Compensation & Benefits I – Outline
A. Two types of Pension Plans:
1. Defined Benefit Plans (DBP)
a. Based on length of service, fixed sum to be paid our upon retirement
b. Plan assets pooled to meet demands
c. Employer bears burden of risk (if not enough money employer is
obligated to pay)
d. Employee is protected against risk
e. Often integrated with Social Security (SS)
f. ERISA is centered on this type of plan
2. Defined Contribution Plans (DCP)
a. Not a specific benefit but based on contributions – which means that
higher compensated employees get more
b. Employee bears risk if not enough money
c. Employer gets tax break and employee pays less over all b/c of
reduction in income
d. Lower cost to maintain for employer
e. Greater variety in types of plans
(i) Money-purchase pension plan – required fixed
contribution (ex: employer will contribute 10% of
aggregate covered employees). If someone forfeits, the
total contribution still must only be the amount annually
(ii) Profit-sharing plan – No fixed contribution – variable
determined by board of directors each year. Most of the
time whether there is a fixed formula is determinative of
profit-sharing v. money-purchase plan. When someone
forfeits, the money goes into the honey-pot.
(iii) Hybrid plan – A Target Benefit Plan – actuary makes a
calculation based on funding for a targeted benefit, the
amount of that contribution needed per employee is
placed into an account for that employee. These are still
DCP even though they think of the defined benefit
(target) b/c employees only get what was in the account.
(iv) Stock-sharing plan – profit-sharing plan where the stock
is the profit – same rights and obligations.
(v) ESOPS – employee stock ownership plans – profit-
sharing plans required by statute to be invested primarily
in employer stock – in addition, ESOPS are allowed to
engage in certain transactions with the company or related
parties that would other wise be prohibited to qualified
plans – like leveraging their stock to borrow $$ from
(vi) Cash or Deferred Plan (CODA or 401(k)) – very popular
– profit-sharing plan with an added feature – employer
makes little or no contributions, employees defer their
own compensation into the plan. Most plans also include
some employer contributions. Limitations on highly
compensated employees‟ deferrals.
B. Qualified v. Non-qualified Pension Plans – all plans must comply with ERISA‟s
PARTICIPATION RULES, whether or not they are qualified plans
1. Qualified Plans – in order for a plan to be “qualified” thus benefiting from the
tax subsidy, it must meet the following requirements:
a. Must have a written plan (doesn‟t mean it isn‟t enforceable if it fails to
have a written plan)
b. Must have a specific provision for amendments in the plan
c. Plans are required to be funded through trusts – except if 100% are
provided for by annuities or insurance plans
d. Exclusive Benefit Rule – plan must be operated for the exclusive
benefit of plan participants and beneficiaries and no other purpose
e. Participation Rules (who can participate) – ERISA
f. Coverage Rules (who is covered) – IRC
g. Non-discrimination Rules (benefits or contributions) - IRC
2. Non-qualified Plans – these plans don‟t get the tax subsidy, but still must meet
a. Participation Rules – ERISA
b. Examples of Non-qualified plans:
(i) Simplified Employee Pension Plans - §408(k) of the IRC
– profit-sharing plan but instead of a trust the money goes
into an IRA for each person – once the $ is in there the
employer no longer has to worry about it (no fiduciary
duties). Administrative costs are low and this is very
simple – easy for small business. Limitations: same as for
qualified plans although may be more restrictive with
respect to highly compensated employees – and you
cannot have a deferred compensation b/c of the SIMPLE
(ii) SIMPLE – funded through IRAs but allows employees to
fund it, only available for employers of less than 100
employees and has fairly limited deferral amount ($8K).
Employer must make a matching contribution or make a
2% employer contribution in order to qualify. (401ks
don‟t have this requirement) Can only accept deferrals
and that limited employer contribution no other
contributions like profit-sharing.
(iii) 403(b) Plans – Educational Annuities – adopted by
governmental entities, or tax exempt entities – can be
employee deferral or that plus employer contributions. It
is unique b/c you can have very little employer
involvement – the plan manages itself (the brokerage or
insurance firm). This can be good and bad – depending
on set up. There are always problems with these b/c of
the laxity of employer involvment.
(iv) 457 Plans – employee deferral plans for gov‟t or tax
exempt entities – after 2001 tax act, you can technically
make a contribution to both a 457 AND a 403(b) –
meaning you can defer the maximum of both if your
employer sponsors this. These don‟t have any non-
discrimination rules. You can add a 457 plan that only
includes special people.
II. QUALIFIED PLANS – in order to “qualify” a plan must meet the A, B, and possibly C
A. Participation Rules – objective tests relating to a particular person (when they can
become a participant). This section requires that in order to be qualified, the plan must
admit an EE no later than: the day he/she turns 21 OR when he/she has completed 1 year
of service, whichever is later.
1. Minimum age requirement – IRC §410(a)(1)(A) and ERISA §202(a)(1)(A)
most restrictive age is 21 years old, once someone has met this requirement
(and the service requirement) they have to come under the plan within six
months of that time
a. Dual entry dates – you come in on the first day of the plan year or the
first day of the year, as long as it is within six months (this allows
employers to track based on 2 plan entry dates)
2. Minimum service requirement – this is to prevent transitory employees from
entering the plan so employers don‟t have to worry about the administrative
costs in tracking them – this is usually 1 year – in general cannot have a
waiting period greater than 1 year of service to join (at least 1000 of service =
roughly 20 hours/week) IRC §410(a)(1)(B)
a. EXCEPTION – if there is no vesting schedule (all $ going in is fully
vested) then the plan can have a 2 year period (except that portion that
relates to a 401(k) b/c those you cannot make someone wait > 1 year)
b. 1000 hour requirement – 9508003 Tech Advice Memo – IRC
§410(a)(1)(B), ERISA §202(a)(1)(B) – this is the exclusive test for full
or part time - cannot exclude those that are part time (not the result but
how it is written – can exclude a class that may also be part-time)
c. ELAPSED TIME METHOD – alternative method of keeping track –
12 months from (or 24 in fully vested plan) date of hire = participation
regardless of hours
d. Year of Service – IRC §410(a)(3), ERISA §202(a)(3) – 12 month
period within which employee has 1000 or more hours of service (can
be shortened so long as hourly requirement is pro-rated)
e. Special rules – EXAMPLE – Maritime rule – allows substitution of
125 days of service in lieu of 1000 hour test
f. One Hour of Service – 60 minutes DoL Regulation 2530.200(b)-2
(DoL is responsible for setting parameters for Hrs of service and yrs of
service) – each hour which someone works and each hour for which
they are paid even if they are not working (vacation, sick, etc.)
(i) What happens if paid severance pay? No – these are not
hours, once employment is being severed, it is not a
payment for service or in lieu of payments
(ii) How do I know how many hours someone has worked?
No one is required to certify this – if there is a reasonable,
customary approach then it will suffice
(iii) Equivalency Standards – this is an alternative which is
more employee friendly – DoL 2530.200(b)-3 – each
period for which you credit (days/weeks/months) has a
defined equivalency (ex: days = 10 hours, weeks = 45 hrs)
– This is a safe harbor standard
(iv) Different methods of counting for different classes of
employees is okay (hourly = hours counted and salary =
equivalency) 2530.200(b)-3(c) as long as the standard is
reasonable and non-discriminatory1
g. What service has to be credited? What if your company is purchased
by another company (what happens to predecessor service?)? With
some minor exceptions, plans don‟t have to count plans with a
With respect to discrimination – you cannot discriminate in favor of highly compensated employees vis a
vis non-highly compensated employees. If you discriminate against one group of highly compensated
employees in favor of some other group of highly compensated employees that is fine! Same for
discrimination between non-highly compensated employees and other non-highly compensated employees.
Ex: Using equivalency standard for salary (which includes highly compensated) and hourly for hourly
employees (no highly compensated) and the hourly people may work more than the salary then there may
be a problem b/c the highly compensated people are getting a benefit that the nons are not.
(i) EXCEPTION – multi-employer plans (collective
bargaining agreements involving unions) – when you
move from one to another you get parity
(ii) MULTIPLE-EMPLOYER PLAN – a plan that has
numerous UNRELATED employers participating – these
DO NOT have to credit service with another member
(iii) EXCEPTION – where the multiple employer plan
members are affiliated for tax purposes (§414(b)) a
controlled group of corporation or a controlled group of
other businesses (same person owns a corporation and
80% of another partnership) under §414(c) – if you have
service under one employer all service is considered the
same under all owned by same person
(iv) AFFILIATED SERVICE GROUP RULES – if you
have a doctor with a corporation employing him and
another employing his staff both operating together – then
those corps will be treated as an affiliated service group
and as a single entity for benefits purposes §414(m)
(v) Acquisitions – in general – if the business continues and
the plan is the plan of the acquired business and nothing is
done to terminate the plan, then those under the plan will
be credited with service. Typically, the acquiring
company forces the acquired company to terminate its
plan and service does not transfer over
(vi) Merger – entity continues, you would have to count
3. Breaks in Service2 - 12 month period during which the participant has 500 or
less hours of service
a. Calendar Year v. Employee’s work year based on date of hire – if
you have a calendar year plan, participant hired on 3/31, but by next
year they don‟t have 1000 hrs – the plan will then look from 1/1 of first
year to 12/31 (with overlap of January to March) for 1000 hours and
every period after would measure on calendar year until had 1000
b. Three situations where you care about a break in service:
(i) §410(a)(1)(B)(i) – 2 year waiting period with 100%
(non-401(k) money) – break before 2 years then you can
disregard service prior to the break. A break in service is
defined as a year of service where the employee works <
500 hours (at least 501 hours). IRC §411(a)(6)(A).
(ii) §410(a)(5)(C) – if employee becomes a participant then
suffers a break in service (that is less than 5 years) the
plan can require that upon rehire they have to have an
additional year of service prior to re-entering the plan
– upon meeting this requirement, the plan must take into
account all service before the break. How does this work
for 401(k) plans with employee participation? Can‟t do it
– this really only applies to DBP or profit sharing – but
this is really complicated to do.
These are not requirements – an employer can disregard all breaks in service and allow all service to
“count.” In fact, many employers do this b/c it is easier! ALWAYS PAY ATTENTION TO THE PLAN
DOCUMENT! JUST B/C ERISA ALLOWS IT DOESN‟T MEAN THE PLAN WILL NECESSARILY
TAKE ADVANTAGE OF IT.
(iii) The 5 year rule for unvested - If an individual becomes
a participant in the plan but are not yet vested, they
separate from service and the number of consecutive 1
year breaks in service > the greater of 5 OR the aggregate
years of service prior to the break, then service prior to
the break can be disregarded.
(iv) 5-year rule for vested participants – see the rules on
vesting VI(I)(1)(D)(ii)ii and iii of this outline.
c. Maternity/Paternity - §410(a)(5)(E) – if you go on leave for this,
during your leave you will be credited with enough hours to prevent a
break in service for that year (to delay a break in service for one year) –
this does not mean that you get 1000 hours = a year of service, it just
means you won‟t BREAK service
B. Coverage Rules – These are generally found in IRC §410(b). Determine how many
HCE v. NHCE must be covered in order to qualify for the tax subsidy – a plan must pass
one or the other of the following in order to be qualified under IRC §401(a):
1. The Ratio-Percentage Test – found in IRC §410(b)(1)(A) and (B). Under this
test, a plan is qualified if it (A) benefits at least 70% of employees who are
NOT HCE OR (B) the percentage of NHCEs that are benefited under the plan
is equal to at least 70% of the percentage of HCEs benefited under the plan.
a. In general, you can ignore the first part of this test and focus on the
second. If it meets the second then it will meet the first. How this
(i) Calculate % of NHCE benefited = N
(ii) Calculate % of HCE benefited = H
(iii) N must be = or > 70%(H), OR
(iv) N/H must be = or > 70%
b. Who is benefited? Anyone that is getting a contribution to their
account regardless of what percentage that might be.
(i) EXCEPTION – 401(k) plans – you are treated as
benefited if you have the right to defer regardless of
whether you actually do defer.
c. This test is only run with respect to active employees – not retirees!
(i) You only have to count retirees if you amend the plan to
include a cost of living adjustment.
(ii) Example: DBP (never happens with DCP) and some
retirees got a bigger benefit than others. You only have to
convince the IRS on a subjective fact based test that the
group that gets these benefits is not receiving a
disproportionately higher benefit.
d. A plan satisfies this test if the employer has no HCEs. Treasury
Regulation §1.410(b)-2(b)(5). Even if the employer chooses to cover
only those employees whose incomes are barely under the threshold for
HCEs and no others, it still passes! If the employer has HCEs but
chooses not to cover them, then it automatically passes. Treasury
e. If the ER covers 100% of NHCEs , the plan passes the test.
f. If the plan only covers union employees, it automatically passes.
Treasury Regulation §1.410(b)-2(b)(7).
g. EXCLUDIBLE EMPLOYEES from this test:
(i) Provided that the plan does not cover those that don‟t
meet the statutory minimum age and service requirement,
these employees can be excluded. IRC
§§401(a)(26)(B)(i), 410(b)(2)(D)(i), 410(b)(4)(A).
(ii) Non-resident aliens without US income. IRC
§§410(b)(3)(C) and 401(a)(26)(B)(i).
(iii) Union employees – provided there is evidence that
retirement benefits were the subject of good faith
bargaining. IRC §§401(a)(26)(B)(i), 410(b)(3)(A).
(Airline pilots too, same code as above but
(iv) Separate lines of business employees. IRC §410(b)(5).
(v) Terminated employees with less than 500 hours of
service. Treasury Regulation §1.410(b)-6(f).
2. Average Benefits Test (if you cannot satisfy the Ratio-Percentage Test, then
run this test) – which consists of two parts:
a. Reasonable Classification Test – The plan must have “reasonable
classifications” that determine who is included or excluded from
receiving benefits. There are two parts to this test:
(i) Subjective – is this classification reasonable? It has to be
“permissible” under the law generally (cannot
discriminate on the basis of age, sex, race etc.)
Furthermore it cannot be based on individuals (can‟t say
Jones, Smith, and Case you are in, but Johnson you
aren‟t). But you can exclude all in a particular area like
word-processing – even though they all may be women.
There must be some business purpose for the exclusion –
like hourly v. salary is okay here. Job categories and
geographic locations are also okay. If you can meet this
test, then go to part (ii). Treasury Regulation §1.410(b)-
(ii) Objective - The plan must meet the safe-harbor or be
between the safe-harbor and the unsafe-harbor – See
Treasury Regulation §1.410(b)-4(c)(2) and (4) (page 413)
there is a table of calculations (use it, it is easy). These
safe-harbors are built around two concepts: ratio
percentage and the NHCE concentration percentage (the
% of the non-excludable employees that are not HCE).
What we are testing here is the ratio percentage for the
i. If the plans ratio percentage is equal to or greater
than an employer‟s safe harbor, the plan meets this
prong of the test. The safe-harbor is the percentage
of NHCEs that must be covered in order for the plan
to pass. If the concentration percentage of NHCEs is
60% or less of total employees, then our safe-harbor
is 50%. Otherwise it is calculated like this: 50% -
(0.75%)[(#NHCEs/#Total EEs) – 60%]. Minimum
safe harbor is 20.75%.
ii. For plans that don’t satisfy the safe harbor but are
above the unsafe harbor, they will possibly satisfy
this prong of the test if3 (Treas. Reg. §1.410(b)-
1. The Commissioner finds that the
classification is nondiscriminatory
(subjective test), and
2. The classification was based on an objective
3. There is high percentage of employees
benefiting from the plan,
No one factor is determinative. All will be examined and taken into consideration.
4. The more representative the employees who
are benefiting from the plan in each salary
range are of the salary range itself,
5. The smaller the difference between the
plan‟s ratio percentage and the employer‟s
safe harbor, and finally
6. The extent to which the plan‟s average
benefit percentage exceeds 70%.
iii. Calculating unsafe harbor – 40% -
(0.75%)[(#NHCEs/#Total EEs) – 60%]. The
minimum unsafe harbor is 20%.
b. Average Benefits Percentage Test – IRC §410(b)(2)(A)(ii) – fairly
straight-forward. The “average benefit percentage” for NHCEs must
be = or > 70% of the “average benefit percentage” for HCEs.
(i) “Average Benefit Percentage” defined – IRC
§410(b)(2)(C)(i) – the employer provided contribution or
benefit expressed as a percentage of the employee‟s
compensation. You add up all of the percentages for a
group then divide by the number in that group. Note: you
must add in those employees that are eligible but are not
participants as ZEROS.
(ii) What if the ER has multiple non-comparable plans?
See Treasury Regulation §1.410(b)-5(d).
i. Convert both plans to either a contributions base or a
benefits base. First, you make an adjustment to a
contribution percentage for what is called “permitted
disparity” - §401(l) – factor in the extra permitted
ii. All plans within a testing group can be taken into
account – aggregate them together. If you have two
different plans and one passes and the other does not,
then you have to aggregate those two plans to
determine whether together they will pass.
iii. Only employer contributions are considered. So
401(k) or any other non-employer contributions are
iv. All plans must be calculated using the same
v. The benefit percentages are computed under the
rules of 401(a)(4) (non-discriminatory against
NHCEs). Regulations 1.401(a)(4)-23-8-9. Take an
individual‟s contribution made on their behalf
divided by their compensation = benefit percentage
for the group they fit into.
vi. Can use multiple test periods: the current year, the
next year or the period before the current year.
Treasury Regulation §1.410(b)-5(c). If the current
year doesn‟t pass, can look at a conglomerate.
Choose a testing period, then include all employees
except those that are excludable under §410(b)(4).
Can exclude a qualified line of business. Run the test
for all active employees NOT JUST THOSE THAT
ARE COVERED BY THE PLAN. For those not
covered they are calculated as a zero. The employer
provided contribution or benefit of an employee of all
plans in a contribution group expressed as a value
percentage – then add all percents in each group then
run test to determine if non-HCEs > HCEs. If there
is an employer contribution in a 401(k), the plan is
disaggregated and treated as having 2 parts.
c. EXCLUDIBLE GROUPS - the following are excluded from all
average benefits test calculations. All other employees of all other
related entities are INCLUDED!
(i) Union employees (subject to a collective bargaining
agreement) can be excluded provided that retirement
benefits were a good faith part of the bargain – IRC
§410(b)(3)(A) and Reg. 1.410(b)-1(c).
(ii) Airline pilots and railway retirees. IRC §410(b)(3)(B)
and Reg. 1.410(b)-1(c).
(iii) Non-resident aliens with no US source income. IRC
C. Additional Requirements for DBP – The Aggregate Test: IRC §401(a)(26)(A) requires
that for a DBP (not applicable to DCPs) trust to be “qualified” it must on each day of the
plan year benefit at least the lesser of4:
1. 50 employees of the employer, OR
2. The greater of:
a. 40% of all includible5 employees of the employer, OR
b. 2 employees (or if there is only 1 employee, such employee).
D. Important Definitions:
1. Compensation – The code allows multiple definitions of compensation – most
plans only use one.
a. Contribution limitations are based on percentage of compensation –
this is the tax-based definition - §414(s) says look at 415(c)(3). In
addition to all compensation on your W-2, amounts that are electively
deferred into a cafeteria plan (medical, dependent care, etc.), which
never show up on the W-2 are included.
b. For running our coverage test, the code is more flexible, we can use
any definition we want as long as it is not discriminatory – W-2
compensation is deemed to be non-discriminatory, any other definitions
like W-2 + other fringe benefits are okay too, so long as you can show
it is non-discriminatory against NHCEs.6
2. Highly Compensated Employee (HCE) - defined in IRC §414(q) as an
employee who is a 5% owner (there are generally always owners – unless they
don‟t draw an income) in either the current or preceding year, OR who
received compensation in excess of $90K in 2004 and if the employer
chooses, employees that are included in the top paid 20% of the workforce.
(This came into play when everyone makes more than $90K, you can treat
only the top 20% as HCE – this is elective with the employer).7
This is a simple percentage test – look at who is covered then take the percentage.
Not including those excluded under age and service requirements, collective bargaining, certain
terminating employees with less than 500 hrs not present at the end of the year, or employees within a
separate line of business – see part B(1)(f).
Generally when going through all these tests we are calculating the percentage of compensation that is
contributed on an individual by individual basis. Average all the percentages individually then take the pot
of highly-compensated people and take the average then compare the two.
Note: If you have two family members in the same company, you do NOT combine their incomes to
determine whether either or both are HCEs.
E. Coverage Rules are Applied on a Plan by Plan Basis – generally each plan is tested
individually against all of the employees of the same employer.8
1. EXCEPTIONS – in order to be tested some plan must be segregated (Treas.
a. 401(k) – the portion of a plan that is a 401(k) is treated as a separate
plan from the portion of the plan that is not one.
b. 401(m) – same as above
c. Contributions to an ESOP must be treated as a separate plan from those
made to a non-ESOP
d. Employees that don‟t meet age and service standards under §410(a)
may ELECTIVELY be tested separately (these are the under age 21 or
less than 1 year of service people) if they are included in the plan.
e. If the plan covers both union and non-union employees, union
employees must be tested separately.
f. Separate lines of business – you are allowed to test each line
separately (this is mandatory if you set up your business in this
2. PERMISSIBLE AGGREGATION (Treas. Reg. §1.410(b)-7(d)) – where an
ER aggregates two or more separate plans and treats them as one plan:
a. It is okay to aggregate the separate plans that you may have in two
b. BUT, you cannot aggregate any plans that you are required to
c. You can only aggregate ONCE per plan – If you have three plans: A,
B, and C then you can test either A+B or B+C – the purpose is to NOT
use the same employees more than once to assist in the passage of a
d. Separate Lines of Business – in certain cases you can aggregate your
plans but it is not clear
e. The plans must have the same plan year!! (Usually not a problem,
more than likely occurs when a plan is adopted by acquisition.)
F. Coverage Tests (Ratio Percentage or Average Benefits Tests) may cause problems
for employers in the following circumstances 9:
1. Related employers – for the purposes of coverage tests, all employees of
certain related employers are treated as employed by one employer:
a. Controlled Groups – IRC §414(b) corporations, or (c) partnerships,
proprietorships, etc. (paralleled by IRC §1563). Two ways you can
have a controlled group:
(i) Parent/subsidiary where parent owns 80% or more,
Treasury Regulation §1.414(c)-2(b); OR
(ii) Brother/Sister where 5 or fewer individuals, estates, or
trusts own 80% or more of 2 or more organizations AND
counting only identical ownership the same people own at
least 50% of all the entities, Treasury Regulation
(iii) Example of Brother/Sister: If someone owns 40% of one
entity, 30% of another, and 20% of a third, you only count
the 20% b/c that is the lowest amount they identically
own in ALL three.
(iv) What employees do we have to take into consideration
once this determination has been made? We must
An employer with multiple offices each with their own plan: each plan‟s participating employees will be
in the numerator with ALL employees from ALL offices being in the denominator.
Congress wanted to prevent abuse by large corporate entities that could spin off subsidiaries where one is
composed of HCEs with full benefits and another is composed of NHCEs with no benefits.
count all of the employees in all members of the group if
it is in a controlled group.
b. Affiliated Service Groups – IRC §414(m) says that when two or more
entities are affiliated either by one performing services for the other or
the two of them together performing services for the public AND the
group is a “service organization” (defined in §414(m)(3) – principle
business is to perform professional services) then the entities will be
treated as a single employer for discrimination and coverage testing.
(i) This section was to plug the hole – see Garland v.
Commissioner, page 294 – Doctors has two separate
organizations: one of doctors and other of service staff.
Doctors had great benefits and NHCEs had none – this
was okay until §414(m).
c. Leased Employees10 – IRC §414(n) they are treated as employees of
the lessee (receiver of employees) therefore that employer will have to
count them in determining whether the plan passes coverage tests. The
loophole is the specific statutory definition of “leased employee,” IRC
§414(n)(2): the leased employees must provide services provided via
an agreement, on a full time basis (1000 hrs in a 12 month period),
and under the primary direction and control of the recipient.
(i) Example: meets ratio test on face, 5 HCE all covered, 20
Non-HCEs – how many non-highs do we have to cover?
70% = 14. But if employer starts leasing employees then
they must add them into the numbers. Now with 2 leased
employees that brings the number of non-highs to 22, then
the plan doesn‟t pass – so you go to average benefits test.
Those two leased employees still must be counted as
zeros for the average benefits test.
(ii) Be sure to look at all entities treated as the same for
(iii) Biggest nightmare is in hospitality industry – a few
different owners of each one, same core group, etc.
d. Separate Lines of Business –one entity has separate lines of business.
Fracture it into its separate components based on each line, then allow
each component to be tested individually. IRC §§401(a)(26)(G),
410(b)(5). Rationale – if the business is truly separate then it is better
business practice to allow each line to operate and choose its retirement
plan in the same vein as its competitors. But in order to qualify to be
treated as a separate line, the business must meet the “Gateway test”:
(i) Gateway Test: IRC §410(b)(5)(B) – similar to part b of
the first prong of the average benefits test. Treasury
Regulation §1.414(r)-8(b)(2). Compute concentration
percentage of all the NHCEs (NHCEs/Total EEs), then
compute the “ratio-percentage” (% of NHCEs that benefit
Variant of the Leased Employee Rules: PEOs (Professional Employer Organizations) – orgs that provide
staffing (leased employees) but don‟t provide the control over those employees. Problem: in order to carry
on their business the PEOs found they needed to have plans for these employees b/c they could not rely on
the lessees. Rev. Proc. 2002-21 by the Service came out and said if you are a PEO you CANNOT sponsor
a plan for those employees who you hire and lease out unless it qualifies as a multiple employer plan
under §413(c), which says if you have a multiple employer plan, in testing for coverage, contributions, or
benefits, each employer within that has to be tested separately. So the only way the leasing company can
sponsor plans for its employees it must look at the plans of the employers where each employee goes.
These groups will not necessarily pass coverage.
under the plan/ % of HCEs that benefit under the plan)
and then use the NHCE concentration percent to
determine the safe harbor based on the Treasury Reg.
§1.410(b)-4(c)(4)(iv) table. The ratio-percentage must
exceed the safe harbor in order to pass this test.
(ii) If you pass the above, you then must determine if the line
of business meets the requirement to be considered a
“Qualified Separate Line of Business” or QSLOB IRC
i. The line must have at least 50 employees;
ii. The ER must notify the IRS that it is being treated as
iii. The line meets guidelines by IRS or it has received a
determination from the IRS that it may be treated as
separate. This one may be avoided, see IRC
(iii) Once you meet both of these then you can test in different
III. In addition to Participation and Coverage Rules, in order for a plan to be QUALIFIED,
it must also be NONDISCRIMINATORY IN EITHER CONTRIBUTIONS OR
BENEFITS, IRC §401(a)(4)
A. A plan can prove it is nondiscriminatory in one of three ways:
1. Design-based Safe Harbor for DCP – the plan is by design
nondiscriminatory – the key thing you look for is a “uniform allocation
formula,” which is where “every employee gets X contribution” – these are
likely to be design-based safe harbors. Treasury Regulation §1.401(a)(4)-
a. If your plan allows a “permitted disparity,” (permitted under Treas.
Reg. §1.401(l)(2)) you won‟t fail to satisfy a uniform allocation
formula. The plan can limit people‟s contributions to a specific
percentage yet still be treated as a uniform allocation.
b. “Last day of the year” clause (employee must be there on last day of
the year to qualify) or requirement of 1000 hour minimum worked over
the plan year are discriminations that are okay.
c. You must have the following per Regulation §1.401(a)(4)-(2)(b)(1) and
(i) All benefits received at the same time (upon the same
(ii) And you must have the same vesting schedule for all
(iii) You have to allocate both contributions and forfeitures in
a uniform manner.
Note: If you can design your plan with one of these, your client does not have to spend time or money on
testing they will automatically pass – serves your client well.
Note: Like 410(b), 401(a)(4) causes you to disaggregate any portion of a plan that is 401k deferrals or
401m matching contributions to 401k deferrals and ignore after-tax contributions. Regulations say with
respect to the above they will be deemed to pass 401(a)(4) if they satisfy the special tests under IRC
§§401(k)(3) or 401(m)(2).
2. Non-design-based Safe Harbor for DCP – still have to do some testing
operationally to show that it is nondiscriminatory, but they are relatively
simple tests. This is essentially:
a. EEs get points for age or for service and/or compensation, the plan
counts the points per participant divides then by the total points and
that is the percent of contributions the participant gets. Treas. Reg.
b. Concept – you are weighting the formula not just on compensation but
also on age or service or both. If you do this you must have:
(i) A single formula that applies to everyone
(ii) Must meet “availability requirements” in 1.401(a)-(4) –
each employee has the ability to have his service counted
(iii) The average allocation rate for NHCEs without taking
into account permitted disparity or the general test has to
be the substantially the same as for HCEs!!
(iv) So unlike above you still have to run a test
3. General Test – used whenever you cannot satisfy one of the safe harbors, can
prove that a plan that appears facially discriminatory is not discriminatory:
rate-groups tested under §410(b), if each satisfies this then it is
nondiscriminatory (Treas. Reg. §1.401(a)(4)-2(c)):
a. In the other two tests you have to have some form of uniform
allocation, but under this test you have no such requirement, you can
allocate it anyway you want
b. How does it work?
(i) Looking at ONLY EMPLOYER CONTRIBUTIONS
(ii) Divide your plan into “rate groups”: for each HCE that
has a different contribution rate, him and all other
employees that have contribution rates equal to or greater
than that HCE‟s rate are considered a “rate group.” There
will be some overlap with some employees.
(iii) Employees that are very close to the same rate (1/4 of 1%
from the midpoint of one group) can be treated as being in
that rate group
(iv) Each “rate group” is treated as a separate plan that
benefits only those employees that fall into that group and
it is tested under §410(b): apply ratio-percentage test and
then if it doesn‟t pass, the average benefits test (with its
(v) NOTE: The rate groups satisfy the classifications test
part of the average benefits test if and ONLY if the ratio
percentage of the rate group (contribution % for
NHCEs/concentration % for HCEs) is greater than or
equal to: the lesser of the midpoint between the safe and
unsafe harbor percentages OR the ratio percentage test of
the plan as a whole.
Note: Failure to meet one of the above three tests means the plan is discriminatory. Therefore it cannot be
a “qualified plan” under IRC §401(a) – same as under IRC §410 if we can‟t satisfy one of the coverage
tests (in other words, you don‟t get the benefit of the tax subsidy).
Note: You need to satisfy coverage and you need to satisfy the nondiscrimination tests in order to qualify.
B. Rev. Proc. 93-42 provides the following four important points regarding
1. In running these tests if precise data isn‟t available at a reasonable cost the
employer can use reliable estimates.
2. These tests may be run on a “snap-shot” (one day per year) basis (typically the
last day of the year).
3. This provides a simplified testing method, but don‟t rely on it – you need to
know the “real” test.
4. You only have to test once every three years unless there is a significant
change in the plan. A change could be an amendment OR a significant
change in your employee demographics! Designing a plan where the
employer can take full advantage of these allowances is dangerous especially
in small businesses b/c this change in demographics can drop them from
C. The NONDISCRIMINATION RULES – a plan must satisfy ALL of these in order
to be a “qualified plan.”
1. TOP HEAVY RULES– IRC §416 – This section focuses on “key
employees” (KE) v. “non-key employees” (NKE) rather than HCEs v.
NHCEs. Be very careful about this!! A plan is “top heavy” (THP) if 60% or
more of the contributions or benefits are held for KEs. IRC §416(g)(1)(A).
a. DCP: Look at account balances – total them up for KE and if that is
60% or more of the aggregate of the accounts of all employees under
the plan, then it is top heavy. IRC §416(g)(1)(A)(ii).
b. DBP: Take the benefits accrued for KE through the last day of the plan
year and if that is 60% or more of the total benefits for all employees
then the plan is top heavy. IRC §416(g)(1)(A)(i).
c. Key Employee - an employee who at any time during the current plan
year or the preceding year, is (IRC §416(i)(1)(A)):
(i) An officer of the employer having compensation > than
(ii) A 5% owner of the employer, or
(iii) A 1% owner of the employer compensated at $150K or
d. Minimum Contribution requirement in a DC THP:
(i) The amount contributed for each NKE must be at least
3% of the NKE‟s compensation and shall not exceed the
highest contribution percentage (of compensation) for a
KE. IRC §416(c)(2)(A) and (B).
(ii) Two traps here:
i. 401(k) Deferrals: For NKE, you don‟t count their
deferrals as an employer contribution. For KE,
deferrals ARE counted in determining the minimum
ii. Coverage Trap: Remember if there is no waiting
period for eligibility even if you don‟t defer, the right
to defer makes you a participant. So the employer
MUST MAKE A CONTRIBUTION on their behalf!
e. Minimum Benefits requirement in a DB THP expressed as a percentage
of the EE‟s compensation:
(i) The lesser of 2% per year of service or 20% of the
employee‟s average compensation. IRC §416(c)(1)(A)
(ii) Trap: Plan says unless participant was there on the last
day of the year or if the participant doesn‟t meet the 1000
hours of service requirement they cannot contribute, but
the employer must still contribute if the participant is
f. Minimum Vesting requirement for both DC or DB THP: A plan meets
this requirement if it satisfies one or the other of the following two
(i) 3-year vesting – employee becomes 100% vested at end
of third year of employment, OR
For plan years prior to 2002, this was different. For this calculation see pages 329 – 330 of the textbook.
(ii) 6-year graded vesting – end of second year = 20%
vested, end of third year = 40%, and so on until 100%
vested at end of sixth year of service.
Note: Regarding an employer with multiple plans - you only have to satisfy these in one of the plans. So if
a company has both a DCP and a DBP, the company must only meet the above in one or the other. This is
assuming you have looked at both plans and they are top heavy. If only one of the two is top heavy that
triggers that you have to make the minimum contribution etc, BUT YOU CAN CHOOSE FOR WHICH
PLAN YOU WANT TO DO THIS!!
Note: IRC §401(a)(4) renders these rules somewhat moot, but not entirely.
Note: This is almost exclusively a problem of small to midsize firms.
2. PERMITTED DISPARITY - This is the incorporation of social security
in the computation of benefits/contributions. IRC §401(l). If a plan takes
into account social security it is called an “integrated plan.” These plans can
provide a higher level of contributions to HCE and still be treated as
nondiscriminatory so long as the following are satisfied:
a. DCP: A plan must choose an “integration level,” (IL) which is usually
the social security wage base (how much you can earn before you stop
paying into FICA – for 2004 = $87,900). For salary amount above the
IL the contribution percentage will be different than for amounts below
the IL and this is called the “excess contribution percentage.” IRC
§401(l)(2)(B)(i). The contribution for salary amounts below is called
the “base contribution percentage.” IRC §401(l)(2)(B)(ii). The BCP is
set by the plan. The excess contribution percentage (ECP) cannot
exceed the base contribution percentage (BCP) by more than the lesser
(i) The base contribution percentage (e.g. ECP = 2xBCP), or
(ii) The greater of:
i. 5.7 percentage points (e.g. BCP + 5.7 = ECP), or
ii. Some other number if 5.7 is no longer correct (SSA
will advise the IRS when this occurs).
b. Changing the IL – IRC §401(l)(5)(A) – The IL cannot be larger than
the social security wage base but can be lower. (This will generally
allow a greater contribution to KEs.)
(i) If the IL is between 80% and the SS wage base, you must
reduce the 5.7% addition above to 5.4%.
(ii) If the IL is less than 80% of the SS wage base, you must
use 4.3% instead.
(iii) Sometimes you can reduce this such that the HCE/KE
actually get more $$ in contributions overall by reducing
the amount to 5.4%. You have to check the numbers.
c. Imputed Disparity Exception - Even if your plan design does not
explicitly say that people above the wage base get this benefit, if the
plan satisfies the test taking into account this disparity, then the plan
passes. This is an “imputed disparity.” The group above the IL must
have compensation above the IL.
d. DBP: Essentially the same as for above, don‟t worry about how to
integrate this for the exam, just have general idea. Two ways to do
(i) Excess Plan – same as for a DCP – have a benefit under
the plan that is a combination of X + Y, where X =
percentage taken of “covered compensation” (the average
over a person‟s life in a DBP of what the SS wage base
has been) and Y = applies to the excess “covered
compensation” (compensation in excess of the covered
compensation). You take X+Y (# of years of service to a
maximum of 35). Y can be no more than 2x the base
percentage and it cannot be more than 0.75% per year.
(Basically it is a separate % amount for the excess
(ii) Offset Plan – start with a base percentage, then offset that
(subtract the amount) by an amount of compensation
below the wage base. This amount is 0.75% per year.
Example: 4% start – (0.75% x years of service to a max of
35). Same idea as above, just working it from the other
(iii) Imputed Disparity Exception - Again this can be
imputed – test as if your formula permitted this amount
even if not stated expressly.
e. Three Percent/Four Percent Rule – Easily identifiable Permitted
Disparity: 3% minimum contribution for all employees, plus another
4% contribution for all, then for those with compensation in excess of
the IL, they will get another 5.7% on top of that. If you see this pattern,
you will know what it is.
Note: The above rules apply primarily to NON-401(k) plans.
IV. SPECIAL 401(k) RULES – These rules are specific to 401(k) plans. They work in tandem
with the top-heavy rules.12 If you satisfy these you AUTOMATICALLY SATISFY THE
A. 401(k) Deferrals - IRC §401(k)(2) –must meet a series of tests in addition to the tests for
1. No distribution will be made out of the plan of those deferrals prior to age 59
½ except for death, disability, or separation from services of the participant.
This is absolute!! It is a qualification issue! IRC §401(k)(2)(B).
2. Employee deferrals must ALWAYS BE 100% VESTED! – IRC
3. You can‟t require more than 1 year of service before allowing participation in
a 401(k) plan. The plan must comply with the same Participation
requirements as all other plans. IRC §§401 (k)(2) and 401(k)(2)(D).
4. No other employee benefit other than matching contributions can be
conditioned upon deferring money into the 401(k) plan. IRC §401(k)(4)(A).
B. Two limitations when dealing with 401(k) plan deferrals:
1. The maximum compensation that can be used in figuring out the percentages
is $200,000 (for 2004 $205,000) – ignore any compensation in excess of
$205K. This is true for §401(k), §401(a)(4) and for §415. IRC §401(a)(17).
2. Dollar limit – how much can be deferred? You are limited to $13,000 for
2004. IRC §402(g). Going up by $1000 per year until it reaches $15,000 then
increases by cost of living. There is only one of these limits PER PERSON –
not per plan.
3. EXCEPTION: Catch-up Deferrals – starting in 2001, in addition to the
current $13,000 deferral allowance into a 401(k), if you are 50+ years old, you
can defer an additional $3,000 per year even if you have otherwise maxed out
your deferrals (either by deferral dollar limit or plan limit based on
A plan that satisfies these special 401(k) rules will not be treated as a top-heavy plan. IRC
percentage). The benefit of this is they are not subject to the ADP test as long
as you meet the ADP test for the basic deferrals.
C. Coverage Requirements – The 401(k) plan must satisfy two coverage tests:
1. The Ratio-Percentage Test13 – outlined in IRC §410(b)(1). IRC
§401(k)(3)(A)(i). See above under Coverage Rules. AND
2. The Average Deferral Percentage Test – IRC §401(k)(3)(A)(ii) - The
average deferral percentage (ADP) for eligible HCEs must not exceed
a. 1.25 x the average deferral percentage of eligible NHCEs, OR
b. The NHCE average deferral percentage + 2% but in no event more than
twice the NHCE ADP.
c. Calculating ADP – Take an average percentage of all the deferrals by
NHCEs and compare it to the same for HCEs.
d. Thorsen’s easy test to explain the above:
(i) If the NHCE ADP < 2% then the HCEs can have a
deferral percentage of (NHCE ADP)(2).
(ii) If the NHCE ADP is between 2% and less than or equal to
8% then the HCE % can be the NHCE ADP + 2%.
(iii) If the NHCE ADP is above 8%, HCEs can have (NHCE
e. Traps in the test: DO NOT TAKE THE COMPENSATION OF ALL
OF YOUR NHCE AS YOUR DENOMINATOR AND THE
COMPENSATION OF ALL OF YOUR HCES AS YOUR
NUMERATOR – THIS WILL THROW YOU OFF.
D. NONDISCRIMINATION test for MATCHING AND EMPLOYEE
CONTRIBUTIONS – IRC §401(m).
1. You take the employer matching contributions accrued by individual PLUS
any after-tax employee contributions, calculate the actual contribution
percentage of compensation and test it the same way as the ADP is tested. Go
to table 6.4 page 335 there is an example. This is the Average Contributions
Percentage Test (ACP).
E. 401(k) Plan Test FAILURES – What you can do to correct the problems that have
resulted in a plan‟s failing a test. See generally Treasury Regulation §1.401(k)-2(b).
1. Qualified Non-Elective Contributions – Treas. Reg. §1.401(k)-2(b)(1)(A) –
the employer can make a contribution that is not an employee deferral
contribution yet is subject to the same 401(k) limitations (can‟t withdraw until
retirement age, must be fully vested, etc.) to NHCEs increasing the ACP such
that the plan will pass the test. When the employer does this is must conform
to what is in the plan rules:
a. Most plans say you make the contribution and allocate it
proportionately to all NHCEs thereby increasing their contribution
percentage to the proper level. OR
b. The employer can allocate all of the contribution to the lowest paid
person or group first and continuing until the plan passes. Why? If you
give a chunk of money to the lowest paid person, it will increase the
percentage by a large amount. If you spread the money out over
several people it will only raise the percentage only slightly. By stair-
stepping like this it is the cheapest to the employer. You only have to
increase enough to satisfy the plan.
c. These can also be used to pass the ADP test as well as the ACP test.
2. Return excess deferrals – Treas. Reg. §1.401(k)-2(b)(2) – “excess deferrals”
are deferrals in excess of what is permissible for HCE under the ADP test and
“excess contributions” are those in excess of the percentage allowed to HCEs
These plans do not have to satisfy the Average Benefits Test because the money contributed to the plan
as a deferral is the money of the employees.
under the ACP test. Use same approach for both (even though the match is by
the employer it is the same method – return to the employee as taxable
a. Distribution of the excess must be made within 12 months of the close
of the year for which you are running the test. If this doesn‟t occur
THE PLAN IS DISQUALIFIED. To the extent that the distribution
occurs in the first 2.5 months of the plan year, two benefits occur:
(i) That amount is included in the income of the employee
for the preceding year (which is the year it was earned),
(ii) The employer avoids the 10% excise tax imposed by IRC
b. If you go beyond the 2.5 months, the amount is included in the EE‟s
income for the year the money was received rather than the year it was
earned and the employer must pay the 10% excise tax (NOTE: the plan
still qualifies if you meet the 12 month test above).
c. This is the same for matching contributions. The employer takes the
excess allocated to the employee and gives it to the employee as
compensation (they have to then pay income tax on it).
d. The Regulations say if you are going to give money back to the
employee, you start with the person with the highest dollar amount in
excess contributions (not the highest percentage of compensation) first
and then move down the list. You ratchet them down to the next tier
(there is software for this).
3. Re-characterization of excess contributions – the excess can be re-
characterized as an “after-tax” contribution (least used method). The money
doesn‟t come out of the plan, but the employee must pay taxes on it. But on a
dollar for dollar basis you increase the contributions for HCEs so you may
still fail the ACP test BUT you solved your ADP test.
Note: Two options for how to run these tests:
1. Test against the current year‟s deferrals by the NHCEs, or
2. Test against the prior year‟s deferrals by the NHCEs.
This allows you to exactly calculate your current year contributions by your HCE so that you reduce the
risk of violating.
Note: If you elect the prior year then you have to continue using the prior year – you can‟t bounce back
and forth in your testing.
F. 401(k) Plan NONDISCRIMINATION Safe Harbors – IRC §401(k)(12). This is the
“design-based” safe harbor for 401(k) plans. If you design your plan like this, it will be
“deemed” nondiscriminatory (even if you run the tests above and it fails miserably!).
1. Notice Requirement – IRC §401(k)(12)(D) – requires that prior to the
beginning of the plan year, eligible EEs must be informed that the plan will be
a “safe harbor” plan and that the normal ACP/ADP rules don‟t apply. Recent
IRS Notice 2000-3 allows as little as 30 days before the plan takes effect to
2. Matching Contributions Safe Harbor - IRC §401(k)(12)(B) – the ER
contributes on behalf of each NHCE an amount equal to:
a. 100% of the first 3% (of compensation) of elective EE deferrals, and
b. 50% for the next 2% of the elective EE deferrals. (Maximum of 5% of
employee compensation contributions can be matched.)
c. This structure insulates the plan from failure of the ADP test because
YOU DON‟T EVEN HAVE TO RUN THE ADP TEST! (See IRS
Notice 98-52.) Maximum exposure of the employer is 4% matching.
Employers can match more than that as long as it is better – this is
called an “enhanced match” – so long as:
(i) The rate of matching does not increase as the rate of EE
deferrals increase IRC §401(k)(12)(B)(iii)(I)., and
(ii) The aggregate amount of matching contributions must
equal at least the amount under the aforementioned basic
safe harbor match. IRC §401(k)(12)(B)(iii)(II).
d. This safe harbor still creates inequities between employees that defer
different amounts. See the safe harbor below, which deals with this.
3. Non-Elective Contribution Safe Harbor – IRC §401(k)(12)(C) – these
contributions are made without regard to whether the EE defers. The ER
makes an across the board 3% of compensation contribution for all
participants who are NOT HCEs. Must be:
a. Fully vested, and
b. Subject to withdrawal limitations based on retirement age.
4. Safe Harbor plans that meet the ADP tests listed above (2 and 3)
automatically satisfy the ACP test if the following are met (See IRS Notice
a. The matching contributions can‟t be made with respect to deferrals
>6% of compensation (you must run the ACP test on deferrals > 5%).
It is not feasible for NHCEs to defer more than this.
b. The rate of matching contributions can‟t increase as deferrals increase.
The matching contributions for HCEs can‟t be any greater as a
percentage of compensation as the matching contributions of NHCEs.
c. If you have after-tax contributions in addition to the matching
contributions, and you satisfy the above you still have to run the ACP
tests with respect to the after-tax contributions.
V. LIMITATIONS ON CONTRIBUTIONS AND DEFERRALS, GENERALLY
A. The maximum compensation used in determining percentages is $200,000 (for 2004
$205,000) – ignore any compensation in excess of $205K. This is true for §401(k),
§401(a)(4) and for §415. IRC §401(a)(17).
B. IRC §415 – the “Annual Addition Limit”
1. §415(c) – DCP – Annual contributions and other additions to any participant‟s
account cannot exceed 100% of their compensation OR $40,000 (subject to
cost of living for 2004 = $41,000)14 whichever is lower. This is not just
employer matching contributions, it also includes all other employer
contributions (like profit sharing) as well as employee deferrals under 401(k)
and any forfeitures allocated to that employee during the year (termination of
employment when not fully vested – the remainder allocated to those
employees left gets included in their amounts). And finally it includes any
a. This limitation is on an employer by employer basis – if the employee
has more than one employer and those employers are not related, then
the employee gets one limit per employer. (This is the opposite of the
401(k) plan limitation).
2. §415(b) – DBP – Participants cannot get a benefit that is greater than 100% of
their average compensation or $160K ($165K for 2004) per year, whichever
is the lesser, as a straight life annuity (for their life expectancy). This is the
benefit they are withdrawing – not their contribution. Pay attention to the
References to “25% of compensation” comes from the law prior to the 2001 tax act.
See page 348 of the text to see how you run the annual addition test. This is easier with a W-2. When
someone is self-employed, it is more difficult – it only applies to the amount net of self-employment tax.
a. You get the full dollar limit only if the number of years of participation
in the plan by the employee is > 10 years. For less than that you must
reduce the limit proportionally (5 years participation = 5/10 or ½ of
$165K benefit per year annuity limit). AND
b. You must limit the percentage proportionally based on their years of
service in the plan when participation is less than 10 years. The
distinction is if you have a 2 year limit to come into the plan and you
have 5 years of participation in the plan (+ 2 years of service prior),
then your limit is 7/10(average compensation).
c. This just changes the maximum limits – you will get the lesser of either
a or b as recalculated.
d. But what if you have a joint and survivor annuity? - you will have to
pay the annual income for a greater than normal time frame. So the
limit must be reduced to prevent making it a tax shelter whenever the
annuity takes another form. Thorson did not clarify how this reduction
VI. VESTING RULES – these apply to both DCP and DBP - ERISA §203(a) and IRC
§411(a)(2)(A) and (B) – most basis vesting rules.
A. Cliff Vesting16 – a participant must be fully vested after 5 years of service (100%
nonforfeitable). Could be zero vested prior to 5 years. ERISA §203(a)(2)(A). These
predominate in DBP.
B. The alternative is the 7 years vesting schedule. You don‟t have to be vested until the
end of the 3rd year (the amount is unspecified) but then vesting graded after that reaching
100% at 7 years – see example page 133. ERISA §203(a)(2)(B).
C. §411(a) and ERISA 203(a) – participants must be fully vested when they reach normal
retirement age and the plan must state this. But it is permissible to define the “normal
retirement age” by reference to both age and service. So you can hire someone who is 63
but if you define “retirement age” as 10 years of service, then they will not be fully
vested at 65 but at 73.
D. Vesting applies if someone terminates (separates from service) but not if someone dies
§411(a)(3)(A) and ERISA §203(a)(3)(A) – so long as the plan satisfies the pre-retirement
survivor retirement annuities it doesn‟t have to provide a benefit in the event of the death
of a participant17. Many plans say “in the event of death” you get a lump sum payment –
without regard to the participants years of service etc. – like an insurance benefit – this is
b/c the purpose of these plans is to provide for retirement not to create an estate.
E. It is permissible for a plan to provide that if someone leaves and starts drawing benefits
then returns to work, you can stop paying benefits until they retire again. This is not a
“reduction” b/c you are funding retirement benefits and if he is not retired you don‟t have
F. The plan can have a 2 year waiting period BUT it means participants must be fully
vested (100%) upon entrance into the plan – this trumps all of the other options (can‟t do
the graded vesting too). ERISA §202(a)(1)(B)(i).
G. ERISA permits waiting periods18 before employees are allowed to participate - but the
service before still counts towards vesting. ERISA §202(a).
H. IRC §411(d)(1) treats compliance with the vesting rules as presumptive compliance with
IRC §401(a)(4) – the nondiscrimination rules of qualification.
I. The rules for vesting under §411 are the same as under §410(a) for participation 19.
For “Top-Heavy plans,” a 3 year cliff vesting or a 6 year graded schedule is required. IRC §416(b).
See notes on REAct, which amended ERISA in 1984.
Like the age 21 requirement or the one-year of service requirement, for example.
§410 only deals with counting years of service for participation (eligibility) in the plan. §411 deals with
counting years of service for vesting purposes. Although there are parallel provisions in the two sections,
there are significant differences. Some plans have provisions that count years of service for benefit accrual.
There is no code section for this – the plan itself will do that.
1. Years of service = 12 month period for which the employee has at least 1000
hours of service20. ERISA §203(b)(2)(A) and IRC §411(a)(6)(A). Not the
years they have as a participant but for all years (even if they change positions
etc. from an ineligible group to an eligible group). You must count all years
of service unless the statute specifically permits you to exclude. Exceptions to
this must not only be in the Code but also IN THE PLAN ITSELF. Four
categories that CAN be disregarded:
a. Service prior to age 18 can be disregarded (you never have to count
b. Service with an employer during the period that the employer doesn‟t
maintain a plan.
c. If the plan requires employee contributions as a condition to participate
and the employee declines participation you don‟t have to count those
years (these are called “thrift plans” which are quite rare now – do not
apply to 401k)
d. Service that follows a break in service as described in IRC §411(a)(6)
(i) 12 month period where someone has 500 or less hours of
service is a “break in service” – 501 to 999 is not a break
but is not counted either. IRC §411(a)(6)(A).
(ii) §411(a)(6) – you can disregard the prior service if there is
a break in service as described above – you can look only
at the service since the employee has returned when:
i. §411(a)(6)(B) – employer may require that an
employee complete a year of service following the
break in service before the service prior to the break
can be counted for vesting credit
ii. §411(a)(6)(C) – if you have a break in service that
exceeds 5 consecutive years then you can disregard
the time prior to the break – if you have a less than 5
year break you have to allow the employer to
continue to vest the amount of money placed in the
account before the break
iii. §411(a)(6)(D) - For non-vested participants if the
consecutive years of breaks in service exceed 5 years
(or the service prior to the break whichever is greater)
then you can disregard that prior service with respect
to this break – this will always be 5 b/c if you have 5
you will always be vested at the very least partially
iv. §411(a)(6)(E) – Maternity/Paternity (or adoption)
absence leaves – if you have a break in service as a
result, it will delay the break in service for that year
but they are not credited with enough hours to get
them up to 1000 to be credited for a year of service
J. Cash Out/Buy Back Rules – Most DCPs use this rule – if an employee forfeits the
amount in their account (breaks service before vesting) when they come back – unless
they have been gone for 5 or more years – you have to give them the option to pay the
amount they received as a payout back into the account.
1. If they never received any distribution b/c they were not vested, then when
they return they get that money in that account again and get to count both
terms of service and that money continues to grow. So long as they were not
gone for > 5 years.
2. If they received a distribution b/c they were partially vested then they must
refund that money to the account – regardless of market changes – then you
ERISA does not require part-time employees to be included in the plan.
must count the term of service and add to the amount of money. If they don‟t
pay it back after returning then you can disregard the prior service.
3. The above is found in ERISA §204(d) through (e) and IRC §411(a)(7)(B)
K. You cannot reduce an individual’s accrued benefit. This is straight-forward when
discussing benefits but - §411(d)(6) includes not only the benefit but rights and features
like the option to take payment in lump sum or annuity (the plan cannot be amended to
take away this option). Treasury Regulation §1.411(d)-(4) gives detailed explanations of
what are “take-aways” and what are not “take-aways.”
1. Note: §411(a)(10) – if there is an amendment that changes a vesting
schedule then any participant with 3 or more years of service can elect to stay
under the old schedule or can go with the new one.
L. Forfeiture for Cause – the “bad boy” clause – these are not enforceable now b/c of
ERISA. You can‟t “unvest” something that is already vested so the forfeiture can never
be greater than what would have been forfeited under any of the permissible vesting
schedules (including the top-heavy plans).
M. EMPLOYER MISCONDUCT - §411(d) – what EEs can‟t do in terms of forfeiting
1. Employer can‟t use a combination of vesting schedules and their operation to
avoid allowing people to vest (can‟t have 5 year vesting cliff then terminate
people at 4 years).
2. §411(d)(3) – all affected employees become fully vested only to the extent
funded21 in the event of a termination or partial termination of the plan – easy
in actual termination but more difficult in partial (see page 140 Halliburton
case). In general the IRS says if an ER terminates 20% or more of the
workforce then there will be a presumption there has been a partial
termination of the plan and those that were terminated must become fully
vested. How do you calculate the 20%? One year period or longer? Based
on un-vested people or all participants? New participants or the old ones
only? The cases are unclear. Generally no one bothers you if your decrease is
<20%, if you are over this then there will be dialogue.
3. §510 of ERISA – (no comparable Code section) – makes it unlawful to
discharge, fine, suspend, expel, discipline, or discriminate against any
participant or beneficiary for exercising any right to which he is entitled under
the provisions of the employee benefit plan for the purpose of “interfering
with the attainment of any right to which such participation may become
a. Gavalik v. Continental Can Co. – page 147 – company came on hard
times and wanted to lay people off – created the “BELL” plan – reverse
acronym for “let‟s limit employee benefits.” There was a high
correlation between unvested employees and those that were laid off.
Third Circuit Appeals found for plaintiffs. Court came up with Title 7
approach and applied it to §510 cases. These are analyzed first by
requiring that the plaintiff establish as least a prima facie case that there
has been a §510 violation, then the burden shifts to the defense who
then must show that there is some other legitimate reason for whatever
action they took. If there is some other nondiscriminatory legitimate
reason then the burden shifts back to the plaintiff to establish by a
preponderance of the evidence that the key reason was to reduce the
benefits. A formulistic approach like in the other sections does not cut
it for §510, you must show an intent to interfere. They also said this is
Think of the Studebaker case – only to the extent that there are assets in the plan. You don‟t get a cause
of action against the employer to contribute assets to the plan so that you get your benefit.
not a fiduciary issue so you cannot argue as a defense in these cases
that you are a settlor22.
Note: §510 is not a Code provision so it applies to everything that ERISA applies to but is not a “qualifying
VII. Benefit Accrual – THIS SECTION ONLY APPLIES TO DBP – IRC §412
A. These rules were created to prevent “back-loading,” where a plan gives some nominal
amount of a benefit accrual for the earlier years of employment then increases it
drastically after that – this benefits HCEs. There are three approved methods of
accrual set out in ERISA §204(b)(1):
1. The 3% Rule – most everyone is going to have a working life that is slightly
over 33.3 years. Three percent per year then = 100%. You take the benefit
that someone would accrue at retirement (age they entered the plan, the
normal retirement age – the difference is the number of years they have to
accrue benefits) – you have to accrue at least 3% per year (you can accrue
more than that but no less).
2. The 133 1/3% Rule – in no later year can you accrue a benefit that is > than
133 1/3 % of the benefit that you accrued in an earlier year.
3. The Fractional Rule – take number of years that someone will be a
participant in the plan as a denominator under “1” then you have to accrue
fractionally over the term – this establishes how much you can accrue, period
– can‟t increase etc.
B. The concept is simple: YOU CAN‟T BACKLOAD. These rules are designed to prevent
this. Any amount of front-loading is permitted.
VIII. Minimum Funding Standards - §412 – for protection of the participants.
A. CONCEPT – we must fund liabilities – we have a period of time that we have to get the
money into the plan this section tells us how much we must put in.
B. IRC §412(b)(1) – requires that every plan subject to these rules establish an accounting
entity called a “funding standard account” – which keeps track of the difference
between actual contributions and the required minimum contributions. There are two
types of entries in this account:
1. Charges – IRC §412(b)(2)
a. The “normal cost,” and
b. The amounts necessary to amortize the past service liabilities.
2. Credits – IRC §412(b)(3) – the main credit is the employer‟s contribution for
the year but there will also be interest.
Note: If an ER contributes an amount equivalent to the “normal cost” plus the amortization of the past
service, the funding standard will be zero.
C. What is the minimum that someone can put in the plan? All pension plans are subject
to these rules, but profit sharing and 401(k)s are not. DBP and DCP (money purchase
plan) fit into the pension plan category.
1. DCP – if your plan establishes how much you will contribute then you must
contribute that amount as a minimum.
2. DBP – This is composed of two parts:
a. The normal cost – cost of benefits that will accrue between today and
the person‟s retirement age under the formula.
b. Past liabilities – either b/c the plan is adopted at a time when adoption
creates liabilities (an employee that already has service for which credit
it given) or from an amendment that increases the formula.
D. §412 includes a series of rules regarding amortization of both current costs and past
costs, which creates your minimum contribution. See below:
An employer who manages a benefits plan but is only the manager or administrator and not a fiduciary.
1. Normal costs amortized over life of participant.
2. Past costs between 10 and 30 years. IRC §412(b)(2)(B).
3. What if your plan‟s interest rate assumption is higher than the actual amount?
You have a deficit that must be amortized over 5 years. IRC §412(c)(9).
4. If there is a change of your actuarial assumptions that causes a change, it can
be amortized over 10 years.
Note: The IRS can extend all of these for an unfunded liability an additional 10 years. IRC §412(e).
Note: Actuarial Assumptions - In terms of what it is that we are required to fund – this depends on what
our actuary assumes. Say assuming we will make 8% and the employee will retire in 10 years you will
fund at one level but if we assume a rate of 4% you must pay in more.
E. Timing of Contributions:
1. DBP: funding must be made within 8.5 months of the time that the plan year
ends. IRC §412(c)(10).
2. DCP: we must fund by the due date of your tax return for the year OR the due
date with extension if extensions are granted. This is to meet the minimum
funding standards. In order to take a deduction for the year for any DCP you
have to make the contribution by the due date of the tax return including any
extensions. If you get an extension on the return and you file your return on
time you still get the extension for your contribution.
F. If you fail to meet the minimum funding standards during a tax year, there are two
1. Participants and fiduciaries can bring a law suit against the employer to put
the money in the plan23
2. There is an excise tax of 10% (5% for multi-employer plans) imposed for
failure to meet this standard. IRC §4971.
a. It runs at a rate of 10% per year for each year that it is not met.
b. If the IRS finds the deficiency and assesses the 10% tax and you still
don‟t make the contribution, there is a 100% excise tax (100% of the
contribution!!!!) IRC §§4971(b), 4961, 4963(e).
G. Possible Waiver of the Standards: It is possible to get a waiver of the minimum funding
standards. IRC §412(d). If you get the waiver before the amount is due, then the
contribution is amortized out into the future. You can do this a maximum of three times
within a 15-year period. The waiver must be submitted within 2.5 months of the close of
the plan year. IRC §412(d)(4). While the waiver is in effect:
1. Plan benefits, including rates of accrual and vesting, may not be increased –
2. The employer must notify the participants, beneficiaries, and employee
organizations when applying for a waiver. IRC §412(f)(4).
3. If the amount is > $1 million, the IRS must consult with PBGC before
granting it. IRC §412(f)(3)(A).
4. If you miss the deadline but get the waiver anyway, the Service cannot waive
the excise tax but can waive the 100% penalty. ERISA §3002(b) says in
“appropriate cases” the 100% tax can be waived. This is one reason you see a
lot fewer DBP b/c DCP don‟t have the minimum funding requirement.
H. Full Funding Limitation – a cap on how much you can place in a plan. The minimum
funding standard does not require funding beyond full funding. IRC §412(c)(6).
1. This minimum funding standard was not only a minimum amount plans are
required to contribute per year but also a limit on the amount plans can
contribute to avoid tax sheltering.
Multi-employer plan members are joint and severally liable for the minimum contributions as well as any
required quarterly contributions. IRC §412(c)(11)(B).
2. Note: You can only contribute funds into a plan in an amount equal to 150%
of the difference between the current liability and the plan assets or the actual
accrued liability of the plan itself. (These created a problem in the late 1990s
b/c assets were growing very rapidly so many plans could not fund!! Then
2000 occurred and many plans lost > 40-50% of their value and they had a
HUGE funding demands. Now there are lots of under funded plans! This is
the fallout on the other side of preventing the abuse.)
3. Note: The Taxpayer Relief Act of 1997 – relaxed limitation slightly – the
limit is increased: 155% in 1999 to 170% in 2005. IRC §412(c)(7)(F).
IX. ANTI-REDUCTION RULES - ERISA §402(b)(3) requires that every plan is amendable.
ERISA §204(g) says you cannot reduce benefits already accrued. ERISA §203(c)(1)(A)
says a plan cannot alter the vesting schedule so that it is unfavorable to the plan
participants. IRC §411(d)(6) says that you cannot reduce the benefits already accrued.
The examples below explain problems in plans where there is a reduction in benefits.
A. Cost of living increase – not uncommon. What happens if the employer doesn‟t have
enough money to fund this, so they take away the cost of living increase. Courts say this
violates §411 (and ERISA §204(g)(1)) and is therefore impermissible.
B. What if the employer says we will change the plan going forward, from now on will pay
you 1.5% per year of service (0.5% reduction) but not reducing the accrued benefit up to
today. Then you calculate which of the two will be higher: original rate x years of
service up to this point v. new rate times all service. The courts say this is okay b/c you
aren‟t reducing an “accrued” benefit. This is called a “wear-away.” See Treasury
1. EXCEPTION – IRC §412(c)(8) permits an amendment within 2.5 months of
the close of the plan year to be retroactive to the first day of such plan year.
But only benefits accruing during or after such plan year may be reduced, and
even then only “to the extent required by the circumstances.” IRC
X. ALIENATION OF BENEFITS - The code at 401(a)(13) (similar rule as a condition of
tax qualification) and ERISA at 206(d)(1) say that the trust must be a “spend-thrift”
trust – meaning that a participant cannot alienate nor assign their rights in the plan to
another person. The purpose is to prevent the participant from “spending” their
retirement account before retirement. This is a more strict rule than the private trust
spend-thrift rule b/c certain preferred creditors are not allowed to collect under ERISA.
But there are three exceptions:
A. This doesn‟t have to reach voluntary and revocable assignments of benefits that are in
“pay” status (already retired and getting benefits) so long as the assignment is 10% or
less of their benefits.
B. The plan can take a security interest in a participant’s account for plan loans.
C. Assignments are permitted pursuant to a Qualified Domestic Relations Order
(QDRO)24 which may include provisions for child support as well as a spousal share.
D. Courts have been extremely strict when dealing with these rules.
E. COMMENTS ON THE SPEND-THRIFT PROHIBITION
1. Guidry v. Sheet Metal Workers National Pension Fund, page 619 –Union
official embezzled $1million and while he was in prison he applied for
benefits from his retirement plan. USSC held that ERISA‟s anti-alienation
rule, §206(d), his retirement benefits are protected. The plan is irrelevant to
what he did so he gets his retirement benefits.
2. Ellis National Bank of Jacksonville v. Irving Trust Co. – page 625 – Wrongful
gains of a stockbroker contributed to retirement account cannot be reached by
the injured party.
3. Coar v. Kazimir, on page 628 – Plan fiduciary harmed the plan itself and had
an account in the plan. The court permitted the injured party to reach the plan
account of the fiduciary b/c the wrongdoing was against the plan itself –
despite ERISA §206(d). This case has been codified in IRC §401(a)(13)(C) –
if there is a conviction or judgment or a settlement of a department of labor or
PBCB claim of wrongdoing that involves a crime or a fraud against the plan
and it allows an offset of that individual‟s account and the wrongdoer‟s
spouse‟s interest is protected or waived (either one) then the injured parties
can go against the wrongdoing fiduciary.
4. Note: The IRC codification does not alter Guidry!!
REAct 1984 amended ERISA to authorize deference to state law – this allowed for the pension plan to be
divided per state qualified domestic relations orders.
5. The only exception to the fact that regular creditors cannot access the plan:
One-person plans – or IRAs – the bankruptcy court has jurisdiction over this
b/c this is a self-settled trust and can take this money.
6. Patterson v. Schumake (page 632). This is the foundation case of the
interplay of creditors rights and plans. This turned on one phrase in the
bankruptcy law that says that the bankruptcy code preempts everything except
applicable non-bankruptcy law (spend-thrift laws etc.) and the Supreme Court
held that ERISA fit under here. There is always the issue when someone is
about to claim bankruptcy and shows a preference to the plan there may be a
problem. The courts otherwise are very rigid in enforcing Patterson.
7. BUT there is one exception to that: THE IRS – TAX LIENS CAN REACH
INTO THE PLAN. THEY ARE THE ONLY CREDITOR WHO CAN. IRC
§6334 exempts certain property from levy it does not exempt pension plans.
Basis for this is that §6334 explicitly states that no property or rights to
property shall be exempt except what is stated in 6334(a), which does not
XI. OVERVIEW OF DOMESTIC RELATIONS RIGHTS IN PLANS
A. Qualified Joint and Survivor Annuities (QJSA) – ERISA §205(c) and (d) (REAct of
1984) and Code §§401(a)(13) and 417 –all DBP and all money purchase DCP are
required to offer QJSAs.
1. DCP can avoid this requirement if:
a. It provides that upon death the entire benefit (100%) will be paid to a
b. The participant does not in fact elect to receive payments in the form of
2. Note: OTHERWISE QJSA IS THE DEFAULT OPTION, SO UNLESS THE
SPOUSE EXECUTES A VALID WAIVER A PARTICIPANT CANNOT
NAME A NONSPOUSE AS BENEFICIARY OF THE ANNUITY.
3. The major effect of the REAct was to transfer the power to elect out of a
QJSA to the non-employee spouse (generally the wife) who must consent in
writing and be either notarized or witnessed by a plan representative.
4. ERISA §205(b)(3) the plan may contain a term requiring that the marriage
have been in effect for a minimum of one year before the non-employee
spouse qualifies for the QJSA.
5. The spouse cannot waive this in a pre-nuptial agreement b/c according to the
Secretary and the Service, the pre-nup is not between spouses therefore the
spouse cannot consent b/c she is not yet a spouse. ERISA §205(c)(2)(A).
6. The plan is not liable if the participant lies to the administrator regarding
marital status. ERISA §205(c)(6). But if a spouse comes forward, the plan
will have to pay that spouse the annuity minus the difference.
7. Most plans provide other options in addition to the QJSA such as a life
annuity, joint and survivor life plus certain (guarantees at least say 10 years of
payments), lump sum, or installments over a period of time (anywhere from
10 years to the life expectancy of participant). Of course as mentioned above,
the spouse must consent.
8. Any time you change the beneficiary to someone other than the spouse,
you are opting out of the default and you must get consent. A waiver by
the spouse in choosing a new beneficiary or another payment option is only
good for that one time – not any other change – so you must get another
consent if you change either again.
B. Qualified Preretirement Survivor Annuity (QPSA) – REAct requires that the plan
recognize the non-employee spouse as a plan beneficiary, with an interest that survives
the participant‟s death, called a QPSA. So if the participant who elects an annuity dies
before retirement (commencement of distributions), yet after full vesting, ERISA
§205(a)(2) requires that the plan pay the annuity to the surviving spouse.
1. The spouse can waive this requirement. ERISA §205(c)(5).
2. The plan can require that the marriage be in effect for at least one year.
3. The most common annuity is 50% of what the participant would have
received. As a minimum, the spouse would get the same amount as if the
participant elected the QJSA then died the next day, for the rest of his/her
life. The statutory minimum is found in ERISA §205(e).
4. Distribution of the annuity to the non-participant surviving spouse must
commence no later than the month in which the participant would have
attained the earliest retirement age. ERISA §205(e)(1)(B).
5. This is applied to the same types of plans as the QJSA above. Defined
Benefit Plans, Money Purchase Defined Contribution Plans, and any Profit
Sharing plans unless the plan establishes that the spouse gets the lump sum at
6. The plan can provide more, but the above is the minimum.
7. The same procedure for electing (waiver and consent) out of this like the
QJSA. But the surviving spouse is allowed to elect any of the other options
for distribution after the participant dies (lump sum, installment, etc.).
8. Both of these are only relevant to the spouse (who is the spouse) at the time of
the participant‟s death.
C. DIVORCE OR DISSOLUTION - WHAT ARE THE RIGHTS OF SEQUENTIAL
SPOUSES? Retirement Equity Act (REAct) in 1984 – community property rights
states said non-participant spouse did have some rights. In separate property states
1. REAct focused on providing that non-participant spouse would have an
interest that they could receive value for. This was accomplished via the
Qualified Domestic Relations Order (QDRO). An amendment exempts
QDROs from ERISA’s preemption section (§514(b)(7)):
2. §206(d)(3) and IRC §414(p) say that a QDRO is exempted from the
assignments and alienation rules
3. Note: DRO is any judgment decree or order r/t child support or alimony
payments, or marital property rights made pursuant to domestic relations law
including community property
4. A QDRO requires payment to an “alternate payee” who is a spouse or
former spouse, child or other dependent of the participant who is recognized
to receive all or a portion of the participant‟s benefit under the retirement plan.
D. TAXATION under QDRO - If the recipient of the pension distribution is a spouse or
former spouse it is taxed as though it was their account – so if the spouse receives a
payment they pay the tax as the participant would have. Rule from IRC §402(e)(1) and
tax procedure from IRC §§72 & 402(a). Spouse or former spouse can also roll over the
amount into another plan. IRC §402(e)(1)(B). BUT if someone other than the spouse
or former spouse receives a distribution the PARTICIPANT (not the recipient) must pay
1. If there is a distribution to an alternate payee who is a spouse or former spouse
they can roll the money into another qualified plan and defer the tax.
E. HOW DOES THE QDRO WORK?
1. The QDRO rules are here for two purposes:
a. To provide a chink in the assignment/alienation rules to permit
disbursement to the spouse.
b. To protect the plan against having to make double payments (via the
2. They set forth a list of items that the order must specify to be considered a
a. §206(d)(3(C) ERISA and §414(p)(2) of the IRC establishes that a
QDRO must clearly specify: The name and last known mailing
address of the participant and of each “alternate payee,” and
b. The amount or percentage of the participant’s benefits to be paid by
the plan to each such alternate payee, or the manner in which such
amount or percentage is to be determined, and
c. The number of payments or periods to which such order applies, and
d. Each plan to which such order applies.
Note: Some are clear and others are not. Example: you must specify what the payment is (1/2 of the
account as of when? Or a dollar amount?).
3.Procedure: The order is presented to the plan, which then has 18 months to
determine if it is a valid QDRO. ERISA §206(d)(3)(H). Then they
determine whether it is sufficiently specific so they know what to do. Then
the plan will act on it – to say they will follow it or state it is insufficient.
They must notify in writing affected persons. ERISA §206(d)(3)(G). The
statute gives the plan a lot of discretion. In general the plan is protected as
long as it follows the letter of the law. The only time this may not work is if
the plan administrator is the participant who is subject to the order. If the
order is insufficient you only have to follow the plan rules. If the order is
sufficient the plan must comply. ERISA §206(d)(3)(A).
4. A QDRO cannot require payment or benefit that is not allowed in the
plan otherwise. ERISA §206(d)(3)(D)(i). If the plan doesn‟t permit lump
sum distributions and the QDRO calls for that, then it is not qualified. This is
the same for the age of distribution.
5. While the plan is making a determination with respect to the order, the plan
must take steps to prevent a distribution of the participant’s account.
Usually this means segregating the account until it has made the
6. A QDRO can require a plan to commence payments to an alternate payee
when the participant reaches retirement age even if the participant is still
working. ERISA §206(d)(3)(E)(i)(I).
7. A QDRO also cannot award an amount that is subject to a prior QDRO.
F. QUALIFIED MEDICAL CHILD SUPPORT ORDER (QMCSO) aka “The Kiddie-
QDRO”- §609 of ERISA
1. Does the same thing except only applies to medical support – a duty to pay
medical insurance – for a child (not a spouse or former spouse).
2. Came about b/c QDRO called for dependency with one spouse and medical
coverage on the other – but insurance companies state they don‟t allow you to
cover anyone that is not a dependent. Congress adopted this to force them to
3. Parallels the QDRO in requirements of orders, timelines, etc.
G. WHAT HAPPENS IF NON-PARTICIPANT SPOUSE DIES WHILE
PARTICIPANT IS STILL WORKING?
1. Ablamis v. Roper, 937 Fed. 2d. 1450 (9th Cir. 1991). DC finds that
community property doesn‟t give the non-participating spouse (who pre-
deceased the participant) the right to bequeath an interest in the spouse‟s plan
and that ERISA and the REAct preempts any state community property law.
9th Circuit affirms.
2. Boggs v. Boggs, in text, the Supreme Court addressed the same issue.
a. Under ERISA there is no way for the non-participant spouse to transfer
an interest in the participant spouse‟s pension plan upon death.
b. Note: The system doesn‟t favor one gender over another, but it favors
the survivor regardless of whether you are the participant or the non-
c. Note: There is a bias that we are funding retirement not death benefits.
d. §V of this case: If it is IN the plan then it is subject to Boggs, but if it is
out of the plan then it is subject to state court jurisdiction.
XII. TAXATION FROM THE PERSPECTIVE OF THE EMPLOYER, THE PLAN, AND
THE BENEFICIARY - Two Primary Code sections: Deduction piece IRC §404 and
Taxation to the recipient IRC §402
A. EMPLOYER DEDUCTIONS - ER deductions to plans (whether qualified or not) are
governed by §404. If non-qualified, §404(a)(5). And for qualifed §404(a)(1) through
1. An ER can take a deduction for the contribution as long as it would
“otherwise be deductible” – meaning constituting an “ordinary or necessary”
business expense under IRC §162 or 212. (Compensation must therefore be
“reasonable” per Treasury Regulation §1.404(a)-1(b).)
2. Timing of Deductions - §404(a)(1)-(3) puts all plans on a “modified cash
a. Generally, contributions are deductible in the year they were made.
(Notes are not considered contributions until the note is paid. Williams
Co. v. Commissioner, 429 U.S. 569 (1977).)
b. In order to get a deduction for a contribution to a prior year, it must be
made by the due date of the tax return (on the following year – like for
individuals, April 15th 2004 for the 2003 tax year) plus extensions, if
any. IRC §404(a)(6). It is common for plans to contribute funds after
the plan-year ends. This period is usually 8.5 months after the close of
the plan year (returns are due 2.5 months after plus the usual automatic
6 month extension).
c. Note: IRC §401(k) deferral contributions (those contributed by
employees) must be funded when withheld from the participant‟s
paystub (at that moment the money becomes a plan asset and must be
funded as soon as reasonably feasible). Other contributions don‟t have
this limitation – matching contributions are subject to the above
d. Although you can pay the contribution after the end of the year, you
can’t adopt a plan after the year-end – for that year. If you want to
make a contribution for a plan that has a 2003 calendar year you must
adopt the plan before the end of December 2003. This is stated in
Revenue Ruling 76-28, 1976-1 C.B. 106.
(i) EXCEPTION: Self-employed or self-owned corporation
– you can adopt a SEP (Simplified Employee Plan) – you
can adopt this up to the day you must file your tax return.
This is b/c it is NOT qualified.
e. Note: IRC §404(a)(6) – courts have held that an ER can only get a
retroactive deduction on contributions if they are based on
compensation earned by the participant in the same year as the
deduction is requested.
f. Revenue Ruling 90-105, 1990-2 C.B. 69 – IRS says for 401(k) plans,
the employer‟s contributions based on year 2‟s compensation cannot be
deducted in year 1‟s taxes.
3. What are the contribution deduction limitations? Follow the minimum
funding standards requirements. These are not about protecting employees
but protecting the IRS – so you can‟t take too large of a deduction.
a. DCP (pension plan = money purchase pension plan) the limit is the
contribution formula of the plan or 25% of aggregate participant
contribution whichever is less. IRC §404(a)(3)(A). This 25% is an
overall basis for the plan so it is okay if your HCE go over that number.
b. DBP (§412) so long as the deduction doesn‟t exceed the amount
necessary to fund past and current service benefits on a level
percentage over the remaining service life of each employee or the
normal cost to the plan plus the amount necessary to fund unfunded
benefit costs from the past over 10 years, it is allowed. §404(a)(1). As
a minimum, an employer can always deduct the amount necessary to
satisfy the minimum funding standard of §412. But the deduction may
NOT exceed the full funding limitation for such year determined by
§412 and IRC §404(a)(1)(A).
c. For profit-sharing and 401(k) plans – it is 25% of compensation
(contributed by employer) plus the amount of any 401(k) deferrals!
IRC §404(n). We apply these against compensation of participants but
we cap this compensation at $205,000 (for 2004). Compensation,
however, is calculated to include the amount deferred into the 401(k)
plan. IRC §415. IRC §404(l) brings in limit in 401(a)(17)(B). See
also §404(a)(3) for the contribution deductions.
d. What if you have both? §404(a)(7) has multiple plan limits. All “like-
plans” of the same employer or affiliated group of employers get
aggregated together and treated as one plan. If you have both a money
purchase pension plan and a profit sharing plan, neither plan can
exceed its own limits and the aggregate limit for both is 25%. Each
plan‟s limits is not a big deal anymore b/c of the 2001 changes – so the
total in aggregate cannot exceed 25%. If you have a DBP and any kind
of DCP, the limit is the greater of the amount necessary to fund and
deduct into the DBP or 25% of compensation. For all practical
purposes multiple plan limits are 25%.
e. These are limits on deductible contributions – different from §415 – has
NOTHING TO DO WITH ANNUAL ADDITIONS.
4. What can be excluded from contributions?
a. Rev. Ruling 86-142, (page 375) Establishes two things:
(i) Administrative costs b/c they are deductible under either
§§162 or 212 are NOT considered to be “contributions.”
(ii) Brokerage fees and commissions, which are deemed to be
“intrinsic to the value of a trust‟s assets” are NOT
deductible under §§162 or 212 (but rather would have to
be capitalized), ARE considered contributions! So if
you establish that the plan will reimburse the employer
for paying brokerage fees (ala the contract) then you may
be able to get away with reclassifying these as
“administrative costs” then deducting them (and not
adding them to the contributions).
b. What happens if you are a fiduciary of the plan and the investment goes
bad and you are worried about getting sued so you want to repay the
plan for its losses? You can do this – without the amounts being
treated as contributions provided there is a bona fide and likely claim
on behalf of a participant – they don‟t have to bring it, just have one.
Rev. Ruling 2002-45 and Private Letter Ruling 199913047.
c. Expenses, legal fees, consulting fees etc. paid by the plan sponsor to
establish a plan are non-deductible capital expenditures. INDOPCO,
Inc. v. Commissioner, 503 U.S. 79 (1992). All professional fees must
d. IRC §4975, added by ERISA §2003(a) imposes a two-tier excise tax on
specified “prohibited transactions.” These are specifically defined in
the statute. One of which is a “sale or exchange of any property
between a plan and a disqualified person.”25 IRC §4975(c)(1)(A).
(i) In Commissioner v. Keystone Consolidated Industries,
Inc., 508 U.S. 152 (1993), the employer contributed two
properties to the plan then treated them as a
sale/exchanged for his own individual income tax
purposes. There was a dispute as to whether the
transactions were actually sale/exchanges. The DoL‟s
biggest concern is if you can contribute property and take
a deduction for the value of the property it will inherently
be overvalued. The participants (and the plan) are then at
risk. Two points:
i. If that is how it is analyzed, then you could take a
deduction for the full value but it has to be treated as
a sale or exchange and you must recognize the gain.
Supreme Court says it was a sale/exchange.
ii. What happens if you don‟t have a DCP with a
required contribution? The employer who is simply
contributing the property might be able to get away
with it. It will probably not work – but the DoL has
not fully spoken on the issue. Good authority to say
if no obligation then it is NOT a prohibited
transaction but be careful b/c not sure yet.
(ii) Note: If the employer obtains an individual administrative
exemption from the DoL from the rules it might be able to
contribute property anyway – see ERISA §408(a).
(iii) BIG EXCEPTION to the In-Kind contribution –
EMPLOYER STOCK is okay. You have three different
types of qualified plans for which this is okay as long as it
is for adequate consideration and no commission is
charged, ERISA §408(e) and IRC §4975(d)(13):
i. Individual Account Plans – profit sharing or money
purchase plan – can hold up to 10% of employer
securities, if plan is drafted to allow this you can
contribute in excess of the 10% (employer gets a
deduction even though they don‟t have a basis!)
ii. Stock Bonus Plans – profit sharing plans – designed
to have 100% of assets in employer stock. Can be
contributed or purchased on market
iii. ESOPS – same rights as stock bonus plan (up to
100% in employer stock) but can also leverage the
purchase of employer stock
Note: Advantage of contributing employer stock over other types of property is b/c under IRC §1032 no
gain or loss is recognized on the “sale or exchange.”
5. What happens if you EXCEED contribution limits?
a. The code sections don‟t prohibit an employer from contributing more
than the maximum deductible amount, but the deduction of that amount
A “disqualified person” in this case is the “employer of the employees covered by the plan. IRC
is prohibited in the current year. The excess can be carried over and
deducted in succeeding years. IRC §404(a)(1)(E), (3)(A)(ii).
b. Money can‟t typically be withdrawn. §404(a)(1) and (3) which limits
the deduction don‟t generate any way to remove the money. These
excesses are carried over to be deducted later!! BUT there is a 10%
excise tax from IRC §4972(a). The excise tax is not deductible. IRC
§275(a)(6). This continues to be applied every year that there is an
excess!! This is taxed against the employer not against the plan money.
There is nothing in the code that will prevent you from simply taking
out the money.
B. TAXATION OF PARTICIPANTS AND BENEFICIARIES (395) IRC §72 – book
talks about a rare situation – how you allocate between after tax contributions and the
deductible contributions? In old plans this made sense, but now these plans are rare.
Now only the money in the plan on which tax has been paid is by mistake. If there is
money on which tax has been paid, it is treated as basis and IRC §72 governs the
procedure of taxation for these distributions.
1. §72 – Annuities (Payments to Beneficiaries from qualified plans)
2. §72(a) Any amount received as an annuity is included in income. (Except the
amount that was contributed – which is your basis.)
3. §72(b) Exclusion Ratio – gross income does not include that amount =
4. §72(b)(1) See the Hand Out #3 (from Fall Quarter Basic Income Tax).
Exclusion Ratio is: [(Investment in the contract, which is your basis)/(annual
payments x life expectancy from table V in Reg. §1.72-9)] x (payments
received) = excluded portion from tax. Everything else is taxed at the current
5. §72(b)(3)(A) If annuitant dies before entire investment (the amount paid as
your basis) is recovered, is a deduction for taxpayer‟s last taxable year.
6. §72(e) Non-annuity payments – the beneficiary is NOT taxed on that portion
of the monthly payments (or lump sum) that bears the same percentage of his
basis to the value of his vested account balance.
7. ROLLOVERS – to avoid paying tax as the participant (see page 399 of
a. You can now roll from an IRA to a qualified plan!!! (Holy Shit!)
b. The only caveat is: the IRS rules say that if you roll from a type of
plan that contains specific restrictions (IRA – no borrowing, no
insurance etc) those restrictions roll over too!26
c. What do we need for a rollover? Three things from IRC §402(c):
(i) Assets distributed from an eligible plan (qualified plan,
401a annuity, a 403b annuity [see IRC §403(b)(8)], IRA,
or a 457 governmental plan (not tax exempt ones) – this is
from the 2001 tax act)
(ii) It must be transferred into another “eligible plan”
(iii) And must occur within 60 days of receipt.
i. Waiver of the 60-day requirement - if you miss the
date but have “good cause” then you may be able to
make the rollover. But be careful. The 2001 Act
allows the IRS to waive the 60-day rule, “where the
failure to waive such requirement would be against
equity or good conscience, including casualty,
So you have to keep these accounts separate. This is largely IRS made-law b/c there is nothing in the act
that states this. This is likely to be less of a problem in the future. Conservative advice: Plans probably
don‟t want to allow people to roll over into qualified plans unless you want lots of additional administrative
disaster, or other event beyond reasonable control of
the” taxpayer. IRC §402(c)(3)(b).
d. Rollovers can be made from distributions from ALL plans except
(i) From those paid in “substantially equal annuity
payments” over the life or life expectancy of the recipient
(ii) From those paid in “substantially equal payments” over a
specified period of 10 years or longer. If you are
receiving distributions over a 12 year span you cannot roll
(iii) From required minimum distributions under the rules of
IRC §401(a)(9); OR
(iv) From hardship distributions from 401(k) and 403(b)
e. Only distributions to the participant or the surviving spouse can be
rolled over! Benefits payable to your children must be reported as
f. Certain kinds of distributions CANNOT be rolled over:
(i) Distributions after age 70 ½;
(ii) Distributions of excess deferrals, excess contributions,
and excess aggregate contributions under IRC §§401(k),
401(m), 402(g) and those resulting from returns of 401(k)
elective deferrals under the §415 limitations;
(iii) Certain defective loans which are deemed distributions
(iv) Post 2001 hardship distributions
Note: There are more, but these are the only ones discussed in class. See page 400, second full paragraph
for a complete discussion. These are not found in the code but are stated to be the Treasury‟s view that
Congress didn‟t intend for these to be “rollovers.”
g. Mandatory Withholdings - 20% of the distribution is to be
mandatorily withheld. IRC §3405(c). Problem: How do recipients
avoid paying the tax when they only get 80% of the entire distribution
and cannot rollover the entire amount??!! They had to pay this out of
pocket. In 1992, direct rollovers attempted to fix this.
(i) Note: Only distributions that are eligible for rollover are
subject to the 20% withholding. So distributions made to
children and those for hardship are not. Treas. Reg.
§1.402(c)-2, Q & A-10(b). Only pension plans are
subject to this as well, IRAs are NOT!
h. Direct Rollovers - IRC §401(a)(31) and §403(b)(10) for annuities
allows direct rollover. Every plan where a participant or beneficiary is
going to receive a distribution that is eligible to be rolled over – must
notify the participant/beneficiary that they have a right to rollover to an
IRA or other plan, directly (no money out of pocket for the recipient).
IRC §402(f). These are not subject to the 20% withholding of federal
income tax. DBP are not eligible plans to receive a direct rollover.
i. Rollovers by non-spousal beneficiaries limited - IRS has taken the
position that this is a distribution to the recipient followed by a
rollover. So then the deemed distribution is subject to the spousal
consent rules as if they were taking the distribution!
j. Only distributions to the employee may be rolled over. IRC
§402(c)(1)(A). Two EXCEPTIONS:
(i) A spouse may roll over distributions after the employee‟s
death as if he/she were the employee. IRC §402(c)(9).
(ii) If an alternate payee were the beneficiary under a
QDRO, he/she is treated as though he/she were the
employee. IRC §402(e)(1)(B). There must be a QDRO!
k. Keep these things in mind:
(i) ERISA plans are completely protected from creditors
(except the IRS) but IRAs are not necessarily;
(ii) A participant who is NOT a 5% or more owner of the
business and who works past 70 ½ is NOT required to
commence receiving distributions from the plan (but IRA
owners must do so even if they are still employed);
(iii) Spousal rights in ERISA plans v. those in IRAs:
i. ERISA plans cannot be bequeathed as community
property but IRAs can;
ii. ERISA plans subject to strict spousal consent rules
but IRAs have none!
(iv) Loans are acceptable from ERISA plans (subject to rules)
but are considered to be deemed distributions from IRAs.
THINGS OF NOTE:
TRANSITIONAL LUMP-SUM AVERAGING (page 408)
The 5-year standard was repealed except for the transitional rule below.
EXCEPTION: Transitional rule that applies to people born before 1936 and who made an election in 1986
to use 10 year averaging. This is very rare. These people are approaching 70 now. They are the only ones
eligible to use the 10-year lump sum averaging.
EMPLOYER SECURITIES (page 409 – these are shares of stock and bonds or debentures issued by
a corporation with interest coupons or in registered form.)
When a participant receives a lump sum distribution of an employer‟s securities, there are special rules in
402(e)(4) that allow the participant to report tax only on the “basis” (the price the stock was valued at when
the employer placed it in the plan) and defer tax on any appreciation that occurred while it was in the plan,
until the participant ultimately sells the stock. The original basis is taxable at ordinary income rates but the
appreciation for the most part is at long term capital gains rates, regardless of how long the participant held
it. The term “lump sum” is defined in IRC §402(e)(4)(D)(i) as a “distribution from a qualified plan, within
one taxable year of the recipient, of the balance to the credit of the employee, which becomes payable to
1. On account of the employee‟s death;
2. After employee attains age 59 ½;
3. On account of the employee‟s separation from service; OR
4. In the case of self-employed, upon the employee‟s becoming disabled.
ABILITY OF PLAN PARTICIPANTS TO TAKE LOANS
You have two sets of rules that don‟t have lots of connections to each other:
1. §72(p) – governs the extent to which a distribution as a loan can avoid being the subject of tax – if
you don‟t meet these then what you thought was a loan is actually a taxable distribution; AND
2. §§406 – 408 of ERISA and §4975 of IRC – create an exemption from the so-called prohibited
transaction rules (essentially self-dealing between the plan and its participants) – unless your loan
satisfies these then it is a prohibited transactions exposing the fiduciary to personal liability and
the plan to an excise tax under §4977 of 15% or higher if not corrected.
§408(b)(1) of ERISA and §4975(d)(1) of IRC – require that in order for a loan from a plan to not be
considered a prohibited transaction27 it must meet all of the following:
1. Available to all participants and beneficiaries on a reasonably equivalent basis;
2. It is not made available to HCEs in an amount (%) > than it is available to other employees;
3. It is made in accordance with specific provisions regarding loans set forth in the plan and any
4. The loan bears a reasonable interest rate; AND
5. The loan is adequately secured.
Note: 4 is generally not a problem. 5 is usually not a problem either b/c the loan is secured by the
participant‟s interest in the plan.
Okay – will the loan be taxed?
§72(p) – a loan will be “deemed a distribution” (treated as a distribution and taxed as one) unless certain
requirements are met:
1. Maximum loan amount requirement – the loan cannot be for an amount greater than the lesser
a. $50K; or
b. The greater of:
(i) $10K (This includes people with no vested interests in the plan! But the
loan still must be secured, so it will likely be by some collateral outside
the plan); or
(ii) 50% of the participant‟s present value of vested interest in the plan.
Note: TRAP – the loan amounts above MUST be reduced by the outstanding balance of all plan loans that
the participant owes for the last 12 months (12 month rule)!!
Loans from a plan to an owner-employee as sole-proprietor or a member of his/her family are NOT
exempt from treatment as a prohibited transaction. IRC §4974(d) and ERISA §408(d). NOTE: THIS WAS
ELIMINATED BY THE 2001 ACT!! Now this is only prohibited in IRAs.
2. The loan must by its terms be repayable within 5 years, with the payments made at least
quarterly and providing for substantially level amortization of the loan.
a. EXCEPTION: Loans used to acquire a principle home (30 year mortgage). IRC
LIMITATIONS ON DISTRIBUTIONS
1. Distributions may not be postponed beyond a specified date unless the employee consents. IRC
2. Participants with a vested accrued benefit worth more than $5K cannot be “cashed out” of the plan
prior to normal retirement age without their consent. IRC §411(a)(11) and ERISA §203(e).
3. Plans must provide a QJSA and a QPSA, unless the participant AND the participant‟s spouse elect
otherwise. IRC §§401(a)(11); 417; ERISA §205(a).
PURE TAX RESTRICTION LIMITATIONS ON DISTRIBUTIONS
Other restrictions are to prevent abuse by the participant or to prevent abuse by the employer. These are
pure tax – there to encourage the response that the IRS wants:
1. Tax on early distributions EXCEPTIONS:
a. The definition of a pension plan is that it must have a definitely determinable benefit – if
you can take a distribution at any time then it isn‟t definitely determinable. Treas. Reg.
1.401-1(b)(1). So you can‟t have a distribution before death or disability, termination, or
reaching retirement age.
b. But in profit sharing plan you can allow distributions while someone is still working:
(i) Revenue Ruling 74-254 – A noncontributory money purchase plan
which allows distributions of vested interests to participants who are
transferred to job locations outside the area covered by the plan will not
be considered a “qualified plan.”
(ii) Profit-Sharing Plan – A plan that allows participants who have been in
the plan for at least 60 months, to take a distribution of any or all their
profit sharing (employer contributions) including those contributed in the
last 24 months is still a qualified plan! – Revenue Ruling 68-24 on pages
417-418 of text.
(iii) The above distributions may still be subject to early distribution tax but
they don‟t imperil the qualification of the plan.
(iv) Can also have hardship distributions defined by the plan – must meet
the following: “hardship” must be defined in the plan, the rules with
respect thereto are uniformly and consistently applied, and the
distributable portion must not exceed the employee‟s vested interest.
Treasury Regulations 1.401-1(b)(1)(ii).
c. 401(k) Plans and the deferrals themselves – these exceptions do not apply – unless there
is hardship. You can make distributions for certain hardships as defined in Treasury
Regulation 1.401(k) – 1(d)(2) while the person is still working. This is the only
exception to the 401(k) distribution rules. The hardship must be a true hardship –
immediate and heavy financial need under the regulation‟s terms and that the distribution
be the minimum amount necessary to satisfy the hardship. He is leaving this to our
reading and will not be tested on this. (Page 419)
2. §72(t) – tax on early distributions – there is a 10% additional excise tax on any distribution form
a qualified plan or IRA prior to death, disability, separation from service, or attainment of age 59
½. Any other distribution is taxable as income AND the 10% excise. If you rollover you avoid
this, of course.
a. What if you have a loan that doesn‟t meet the requirements of §72(p)? Then it is taxable
AND the excise tax will also apply.
b. EXCEPTIONS to §72(t) 10% tax:
i. Annuity distributions that began after a severance of employment payable over life
of spouse or participant – still subject to regular income tax – (doesn‟t apply to
j. Distributions made after separation from service after attainment of age 55 (does this
apply to IRAs?)
k. Medical expenses deductible under §213
l. Distribution to alternate payee under a QDRO are not subject to the 10% penalty –
the alternate payee pays income tax but not excise tax – doesn‟t apply to IRAs BUT
under §408 IRAs can be separated into two IRAs with no tax effect at all.
m. Distribution of excess deferrals where the money never got credited into the plan
(see list on page 422)
n. Note 2 on page 422 of text – distribution taken in a bankruptcy will not be taxed
o. Distributions as a result of a levy by the IRS.
MINIMUM DISTRIBUTION RULES
The “primary purpose” of a qualified plan must be to provide retirement benefits or deferred compensation.
Treasury Regulation §1.401-1(b)(1). They should be designed to prevent people from deferring the
benefits of the plans beyond their lifetime.
§401(a)(9) of the IRC establishes the MDR to accomplish this purpose:
1. Pre-Death Minimum Distributions: either the entire interest of the employee OR periodic
annuity payments must begin by the “required beginning date,” meaning that it must occur:
a. By April 1 of the calendar year following the later of:
(i) The calendar year in which the employee turns 70 ½, OR
(ii) The calendar year in which the employee retires. IRC §401(a)(9)(C)(i).
b. EXCEPTION – in the case of 5-percent owners (as defined in §416) distributions must
commence by April 1 of the calendar year following the year in which the owner attains
age 70 ½, even if they are still working. IRC §401(a)(9)(C)(ii). So if you are NOT a “5-
percent owner” as long as you are working, you don‟t have to take these distributions.
TRICK – you don‟t have to take a distribution until April 1st of the year following the year in which you
attain the age 70 ½. So if you turn 70 in July you don‟t turn 70 ½ until the following year and you have
until the NEXT year to start! Although you can defer the first distribution until that April 1st, that first
distribution is on account (attributable) of the year your turned age 70 ½. So you get the distribution from
that year PLUS the year you start getting them – meaning you pay taxes on TWO distributions.
So what is the period of distribution?
Participant? Generally it is the participant‟s life expectancy
Married? It is the joint life expectancy of the participant and his/her beneficiary – (“or over a period not
extending beyond the life expectancy of such employee or the life expectancy of such employee and a
This is found at IRC §401(a)(9)(A)(ii).
Calculating life-time distributions that commence before death:
This is primarily left to the regulations: Temporary Treasure Regulation §1.401(a)(9)-6T. You determine
the age of the participant at the end of the year, but you look at their account balance on the last day of the
prior year, then you use the life-time table in Treasury Regulation §1.401(a)(9)-9, A-2. Based on the
employee‟s age you will get a distribution period, which you divide the employee‟s account balance by to
determine how much they should get per year.
When calculating after–death distributions, there are 2 rules:
1. If the participant dies on or after the “required beginning date,” meaning distributions have
already commenced, and the sole beneficiary is the spouse, the spouse will get the greater of:
continuing distributions over life expectancy of participant or over the life expectancy of the
spouse. Treasury Regulation §1.401(a)(9)-5, Q&A-5. Additionally, the spouse can delay
distributions until the participant would have been 70 ½ then take distributions over the spouse‟s
life expectancy. The spouse could also roll over the amount into his/her IRA, tax free, and then it
would be subject to the same MDR as his/her other IRAs.
a. If the beneficiary is someone other than the spouse, then the distributions can be made
over the life expectancy of the beneficiary, commencing the year following the year the
b. If the beneficiary is a trust (the payments go from the trust to individuals, not a charity or
an estate) – see Treasury Regulation §1.401(a)(9)-4, Q&A-5(a), you must look to ages of
beneficiaries because the payments are based on those ages and subsequent life
expectancies. Furthermore, the trust must be a “qualified trust” under §1.401(a)(9)-4,
Q&A-5(b). If there are multiple beneficiaries – take the oldest one UNLESS separate
shares are established for each beneficiarie – then each is on their own life expectancy
distribution schedule. If the trust is NOT a qualified trust or the money is payable to an
estate – all amounts must be paid out within 5 years. IRC §401(a)(9)(B)(i). (See below
for the “5-year rule.”)
2. If the participant dies before the “required beginning date,” meaning the employee‟s interest
is intact and no distributions have begun, the “5-year rule” applies. This states that the employee‟s
entire interest must be distributed within 5 years after the employee‟s death. IRC
§401(a)(9)(B)(ii). But there is an EXCEPTION to the “5-year rule”:
a. If any portion is payable to an actual designated beneficiary (spouse or any other);
b. That portion will be distributed over the life expectancy of the beneficiary; AND
c. The distributions must begin:
(i) For a spouse, on or before the later of: the end of the calendar year
immediately following the calendar year in which the employee died, OR
the end of the calendar year in which the employee would have attained
age 70 ½. Treas. Reg. §1.401(a)(9)-3, Q&A-3(b).
(ii) For a NON-spouse, on or before the end of the calendar year immediately
following the calendar year in which the employee died. Treas. Reg.
FAILURE to satisfy MDR
You will be hit with a 50% excise tax on the shortfall of your distribution. This is very severe. IRS may
waive this penalty – don‟t count on it. §4974 IRC. There used to be taxes on excess distributions but those
are long gone.
Retirement distributions to people who no longer reside in the state may be taxed in the future. This might
be some sort of income tax. Courts have said no so far but this is likely to change.
XIII. FIDUCIARY RULES UNDER ERISA – GENERALLY
Basic Fiduciary definition is found at ERISA §3(21)(A). Except as otherwise provided in subparagraph
A person is a fiduciary with respect to a plan to the extent that he/she:
1. Exercises any discretionary authority or control respecting management of such plan or
exercises any authority or control respecting management or disposition of its assets;
2. Renders investment advice for a fee or other compensation, direct or indirect, with respect to any
monies or other property of such plan, or has any authority or responsibility to do so; OR
3. Has any discretionary authority or discretionary responsibility in the administration of such
What if I was authorized but didn’t actually exercise control? Regardless of whether you actually
exercise control or authority over the plan, you are a fiduciary if you CAN do so. You can‟t say you didn‟t
do anything and not be held liable if you were in fact given the authority to make decisions.
Authority/Control v. Ministerial Functions - There is a difference between having authority and
control over the administration of the plan and carrying out mere ministerial functions with respect to the
plan. If you can control the way the plan works you are a fiduciary but if you only carry out terms that are
clearly prescribed instructions then you are not. Likewise if you have authority and control over plan assets
you will be a fiduciary.
DOL Interpretation of Discretion - Discretion with respect to being a fiduciary implies the “power to
make decisions as to plan policy, interpretations, practices or procedures.” Department of Labor
Regulations, 29 C.F.R. §2509.75-8.
WHO IS A FIDUCIARY AND WHO IS NOT?
ERISA §402(a)(1) says that a plan must have a fiduciary and the administrative functions are to be carried
out by the fiduciary (so by default the plan administrator is a fiduciary).
ERISA §402(a)(2) says the employer or employee organization (union) can designate some other party as
fiduciary (like an investment firm).
ERISA §3(16) treats the plan sponsor, normally the employer, as the administrator unless the plan
designates someone else.
Note: Not everyone doing administrative functions is a fiduciary. The Department of Labor says that
processing claims and applying the rules (with no interpretation), communicating with employees and
calculating benefits – these are all ministerial and are not discretionary, therefore are not the functions of a
fiduciary. 29 C.F.R. §2509.75-8.
CASE EXAMPLES OF WHO IS OR IS NOT A FIDUCIARY
Blatt v. Marshall & Lassman (812 F.2d 810) – page 648 – Even though the appellees were not granted the
authority or control over plan assets or administration, they were held to be fiduciaries b/c they exercised
this authority/control by failing to file appropriate paperwork to allow the appellant access to his funds for
1.5 years. RULE: A court will look to the action performed to determine whether an individual can be
considered a fiduciary rather than just at the plan‟s authorization.
Gelardi v. Pertec Computer Corporation, (761 F.2d 1323) and Munoz v. Prudential Ins. Co., (633 F. Supp.
564) page 653 – In both cases the court held that third-party plan administrators who were engaged in
nothing more than, “processing claims within a framework of policies, rules, and procedures established by
others,” were not fiduciaries. These were considered to be “ministerial functions,” and as such were not the
exercise of authority or control over the plan or its assets.
Mertens v. Hewitt Associates (508 U.S. 248) – page 755 – RULE: Non-fiduciaries cannot be held liable
under ERISA. This has been eroded to some extent b/c of Harris Trust case below.
Harris Trust & Sav. Bank v. Salomon Smith Barney Inc., 530 U.S. 238 – Salomon Smith Barney was
selling proprietary funds to retirement plans for which it was also the trustee/custodian. The claim was
(when funds went south) you are liable as a fiduciary. Solomon said no – following Mertens. The court
agreed but then said BUT you are a party in interest involved in a prohibited transaction and can be held
liable. How far does this go???? RULE: Non-fiduciaries that participate in prohibited transactions may be
liable under ERISA.
MULTIPLE FIDUCIARIES FOR ONE PLAN
ERISA contemplates multiple fiduciaries:
ERISA §403(a)(1) requires the designation of a named fiduciary.
ERISA §403(a)(2) allows delegation or allocation of fiduciary duties amongst fiduciaries.
ER as Fiduciary v. Other Named Fiduciary: In general the plan can allocate these duties among
fiduciaries and only the party to whom responsibility is allocated will be held liable. ER is always the
default fiduciary unless they hire or designate some other firm/person to be fiduciary. Generally, if that
firm makes bad investment decisions and there is a claim, the ER is off the hook unless the ER was
negligent in the selection of or monitoring of the fiduciary.
EXAMPLES OF WHO IS OR IS NOT A FIDUCIARY based on job category
Is an insurance company acting as third-party administrators a ficuciary? – 9th and 11th say ministerial, 6th
says goes beyond the heart of the issue therefore = discretionary. Courts are split.
Attorneys, Accountants, Actuaries, and Consultants:
Department of Labor Regulation 29 C.F.R. §2509.75-5 (D-1) says in most cases those performing their
usual professional functions for the plan are NOT going to be considered fiduciaries. Courts generally
Note: But, when these professionals exercise sufficient discretion (generally in egregious situations) courts
have them to be fiduciaries. The auditors in ENRON case may be held to be fiduciaries. See cases cited on
ERISA makes it clear that they will virtually always be fiduciaries. This is because they render investment
advice and collect a fee. ERISA §3(21)(A)(ii). Very clear cases generally.
The Department of Labor limits this somewhat:
1. Advice must be rendered “on a regular basis,” and “pursuant to an agreement or undertaking that
such services will serve as a primary basis for investment decisions.” 29 C.F.R. §2510.3-21(c).
2. But they must actually be giving advice on investments rather than just generalized investment
theories. The above regulation states, “such person will render individualized investment advice
to the plan on the particular needs of the plan.”
a. DoL tries to distinguish between investment advice v. simply educating participants
(which is NOT a fiduciary activity).
i. In general, investment advice is the rendering of advice as to the value of
securities or as to the investment in securities or other property. Or, the advisor
directly or indirectly has discretionary authority to invest or their advice serves
as the primary basis as to the decision.
ii. As opposed to the following which are not investment advice: plan
information, benefits, impact of pre-retirement withdrawals, plan terms, etc. –
general financial or investment information, asset allocation models (of
portfolios) of generic asset classes, interactive investment materials (worksheets,
programs etc.) as long as based on generally accepted investment theories, an
objective correlation between risk and return is shown, material assumptions and
facts are disclosed, and if the materials identify a specific investment product,
alternatives must be disclosed and the entire thing must be accompanied by a
ERISA allows fiduciaries to appoint investment managers in §402(c)(3) and §403(a)(2).
ERISA singles out one particular class of investment managers for special treatment – to the extent an
advisor is an investment manager (meaning he is registered under the 1940 Investment Manager‟s Act and
they agree in writing they are fiduciaries to the plan – see ERISA §3(38) – these are “bright-line-type”
factors) then designating them as the named fiduciary frees the other fiduciaries on the plan from liability.
Stock and Bond Brokers?
Department of Labor regulation 29 C.F.R. §2510.3-21(d) says that generally, the routine execution of
customer orders does not make them ERISA Fiduciaries. Case law though has not been friendly to them –
the courts are split. If you have a situation where it is a pure broker relationship, and they call you up and
tell you to invest in a particular security, even though they get a commission (for transacting the sale – not
b/c they are giving you advice) and you buy it then they are off the hook to some degree.
ERISA has not had too many lender liability problems – generally not treated as fiduciaries – maybe liable
under other aspects of law.
Medical Coverage Providers – health and welfare area?
Example: Group Health provides health coverage for an employer and GH has decision power over what is
covered or not. They deem something as not medically necessary then decline to cover it. Participant dies
and the claim is made that they wouldn‟t have died if it had been covered. There are a series of cases that
go back and forth on this issue as far as preemption.
This is pretty unclear – see Pegram v. Herdrich, supplement on page 57. Supreme court doesn‟t do a lot to
clarify – you have mixed decision making that includes both fiduciary and non-fiduciary aspects and to the
extent you have this mix the court will not automatically declare the status of the decision maker as a
Note: ERISA preemption would not keep you from instituting a state-court action if the decision-making
was NOT in a fiduciary capacity. There is not a lot of guidance.
Who is Actually Exerting Control?
The Reich v. Lancaster (55 F.3d 1034) – cited in text – page 659 – a company hired an insurance agent to
make purchasing decisions re: the company‟s health, medical, and life insurance needs – the agent
encouraged trustees to buy the products that generated the largest commission instead of what might have
been in the best interest of the company (it charged $500K in fees and commissions over a 2 year period).
The claim was that this was a breach of fiduciary duty b/c it was an overcharge – court said you can reach
through a company to the parties that are actually exerting control and hold them liable as fiduciaries.
Co-Fiduciary Liability under ERISA
ERISA provides a broader net statutorily on co-fiduciaries – instead of relying on common law – it talks
about how they have DIRECT liability if they:
a. Knowingly participate in breach, ERISA §405(a)(1);
b. If their own breach (under ERISA §404(a)(1)) facilitates the known breach of another
party, ERISA §405(a)(2); OR
c. Knowledge of another fiduciary‟s breach he/she doesn‟t make reasonable attempts to
remedy the breach. ERISA §405(a)(3) says directly liable.
Note: ERISA §405(b) makes co-trustees jointly responsible for the management and control of plan assets
and imposes a duty to use reasonable care to prevent a co-trustee from committing a breach.
Functions that are fiduciary: control over plan assets etc. v. those that are Settlor Functions
McGann v. H&H Music (946 F.2d 401) – HALLMARK CASE FOR SETTLORS – employer had a
health plan which had a maximum benefit limit of $1 million per person – ER found out that EE was HIV +
and amended the plan to limit HIV/AIDS related benefits to $10K, the EE participant sued. RULE: ER did
not breach fiduciary duty b/c amending the plan is an absolute settlor function - so long as the plan reserves
to the ER the right to amend the plan – regardless of the intention of the ER.
Note: this wouldn‟t happen today b/c of Americans with Disabilities Act. But under ERISA, it is still good
law. ER exerting ER (settlor) functions is NOT liable as a fiduciary.
Equitable Relief under ERISA
ERISA §502(a)(3) – Civil Enforcement – A civil action may be brought by any person to (B) obtain other
appropriate equitable relief.
Varity Corp. v. Howe, page 663 – most important case – like McGann it has nasty facts – Varity was big
conglomerate with subsidiaries that were real dogs. Someone got the idea of packaging the dogs together
and spinning them off: Massey-Ferguson Combines – they held a series of meetings with employees to
convince them to go to the new corporation saying that the EE benefits are just as secure there. But Massey
was insolvent upon incorporation! The EEs who transferred in lost all their benefits – particularly health
benefits. EEs files lawsuit saying there was misrepresentation in getting them to go there and if that hadn‟t
happened they would have stayed put. District court found for EEs. Varity claimed:
1. In general, ERs don‟t have a duty to disclose future actions that may be taken unless they are
asked about them;
2. McGann – Varity was a settlor not a fiduciary so they are protected
District Court found that EE could get other “appropriate equitable relief” under §502(a)(3). But the
Appeals Court reversed.
Supreme Court went back to the DC opinion – and says that ER was acting as plan administrator and
engaging in fiduciary functions NOT settlor functions so Varity IS liable. They also agreed with the DC,
impossible to come up with monetary damages, so DC is correct that the provisions of ERISA §502(a)(3) –
is the right basis for the holding.
1. This is the first case that looked at this language and talked about equitable relief and applied it.
2. Since Varity (1995) there have been a multitude of cases making this claim. What did Congress
have in mind with respect to this particular term? Injunctive relief, restitution relief, but beyond
that? - it is WIDE OPEN!
Fischer v. Philadelphia Electric Co. (II) - page 688 – representative of the relatively few cases that hold
there is an affirmative duty not to conceal facts from a participant – like the fiduciaries in Varity did.
The court stated that, “a plan administrator may not make affirmative material misrepresentations to plan
participants about changes to an employee pension benefits plan.” This means the fiduciary must volunteer
Eddy v. Colonial Life Ins. Co. - page 699 – Thorson says this case clarified the issue and limited it to fairly
unique situations. RULE: In the context of health and life insurance, once a participant (who is separating
from service) reveals their predicament, the fiduciary must disclose all options to the participant including
continuing insurance under the plan and converting.
In addition to ERISA claims there are other bases for claims in situations involving plans:
1. ADA (Americans with Disabilities Act)
2. Age discrimination Act
3. Securities Laws – look at International Brotherhood of Teamsters v. Daniel - page 727 – a
noncontributory plan (ER money only) and EE had no election over what investments were made
(ER invested in ER stock then the stock went south), participants claimed there was a violation of
securities law and sued the employer. Supreme Court said no, ERISA establishes a fairly
comprehensive procedure for dealing with benefit claims therefore we will limit the application of
securities law to when:
a. A plan is contributory (like a 401k); AND
b. The EE designates in which investments those monies are invested (and one is ER stock).
Note: Plan interests must be registered OR you have to have an exemption (under securities act).
What are PLAN ASSETS?
Plan “assets” are not defined under ERISA.
Department of Labor Regulation 29 C.F.R. §2510.3-101 deals with this. It states plan assets include those
that are held in investment vehicles the plan invests in. EXCEPTION: if the assets in the investment
vehicles are publicly held, then the plan assets are only the shares themselves. See ERISA §§401(b)(1) and
Concept: you look through small ventures to the underlying assets.
Why? In dealing with fiduciary responsibilities and problems of self-dealing, a transfer between a
company and a plan – there may potentially be a fiduciary violation.
John Hancock Mutual Life Ins. Co. v. Harris Trust & Savings Bank – page 737 –
When shares of mutual funds are purchased, the purchaser is generally blind to what assets are in the funds.
With insurance companies that have their own funds, the assets may not be clearly demarcated as plan fund
assets v. insurance company assets. If the shares are part of the insurance company‟s assets and they sell
the plan interests, then there is a fiduciary breach for self-dealing (the insurance company is liable). This
comes up in small companies a lot. Look through transparent companies to the underlying assets unless
they are publicly traded companies.
XIV. HOW FIDUCIARY RULES APPLY IN THE CONTEXT OF INVESTMENT ISSUES -
Once you conclude that someone is a fiduciary then what does this mean?
A. Fiduciaries must exercise their duties satisfying all of the following:
1. ERISA “exclusive benefit” rule - §404(a)(1)(A) – A fiduciary shall discharge his duties with
respect to the plan for the exclusive purpose of:
a. Providing benefits to participants and their beneficiaries. A high number of lawsuits
involve this rule. Enron is a classic example. Series of cases on page 680 – discuss the
rule and the fact that the rule presumes that participants and beneficiaries will be treated
in an equal manner. Inherent in this rule is an equality of treatment under the plan. But,
the plan can have terms based on monetary amounts. But if you don‟t have plan terms
that differentiate the participants benefits based on monetary amounts, then the
fiduciaries cannot make a differentiation.
b. Defraying reasonable expenses of administering the plan.
2. Fiduciary Prudence – ERISA §404(a)(1)(B) – you have to act as a reasonable person in like
circumstances – courts have interpreted this to be a reasonable person “undertaking that function”
not just a person off the streets. It is NOT sufficient to say, well I just didn‟t know. This comes
up with employer stock in ESOPS – which are sold in corporate financing – you have someone
running their business who invests but is not skilled in doing so. Then the stock crashes and a
plaintiff‟s lawyer says you failed the standard of an investment professional – should have
liquidated. Many courts have bought this argument.
3. ERISA §401(a)(1)(C) – requires diversification by statute (even above prudence) – plan assets
must be acquired in a way to minimize the risk of large losses, but there is an EXCEPTION:
a. 10% of plan assets can be invested in employer securities – ERISA §407(a)(2) even in a
defined benefit plan. ESOPS and other DCP can invest up to 100% in employer
securities. How does this tie in to diversification? It is not absolute – just a manner
necessary to minimize the risk of large losses. Note: If there is risk you cannot take
advantage of this exception (the fiduciary is still liable under the “prudence” standard).
4. ERISA §404(a)(1)(D) – most violated of all rules – fiduciary must act in accordance with
documents or others instruments governing the plan so far as they are consistent with
ERISA titles 1 and 4. Even if code says you can do something if the plan doesn‟t allow you to do
it and you do it anyway, you are possibly breaching your fiduciary duty and you can be sued for
any losses participants suffer as a result of your failure to follow the terms of the plan.
5. ERISA §406 and IRC §4975 – prohibited transaction rules – grafted onto ERISA coming out of
exempt organization rules against self-dealings – it is a prohibited transaction for fiduciary to
allow certain conduct (sales/leases etc. between the plan and a party of interest) and if the
fiduciary allows this there are two issues:
a. The fiduciary has personal liability (ERISA §406); AND
b. There is an excise tax on the party of interest (not the fiduciary) under IRC §4975.
B. Prohibited Transactions
The code and ERISA are almost parallel in the language but the Code talks about the “disqualified person”
and ERISA talks about a “party of interest.” There is a huge overlap in these but they are not identical:
With respect to loans, under IRC §4975, a disqualified person does NOT include just any participant, you
have to be a HCE etc. But, under ERISA §406, ANY participant or beneficiary is a party of interest. You
can be one and not the other! So what is prohibited?
1. 4975(c)(1)(A) – (F) – (look at this section in the CODE!!) almost any transaction between these
people and the plan will be prohibited – and the fiduciary is liable.
2. Who are disqualified people? IRC §4975(e)(2)(A) – (I): The fiduciary or anyone providing
services, any employer that sponsors the plan, an employee organization (union), an owner (direct
or indirect of 50% or more of combined voting power of stock or capital interest or profits interest
in a partnership, members of the family of the individual, corporation, partnership, estate or trust,
officer, 10% or more shareholder, HCE, etc.). WARNING: This is very broad!! You may be
able to get an exemptions, see below:
Three types of exemptions from prohibited transactions rules:
a. Express codified exemptions ERISA §408 and IRC §4975(d)(2) – as long as not
compensated above fair market value services can be given. Biggest exemption is for
ESOPS – involve not only sale of stock to the plan but also a debt!
b. Class exemptions – published by department of labor – typically involve financial
institutions that create a fund and sell shares in that fund to a plan to whom they are a
fiduciary. This allows insurance companies, banks, etc. to have transactions between
themselves and the plan.
c. Individual exemptions – anyone can go to the DoL and seek one. Department of Labor
has a series of requirements in Regulation 29 C.F.R. §2570.30 and if you meet them then
you can apply for an exemption and possibly get one. If you have a large medical clinic
you may buy an office building to put your clinic in which is held in the plan – you can
try to get an exemption for this.
Note on Seeking Individual Exemptions: Seeking and obtaining exemptions is expensive and takes a
long time (6 months shortest). You must have at least 2 fiduciaries to agree that it is a FMV transaction
and you must have appraisals often – this is an uphill battle b/c the DoL comes from the perspective that
you are trying to rip off the plan. Persistence really pays off though in this.
Note on Monitoring Published Exemptions: Virtually all exemptions are published – CCH, etc. will
have access to them – “PTE” with a year and number. Can you rely on them? If they are a class exemption
then it is like a published ruling. If it is individual exemption – it is like a private letter ruling. You will
almost always want one of these unless you are part of an exempt class.
Note: Expedited process – if you have substantially identical factual terms to two other exemptions
granted in the last 5 years – you can use this (6-8 months instead of 2-3 years).
C. Exculpations and Indemnities
ERISA says the plan cannot agree to indemnify fiduciaries – it is void against public policy. See
§410(a)!!! BUT there is nothing that prohibits an employer from indemnifying a fiduciary! In fact, this is
common for employees that are asked to do this – you can insure against fiduciary liability too.
Note: It must be a contract between the employer (or union) and the fiduciary it CANNOT be in the terms
of the plan.
D. Fiduciary Due Diligence
Donovan v. Bierwirth, page 810, - Another company had planned a hostile takeover, the plan trustees (who
were also officers in the target corporation) were opposed to the takeover. The plan owned a significant
amount of target corporation stock, but the trustees decided to buy more so that their voting power was
stronger. The takeover bid was enjoined b/c of anti-trust laws and the shares fell in value. The takeover
failed. Participants sued wanting the trustees to pay back the loss of the value of the stock. DC found a
violation. Holding: Second Circuit affirmed a violation but not on the amount of ER stock in the plan but
b/c the trustees violated the prudence standard (ERISA §404(a)(1)(B)) and failed to act for the sole benefit
of participants (ERISA §404(a)(1)(A)) by not examining more closely (due diligence) the need to buy more
stock or the effects of buying more stock on the plan at inflated prices.
Issue of Damages (In Bierwirth)
For totally unrelated reasons, primarily that the aircraft industry expanded in the following years, the stock
value was a lot higher than it originally was. So what is the measure of damages? The issue is not all that
clear. What period of time to you look at?
Some courts allow DC to select for itself the time frame at issue. Many judges choose to have the
difference between what profit was made and what would have been made if the discreet investment had
not been made be the damages. If there is no loss, then there are no damages.
E. Social Investing – socially desirable investments only
How does this play into fiduciary rules?
Department of Labor Interpretive Bulletin §2509.94-1 says that fiduciaries cannot subordinate the
participants best interests to social interests (or any other unrelated objectives)! You must be able to show
that you can build a portfolio that will be just as successful and just as low risk – so that the social
investment is not at the expense of participants.
F. Two Example Cases:
Firestone Tire and Rubber v. Bruch (1989), page 803, - Firestone sold a subsidiary and all of the former
employees of Firestone went with it. The EEs requested severance benefits but Firestone said no, they
don‟t qualify b/c this is not a “reduction in work force.” The case is cited for the standard of review of the
fiduciary‟s decision making. It contemplates two scenarios:
1. If the plan gave the fiduciary or administrator discretionary authority to determine eligibility or to
construe the plan‟s terms then the standard of review is arbitrary and capricious.
2. If, however, the plan is unclear or simply does not specify this, then the standard of review is de
1. If we say that we are granting discretion, is it over facts AND law or just facts? (Plans will likely
try to be aggressive and give it over both. Courts will likely say nope plan can only grant
discretion over issues of fact!)
2. What can the court consider? Assuming Firestone is met and the issue ends up in court for review,
Thorson assumes the only thing the court can look at is the evidence presented to the fiduciary
during the review or hearing (evidence on the record) and not new evidence – but this is not clear
and there is law going both ways!
Blau v. Del Monte Corp. (1985) - page 862 – The ER operated a severance pay plan without disclosing the
plan‟s terms to participants. The ER attempted to escape liability by showing that it could not have
complied with the non-existent terms. The court found that anything the fiduciary did (since it was all
“outside” of the plan‟s terms) was arbitrary and capricious. Just b/c you didn‟t have plan terms does not
mean a court cannot review your actions.
G. PARTICIPANTS’ ABILITY TO DIRECT THEIR OWN INVESTMENTS - ENRON AND
Fiduciaries are not guarantors of the result – it is all about doing it right: comply with duties and document
all of their decisions and actions (that are prudent) – some due diligence to determine what is in the interest
of plan participants. This might protect them from a SUCCESSFUL liability claim – this may not prevent
them from being sued but might not make them lose. It might be helpful to set up independent committees
to make decisions – delegate this out! This may insulate against the fodder to sue one person or entity.
§404(c) of ERISA provides an additional layer of protection for the fiduciary – to the extent that you
grant participants the right to direct their own investments, the plan fiduciaries won‟t be held responsible
for the participants‟ losses. But, the fiduciary must do three things (Department of Labor Regulation
1. Must have offerings from a broad range – to the participants, so they can choose from investments
with widely different return and risk characteristics;
2. You have to allow participants the opportunity to change investment allocations as frequently as
appropriate – at least once per quarter (depending on the nature of the investment – more frequent
if it is necessary to protect the participant); AND
3. You have to be sure that the participant is given sufficient information about the nature of this lack
of liability under ERISA §404(c) (notice) and about the available investments – see reg.
2550.404(c)-1, which details notice that fiduciaries will NOT be liable for participants choices.
Note: You can have employer stock as an option but you must have at least three core options with
substantially different return and risk characteristics.
ENRON and 404(c) plans and discussion of a LOCK DOWN –
But you couldn‟t move out of employer stock until you were 50 years old. DoL would think this was not
adequate ability to move investments around. Additionally matching investments were in ENRON stock
and you couldn‟t move it around. Lockdown – if you change from one investment manager to another they
will require that no trades occur for a specific amount of time – this is known as the lockdown. This
occurred while the stock crashed! So no one could sell and get out of the stocks. This is not uncommon
but it was unfortunately planned. This might not have been a breach if they had been told in advance and it
everything was documented etc. You have to give advance notice and keep lockdown time down to a
reasonable amount of time. The question is too, what was the communication to the employees? If the
fiduciaries knew of the impending doom (liquidating their own stock) while spreading disinformation about
the stock (telling employees to keep buying stock) – this is the real issue. But must be wary of violating
securities law (insider trading information).
XV. PREEMPTION – ERISA §514 “Other Laws”
General rule – Extremely broad – anything that relates to an employee benefits plan federal law will
preempt. ERISA §514(a).
Exception – the “Savings Clause” - §514(b)(2)(A) – Any state law regulating insurance, banking, and
securities is NOT preempted by ERISA.
Note on state law: It is NOT just a state statute – it includes the entire body of legal jurisprudence: statute,
common law, administrative law, etc. etc. This is big.
The “Deemer Clause” – an exception to the exception - §514(b)(2)(B) – A preemptive strike at a state
deeming employee benefit plans to be “an insurance company or other insurer, bank, trust company, or
investment company” in order to fall under the above exception. This clause says regardless, it is still
preempted by ERISA.
When looking at any preemption case there is a 4-step analysis:
1. Is there an employee benefit plan? If not, you are out of preemption.
2. Can the plan be exempted from ERISA in general (like church or gov‟t plans)?
3. Does the state law relate to an employee benefit plan? If not, you are done with the analysis.
4. Can the law be classified as the regulation of insurance, banking, or securities and therefore be
“saved” even though it relates to the employee benefit plan?
Breakdown of the four steps above:
Is there an employee benefit plan?
1. Massachusetts v. Morash (1989) - page 497 – The court held that a Massachusetts statute
forbidding the forfeiture of accrued vacation pay when an employee terminates employment was
NOT preempted since the vacation pay was not a “plan” under ERISA. The result would have
been different if the vacation pay had been payable from a separate trust or fund instead of the
ER‟s general assets.
2. Fort Halifax Packing Co. v. Coyne (1987) – page 497– A state statute requiring severance pay for
workers terminated incident to a plant closing was held NOT to be preempted. The Court
determined that the “one-time, contingent nature” of the required payment did not amount to a
3. Williams v. Wright (1991) - note 5 on page 109 – The 11th Circuit held that a single-participant
plan was still a plan!
Can the plan be exempted from ERISA in general? There are two categories under ERISA §4(b) that
1. Church plans (as defined in ERISA §3(33)) and
2. Governmental plans (as defined in ERISA §3(32))
This is bullet proof but narrowly construed:
Shaw v. Delta Air Lines (1983) - page 506 - The Court‟s broad interpretation of §514(a) made preemption
of state statutes almost automatic such that these exemptions were very narrow. The court held that §
4(b)(3) of ERISA excluded "plans," not parts of plans, from ERISA. So the employer's entire plan had to
be maintained for the purpose of complying with an applicable state disability insurance law in order to
claim an exemption to ERISA preemption under § 4(b)(3).
Does the state law relate to an employee benefit plan?
This is the heart of the issue!
Prior Law: As of „92 or „93 there were about 3000 cases dealing with preemption. Most found very
broadly that anything that named the plan or otherwise affected benefits was related to the plan and subject
New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Insurance Co. (1995) – page
510 - took a phrase out of Shaw which said that certain state laws are too remote or tenuous or incidental to
cause preemption and expanded that. The state statute exacted a surcharge from health plans and hospitals
that did not cover Medicaid patients. The statute was challenged as being preempted by ERISA. The
Supreme Court held that within the meaning of §514(a) the statute did not “relate to” employee benefits
plans. The statute was not sufficiently directed towards employee benefits plans to be preempted by
Note on Travelers: This was a 180‟ turn around! Most cases since have held that state acts don’t relate to
employee benefit plans unless they are directed at the plan and have some impact on the plan – so an
economic affect on the plan is NOT enough. State courts have taken this and run with it.
The Supreme Court limited Travelers in Egelhoff:
Egelhoff v. Egelhoff (532 U.S. 141 (2001)) – Washington statute provided that upon divorce designation of
the spouse as beneficiary (directed at insurance policies) was automatically revoked. The state supreme
court applied this to both the decedent‟s insurance policy AND his pension plan. The US Supreme Court
stated that with respect to the pension plan, ERISA preempted the statute b/c although it was directed at
insurance the court‟s “application directly affected” employee benefit plans.
Can the law be classified as the regulation of insurance, banking, or securities and therefore be saved
even though it relates to the employee benefit plan?
Metropolitan Life Ins. Co. v. Massachusetts (1985) - page 530 – Mass statute required that any health plan
in the state had to include mental health benefits. Some plans that were self-insured sued and said the
statute was preempted by ERISA. The Court says that to the extent a state is imposing a restriction on
insurance this is fine, but to the extent that a state is imposing this on an employee benefit plan where there
is no insurance involved it is preempted. So insured plans can be regulated but self-insured plans cannot
b/c of ERISA preemption. This is the law today and it causes problems still. Self-insured plans are
generally very large plans and can escape regulation under §514(b)(2)(A).
Pegram v. Herdrich (530 U.S. 211 (2000)) – When dealing with mixed eligibility decisions regarding
treatments that will be covered by an HMO (mixed b/c eligibility is also determined by medical
professionals) the decision makers will not be held to be fiduciaries under ERISA.
ERISA §502 is the centerpiece for enforcement. Component parts:
§502(a)(1) – participants and beneficiaries get the most common means of enforcement: right to recover
and sue to enforce benefit promises (civil action). Last phrase under (B) is worth noting with regard to the
ripeness doctrine – in case of retirement plans in particular, you might have someone who starts working at
25 and doesn‟t get a benefit until 60 but gets terminated at 35, he doesn‟t have to wait until the harm occurs
but he can file suit NOW. Damages in the form of benefits must be paid directly to the participant.
§502(a)(2) – Statutory basis for the personal liability of a plan fiduciary (See ERISA §409). Even if there
is no damage to the participants the fiduciary must reimburse the plan if he benefited from his actions.
Here, damages are paid to the plan NOT directly to the participant, but the participants will benefit
indirectly. The right to enforce §409 includes the right to ask the court to remove the fiduciary from the
plan OR such other “equitable or remedial relief” as the court deems appropriate.
§502(a)(3) – This section allows an action by a participant, a beneficiary, or a fiduciary to sue for:
(A) Injunctive action; OR
(B) Other appropriate equitable relief to redress violations or to enforce provisions of this
title or terms of the plan (Remember Varity where this was used for the first time.)
Criminal Actions under ERISA:
§501 – Imposes criminal liability for willful violations of ERISA‟s reporting and disclosure requirements.
Note: ERISA explicitly exempts STATE CRIMINAL LAW from ERISA preemption. ERISA
§514(b)(4). So in addition to the above provision, all state criminal law applies to fiduciaries and others
who act criminally towards an employee benefits plan. So, the US Attorney CAN bring an action but it
will likely be a combination of BOTH federal and STATE law.
Keys to dealing with litigation – particularly defense:
Metropolitan Life Ins. Co. v. Taylor (1987) – page 749 – This case is cited for the fact that any action
involving ERISA benefits or plans, which is filed in state court can be removed by the defendant to federal
court. There are no contrary cases. To remove the suit, the claim has to be one that “arises under” ERISA.
That doesn‟t mean the plaintiff must plead it as an ERISA case. So if you look at the issue on its face and
there is a claim under ERISA, it can be removed.
Punitive or Extracontractual Damages:
Most cases involve a claim for benefits that the participant was entitled to receive. But what about punitive
damages, extracontractual damages, etc.? The case law says no, you can have equitable relief like in Varity
but no other damages.
Who can be the parties?
The participant/beneficiary, unions, spouses, etc.
Note on ASSIGNEE: You don‟t have the rights of a participant under ERISA just b/c you are an assignee
(like a hospital suing without naming the participant as a party) – you must name the participant in the
lawsuit as well.
ERISA §502(g)(1) – authorizes the court to grant reasonable attorneys to either party in its discretion. The
cases often recite the fact that it is not a “loser pays” standard.
Eaves v. Penn – this exemplifies this: someone wanted to purchase a company and convinced the seller to
sell a small amount to the buyer but sell the rest to the ESOP, that way the buyer became the trustee of the
ESOP. The buyer looted the company and drove the price of the stock to $0 – most of which was in the
plan! This is a classic case on fiduciary duty, but here it also goes into detail for what the standards are for
1. Relative culpability of the parties
2. The ability of the culpable party to pay
3. Whether the award will deter similar action in the future
4. The amount of benefit conferred on the participants and beneficiaries from the suit
5. The relative merits of the parties‟ positions
This case is cited routinely on this issue.
How much can be granted? Most courts have accepted the lodestar method – hours into the case and
prevailing rate. Page 789 – discussion of 9th Circuit view – multiplier should not take into account the risk
of losing the case on the part of the attorney – but DC DO take this into account, they are much more likely
to give a multiplier to the time invested. The hourly rate of the attorney is usually accepted as
“reasonable.” Typically a contingency fees case usually get 1 – 1.5 times the hours put into the case.
Keep the Burtons case in mind b/c it is obviously an enforcement issue.
Spinelli v. Gaughan - page 790 – almost unanimous that there is NO right to a jury trial on ANY issues
in an ERISA case. This benefits the defendant in that you can rely on the facts rather than the emotion of
the jury. This is true for ERISA §510 (claim that plan sponsor or ER interfered with ERISA rights) and
generally true whether there is a benefits claim or an equitable claim under §501(a)(1)(b) or (c).
Statute of Limitations - ERISA §413
Only applicable to fiduciary claims – to the extent you have a fiduciary claim it must commence within 6
years of the breach or 3 years of the claimant‟s becoming aware of the breach, whichever is earlier. To the
extent that the defendant has actively concealed what they were doing – then it is 6 years from date of
Exhaustion of Administrative Remedies
To what extent is there an exhaustion of administrative remedies doctrine with respect to plans – there is
nothing in the statute, but the courts say look at the plan document, which will control unless ERISA
provisions are to the contrary (which there are none to the contrary). Your claim will be barred on this
basis if you haven‟t gone through the procedures unless this is “futile.”