T Reconciliation Act of 2001 (the Act) ushers many of the Acts - - PDF document

Employee Benefits Alert

August 2001

The Economic Growth and Tax Relief Reconciliation Act of 2001

T

he Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”) ushers in the most significant changes to employee benefit plans in 15 years. Although some changes are phased in over a period of years, many are effective January 1, 2002. As a result, employers will need to take swift action to determine how the Act will affect their employee benefit plans. Every employer, large and small, that maintains a tax-qualified pension, profit sharing or 401(k) plan can expect to be affected by the Act. The Act significantly raises many benefit and contribution limitations and includes helpful administrative

• provisions. While some provisions of the Act are

phased in over a period of years, many benefits changes are either fully effective, or begin to be effective, for plan years beginning after December 31,

• 2001. Accordingly, employers must take steps to

review the Act’s effects on their benefit plans as soon as possible. The Act does not extend the deadline for employers to amend their plans to comply with the requirements of “GUST,” an acronym for a series of tax law changes enacted between 1994 and 1998. Thus, employers still must amend their plans to reflect the GUST changes by the last day of the “GUST remedial amendment period,” that is, by the last day of the first plan year beginning on or after January 1, 2001 (December 31, 2001, for calendar year plans). In addition, the IRS has recently stated that changes to the law made by the Community Renewal Tax Relief Act of 2000 (i.e., changes to the definition of compensation for certain qualified transportation fringes) must be reflected in plans no later than the last day of the GUST remedial amendment period. Plans must be operated in accordance with the GUST and Community Renewal Tax Relief Act changes prior to the adoption of actual plan amendments. This Alert and the enclosed table summarize many of the Act’s employee benefits changes and highlight our observations and recommendations for employers to consider in adapting their benefits programs to the Act. Increases in Benefit and Contribution Limitations The Act significantly increases many benefit limitations applicable to tax-qualified plans. The following are highlights:

• The 401(k) contribution limit will increase to

$11,000 effective January 1, 2002, and will continue to increase each year thereafter by $1,000 until the limit reaches $15,000 in 2006.

• Aggregate

“annual additions” to defined contribution plans will increase from $35,000 to $40,000 effective for the first plan year beginning after December 31, 2001.

• The deductible limit on contributions to a profit

sharing plan will increase from 15% to 25% of compensation effective for plan years beginning after December 31, 2001.

• The annual benefit payable under a defined benefit

pension plan is increased from $140,000 to $160,000 effective for plan years beginning after December 31, 2001, and is unreduced for benefits commencing at the age of 62.

• The annual limit on participant compensation is

increased from $170,000 to $200,000 effective for plan years beginning after December 31, 2001. These benefit limit changes can be expected to have significant consequences. For example:

• Subject

to non-discrimination testing, the increased 401(k) contribution limit will permit

G

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only.

65 Livingston Avenue www.lowenstein.com

L

Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

highly compensated employees to defer more of their income.

• The increase in the deductible limit for profit-

sharing plans makes money purchase pension plans less attractive. Any employer currently maintaining a money purchase pension plan should consider converting it into a profit sharing plan.

• The increase in the annual benefit that may be paid

under a defined benefit pension plan can be expected to have substantial consequences for employers. Employers with supplemental “non-qualified” plans will be able to shift some of the liability for such supplemental benefits to the tax-qualified plan. Employers without existing supplemental plans can restore benefits for key employees that were previously limited to $140,000 per year. However, employers must be cautious. The higher limit can also create an additional funding

• bligation to the plan. Because the new limit

automatically becomes effective for plan years beginning after December 31, 2001, employers must promptly review their plans to determine whether the 2001 limit should remain in effect. Employers also should consider adopting plan amendments before January 1, 2002, to keep 2001 limits in place until the impact of the increase can be evaluated fully.

• The increase in the compensation limit will also

have enormous consequences. Like the increase in the pension annual benefit limitation, the increased compen-sation limit can also have a significant impact on funding obligations. The new compen- sation limit should make it easier for 401(k) plans to pass non-discrimination testing require-ments, thereby allowing highly compensated employees to defer more of their income. Simplification of Plan Aaministration In addition to increasing many important benefit limitations, the Act includes a number of measures that will simplify plan administration and reduce plan costs:

• Defined contribution plans may be amended to

eliminate any optional form of distribution, so long as a lump sum option is retained or provided. Employers with profit sharing plans should consider eliminating installment and annuity options since most participants choose to receive a lump sum anyway.

• Effective for plan years beginning after December

31, 2001, matching contributions can be counted towards a top-heavy plan’s minimum contribution require-ments. This change will eliminate the need to make minimum contributions under many top- heavy plans.

• Effective for plan years beginning after December

31, 2001, plan loans can be made to owner- employees on the same basis as they are made to non-owner employees.

• Effective January 1, 2002, after-tax contributions

can be rolled over by participants to an IRA or another qualified plan, thereby eliminating the need to distribute after-tax contributions separately. ESOP Changes The Act also includes provisions directed at employee stock ownership plans:

• Effective for taxable years beginning after

December 31, 2001, an employer may deduct dividends paid to an ESOP if the dividends are reinvested in employer stock, provided that participants also have the opportunity to receive the dividends in cash. Under existing law, ESOP dividends are not deductible unless used to repay an ESOP loan or distributed to participants.

• Under the Act, certain “disqualified persons” may

not be allocated stock under an ESOP maintained by an S corporation. Conclusion Employers will have many important decisions to make in determining how to apply the new law to their benefits plans. Since many of the new changes are effective January 1, 2002 (for calendar year plans), the effects of the new law should be evaluated immediately. While this Alert summarizes the benefits provisions of the Act, the application of the law to each employer’s benefits program will differ on a case-by-case basis. To discuss how the Act affects your benefits program, please contact Andrew E. Graw, head of the firm’s Employee Benefits and Executive Compensation Practice, at (973) 597- 2588 or at agraw@ lowenstein.com. 2

G

3 ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF 2001 EMPLOYEE BENEFIT PROVISIONS

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

• I. Contribution, Benefit and Deduction Limitations Under

Tax-Qualified 401(k), Defined Contribution and Pension Plans

• A. 401(k) Plans

Elective Deferral Limit Annual elective deferrals for 2001 are limited to $10,500 per participant; annual inflation adjustments for 2002 and subsequent years are to be made in increments of $500. Effective January 1, 2002, the annual deferral limit will increase to $11,000, and continue to increase each following year by $1,000 (up to $15,000 in 2006). Thereafter, the limit is subject to inflation increases in $500 increments. Although the increase in the annual 401(k) deferral limit is welcome, contributions of HCEs∗ are still subject to annual discrimination

• testing. Employers should

determine that any applicable discrimination tests will be satisfied at the higher elective deferral threshold before allowing HCEs to increase their contributions. Catch-Up Contributions for Workers Age 50 and Older Current law does not permit catch-up contributions. Effective for taxable years of participants beginning after December 31, 2001, 401(k) plans may permit participants who have attained age 50 to make additional annual “catch-up” contributions of up to the following dollar amounts: Year Amount 2002 $1,000 2003 $2,000 2004 $3,000 2005 $4,000 2006 $5,000 2007 and beyond $5,000, indexed for inflation in increments of $500 Catch-up contributions are not subject to the nondiscrimination rules or

• ther contribution limits otherwise

applicable to 401(k) plan

• contributions. Aside from the desire

to avoid the additional administrative complexity involved in permitting catch-up contributions, there appears little reason for an employer not to permit such contributions.

∗ “HCEs” refers to “highly compensated employees; that is, generally, to employees who earned more than $85,000 for the preceding plan year.

4

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

Matching Contributions Under current law, matching contributions must either fully vest after 5 years of service or vest in increments of 20% per year beginning with the third year of service. Matching contributions made for plan years beginning after December 31, 2001 must either fully vest after 3 years of service or vest in increments of 20% per year beginning with the second year of service. Employers should review their 401(k) plans to determine the impact, if any, of the accelerated vesting schedules on plan funding

• requirements. Employers may also

consider making the new vesting schedule applicable to pre-2002 matching contributions in order to make the vesting schedule for all such contributions uniform.

• B. Defined Contribution Plans

Annual Contribution Limit The maximum amount that can be contributed to a participant’s account for a year cannot exceed the lesser

• f 25% of compensation or

$35,000. The $35,000 limit is adjusted for inflation in $5,000 increments. Effective for plan years beginning after December 31, 2001, the maximum amount that can be contributed to a participant’s account for a year cannot exceed $40,000 (adjusted for inflation in $1,000 increments). The percentage limit is eliminated. Most 401(k) plans limit participant contributions to 20% of pay (or less depending on the rate of matching or profit-sharing contributions). Employers may now consider allowing employees to contribute a greater percentage of pay. Annual Deduction Limit for Stock Bonus and Profit- Sharing Plans Current law generally limits an employer’s annual deduction for contributions to a profit sharing or stock bonus plan to 15% of plan participants’ compensation. In addition, participants’ 401(k) contributions are treated as employer contributions in determining the maximum deductible amount for a year. Effective for taxable years beginning after December 31, 2001, the limit on deductions to a profit sharing or stock bonus plan is increased to 25% of plan participants’ compensation. Also, participants’ 401(k) contributions will not be counted in determining the maximum deductible amount for a year. Under current law, in order for an employer to be able to deduct up to 25% of participants’ compensation, it has to maintain a money purchase pension plan (or a leveraged ESOP). A money purchase pension plan is substantially similar to a profit sharing plan except that contributions are fixed by plan

• formula. In contrast, a profit sharing

plan provides for discretionary employer contributions.

5

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

Under the new law, an employer that sponsors a money purchase plan should consider converting it into a profit sharing plan. Elimination of Optional Forms

• f Benefit

A tax-qualified retirement plan may not be amended to eliminate an optional form of distribution. Effective for plan years beginning after December 31, 2001, an employer may amend a defined contribution plan to eliminate any optional form of benefit provided that a single lump sum payment option is retained. Annuity and installment options under a defined contribution plan can be a significant administrative

• burden. The new law is an
• pportunity for employers to reduce

administrative cost and complexity by eliminating such forms of distribution.

• C. Defined Benefit Plans

Benefit Limits Under current law, a participant’s maximum annual benefit is limited to the lesser

• f 100% of three-year highest

average compensation (the “percentage limit”) or $140,000 (the “dollar limit”). The dollar limit must be reduced if benefits are paid before social security retirement age (which can be age 65, 66, or 67 depending on the participant’s date of birth), and can only be increased for benefits that begin after the participant attains social security retirement age. Effective for plan years beginning after December 31, 2001, the dollar limit is increased to $160,000 and applies without reduction to benefits payable on or after age 62. The dollar limit is increased for benefits that begin after age 65. This change is a significant increase in the amount of benefits payable under a defined benefit pension

• plan. Employers with non-qualified

“excess benefit plans” (i.e., plans maintained by employers solely for the purpose of providing “excess” benefits to those employees whose qualified plan benefits are limited by the percentage or dollar limit) may now shift some of the liability for those benefits from general corporate assets back to the tax- qualified pension plan. Employers with large numbers of HCEs should consider the additional funding liabilities associated with

6

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

increased pension benefits. Because the new limits will automatically go into effect for calendar year plans on January 1, 2002, employers will quickly need to consider whether to adopt plan amendments to continue existing benefit limitations until the potential cost of the new limits can be evaluated. Repeal of Current Liability Full Funding Limitation Under current law, employer contributions to a defined benefit pension plan for a year are not deductible to the extent that they exceed the lesser of (1) 160% of the plan’s “current liability” (i.e., all liabilities to plan participants and beneficiaries accrued to date) or (2) the plan’s liability for projected benefits. Under the new law, the current liability full funding limitation is increased to 165% for plan years beginning in 2002 and 170% for plan years beginning in 2003. The current liability full funding limitation is repealed for plan years beginning in 2004 and thereafter. Because, in most instances, projected benefit liabilities exceed current liability, the increase (and ultimate repeal) of the current liability full funding limitation will allow employers to increase their deductible defined benefit pension plan contributions. Maximum Deductible Contribution An employer may make fully deductible contributions to a defined benefit pension plan equal to the plan’s unfunded current liability, provided that the plan has more than 100 participants. Effective for plan years beginning after December 31, 2001, an employer may make fully deductible contributions to a defined benefit pension plan equal to the plan’s unfunded current liability, irrespective of whether the plan has more than 100 participants. Also, in the year of termination, defined benefit pension plans will be permitted to deduct 100% of the termination liability. However, in the case of a plan with fewer than 100 participants, the termination liability attributable to benefit increases for HCEs within the last two years is disregarded, and, therefore, not deductible. The new deduction rules place small defined benefit pension plans (i.e., those with less than 100 participants) on a par with larger plans, allowing small businesses the

• pportunity to accelerate pension

fund contributions on a deductible basis.

7

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

• D. Provisions of General Applicability

Annual Compensation Limit Under current law, no more than $170,000 of a participant’s annual compensation may be taken into account in determining benefits and contributions. This limit is adjusted for inflation in increments of $10,000. Effective for plan years beginning after December 31, 2001, the annual compensation limit is increased to $200,000. Thereafter, the limit is subject to increases for inflation in $5,000 increments. The increase in the compensation limit has far-ranging significance because it is a factor not only in determining benefits and contributions, but also for purposes

• f most nondiscrimination tests.

The new limit will enable HCEs to contribute more to 401(k) plans. In addition, as in the case of the increased defined benefit dollar limit discussed above, the new compensation limit will enable employers to shift liability for non- qualified pension benefits to a tax- qualified plan. Rollovers from IRAs to Tax- Qualified Retirement Plans Under current law, distributions from an IRA may be rolled over into another IRA, but not a tax-qualified retirement plan (unless the IRA is a “conduit IRA” used to temporarily hold a distribution from a tax- qualified plan). Effective for distributions made after December 31, 2001, eligible rollover distributions from IRAs can be rolled over into a tax-qualified plan (provided the tax- qualified plan accepts the rollover). Some employers may wish to consider allowing their tax-qualified plans to accept rollovers from IRAs. Since a tax-qualified plan, but not an IRA, can permit participant loans, an individual may wish to have his or her assets held in a tax-qualified plan to have greater access to funds without having to receive a taxable withdrawal. Also, in some jurisdictions, assets held under a tax-qualified plan enjoy greater protection from creditors than do IRA assets.

8

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

Rollovers of After-Tax Contributions After-tax contributions under a qualified plan may not be rolled over to any other retirement plan or an IRA. Effective January 1, 2002, after-tax contributions may be rolled over to an IRA or a tax-qualified plan. The change in the law will allow individuals to continue to accumulate earnings on after-tax contributions tax-free by rolling

• ver such amounts to an IRA or an

accepting tax-qualified plan.

• II. Small Business Provisions

Top Heavy Limits Top heavy plans (i.e., plans under which owners and other “key employees” are entitled to a disproportionately large percentage of plan benefits) are required to provide minimum levels of contributions or benefits to “non-key employees.” Effective for plan years beginning after December 31, 2001, the definition of “key employee” is made more narrow and matching contributions will count toward satisfying the minimum contribution requirement. In addition, “safe harbor” 401(k) plans that offer a matching contribution will be exempt from the top heavy rules. By taking matching contributions into account for purposes of the top- heavy minimum contribution requirements, many employers will likely either no longer be required to comply with such requirements or significantly reduce their top-heavy contribution obligations. Small business employers should review their tax-qualified plans to determine whether they remain subject to top-heavy rules at all, and whether their top-heavy contributions can be eliminated or reduced. Plan Loans Under current law, participants may borrow up to $50,000 against their tax- qualified plan benefits. However, plan loans are not permitted by owner- employees, such as sole proprietors, partners owning more than 10% of the capital Effective for years beginning after December 31, 2001, qualified plans may make loans to owner-employees. The change in the law will permit

• wner-employees to borrow against

their tax-qualified benefits on the same terms as other employees.

9

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

• r profits interest in a

partnership, and S corporation employees owning more than 5% of the outstanding stock of the S corporation. Small Business Tax Credit for New Plans Under current law, an employer generally may deduct costs incurred to establish and maintain a new plan (e.g. consulting fees) as

• rdinary and necessary

business expenses. Current law does not provide a tax- credit for plan start-up costs. Effective for taxable years beginning after December 31, 2001, a small business employer (one not employing more than 100 employees with compensation greater than $5,000 in the previous year) can claim a nonrefundable tax credit for 50 percent of the first $1,000 of administrative and retirement-education expenses incurred for the adoption and maintenance of a new qualified plan. The credit can be claimed for each of the first 3 years of the plan. The plan must cover at least one non-highly compensated employee. The new tax credit can help a small business defray some of the start-up costs incurred in connection with implementing a new tax-qualified retirement plan.

• III. ESOPs

Deduction for Dividends Under current law, C corporations are allowed to deduct dividends paid on employer stock held by an ESOP only if the dividends are (1) paid in cash to participants or beneficiaries, (2) paid to the ESOP and subsequently distributed to participants or beneficiaries or (3) used to make payments on a loan the proceeds of which were used to purchase employer securities. Effective for taxable years beginning after December 31, 2001 an employer may deduct dividends paid to an ESOP that are reinvested in employer stock, provided that participants also have the option of taking the dividends in cash. The new law presents a planning

• pportunity for an employer that

sponsors an ESOP. Such an employer can now deduct dividend “contributions” that are used to purchase additional shares of employer stock without having to finance the purchase with a loan.

10

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

Prohibited Allocations of Stock in an S Corporation ESOP Under current law, an ESOP may be a shareholder, or even the sole shareholder, of an S corporation; and there are no restrictions on who may be a participant of the ESOP. The new law prohibits allocations under an S corporation ESOP to “disqualified persons” who own, or who are deemed to own, at least 50% of the number of

• utstanding shares of the S corporation. For such

purpose, a disqualified person’s ownership interest includes any “Deemed Owned Shares”. An individual’s Deemed Owned Shares are shares that are, or are expected to be, allocated to the individual under the ESOP plus any “synthetic equity” of the individual (such as stock options and phantom stock). A “disqualified Person” is, in general, an individual who has “Deemed Owned Shares” constituting more than 10% of all the company’s Deemed Owned Shares. Significant excise taxes and other penalties apply for violating this prohibited allocation rule. These changes are effective for plan years beginning after December 31, 2004, unless the ESOP was adopted after March 14, 2001. The new law is an effort to ensure that S corporation ESOPs have broad-based participation. All S corporations that currently sponsor an ESOP will need to review their plans and other equity compensation arrangements to make certain they comply with the new law. However, for S corporation ESOPs in existence prior to March 14, 2001, the new law is not effective until 2005. Thus, there is time to do take remedial action if necessary.

• IV. Administrative Simplification

Repeal of “Multiple Use” Test For any year in which at least

• ne HCE is eligible to

participate in an employer’s 401(k) plan that also provides for matching and/or voluntary after-tax contributions, a complicated test known as the “multiple use” test must be performed. The multiple use test is repealed effective for plan years beginning after December 31, 2001. The repeal of the multiple use test simplifies nondiscrimination testing for 401(k) plans that also provide for matching and/or voluntary after-tax contributions.

11

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

Repeal of “Same Desk Rule” Under current law, a participant must generally incur a “separation from service” in order to be eligible to receive a distribution. The term “separation from service” has been defined as excluding situations where an employee goes to work for a successor employer as a result

• f a liquidation, merger,

consolidation or other similar corporate transaction. This rule has come to be called the “same desk rule”. The “same desk rule” will not apply with respect to distributions occurring after December 31, 2001, regardless of when the severance of employment

• ccurred.

Employers engaging in corporate transactions may now distribute account balances to participants who experience a severance from employment as a result of such transactions without regard to the “same desk rule.” In the case of any participant who experienced a severance from employment prior to January 1, 2002 and could not receive a distribution due to the “same desk rule”, the employer may make distribution to such participant. Disregarding Rollovers in Mandatory Cash-Outs In determining whether a participant’s accrued benefit is less than or equal to $5,000, rollovers into the plan are taken into account. Effective for distributions occurring after December 31, 2001, a plan is permitted to exclude rollovers to the plan from the participant’s accrued benefit in determining whether the value of such benefit exceeds the $5,000 cash-out limit. The new law makes it easier for a plan to cash-out a participant who has made a rollover contribution to the plan.

• V. IRAs

IRA Contribution Limits Under current law, an individual generally may make deductible contributions to an IRA up to the lesser of $2,000 or the individual’s compensation (subject to phase-out rules based on the individual’s adjusted gross income). Effective for taxable years after December 31, 2001, an individual generally may make deductible contributions to an IRA up to $3,000 for 2002 through 2004, up to $4,000 for 2005 through 2007, and up to $5,000 for 2008. With increased IRA contribution limits, some employees may decline to participate in a 401(k) plan that does not provide an incentive to do so (such as a matching contribution). This could adversely affect the ability of HCEs to contribute high levels of 401(k) contributions.

12

PROVISION CURRENT LAW NEW LAW OBSERVATIONS/ RECOMMENDATIONS

IRA Catch-Up Contributions Under current law, IRA catch- up contributions are not permitted for individuals aged 50 or older. Effective for taxable years beginning after December 31, 2001, individuals aged 50 or older may make additional IRA catch-up contributions of $500 for 2002 through 2005, and $1000 for 2006 and subsequent years. Eligible individuals should consider increasing their IRA contributions to take advantage of the new limits.

G

L

www.lowenstein.com