Publications: Year-End Benefits Alert

To read the original Client Update in PDF format, please click the Related Files link.

As you may know, there have been several recent legal developments affecting employee benefit plans, which may require action by December 31, 2004 (or shortly thereafter). We have prepared brief descriptions of each development (see attached), to help you determine which developments are relevant to your company, and the deadline for getting into compliance. These developments are as follows:

Qualified Retirement Plans

• Automatic IRA rollover rules for cash-outs from $1,000-$5,000
• New regulations for Section 403(b) programs

Welfare Benefit Plans

• New COBRA notice rules
• New tax definition of “Dependent”

Executive Compensation Arrangements

• New tax legislation affecting individual and group deferred compensation arrangements, including nonqualified deferred compensation plans, SERP’s, incentive bonus arrangements, certain employment and director agreements and other arrangements involving the deferral of taxable compensation

Highlights of the New Automatic IRA Rollover Rules For $1,000 - $5,000 Cash Outs

Most 401(k), profit sharing and defined benefit pension plans require terminated participants whose vested benefit is $5,000 or less to take a distribution (i.e. “cash-out”) of their benefit. Participants are typically given a choice to take the distribution in cash (taxable) or roll it over to an individual retirement account or new employer’s qualified plan (tax-deferred). If participants do not return their election forms, many plans include a “cash-out” procedure allowing them to make a lump sum distribution to the participant if the vested benefit does not exceed $5,000. The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) requires plans to replace this “cash-out” provision with an automatic IRA rollover provision for benefits in excess of $1,000 and not greater than $5,000. Plan sponsors will be forced to establish rollover IRA’s for these participants effective March 28, 2005. Benefits of $1,000 or less may continue to be paid out in cash or may be rolled over under the plan’s new automatic rollover procedures.

In connection with these new tax rules, the Department of Labor (“DOL”) recently issued companion regulations, providing a “safe harbor” from fiduciary liability if the rollover IRA is established pursuant to such regulations. The DOL “safe harbor” resolutions provide guidance on which financial institutions may accept and maintain automatic rollover IRA’s, and how such funds should be invested to insulate the plan sponsor from fiduciary liability. The “safe-harbor” also sets limits on the fees that can be deducted from the IRA by the financial institution to establish and maintain the IRA, and requires the plan sponsor to provide written notice to participants of these new rules. Compliance with the DOL regulations means that the plan sponsor or fiduciary acting on behalf of the plan (e.g., Plan Committee) has met its fiduciary obligations with respect to both selecting the IRA provider and the investment of the transferred amounts. Once transferred, the plan no longer has any responsibility for the participant’s benefit.

To comply with the new tax rules and DOL “safe harbor” by March 28, 2005, plan sponsors with
cash-out provisions should start to:

• Determine the plan design options available under the new law, and the company’s preferences in this area
• Begin a dialogue with one or more qualified financial institutions (including your current plan vendor) to determine the parameters/procedures and costs for implementing an automatic IRA rollover feature
• Review draft agreements with the financial institution(s), which should cover such matters as the available safe-harbor investment options, fees and participant rights
• Prepare a draft amendment to the retirement plan to modify the cash-out provisions
• Draft an appropriate notice to participants regarding these new rules
• Draft revisions to the summary plan description, and
• Draft revisions to certain administrative forms

We can assist you in moving forward in an orderly fashion. Most of this work can be done after the holidays.

New COBRA Notice Rules Effective January 1, 2005

The U.S. Department of Labor has issued final regulations on the timing and content of COBRA continuation notices. These new rules are effective for plan years beginning on or after November 26, 2004, which means they are effective January 1, 2005 for calendar year plans. The new rules describe six COBRA notice requirements. Two of these require new notices to be drafted, while the other four modify or formalize existing COBRA notice rules.

What needs to be done?

Employers who handle COBRA administration in-house will need to revise their current COBRA notices, including both the initial notice and the qualifying event notice. They will also need to update their internal COBRA procedures and summary plan descriptions (“SPDs”) to make sure they are consistent with the new rules. In addition, employers will need to create (or formalize) new notices for specific situations as required under the new rules (i.e., notice of unavailability of COBRA coverage and notice of early termination of COBRA coverage). We can assist employers in updating these forms and procedures in December, 2004 to comply with the new rules.

Employers who outsource COBRA administration should discuss the implementation of these new rules with their COBRA administrators. Although the COBRA administrator may provide new notices to assist the employer in complying with the new rules, it is important to note that most COBRA administrators do not take legal responsibility for the sample documents they provide (read the fine print in your service agreement with them). Thus, the new notices and other documentation provided by your COBRA administrator should be reviewed briefly by ERISA counsel to confirm full legal compliance. Also, employers may need to modify the COBRA provisions in their SPDs and make sure they reflect the administrator’s practices. Finally, the COBRA service contract should be reviewed and modified if necessary to ensure that the administrator (rather than the employer) is obligated to meet the timing and content requirements for the various notices described in the new rules (including the two new notices), and to provide procedural information necessary for the SPD. (This may also be an excellent time to review the COBRA service contract generally to make sure it adequately protects the employer through indemnification for the COBRA administrator’s mistakes, etc.)

We can assist you in preparing a short agenda to timely comply with these new rules.

New Section 403(b) Regulations For Tax-Sheltered Annuities And Custodial Accounts

The Internal Revenue Service has recently issued proposed and temporary regulations for taxsheltered annuity arrangements under Code Section 403(b). The temporary regulations, which are effective immediately, address the FICA payroll tax treatment of employee deferrals under Section 403(b) arrangements. Under current law, amounts deferred by employees under a Section 403(b) arrangement pursuant to a qualified salary reduction agreement are treated as current wages for purposes of FICA. The temporary regulations define what constitutes a “qualified salary reduction agreement” for this purpose and clarify that amounts deferred pursuant to a one-time irrevocable election are also subject to this rule.

The proposed regulations, which represent the first comprehensive guidance on Section 403(b) arrangements in 40 years, are scheduled to take effect in 2006. They clarify and formalize existing IRS guidance, and also impose several new requirements, including new documentation requirements for salary deferral arrangements, as well as new coverage and nondiscrimination rules for employer-funded arrangements.

At this time, employers who sponsor Section 403(b) arrangements should confirm that employee deferrals pursuant to salary reduction agreements (including one-time irrevocable elections) are being properly treated for FICA purposes as set forth in the temporary regulations. During 2005, all existing tax-sheltered annuity and custodial account arrangements will need to be reviewed and updated to comply with the new regulations.

New Tax Definition Of “Dependent” Under the Working Families Tax Relief Act of 2004

The Working Families Tax Relief Act, which was recently signed into law, makes several changes to individual tax provisions. One of the technical changes may affect your medical and other welfare benefit plans. Specifically, the definition of a “dependent” under the Internal Revenue Code has been modified in several respects. (The statute also creates a uniform definition of “qualifying child” for purposes of several provisions that previously had different definitions, such as the child credit, dependent care credit and earned income tax credit.) These changes are effective January 1, 2005.

As a practical matter, the new tax definition of “dependent” will not dramatically alter the group of persons who will qualify for dependent status under the Code, but it may alter the eligible group in certain cases. Therefore, all relevant welfare plan documents, summary plan descriptions and insurance policies should be reviewed to make sure they are consistent with the new definition. If a plan and/or policy has a definition of “dependent” which is broader than the new Code definition, any benefits provided to a dependent who meets the plan or policy definition, but does not meet the new Code definition will be taxable income. In such event, the employer must report the benefit to the IRS as taxable income and may have tax withholding responsibilities as well.

We can easily help you determine which documents need to be reviewed and help you discuss any needed changes with your insurers and/or TPA’s.

Highlights of the New Deferred Compensation Rules Under the American Jobs Creation Act of 2004

Scope of the New Law

Applies to most group and individual deferred compensation arrangements

• Including group programs such as nonqualified retirement plans, supplemental executive retirement plans, discounted stock options, deferred stock units, stock appreciation rights/phantom stock plans, severance pay, and 457(f) plans of tax-exempt employers
• Including individual deferral and severance pay arrangements for executives, directors, and
  others

Takes effect January 1, 2005 for all deferred amounts not yet earned and vested by December 31, 2004

• 2004 bonuses will be affected if “earned” in 2005
• All prior deferrals not yet vested will be affected
• All deferrals of compensation earned after 2004 will be affected

New Deferral Election Timing Rules

• Generally must defer before the calendar year in which the compensation is earned
• Newly eligible individuals can defer in first 30 days of eligibility
• For “performance-based” compensation (earned based on at least 12 months of service) must elect to defer at least 6 months before end of service period

New Distribution/Payout Rules

Distributions can be made only after certain events:

• Separation from service (6 month delay for “key employees” of public companies)
• Death
• Disability (as defined by the Act)
• Change of Control of employer (as will be defined and permitted by IRS regulations)
• Date – not an event – specified by the Plan or by the individual’s election or
• Unforeseeable financial emergency (as defined by the Act)

Individual’s election of form or timing of payout must be made at time of deferral election

• Changes to that election will not take effect for 1 year, must be made at least 1 year before the originally scheduled distribution and must delay distribution for at least 5 years
• Previously scheduled distributions may not be accelerated; no exception for “haircuts”

New Funding Prohibitions

• No offshore rabbi trusts or other offshore funding arrangements
• Funding triggers based on poor financial health of employer are prohibited

Adverse Tax Consequences of Noncompliance

• Affected individuals are taxed currently on current and all prior deferrals
• Affected individuals also pay interest and 20% tax penalty on all prior untaxed deferrals

What should Employers do?

• Identify all plans, employment contracts and informal deferral election arrangements that
  might be affected by the new rules
• Assess how those plans and arrangements must be changed to comply
• Communicate the changes to affected employees/individuals
• Amend for compliance but (i) consider upcoming (December) regulatory guidance on
  deadline for amendments, and (ii) avoid making material amendments not authorized by the
  regulations that could cause an entire plan to become subject to the Act immediately
• Consider necessary changes for 2005 compensation deferral elections to be made in
  December, 2004
• Contact your Ungaretti & Harris benefits attorney to start this compliance process