all pension plans (other than multiemployer plans) maintained by the employer. In addition, this provision does not apply to ESOPs.

* So long as the 1% threshold described above is not exceeded, the amount of elective deferrals that may be voluntarily invested by employees in employer securities or real property is not limited to 10%.

* This provision is effective with respect to elective deferrals for plan years beginning after December 31, 1998.

3. Increase in Current Liability Funding Limit: Pension Plan Full Funding Limit Increases

* Under present law, defined benefit pension plans are subject to a maximum limit on contributions that can be made to a plan, called the "full funding limit." The full funding limit is the lesser of the plan's accrued liability and 150% of the plan's current liability. TRA '97 increases the 150%-of-current-liability limit on a graduated basis such that the limit is 170% of current liability for plan years beginning in 2005 and thereafter.

* In addition, TRA '97 lengthens to 20 years the period over which amounts that cannot be contributed because of the current liability full funding limit must be amortized.

* These provisions are effective with respect to plan years beginning after December 31, 1998, with transition relief for unamortized balances under existing law.

4. Modification of 10% Tax on Non-Deductible Contributions - Rules on Non-Deductible Contributions Relaxed

* Under present law, a 10% non-deductible excise tax is imposed on contributions by employers to qualified plans that are not deductible. TRA '97 modifies this provision for taxable years beginning after December 31, 1997, so that the excise tax does not apply to contributions to one or more defined contribution plans that are not deductible because they exceed the combined plan deduction limit, but only to the extent such contributions do not exceed the amount of the employer's matching contributions plus the elective deferral contributions to a 401(k) plan.

5. Revised Treatment of Matching Contributions of Self Employed Individuals - Parity for Self-Employed Individuals

* Under present law, matching contributions made for a self employed individual to a 401(k) plan generally are treated as additional elective contributions of the self-employed individual that are subject to the actual deferral percentage ("ADP") nondiscrimination test and the annual elective contributions dollar limit ($9,500 for 1997). TRA '97 repeals this treatment so that matching contributions for self-employed individuals will be treated the same as matching contributions for other employees. That is, they will be subject to the actual contribution percentage ("ACP") nondiscrimination test (except to the extent that the employer elects to treat them as "qualified matching contributions" subject to the ADP test) and will not be subject to the annual elective contributions dollar limit.

* This provision is effective for years beginning after December 31, 1997 (or, with respect to SIMPLE retirement accounts, years beginning after December 31, 1996).

6. Elimination of Excess Distribution and Excess Retirement Accumulation Taxes - Success Taxes Eliminated

* Under present law, Code section 4980A imposes a 15% excise tax on excess distributions from qualified plans, tax sheltered annuities, and IRAs. In addition, a 15% estate tax is imposed on a decedent's excess retirement accumulations. These taxes are sometimes referred to as "success taxes" that penalize an individual for having saved successfully for retirement. The SBJPA temporarily suspended the imposition of the 15% excise tax on excess distributions made in 1997, 1998 and 1999. TRA '97 repeals the "success taxes" under Code section 4980A in their entirety.

* The repeal is effective with respect to excess distributions received by individuals after December 31, 1996, and with respect to excess accumulations of decedents dying after December 31, 1996.

7. Increase in Prohibited Transactions Excise Tax - Excise Tax Increased Again

* The rate of the initial excise tax on prohibited transactions is increased from 10% to 15%, effective with respect to prohibited transactions occurring after August 5, 1997.

8. Modification of Prohibition on Assignment or Alienation of Plan Benefits - Benefit Offsets Permitted for Fiduciary Breach

* Effective immediately, the provisions of the Code and ERISA regarding the prohibition on assignment or alienation of qualified plan benefits are amended to permit a participant's benefit in a qualified plan to be reduced to satisfy liabilities of the participant to the plan due to: (i) the participant being convicted of committing a crime involving the plan, (ii) a civil judgment, consent order or decree entered by a court in an action brought in connection with a violation of the fiduciary provisions of ERISA, or (iii) a settlement agreement between the Secretary of Labor or the Pension Benefit Guaranty Corporation and the participant in connection with a violation of the fiduciary provisions of ERISA. Special rules apply in the case of plans to which the survivor annuity requirements apply.

9. Acceptance of Rollover Contributions - Employer Relief for Rollover Contributions

* The Secretary of the Treasury is required to clarify that, in order for an administrator of a qualified plan receiving a rollover contribution to reasonably conclude that the contribution is a valid rollover contribution, it is not necessary for the distributing plan to have a determination letter with respect to its status as a qualified plan under Code section 401.

10. Elimination of Paperwork Burdens on Plans - Filing of SPDs and SMMs Eliminated

* Effective immediately, plan administrators are no longer required to file with the Department of Labor summary plan descriptions and summaries of material modifications for qualified plans. However, plan administrators will be required to furnish these documents upon request of the Secretary of Labor.

* A civil penalty of up to $100 per day (maximum $1,000) could be imposed by the Secretary of Labor on the plan administrator for a failure to comply with any such request.

11. New Technologies in Retirement Plans - IRS and DOL to Update Rules for New Technology

* The Secretaries of the Treasury and Labor are required to issue guidance clarifying the extent to which writing requirements under the Code and ERISA will be interpreted to permit paperless transactions and to interpret the notice, election, consent, disclosure, and time requirements (and related recordkeeping requirements) relating to qualified plans as applied to the use of new technologies.

12. Clarification of Rules Relating to ESOPs for S Corporations:

* For taxable years beginning after December 31, 1997, TRA '97 provides that ESOPs established or maintained by S corporations need not give participants the right to demand their distributions in the form of employer securities, if the participants have the right to receive their distributions in cash. This provision operates as an exception to the general requirement that ESOP participants must be given the right to demand stock distributions. S Corporation ESOPs

* TRA '97 also creates a statutory exemption from the prohibited transaction rules as applicable to ESOPs established or maintained by S corporations. Specifically, TRA '97 exempts the sale of employer securities to the ESOP by a shareholder-employee, family member of the shareholder-employee, or corporation in which the shareholder-employee owns at least 50% of the stock. Thus, the statutory exemptions for such a transaction (including the exemption for a loan to the ESOP to acquire employer securities in connection with such a sale or a guarantee of such a loan) apply.

* For taxable years beginning after December 31, 1997, certain tax-exempt organizations, including ESOPs, can be shareholders of an S corporation. Items of income or loss of the S corporation will flow through to qualified tax-exempt shareholders as unrelated business taxable income ("UBTI"), regardless of the source of the income. TRA '97 repeals the provision treating items of income or loss of an S corporation as UBTI with respect to employer securities held by an ESOP maintained by an S corporation. 13. Modification of Section 403(b) Exclusion Allowance to Conform to Code Section 415 Modifications:

§403(b) Exclusion Allowance Reformed

* TRA '97 conforms the Code section 403(b) exclusion allowance to the Code section 415 limits by providing that includible compensation includes elective deferrals (and similar pre-tax contributions or deferrals under Code sections 125 or 457) of the employee effective for years beginning after December 31, 1997.

* In addition, the Secretary of the Treasury is directed to revise the regulations regarding the Code section 403(b) exclusion allowance to reflect the fact that the overall limit on benefits and contributions under Code section 415(e) is repealed for years beginning after December 31, 1999.

No Non- Discrimination Rules for State and Local Governmental Plans 14. Moratorium on Application of Nondiscrimination Rules to State and Local Governmental Plans

* The nondiscrimination and minimum participation rules generally applicable to qualified plans will not apply to governmental plans maintained by a State or local government or political subdivision thereof (or instrumentality thereof). The IRS had repeatedly extended the time within which governmental plans must come into compliance with the nondiscrimination and minimum participation rules. TRA '97 now places a permanent moratorium on the application of these rules to State and local governmental plans.

15. Permissive Service Credit Under Governmental Pension Plans - Broadening of Permissive Service Credit Rules Under Governmental Plans

* TRA '97 modifies the Code section 415 limits on contributions and benefits under qualified pension plans as applied to state and local governmental plans. Under present law, voluntary employee contributions made to purchase permissive service credit under a governmental plan are limited by the Code section 415 defined contribution limit (as though the contributions were made to a separate plan). TRA '97 permits such voluntary employee contributions made to a state or local governmental plan for the purchase of permissive service credit to be subject, on a participant-by-participant basis, to either the defined contribution limit or the defined benefit limit of Code section 415, whichever is more favorable to the participant.

* Code section 415 is violated if more than 5 years of permissive service credit is purchased for certain "non-qualified service" or if "non-qualified service" is taken into account for an employee who has less than 5 years of participation under the plan.

* This provision does not affect the application of "pick-up" contributions to purchase permissive service credit or the treatment of pick-up contributions under Code section 415. In addition, this provision does not apply to purchases of service credit for qualified military service under the rules relating to veterans' reemployment rights.

* This provision is effective generally with respect to contributions to purchase permissive service credits made in years beginning after December 31, 1997, with a transition rule applying to plans that provided for the purchase of permissive service credit prior to August 5, 1997.

16. Enhancements to Individual Retirement Arrangements - New IRA Rules

* The income ranges over which the $2,000 IRA deduction limit is phased out for individuals who are active participants in an employer-sponsored retirement plan are increased.

* Deductible contributions for spouses of individuals who participate in an employer-sponsored retirement plan are permitted, subject to a phase-out for taxpayers with adjusted gross income between $150,000 and $160,000.

* Penalty-free withdrawals from IRAs for first-time homebuyer expenses (up to $10,000) and higher education expenses are permitted.

* A new, tax-free non-deductible IRA, called the "Roth" IRA, has been created effective for taxable years beginning after December 31, 1997. Distributions from a Roth IRA are tax-free (and are not subject to the 10% early distribution excise tax) if made more than five years after the Roth IRA is established and if the distribution is (1) made after age 59½, death, or disability, or (2) for first- time homebuyer expenses (up to $10,000).

* TRA '97 includes provisions for converting existing IRAs to Roth IRAs provided that the taxpayer's adjusted gross income does not exceed $100,000 and the taxpayer takes into income currently the amount converted (however, if the conversion occurs before January 1, 1999, the amount converted may be taken into income ratably over four years). Amounts taken into income in the conversion process are not subject to the 10% early distribution excise tax.

Excise Tax Loophole

* Eligible taxpayers may consider using this conversion right as a loophole to circumvent application of the 10% early distribution excise tax to amounts that they wish to withdraw from existing IRAs. This can be accomplished by converting an existing IRA to a Roth IRA and immediately withdrawing funds from the Roth IRA. The 10% early distribution excise tax does not apply to the conversion. In addition, to the extent that amounts withdrawn from the Roth IRA have already been taken into income, such amounts will not be subject to the 10% early distribution excise tax (which only applies to amounts that are includible in income when withdrawn from the IRA).

17. Acceleration of Health Insurance Deduction Allowed to Self Employed Individuals:

Bigger Health Insurance Deductions for Self-Employeds * Under present law, the amount that a self-employed individual is entitled to deduct for health insurance expenses is subject to a graduated phase-in schedule, starting at 40% of health insurance expenses for 1997 and increasing to 80% for 2006 and thereafter. TRA '97 accelerates the rate of the phase-in generally, increasing the deduction to 100% in 2007 and for years thereafter.

18. Extension of Exclusion for Employer-Provided Educational Assistance - Educational- Assistance Deduction Extended

* The $5,250 income exclusion for employer-provided educational assistance under Code section 127 is extended for three years (i.e., will apply to expenses paid with respect to courses beginning on or before May 31, 2000). The exclusion will apply to undergraduate education only.

19. Date for Adoption of Plan Amendments Required by TRA '97 - TRA '97 Amendment Dates

* Any amendments to a plan or annuity contract required to be made by TRA '97 are not required to be made before the first day of the first plan year beginning on or after January 1, 1999. In the case of a governmental plan, the date for amendments is extended to the first day of the first plan year beginning on or after January 1, 2001.

B. IRS GUIDANCE REGARDING IMPLEMENTATION OF PRIOR LEGISLATION

1. Remedial Amendment Period for SBJPA, GATT and USERRA:

* The SBJPA, GATT and USERRA enacted multiple provisions regarding qualified plans, with varying effective dates, for which qualified plans are required to be amended. Revenue Procedure 97 41 now sets a single deadline for qualified plans to adopt such required amendments.

Single Deadline Set for Plan Amendments for SBJPA, GATT & USERRA * For non-governmental qualified plans, the remedial amendment period for making all such amendments on a retroactive basis ends on the last day of the first plan year beginning on or after January 1, 1999. This provision includes amendments required to reflect certain limitations under Code section 415(b), as amended by GATT and SBJPA, on which the IRS promises to provide additional guidance in the near future.

* For governmental qualified plans, the remedial amendment period for making retroactive amendments is extended to the later of (i) the first day of the first plan year beginning on or after January 1, 2000, or (ii) the last day of the first plan year beginning on or after the 90th day after the opening of the first legislative session beginning on or after January 1, 1999, of the governing body with authority to amend the plan, if that body does not meet continuously.

* The time period for adopting the required amendments is further extended until the 91st day following receipt of a favorable determination letter on a proposed amendment provided that the determination letter application is timely filed within the applicable remedial amendment period stated above.

* Amendments for SBJPA to Code section 403(b) plans, or to annuity contracts purchased under Code section 403(b) plans, are not required to be adopted before the first day of the first plan year beginning on or after January 1, 1998. However, with respect to a Code section 403(b) plan that is a governmental plan, the remedial amendment period is extended to the date stated above for governmental qualified plans. Operational Compliance Required Before Plan Amendments

* Although plan and annuity contract amendments are not required to be made before the end of the remedial amendment period, plan sponsors must operate their plans in compliance with the provisions of the SBJPA, GATT and USERRA prior to the time plan amendments are required. Any retroactive amendments will have to reflect the choices the plan sponsor has already made in the operation of the plan.

2. Implementation of Simplified Definition of Highly Compensated Employees - Implementing the Simplified HCE Definition

* The SBJPA modified the definition of "highly compensated employee" ("HCE") for purposes of nondiscrimination requirements applicable to qualified plans. Under the modified definition, which applies generally to years beginning after December 31, 1996, an HCE means any employee who: (i) was a 5% owner at any time during the year or the preceding year, or (ii) for the preceding year had compensation from the employer in excess of $80,000 and, if the employer so elects (the "top-paid group election"), was in the top-paid group for the preceding year.

New "Calendar Year Data" Election Permitted

* IRS Notice 97-45 introduces a new "calendar year data election" that may be made for implementing this definition of HCE. The calendar year data election permits an employer that maintains one or more plans on a fiscal year basis to use calendar year data, rather than fiscal year data, for purposes of determining whether an employee is an HCE on account of the employee's compensation level.

No Filing Required

* Notice 97-45 also clarifies that employers need not make a formal filing with the IRS in order to make the top-paid group election or calendar year data election.

Consistency Rule

* To the extent an employer makes a top-paid group election and/or calendar year data election, such election must be applied consistently to all plans of the employer (without regard to any multiemployer plans in which the employer participates). Transition relief is provided from this consistency requirement for years prior to 2000.

* Plan amendments to reflect the modified definition of HCE must be made by the end of the remedial amendment period set forth in Revenue Procedure 97-41 (see above).