- March Employee Benefits Deadlines Approaching
- March 8, 2005 | Authors: Peter Turza; Michael J. Collins
- Law Firms: Gibson, Dunn & Crutcher LLP - Los Angeles Office ; Gibson, Dunn & Crutcher LLP - Dallas Office; Gibson, Dunn & Crutcher LLP - Washington Office
Two important employee benefits deadlines are rapidly approaching. First, IRS Notice 2005-1 permits certain nonqualified deferred compensation elections to be made or revised by March 15, 2005. Second, the new automatic IRA "rollover" rules for automatic cashouts under tax-qualified retirement plans become effective on March 28, 2005.
Deferred Compensation Elections
The American Jobs Creation Act of 2004, which was enacted in October 2004, includes major changes to the tax rules governing nonqualified deferred compensation. One of the key rules under new section 409A of the Internal Revenue Code is that deferral elections generally are required to be made in the taxable year preceding the year in which the compensation is earned (i.e., the year in which the underlying services are provided). There are limited exceptions for newly-eligible participants and for "performance-based compensation" that is based on services performed over at least a 12-month period.
IRS Notice 2005-1 provides a limited exception to the rule that elections with respect to non-performance based compensation generally must be made in the prior year. Specifically, a deferral election may be made (or changed) by March 15, 2005 with respect to compensation for services performed on or before December 31, 2005 if the following conditions are satisfied:
- The amounts to which the deferral election relate have not been paid or become payable at the time of election,
- The plan under which the deferral election is or was made was in existence on or before December 31, 2004;
- The elections to defer compensation are made in accordance with the terms of the plan in effect on or before December 31, 2005 (other than a requirement to make a deferral election after March 15, 2005);
- The plan is otherwise operated in accordance with section 409A with respect to deferrals subject to section 409A; and
- The plan is amended to comply with the requirements of section 409A by December 31, 2005.
For this purpose, a plan will be treated as in existence before December 31, 2004 only if a written plan document (a) identifies a specific amount or type of compensation that is subject to the plan and not otherwise payable at the time of the deferral election, and (b) provides that a participant in the plan may elect to defer the compensation beyond the taxable year in which the amount otherwise would have been payable. In addition, it is important to note that, solely for purposes of this IRS-provided relief, neither the availability of the election to the participant nor the making of the election by the participant will be treated as causing amounts the participant defers to be includible in income under constructive receipt or other tax rules.
One unclear issue that is expected to be addressed in future guidance is for nonqualified plans that "mirror" 401(k) plans. For example, some nonqualified plans provide that the deferral election under the 401(k) plan also applies to the nonqualified plan. Thus, for example, if an employee reduces his or her 401(k) contribution election during the year, the nonqualified plan election is also changed to the same extent. Given the lack of current guidance and the possible risks of noncompliance, the prudent approach is to "decouple" the nonqualified plan from the 401(k) plan and require the employee to lock in the nonqualified plan election no later than March 15, 2005.
Many tax-qualified plans provide that employees with vested benefits of $5,000 or less are automatically "cashed out" upon termination of employment. The cashout is paid directly to the employee unless the employee affirmatively elects to roll over the distribution to another employer plan or to an IRA.
Recently-finalized Department of Labor regulations modify this rule with respect to distributions made on or after March 28, 2005. Those regulations generally require an automatic rollover to an IRA selected by the plan of cashout distributions of between $1,000 and $5,000 unless the recipient affirmatively elects to directly receive the distribution in cash (or to roll it over to a plan or IRA of the recipient's choice). Under the regulations, employers essentially have two options: (i) not to automatically cashout benefits in excess of $1,000; or (ii) automatically roll over all distributions of between $1,000 and $5,000 unless the recipient otherwise elects.
Under the Department of Labor regulations, employers that automatically roll over such distributions to IRAs can limit their fiduciary exposure by complying with a regulatory "safe harbor." The safe harbor requires that the employer enter into a written agreement with an IRA provider and provide an explanation to employees. The written agreement must limit the form of investments and must describe the investment goals and the fees charged to the IRA. The explanation must be provided in the summary plan description or a summary of material modifications. The explanation must also state that automatic cash-outs will be invested in an IRA designed to preserve principal, explain the fees and how they will be allocated and provide contact information so employees may obtain further information.
IRS Notice 2005-5 addresses some of the tax qualification issues raised by the new rules. Of particular note:
- Plan amendments that eliminate mandatory cashout provisions are not subject to the "anti-cutback" rule.
- If a plan adopts the procedure to automatically roll over distributions of between $1,000 and $5,000, a "good faith" amendment must be adopted by the end of the first plan year ending on or after March 28, 2005 (i.e., by December 31, 2005 for calendar year plans).
- Although not directly addressed by the guidance, it appears that a plan sponsor that chooses to eliminate cashout distributions in excess of $1,000 must amend its plan to do so no later than March 28, 2005.
The method adopted by the employer should be described to employees in an updated summary plan description or in a summary of material modifications as soon as possible, and preferably by March 28, 2005. The SPD/SMM update rules technically do not require notice of the change until the end of July, 2006, but disclosing the change to employees as soon as possible reduces the risk of a claim that ERISA's fiduciary duty rules require earlier disclosure.
In light of the approaching deadline, employers that choose to utilize the automatic rollover approach should begin discussing this with potential IRA providers as soon as possible. We recommend that any contract with the provider be reviewed by outside counsel.