One of the most commonly used words in the world of taxation is the word "rollover." However, many times when a question about rollovers comes, there is confusion as to the correct answer. The following is a discussion of some of the pertinent areas involving rollovers.

What is a Rollover?

A rollover is a transfer of assets from one retirement plan to another. Such a transfer is generally not recorded as a distribution from the program from which the assets are transferred and is not recorded as a contribution to the program receiving the assets. Thus, the distribution is free of tax, and the contribution is not deductible or subject to any of the various limitations imposed on contributions to retirement plans.

Distributions from Individual Retirement Accounts (IRAs). A taxpayer may withdraw all or part of the assets from one IRA and contribute those assets to one or more other IRAs owned by that taxpayer. The taxpayer is not entitled to a deduction for the contribution of the assets to the second IRA, and no part of that contribution to the second plan is regarded as an excess contribution. A tax-free rollover from an IRA can occur only once in a one-year period which begins on the date of the first distribution. If an earlier rollover distribution was received by an individual within the one-year period ending on the day of the present rollover distribution, the present distribution will be taxable. For tax years beginning after 1983, tax-free rollover treatment is denied for any amount received by an individual from an inherited IRA. However, an IRA received by an individual who is a surviving spouse of the original IRA owner is not an inherited IRA and thus will not be denied tax-free rollover treatment. The direct transfer of assets between IRA trustees (the funds are never distributed to the taxpayer) will not be considered paid or distributed out of an IRA and will not be taxable as gross income to the participant whose account was transferred. Furthermore, such a transfer will not be considered a rollover.

A taxpayer is not required to rollover the entire amount received from an IRA, but the amount not rolled over will be treated as an ordinary distribution, and if the taxpayer is not age 59-1/2, may be treated as a premature distribution.

Distributions from Qualified Plans. A distribution from a qualified pension, profit sharing, stock bonus or annuity plan may be rolled over to an IRA if it is: 1) a qualified total distribution (generally defined as a lump-sum distribution); or 2) a partial distribution--a distribution which satisfied each of the following requirements:

* It must be at least 50% of the entire interest of the participant in the plan immediately before the distribution. In determining an employee's interest it is not necessary that different qualified plans be aggregated.

* It must be made on account of the participant's death or other separation from service or after the participant has become disabled.

* In the case of distributions after March 31, 1988, the distribution must not be one of a series of periodic payments. The committee reports on TAMRA 1988 state that the mere fact that payments to an employee are made in more than one taxable year does not automatically mean that they constitute a series of periodic payments. For example, an employer may make a lump-sum distribution to an employee in one taxable year and discover a calculation error in the following taxable year that requires another distribution. Under these circumstances, the first distribution would be treated as a lump-sum distribution, and the second distribution would be treated as a partial distribution eligible for rollover treatment.

* The participant must elect rollover treatment for the distribution. The spouse of a deceased employee may also make this election.

If a partial distribution from a qualified plan is rolled over to an IRA, two special rules take effect:

1. Any future distribution by that plan will not be eligible for capital gain or averaging treatment even though it otherwise meets the definition of a lump-sum distribution; and

2. If securities of the employer corporation are included in any portion of the distribution that is not rolled over, any unrealized appreciation will be fully includible in the employee's income upon future distribution.

A distribution from a qualified plan may be rolled over to another qualified plan if it is qualified total distribution. If any part of a distribution from a qualified plan that would be eligible for rollover treatment made to the employee is received by the employee's surviving spouse, the spouse may rollover that distribution to an IRA under essentially the same terms and conditions that would have applied to the employee (the spouse may not rollover the amount to a qualified plan). Heirs, legatees, and other successors (other than a surviving spouse) who receive a distribution from a qualified plan are not entitled to rollover that distribution.

Distributions from Keogh Plans. When there is a distribution from a Keogh plan to a self-employed individual or a common-law employee of the entire balance in an account, the distribution can be rolled over into another Keogh plan, a qualified plan or an individual retirement account (other than an endowment contract). When there was a distribution from a Keogh plan to a self-employed individual of the entire balance in an account prior to 1987, and this individual was a 5% owner or a key employee, the distribution generally could not be rolled over to another Keogh or a qualified plan.

What Can Be Rolled Over?

If there is a distribution from a qualified plan, and if the participant or his orher spouse received property other than cash, he or she may sell the property and rollover the proceeds to an IRA or other qualified plan. No gain is recognized on the sale of the property. The property must be sold; you cannot keep the property and rollover an amount equal to that amount which you would have received if you sold the property. Of course, you can sell the property and then repurchase it with non-IRA funds. Also, the property itself can be rolled over. Amounts rolled over, either partially or completely, to an IRA cannot include the individual's nondeductible contributions to the qualified plan. The individual retains these after-tax contributions without paying further tax. A life insurance contract received in a lump-sum distribution from a qualified plan may not be rolled over into an IRA; its value is taxable to the employee. If a plan participant receives a distribution and has a loan outstanding from the plan, he or she must rollover the amount of the loan as well in order to avoid taxation on it.

If a taxpayer receives property other than cash from an IRA, he or she must contribute the same property to another IRA if the transaction is to qualify as a tax-free rollover. It is not permissible for the participant to sell the property and contribute the proceeds.

When Must a Rollover be Made?

The distribution must be contributed to an IRA or another qualified plan within 60 days following the day of its receipt. If there are several distributions within one taxable year which, together, qualify for rollover treatment as a lump-sum distribution, the IRS takes the position that the 60-day period does not begin to run until the last day of the series of distributions is made.

In a recent case, it was ruled that when a distribution is received in year one, and the 60-day period does not end until year two, and the amount is not rolled over within the 60-day period, the distribution is reportable as income in year one.

Miscellaneous Provisions

There are no restrictions on the number of IRAs that can be used to receive a lump-sum distribution. Amounts required to be distributed from a qualified plan, tax-sheltered annuity, or IRA, under the required distribution rules are not eligible for rollover treatment. This insures that an individual will not be able to circumvent the required distribution rules by taking a required distribution at the end of a year and rolling over that distribution before or after the beginning of the next year.

Only those amounts which are distributed from a plan are eligible for tax-free rollover to an IRA. Therefore, payments from an employer, other than a terminated pension plan, which represented the employer's pension obligation under an employment agreement, are not eligible for a tax-free rollover. Amounts received from a qualified plan may be transferred to another qualified plan through an individual retirement account (referred to as "conduit" account). An individual conduit account, however, must have no assets other than those which were previously distributed to the individual from the qualified plan. Also, the new qualified plan must provide for the acceptance of the amounts.

A rollover will be permitted in a year in which the recipient has attained an age exceeding 70-1/2 if annual distributions from the IRA commence by the close of the taxable year of the rollover.

Penalty Tax on Qualified Plan

Reversions

Sec. 1112(e) of TRA 86, made minimum participation requirements more stringent than they had been under prior law. For example, under former rules, the use of separate plans by members of affiliated service groups or controlled groups of entities was permissible as long as the plans did not discriminate and were deemed comparable with respect to benefits. Sec. 111(e) amended Sec. 401(a) to require a new "minimum number of participants" rule Sec. 401(a)(26). All plans must now satisfy this rule on an individual basis. This new provision prevents a plan from being qualified unless it benefits no fewer than the lesser of:

* 50 employees of the employer; or

* 40% or more of all employees of the employer.

Many Opt for Termination

As a consequence of this revised minimum participation rule, many employers have opted for the termination of their plans. They did not wish to face the additional costs of covering substantial numbers of employees under their qualified plans or risk having their plans disqualified. When these plans are terminated, there may be cash and/or property in the plan which, after payment of all benefits to participants or their beneficiaries, will revert to the employer. In general, this cash and/or property is includible in the employer's gross income and is also subject to a 15% non-deductible excise tas see IRC Sec. 4980. For reversions occurring prior to October 22, 1988, the excise tax was 10%. The excise tax must be paid by the employer and is due on the last day of the month following the month in which the reversion occurs.

Several exemptions exist regarding the imposition of the excise tax. One such exemption is provided for in the case of transfers of surplus assets from a defined benefit plan, upon plan termination, to an ESOP. Nevertheless, there are various prerequisites to the application of the ESOP exception which must be satisfied, including the requirement that the reversion occurs after March 31, 1985, and before January 1, 1989, or that it be received after December 31, 1988, as a result of terminations occurring after March 31, 1985, and prior to January 1, 1989.

Another exception which may not be as obvious as the ESOP exception, but may be more significant, is found in Sec. 1112(e)(3)(A) of TRA 86. Pursuant to this provision, the excise tax on reversions is waived under the following conditions:

1. The plan was in existence on August 16, 1986;

2. The plan would fail to satisfy IRC Sec. 401(a)(26) for the plan year including August 16, 1986;

3. There was no transfer of assets to or liabilities from a plan or merger or spinoff involving the plan after August 16, 1986; and

4. The plan terminated or merged before the first day of the plan year in which IRC Sec. 401(a)(26), becomes effective. (Note: Pursuant to proposed regulations under Sec. 401(a)(26) there is a special extension until May 31, 1989 to terminate or merge the plan, which has, by IRS notice been further extended to December 31, 1989.)

Consider Rollover

Generally speaking, Sec. 401(a)(26) applies to plan years beginning after December 31, 1988. Accordingly, with respects to a plan year which begins before December 31, 1988, and ends thereafter, Sec. 1112(e)(3)(A) may still be available to shelter an employer from the imposition of the Sec. 4980 excise tax on reversions. Unfortunately, a similar exemption from the excise tax on early withdrawals IRC Sec. 72 (t) or on excess distributions IRC Sec. 4980A, occasioned by a plan termination, is not available to plan participants or beneficiaries receiving plan distributions on termination. This appears to be the rule in the absence of the passage of a once proposed technical correction to Sec. 1112. Such a technical correction was contemplated, but has not been formally adopted at this time. Nevertheless, under such circumstances, consideration should be given by plan distributees to the rollover privilege, which may be available to avoid the imposition of both excise taxes and income taxes otherwise imposed on plan terminations.

Technical Corrections Act of 1988

May Limit Certain VEBA Funded

Benefits

The Technical Corrections Act of 1988 added Sec. 505(b)(7) to the IRC. This section limits to $200,000 the amount of annual compensation of each employee that can be taken into account to determine certain employee benefits under a qualified Voluntary Employee' Beneficiary Association (VEBA).

A qualified VEBA is an organization which provides for the payment of life, sickness, and accident insurance, or designated payments to beneficiaries see Sec. 501(c)(9). Like other Sec. 501(c) organizations, VEBAs are exempt from federal income taxes if they comply with the various rules established in the IRC.

Many large employers maintain VEBAs to serve as funding vehicles for a variety of employee benefit plans.

Failure to adjust VEBA funded benefit plans to meet the new Sec. 505(b)(7) annual compensation standards could result under Sec. 505(a)(1) in the disqualification of the entire VEBA from its tax-exempt status. However, the Sec. 505(b) nondiscrimination rules only apply to those VEBA funded benefits which are not subject to Sec. 89 nondiscrimination rules.

The most prominent VEBA funded benefit that may have to be restructured to comply with Sec. 505(b)(7) is employee long-term disability coverage, which is specifically exempted under Sec. 89(j)(10) where plan benefits would be includible in gross income when received. Most VEBA funded long-term disability plans are structured in this manner, and therefore are subject to the new Sec. 505(b)(7) employee compensation limitation. A number of insurance carriers are now beginning to offer specialty plans to provide the long-term disability benefits that may be lost by senior executives if VEBA funded plans are restructured to comply with Sec. 505(b)(7).

Restriction On Distributions To

Highly Compensated Employees

In order for a retirement plan to be qualified, it must satisfy a number of requirements enumerated in Sec. 401, one of which is a requirements that the contributions or benefits do not discriminate in favor of the highly compensated group. Sec. 401(a)(4). The regulations indicate that such discrimination could occur if the plan is terminated after providing for substantial benefits to the highly compensated group, but before the rank and file has derived such benefits. Reg. Sec. 1.401-4(c)(1). Unless it is clearly determined that rank and file employees will not be discriminated against by early termination of a plan, the plan must contain provisions which restrict distributions to the highly compensated group. Specifically, if the plan will provide an annual benefit in excess of $1,500 to an employee who is among the 25 highest compensated employees, the distribution of employer contributions used to fund such benefit must be restricted if:

* The plan is terminated within 10 years;

* The benefits of the employee who is among the 25 highest compensated become payable within 10 years of establishing the plan; or

* The benefits of the employee who is among the 25 highest compensated employees become payable after 10 years have elapsed, but the full cost of the plan for the first 10 years has not been funded.

Restriction on Funds Permitted to

be Distributed to a Highly

Compensated Employee

In the event that any of the circumstances requiring restriction apply, the amount of employer contributions permitted to be distributed to a highly compensated employee is not to exceed the greater of $20,000 or 20% of the first $50,000 of annual compensation of the employee multiplied by the number of years for which the plan has been in effect.

Procedures Which Avoid

Restriction on Distributions

The restriction on the amount permitted to be distributed to a highly compensated employee is waived if other precautions are taken to assure compliance with the regulations discussed above. Rev. Rul. 81-135 provides guidance as to the procedure for obtaining assurance that the prohibited discrimination will not occur.

In the ruling, the retiring employee agreed that if: 1) the plan terminates within the 10 year period; or 2) the employer fails to satisfy the funding provisions within the 10 year period, he or his estate would repay the actuarial equivalent of the excess amount that was distributed to him. The distributee guaranteed such repayment by depositing with a depositary property having a value of 125% of the amount which would be repayable if the plan had terminated on the date of the distribution. This amount was to be held on deposit until the distributee's obligation to repay lapsed.

Another method for meeting the requirements of the regulations is for the employee to rollover the distributiom to a restricted Individual Retirement Account with the IRA serving as security for the retiree's repayment obligation. However, if the value of the IRA drops below 11% of the amount potentially required to be repaid, the retiree must establish a backup escrow arrangement as set forth in Rev. Rul. 81-135. (Private Letter Ruling 8850046).

Lump-Sum Treatment Permitted

Rev. Rul. 81-135 further provides that the distribution to the employee constituted a lump-sum distribution qualifying for favorable treatment even though part of the distribution may have to be repaid in the future. It should be noted that although lump-sum treatment does not provide as great a tax benefit as it did in the past, the threshold amount exempt from the excise tax on excess distributions is five times the normal amount. In fact, two threshold amounts are available, one for lump-sum distributions and one for annuity distributions.