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As with all recent tax legislation, there is good news and bad news.

Pension Simplification Provisions of The Small Business Job Protection Act

By Peter E. Haller

The Small Business and Job Protection Act of 1996 changed both ERISA and the Internal Revenue Code. Included among the changes are those that impact the taxation of individuals, retirement plan distributions, and governmental and tax-exempt employers. It also introduces a new retirement plan for small businesses.

On August 20, 1996, President Clinton signed the Small Business and Job Protection Act of 1996 (the act), which contains important changes to the Internal Revenue Code (the code) and the Employee Retirement Income Security Act of 1974 (ERISA) affecting pension plans. This article highlights several of the more important "pension simplification" changes, such as tax rules impacting individuals, retirement plan distribution rules, the introduction of a new tax-favored retirement plan (the SIMPLE plan), technical corrections to the code to assure the continued qualification of plans accepting contributions for veterans under the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA), and other provisions affecting specific groups and organizations such as governmental and tax-exempt employers. Thus, even simplification yields new complex and detailed rules that employers, plan administrators, and human resource professionals will need to know.


The act creates a new type of tax-favored retirement arrangement for small businesses known as the Savings Incentive Match Plan for Employees (SIMPLE). Generally, employers that employ 100 or fewer employees who earned at least $5,000 the preceding year and do not maintain any other employer sponsored retirement plan may establish individual SIMPLE accounts for their employees.

IRA Format. A SIMPLE plan may be adopted as an IRA for each employee or part of an IRC section 401(k) plan. Generally, every employee (except for certain nonresident aliens and collectively bargained employees) who earned $5,000 or more during any previous two years of employment with the qualified employer and is reasonably expected to receive at least $5,000 of compensation during the current year is eligible to establish a SIMPLE account. SIMPLE accounts will not be subject to the nondiscrimination and top-heavy rules generally applicable to qualified plans.

A SIMPLE plan allows participants to defer a percentage of their pretax compensation, up to $6,000 per year. The $6,000 limit is indexed for inflation, and will increase in $500 increments. Employers must also generally contribute to the SIMPLE account, in accordance with one of two contribution formulas:

* Dollar-for-dollar match on employee contributions up to three percent of the employee's compensation (with a provision allowing matching contributions of as little as one percent of compensation in no more than two out of every five years), or

* No matching contribution, but two percent mandatory employer contribution on behalf of each eligible employee.

It appears the current $150,000 limitation on compensation that may be used in computing retirement benefits under qualified plans would not apply to limit an employee's matching contribution under a SIMPLE account. However, this limit would apply to the amount of compensation that could be considered for purposes of determining the mandatory two percent employer contribution under the second SIMPLE contribution formula option. The effect of this limit would be that employers using the 100% match (limited to three percent of compensation) could match the employee's entire $6,000 elective contribution, because they would not have a match limit of three percent of $150,000 (i.e. $4,500). Thus, the most these employers could contribute is $6,000 per year. By contrast, the most that employers who adopt the mandatory two percent employer contribution formula could contribute is $3,000 (two percent of $150,000). No other employer or employee contributions may be made to SIMPLE accounts.

IRC Section 401(k) Plan Format. Alternatively, employers may adopt a SIMPLE plan as part of an IRC section 401(k) plan. Similar to the IRA format, if the SIMPLE formula is used (e.g., the employer matches elective deferrals up to three percent of the employee's compensation, or makes annual nonelective contributions of two percent of compensation for eligible employees), the IRC section 401(k) plan need not comply with the complex nondiscrimination and top-heavy requirements that apply to other IRC section 401(k) plans. The plan will, however, be subject to the other qualified plan rules, including the limits on contributions and benefits under IRC section 415.

The SIMPLE rules also modify ERISA to provide for simplified employer reporting requirements with respect to such arrangements. In addition, there is relief under certain circumstances from fiduciary liability for the investment decisions of SIMPLE arrangement participants.

Tax Treatment of SIMPLE Plans. The act provides that employees will not be taxed on contributions made to SIMPLE arrangements until withdrawn. Contributions made by the employer are deductible by the employer if made
by the due date (including extensions) of the return for the year.

Distributions from SIMPLE arrangements are taxed when withdrawn or distributed. The act also amends IRC section 72(t) to provide for
a special, more onerous, early withdrawal tax
of 25% (rather than the present 10% excise tax) for withdrawals from SIMPLE arrangements made within two years of the employee's initial participation in the SIMPLE arrangement and before the employee attains age 59As. The effective date for the
SIMPLE provisions is
January 1, 1997.

Changes Impacting Individuals and Plan Distributions

Excise Tax on Excess Retirement Distributions. IRC section 4980A imposes a 15% excise tax on excess distributions from qualified retirement plans, tax sheltered annuities, and individual retirement arrangements (IRAs). In 1996, a plan participant may distribute $155,000 in annual benefits and $775,000 in lump-sum distributions without triggering the excess distribution tax.

Under the act, the excess tax shall not apply to excess retirement distributions during years beginning after December 31, 1996, and before January 1, 2000. The act does not suspend the 15% excess accumulation tax, which is imposed on excess retirement accumulations at death. Further, such amounts shall be treated
as made first from nongrandfathered amounts (i.e., the exemption of accrued benefits in excess of $562,500 on
August 1, 1986).

Spousal IRAs. Present law allows every individual to contribute to an IRA the lesser of $2,000 or 100% of compensation. In the case of a married individual whose spouse has no compensation (and thus would be unable to make an IRA contribution), the $2,000 limit increases to $2,250 per year. These limits apply regardless of whether the IRA contribution is tax deductible. The code, however, restricts an individual from deducting IRA contributions if the individual or his or her spouse is already participating in a qualified plan. In addition, an individual's filing status affects the amount of the IRA contribution that may be deducted.

The act revises the IRA contribution limit by permitting an IRA contribution of up to $2,000 for each jointly-filing spouse, so long as the combined compensation of both spouses is at least equal to the contributed amount. Therefore, the act increases the contribution limit for a single-income, married couple by $1,750 ($4,000 less the prior limit of $2,250). This limit applies regardless of whether the IRA contribution is tax deductible. This provision is effective for tax years starting after 1996.

Repeal of $5,000 Exclusion. Under IRC section 101(b), the beneficiary or estate of a deceased employee generally can exclude from income tax up to $5,000 in benefits paid by or on behalf of an employer by reason of the employee's death.

The act repeals the $5,000 exclusion for employer-provided death benefits. The provision applies with respect to decedents dying after the date of enactment of the act.

Repeal of Five-Year Income Averaging. Under present law, lump-sum distributions from qualified plans are eligible for special five-year forward averaging treatment if the distribution qualifies as a lump-sum distribution and the taxpayer elects to treat all amounts received during the year in the same manner.

A taxpayer is permitted to elect five-year forward averaging treatment only once. The election allows the taxpayer to pay a separate tax on the lump-sum distribution that approximates the tax that would be due if the lump-sum distribution were received in five equal installments.

The act repeals the five-year averaging rule for lump-sum distributions from qualified plans. The act allows individuals who attained age 50 before January 1, 1986,
to continue to elect 10-year averaging, and capital gains treatment (for the pre-1974 portion of a lump-sum distribution). After December 31, 1999, individuals
eligible for the 10-year averaging and capital gains treatment will not be eligible for five-year averaging. The provision is effective for taxable years beginning after December 31, 1999.

Simplified Method for Taxing Annuity Distributions. Amounts received as an annuity under a qualified plan generally are taxable in the year received, except to the extent they represent return of the recipient's investment in the contract (i.e., cost basis). Thus, if the employee has no cost basis, the full amount of each payment is taxable as ordinary income.

Under current law, rules provide for a pro-rata basis recovery principle that would apply following the annuity starting date so that the portion of any annuity payment that represents the employee's investment in the contract is determined by applying an exclusion ratio (determined as of the annuity starting date) equal to the employee's total investment in the contract divided by the total expected return over the term of the annuity. The total expected return is the amount the participant will receive under the contract. The resulting quotient is the percentage of each payment that may be excluded from gross income.

A simplified "safe harbor" method for taxing annuity payment already exists, and can be used if the annuity payments depend on the life of the employee or the joint lives of the employee and a beneficiary. Under this method, the investment in the contract is the employee's cost basis in the plan. The investment in the contract is divided by the total number of monthly annuity payments expected. The number of payments is taken from a table (very similar to the payment table under the new provision) and is based on the employee's age at the annuity starting date.

The act provides a simplified method for determining the nontaxable portion of the annuity payment, similar to the current simplified alternative. The method under the act will become the required procedure. The act provides that the portion of each monthly annuity payment that represents a return of basis equals the employee's total basis as of the annuity starting date divided by the number of anticipated payments under the following table:

Number of

Age payments

Not more than 55 360

More than 55

but not more than 60 310

More than 60

but not more than 65 260

More than 65

but not more than 70 210

More than 70 160

Special rules apply where payments are not monthly, a lump sum is paid prior to the start of annuity payments, the annuity is from a defined contribution plan, or if the employee is age 75 or older when the annuity payments commence. The provision is effective for annuity starting dates commencing 90 days after the enactment of the act.

Required Minimum Distributions

Present law provides uniform minimum distribution rules that are applicable to all types of tax-favored retirement vehicles. Distributions of a participant's retirement benefit under a qualified plan must generally begin no later than the participant's required beginning date, which is April 1 of the calendar year following the calendar year in which the plan participant or IRA owner attains age 70 As . In the case of a governmental or church plan, distributions may be delayed until April 1 of the calendar year following the later of the year in which the participant actually retires or attains age 70 As .

The act replaces the current rule with the rule in effect prior to the Tax Reform Act of 1986. Under the act, distributions generally are required to begin by April 1 of the calendar year following the later of (1) the calendar year in which the employee attains age 70 As or (2) the calendar year in which the employee retires. For five percent owners, however, the current rules remain in effect.

In the event an employee retires in a calendar year after attaining age 70 As , the act requires the employee's accrued benefit to be increased to account for the period in which the employee was not receiving benefits under the plan after attaining age 70 As . This actuarial adjustment rule does not apply in the case of a governmental or church plan. The conference committee report includes a provision stating that the actuarial adjustment rule does not apply in the case of a defined contribution plan. The conference report also clarifies the procedure for employees who have attained age 70 As , are receiving minimum distributions, and are still working. For these individuals, the applicable plan (or annuity contract) may--but would not be required to--allow the participant to stop plan distributions until later required under the provisions of the act (e.g., when the employee later retires). The new minimum distribution rules do not apply to IRAs. This provision of the act is effective beginning after December 31, 1996.

Minimum Waiting Period May Be Waived. Plans subject to the automatic survivor benefit requirements must provide that, unless waived by the participant with the consent of his or her spouse, retirement benefits will be paid in the form of a qualified joint and survivor annuity (QJSA). In the case of a QJSA, a written explanation of the form of benefit must generally be provided to participants no less than 30 days and no more than 90 days before the annuity starting date. Temporary Treasury regulations provide for a waiver of the 30-day period as long as the distribution commences more than seven days after the explanation is provided.

The act codifies the "waiver" rule currently found in the temporary Treasury regulations. The act also provides that a plan is permitted to provide notice after the annuity starting date if the distribution commences at least 30 days after the notice is provided, subject to the participant and spouse's right to waive the 30-day minimum waiting period. This provision is intended to allow retroactive payments of benefits that are attributable to the period before the explanation was provided. The provision is effective with respect to plan years beginning after December 31, 1996.

Salary-Reduction Simplified
Employee Pensions Repealed

In connection with the establishment of SIMPLE arrangements, the act eliminates salary reduction features for simplified employee pension plans (SARSEPs) beyond December 31, 1996. SARSEPs created before January 1, 1997, may continue to receive contributions and new employees may make salary reduction contributions to the existing SARSEPs.

Changes to IRC Section 401(k) Plans

Although the act makes several changes with respect to testing of IRC section 401(k) plans and matching contributions, a detailed discussion of those rules is beyond the scope of this article. The rules concerning IRC section 401(k) plan testing (such as ADP and ACP discrimination testing, safe harbor discrimination testing, return of excess plan contributions, and coverage rules for certain employees) have been modified, generally effective for years beginning after December 31, 1996.

Miscellaneous Employee Benefit Changes

Extension of Tax Exclusion for Employer-Provided Educational Assistance Program. For taxable years before January 1, 1995, employees were permitted to exclude up to $5,250 from gross income for amounts paid or incurred by their employer for educational assistance provided to the employee if such amounts were paid or incurred pursuant to an educational assistance program that met certain requirements under IRC section 127. This exclusion expired for taxable years beginning after December 31, 1994. Excludable educational expenses were defined to include those incurred for undergraduate or graduate level studies.

The act retroactively restores the $5,250 exclusion for employer-provided educational assistance for taxable years beginning after December 31, 1994. The act also directs the IRS to establish procedures for the refund of income taxes to employees who may have been required to report and pay income tax on employer-paid educational expenses after 1994. As part of these procedures, employers may be required to issue a revised Form W-2 to certain employees, reflecting the retroactive exclusion of educational expenses from income.

The act denies the exclusion for expenses related to graduate level study if the graduate level course began after June 30, 1996. The educational expense income exclusion provisions are scheduled to expire with respect to courses commencing after June 30, 1997.

Definition of Highly Compensated Employees and Repeal of Family Aggregation Rules. Under current law, a qualified plan must satisfy certain requirements that prohibit discrimination in favor of an employer's highly compensated employees (HCEs). That definition was seen as being overly complicated. In addition, there were complicated family aggregation rules that applied to compensation paid and contributions or benefits under such plans.

Under the act, these rules have been remarkably simplified so that an employee will be treated as an HCE if the

* was a five-percent owner of the employer at any time during the current year or the preceding year or

* had compensation for the preceding year in excess of $80,000 (as indexed for inflation) and, subject to an employer election, was in the top 20% of employees by compensation for the preceding year.

Further, the act eliminates the requirement that, regardless of the level of compensation, there must always be at least one officer who is treated as an HCE. In addition, the act repeals the rules relating to family aggregation. Thus, family members of certain HCEs will be treated as separate employees for purposes of the compensation and contribution or benefit limits applicable to qualified plans.

The changes made by the act are effective for years beginning after December 31, 1996, except that in determining whether an employee is an HCE for 1997, the act changes shall be treated as having been in effect for years beginning in 1996.

Definition of Compensation. Under the act, compensation, as defined in IRC section 415(c)(3), will now include amounts contributed to IRC section 401(k) and similar plans and IRC section 403(b) plans, amounts contributed under IRC section 457 plans, and pretax cafeteria plan contributions. Thus, defined contribution and defined benefit plans should be favorably impacted by this change since compensation will now include amounts excluded from gross income as a result of an employee's salary reduction elections under qualified plans and cafeteria plans. This change will be effective for years beginning after 1997.

Repeal of IRC Section 415(e) Combined Plan Limit. Under current law, in addition to the limit placed on contributions to defined benefit plans ($30,000 for 1996 or, if less, 25% of compensation), and the limits placed on annual benefits from such plans (generally the lesser of $120,000 for 1996 or 100% of average high three-year compensation), an additional limit applies where an employee participates in both a defined contribution plan and a defined benefit plan. This limit, under IRC section 415(e), requires complex actuarial calculations to apply and may require that either the defined contribution plan contributions or the defined benefit plan benefits be further restricted.

Under the act, the IRC section 415(e) limit is effective for testing years starting after 1999. Until then, the limit will continue to apply.

Uniform Retirement Age. The nondiscrimination regulations under IRC section 401(a)(4) provide that to qualify for safe harbor protection, a defined benefit plan's benefit formula must use a uniform retirement age and that all subsidized early retirement benefits must be available to employees on similar terms. It has been unclear whether a defined benefit plan's use of the Social Security Retirement Age (which is currently age 65, but is scheduled to gradually increase) as the plan's normal retirement age would qualify for the safe harbor under the regulations.

The act provides that a qualified plan will not violate the nondiscrimination rules if it provides that the Social Security Retirement Age is the plan's normal
retirement age. Further, subsidized early retirement benefits and joint and survivor annuities shall not be treated as being unavailable to employees on the same terms merely because such benefits
or annuities are based on an employee's Social Security Retirement Age. The
effective date for this provision is January 1. 1997.

Contributions for Disabled Employees. Currently, IRC section 415(c)(3)(C) provides that employers may elect to continue making deductible employer contributions to defined contribution plans on behalf of permanently and totally disabled employees, using their compensation level prior to their becoming disabled. However, such contributions are not permitted to be made on behalf of employees who were highly compensated before they became disabled.

The act provides that employer contributions on behalf of permanently and totally disabled employees to defined contribution plans may be made on behalf
of highly compensated employees if the plan similarly provides for the continuation of contributions on behalf of all participants who become permanently and totally disabled. There are no comparable provisions for defined benefit plans. The effective date of this provision is January 1, 1997.

Leased Employee Rules. Under current law, a "leased employee" is treated as an employee of a qualified plan sponsor for various employee benefit rules, such as participation, contributions, and vesting. Generally, a leased employee is one who provides services pursuant to an agreement between a "leasing" employer and the "recipient" employer, where the same person performs services for the recipient and related entities on a substantially full-time basis for at least one year. In addition, current law requires the services be of a type historically performed in the business field of the

While employers are not absolutely required to cover leased employees under their plans, in many circumstances they must be considered when applying the coverage and discrimination tests that apply to qualified plans and other benefit arrangements. In some instances, therefore, coverage of leased employees is required to pass those tests.

The act removes the requirement that services be of a type historically performed in the business field of the recipient, and replaces it with a requirement that the services be performed under the primary direction or control of the recipient. According to the conference report, whether services are performed by an individual under the primary direction and control of the service recipient depends on the facts and circumstances. The right to hire or fire the individual is not the relevant factor. The conference report suggests that where personnel are subject to the day-to-day control of an employer in essentially the same manner as a common law employee, they may be treated as leased employees if the period of service level is met.

The act's change is effective with respect to years beginning after 1996. However, it will not apply to any relationship that the IRS has already determined (prior to enactment of the act) did not involve a leased employee.

Technical Corrections to Veterans Reemployment Legislation. Under the Uniformed Services Employment and Reemployment Rights Act of 1994
(USERRA), plans must make retroactive contributions for returning veterans under certain circumstances to cover their period of military service. Technical corrections to the code were necessary to assure the continued qualification of plans accepting the required contributions on behalf of veterans (e.g., changes were necessary so that applicable contribution limitations could not be exceeded).

Under the act, a contribution made by an employer or an employee under an individual account plan, or by an employee to a defined benefit plan that provides for employee contributions, pursuant to the employee's rights under USERRA, will not be taken into account in the year contributed, but will be taken into account for the year to which the contribution relates, for purposes of the limits for certain code sections. Conforming changes were made to a variety of code requirements, including IRC section 415 limits, IRC section 402(g) limits on IRC section 401(k) contributions, and IRC section 401(a)(4) nondiscrimination rules. The USERRA provisions are effective December 12, 1994 (the effective date of USERRA).

Dates for Adoption of Plan Amendments. Generally, any plan amendments required by the act will not be required to be made before the first day of the first plan year beginning on or after January 1, 1998, provided that during the interim period between the effective date of the act's provision and the plan amendment, the plan is operated in accordance with the requirements of the act, and the amendment applies retroactively. In the case of a governmental plan, the date for amendments is extended to the first day of the first plan year beginning on or after January 1, 2000, subject to the same interim compliance rule described above.

Provisions Impacting
Tax-Exempt Employers

Nongovernmental Tax-Exempt Entities Eligible to Establish IRC Section 401(k) Plans. With few exceptions, state and local governmental and other tax-exempt entities were prohibited from establishing IRC section 401(k) plans. The act provides that nongovernmental, tax-exempt entities may now establish and maintain IRC section 401(k) plans for their employees.

Several of the practical implications of this change are as follows: Tax-exempt employers that are ineligible to establish a IRC section 403(b) plan (i.e., non-IRC section 501(c)(3) organizations) may now offer their employees a tax-deferred savings vehicle; tax-exempt employers that offer only IRC section 401(k) plans could be relieved from the complicated exclusion allowance calculations that apply to each participant in a IRC section 403(b) plan; and employees of tax-exempt employers will be permitted to roll over IRC section 401(k) plan accounts from their former employers. This provision is effective for plan years beginning after December 31, 1996.

Annuity Contracts Under IRC Section 403(b) Plans. Under current law, IRC section 403(b) plans must provide that elective deferrals may not exceed the annual elective deferral limit of $9,500 (for 1996). That is, the act provides that each annuity contract (as opposed to the 403(b) plan document) must provide that elective deferrals made under a plan each year will not exceed the applicable elective deferral limit. The effective date for this provision is January 1, 1996, but any existing annuity contract will not be required to be amended to meet this requirement until 90 days after the enactment of the act.

Multiple Salary Reductions Under IRC Section 403(b) Plans. Previously, a participant in an IRC section 403(b) plan was not permitted to enter into more than one salary reduction agreement in any one year. Thus, participants in IRC section 403(b) plans did not have the same flexibility in making and changing salary reduction agreements as IRC section 401(k) plan participants who may make as many salary reduction elections and modifications (on a prospective basis) as the plan allows.

The act makes the salary reduction election rights of IRC section 401(k) plans described above applicable to IRC section 403(b) plans. This provision is effective for tax years beginning after December 31, 1995. Thus, for current IRC section 403(b) plan participants, this change would be effective immediately. *

Peter E. Haller, JD, CPA, is an
associate in the employee benefits and executive compensation department
of Patterson, Belknap, Webb & Tyler LLP, a law firm in New York City.
The author wishes to thank his employee benefits colleagues Brian O'Hare, David Glaser, Bruce Wolff, Avroham Dubin, and Timothy Klapak for their assistance in the preparation of this article.

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