LEGISLATIVE UPDATE PRESENTATION

SEPTEMBER 14, 2005

PROPOSED 415 REGULATIONS, FINAL 401(k) REGULATIONS,

PROPOSED ROTH 401(k) REGULATIONS,

STAGGERED IRS DETERMINATION LETTER PROGRAM, AND

REGULATIONS ON ELIMINATING OPTIONAL

FORMS OF BENEFIT IN DB PLANS

PROPOSED 415 REGULATIONS

On May 25, 2005, the Internal Revenue Service ("IRS") issued proposed regulations under Section 415 of the Code, which governs the maximum amounts contributed/accrued under qualified plans and other arrangements (e.g., Section 403(b) plans, SEPs, etc.). The proposed regulations reflect guidance issued by the IRS in various formats since the current regulations were issued in 1981. The proposed regulations include some new provisions (which new provisions, if the proposed regulations are finalized, will represent a change in the law). On a practical note, the proposed regulations provide guidance on the treatment of "post-termination compensation" (i.e., amounts paid after an employee terminates from service). This issue has plagued plan administrators for years. For example, can an employee defer all or a portion of his payment for unused vacation/sick leave? His trailing bonus? Are these amounts included in "compensation" for purposes of determining the allocation of employer contributions?

Post-termination Compensation. Under the proposed regulations, "compensation" generally does not include amounts paid after an employee terminates service. There are exceptions to the general rule. First, payments to an employee within 2 ½ months of termination of employment are included in compensation if (1) the payments are amounts the employee would have received if he had continued employment (i.e., regular compensation, bonuses, commissions, shift differential overtime, etc.), or (2) the payments are for unused sick leave, vacation time, etc. which the employee could have used if he had continued employment. Second, military continuation pay or differential pay paid to an employee who enters active U.S. military service is included in compensation provided that the amount does not exceed the compensation that the employee would have received had he remained with his employer.

Other post-termination compensation payments are not included in compensation. Accordingly, severance pay, non-qualified deferred compensation and parachute payments are not compensation for qualified plan purposes. Moreover, the proposed regulations specifically prohibit a 401(k) plan, a 403(b) plan or a 457 plan from accepting deferrals of amounts not included in compensation.

The proposed Section 415 regulations will apply to limitation years beginning on or after January 1, 2007. The IRS has indicated that plan sponsors can rely on the post-termination compensation guidance immediately; however, there is no "immediate reliance provision" for other sections of the proposed regulations.

Correction of Excess Annual Additions. This is another "common" issue. Treasury Regulation Section 1.415-6(b)(6) describes the method for correcting excess annual additions under certain conditions. The proposed 415 regulations eliminate this method. Instead, the preamble to the 415 regulations states that excess annual additions will now be corrected based on the methodology prescribed under EPCRS. An advantage to this approach is that the 1.415-6(b)(6) method was only available under certain conditions and EPCRS does not impose similar conditions. A disadvantage to this approach is that some corrections under EPCRS require the plan sponsor to submit an application under the Voluntary Correction Program.

The proposed regulations permit a plan to include a fail-safe provision that automatically reduces allocations to the accounts of participants who would otherwise have excess annual additions, but require the provision to operate without employer discretion (to avoid conflict with the requirement that a DC plan must have a defined allocation formula).

Definition of Compensation of Self-Employed Individuals. Compensation for a self-employed individual is based on "earned income." Although contributions on behalf of a self-employed individual are generally excluded from earned income, the proposed regulations provide that the items generally added back to compensation for employees are also added back for self-employed individuals (with the limit that add-backs for qualified plan contributions are limited to contributions that qualify as elective deferrals).

Interaction with Section 401(a)(17). The proposed 415 regulations state that a plan's definition of compensation used for purposes of the Section 415 limits cannot consider compensation in excess of the Section 401(a)(17) limit. For DB plan purposes, the 401(a)(17) limit is generally higher than the 415(b) dollar limit. However, the 415(b) dollar limit increases for post age 65 benefit commencement dates and, accordingly, may be higher for older participants.

The regulations also require that 401(k) deferrals be made only from Section 415 compensation. Some practitioners have questioned whether this position will prevent a HCE who earns more than the 401(a)(17) limit early in the year but does not make any 401(k) deferrals during that time from making deferrals later in the year out of compensation in excess of the 401(a)(17) limit. [To me, this is an "ivory tower" concern, but one never knows.]

Other provisions of the 415 regulations are highlighted below.

· Employee Contributions to Defined Benefit Plans: voluntary employee contributions to DB plans are treated as if made to a separate DC plan and are therefore treated as annual additions [this rule does NOT apply to employee contributions "picked up" by a governmental employer]

· 415(c) generally limits contributions to Section 403(b) plans, SEPs, SIMPLE plans, and contributions to provide post-retirement health benefits, and these contributions must be aggregated with annual additions under qualified plans. However, contributions to a 403(b) plan are NOT aggregated with contributions to any other plan unless the employee and the employer that maintains the other plan are members of a controlled group or affiliated service group. [This rule affects physicians who have private practices and are affiliated with tax-exempt hospitals.]

· ESOP Rules:

o Reflecting an EGTRRA change, ESOP dividends that are not reinvested pursuant to Section 404(k)(2)(A)(ii) are not considered annual additions.

o A leveraged ESOP may provide that if the value of the allocated shares is less than the related principal and interest payment, the annual addition is limited to the value of the shares when paid.

· Tax-Exempt Employers: The proposed regulations will allow an exempt employer's contributions to be included in annual additions for a limitation year so long as they are made no later than the 15^th day of the tenth month following the end of the tax year.

FINAL 401(k) REGULATIONS

On December 29, 2004, the IRS issued final regulations under Section 401(k) and Section 401 (m) of the Code. The regulations were originally proposed in 2003. The final regulations provide comprehensive guidance including:

· codification of automatic enrollment provisions

· limiting use of targeted nonelective contributions to satisfy nondiscrimination tests (a/k/a "bottom-up QNECs")

·

o A plan can count a QNEC greater than 5% of compensation only if the QNEC does not exceed two times the plan's "representative contribution rate." The representative contribution rate measures the rate of QNECs (and QMACs used in the ADP test) received by all members of a testing group. A similar 5% limitation applies to QNECs taken into account in the ACP test. [There is a special exception for plans subject to prevailing wage laws such as the Davis Bacon Act.]

· restriction of targeted matching contributions

·

o The targeted match restrictions apply if the matching contributions exceed the greatest of (1) 5% of compensation; (2) 100% of an employee's deferrals; or (3) two times the plan's "representative matching rate." The representative matching rate is determined in a manner similar to the representative contribution rate that limits targeted QNECs (except that the matching rate is the employee's matching contributions divided by deferrals). If the matching rate is not uniform for all deferrals, the employee's matching rate is based on the assumption that he deferred 6% of compensation.

· expansion of the hardship distribution provisions to include.

·

o funeral expenses of parents, spouse, children or dependents

o certain expenses relating to the repair of damage to the employee's principal residence that would qualify for the casualty deduction, such as those resulting from hurricane or flood damage.

The final regulations are generally effective for plan years beginning on or after January 1, 2006. Plan sponsors may elect to apply the new rules as of the first plan year beginning after December 29, 2004 provided that all final regulations are adopted.

Other provisions of the final 401(k) regulations are summarized below.

General Anti-Abuse Provisions. The final regulations specifically provide that a plan will not satisfy the nondiscrimination requirements where there is a pattern of "repeated changes to plan testing procedures or plan provisions that have the effect of distorting the ADP so as to increase significantly the permitted ADP for HCEs, or otherwise manipulate the nondiscrimination rules…if a principal purpose of the changes was to achieve such a result."

Distributions Upon Severance of Employment. Distributions are permitted upon severance of employment. An employee has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan. An employee does not have a severance from employment if the new employer continues to maintain the existing retirement plan with respect to the employee (e.g., if the new employer becomes the plan sponsor of the plan or accepts a transfer of assets and liabilities under Section 414(l) of the Code).

Safe Harbor Matching Plans. A plan that adopts the safe harbor matching contribution approach may not exclude catch-up contributions in determining the match.

Plan Testing Specifications. The 401(k) plan document must specify the testing options to be used. A safe harbor plan may not provide that the plan will use the ADP test if the plan does not satisfy the safe harbor requirements. The plan sponsor may not amend the safe harbor provisions for the plan year except as provided in unless it follows the specified rules for reducing or eliminating the safe harbor match.

ESOPs. The final 401(k) regulations eliminate the mandatory disaggregation of the ESOP and non-ESOP portions of a plan for purposes of ADP and ACP testing.

Employer Prefunding Repealed. Only amounts contributed by the employer after the employee's services have been rendered will be considered for purposes of the ADP and the ACP tests. [This reverses the position set forth in IRS Notice 2002-48.]

PROPOSED ROTH 401(k) REGULATIONS

EGTRRA allowed after-tax Roth contributions to 401(k) plans. Most practitioners believe that these accounts will require fairly significant administrative burdens and complex participant education materials. However, some employers appear to be interested in exploring the option (possibly because Roth contributions may have special appeal for younger, lower-paid and/or lower-tax bracket employees).

The Roth contribution rules are generally effective in 2006. Plan sponsors choosing to offer this feature for a plan year must adopt good-faith amendments by the end of that plan year (December 31, 2006, for calendar year plans offering Roth contributions in 2006).

The IRS issued proposed regulations on March 2, 2005. The substantive provisions are highlighted below:

· Plan Documentation Requirements. Roth 401(k) contributions must be designated irrevocably by the employee as a Roth contribution at the time the contribution election is made. Accordingly, employers must amend their plans to permit Roth contributions, and update their administrative procedures to allow employees to designate 401(k) contributions as Roth contributions. Related issues include

o plan must specify if employee will be allowed to choose between distribution of excess contributions from "regular" accounts or Roth accounts

o ordering rules for distributions, withdrawals, plan loans

· Income Tax Requirements. Employer must include Roth contributions in income during the current year (and follow withholding requirements).

· Recordkeeping Requirements. Roth contributions must be maintained by the plan in a separate account. Plan sponsor must maintain a record of the employee's "investment in the contract" (i.e., the portion of the account that the participant has paid taxes on).

The proposed regulations also clarify that:

· A designated Roth contribution must satisfy the requirements applicable to elective contributions made under a qualified cash or deferred arrangement (such as ADP, nonforfeitability and distribution restrictions).

· Designated Roth contributions may be rolled over only to another plan maintaining a designated Roth contribution account or to a Roth IRA.

STAGGERED IRS DETERMINATION LETTER PROCESS

On August 26, 2005, the IRS issued Revenue Procedure 2005-66 providing for a new system of issuing determination letters for both individually designed and pre-approved qualified plans. Specifically, the IRS established a staggered remedial amendment period or "RAP" system that includes a regular, five-year cycle for plan amendments and determination letters for individually designed plans and two six-year cycles (one for defined contribution plans and another for defined benefit plans) for opinion letters for pre-approved plans (i.e., master and prototype and volume submitter plans). Plan sponsors will need to submit determination letter applications (or applications for opinion letters) regularly once every five or six years.

The new system will be used for applications for determination letters that take into account the requirements of the EGTRRA and will extend an individually designed plan’s EGTRRA remedial amendment period to the following dates based on the plan sponsor’s taxpayer identification number:

TIN Ends in	Last day of EGTRRA Remedial Amendment Period	Next 5-Year Remedial Amendment Period Ends on
1 or 6	January 31, 2007	January 31, 2012
2 or 7	January 31, 2008	January 31, 2013
3 or 8	January 31, 2009	January 31, 2014
4 or 9	January 31, 2010	January 31, 2015
5 or 0	January 31, 2011	January 31, 2016

The IRS will open the EGTRRA filing program on February 1, 2006.

REGULATIONS ON ELIMINATING FORMS OF DISTRIBUTION IN DB PLANS

On August 12, 2005, the IRS published final and proposed regulations regarding the types of optional forms of benefit that can be eliminated from defined benefit plans without violating the 411(d)(6) anti-cutback rules. The final regulations adopt the proposed regulations published on March 24, 2004, with some revisions. The final regulations are generally effective with respect to amendments adopted and effective after August 12, 2005.

The final regulations provide plans with two methods of potentially eliminating optional forms. Under the first option, plans may eliminate options that are redundant (provided they are not “core” options described below). There is a waiting period equal to the maximum notice period under the QJSA rules (currently 90 days with legislative proposals to extend that period to 180 days). Options are redundant if they fall within the same “family” of optional forms, and the regulations designate six option “families":

50 percent or more joint and survivor annuity

Less than 50 percent joint and survivor annuity

10 years or less term certain annuity

Greater than 10 years term certain annuity

10 years or less of installment payments

Greater than 10 years installment payments.

Alternatively, plans can generally eliminate other optional forms of benefit, four years after the amendment is adopted, if the plan provides the following four “core” benefit options:

Straight life annuity

50, 75 or 100 percent QJSA

10 year certain annuity

Most valuable option for participant with a short life expectancy.

Effective for amendments adopted after December 31, 2005, benefits that are contingent on the occurrence of certain events, such as a plant shutdown or involuntary separation, and that continue after retirement are protected retirement-type subsidies that cannot be eliminated, both before and after the occurrence of the contingency. The rule is limited to benefits that are permitted to be in a qualified defined benefit plan.

The proposed regulations address two topics: (1) the interaction of the permitted forfeiture rules under Code Section 411(a) with the anti-cutback rules under Code Section 411(d)(6) (to reflect the holding in Central Laborers’ Pension Fund v. Heinz (541 U.S. 739, June 7, 2004)), and (2) a new utilization test method under which a plan amendment is permitted to eliminate an optional form of benefit that has not been utilized during a look-back period.

In Central Laborers, the Supreme Court ruled that ERISA Section 204(g) [the ERISA equivalent of the 411(d)(6) anti-cutback rule] prohibits a plan amendment that expands categories of post retirement employment that result in suspension of the payment of early retirement benefits already accrued. The proposed regulations adopt this position. This section of the proposed regulation is scheduled to be effective June 7, 2004. Plans that have violated this requirement must adopt a reforming amendment retroactive to June 7, 2004. For additional information, see Rev. Proc. 2005-23.

The utilization test will allow plans to be amended, provided certain conditions are met, to eliminate optional forms of benefit that have not been elected or utilized during a look-back period. Core options (see above) cannot be eliminated. The look-back period is generally the two plan years immediately preceding the plan year in which the plan amendment eliminating the optional form is adopted. However, at least 100 participants must be considered during the look-back period (so the look-back period may be expanded to the 3, 4 or 5 years immediately preceding). The utilization test may not be used if the plan does not have at least 100 participants that may be considered during the relevant 5 year period. The rules relating to the utilization test are proposed to be effective for amendments adopted after December 31, 2006.