If you submitted your retirement plan for a determination letter review, hopefully you got your determination letter back in quick order and it was perfect. However, everyone makes mistakes, even (sometimes) the IRS. It pays to double-check to make sure that all amendments you submitted are referenced in the favorable determination letter to the extent they were not covered by a prior determination letter. If all amendments since the last determination letter are not referenced in the current determination letter, you could have a potential issue down the road in an IRS audit or during the next determination letter application submission. The good news is that the IRS has a program for reviewing and correcting determination letter errors. The program requires you submit a request in writing detailing the corrections you believe are required.
But what if, during the course of your determination letter review, the IRS required you to submit a proposed amendment? The general rule is that the proposed amendment has to be adopted within 91 days of the date on the determination letter. So how does this rule apply if you submit a request to correct the letter?
According to the IRS, you should go ahead and adopt the amendment within 91 days of when the original letter was issued. The rationale (as communicated informally by IRS agents) is that if the IRS does not agree with your proposed correction to the letter, you will be bound by the original deadline. Therefore, as a protective measure, you should adopt the amendment within 91 days of when the original (potentially incorrect) determination letter was issued. The IRS will only extend the 91-day period if (1) the IRS agrees that the determination letter was issued in error and (2) the error relates to the proposed amendment.
Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections.
It should (but will not) go without saying that Code Section 409A has an extraordinarily broad reach. Many claim this reach is overbroad. One commonly cited example of this overbreadth is that Code Section 409A regulates taxable employee reimbursements.
Why does Code Section 409A regulate reimbursements? The concern is that an employee and employer will collude to achieve reimbursement of extravagant personal expenses many years after the expense is incurred. This “late” reimbursement would have the effect of unreasonably deferring taxation of the reimbursable expense, potentially into a year that is tax-advantageous for the employee.
The IRS’s solution? Ensure that expenses eligible for reimbursement are objectively determinable and reimbursed within a limited period of time following the date in which the expense is incurred. Here’s a list of the IRS’s requirements:
- Definition of Reimbursable Expense. Code Section 409A requires an objectively determinable definition of an expense eligible for reimbursement. The description of the reimbursable expense does not need to be extensive, but does need to be written into the relevant plan document (which could be an employment agreement).
- Prescribed Reimbursement Period. Eligible expenses must be incurred during a prescribed period of time. This period of time can be as long or as short as desired – the lifetime of the service provider works for Code Section 409A purposes. Again, this needs to be written into the plan document.
- Reimbursement Limits Affect Only One Calendar Year. The amount of expenses eligible for reimbursement in one taxable year cannot affect the amount eligible for reimbursement in other taxable years. This requirement must be reflected in the plan document.
- Reimbursement Timing. Reimbursements must occur by the end of the taxable year following the year in which the expense was incurred.
- No Exchange or Liquidation. The right to reimbursement can not be subject to liquidation or exchange for another benefit.
Of these requirements, the requirement that the amount of reimbursements in one year not affect another year is often the biggest stumbling block. Consider, for example, a multi-year employment agreement that, for corporate governance reasons, limits reimbursable expense over the life of the agreement to $20,000. This provision violates Code Section 409A.
Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections. This is the first of those posts.
You are designing an executive employment agreement with a substantial severance component. For the amount of severance, it seems fair to condition payment upon execution of an agreement waiving all employment claims (ADA, age discrimination, etc.). Why not just say that severance payments don’t begin until the executive returns the claims release? The answer – Code Section 409A.
Incredulous? Here’s the concern. An employee who will begin to receive severance upon return of a release could potentially hold on to the release until the year following his or her termination. What does that achieve? Because the severance is taxable when actually paid, the employee could hold on to a release, defer taxation, and ultimately pay fewer taxes on the severance. Employee discretion as to the timing of taxation exercised opportunistically upon termination of employment is anathema to Code Section 409A.
There are two common solutions to this design problem, both with advantages and disadvantages.
The DOL recently filed an amicus brief in two companion “stock drop” cases on appeal to the Second Circuit Court of Appeals. In re Citigroup ERISA Litigation, 2d Cir., No. 09-3804-cv,. The DOL’s amicus brief urges the Second Circuit to reject the “presumption of prudence” first adopted in Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995).
In Moench, the Third Circuit ruled that an ESOP fiduciary who invests plan assets in employer securities is entitled to a “presumption” that it acted consistently with ERISA in making that decision. A challenging party may rebut that presumption, however, “by establishing that the fiduciary abused its discretion by investing in employer securities.” Id.
Over the years, Moench has been adopted by a majority of the circuits that have addressed the issue, and its presumption has been applied not only to ESOPs but also to eligible individual account plans holding employer securities, such as 401(k)s. In recent years, the DOL has begun attacking this presumption of prudence and has filed numerous amicus briefs in so-called “stock-drop” cases. The Department’s general position is that there is no support for the Moench presumption in ERISA.
In its most recent amicus brief, the DOL expressed strong support in favor of plaintiff-appellants’ petition for a panel or “en banc” rehearing of the Second Circuit’s application of the Moench presumption in the Citigroup companion cases. The majority in each case held the presumption of prudence can be overcome only where there is a “dire situation” that was objectively foreseeable. The DOL’s responded that this holding “cannot be squared with ERISA’s mandate that the fiduciary’s general obligation to follow plan documents always gives way to the overriding statutory duty to act prudently and loyally in managing the plan and its assets.”
If the DOL’s position gains favor and is adopted by an en banc Second Circuit, plan sponsors offering employer securities as an investment alternative may be held to a more stringent standard in prospective “stock drop” litigation. As a matter of general fiduciary prudence, these plan sponsors might consider revisiting their monitoring and disclosure practices now in order to ensure compliance with ERISA.
Yesterday, the Department of Labor (“DOL”) issued the final rule on the disclosures that a covered service provider must furnish to a plan fiduciary in order for a contract or arrangement for services for a covered plan to be “reasonable” as required under ERISA §408(b)(2). These fee disclosure requirements become effective July 1, 2012 and apply not only to service contracts and arrangements entered into on or after that date but existing contracts and arrangements entered into prior to July 1, 2012.
For those of you who remember in detail the disclosure requirements under the interim rules issued in July, 2010, the DOL has posted an overview of the changes from the interim final rule its website. For everyone else, the disclosure requirements under the final rule are briefly described below.
The final rule generally applies to ERISA-covered defined benefit and defined contribution pension plans. However, simplified employee pension plans, simple retirement accounts, individual retirement accounts, individual retirement annuities and certain Keogh plans and 403(b) annuity contracts and custodial accounts are excluded.
Covered Service Providers
Disclosure is required in the case of a service provider who enters into a contract or arrangement with the covered plan and reasonably expects to receive at least $1,000 in direct or indirect compensation in connection with the provision of services in one or more of the following categories:
- Services as an ERISA fiduciary or as an investment advisor registered under either the Investment Advisors Act of 1940 or any state law.
- Recordkeeping or brokerage services to an individual account plan that permits participant-directed investments, if one or more designated investment alternatives will be made available in connection with such recordkeeping or brokerage services.
- Accounting, auditing, actuarial, appraisal, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third-party administration or valuation services to the covered plan when the provider (or an affiliate or subcontractor) reasonably expects to receive indirect compensation or certain payments from related parties.
The fee disclosure requirements continue to apply to a service provider even if some or all of the covered services are performed by affiliates or subcontractors.
Required Information for Disclosure
Reasonably in advance of entering into, or extending or renewing the services contract or arrangement, the covered service provider must furnish the following information in writing to the responsible plan fiduciary:
- a description of all services to be provided (including services that will be performed by affiliates and subcontractors);
- a statement that the service provider, an affiliate or subcontractor will provide, or reasonably expects to provide services as a fiduciary, within the meaning of ERISA § 3(21), if applicable;
- a statement that the service provider, an affiliate or subcontractor will provide, or reasonably expects to provide services as an investment advisor registered under the Investment Advisors Act or State law, if applicable;
- comprehensive information about the direct and indirect compensation that will be received in connection with the provided services;
- a description of any compensation that will be paid among the service provider, an affiliate or a subcontractor that are set on a transaction basis or are charged directly against the covered plan’s investment and reflected in the net value of the investment, identification of the services for which such compensation is paid and the identity of the payers and recipients of such compensation (including the status of the payer or recipient as an affiliate or a subcontractor);
- a description of any compensation that the service provider, an affiliate or a subcontractor reasonably expects to receive in connection with the termination of the contract or arrangement and how any prepaid amounts will be calculated and refunded upon such termination; and
- a description of the manner in which any of the above-listed compensation will be received (e.g., covered plan will be billed or the compensation deducted directly from the covered plan’s accounts or investments).
The following additional disclosures are required depending on the category of services to be provided to the covered plan:
- Recordkeeping Services. A description of all direct and indirect compensation that the service provider, an affiliate or a subcontractor reasonably expects to receive in connection with the recordkeeping services. If the service provider reasonably expects recordkeeping services to be provided, in whole or in part, without explicit compensation for such services, or when compensation for recordkeeping services is offset or rebated based on other compensation received by the service provider, an affiliate or a subcontractor, the covered service provider must furnish a reasonable and good faith estimate of the cost to the plan of such recordkeeping services, including an explanation of the methodology and assumptions used to prepare the estimate and a detailed explanation of the recordkeeping services that will be provided.
- Fiduciary Services. A description of (1) any compensation that will be charged directly against the amount invested in connection with the acquisition, sale, transfer of, or withdrawal from the investment contract, product, or entity (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees and purchase fees); (2) the annual operating expenses (e.g., expense ratio) if the return is not fixed; (3) any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees), or for an investment contract, product or entity that is a designated investment alternative, the total annual operating expenses expressed as a percentage and any other information or data about the designated investment alternative that is within the control of, or reasonably available to, the covered service provider and that is required for the administrator of the covered plan to comply with its participant-level disclosure obligations
- Recordkeeping and Brokerage Services. If one or more designated investment alternatives will be made available in connection with the recordkeeping or brokerage services, the covered service provider must furnish the same information described above with respect to fiduciary services for each such designated investment fund alternative.
The final rule does not require a specific format for providing the required disclosure; however, the DOL expressed its intent to publish a Notice of Proposed Rulemaking under which service providers may be required to furnish a guide or similar tool with the initial disclosures. To encourage service providers to provide a guide or index to the disclosures, the final rule includes a “sample guide”.
Changes in Reported Information and Disclosure Errors
A covered service provider generally must disclose changes to the previously disclosed information as soon as practicable, but not later than 60 days from the date on which the service provider is informed of such changes. The final rule provides a compliance alternative for changes to investment information. Rather than furnishing notification of a change within 60 days, the service provider must, at least annually, disclose any changes to the investment information.
If a covered service provider makes a good-faith error or omission in disclosing the required information, the service provider must disclose the correction information to the responsible plan fiduciary as soon as practicable, but not later than 30 days from the date on which the covered service provider knows of such error or omission.
Prohibited Transaction Exemption Available
If a prohibited transaction occurs because the covered service provider does not make the required disclosure, and the plan fiduciary did not have reason to know of the failure and reasonably believed that the service provider disclosed the information, prohibited transaction relief is afforded to the plan fiduciary if: (1) the plan fiduciary makes a written request for information from the service provider, and (2) if the service provider does not respond within 90 days, the plan fiduciary reports the service provider to the DOL within 30 days of the earlier of the 90th day following the request or the 30th day following the service provider’s refusal. No prohibited transaction relief is available for the covered service provider.
Today, the Treasury and Internal Revenue Service (IRS) released proposed regulations along with a series of rulings intended to reduce regulatory barriers and increase the employer’s ease in offering lifetime income choices (i.e., annuities) to retirees to help them avoid outliving their retirement savings. As described in the “fact sheet” issued by the Treasury, these proposed regulations aim to offer workers more accessible options as to how they receive their retirement benefits, including:
- a combination retirement benefit option, which would allow an individual to take a portion of their income as a lifetime annuity while taking the remainder in another form (e.g., a lump-sum);
- a “longevity annuity” option, which would allow employees to use a portion of their account balance (the lesser of 25% or $100,000) to provide a life annuity that would not begin until the retiree had reached age 80 or 85, to protect those individuals who live beyond their life expectancy;
- the opportunity for employees to receive lump-sum cash payouts from their employer’s 401(k) plan that can be transferred (partially or in full) to the employer’s defined benefit plan—so long as the employer maintains a defined benefit plan and allows for the transfer—so the employee could receive an annuity from the plan with the defined benefit plan’s “reduced” annuity purchase rate; and
- the use of deferred annuities (including longevity annuities) despite the requirement of written, notarized spousal consent for optional forms of benefits.
For the employer, the difficulty in offering these forms of benefits options has been the administrative burden assessed with each option. As such, the proposed regulations aim to eliminate the regulatory barriers associated with these forms. The high-level guidance offered in the Treasury’s fact sheet has been provided in a problem & solution format, summarized below.
Offering of Partial Annuities “Split” Benefit Option
Problem: The current regulations generally require plans that allow split distribution options to apply the statutorily prescribed interest rates and mortality assumptions to calculate both the lump sum and the annuity with a split benefit option.
Solution: The proposed rule would allow the partial annuity to be calculated with the plan’s regular conversation factors and only require that the lump sum be determined with the statutorily prescribed actuarial assumptions.
Offering of “Longevity Annuity”
Problem: Current regulations require defined contribution plans and IRAs to calculate required minimum distribution by dividing the employee’s entire account balance by the employee’s life expectancy. Within that determination of an account balance, the value of the annuity must be included when calculating the minimum distribution for each year before the annuity begins.
Solution: The proposed regulations offer special relief from the required minimum distribution rules; specifically, an annuity that (1) costs no more than the lesser of (i) 25% of the account balance or (ii) $100,000, and (2) will begin by age 85 will not be added to the calculation.
Offering 401(k) Participants the Option to Purchase Annuity from Employer’s Defined Benefit Plan
Problem: Under current guidance, it is unclear whether employers who may wish to offer participants the opportunity to purchase an annuity in the company’s defined benefit plan may do so and what rules apply.
Solution: A new Treasury/IRS ruling provides employers who sponsor both a defined contribution and defined benefit plan a roadmap to offering employees the option of rolling over some or all of their 401(k) plan payouts to the defined benefit plan in exchange for an immediate annuity from that plan. Both traditional and hybrid (e.g., cash balance) defined benefit plans can accept a rollover from a defined contribution plan.
Offering a Deferred Annuity Consistent with Plan Qualification Rules
Problem: When an employer offers optional forms of benefits, plan qualification rules require employees who choose to elect such an optional form to obtain written, notarized consent from the participant’s spouse. Employers are uncertain how and when this rule will apply if an employee elects lifetime income.
Solution: A new Treasury/IRS ruling provides various hypothetical scenarios when spousal consent provisions apply and identifies plan and annuity terms that will automatically protect spousal rights without requiring spousal consent before the annuity begins. When the annuity begins, compliance with spousal consent rules would lie with the issuing insurance company.
Further guidance pertaining to these regulations and rulings is expected from both the Treasury and Department of Labor later this year. The Treasury’s complete fact sheet is available here.
We’d like to thank our extern, Melissa Travis, for her extraordinary contributions to this post.