The Technical Corrections and Miscellaneous Revenue Act of 1988 (Act) made important changes affecting employee benefits. In addition to extensive technical corrections that correct drafting errors and omissions in TRA 86 and other recent tax acts, the Act contains a number of substantive changes. This article discusses these changes.

Nondiscrimination Rules for Welfare

Plans

Sec. 89, added to the IRC by TRA 86, imposes significant new qualification standards and nondiscrimination rules on employer- sponsored health plans, group-term life insurance plans and other welfare plans. These complex rules will become effective for plan years beginning in 1989. Since passage of TRA 86, companies have lobbied heavily for simplification and modification of the Sec. 89 rules. The act includes many changes to Sec. 89 rules. They include the following.

. Valuation tables for health coverage to be issued by the Treasury Department will not be effective before the later of the first testing year beginning at least one year after the issuance of such rules, or after 1990. In the meantime, employers are permitted to use other reasonable methods of determining the value of health coverage, including the use of costs as determined for purposes of the health care continuation rules.

. An employer may designate a common 12-month testing period for plans subject to Sec. 89 nondiscrimination rules. Also, an employer is allowed to test its plans based on the benefits available and provided on a designated day in each year (testing date). However, changes in plan design and elections of highly compensated employees must be taken into account.

. Employers may test discrimination under Sec. 89 on the basis of a statiscally valid random sample that produces at least a 95% level of confidence with a margin of error not greater than 3%.

. New rules increase the range in value between plans that may be considered comparable. For the 80% benefits test, a group of plans is considered comparable if the value of employer-provided coverage for each employee in the plan of lowest value is at least 90% of the value of the highest valued plan. In addition, there is a new comparability rule related to employee contributions. Under this rule, plans are considered comparable if they are available to all employees within the same group on the same terms, and the differential in annual employee cost for each plan is no greater than $100 (indexed).

. In applying the 80% test to small employers (less than 10 employees), phased-in rules regarding treatment of certain part-time employees are provided.

. Employees who separate from service prior to January 1, 1989 generally may be disregarded in applying the nondiscrimination rules to former employees.

. New rules are provided regarding sworn statements and testing family coverage.

. A safe harbor is provided whereby operating units are considered to be in significantly separate geographic areas if they are at least 35 miles apart.

. The written plan requirement of Sec. 89(k) will be satisfied if the required document is completed by the end of the 1989 plan year. Moreover, a separate stand-alone document is not required for each plan; several documents may comprise a "written plan."

. Sec. 89 does not apply to statutory employee benefit plans maintained by a church for church employees.

Highly Compensated Employees

Under complex rules, employers must identify highly compensated employees for several purposes, including testing for discrimination in 401(k) plans and welfare plans. To determine who is a highly compensated employee, the Act provides a simplified elective method for employers who, at all times during the year, maintained significant business activities and employees in at least two significantly separate geographic areas. Eligible employers generally may elect to consider as highly compensated any employee who, during the year or preceding year, was a 5% owner, earned more than $50,000, or was an officer of the employer earning more than $45,000.

Health Care Continuation Coverage

Group health plans are generally required to make health care continuation coverage available for purchase by "qualified beneficiaries." Under present law, the penalty for failing to comply with the health care continuation coverage provisions is a denial of the employer's deductions for group health expenses in the years the failure occurs, and until the failure is corrected. In addition, the employer's highly compensated employees may not exclude from income the value of the employer-provided health care during the time of the failure.

The Act replaces these harsh penalties with a new excise tax, equal to $100 per qualified beneficiary per day during the period of noncompliance. If there is noncompliance with respect to a family with more than one qualified beneficiary, the excise tax is capped at $200 per day for the family. The maximum liability for a taxable year for an employer with violations is the lesser of 10% of the preceding year's total cost for group health plans, or $500,000. For nonemployers liable for violations, the maximum liability for a taxable year is $2 million.

Asset Reversion Excise Tax

The 10% excise tax on asset reversions from terminating defined benefit pension plans has been permanently increased to 15% for reversions received after October 20, 1988. However, the 10% excise tax will continue to apply for terminations for which notices of intent to terminate were provided to employees before October 21, 1988.

The Act also accelerates the time for payment of the excise tax; it must be paid by the end of the month following the month in which the reversion occurs.

Educational Assistance and Group

Legal Services

The exclusion from income for employer-provided educational assistance is restored retroactively and expires for taxable years beginning after December 31, 1988. In addition, for tax years beginning after 1987, the exclusion generally does not apply to graduate level courses.

The exclusion from income for employer-provided group legal services is also restored retroactively and expires for taxable years beginning after December 31, 1988. The exclusion is limited to an annual premium value of $70.

Group-Term Life Insurance

The cost of employer-provided group-term life insurance must be included in wages for FICA tax purposes to the extent it is includible in income for income tax purposes. Under the Act, payments for group- term life insurance provided to individuals who separated from service before January 1, 1989 would generally be excluded from FICA tax.

For purposes of determining the cost of this life insurance, the IRS will revise its tables to include rates for age brackets over age 64, for insurance provided after December 31, 1988.

Minimum Participation Requirements

Beginning in 1989, qualified plans will have to satisfy new minimum participation rules. Plans will have to benefit the lesser of 50 employees or 40% or more of all employees. Comparable plans may not be aggregated to satisfy this requirement. TRA 1986 provided a transitional rule limiting the favorable tax treatment available to highly compensated employees (particularly those maintaining one- participant plans) who terminate their plans because they would not satisfy this new rule.

Under this transitional rule, the amount of a distribution, to a highly compensated employee, that will be eligible for favorable tax treatment (forward averaging or rollover treatment) is generally based on the Pension Benefit Guaranty Corporation (PBGC) interest rate used in valuing lump sum distributions upon plan termination. The amount of the actual distribution is determined using the plan's stated interest rate. The employee (typically an owner-employee or partner) would be taxed under the rules for nonqualified plans on the amount reflecting the difference between these interest rates.

The Act provides relief to highly compensated employees by permitting them to use a lower interest rate to determine the amount of the distribution that will be eligible for lump sum or rollover treatment or that may be transferred to another plan. The interest rate may be the highest of:

. The plan's rate on August 16, 1986;

. The highest rate used under the plan since August 16, 1986 to calculate the accrued benefit of a nonhighly compensated employee; or

. 5%.

The amount of the actual distribution that is not eligible for favorable tax treatment will not be subject to the 10% premature distribution penalty or the 15% excise tax on excess distributions.

Estate Tax on Excess Accumulations

TRA 1986 imposes a 15% excise tax on certain large distributions from tax-favored retirement plans. There is also a 15% estate tax imposed on an individual's "excess accumulations" upon death. A special grandfather rule is provided for individuals whose accrued benefits as of August 1, 1986 equaled or exceeded $562,500. The Act allows a spouse who receives all of a decedent's retirement benefits to elect to not have the estate tax apply and to include these distributions in determining the excise or estate tax on the surviving spouse's distributions.

Excise Tax on Nondeductible

Contributions

Under TRA 1986, contributions to qualified plans that exceed applicable deduction limits result in an annual 10% excise tax until the excess is eliminated. Under the Act, nondeductible contributions made prior to the 1987 tax year are not subject to the excise tax, even if carried forward to the 1988 tax year and subsequent tax years. Carry- forwards from pre-1987 tax years are applied first against the IRC Sec. 404 deduction limit.

The Act further provides that tax-exempt employers will not be subject to the excise tax except to the extent the employer has been subject to unrelated business income tax or has otherwise derived a tax benefit from the qualified plan. This exemption is based on the rationale that a tax-exempt employer has no incentive to use qualified plans for tax- free growth because it could hold the funds directly without incurring current income tax.

Incentive Stock Options (ISOs)

If an executive acquires vested shares pursuant to the exercise of an ISO after December 31, 1987 and in the following year disposes of the shares in a disqualifying disposition, the spread between the fair market value and the option price will be included in alternative minimum taxable (AMT) income in the year of exercise and in regular taxable income (but not in AMT income) in the disposition year. ISO shares subject to SEC insider or other "lapse" restrictions will require recognition of the tax preference at the time the restriction lapses. Disqualifying dispositions of ISO shares acquired on or before December 31, 1987 in a year subsequent to the year of exercise will eliminate the tax preference in the year of exercise.