EMPLOYEE

BENEFIT

PROVISIONS

of the Taxpayer Relief Act of 1997

A response to complaints about the complexity of the rules

Under the Taxpayer Relief Act of 1997 (the act) signed into law by the President in the summer of 1997, a number of changes were made that impact retirement and savings plans maintained by employers. Changes were also made that impact an employer's fringe benefit programs (e.g., parking benefits) as well as employer group medical plans.

Unlike previous tax legislation where the changes have been sweeping and entailed additional administrative burdens for employers and plan administrators, many of the changes under the act are helpful (such as the elimination of the requirement to file summary plan descriptions) and responsive to the employer community, which has complained about the complexity of the employee benefit rules. The following is a description of some of the more significant changes made by the act. Other changes affecting employee benefit provisions were covered in previous articles on the act that appeared in The CPA Journal.

Excise Tax on Large
Pension Distributions and
Accumulations

Under prior law, a 15% excise tax was imposed on excess distributions from qualified retirement plans, tax-sheltered annuities, and IRAs. Excess distributions are generally the aggregate amount of retirement distributions from such plans during any calendar year in excess of a threshold amount, which is adjusted for inflation ($160,000 for 1997), or five times that amount in the case of a lump sum distribution ($800,000 for 1997). The 15% excise tax on excess distributions was suspended as part of the Small Business Job Protection Act, and did not apply to excess distributions received in 1997, 1998, and 1999. The 15% excise tax did, however, continue to apply to excess retirement accumulations. An excess retirement accumulation is the excess (if any) of the value of the decedent's interest in all qualified retirement plans, tax-sheltered annuities, and IRAs, over the present value of a single life annuity that would not be subject to the 15% tax on excess distributions.

The excess distribution and accumulation taxes were designed to limit overall tax-deferred savings by individuals, as well as to help ensure that tax-favored retirement vehicles are used primarily for retirement purposes.

The act repeals both the 15% excise tax on excess distributions and the 15% excise tax on excess accumulations. The excise taxes were repealed because Congress believes the annual limits on contributions are sufficient limits on tax-deferred savings and additional penalties are unnecessary and may, in fact, deter individuals from saving.

The excess distribution tax is repealed for excess distributions received after December 31, 1996. The excess accumulation tax is repealed for estates of decedents dying after December 31, 1996.

Changes to IRC Section 401(k) Plans

Diversification of Investments. Section 407 of ERISA prohibits certain employee benefit plans from investing more than 10% of the plan's assets in the securities and real property of the employer that sponsors the plan. This 10% limitation does not apply to "eligible individual account plans," which include defined contribution plans like IRC section 401(k) plans.

The act amends section 407 of ERISA to provide that IRC section 401(k) plans [or the part of a defined contribution plan that constitutes an IRC section 401(k) arrangement] are not considered "eligible individual account plans" for purposes of the exception to the 10% limit rule if elective deferrals are required to be invested in employer securities or real property, or are so invested at the direction of anyone other than the participant or beneficiary. Thus, this new provision would generally prohibit the trustee of an IRC section 401(k) plan from investing more than 10% of the plan's assets that are elective deferrals in employer real property or securities. However, in an IRC section 401(k) plan where participants direct the investment of their accounts, this limitation is not applicable. This provision does not apply to--

* employee stock ownership plans (ESOPs);

* individual account plans if on the last day of the preceding plan year, the fair market value of all of the assets of all of the employer's individual account plans (considered together) is no more than 10% of the fair market value of all the assets of all of the employer's pension plans (excluding multi-employer plans); or

* individual account plans that do not require investment in employer securities and real property of more than one percent of the employee's compensation eligible for deferral.

This provision is effective for elective deferrals for plan years beginning after December 31, 1998, but will not apply to earnings on elective deferrals that accrued through December 31, 1998.

Matching Contributions for Self-Employed. IRC section 402(g) provides that, to the extent a self-employed individual receives a matching contribution on his or her elective deferrals (i.e., pre-tax contributions) made to an IRC section 401(k) or a SIMPLE plan, matching contributions must be applied toward the elective deferral limit in effect for that particular year. The 1997 limitation on the amount of elective deferrals permissible under IRC section 401(k) plans is $9,500. The 1997 limitation for SIMPLE plans is $6,000. Thus, plans that provide for matching contributions are required to monitor a different elective deferral limit for self-employed participants in the plan.

Under the act, the general rule that requires matching contributions attributable to the elective deferrals of self-employed persons to be counted toward the IRC section 402(g) limit has been eliminated. This change equalizes the elective deferral limit for employees and self-employed persons.

For IRC section 401(k) plans, this provision is effective for years beginning after December 31, 1997. For SIMPLE plans, this provision is effective for years beginning after December 31, 1996.

Employer Provided Health Insurance

Maternity, Newborn, and Mental Health Benefits. The Newborns and Mothers Health Protection Act of 1996 ("NMHPA") amended ERISA and the Public Health Service Act ("PHSA") to impose certain requirements on group health plans with respect to coverage of mothers and newborns including minimum hospital stay coverage in connection with childbirth. The provisions of the NMHPA are effective for plan years beginning on or after January 1, 1998.

The Mental Health Parity Act of 1996 ("MHPA") also amended ERISA and PHSA. Effective for plan years beginning in 1998, the MHPA restricts the types of limits that group health plans can place on mental health benefits. The provisions of this new law will not apply to benefits for services furnished on or after September 30, 2001.

Neither law amended or was incorporated into the code. Thus, violations of either of these laws does not result in
the imposition of an excise tax under
the code.

The act incorporates both the NMHPA and the MHPA into the code. This means that failures to comply with these laws will result in the imposition of the excise tax that is generally applicable to failures to comply with the laws applicable to group health plans. Thus, an excise tax of $100 per day during the period of noncompliance will be imposed on the employer sponsoring the plan if the plan fails to comply with the NMHPA or the MHPA. The maximum tax that can be imposed during a taxable year cannot exceed the lesser of 10% of the employer's group health plan expenses for the prior year or $500,000. The tax may be waived if the employer did not know, and exercising reasonable diligence would not have known, that the failure existed.

These provisions are effective with respect to plan years beginning on or after January 1, 1998.

The Health Insurance Portability and Accountability Act. A number of clarifying changes were made to the provisions of the code that were enacted into law by the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). An individual's coverage by Medicare supplemental insurance will be taken into account in determining whether such individual is eligible to participate in a Medical Savings Account. In addition, the determination of whether a self-employed person is not entitled to a special deduction for health insurance costs because such person is eligible to participate in an employer-sponsored subsidized health plan must be made separately with respect to qualified long-term care coverage and coverage not offering such care.

The amendments made to clarify HIPAA are effective as if they had been originally enacted as part of HIPAA.

Deductions for Health Insurance Costs of Self-Employed Individuals. Self-employed individuals can deduct 40% of their medical expenses in 1997. The act accelerates the increase in the percentage of medical costs that self-employed individuals can deduct as follows:

For Taxable Years

Beginning in Applicable

Calendar Year-- Percentage

1997 40%

1998 & 1999 45

2000 & 2001 50

2002 60

2003-2005 80

2006 90

2007 and thereafter 100

Miscellaneous Changes

Nonassignment Rules. Plans subject to ERISA may not permit the assignment of plan benefits, except for limited
exceptions (e.g., for qualified domestic relations orders).

The act modifies both the code and ERISA to permit the offset of a plan participant's plan benefit if the participant has been convicted of committing a crime involving the plan or if a civil judgment has been entered against the participant involving a violation of ERISA's fiduciary provisions. (The act also provides that a settlement agreement between the participant and the DOL or the Pension Benefit Guaranty Corporation may also provide for such an offset.) Note, however, that the spousal consent rules with respect to such an offset must be complied with unless the spouse is also required to make restitution to the plan. This provision is effective for judgments and settlements reached after the day of enactment.

Plan Summaries

Under prior law, summaries of material modifications to plans, as well as summary plan descriptions, had to be filed with the DOL.

One of the most popular changes made by the act is to eliminate the requirement imposed on plan administrators to file summary plan descriptions and summaries of material modifications with the Secretary of Labor. Many practitioners had questioned the usefulness of such filings. The act eliminates such requirement effective immediately. However, the DOL retains the right to request the plan administrator to furnish such documents. Further, a penalty of $100 a day, up to a maximum of $1,000 per request, may be imposed for a failure to comply.

Nondiscrimination Rules for State and Local Governmental Plans. The code has detailed requirements designed to prevent qualified retirement plans from discriminating in favor of highly compensated employees. Governmental plans had received several delayed effective dates with respect to such provisions.

The act now exempts state and local governmental plans from ever having to meet the code's nondiscrimination [including the discrimination tests for IRC section 401(k) plans] and minimum participation rules. These rules become effective January 1, 1998, but governmental plans are deemed in compliance with such rules for periods prior to such date.

New Technologies in Retirement Plans. Under current law, it is not entirely clear how qualified pension plans may use electronic mail in administration. For example, many plan administrators would like to satisfy notice and disclosure requirements under ERISA and the code by electronically communicating such notices, forms, and disclosures via fax or e-mail, as appropriate. However, the provisions of the code and ERISA and their regulations generally do not contemplate the use of electronic means to satisfy these requirements.

The act contains a special provision directing the IRS and DOL to each issue guidance on how plans may use new communications technologies in plan administration, while still satisfying the litany of existing requirements that apply to notices, elections, consents, and disclosures and related issues of timing and recordkeeping under qualified plans. The IRS and DOL are also specifically directed to examine and clarify the extent to which writing requirements under
the code are to be interpreted in
connection with "paperless" electronic transactions.

The IRS and the DOL are directed to issue these regulations no later than December 31, 1998. However, final regulations may not be effective until the first plan year beginning at least six months after the actual date such regulations are issued.

This provision became effective August 5, 1997.

Cost Basis Rules. Under the code, amounts received as an annuity under a tax-qualified pension plan generally are includable in income in the year received, except to the extent the amount received represents return of the recipient's investment in the contract (i.e., basis). The portion of each annuity payment that represents a return of basis generally is determined by the simplified method codified pursuant to the Small Business Job Protection Act of 1996. Under this method, the portion of each annuity payment that represents a return of basis is equal to that employee's total basis as of the annuity starting date, divided by the number of anticipated payments under a specified table. Prior to the changes made by the act, the number of anticipated payments listed in the table is based on the age of the primary annuitant on the annuity starting date regardless of the form in which benefits are paid out.

Effective for annuity starting dates after December 31, 1997, the act will require application of a separate table for benefits that are payable based on the life of more than one annuitant (i.e., joint and survivor annuities). The new table applies even if the amount of the annuity varies by the annuitant. It does not, however, apply to a single life annuity with a period certain even though a beneficiary might receive a portion of the benefits.

The table provides that if the combined age of the annuitants on the annuity starting date is--

* not more than 110, the number of anticipated monthly payments is 410;

* more than 110 but not more than 120, the number of anticipated monthly payments is 360;

* more than 120 but not more than 130, the number of anticipated monthly payments is 310;

* more than 130 but not more than 140, the number of anticipated monthly payments is 260; or

* more than 140, the number of anticipated monthly payments is 210.

With respect to benefits payable based on the life expectancy of only one person, the number of anticipated payments should still be determined as under
prior law.

IRC Section 403(b) Exclusion Allowance. An individual's tax-deferred contributions to an IRC section 403(b) plan are subject to multiple limits. One such limit is the individual's "exclusion allowance." The exclusion allowance is generally equal to 20% of the individual's "includable compensation" (i.e., generally taxable compensation) multiplied by his or her years of service, reduced by IRC section 403(b) contributions made on that individual's behalf in prior years. Alternatively, an individual may elect to have his or her IRC section 403(b) plan contribution limited by IRC section 415, which generally provides that defined contribution plan contributions may not exceed the lesser of (i) 25% of "compensation" or (ii) $30,000. Under recent changes to IRC section 415, "compensation" now includes the individual's pre-tax contributions to plans such as IRC section 401(k) or cafeteria plans.

Further, until the end of 1999, IRC section 415(e) imposes an additional limitation based on the contributions of an individual under any defined contribution plan and his or her benefit accruals under a defined benefit plan. This is known as the IRC section 415(e) "combined limit."

The act amends IRC section 403(b) to provide that "includable compensation" for purposes of determining the exclusion allowance shall conform to the definition of "compensation" under IRC section 415. This means participants in IRC section 403(b) plans will be able to enjoy a potentially larger "includable compensation" for purposes of determining the limits on contributions to the plan because "includable compensation" will now include nontaxable compensation such as IRC section 403(b) plan pre-tax deferrals and cafeteria plan contributions.

Further, the act directs the IRS to make a technical change to the IRC section 403(b) regulations to recognize that the IRC section 415(e) combined limit will be repealed after December 31, 1999.

This provision is effective for years beginning after December 31, 1997.

Employee Parking Fringe Benefits. IRC section 132(f) currently provides for a limited exclusion from income for the value of employer provided parking (up to $170/month for 1997). However, for this exclusion to apply, the parking benefit must be provided in addition to, and not in lieu of any compensation otherwise payable to the employee.

The act permits employers to offer taxable cash in lieu of nontaxable parking benefits. The cash is taxable if the employee accepts it instead of the parking benefits. The legislative history to this provision indicates that it was designed to cut down on the provision of nontaxable parking benefits. The idea appears to have been that if employees are given the choice between taxable cash and nontaxable parking benefits, they will more frequently choose taxable cash, thereby increasing tax revenues.

This provision is effective for years beginning after December 31, 1997.

Rollovers. Under present law, a qualified retirement plan can risk disqualification if it accepts a rollover from a plan that is not qualified at the time of the rollover. However, the accepting plan will not be disqualified if, prior to accepting the rollover, it reasonably concludes that the distributing plan is qualified, e.g., by verifying that the distributing plan has a determination letter with respect to its qualified status.

The act requires the Secretary of the Treasury to clarify that the administrator of the receiving plan may reasonably conclude that a contribution is a valid rollover contribution even if the distributing plan does not have a determination letter.

Mandatory Cash Outs. Under present law, plans may require participants who terminate service with accrued
benefits of $3,500 or less receive an
immediate distribution of such benefits.

The act raises the permitted amount by which a plan can involuntarily cash out a participant to $5,000, effective for
plan years beginning after the act's enactment date.

Tax on Prohibited Transactions. Certain transactions between a qualified plan and a disqualified person are prohibited to prevent persons with a close relationship to the qualified plan from using that relationship to the detriment of plan participants and beneficiaries. A two-tier excise tax is imposed on prohibited transactions. The initial level of excise tax is equal to 10% of the amount involved with respect to the transaction. If the transaction is not corrected within a certain period, a tax equal to 100% of the amount involved may be imposed.

The act increases the first-tier excise tax on prohibited transactions from 10% to 15%. Congress believes it is appropriate to increase the first-tier prohibited transaction tax to discourage disqualified persons from engaging in such transactions. This change amends IRC section 4975(a), but does not change the
prohibited transaction provisions of Title I of ERISA.

The provision increasing the excise tax rate became effective for prohibited transactions occurring after August 5, 1997.

S Corporations/ESOPs. Under current law, for taxable years beginning after 1997, an ESOP can be a shareholder of an S corporation (subject to a maximum number of S corporation shareholders of 75). ESOPs must generally make distributions, if a participant so elects, in the form of employer securities. An exception exists for ESOPs maintained by employers whose bylaws or charters restrict ownership of substantially all employer securities to employees or qualified plans, in which case the plan may make distributions solely in cash.

In addition, certain transactions involving an ESOP and certain persons who possess a close relationship to the ESOP are prohibited under ERISA and the code. Certain exemptions from the prohibited transactions exist. However, these exemptions do not apply to the lending of plan assets to, payment of plan assets as compensation for personal services rendered to the plan to, or the acquisition or sale by the plan of any property from, or to, a "shareholder employee" of an S corporation, a member of the family of such shareholder employee, or a corporation controlled by the shareholder employee.

Under the act, an ESOP established and maintained by an S corporation may limit a participant's right to receive a distribution solely in cash. Such a limitation is intended to avoid the possibility that substantial stock distributions from the ESOP could cause the S corporation to violate the 75-shareholder limit.

In addition, under the act, a transaction involving the sale of employer securities to an ESOP by a shareholder employee, a member of the family of the shareholder employee, or a corporation in which the shareholder employee owns, directly or indirectly, 50% or more of the total voting power or value of all classes of the corporation's stock (and a transaction involving a loan to the ESOP to acquire employer securities in connection with such a sale or a guarantee of such a loan) will be exempt from the prohibited transaction provisions of ERISA and the code. For purposes of this prohibited transaction exemption, a "shareholder employee" means an employee or officer of an S corporation who owns, directly or indirectly, more than five percent of the outstanding stock of the S corporation on any day during the taxable year of the corporation. The other prohibited transaction rules still apply to shareholder employees participating in a qualified plan maintained by an S corporation (e.g., borrowing from the shareholder employee's plan account is prohibited).

The changes made by the act are effective for taxable years beginning after December 31, 1997.

Under current law, for taxable years beginning after December 31, 1997, if an ESOP is a shareholder of an S corporation, the ESOP would be required to treat its allocable share of the items of income or loss of the S corporation as subject to the unrelated business income tax, regardless of the nature of the S corporation's income passed through to the ESOP. The unrelated business income tax applicable to a tax qualified plan, such as an ESOP, is an income tax (applying the same tax rates applicable to the taxable income of regular corporations) imposed generally on the income derived by a tax-qualified plan from sources unrelated to the plan's tax-exempt purpose.

Under the act, the items of income or loss otherwise allocable to the employer securities held by an ESOP maintained by an S corporation will not be treated as unrelated business income of the ESOP, and thus will not be subject to the unrelated business income tax.

The changes made by the act are effective for taxable years beginning after December 31, 1997.

Funding Requirements. Under current law, defined benefit pension plans are required to satisfy certain minimum funding requirements. There are also limits on the maximum amount that may be contributed to a defined benefit pension plan. This maximum contribution limit, known as the "full funding limit," is presently equal to the lesser of a plan's accrued liability or 150% of the plan's current liability. Under current IRS rules, amounts that cannot be contributed because of the current liability full funding limit are amortized over 10 years.

Under the act, the percentage of current liability that can be taken into account in determining the full funding limit is increased gradually through the year 2005, as follows:

* 155% for plan years beginning in 1999 or 2000;

* 160% for plan years beginning in 2001 or 2002;

* 165% for plan years beginning in 2003 or 2004; and

* 170% for plan years beginning in 2005 or later.

In addition, the act provides that the amounts that cannot be contributed to the plan because of the current liability funding limit are to be amortized over 20 years. If there are amortization bases remaining to be amortized at the end of the 1998 plan year, the 20-year amortization period applicable to such amounts is reduced by the number of years since the amortization base was established.

The changes made by the act are effective for plan years beginning after December 31, 1998.

Excise Tax on Nondeductible Contributions. Under current law, employer contributions to a tax-qualified plan are tax-deductible subject to certain limits. If such deductible limits are exceeded, a 10% nondeductible excise tax is imposed on the amount of the nondeductible contributions. An exception to the nondeductible contribution excise tax applies to contributions to one or more defined contribution plans that are nondeductible because they exceed the deduction limit applicable to employers who sponsor both a defined contribution plan and a defined benefit plan (the "combined plan deduction limit"), but only to the extent such contributions do not exceed six percent of compensation paid to participants under the defined contribution plans for the year in which the contributions are made.

Under the act, an additional exception to the 10% excise tax on nondeductible contributions applies. Under this exception, the 10% excise tax does not apply to contributions to one or more defined contribution plans that are nondeductible because they exceed the combined plan deduction limit, but only to the extent the contributions do not exceed the sum of (i) the elective deferral contributions to a 401(k) plan, and (ii) the employer's matching contributions to such plan.

The changes made by the act are effective for taxable years beginning after December 31, 1997.

GATT Interest and Mortality Rate Provisions. Under current law, IRC section 415 imposes certain limits on the amount of benefits that may be paid under a defined benefit pension plan. If the pension benefit is payable in a form other than a straight life annuity, the IRC section 415 benefit limits are determined based on an interest rate that cannot be less than the greater of five percent or the rate specified in the plan. Under changes made to the pension tax laws in 1994 (referred to as the "GATT rules"), if the pension benefit is payable in the form of a lump sum payment, the interest rate on 30-year U.S. Treasury securities is substituted for five percent in calculating the applicable IRC section 415 limits. In calculating the amount of lump-sum payments, however, sponsors of defined benefit pension plans are allowed generally to defer the use of the interest rate and mortality assumptions prescribed by the GATT rules with respect to the calculation of the present value of accrued benefits under the plan until the plan's limitation year beginning in 2000.

Under the act, the effective date for the implementation of the interest rate and mortality assumptions under the GATT rules (the "GATT rates") with respect to a plan's calculation of the IRC section 415 benefit limits now conforms to the delayed effective date applicable to a plan's use of the GATT rates in determining lump sum payments. Thus, under the act, the interest rate and mortality assumptions to be used in calculating the IRC section 415 benefit limits will be those rates and assumptions as were in effect under the plan and IRC section 415 on December 7, 1994 (i.e., the day preceding the enactment date of the GATT rules), provided the plan provisions are otherwise in compliance with the applicable requirements under IRC section 415 as in effect on December 7, 1994. Thus, the application of the GATT rates under IRC section 415 can be deferred until the earlier of the adoption (or, if later, the effective date) of the applicable plan amendment implementing the GATT rates or the first limitation year beginning after 1999.

The changes made by the act will be effective as of December 8, 1994.

Plan amendments required by the act must be made by the first day of the first plan year beginning on or after January 1, 1999. If amendments are made by such date, and such amendments apply retroactively to the effective date of the applicable legislation, the plan will be treated as having been operated in accordance with the terms of the plan for the entire period, and the plan will not fail to meet the anti-cutback provisions of IRC section 411(d)(6). *

Peter E. Haller, JD, CPA, is an associate in the employee benefits and executive compensation department at
Morgan, Lewis, and Bockius LLP in
New York City.

By Peter E. HallerIn Brief

Some Helpful Changes

The Taxpayer Relief Act of 1997 contains many provisions affecting employee benefit programs. The excise tax on large pension distributions and accumulations has been repealed. Diversification and matching contribution requirements for 401(k) plans have been modified. Employer provided health insurance plan rules have been changed, and the increase in the percentage of medical costs that self-employed individuals can deduct has been accelerated.

Other provisions include--

* modification of nonassignment rules.

* elimination of filing requirements for Summary Plan Descriptions and Summaries of Material Modifications.

* the exemption from nondiscrimination rules for state and local government plans.

* new technology in retirement plans.

* change in cost basis rules.

* modification to IRC section 403(b) exclusion allowance.

* employee parking fringe benefits enhanced.

* enhanced flexibility for rollovers.

* increase in mandatory cash-out amount.

* increase in tax on prohibited transactions.

* clarification of rules pertaining to S corporations/ESOPs.

* changes in funding requirements.

* modification of excise tax on nondeductible contributions.

* changes in GATT interest and mortality rate provisions.