Guest Article

(From the February 3, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Rev. Rul. 2003-11, Relating to Using Increased Covered Compensation Limit to Increase Future Benefits for Retirees, Does Not Address Section 401(a)(26) Additional Participation Requirements

(Thanks to Paul Wagenbach of the Washington National Tax Group for preparing this article.)

The Internal Revenue Service ("IRS") recently issued Revenue Ruling 2003-11, which provides that a defined benefit plan may use the Internal Revenue Code ("IRC") § 401(a)(17) limit, as increased by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), to increase future benefits for retirees without violating the nondiscrimination requirements of IRC § 401(a)(4) and the minimum coverage requirements of IRC § 410(b). By applying the increased limit to prior years' compensation, benefits can be significantly increased for retirees whose benefits were previously limited by § 401(a)(17). However, the ruling fails to address IRC § 401(a)(26). Therefore, plan amendments that take advantage of Revenue Ruling 2003-11 could violate IRC § 401(a)(26). Consequently, the potential impact, if any, of IRC § 401(a)(26) must be analyzed and communicated to employers when plan designs take advantage of the increased limit.

Treasury and the IRS National Office are aware of this issue and appear to be sympathetic to providing additional published guidance to alleviate the restriction. However, until such guidance is released, increased benefits must satisfy the rules as promulgated in existing guidance.

EGTRRA and Revenue Ruling 2003-11

Section 611(c) of EGTRRA amended IRC § 401(a)(17) by increasing the amount of compensation that can be considered for certain qualified plan purposes from $150,000 (as adjusted) to $200,000 (as adjusted), and by changing the method used to make cost of living adjustments.

In Revenue Ruling 2003-11, the IRS considered amendments made during 2002 to a qualified defined benefit plan ("Plan A") as a result of EGTRRA's amendment of IRC § 401(a)(17). The amendment provided, inter alia, that the $200,000 compensation limit would be used to determine retirement benefits to be paid after December 31, 2001 to employees who retired on or before December 31, 2001. Essentially, the amendment to Plan A allows for the recalculation of future benefits to retired participants to take into account compensation that could not be considered under the pre-EGTRRA compensation limits. Accordingly, certain retired participants, who previously earned compensation in excess of the former IRC § 401(a)(17) compensation limit, could realize an increase in future benefits.

The ruling illustrates the effect of the amendment of Plan A on Participant B, a former plan participant who retired as of December 31, 2001. Plan A's benefit formula provides an annual benefit at normal retirement age equal to the product of: years of service x 1% x high three year average compensation. As of December 31, 2001, Participant B has 10 years of service and compensation of $250,000 for each of the years 1999, 2000, and 2001. Subsequent to EGTRRA, the IRS issued Notice 2001-56, which allowed a plan that uses annual compensation for periods prior to the first plan year beginning on or after January 1, 2002, to determine accruals or allocations for a plan year beginning on or after January 1, 2002, the plan is permitted to provide that using the $200,000 compensation limit applies to annual compensation for such prior periods in determining such accruals or allocations.

Prior to EGTRRA and the amendment of Plan A, Participant B's high 3-year average compensation was $166,667, determined as the average of annual compensation [as limited by former IRC § 401(a)(17)] of $160,000 for 1999, $170,000 for 2000, and $170,000 for 2001. B's annual benefit under the plan formula as of December 31, 2001, is $16,667, calculated as (10) x (1%) x ($166,667).

Subsequent to EGTRRA and the amendment of Plan A, a high 3-year average compensation of $200,000 is determined for Participant B as of December 31, 2002, as the average of annual compensation [as limited by amended IRC § 401(a)(17)] of $200,000 for 1999, $200,000 for 2000, and $200,000 for 2001. As of December 31, 2002, B's annual benefit under the plan formula is $20,000, calculated as (10) x (1%) x ($200,000). IRC § 401(a)(4) provides that a qualified plan may not discriminate in favor of highly compensated employees with regard to contributions or benefits. A highly compensated employee is defined in IRC § 414(q) as any employee who was a five percent owner at any time during the current or preceding year, or had compensation from the employer in excess of $80,000 (as adjusted, $90,000 for 2003).

Treas. Reg. § 1.401(a)(4)-5(a)(2) provides that the determination of whether the timing of a plan amendment has the effect of discriminating in favor of highly compensated employees or former highly compensated employees is made at the time of the plan amendment based upon all relevant facts and circumstances. Treas. Reg. § 1.401(a)(4)-10 provides that a plan satisfies the nondiscriminatory amount requirement of Treas. Reg. § 1.401(a)(4)- 1(b)(2) with respect to former employees (generally in the form of an amendment) if, under all the relevant facts and circumstances, the amount of contributions or benefits provided to former employees does not discriminate significantly in favor of former highly compensated employees.

IRC § 410(b) imposes minimum coverage requirements on qualified plans. Pursuant to Treas. Reg. § 1.410(b)-2(c), a plan satisfies IRC § 410(b) with respect to former employees if under all of the relevant facts and circumstances the group of employees benefiting does not discriminate significantly in favor of highly compensated former employees. Revenue Ruling 2003-11 concludes that based on all of the relevant facts and circumstances, the amendment of Plan A satisfies the nondiscrimination requirements of IRC § 401(a)(4) and the minimum coverage requirements of IRC § 410(b).

Essentially, via revenue Ruling 2003-11, it appears that the IRS intended to provide a bright line rule condoning the amendment of defined benefit plans to allow such plans to use the increased IRC § 401(a)(17) limit to determine retirement benefits to be paid after December 31, 2001 to employees who retired on or before December 31, 2001. However, Revenue Ruling 2003-11 is silent with respect to IRC § 401(a)(26).

IRC § 401(a)(26)

IRC § 401(a)(26) provides that a qualified defined benefit plan must benefit the lesser of (i) 50 employees or (ii) the greater of 40% of all employees or 2 employees. If, for example, an amendment to a qualified defined plan, as described in Revenue Ruling 2003- 11, only increases the future benefits of ten employees, and the employer has 1000 employees, such amendment violates IRC § 401(a)(26).

Treas. Reg. § 1.401(a)(26)-4, which generally applies to any defined benefit plan that benefits former employees in a plan year within the meaning of Treas. Reg. § 1.401(a)(26)- 5(b), sets forth two rules governing the testing of former employees for compliance with IRC § 401(a)(26). Generally, a defined benefit plan must benefit the lesser of 50 former employees or 40 percent of former employees. Treas. Reg. § 1.401(a)(26)-4(b). A special rule provides that a plan will satisfy the minimum participation rule if the plan benefits at least five former employees and if either: (1) more than 95% of all former employees with vested accrued benefits under the plan benefit for the plan year or (2) at least 60% of the former employees who benefit under the plan for the plan year are nonhighly compensated employees. Treas. Reg. § 1.401(a)(26)-4(c).

Treas. Reg. § 1.401(a)(26)-5(b) provides that a former employee is treated as benefiting for a plan year if and only if the former employee would be treated as benefiting under the rules in § 1.410(b)-3(b). Under Treas. Reg. § 1.410(b)-3(b)(1), a former employee is treated as benefiting for a plan year if and only if the plan provides an allocation or benefit increase described in paragraph (a)(1) of this section to the former employee for the plan year. Thus, for example, a former employee benefits under a defined benefit plan for a plan year if the plan is amended to provide an ad hoc cost-of-living adjustment in the former employee's benefits.

Treas. Reg. § 1.410(b)-3(a)(1) provides that in the case of a defined benefit plan, an employee is treated as benefiting under a plan for a plan year if the employee has an increase in a benefit accrued or treated as accrued under IRC § 411(d)(6). IRC § 411(d)(6) prohibits the reduction of participants' accrued benefits, including the elimination or reduction of early retirement benefits or retirement-type subsidies or the elimination of optional forms of benefits, by plan amendment.

An argument has been advanced that a defined benefit plan under which at least 50 former employees or 40% of all former employees have vested benefits, regardless of when those benefits accrued, is sufficient to satisfy Treas. Reg. § 1.401(a)(26)-4(b), and therefore IRC § 401(a)(26). This argument is premised on the fact that Treas. Reg. § 1.401(a)(26)-4(b) requires that the plan merely "benefit" former employees while Treas. Reg. § 1.401(a)(26)- 4(c) requires that former employees "benefit under the plan for the plan year." According to this argument, if at least 50 former employees (or 40 percent of all former employees) have vested benefits, those former employees benefit under the plan and IRC § 401(a)(26) is satisfied.

However, Treas. Reg. § 1.401(a)(26)-4(a) explicitly states that such section "applies to any defined benefit plan that benefits former employees in a plan year within the meaning of Treas. Reg. § 1.401(a)(26)-5(b)." [Emphasis added.] Moreover, Treas. Reg. § 1.401(a)(26)-5(b) defines "benefiting for a plan year" by reference to Treas. Reg. § 1.410(b)-(3)(b), which too contains the "benefiting for a plan year" concept. Therefore, such an argument, although credible and based upon an inconsistency in the regulations, does not resolve the issue. /1/

/1/ Nonetheless, all former employees may benefit for a plan year by adding a modest ad hoc cost-of-living increase for all former employees.

Moreover, informal discussions with IRS personnel indicate that absent additional guidance a plan amendment described in Revenue Ruling 2003-11 would violate IRC § 401(a)(26) if less than 50 former employees or 40% of former employees did not receive an increase in future benefits. Therefore, the only certain way to avoid this potential issue is for the IRS to publish additional guidance.

The Proposed Solution

Deloitte employee benefits specialists are currently drafting a suggested approach to be submitted to the IRS. We expect the IRS to issue corrective guidance. The suggested approach is based, in part, upon the legislative history of IRC § 401(a)(26). In particular, it is based upon the legislative history of the Tax Reform Act of 1986, which added IRC § 401(a)(26).

This legislative history clearly indicates that Congress enacted IRC § 401(a)(26) to ease the administrative burden associated with analyzing and monitoring compliance with the nondiscrimination requirements of IRC § 401(a)(4). See infra. Because Revenue Rule 2003-11 explicitly provides that a defined benefit plan may use an increased IRC § 401(a)(17) limit to increase future benefits for retirees without violating the nondiscrimination requirements of IRC § 401(a)(4), the purpose of, and need to comply with IRC § 401(a)(26), is made unnecessary. Therefore, whether one or fifty former employees receive a benefit from an amendment described in Revenue Ruling 2003-11, no issues exist with respect to the nondiscrimination requirements of IRC § 401(a)(4).

The legislative history provides, in pertinent, part:

Congress believed that it was inappropriate to permit an employer to maintain multiple plans, each of which covered a very small number of employees. Although plans that are aggregated are required to satisfy comparability requirements with respect to the amount of contributions, such an arrangement may still discriminate in favor of the prohibited group. Differences in the rates at which benefits are accrued (e.g., presence or absence of past service credit) and the selective use of actuarial assumptions in valuing plan benefits may cause a plan that satisfies the requirement of comparability with respect to the amount of contributions or benefits to favor the highly paid. Similarly, in the case of plans that are comparable with respect to the amount of contributions or benefits, discrimination in favor of the highly paid may occur because disparate funding levels and benefit options are not taken into account for purposes of comparability analysis.

Although such arrangements were vulnerable to challenge as discriminatory under prior law, Congress was concerned that because of the large number of these arrangements, the inherent complexity of comparability analysis, and the difficulties in discovering all differences in funding levels and benefit options, the IRS lacked sufficient resources to monitor compliance with the nondiscrimination standards by small aggregated plans. Accordingly, the Act establishes a new "minimum number of participants" rule that must be satisfied by all plans on an individual basis. [Emphasis added.] General Explanation of the Tax Reform Act of 1986, JCS-10-87, May 4, 1987; S. Rep. No. 99-313, 99th Cong. 2d Sess. § 1212 (May 29, 1986).

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.