United States: Section 162(M) Performance Based Exception Jeopardized Under Recent Private Letter Ruling And Revenue Ruling

Internal Revenue Code (IRC) §162(m) generally provides that a publicly traded company may not deduct compensation with respect to "covered employees" to the extent that the compensation exceeds $1 million unless the compensation meets some exception, such as "performance based compensation." In a recently released private letter ruling (PLR 200804004) and a subsequent Revenue Ruling 2008-13, the Internal Revenue Service (IRS) determined that a plan that paid amounts on an executives termination of employment without cause, on termination with good reason, or on voluntary retirement without the attainment of a performance goal established under the plan does not satisfy the requirements of IRC §162(m) as "performance based compensation." Under the rulings, the IRS determined that no amounts payable under the plan qualify for the performance based compensation exception, including amounts that are otherwise paid solely as a result of the satisfaction of the performance goal. The private letter ruling and Revenue Ruling 2008-13 directly conflict with private letter rulings issued by the IRS in 1999 and 2006. This change in position by the IRS has been the subject of much criticism. As a response to this criticism, Revenue Ruling 2008- 13 provides that the holdings will not apply to arrangements that contain provisions similar to the terms described in the revenue ruling if they have performance periods beginning on or before January 1, 2009. They will also not apply to employment contracts that (without respect to future renewal and extensions, including automatic extensions of those contracts) were in effect on February 21, 2008. Employers with plans that are intended to satisfy the IRC §162(m) performance based pay exceptions should review their plans to determine whether they would have features that would be prohibited under the 2008 rulings.

Supreme Court permits 401(K) plan participant to sue over losses

In a unanimous decision that has attracted considerable attention, the U.S. Supreme Court held that an individual participant in a defined contribution plan may bring suit for fiduciary breaches under the Employee Retirement Income Security Act (ERISA) to recover losses in an individual account. The decision overturns a ruling by the Court of Appeals for the Fourth Circuit holding that suits alleging fiduciary breaches must be brought to recover benefits for an entire plan. Prior to the Supreme Court decision, participants generally could not sue individually for losses in the value of their plan accounts; they could sue plan fiduciaries for losses only by bringing a class-action lawsuit.

The participant in this case sued his former employer for breach of fiduciary duty for allegedly failing to carry out his instructions to change the investment allocations in his 401(k) account. He claimed the failure resulted in a loss of about $150,000. Relying on an earlier Supreme Court precedent, the lower courts dismissed the case, holding that ERISA did not permit individual participants to bring suit on behalf of their own interests. In overturning the Fourth Circuit, the majority drew a distinction between traditional defined benefit plans and defined contribution plans, noting that misconduct by a defined benefit plan administrator would affect the benefits of an individual participant only if the misconduct created or enhanced the risk of default by the entire plan. For a defined contribution plan, on the other hand, "fiduciary misconduct need not threaten the entire plans solvency to reduce benefits below the amount that participants would otherwise receive."

Although the decision was unanimous, the rationale for permitting individual lawsuits was not. In particular, Chief Justice Roberts (joined by Justice Kennedy) questioned whether the claim by the plaintiff was more properly a claim for benefits due under ERISA §502(a)(1)(B) rather than a claim for fiduciary breach under §502(a)(2). The distinction may be important, because a claim for benefits due, as opposed to a claim for fiduciary breach, would provide fewer remedies and a requirement that a participant exhaust the administrative remedies mandated by ERISA before filing suit. The ultimate impact of the decision and the significance of the disagreement in reasoning by the justices remain to be seen. (LaRue v. DeWolff, Boberg & Associates, Inc., U.S., 2008)

Plan investments in employer securities new proposed regulations

The Pension Protection Act of 2006 (PPA) added IRC §401(a)(35), which generally provides that participants and beneficiaries in defined contribution plans must have the right to direct the plan to divest employer securities allocated to the individuals account that are attributable to employee contributions or elective deferrals and to reinvest an equivalent amount in other investment options. Following the enactment of IRC §401(a)(35), the IRS published guidance in the form of IRS Notice 2006-107 (see the January 2007 Employee Benefits Developments). In January, the IRS published proposed regulations under IRC §401(a)(35). The proposed regulations incorporate much of the guidance provided under Notice 2006107. The regulations would be effective for plan years beginning on or after January 1, 2009. Until the regulations go into effect, Notice 2006107 will continue to apply.

Highlights from the proposed regulations:

• If an applicable defined contribution plan holds employee contributions (including rollover contributions) or elective deferrals with respect to an individual that are invested in employer securities, the plan must provide that the individual is given the opportunity to divest the employer securities and reinvest an equivalent amount in another investment.

• If employer contributions (other than elective deferrals) are invested in employer securities under the plan, the divestment right must be provided to each participant who has completed at least three years of service, to each alternate payee who has an account under the plan with respect to a participant who has at least three years of service, and to each beneficiary of a deceased participant regardless of whether the participant had completed at least three years of service. A participant has completed three years of service on the last day of the vesting computation period, as determined under the plan that constitutes the completion of the third year of service (or the third anniversary of hire for a plan that either uses the elapsed time method or that does not define the vesting computation period because the plan provides for full and immediate vesting).

• The regulations would require a plan to provide individuals who have IRC §401(a)(35) diversification rights the opportunity to divest the employer securities and reinvest an equivalent amount in another investment at least quarterly. The individuals must be permitted to select among no less than three investment options, each of which is diversified and has materially different risk and return characteristics.

• A defined contribution plan that holds publicly traded employer securities (referred to as an applicable defined contribution plan) is subject to the diversification requirements of §401(a)(35), unless it is exempted as a stand-alone ESOP or as a one-participant retirement plan.

• An employ stock ownership plan (ESOP) that is a separate plan holding no contributions that are subject to § 401(k) or § 401(m) is not an applicable defined contribution plan. The proposed regulations would clarify that a plan does not lose this exemption merely because it receives rollover contributions of amounts from another plan that are held in a separate account, even if those amounts were attributable to contributions that were subject to §401(k) or 401(m) in the other plan.

• Notice 2006107 provides that employer securities held by an investment company registered under the Investment Company Act of 1940 or similar pooled investment vehicle are not treated as being held by the plan. The proposed regulations clarify the types of pooled investment vehicles that are exempt from the diversification requirements. Under the proposed regulations, to be exempt from the diversification requirements, the pooled investment vehicle must be a common or collective trust fund or pooled investment fund maintained by a bank or trust company supervised by a state or federal agency, a pooled investment fund of an insurance company that is qualified to do business in a state, or an investment fund designated by the commissioner in revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin.

• The proposed regulations would provide that the prohibition on restrictions or conditions with respect to the investment of employer securities that are not imposed on the investment of other assets of the plans applies to a direct or indirect restriction on an individuals rights to divest an investment in employer securities that is not imposed on an investment that is not employer securities as well as a direct or indirect benefit that is conditioned on investment in employer securities. However, like Notice 2006107, the regulations would not apply this prohibition to restrictions that are imposed by reason of the application of securities laws and in certain other situations.

  (73 Fed. Reg. 421)

Failure to implement 401(k) elections what is the fix?

It is not uncommon for an employer not to execute an employees election to defer amounts to a 401(k) plan. But how does the employer correct the error when the employee misses a deferral opportunity? In the fall 2007 edition of Retirement News for Employers, the IRS answers that question. The problem can be rectified by making a qualified nonelective contribution (QNEC) to the plan on behalf of the employee and, as in the case of other operational problems, the error can be fixed through the Employee Plans Compliance Resolution System. The remedy requires the employer to make a corrective QNEC equal to 50 percent of the missed deferral (adjusted for earnings) on behalf of the affected employee. The missed deferral and the corresponding corrective QNEC (50 percent of the missed deferral) are based on the participants actual election. The employee is fully vested in the corrective QNEC, which is subject to the same withdrawal restrictions that apply to elective deferrals. Before correcting for the exclusion, however, the plan must evaluate whether, in the event that the employee had made the missed deferral, it would still pass the applicable actual deferral percentage (ADP) test. The ADP test should be corrected according to the plans terms before implementing any corrective QNEC on behalf of the employee. In addition, the missed deferral amount should be reduced, if necessary, to ensure that the employees elective deferrals (the sum of deferrals actually made and the missed deferrals, for which a corrective QNEC may be required) comply with all other applicable plan and legal limits (e.g., the IRC §415 limit on annual additions). The described correction only applies to missed deferrals. The corrective QNEC also must be adjusted for earnings from the date that the elective deferrals should have been made through the date of the corrective QNEC.

IRS letter ruling on post-retirement medical benefits

The IRS has ruled on the tax treatment of a jointly trusteed trust fund established to fund retiree medical benefits. The trust is governed by a board comprised of an equal number of employer and union trustees. Contributions to the trust were negotiated in labor contracts and consist of mandatory salary reduction contributions from employee compensation and deposits of the value of accrued sick and vacation leave upon retirement. All of the contributions to the trust are provided for under the terms of various labor agreements covered by the trust. The arrangements have been set up in a matter that precludes employee choice or elections. Thus, the amount of the salary reduction contributions as well as the rules pertaining to the deposits in the trust of accrued sick and vacation leave are fixed under the labor agreements and not subject to individual employee choice. Trust accounts are established for each covered employee, and the funds accumulated in the trust are used to provide health benefits for the employee after retirement and for a spouse, dependents, and non-dependent domestic partners. The trust fund will only provide health benefits and cannot be rebated or refunded to employees. The IRS ruling concludes that the contributions to the trust are excludable from the gross income of the employees. The health benefits are likewise non-taxable as provided to the employees, spouses and dependents. In the case of non-dependent domestic partners, the value of any health coverage provided to a domestic partner is included in the employees gross income. This ruling reflects the IRS position that trusts established to fund retiree medical benefits can be funded with pre-tax dollars and provide tax-exempt health benefits provided that employees cannot make individual choices about receiving cash or health benefits. (PLR 200805006.)

IRS issues employer-owned life insurance reporting form

The IRS issued reporting Form 8925 for policyholders who own employer-owned life insurance contracts. This form is one piece of the reporting requirement established as part of the PPA for contracts subject to IRC §101(j). Policyholders must report on this form:

• The number of employees the policyholder had at the end of the tax year.

• The number of employees who were insured under employer-owned life insurance contracts issued on or after August 17, 2006.

• The total amount of employer-owned life insurance in force at the end of the tax year.

• Whether the employer has obtained valid consent from the insured regarding the contract.

Policyholders owning employer-owned life insurance contracts issued after August 17, 2006, must file Form 8925 for each tax year the contract is owned. However, policyholders are not required to file for any tax year ending before November 14, 2007.

Contra proferentem not needed to interpret plain words

Another court case has reminded us of the importance of words used in employee benefit plan documents. In a dispute over long-term disability (LTD) benefits, a plan sought to reduce benefits by a pension plan distribution that had been paid out of a pension plan in a direct rollover to an IRA. The LTD plan provided that the disability benefits were to be offset by any employer-provided pension that the employee is "receiving" and any other disability payments the employee is "eligible" to receive from an employer-provided insurance policy or a government plan. The pension plan direct rollover amount had remained in the IRA and had not been paid out to the individual. In its ruling, the court did not apply the doctrine of "contra proferentem," meaning the interpretive rule whereby ambiguous terms in a plan are construed most strongly against the author of the terms. Instead, the court found that the plain meaning of "receiving" benefits could not be applied to an IRA rollover where no amounts are actually paid to the employee. If the plan intended to impose the offset based on an IRA rollover, the plan language would have to say so. (Neiheisel v. AK Steel Corporation and AK Steel Long-Term Disability Plan, S.D. Ohio, 2008)

What you dont know can really hurt you

Employers often agree to provide pension benefits for collectively bargained employees through multi-employer pension funds. Union representatives are eager to point out to employers that by joining a union-sponsored plan (instead of developing their own), employers can reduce administrative responsibilities, shed fiduciary liability under ERISA, and provide meaningful benefits all for a relatively predictable cost. While these may be advantages associated with participation in a multi-employer pension plan, all employers should weigh these advantages against the potential for withdrawal liability. Under federal law, if a contributing employer "withdraws" from an underfunded multi-employer pension plan (e.g., the employer ceases to have an obligation to contribute), the contributing employer and each member of its controlled group is jointly and severally liable for the contributing employers share of the plans unfunded vested benefits (withdrawal liability).

A recent case serves as a grim reminder to employers who participate in multi-employer pension funds to pay close attention to not only the financial affairs of those funds but to their own affairs as well or risk significant liability. In Trustees Carpenters Pension Trust Fund Detroit and Vicinity v. Cimarron Services, Inc., a corporate employer had been a contributor to the Carpenters Pension Trust Fund Detroit and Vicinity (Pension Fund) for a number of years. The contributing employer was part of brother-sister controlled group consisting of the contributing employer and three other companies. In June 2005, the contributing employer terminated its collective bargaining agreement and thereby ceased to have an obligation to contribute to the trust fund. Shortly thereafter, the pension fund determined that the contributing employer owed the pension fund approximately $1.375 million representing the withdrawing employers share of the pension funds unfunded liability (i.e., withdrawal liability).

In accordance with ERISA, the pension fund mailed a notice of the liability and a demand for payment to the withdrawing employers registered address. ERISA does not require a multiemployer plan to also notify the non-contributing members of the controlled group. As a general rule, notice to the withdrawing employer is deemed to be notice to all members. Under ERISA, a withdrawing employer has a limited period of time after receiving a withdrawal liability notice and demand for payment to request arbitration, which is the exclusive forum for challenging the amount of the liability. The withdrawing employer in this case failed to do so. The withdrawing employer had vacated its registered address and claimed that it had not actually received the notice. If an employer fails to request arbitration by the prescribed deadline, the employer and each member of its controlled group forfeits the right to challenge the amount of the liability. Therefore, because the withdrawing employer had failed to demand arbitration within the time prescribed by ERISA, the court entered an order directing judgment in favor of the pension fund and against the contributing employer and its controlled group members for 1.375 million dollars. (Trustees Carpenters Pension Trust Fund Detroit and Vicinity v. Cimarron Services, Inc., E.D. Mich., 2008)

What can employers learn from this case?

• First and foremost, before deciding to join a multiemployer pension fund, an employer should make all reasonable efforts to determine the financial stability of the fund. An employer should request copies of all relevant plan documents and actuarial and financial reports and have them reviewed by legal counsel. Employers should have as complete an understanding as possible of the potential for withdrawal liability before joining.

• Employers who contribute to multiemployer plans should periodically ask the fund to provide information sufficient to assess the potential for withdrawal liability. ERISA now requires multiemployer pension funds to furnish to any contributing employer who requests it, within 30 days of receiving a written request, (a) any periodic actuarial report that has been in the plans possession for at least 30 days, (b) any quarterly, semiannual, or annual financial report prepared for the plan by any plan investment manager or advisor or other fiduciary that has been in the plans possession for at least 30 days, and (c) any application filed with the Secretary of the Treasury requesting an extension of the plans obligation under ERISA to make annual minimum required contributions. In addition, ERISA now enables contributing employers to receive upon request a copy of the estimated amount of withdrawal liability that would be assessed in the event of a withdrawal, together with an explanation of how this liability was determined, including actuarial assumptions and methods, data, and the application of any relevant limitations.

• A contributing employer should make sure that each other employer within its controlled group is aware of the contributing employers potential withdrawal liability and should institute procedures designed to ensure proper notification to non-contributing employers should the contributing employer receive a withdrawal liability notification.

• If an employer receives a withdrawal liability notice and demand, it must take immediate action to preserve its rights. Failure to request arbitration within the requisite time period will result in waiver of the right to challenge the amount of the liability.

Another court holds payments made by ESOP sponsor to redeem stock deductable as dividend paid

The District Court for the District of Minnesota has granted summary judgment to General Mills Inc., allowing it a tax deduction for shares General Mills redeemed from its ESOP in order to pay terminating employees cash distributions from the ESOP. The holding in this case allows General Mills to receive a deduction not only for its contributions to the ESOP, but also a deduction for amounts it pays to redeem the ESOP stock when an employee is paid his or her benefit in cash. The result is similar to that reached in Boise Cascade in the Ninth Circuit in 2003 (see Employee Benefit Developments May 13, 2003 to May 30, 2003). An issue in the General Mills decision was the IRS argument that Revenue Ruling 2001-6 disallowed the claimed deduction because such treatment would constitute, in substance, an evasion of taxation. The district court rejected the application of Revenue Ruling 2001-6 because the provision of the IRC provided that the Secretary of Treasury may disallow a deduction that would constitute, in substance, an evasion of taxation and that the issuance of the revenue ruling by the Office of Chief Counsel was not an action by the Secretary of Treasurys delegate. The district court did not address the more recent treasury regulations (TD 9282), which holds that these payments would constitute, in substance, an avoidance or evasion of taxation and disallows a deduction. The new regulations are applicable with respect to payments made on or after August 30, 2006 and would, therefore, not apply to the payments at issue in the General Mills case. (General Mills Inc. v. United States, D. Minn., 2008)

Cash balance plans again held not age discriminatory

Two recent cases, both located in District Court for the District of Connecticut, have ruled that cash balance pension plans do not discriminate against older workers. These district court decisions are consistent with recent rulings in the Third, Sixth and Seventh Circuits. However, the split among district courts located in the Second Circuit as to whether or not the cash balance plan violates the age discrimination rules remains. The Second Circuit is currently scheduled to hear appeals of two other cases involving cash balance plans. (Custer v. Southern New England Telephone Co., D. Conn., 2008; Amara v. Cigna Corp., D. Conn., 2008)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.