Pension reform proposals that have been languishing in Congress every year for the last several years finally became law when they were wrapped into the Small Business Job Protection Act passed by Congress on August 2, 1996 and signed by President Clinton on August 20. This is the largest package of pension reform rules to be enacted for 10 years.
For reasons that are almost entirely revenue driven, many of these provisions will not be effective until 1998, 1999 or, in some cases, 2000. Plan amendments are generally not required to be made before the 1998 plan year, though plans must be operated in accordance with new requirements as they become effective.
This is a brief summary, organized by effective date, of those provisions in the Act that affect qualified retirement plans. Provisions affecting tax-exempt, government and small employers, and other benefits-related provisions are summarized in separate articles.
Effective Beginning in 1996
Rehired Veterans' Benefit Accrual Rights Clarified. The Uniformed Services Employment and Reemployment Rights Act of 1994 ("USERRA") requires certain veterans rehired after December 12, 1994 to receive retroactive vesting and benefit-accrual credits. What USERRA failed to make clear was how a defined contribution plan could give retroactive accruals, when the plan requires participant contributions and is subject to certain legal limitations that play off of a participant's compensation received in the accrual year. The new act clarifies how a defined contribution plan is to comply with the retroactive-accrual rules. The plan is required to be in compliance with USERRA by October 13, 1996, but plan amendments are not required until 1998. The IRS has announced informally that it intends to issue a model plan amendment in late 1996.
Simplified Rules for Figuring the Nontaxable Portion of Plan Payments. Code section 72 imposes fairly complex rules for determining how much of an annuity or installment payment is treated as nontaxable in the case of an employee who has contributed after-tax contributions to a benefit plan. The Act introduced some simplifications to the section 72 rules for annuity and installment distributions that begin as of a date after November 18, 1996 (90 days after enactment).
Elimination of the 50% Exclusion for ESOP Loan Interest. Internal Revenue Code section 133 permits qualifying lenders to exclude from income 50% of the interest they received on qualifying ESOP loans. When section 133 was available, it would result in a reduction of the ESOP loan rate, because the lender would split the benefit of the exclusion with the plan. The Act repeals section 133 immediately upon enactment, except for loans made pursuant to a binding written contract in effect before June 10, 1996 and certain refinancings.
Effective Beginning in 1997
Some Simplification in Contributions Testing. Most employee and employer contributions to 401(k) plans are subject to so-called ADP and ACP testing. This testing requires that plan-year contributions by and for highly compensated employees, measured as a percentage of compensation, not exceed those by and for other employees by more than a certain corridor amount. Projected tests can be run during a plan year, and contribution ceilings lowered for the rest of the plan year if the projections look bad, but test results are not definitive until the year had ended. So employers sometimes flunk the tests and have to make refunds to the highly compensated employees who have the highest contribution percentages. Beginning with the 1997 plan year, companies may opt to ADP/ACP test by using nonhighly compensated employees' prior-year percentages as the benchmark against which the highly compensated employees' current-year contributions are tested. Because this election, once made, can only be changed in accordance with yet-to-be-issued IRS regulations, we recommend that employers study the issue carefully before deciding whether to adopt this testing method. We would be happy to assist in this study.
Beginning with the 1997 plan year, if a plan flunks ADP or ACP testing, refunds will no longer be made to those highly compensated employees with the highest contribution percentages--which tends to mean the lowest-paid among the highly compensated group. Instead, refunds will be made to the highly compensated employees with the largest contribution dollar amounts. This new methodology will be mandatory, not elective.
Highly Compensated Employee Definition Improved and Simplified. Nearly all of the nondiscrimination compliance rules that apply to qualified retirement plans compare the coverage and benefits provided to "highly compensated employees" to those provided to other employees. Yet the critical highly compensated employee definition has always been an excruciatingly complicated one. Whether an employee was considered highly compensated depends not only upon his or her compensation, but also officer status and whether a family member worked for the employer. In addition, for many employers' demographics, the compensation cutoff is very low---just $66,000 for 1996. Beginning in 1997, the "family aggregation" rules are eliminated and a highly compensated employee is simply an employee who was last year or is this year a five-percent owner of the enterprise or who received more than $80,000 of compensation last year. If the employer wishes, it can elect to count only employees who both made $80,000 last year and were also among the top-paid 20% of all employees. The $80,000 threshold will be adjust to reflect annual changes in the cost of living.
Age 70= Minimum Required Distributions. Beginning in calendar-year 1997, employers will no longer have to make minimum required distributions to employees who continue in employment after age 70=, unless they are five-percent owners of the enterprise. If an employer has employees who have already begun getting annual minimum required distributions, further guidance is expected that will allow the employer to let these employees opt out of minimum required distributions during employment. But if those employees don't opt out, the plan will have to continue with the complex minimum required distributions for that group of employees. Of course, the plan will have to continue with minimum required distributions to terminated employees over 70= who still have Plan accounts.
Three-Year Holiday from the 15% Excess Distribution Tax. Today, employees generally incur a 15% "excess distribution" excise tax if their payments from employer-sponsored retirement plans and IRAs exceed $155,000 in a year. There is a complete holiday from the 15% excise tax for payments made in 1997, 1998 and 1999. The holiday was enacted as a revenue raiser: Congress hopes the holiday will encourage taxpayers to withdraw funds from retirement vehicles and pay income taxes on the withdrawals sooner than they otherwise would.
Penalties for Failure to Give Rollover Notices. When an employer is paying a distribution that is eligible for rollover to an IRA, the employer is required to give the employee a written notice explaining the rollover right. Effective in 1997, the penalty for each failure to provide a rollover notice is raised from $10 to $100. The aggregate annual maximum amount of these penalties is also raised from $5,000 to $50,000.
Leased Employee Rules Rationalized. Someone who performs services for an employer but is not treated as an employee may be considered a "leased employee" as to the company for employee benefits purposes. A leased employee need not be given employee benefits, but the company must count leased employees as non-benefiting employees when it applies its nondiscrimination testing. A compliance problem could result if a high proportion of service-providers are leased employees.
As part of the definition of the term "leased employee," the Internal Revenue Code currently takes into account employees performing services "of a type historically performed, in the business field of the recipient, by employees." The "historically performed" test was the subject of overreaching IRS proposed regulations and was generally agreed to be an unworkable and overexpansive standard.
Finally, Congress has replaced the test with one that will focus on whether the individual performs the services under the "primary direction or control" of the recipient company. Although this standard sounds similar to the standard for determining whether an individual is an employee or independent contractor for employment tax purposes, the legislative history cautions that the two standards are not the same and that an individual may very well be an independent contractor for employment tax purposes and still be a leased employee for employee benefits compliance purposes. It is expected that the IRS will issue regulations providing guidance on how the new standard is to be applied.
Minimum Participation Rule Eliminated for Defined Contribution Plans. Code section 401(a)(26) requires that a plan cover the lesser of 50 employers or 40% of the total workforce. Beginning with the 1997 plan year, the rule has been eliminated for all qualified retirement plans except for defined benefit pension plans.
Effective Beginning in 1998
An Effective Increase in the 25%-of-Compensation Limit on Contributions. Today, for any plan year, total employer and employee contributions and forfeitures allocated to a plan participant (called "annual additions") in a defined contribution plan cannot exceed 25% of the W-2 compensation of an employee whose W-2 compensation is less than $120,000. (For higher earners, annual additions are capped at a flat $30,000.) Since W-2 compensation does not include before-tax employee contributions to a retirement plan or flexible benefits plan, an employee who would like to make substantial before-tax contributions to those plans might be prevented by the 25%-of-W2 rule and/or might suffer a cutback in company contributions. Starting with the 1998 plan year, the 25% limitation can be applied to W-2 compensation plus an add-back of those before-tax contributions, which will eliminate this problem.
Effective Beginning in 1999
Safe Harbors Can Eliminate the Need for ADP/ACP Testing. Starting with plan years that begin in 1999, employers may avoid ADP and/or ACP testing entirely--except as to employee after-tax contributions--if their employer contribution designs meet one of two safe harbors:
Matching Contribution Safe Harbor. ADP testing can be avoided if the plan provides a matching contribution for all nonhighly compensated employees eligible to make contributions equal to 100% of their contributions through three percent of compensation and 50% of their contributions equal to four and five percent of compensation. Different formulas that produce at least the same amounts can also qualify for the safe harbor, but a matching contribution formula does not qualify as a safe harbor if the match rate of any highly compensated employee is greater than that of a nonhighly compensated employee. ACP testing can also be avoided by using this matching contribution safe harbor if no employee contributions over six percent of compensation are matched.
QNEC Safe Harbor. ADP and ACP testing can be avoided if the employer provides a contribution for all nonhighly employees eligible to make contributions equal to three percent of their compensation, regardless of whether the employees make contributions to the plan. This contribution is called a qualified nonelective contribution, or "QNEC."
Safe-harbor contributions must be fully and immediately vested and cannot be withdrawn while an employee is in service except on account of financial hardship, disability or attainment of age 59=.
Employers with plans that permit employee after-tax contributions should not use the safe-harbor rules for ACP testing before they have carefully analyzed the effect on after-tax contributions. As a general rule, employee after-tax contributions tend to be made mainly by highly compensated employees. If the ACP safe harbor is used, after-tax contributions will be the only amounts being ACP tested and, without the company match as a buffer in testing, the ACP test would likely be failed. If so, all or a portion of after-tax employee contributions would have to be refunded to highly compensated employees.
"Early Participation" Plans Get a Break on ADP/ACP Testing. Rather than imposing the age-21 and one-year waiting periods permitted under the Internal Revenue Code, some plans allow earlier entry. Today, a plan may apply the ADP and ACP tests separately to those employees who are in the otherwise-excludable group, so long as that group is not disproportionately highly compensated. That separate testing rule can be beneficial to those highly compensated employees who are not in the otherwise-excludable category, because new employees tend to be nonhighly compensated employees who contribute at a low rate, which would otherwise drag down the ADP and ACP percentages of the whole nonhighly compensated group and, in turn, reduce the contribution percentages permitted for highly compensated employees. The tradeoff for this separate testing benefit is that newly hired highly compensated employees are likely to be fairly severely restricted in the amount they can contribute. Beginning with the 1999 plan year, instead of the separate testing rule, a plan can completely eliminate from ADP testing those nonhighly compensated employees who are less than 21 and/or who have less than one year of service. This could likely permit any newly hired highly compensated employees to make higher contributions for their first year of employment.
Effective Beginning in 2000
Repeal of Section 415 combined-plan limits. Defined contribution plans must limit total annual contributions of all kinds to a participant's account to the lesser of $30,000 or 25% of compensation. A defined benefit plan participant is subject to a separate limit on his or her annual pension payable at age 65 (the limit was generally $120,000 for 1996). By establishing a defined benefit and defined contribution plan, an employer can increase the amount of tax-deferred retirement benefits employees can accrue each year. But Internal Revenue Code section 415(e) includes extremely complex limitations that generally limit total benefits to about 125%, not 200%, of what a single plan would allow.
In light of the various other types of limitations rules enacted since 1986, such as the $150,000 limit on pensionable compensation, employers have lobbied for the repeal of Code section 415(e). Finally, Congress has responded, though the repeal is not effective for another four years.
The repeal of section 415(e) is likely to cause renewed interest in defined benefit plans among those companies that previously terminated their plans or avoided ever adopting them. In particular, we anticipate that traditional pension plans may enjoy a renaissance among smaller, professional service companies, while cash-balance plans may experience much-expanded popularity among companies with larger employee populations. Employers without defined benefit plans may want to study the feasibility of adding a defined benefit retirement plan to their benefits packages after the repeal of section 415(e) takes effect. Defined benefit plans have several drawbacks, such as required employer payment of PBGC insurance premiums and complex, and often expensive, nondiscrimination testing requirements, but those drawbacks can be taken into account in a feasibility study.
Repeal of 5-year averaging. Beginning in 2000, the ability to use five-year averaging to reduce income taxes on lump-sum distributions that are not rolled over will be eliminated. However, individuals who reached age 50 before 1986 will still be able to use the old grandfathered 10-year averaging rules. Because 10-year averaging will still be available, employers will have to continue describing the complexities of income tax averaging in its employee communications on the taxation of distributions for many years to come.