The IRS recently released Revenue Ruling 2011-7 (the “Ruling”) to clarify the requirements for employers terminating 403(b) plans. The Ruling also explains the tax consequences for participants receiving 403(b) plan termination distributions, such as annuity contracts or certificates.
Before the IRS issued regulations in 2007, plan termination, unlike severance from employment, disability, death or attainment of age 59½, was not a distributable event for 403(b) plans. As a result, most employers froze rather than terminated their 403(b) plans because the plans could not make plan termination distributions. Freezing a 403(b) plan meant simply stopping contributions to the plan. As long as the plan assets were not fully distributed, however, employers whose 403(b) plans were subject to the Employee Retirement Income Security Act of 1974 (“ERISA”) had an obligation to continue complying with ERISA’s reporting and disclosure rules (e.g., filing annual Forms 5500).
The 2007 regulations generally became effective January 1, 2009, and they permit 403(b) plans to have provisions that allow for plan terminations and distributions upon plan termination under certain conditions. It should be noted, however, that an employer generally cannot contribute to another 403(b) plan during the period beginning on the 403(b) plan termination date and ending 12 months after the date that all plan assets have been distributed. (An exception to this rule allows an employer to terminate a 403(b) plan while contributing to other 403(b) plans, but only if 2% or fewer of the participants eligible under the terminated plan are also eligible under the other 403(b) plans.) The 2007 regulations also require employers to distribute the 403(b) plan assets as soon as administratively feasible after plan termination.
Unfortunately, the 2007 regulations did not address key questions that employers and their advisors had about the plan termination process and the income tax consequences for plan participants. The Ruling now addresses those questions.
Revenue Ruling 2011-7
Employer Requirements for 403(b) Plan Termination
The Ruling clarifies that an employer can terminate its 403(b) plan by adopting a binding resolution to: (i) cease contributions, (ii) terminate the 403(b) plan as of a stated effective date, (iii) fully vest participants as of the termination effective date, and (iv) direct that all benefits be distributed as soon as practicable thereafter. Participants should also be notified of the plan termination. In addition, if the terminating 403(b) plan and the 403(b) contracts used to fund the plan permit cash distributions that may be rolled over to another tax-favored retirement savings arrangement, participants must be provided notice of their rollover rights and afforded the opportunity to exercise such rights.
Tax Impact on Participants Receiving 403(b) Plan Termination Distributions
The Ruling clarifies that, if the plan termination distributions are not in cash but in the form of fully paid individual annuity contracts (or certificates evidencing fully paid benefits under a group annuity contract), participants will not be taxed on their benefits until such amounts are actually paid to participants. However, those individual and group annuity contracts must continue to comply with the 403(b) requirements in effect when the contracts or certificates are delivered to the participants.
If the plan termination distributions are in cash, then participants will be subject to income taxation unless the cash is rolled over to another tax-favored retirement savings arrangement (i.e., a tax-qualified plan or an individual retirement account) within 60 days after distribution.
Action Steps for Plan Sponsors Considering Terminating 403(b) Plans
403(b) plan terminations require advanced planning and awareness of the legal requirements and tax consequences. Employers that are considering terminating their 403(b) plan should review the plan document to determine whether it needs to be amended to provide for plan termination distributions. Employers also need to determine whether cash distributions are allowed under any 403(b) contracts used to fund the plan, thereby permitting participants to roll over cash plan termination distributions into IRAs or another tax-qualified retirement plan. If cash is available, the employer must ensure the appropriate rollover notice is provided to plan participants and should assist plan participants in dealing with the 403(b) contract vendors. For participants receiving annuity contracts (or certificates under a group annuity contract) instead of cash, the employer should obtain confirmation from the 403(b) contract vendor that the contract complies with the 403(b) requirements in effect when the plan termination distributions occur so that participants are not taxed on the value of the contracts at the time of distribution.
In addition to the IRS-imposed requirements for 403(b) plan terminations, employers should also investigate whether their 403(b) contracts impose cash surrender charges against participants who elect to receive a cash distribution instead of an annuity contract (or certificate) distribution. Surrender charges are usually based on a percentage of the participant’s account and decrease based on the length of time the participant has had the account. If an employer cannot negotiate a waiver of any surrender charges, it should insist that the 403(b) contract vendors communicate and explain the surrender charge before participants make their plan termination distribution elections. Employers should also be cognizant of their fiduciary responsibilities concerning surrender charges, and behave and negotiate accordingly.
Common 409A Compliance Problems for Employers
While the IRS regularly provides formal and informal guidance to assist employers with understanding the application of Internal Revenue Code (the “Code”) Section 409A, some of the rules continue to create compliance and plan design challenges for employers. Given the serious nature of the penalties under Section 409A for compliance failures, employers should review their plans on an ongoing basis for operational and document-related compliance. Section 409A penalties, which are imposed directly on the employee who receives the deferred compensation, include the following:
- Immediate inclusion in taxable income of the amount of compensation deferred for the year in which the amount was deferred regardless of whether the compensation has been paid;
- An additional 20% income tax on the amount deferred; and
- Additional interest and penalties for failure to timely remit the income taxes.
Although employers are not directly exposed to Section 409A penalties, they may decide or have agreed to pay any such penalties incurred by employees. Moreover, employers may face tax reporting and withholding penalties attributable to the Section 409A violation.
Below is a list of 409A compliance issues that employers frequently encounter:
Deferral of Bonuses
Section 409A provides that an employee may elect to defer compensation for services performed if the employee makes the election before the close of the taxable year preceding the year in which the services are performed. However, many employers mistakenly allow employees to defer discretionary bonuses under a deferred compensation plan in the year before it is paid rather than in the year before it is earned.
Under Section 409A, a termination of employment occurs when both the employer and employee reasonably believe that the employee will perform no further services for the employer, or that the level of services to be performed will be less than 20% of the services performed by the employee during the preceding 36-month period.
Quite often, when key executives retire, employers retain their services as independent-contractors or consultants. Section 409A requires that such consulting services be counted for purposes of determining whether there has been a termination of employment. For example, if an employer retains a retired executive as a consultant to perform services at a level of 20% or more than that which the executive provided during the prior 36-month period, then, for Section 409A purposes, the executive has not terminated employment with the employer. As a result, any severance payments scheduled to commence under a nonqualified deferred compensation plan at termination of employment cannot begin until the executive experiences a true termination of employment.
Short-Term Deferral Rule
When an employment agreement provides for the payment of an award immediately upon vesting, the award is exempt from Section 409A under the “short-term deferral” rule. If, for example, an employee is required to be employed with the employer on the last day of the year in order to receive the award, and the award is, in fact, paid to the employee within 2½ months after the end of the year, the award satisfies the short-term deferral rule and the arrangement is exempt from the rules of Section 409A.
Long-term bonus plans and restricted stock plans often contain early vesting provisions for retirement. Typically, these agreements will provide that once certain age and service requirements have been satisfied, an employee can voluntarily terminate employment at any time and receive either a full or pro-rated bonus or award. Because this bonus or award vests upon satisfaction of the required age and service requirements, but its payment is usually not made within 2½ months after the close of the plan year in which vesting occurred, it is not a short-term deferral and is subject to Section 409A. Many employers incorrectly believe such plans are exempt from Section 409A and fail to incorporate the required Section 409A language into the plan document, thereby creating a document failure under Section 409A.
When an executive’s employment is involuntarily terminated, the employer may attempt to negotiate new severance payments that are structured differently and would replace existing severance payments provided for under the executive’s employment agreement. In general, if severance payments are subject to Section 409A, the time and form of the severance payments may not be changed by giving up rights under an old agreement for payments under a new agreement.
Section 409A severely restricts employers’ ability to offset non-qualified deferred compensation plan payments based on other benefits owed to, or debts owed by, an employee. Sometimes, employers attempt to offset the amount of one deferred compensation plan from another deferred compensation plan. Section 409A permits such an offset, but only if payments under both deferred compensation plans are scheduled to begin at the same time and are paid in the same form (e.g., lump sum, installments).
Understanding the Definition of Compensation for Elective Deferral Purposes
Plan documents for elective deferred compensation plans usually define what compensation participants may defer. Occasionally, however, employers do not operate their deferred compensation plan in accordance with the terms of the plan document, and Section 409A operational failures occur. Employers must ensure that their payroll departments clearly understand what the plan document defines as compensation eligible for deferral.
For instance, a plan document may provide that the amount to be deferred will be calculated based on the compensation paid to the employee before any deferrals made under Section 125 cafeteria plans and 401(k) plans. However, when the employer’s payroll department effectuates the deferral election, it calculates the deferrals based on compensation paid to the employee after deferrals under the Section 125 cafeteria plans and 401(k) plans. Consequently, a Section 409A operational failure results because of the incorrect amount of compensation being deferred into the deferred compensation plan.
Past Service Elections
In general, employees must make elections regarding the time and form of payment of any deferred compensation before performing the services related to such compensation. Some benefit formulas found in deferred compensation plans may use years of service to calculate benefits (e.g., employee earns $1,000 for each year of service with employer). If past years of service are used to calculate benefits and an employee is immediately vested in the plan benefit on the day he becomes a participant in the plan, the employee generally cannot elect the time and form of payment under the plan without violating Section 409A as such an election would apply to services already performed. However, Section 409A contains an exception to this general rule. Section 409A permits an employee to make elections regarding the time and form of payment for a benefit that includes past services if the elections occur within the 30 days following the date the employee becomes a participant and the benefit does not vest for at least 12 months after the 30-day election period.
Extension of Applicability Dates for ERISA Fee Disclosure Rules
The U.S. Department of Labor (the “DOL”) recently revised the interim final regulations concerning service provider fee disclosures under Section 408(b)(2) of ERISA, and the final regulations concerning participant fee disclosures under ERISA Section 404(a)(2). These revisions extend the deadline for fiduciaries and plan administrators to comply with the regulations. Below is an explanation of the new rules.
Service Provider Fee Disclosure Regulations
On July 16, 2010, the DOL issued interim final regulations under ERISA Section 408(b)(2) that require certain retirement plan service providers to disclose information to assist plan fiduciaries in assessing the reasonableness of the service provider’s compensation and potential conflicts-of-interest. These disclosure requirements were initially slated to apply to service contracts or arrangements in existence on or after July 16, 2011.
The new guidance extends the date by which covered service providers must provide initial disclosures required under Section 408(b)(2) to plan fiduciaries to April 1, 2012. The DOL believes this extension will afford service providers and fiduciaries sufficient time to adjust to any changes contained in the final regulations, which have yet to be released. The DOL intends to issue the final regulations by the end of 2011.
Participant Fee Disclosure Regulations
On October 20, 2010, the DOL issued final regulations under ERISA Section 404(a)(2) that require plan administrators to make significant disclosures to participants in defined contribution plans that have participant-directed investments. In particular, plan administrators must provide participants (as well as employees who are eligible to participate) with information about plan-related and investment-related fees and expenses.
The applicability date of the Section 404(a)(2) disclosure requirements continues to be for plan years beginning on or after November 1, 2011. However, under the final regulation, plan administrators are not required to provide the first disclosure until 60 days after: (1) the effective date of the 408(b)(2) service provider fee disclosure rule (i.e., April 1, 2012), or (2) the date the regulations apply (i.e., plan years beginning on or after November 1, 2011). Thus, plan administrators of calendar year plans have until May 31, 2012, to provide the initial disclosure.
The new guidance additionally clarifies the deadline for plan administrators to provide the first quarterly expense disclosure required under the final regulations, which is the 45th day of the calendar-quarter following the quarter in which the plan must provide the initial disclosures. Therefore, plan administrators of calendar year plans have until August 14, 2012, to start providing quarterly accountings of fee and expense deductions to individual participants.
The DOL has announced that plan administrators may provide participant fee disclosures using electronic media, relying on the Internal Revenue Service’s 2006 electronic disclosure rules, which are more flexible than the DOL’s 2002 electronic disclosure rules. Moreover, the DOL has indicated that it will issue revised electronic disclosure rules (later this year) as well as transitional guidance on electronic delivery (within the next month).
ERISA Section 404(c) Changes
One item left unchanged by the new guideance is the effective date of the changes made to the ERISA Section 404(c) regulations, which is the first day of the plan year beginning after October 31, 2011. The participant fee disclosure rules moved most disclosure requirements from the Section 404(c) regulations to the Section 404(a)(2) regulations. A plan now satisfies the Section 404(c) disclosure requirements by providing plan participants with: (1) an explanation that the plan is a Section 404(c) plan, (2) the disclosures required under the new Section 404(a)(2) regulations, and (3) if the plan offers employer securities as an investment alternative, a notice of the plan confidentiality rules on voting employer stock.
Form 5500 Updates
The IRS has released final versions of Form 8955-SSA and 2010 Form 5500-EZ and published the corresponding deadlines for filing each form.
The IRS recently released the 2009 version of Form 8955-SSA. Form 8955-SSA, which replaces Form SSA, is used by plans sponsors to report participants that separate from service with deferred vested pension benefits. The IRS extended the deadline for plan sponsors to file 2009 and 2010 Forms 8955-SSA from August 1, 2011, to January 17, 2012.
In completing Forms 8955-SSA, plan sponsors should be aware of the following:
- As noted above, for calendar year plans, sponsors must file 2009 and 2010 Forms 8955-SSA by January 17, 2012. The IRS has stated that plan sponsors cannot extend this deadline by filing a Form 5558.
- The IRS will allow plan sponsors to combine data for the 2009 and 2010 Forms 8955-SSA into one Form 8955-SSA filing.
- Plan sponsors can file Forms 8955-SSA with the IRS either on paper or electronically. Electronic filings must be filed via the IRS’s Filing Information Returns Electronically (“FIRE”) system, and the IRS requires third-party software to prepare Forms 8955-SSA in a format compatible with FIRE.
- Plan sponsors must notify participants listed on the Form 8955-SSA that they are entitled to a deferred vested pension benefit. (See Code Section 6057(e).) In fact, Form 8955-SSA requires plan sponsors to certify that they have provided such notice to applicable participants.
Plan sponsors must begin collecting the information required to be included on 2009 and 2010 Forms 8955-SSA and ensure that they comply with the participant notification requirement. A list of Frequently Asked Questions that address Form 8955-SSA filing requirements and deadlines is available online.
2010 Form 5500-EZ
The IRS recently released the 2010 Form 5500-EZ for use by “one-participant” retirement plans. A one-participant plan means a retirement plan (i.e., a defined benefit plan or defined contribution profit-sharing or money purchase plan), other than an Employee Stock Ownership Plan, that:
- covers an individual (or the individual and their spouse) who owns the entire business (which may be incorporated or unincorporated) or one or more partners (or partners and their spouses) in a business partnership; and
- only provides benefits for the individual (or the individual and their spouse) or one or more of the partners (or partners and their spouses), as applicable.
For calendar year plans, the filing deadline for the 2010 Form 5500-EZ is July 31, 2011. Plans that file a Form 5558 with the IRS by July 31, 2011, will receive a 2½ month extension to file the 2010 Form 5500-EZ.
The 2010 Form 5500-EZ cannot be electronically filed and must be filed on paper. However, one-participant plans may be able to satisfy their Form 5500 filing obligations by filing a Form 5500-SF electronically in place of Form 5500-EZ, provided that the plan covered fewer than 100 participants at the beginning of the plan year. The IRS encourages eligible one-participant plans to electronically file using Form 5500-SF. Eligible one-participant plans complete only the following questions on the Form 5500-SF:
- Part I, lines A, B and C;
- Part II, lines 1a – 5b;
- Part III, lines 7a – c and 8a;
- Part IV, line 9a;
- Part V, line 10g; and
- Part VI, lines 11 – 12e.
Supreme Court Lists Remedies for Misrepresentations in SPDs
The U.S. Supreme Court recently addressed the issue of appropriate remedies under ERISA when an employer misstates information in a summary plan description (“SPD”). In CIGNA Corp. v. Amara, the Court held that SPDs are not part of a plan document and, as a result, ERISA does not allow plan participants to enforce the terms of an SPD or change the terms of a plan to conform to representations made in the SPD. However, the Court said that aggrieved participants may “obtain other appropriate equitable relief” under ERISA, such as monetary compensation and make-whole relief for breaches of fiduciary duty.
CIGNA converted its defined benefit pension plan to a cash-balance plan. It provided an SPD to participants who then claimed the SPD misled them into believing that all participants would receive the full value of their frozen defined benefit, as well as additional benefits under the cash balance plan. Current and former employees filed a class-action suit when they learned that many participants would, in fact, receive smaller pension benefits.
The lower court ruled in favor of the plaintiffs, finding that CIGNA’s SPD was significantly incomplete and intentionally misleading. As a remedy for these violations, the court said the provisions of the plan should be conformed to the representations made in the SPD.
The Supreme Court ruled that ERISA did not permit a court to rewrite the plan document to conform to the terms of the SPD. The Court reasoned that representations made in an SPD are simply communications about the plan and not actual terms of the plan.
However, the Court next discussed the “appropriate equitable relief” that may be available under ERISA and proceeded to identify certain legal principles that could be applied. The first is “reformation,” which allows a court to rewrite a plan to reflect the “real agreement” between the employer and participants. Next, the Court found that “equitable estoppel” was a remedy that could be used by courts. Equitable estoppel would prevent an employer from reneging on non-contractual promises to participants if the participants acted in reliance on such promises. Finally, the Court recognized that, under the doctrine of “surcharge,” participants could seek relief in the form of monetary compensation directly from the plan fiduciaries, in the event of a breach of fiduciary duty.
The Court’s opinion in CIGNA will apply to both pension and welfare plans and will undoubtedly impact plan participants, plan sponsors and fiduciaries for years to come. Before CIGNA, many U.S. Appeals courts had found that when an SPD contains terms that are more favorable to participants than the terms in the actual plan document, the SPD’s terms must control. These rulings have now been overturned by the Supreme Court. However, the Court has opened various forms of other relief for participants, which may lead to additional litigation and liability for plan sponsors with inaccurate SPDs.