Employee Benefits Highlights of Taxpayer Relief Act of 1997

The major 1997 Tax Act changes are as follows:

Capital Gains

Most people already know that the 1997 Tax Act introduced lower capital gains tax rates. The new rates are as follows:

• A maximum tax rate of 20% for sales of property held for more than 18 months at the time of sale and sold on or after July 29, 1997. This 20% rate is also available for property sold after May 6, 1997 and before July 29, 1997, if the property had been held for more than 12 months (even if it had not been held for 18 months).
• A maximum rate of 10% for taxpayers in the 15% bracket, subject to the limitations set forth above.
• A maximum tax rate of 18% for sales of property acquired after December 31, 2000, that are held for more than 5 years at the time of sale.
• A maximum rate of 25% for real estate depreciation recapture treated as capital gain, but only for gain after May 7, 1997.
• The current 28% maximum capital gain rate will continue to apply to sales of collectibles (art work, coins, etc).

Note that a taxpayer may now elect to roll over gain from the sale of "qualified small business stock" held for more than six months so that the gain is recognized only to the extent that the amount realized exceeds (a) the cost of qualified small business stock bought by the taxpayer during the 60-day period beginning on the sale date, reduced by (b) the portion of such cost previously taken into account under such rule. This became effective August 5, 1997.

The new rates mean that employers should update their prospectuses and equity compensation summaries and pay special attention to tax descriptions in upcoming proxy statements.

In addition to changing capital gains rates, the 1997 Tax Act made a number of changes affecting qualified plans, IRAs and ERISA welfare plans:

401(k) Plans

• Limit on ability of plan to require (or on person, other than participant, to direct) investment of more than 10% of plan assets attributable to employee salary deferrals in employer stock and employer property. Not applicable to employer matching contributions. Exceptions for ESOPs, situations where value of individual account plans is 10% or less of value of all employer pension plans, and individual account plans that do not require investment in employer stock/property of more than 1% of an employee.s deferrable compensation. A compromise solution to problems perceived by some in Congress of pension risk adding to job risk. Effective for plan years beginning after 1998.
• Matching contributions of self-employed persons not treated as elective deferrals and thus neither counted toward $9,500 annual limit nor included in actual deferral percentage (ADP) test. May encourage some partnerships to adopt 401(k) plans with matching contributions because such contributions will not count against partners. deferral limits. Effective for plan years beginning after 1997.

Retirement Plan/IRA Distributions

• Involuntary cashouts of up to $5,000 permitted without consent of either participant or spouse. Should ease administrative burden and reduce costs of maintaining plan accounts and benefits for terminated employees. Effective for plan years beginning after August 5, 1997.
• With respect to rollovers, disqualification of transferor plan will not disqualify transferee plan where administrator of transferee plan "reasonably concludes" that transferor plan was qualified even in the absence of a transferor plan determination letter. Effective for rollovers made after 1997 (although it may be effective earlier since mandated regulations are to "clarify").
• Repeal of 15% excise tax on excess distributions from qualified plans, IRAs and TSAs and excess retirement accumulations in such arrangements. Congress agreed (finally) that such taxes are unnecessary in light of other limits on tax-advantaged savings, penalize good investment performance and deter savings. Effective for distributions received and decedents dying after December 31, 1996.
• Expansion of penalty-free with-drawals from IRAs to include purchases by first-time home buyers ($10,000 lifetime maximum) and payments of qualified higher education expenses. Effective for distributions after 1997.

Reporting and Disclosure

• Summary plan descriptions and summaries of material modifications need to be filed with U.S. Department of Labor (DOL) only on request. Effective August 5, 1997.
• Secretaries of Treasury and Labor are required to issue guidance regarding use of "new technologies" in connection with notice, election, consent, disclosure and time requirements applicable to retirement plans under the Internal Rev-e--nue Code and ERISA. They are also required to clarify the extent to which the Code.s "writing requirements" will permit "paperless transactions" involving retirement plans. Guidance required no later than December 31, 1998. Given the fact that plan sponsors, particularly technology companies, are already relying on the "new technologies" for plan administration, guidance is overdue but will be helpful. Interim regulations under HIPAA (Health Insurance Portability and Accountability Act) already permit electronic summary plan descriptions for group health plans.

Prohibited Transactions

• First tier tax on prohibited transaction (e.g., loan of plan assets to employer) increased from 10% to 15% of amount involved in transaction. Effective for transactions occurring after August 5, 1997.

Anti-Assignment Exception

• Rule prohibiting assignment or alienation of benefits now subject to exception for amounts a participant is ordered to pay upon conviction of a crime against the plan or breach of fiduciary duty. Money owed may be paid from plan benefits, subject to spousal benefit rights absent spousal consent. Effective for judgments, orders, decrees and settlement agreements entered into, on or after August 5, 1997.

S Corporation ESOPs

• S corporation ESOPs need not give participants right to demand employer securities upon distributions as long as equivalent value distributed in cash. Will permit S corporation to continue to satisfy 75 shareholder limit. Effective for taxable years beginning after 1997.
• Shareholder-employees of S corporations exempted from prohibited transactions involved in sale of stock to ESOP. Effective for taxable years beginning after 1997.
• ESOP of S corporation may obtain a loan or S corporation may guarantee a loan to the ESOP in connection with the sale of stock by a shareholder-employee to the ESOP. Effective for taxable years beginning after 1997.
• Unrelated business taxable income (UBTI) no longer generated by stock held by ESOP of S corporation. Effective for taxable years beginning after 1997.

IRAs

• Phase-out ranges for deductible IRAs of active participants in employer-sponsored retirement plans will increase annually beginning in 1998 until they reach double the current phase-out ranges in 2007.
• New Roth IRAs permit annual, nondeductible contributions, limited to $2,000 less the taxpayer.s deductible IRA contributions (subject to a phase-out for taxpayers above certain income levels). Qualified distributions from a Roth IRA are not taxable, and transfers from deductible IRAs are permissible provided the taxpayer.s adjusted gross income (AGI) for the transfer year is $100,000 or less. (Transferred amounts are includible in income, but exempt from the early withdrawal tax.)
• New education IRAs permit annual nondeductible contributions of up to $500 per beneficiary under the age of 18 (subject to phase-out for taxpayers above certain income levels). Distributions are excludable from income to the extent of qualified higher education expenses. Any balance remaining in the account when beneficiary reaches age 30 will be distributed and taxed to the beneficiary (and subject to 10 percent excise tax). However, the balance may be rolled over tax free to another education IRA benefiting another family member.
• The 10% early withdrawal penalty will not apply to distributions used to pay qualified higher education expenses.
• The 10% early withdrawal penalty does not apply to "qualified first-time homebuyer distributions." A "first-time homebuyer" includes any individual (and spouse, if any) who had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition and can be the individual, spouse, or any child, grandchild, or ancestor of the individual or spouse. Withdrawals eligible for this exception cannot exceed $10,000 during the individual.s lifetime. The distribution must be used within 120-days. If the 120-day rule cannot be met, all or part of the distribution may be recontributed to the same or another IRA.

Employee Fringe Benefits

• Employees permitted to exclude from gross income up to $170 per month of employer-provided parking even if offered equivalent amount of cash. Cash included in gross income only if elected. Effective for taxable years beginning after 1997.
• Exclusion for employer-paid educational assistance (up to $5,250) extended to courses beginning before June 1, 2000. As before, exclusion applies only to undergraduate courses.

Worker Classification

• New Code Section 7436 permits taxpayer, in connection with an audit where there is an actual controversy over the employment status of a person performing services, to file pleading with Tax Court to determine if IRS determination is correct. Assessment and collection are suspended during Tax Court proceedings. Tax Court review is de novo, without consideration of IRS.s findings in the administrative record. During the Tax Court proceeding, taxpayer changing the employment tax status of individual whose employment tax status is at issue (or of individual holding substantially similar position) will not be taken into account by Tax Court. Effective August 5, 1997. Tax Court on September 16, 1997 announced adoption of interim rules setting forth procedures for actions filed under Code Section 7436.

Microsoft Decision

The Microsoft decision has made proper worker classification more important than ever. In Microsoft, the Ninth Circuit Court of Appeals concluded that as common law employees of Microsoft, so-called "independent contractors" and "freelancers," were entitled to coverage under Microsoft.s employee stock purchase plan and were entitled to pursue a claim for benefits under Microsoft.s 401(k) plan. The 401(k) plan defined "employee" to mean "any common law employee who receives remuneration for personal services rendered to the employer and who is on the United States payroll of the employer." The court stated that the 401(k) plan administrator must now decide whether these common law employees are "on the United States payroll." The court expressed doubt whether Microsoft could properly manipulate 401(k) plan coverage by assigning, or not assigning, common law employees to the United States payroll as it saw fit. Nevertheless, the issue is now back with the 401(k) plan administrator, but presumably a decision of the administrator to exclude these common law employees from coverage will result in further litigation over this issue.

The lesson of Microsoft is that precise drafting of a 401(k) plan.s definition of "employee" can avoid the consequences of an IRS reclassification of an independent contractor as an employee. In some cases, the existing definition in an employer.s 401(k) plan will be sufficient to prevent such a problem. In other cases, a minor plan amendment may be necessary. There is, however, no simple solution for employee stock purchase plans. Under these plans, employers must cover all eligible common law employees.