Employee Benefits, Employment Law and Estate Planning Update

Sanders, Schnabel, Brandenburg & Zimmerman, P.C.

---

Volume XII, Number 4, December 1997

---

YEAR END GIFT PLANNING

As the year end approaches, everyone is reminded to consider year end gifts to children, grandchildren and any other objects of bounty or affection. Annual gift giving is an important, integral part of estate planning because the amount of the gift is removed from the gift givers estate without tax cost. An individual may give up to $10,000 to any one other individual in any one calendar year without filing a gift tax return or using up a portion of his or her $600,000 unified credit exemption equivalent or $1,000,000 generation- skipping transfer tax exemption. (Beginning in 1998, the $600,000 will increase gradually to $1,000,000 in 2006.) If a gift is by check it must be dated and delivered or mailed to the donee on or before December 31st, and if it is a gift of anything else, delivery must be completed by that same date. However, before one starts to write that $10,000 check to his or her favorite grandchild, keep in mind that other gifts during the year, including non-cash gifts, such as for a birthday, wedding, or other special event (or no reason at all), also count against the $10,000 limit.

Husband and wife may give up to $20,000 each calendar year, but in order to use this provision, they both must elect to split gifts and that election must be made on a timely filed Gift Tax Return (IRS Form 709) for each spouse. Gift Tax Returns are due on April 15th, the same as income tax returns. Of course, a husband may make a $10,000 gift from his own separate property and his wife a separate $10,000 gift from her own property, but this approach may interfere with other estate and gift planning. Therefore, the split gift technique is usually simpler. Year end charitable gifts not only remove the amount of the gift from the estate, but also generate an income tax deduction. One may also wish to consider making gifts using up a portion of his or her $600,000 lifetime unified credit exemption, thus removing future appreciation on the gift from the estate.

Gifts must also be of a present interest to obtain full benefit of the exclusion for the full amount of the gift. In other words, the gift cannot be in trust, with certain exceptions for gifts to minors which the minor must have an absolute right to obtain at or before age 21.

Beginning in 1999, the $10,000 exclusion will be adjusted for inflation. Begin planning now for year end gifts and if one wants to make a Happy New Year gift, remember that January 1st starts a new year and a new $10,000 exclusion. William H. Bradford, Jr.

INVOLUNTARY CASH-OUT LIMIT INCREASED TO $5,000

Under the Taxpayer Relief Act of 1997, signed into law by President Clinton on August 5, 1997, a qualified plan may increase the involuntary cash-out limit from $3,500 to $5,000. This new elective limit is effective for plan years beginning after August 5, 1997. The IRS has unofficially indicated that the increase in the limit will apply in a similar manner as did the increase in the limit from $1,750 to $3,500 in 1985.

IRS regulations require that if a participant's benefit at the time of any distribution exceeded the limit, a subsequent distribution is treated as if it exceeded the limit, regardless of amount. In other words, the participant should be notified of any choices of forms of payment or spousal consent rules under the plan that would apply for amounts in excess of the cash-out limit. The participant alternatively may elect to leave his benefit in the plan. For example, if a participant had an account balance in a defined contribution plan of $6,000, received a termination distribution of the entire $6,000, and subsequently received an employer contribution for his final year of employment of $3,000, the distribution of the final contribution would be subject to the same rules as the initial distribution. Therefore, the participant could elect to leave the $3,000 in the plan. It would appear that, if a participant received a distribution in excess of the $3,500 limit in a plan year beginning before August 5, 1997, any subsequent distribution (after the $5,000 limit is in effect) would be subject to the elective distribution rules rather than the involuntary cash-out rules.

Plan sponsors may prefer to amend their plan to include the new $5,000 involuntary cash-out limit before implementing the new limit. Under IRS rules, a design change such as this change may be adopted at any time before the end of the plan year for which it is first effective. David Weingarten

RETIREMENT DISTRIBUTIONS AT AGE 70-1/2 FOR ACTIVE EMPLOYEES: CONSIDERATIONS FOR PLAN SPONSORS

As we previously reported (see March 1997 issue), the Small Business Job Protection Act of 1996 ("Small Business Act") amended Section 401(a)(9) of the Internal Revenue Code ("Code"), effective January 1, 1997, to provide that the distributions to a participant (other than a 5% owner) in a qualified retirement plan must begin no later than April 1 of the calendar year following the later of the calendar year in which the participant attains age 70-1/2 or retires. Previously, the required beginning date applied even if the participant was still employed by the plan sponsor and even if the plan otherwise did not provide for in-service distributions. The required beginning date for 5% owners is the same as under prior law.

This change in the law poses several significant design and operational compliance questions for plan sponsors. The Internal Revenue Service ("IRS") has provided guidance that offers some, but not all, of the answers to these questions and has promised more complete guidance. The following is a discussion of these questions and most of the IRS guidance that has been issued to date. IRS Notice 97-75 was issued December 9, 1997, as this newsletter was going to press. We have highlighted below some of the more important guidance set forth in this Notice, and will publish a follow-up article discussing the remaining guidance, including guidance regarding: (a) the actuarial increase that must be provided under a defined benefit plan for an employee who retires after age 70-1/2, (b) whether a pre-retirement age 70-1/2 distribution that is available only to 5% owners violates the nondiscriminatory current and effective availability requirements under the rules under Section 401(a)(4) of the Code, and (c) the notice and spousal consent requirements applicable to certain plans, by law or plan terms, that allow participants who are currently in pay status to elect to stop their distributions until after retirement. Please contact us if you would like to discuss how any of these issues apply to your qualified plan. We will keep you apprised of further IRS guidance as it is issued.

Question: To what extent may a plan eliminate by amendment the right of a participant to commence his or her distribution under the plan prior to retirement?

Answer: It depends on whether the amendment would violate the anti-cutback rules of Section 411(d)(6) of the Code, as discussed below. In general, we are recommending that plan sponsors wait to amend their plans until further guidance is issued.

There are circumstances under which no relief from the anti-cutback requirements is necessary in order for certain plan sponsors to amend their plans to implement the change in the law:

1. A defined contribution plan that provides for pre- retirement distributions under its general distribution provisions (e.g., a plan that permits in- service withdrawals at age 59-1/2) already encompasses a pre-retirement distribution at age 70-1/2, and may be amended to eliminate the pre- retirement distribution without meeting the special requirements of the proposed Regulations.

2. A plan sponsor may amend its plan, without complying with the proposed Regulations, to eliminate the right to pre-retirement distributions after age 70-1/2 with regard to benefits earned after the date of the amendment, but participants must still have the right to receive pre-retirement distributions after age 70-1/2 for the portion of their accrued benefits earned before the date of the amendment.

Under recently-issued proposed Regulations, relief is granted from the anti-cutback requirements of Section 411(d)(6) of the Code for an amendment to a plan to eliminate pre- retirement distributions at age 70-1/2, so long as:

1. The amendment applies only to participants who attain age 70-1/2 in or after a calendar year that begins after the later of December 31, 1998, or the adoption date of the amendment. Therefore, there will be a right for participants who are still employed to receive initial minimum required distributions as late as April 1, 1999 under the special deferral rule for a participant's first post-70-1/2 distribution;

2. The plan does not preclude a participant who retires after the calendar year in which he or she attains age 70-1/2 from receiving benefits in the same optional forms of benefit that would have been available had the participant retired in the calendar year in which he or she attains age 70-1/2; and

3. The amendment is adopted no later than the last day of the remedial amendment period (the period during which amendments may timely be made) that applies to the plan for changes under the Small Business Act.

Please note that the proposed Regulations may not be relied upon until after the date that final Regulations are issued. This limitation is unique. Plan sponsors should, therefore, wait until final Regulations are issued before amending their plans. IRS has indicated that it intends to finalize the proposed Regulations on an expedited schedule. A plan may, on the other hand, continue to maintain under the terms of the plan the current rules requiring distributions to commence by April 1 following the calendar year in which the participant attains age 70-1/2 for all participants. IRS Notice 97-75, however, makes clear that the participant's required beginning date will be as provided under new law (i.e., April 1 of the year following the year of retirement) for purposes of the excise tax for failure to distribute required minimums under Section 4974 of the Code and for determining whether the distribution is an eligible rollover distribution. Therefore, no excise tax under Section 4874 of the Code will apply prior to the calendar year in which a participant retires, and whether the distribution is an eligible rollover distribution is determined as described below (under the Q&A regarding the withholding rules).

Question: To what extent may a plan, which currently requires that distributions begin at age 70-1/2, permit a participant who is not a 5% owner to defer commencement of his or her distributions until after retirement, without the plan first being amended?

Answer: A plan may, without first being amended, permit a participant to defer commencement of his or her distributions until after retirement, as discussed below. In general, we are recommending that defined benefit plans continue to pay out participants as under prior law and that defined contribution plans with an in-service withdrawal right permit a participant to elect whether to defer commencement of his or her distributions.

IRS Announcement 97-24, issued earlier this year, provides that, prior to amendment, a plan sponsor (including an adopter of a master or prototype or regional prototype plan) may offer a participant (other than a 5% owner) who attains age 70-1/2 in a calendar year after 1995, and who does not retire by the end of that calendar year, the election to delay commencement of distributions until after the participant retires. Under IRS Announcement 97-70, a plan will not fail to meet the qualification requirements of the Code merely because it fails to make distributions between August 20, 1996 and December 31, 1997 that are required to be made under plan terms that are consistent with old law. This relief is available only if the participant: (1) is offered an option to defer the distribution, and (2) elects to defer the distribution, or is paid a make-up distribution including all of the distributions required by the plan terms up to that date, by December 31, 1997. However, please note that plans do not need to provide this election to a "grandfathered" participant who turned 70-1/2 prior to 1988. (These individuals would be at least 80-1/2 years of age by the end of 1997.) IRS has indicated that future guidance will provide that a plan sponsor, including an adopter of a master or prototype or regional prototype plan, that offers this election must amend its plan retroactively.

Question: To what extent may a plan permit a participant who began minimum required distributions before the effective date of the Small Business Act, and who is still employed by the plan sponsor, to elect to stop receiving those distributions until after retirement?

Answer: Plans may, under certain circumstances, permit participants who are not 5% owners and are currently in pay status to elect to stop receiving their distributions.

The legislative history indicates that Congress intends that a plan may, but is not required to, permit participants (other than 5% owners) who already have begun to receive distributions to stop receiving distributions until after they retire. In IRS Notice 97- 75, the IRS indicates that participants may elect affirmatively at any time to stop receiving distributions. If the plan is required by law or under the terms of the plan to obtain spousal consent to a distribution, IRS Notice 97-75 provides two safe harbor methods that the plan may use to comply with the rules regarding notice and spousal consent in permitting a participant to elect to stop receiving distributions. These methods will be discussed as part of a subsequent article.

Question: How do the withholding rules apply?

Answer: The withholding rules apply as provided below.

Distributions made in 1997, and thereafter, to a participant (other than a 5% owner) who has attained age 70-1/2, and who is still employed by the plan sponsor, are considered eligible rollover distributions and, therefore, subject to mandatory 20% withholding, so long as the distributions are not considered installment payments made over a period of 10 or more years. IRS Notice 97-75 provides a transitional rule for pre-retirement distributions made in 1997 that are eligible rollover distributions: a plan will not be considered to have a qualification defect in connection with such a distribution because the participant was not provided with a direct rollover option or the Special Tax Notice, or because the distribution was not subject to 20% mandatory withholding. The transition rule does not, however, extend relief to a plan that does not provide for elective withholding in connection with pre-retirement distributions made in 1997 that are not eligible rollover distributions.

Notice 97-75 indicates that any distributions that are calculated as minimum required distributions under the regulations under Section 401(a)(9) of the Code, and that are being distributed in a series of payments that would be equal to the required minimum distribution amount, are considered to be installment payments made over a period of 10 or more years and not eligible rollover distributions. Therefore, these distributions are subject to elective withholding, as under prior law.

Distributions to a 5% owner or to a participant who has attained age 70-1/2 and is retired are subject to elective withholding as under prior law because they are still minimum required distributions. Cheryl Risley Hughes

NEW 401(k)/401(m) PLAN NON-DISCRIMINATION TESTING RULES FOR 1997

As the time for year-end non-discrimination testing of 401(k)/401(m) plans approaches, please remember the new testing rules in effect for the 1997 plan year. Generally, the nondiscrimination tests of Sections 401(k) and 401(m) of the Internal Revenue Code ("Code") require the comparison of the actual deferral percentage ("ADP") and the actual contribution percentage ("ACP") of non-highly compensated employees ("NHCEs") to the ADP and ACP of highly compensated employees ("HCEs"). Prior to 1997, current year data was required to determine the ADP and ACP for both the NHCEs and HCEs. The Small Business Job Protection Act of 1996 ("Small Business Act"') amended Code Sections 401(k)(3)(A) and 401(m)(2)(A) to allow the use of prior year data to determine the ADP and ACP of NHCEs and current year data to determine the ADP and ACP of HCES. Simply put, the Code now allows the comparison of the actual figures for the ADP and ACP of the NHCEs from the prior year to the ADP and ACP of HCEs calculated for the current year. The use of data from the prior year for the ADP and ACP of the NHCEs facilitates periodic testing during the current plan year, so that plans can take necessary steps to ensure that they will pass the non-discrimination tests at the end of the plan year.

As an alternative to using prior year data, employers may still use current year data to determine the ADP and ACP for both the NHCEs and HCES. However, the employer must use current year data for all subsequent plan years unless the employer amends the plan or makes a formal election to use prior year data. Transition relief is provided to those employers using current year data to determine the ADP and ACP of both the NHCEs and HCEs for the 1997 plan year. Such employers may elect to use prior year data for the 1998 plan year without receiving approval from the Internal Revenue Service ("IRS").

Use of prior year data has the peculiar effect, as a result of the change in the definition of HCE effective January 1, 1997 (see November 1997 issue), of excluding from testing altogether an individual who was an HCE in 1996 but made less than $80,000. Such an individual will not be counted as an NHCE for employers using 1996 data and will not be counted as an HCE for 1997 under the new definition of HCE.

In addition to providing new non-discrimination testing rules, the Small Business Act amended Code Sections 401(k)(8) and 401(m)(6) to provide new procedures for correcting a plan's failure to satisfy the non-discrimination tests. Excess contributions and excess aggregate contributions are determined in the usual manner. Refunds of excess amounts, however, are now based upon dollar amounts rather than percentages. We are fully prepared to assist clients with satisfying these requirements. Stacey A. Bradford

IRS EXTENDS APRSC CORRECTION PERIOD

The Internal Revenue Service's ("IRS") Administrative Policy Regarding Self-Correction ("APRSC"), as established earlier this year (see March 1997 issue), permits plan sponsors that detect an operational violation or defect in a qualified retirement plan to correct the problem within one year following the plan year in which it occurred.

IRS has just announced that, because of the success of APRSC, it is extending the self-correction period from one year to two years following the year in which the operational defect or violation occurred. It is not clear whether the new two-year correction period will apply retroactively for violations that occurred in 1996, which would give plan sponsors until the end of the 1998 plan year to make corrections. Additional guidance providing clarification of such issues as the timing of correction is expected to be issued in the near future. IRS also expects to issue in 1998 a consolidated guide to all its compliance programs (i.e., APRSC, the Closing Agreement Program ("CAP"), the Standardized and the regular Voluntary Compliance Programs ("SVP" and "VCR", respectively), and the Voluntary Closing Agreement Program ("Walk-in CAP"). Pamela Hobbs

EMPLOYERS MUST REPORT NEW HIRES

Effective July 1, 1997, employers are required to report to their state specific information about new hires. The Federal Personal Responsibility and Work Opportunity Reconciliation Act of 1996 requires each state to set up a "State Directory of New Hires" by October 1, 1997. The information in the Directory will provide a means by which to locate employees who are violating child support orders, and to verify eligibility for state assistance programs such as Medicaid, Social Security, and unemployment compensation. Each employer must provide the name, address and social security number of each new employee, as well as the employer's name, address and tax identification number (some states require additional information, such as salary or wage information) to the state in which the employer is based regardless of where the employee works or lives. Multi-state employers that report electronically or magnetically may report to a single state as long as they notify the Secretary of the Department of Health and Human Services which state they have chosen. The new-hire information must be provided within 20 days of the date of hire. Employers that report electronically or magnetically must submit new-hire information twice per month not less than 12 days and not more than 16 days apart.

Maryland employers can submit the "Maryland New Hire Registry Reporting Form" by first class mail or electronically to LMIMS.BA@IX.netcom.com. The information can also be submitted over the telephone by calling (888) MDHIRES or (410) 347-9911. Virginia employers may simply mail a copy of the new employee's W-4 form to the state or transmit the information by magnetic tape. The District of Columbia is in the process of enacting legislation making reporting of new hires mandatory but, in the meantime, has requested that employers voluntarily comply by submitting the D.C. New Hire Registry Reporting Form or W-4 by mail, fax or telephone to the D.C. New Hire Registry. The address for mailing information is District of Columbia New Hire Registry, P.O. Box 97236, Washington, DC 20090- 7236. The fax number is 1-888-689-6089. The District of Columbia also has a Help Desk reachable at 1-888- 689-6088. Employers in other states should contact the state agency responsible for tracking down parents who are delinquent with their child support payments for more information on their state's registry requirements. Our firm can assist with checking these requirements. Stacey A. Bradford

RECENT GUIDANCE REGARDING CHANGES OF ELECTION UNDER CAFETERIA PLANS

The Internal Revenue Service ("IRS") recently issued guidance clarifying when a participant in a cafeteria plan under Section 125 of the Internal Revenue Code ("Code") may change his or her election during the plan year. The recent guidance sets forth new "change in status" rules for accident and health plans and group term life insurance, and maintains the existing "change in family status" rules for other qualified cafeteria plan benefits, such as dependent care flexible spending accounts. The guidance also sets forth several other new rules under which a cafeteria plan is permitted to allow mid-year changes in election for accident and health or group term life insurance benefits. This article discusses the new rules.

Sponsors of cafeteria plans offering an accident and health plan (including a medical flexible spending account) or group term life insurance should consider whether to adopt the new change in election rules. The guidance was issued in the form of temporary and proposed Regulations that are effective for plan years beginning after December 31, 1998. In the interim, plan sponsors may rely on either the new rules or the existing rules. For the 1999 plan year, however, cafeteria plans will be required to use the new rules.

Generally, the new temporary Regulations require that a participant in a cafeteria plan have a "change in status event," and that the change in election be "consistent" with the change in status, in order for the participant to make a mid-year change to his or her election for accident and health or group term life insurance benefits. Under the existing change in family status rules, it is not clear that a change in election must be consistent with the change in family status event. Furthermore, the existing change in family status rules set forth a list of examples of acceptable changes in family status, and permit the plan to give the Plan Administrator some flexibility to determine if other unrelated events qualify. The temporary Regulations, on the other hand, provide an exclusive list of six categories of change in status events (although it is our understanding from one of the drafters of the temporary Regulations that some of the change in status events within the six categories below are meant to be "expandable" to cover other related events). The new change in status events are:

1. Change in Legal Marital Status - including marriage, death of a spouse, divorce, legal separation or annulment.

2. Change in Number of Dependents - including birth, adoption, placement for adoption or death of a dependent.

3. Change in Employment Status - termination or commencement of employment by the employee, spouse or dependent.

4. Change in Work Schedule - a reduction or increase in hours of employment of employee, spouse or dependent, including a switch between part-time and full-time, a strike or lockout, or commencement or return from an unpaid leave of absence.

5. Dependent Satisfies or Ceases to Satisfy Requirements to be a Dependent - due to attainment of age, student status or any similar circumstances as provided under the underlying accident and health plan.

6. Change in Residence or Worksite - of the employee, spouse or dependent.

It is our understanding that only the Change in Legal Marital Status, Change in Number of Dependents and Change in Work Schedule events are intended to be read as "expandable" to cover other related events.

Where a participant has one of the six change in status events occur, the participant also must meet the applicable consistency rule in order to change his or her election. The temporary Regulations provide a consistency rule for accident and health plans and a similar consistency rule for group term life insurance:

1. Consistency Rule for Accident and Health Plans - A participant's change of an accident and health election is consistent with the change in status only if:

   a. The change in status results in the participant, spouse or dependent "gaining or losing eligibility" for accident and health coverage (or a benefit package option) under the cafeteria plan or an accident and health plan of the spouse's or dependent's employer. Additionally, if the change in status results in the participant, spouse or dependent gaining eligibility for coverage under the spouse's or dependent's accident of health plan, the individual actually elects coverage under that plan; and

   b. The election change corresponds with the gain or loss of coverage.

   The temporary Regulations provide an exception to the consistency rule for accident and health plans where the participant, spouse or dependent becomes eligible for COBRA continuation coverage. In that case, the participant may elect to increase his or her election under a cafeteria plan in order to pay for COBRA continuation coverage without regard to the consistency rule.

2. Consistency Rule for Group Term Life Insurance - Under the temporary Regulations, the consistency rule used for accident and health plans also applies to group term life insurance, except that:

   a. A cafeteria plan may permit an increase in coverage only in the case of marriage, birth, adoption or placement for adoption; and

   b. A cafeteria plan may permit a reduction in coverage only in the case of divorce, legal separation, annulment or death of a spouse or dependent.

The temporary Regulations also permit a cafeteria plan to allow a participant to change his or her election with regard to an accident or health plan to comply with the special enrollment rights granted by the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"), which generally will overlap with one or more of the change in status rules. Pursuant to the temporary Regulations, a cafeteria plan may be amended to allow a participant who exercises his or her right under HIPAA to enroll in his or her employer's group health plan or to add coverage (including retroactive coverage) for a spouse or dependent to make a conforming change under the cafeteria plan in order to pay for his or her share of the premiums for that coverage on a pre-tax basis. Under HIPAA, an employee may enroll in his or her employer's group health plan after his or her initial eligibility if, among other requirements, the employee states in writing upon declining to enroll in the group health plan that coverage under another group health plan or other health insurance coverage was his or her reason for declining to enroll in the plan, provided that the plan required such a statement when the participant declined enrollment. Therefore, if a group health plan is offered as a benefit under a cafeteria plan, plan sponsors also should consider whether to require that each employee state in writing when he or she initially declines enrollment that coverage under another group health plan or other health insurance coverage was his or her reason for declining enrollment.

Additionally, the temporary Regulations provide that a cafeteria plan may change a participant's elections mid-year to comply with a judgment, decree or order (including a Qualified Medical Child Support Order under Section 609 of ERISA) that requires accident or health coverage for the participant's child, or may permit a participant to make an election change to cancel accident or health coverage for the participant's child to comply with a judgement, decree or order that requires the participant's former spouse to provide coverage. Finally, a cafeteria plan may permit a participant, spouse or dependent who is enrolled in an accident and health plan of the employer who becomes entitled to Medicare or Medicaid to make an election change under the cafeteria plan to cancel coverage under the accident and health plan.

Although cafeteria plans are not required to follow the new change of election rules until the 1999 plan year, it is not too early to review your company's cafeteria plan to determine whether it should be amended to incorporate the new rules. Cheryl Risley Hughes

NEW LAW CHANGES REGARDING SECTION 457 PLANS

The Small Business Job Protection Act of 1996 ("Small Business Act") contained several provisions that affect section 457 plans. A brief description of these changes follows.

Deferral Limit Increased. The Internal Revenue Service recently announced that, effective January 1, 1998, the annual dollar limit on deferrals under section 457(b) plans (i.e., deferred compensation plans of tax-exempt organizations or state or local governments) will increase from $7,500 to $8,000. This increase is the result of a change in the law made by the Small Business Act, which, for tax years beginning after December 31, 1996, made the $7,500 per year limit on deferrals subject to a cost of living index, with adjustments to the dollar limit to be made in $500 increments. The $500 increase in 1998 represents the first increase under this new cost of living index.

Coordination with 401(k) Plans. The Small Business Act made a number of other changes affecting tax-exempt organizations. Under the Small Business Act, tax-exempt organizations may once again establish and maintain 401(k) plans, effective for plan years beginning after December 31, 1996. Given that the current section 457(b) limit of $7,500 ($8,000 beginning January 1, 1998) and the current section 401(k) limit of $9,500 ($10,000 beginning January 1, 1998) must be coordinated, executives in tax-exempt organizations may have to choose between continuing to defer compensation under a section 457(b) plan or making section 401(k) deferrals in the event the organization chooses to establish a section 401(k) plan. We would be pleased to assist tax-exempt organizations in dealing with these issues.

In-Service Distributions. The Small Business Act also changed the rules regarding the timing of distributions under section 457(b) plans. The Small Business Act permits an employer to distribute to participants as in-service distributions accounts that do not exceed $3,500, but only if: (1) no amount has been deferred under the plan with respect to that participant during the two-year period ending on the date of the distribution; and (2) there has been no prior distribution under the plan to that participant. (For plan years beginning after August 5, 1997, the Taxpayer Relief Act of 1997 has increased the $3,500 amount to $5,000). This change by the Small Business Act represents an exception to the general rule that amounts deferred under a section 457(b) plan may not be distributed to a participant before the earlier of : (a) the calendar year in which the participant attains age 70 1/2; (b) when the participant is separated from service with the employer; or (c) when the participant is faced with an unforeseeable emergency.

Deferrals of Distributions. The Small Business Act also changed the rules regarding the extent to which a participant in a section 457(b) plan can defer the commencement of distributions from the plan without such amounts being considered to have been "made available" to the participant. Generally speaking, amounts deferred under a section 457(b) plan are includible in the gross income of a participant in the tax year in which the amounts are paid or otherwise "made available" to the participant. However, under an exception to this rule, as modified by the Small Business Act, a participant under a section 457(b) plan will be able to elect to defer the commencement of distributions under the plan, without such amounts being considered to have been made available to the participant, provided that: (1) the election is made after amounts may be distributed under the plan, but before the actual commencement of benefits; and (2) the participant may only make one such election. Prior to the passage of the Small Business Act, this exception was not nearly as generous, merely providing that if the total amount payable to a participant under the plan did not exceed $3,500 and no additional amounts could be deferred under the plan with respect to the participant, the amount payable to the participant under the plan would not treated as "made available" merely because the participant had the right to elect to receive a lump sum payable after separation from service and within 60 days of the election.

Trust Requirement for Governmental Plans. Finally, in addition to the changes described above, the Small Business Act imposed a trust requirement on section 457(b) plans maintained by a state or local government employer, under which all of the assets of the plan must be held in trust for the exclusive benefit of participants and their beneficiaries. (For governmental plans in existence on August 20, 1996, a trust does not have to be established before January 1, 1999). This trust requirement, however, does not apply to section 457 plans sponsored by tax-exempt organizations.

Due to the changes in the law discussed above, now is an opportune time for tax-exempt organizations to review their deferred compensation programs to determine whether any changes are needed or beneficial, and also to evaluate whether a section 401(k) plan (or a section 403(b) plan) would meet their needs better than their current section 457 plans. Our firm assists clients in resolving these issues. Mark B. Wychulis

---

Copyright 1997 Sanders, Schnabel, Brandenburg & Zimmerman, P.C.

Sanders, Schnabel, Brandenburg & Zimmerman, P.C.
900 Seventeenth Street, N.W.
Suite 900
Washington, D.C. 20006-2501
(202) 638-2241
Telecopier: (202) 293-3419 Email: ssbz@ssbz.com