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January 2008

PPA Amendments for Ongoing Plans Can Wait

Many practitioners are uncertain about the deadline for adopting amendments relating to the Pension Protection Act of 2006. Some PPA provisions went into effect in 2006 and many others became effective this year. Practitioners are concerned, in light of Rev. Proc. 2005-66, that the IRS will require good faith amendments in 2007.

PPA §1107 is very unclear that PPA amendments are not due until the last day of the 2009 plan year. For governmental plans, the deadline is 2011. The law does not distinguish between required amendments and discretionary amendments (such as the nonspouse rollover provisions). The employer must operate the plan in conformance with the law in the interim (including any discretionary provisions the employer elects to implement), and when the employer does amend the plan to incorporate the PPA provision, the amendment must be effective retroactively. In the interim, the law treats as being operated in accordance with its terms.

Except to the extent the Treasury provides otherwise, the anti-cutback rule of Code §411(d)(6) does not apply to a PPA amendment. While PPA gives Treasury the right to limit anti-cutback relief, PPA does not give the Treasury the Power to require earlier adoption of amendment.

The IRS already has confirmed on six separated occasions that an employer can wait until 2009 before adopting a PPA amendment:

• Notice 2006-89: confirms that an employer maintaining an Indian Tribal Government plan can wait until the end of the 2011 plan year to amend for PPA.
• The 2006 Cumulative List (Notice 2007-3) discusses the 2009 adoption deadline as part of its explanation of why the IRS will not review most PPA issues in the current amendment cycle (Cycle B).
• Notice 2007-6 discusses adoption deadlines in the context of cash balance plans.
• Notice 2007-7 states that an employer can amend retroactively in 2009 to comply with the lump sum distribution rules of PPA §303.
• The preamble to the final 415 regulationsspecifically lists §415 regulations issues affected by PPA and confirms the extended amendment deadline.
• The Spring 2007 IRS Employee Plans News reminds practitioners of the extended deadline.

Of these, perhaps the most instructive in the discussion of cash balance plans in Notice 2007-6. PPA provides cash balance plans with relief from "whipsaw," a higher §417(e) lump sum distribution than a participant's hypothetical account balance. Since this relief may reduce benefit accruals, the relief is not effective until 30 days after the employer gives an ERISA 204(h) notice. However, even though the employer must give this notice, the employer still can wait until 2009 to adopt the plan amendment, even though this is a discretionary amendment (i.e., an employer is not required to eliminate "whipsaw"). Moreover, the amendment will not violate the anti-cutback rules.

It is possible that the IRS could require interim good faith amendments before 2009, but the IRS has not done so, and in light of PPA it is questionable whether the IRS has the authority to do so. With the guidance the IRS has already issued, it would be very surprising if the IRS were to require interim PPA amendments before 2009. If the IRS did impose such requirement, it certainly would allow substantial time for practitioners to comply.

Accordingly, a PPA amendment is not required for ongoing plans.

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Final §415 Regulations Make Significant Defined Contribution Changes

The Treasury has released the final §415 regulations, providing a much needed update to 1981 regulations. The final regulations incorporate and expand upon much of the material in the May 2005 proposed regulations, and add new provisions to deal with PPA changes. This technical update will focus on those changes applicable to qualified defined contribution plans, and then briefly highlight some of the defined benefit plan changes.

Post-severance Compensation

The final rules limit a plan's ability to count compensation after a participant severs employment. In general under the new regulations, compensation does not include compensation paid after an employee severs employment. However, there are 2 exceptions:

1. A plan can count compensation paid to former employees who are in the US military or permanently and totally disabled.
2. A plan can count compensation paid by the later of 2 1/2 months after severance of employment or the last day of the limitation year in which the employee served employment if:
   
   a. The payment was for services rendered (e.g., salary, commissions, overtime, bonus, etc.) which the employer would have paid if employment had continued.
   
   b. The payment was for unused accrued sick leave, vacation pay, or other leave which the employee could have taken if employment had continued, or
   
   c. The payment was from an unfunded nonqualified deferred compensation plan, to extent includible in income, if the employee would have received the payments at the same time if employment had continued.

Payments in 2.b and 2.c count as compensation only if they would have been compensation if the employment had continued. Compensation does not include any of the following amounts paid after employment termination: severance pay, parachute payments, or payments from unfunded deferred compensation plans which are "triggered" by severance.

Other Compensation Issues

The §415 regulation definition of compensation now includes income from deferred compensation plans under Code §409A or §457(f)(1) or the constructive receipt doctrine. The regulations also deal with foreign compensation.

Deferrals

401(k) and §457(b) plans cannot accept deferrals from amounts which are not compensation under the revised rules. Presumably, the final §403(b) regulations, when issue, will include a similar restriction.

The preamble to the regulations clarify that although the new rules apply the Code §401(a)(17) compensation limit (currently $225,000) to Code §415 limits (see below), a plan need not determine compensation based on the earliest payments during the year. Effectively, this means that a participant making more than the §401(a)(17) limit can continue to defer all year long, subject to any applicable plan limit.

Plan Aggregation Rules

Like the proposed rules, the final regulations address controlled and affiliated service groups and predecessor employers. Additionally, the final regulations address, for the first time what happens when an affiliated group breaks up. The final regulations correct an erroneous interpretations of §415(h) in the proposal.

In a change from existing law, the new rules provide that when two plans are aggregated for 415 purposes midyear (perhaps because of the formation of a controlled group), the effect if aggregation is immediate. If an individual participates in both plans, and already has total annual additions in excess of the 415 limits, the individual cannot have any further annual additions until the next limitation year.

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Annual Addition Timing

Generally, an amount is an annual addition for a given limitation year only if the employer contributes it to the plan no later than 30 days after the due date of the employer's tax return (including extensions). In the case of a tax-exempt or governmental employer, the deadline is the 15th day of the 10th month following the end of the limitation year. This is the extended Form 5500 filing deadline. After-tax employee contributions for a limitation year only if the employee makes the contribution within 30 days after the end of the limitation year.

Correction

As expected, the final regulations no longer include authorization for correcting excess annual additions under the terms of the plan. Instead, the preamble directs plan sponsors to use the EPCRS program for correction of these operational defects. The IRS is considering further guidance on this issue. Until then, the corrective methods available under the 1981 regulations can be used for EPCRS correction, but only if all of the rules of EPCRS are satisfied.

Defined Benefit Plans

The most significant changed affect defined benefit plans. The final regulations follow the PPA mandate to count all years of service to determine a participant's high 3 years of compensation, not just years of participation. However, the final rules retain the controversial provision from the proposed regulations to apply the Code §401(a)(17) compensation limit to Code §415, effectively cutting-off benefits for highly compensated individuals who retire after age 65.

The Treasury did not finalize its 15 pages of proposed rules dealing with multiple annuity starting dates. The Treasury will spend more time evaluating that issue, and will reissue that proposal, along with a revised 401(a)(9) rules for defined benefit plans.

Effective Date

The final regulations are effective for limitation years beginning after June 30, 2007. For calendar year plans, this means that the new rules will be effective in 2008. Plans have the option of applying the post-severance compensation rules earlier than the regular effective date. There is a delayed effective date for governmental plans.

If a defined benefit plan complied with existing law prior to the effective date, and accrued benefits exceed those allowable under the final rules, the plan can pay those benefits. In doing so, the plan must disregard amendments adopted or effective after April 5, 2007. The final regulations provide that a plan will be able to use this grandfather rule even though the plan provided for benefits in excess of the 401(a)(17) limit.

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Vesting and Benefit Statements

The Pension Protection Act of 2006 (PPA) says that plans with participant direction of investment must provide the quarterly benefit statements. These statements must include vesting information. However, the law allows that plan to provide vesting information annually in a separate statement, in accordance with the rules of the Department of Labor (DOL).

Treasury Issues Final Code §409A Regulations

On April 10, 2007, The Treasury Department issued final Code §409A regulations. Although, the final regulations adopt significant portions of the proposed regulations, the regulations significantly expand the rules governing nonqualified deferred compensation plans.

Effective Date

Plans must comply with the final regulations as of January 1, 2008. However, an employer must bring its plan documents into compliance no later than December 31, 2007. The IRS has required operational compliance with Code §409A Since January, 2005. However, prior to January 1, 2008, an employer is subject to a good faith compliance standard. Accordingly, an employer may rely on the statute, interim guidance (e.g., Notice 2005-1) and the proposed regulations to effect good faith compliance. An employer also may rely immediately on the final regulations.

Written Plan Requirement

The final regulations provide that each nonqualified deferred compensation arrangement subject to Code §409A must be in writing and must reflect the requirements of Code §409A. The provisions that an employer must include in its plan document are:

• The payment amount under the plan (or formula used to determine the payment amount)
• The payment schedule
• The payment triggering events
• Conditions for initial and subsequent payment elections (if any)
• The six-month delay requirement for specified employees of publicity-traded companies (if applicable)

The final regulations provide that a plan does not need to include the permissible conditions to accelerate payments. Furthermore, an employer will not need to amend its plan retroactively to reflect actions taken during the transitional period (i.e. prior to January 1, 2008), or amend or adopt a written plan document with regard to amounts already distributed. Finally, the regulations describe provisions that the plan may incorporate by reference.

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Highlights

The final regulations are 397 pages in length and contain man changes and additions. This technical update highlights some of the more important changes made by the final regulations.

• In general, an employee must elect to defer compensation no later than the end of the year prior to the year compensation is earned. However, for a newly eligible participant, the deferral election deadline is 30 days after an employee first becomes eligible. The regulations provide that the 30-day initial election rule also applies to certain rehired or transferred employees.
• The proposed regulations consider an employer to have made payments on a fixed payment date or fixed schedule if the plan makes the payments no later than the later of (1) the end of the year in which the fixed payment date or the due date of a payment under a fixed schedule occurs, or (2) the 15th day of the third month following such fixed date or due date. The final regulations clarify that this rule also applied to payment triggering dates. For example, if the employee's death triggers a payment, the regulations will consider the payment as timely if it is made no later than the later of (1) December 31st of the year in which the death occurs, or (2) the 15th day of the third month following the date of death.
• A plan may delay payments if the plan bases the delay upon an objective, nondiscretionary formula related to bona fide business issues (e.g., payments limited to percentage of revenue). The final regulations also permit a delay if the payment would jeopardize the employer's ability to continue as an ongoing business.
• The proposed regulations provide that a payment made within the time period specified under the short-term deferral rule is not deferred compensation. The final regulations provide that the short-term deferral rule will not apply if a payment date will or may occur after the short-term deferral period. Accordingly, even if a plan makes the payment within the short-term deferral period, the exception may not apply.
• With limited exceptions, Code §409A does not permit a participant to accelerate distributions. The final regulations provide that if a distribution occurs no earlier than 30 days before the specified date and the employee cannot specify the taxable year in which payments are to be made, the regulations will not consider the payment to be an acceleration. The final regulations also permit an acceleration where the payments occur as a result of a settlement of an arm's length dispute between an employer and employee. However, the payment will not qualify for this exception where the payment does not result in a 25% reduction in payments or where the payment is connection with a down turn of the employer's financial health.
• The final regulations retain the rule that a plan may not make a payment on account of an unforeseeable emergency to the extent the emergency is satisfied by reimbursement, insurance, liquidation of the employee's assets, or by cessation of deferrals. However, the regulations do not require an employee to obtain available loans from qualified plans or distributions from a qualified or nonqualified plan. Employees may retain discretion to request, and employers may retain discretion to grant, unforeseeable emergency distributions without invoking the change election rules.
• The final regulations provide that a payment made as a substitute for the payment of deferred compensation is considered deferred compensation subject to the anti-acceleration rule. Substitute payments include offsetting an employee's deferred compensation in connection with securing a loan or providing a bonus simultaneously with the relinquishment or forfeiture of deferred compensation.
• The proposed regulations generally exempt separation pay arrangements paid upon involuntary separation from service if the payment did not exceed two times the lesser of (1) the employee's annual compensation, or (2) the Code §401(a)(17) limit for the year of separation. The final regulations provide that Code §409A only will apply to the portion of the separation pay that exceeds the limit. The final regulations also provide that, subject to certain conditions, a right to receive separation pay upon voluntary termination for good reason will treated as a payment made upon involuntary separation. Furthermore, the final regulations provide a rebuttable presumption that the characterization of the nature of separation by the employer and employee in documentation is proper.
• Under Code §409A, a plan must include a six-month delay for distributions upon separation form service for a specified employee of publicly traded company. The final regulations clarify that the public companies includes stock traded on a foreign exchange or on a U.S. exchange as American Depository Receipts. For purposes of identifying specified employees, the plan may use any 415 definition of compensation. In identifying specified employees, the plan may utilize an earlier date. The final regulations also provide that plans use other methods to determine specified employees as long as the methods are objectively determinable. A plan may avoid identifying specified employees by including a six month delay for all payments of deferred compensation.
• Stock options and stock appreciation rights (SARs) are not subject to Code §409A if they are issued at fair market value, are stock of the service recipient and do not include any deferral features. The final regulations expand the definition of service recipient stock. The final regulations also provide guidance for determining fair market value of the stock of non-publicity traded stock. Generally, the extension of a stock option or SAR would subject the option or right to Code §409A. However, the final regulations modify this rule to permit an extension of options or rights that are under water or where the option or rights is extended but not beyond the earlier of the maximum term, or ten years from the date of grant.
• Expense reimbursements can be subject to Code §409A if the reimbursement is made in a year other than the year in which the employee incurred the expense. The final regulations expand some of the exceptions included in the proposed regulations and added some additional exceptions. Reimbursements that are not taxable upon receipt are not deferred compensation. In addition, the final regulations retain the rule that permits reimbursement for certain expenses and in-kind benefits for a period of time following separation from service without being treated as 409A deferred compensation. The regulations extend the time period until the end of the third year. However, the employee must incur the expense no later than the close of the second year following separation from service. Also, the final regulations expand the moving expense exception to include reimbursement for a loss incurred upon the sale of a principal residence. The regulations increase the de minimis exception from $10,000 to the amount in effect under Code §402(g) for the year. The final regulations extend the time period during which taxable reimbursement for medical expenses may incurred to the COBRA period, without the reimbursement being considered deferred compensation.
• The regulations provide that tax gross-up payments comply with Code §409A as long as the employer makes the payment by the end of the employer's taxable year following the year in which such taxes are paid to the taxing authority. The final regulations retain the provision in the proposed regulations permitting distribution upon plan termination. However, the regulations reduced the time period during which an employer may not established a new plan from five years to three years.
• Code §409A generally required a plan to specify the time and form of payment at the time of deferral. The proposed regulations treated certain actuarial equivalent annuities as a single form of payment. The final regulations expand the list of annuities to include annuities with certain features (e.g., term certain, cash refund, leveling options.
• In connection with the issuance of the final regulation, the IRS issued Notice 2007-34, which permits the modification of split dollar life insurance arrangements without the modification treated as a material modification.

The final regulations require a nonqualified deferred compensation arrangement to comply with Code §409A both in form and in operation. Before December 31, 2007, practitioners must immediately review all arrangements to determine which arrangements will need amendment.

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