Compensation Benefits Thorsen Compensation by mikeholy


									                     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
                                        related parties.
                              (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
                      the following:
                        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
                                    predecessor employer

 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
                                                  predecessor service
                        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

                            (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
                       Regulation §1.410(b)-2(b)(6).
                  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
                                                                    business reason,
                                                                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
                        not counted.
                  iv. All plans must be calculated using the same
                        calendar year.
                   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.
                           Reg. §1.410(b)-7(c)):
                              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
                                  different offices.
                              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
                                                         separate; AND
                                                   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,
             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
                                                    retirement age).
                                          (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
                                                   two parts).
                                         (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
                 Nondiscrimination Tests:
                        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
                                                   $130K, or
                                          (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)
                                                   and (B).
                                          (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

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
                                                   compensation amount.)
                                          (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
             ABOVE RULES.
             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.
                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
                            give notice.
                        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.

             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
                           after-tax contributions.15
                              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
                                     would occur.
     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
                 to pay.
             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
                                                           for vesting.
               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)
                            through (C).
             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
                EE‟s benefits:
                       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 –
                            IRC §412(f)(1).
                       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
                  Regulation §1.411(b)-1(b)(2).
                         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.
                         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
                      §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
                      include pensions.

      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
                            spouse, and
                       b. The participant does not in fact elect to receive payments in the form of
                            an 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.
               ERISA §205(f)(1).
          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.
   SPOUSES? Retirement Equity Act (REAct) in 1984 – community property rights
   states said non-participant spouse did have some rights. In separate property states
   no interest.
          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.
               ERISA §206(d)(3)(K).
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
   the tax!!!!
          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.
          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
                      court order)
          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.
                  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
                          do so.
                      3. Parallels the QDRO in requirements of orders, timelines, etc.

                    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.
       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
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
          be capitalized.
      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!)
                                                       ERISA §407.
                                                  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.
                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 =
                            taxpayer‟s investment.
                       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
                            the text)
                              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
                                    [IRC §402(c)(4)]:
                                         (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
                                                 them over;
                                         (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
                                                 (default); AND
                                         (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.
                                    IRC §401(a)(31)(D).
                               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.


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
the recipient:
     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.

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
        incorporated documents;
    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


    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).


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.


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
designated beneficiary)
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
                 participant died.
             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.
                                  §1.401(a)(9)-3, Q&A-3(a).

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.


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.


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.


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.


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.


Insurance Companies:
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
follow this.
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
page 656.

Investment Advisors?
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
                           disclaimer statement.

Investment Managers?
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.
ERISA §405(d)(1).

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
relevant information.

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).

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.

             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.

ERISA §404(c)

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 Plans
§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
are exempt:
     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
to preemption.
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.

Attorneys’ Fees
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
attorney‟s fees:
     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.

Jury Trial
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.”


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