Copyright © WALLINGFORD LAW, P.S.C.
This Chapter was published in the University of Kentucky College of Law, Office of Continuing
Legal Education 2000 Employment Law in Kentucky Handbook.
I.
[11.1.] Introduction
A.
[11.2] General Overview
In 1974 Congress enacted the Employee Retirement Income Security Act (“ERISA”) primarily in
response to growing concerns regarding the inadequate standards and safeguards then applicable to the
establishment, operation and funding of employee benefit plans. ERISA §2, 29 U.S.C.S. §1001b. While
the initial congressional focus centered around abuses in the area of retirement plans, ERISA coverage was
extended to encompass other employee benefit plan programs as well.
ERISA’s broad scope can easily be detected by reviewing its table of contents. Title I is intended
to protect employees and plan participants by establishing minimum standards regarding
(i)
Part 1 - reporting and disclosure (ERISA §§101-111. 29 U.S.C.S.
§§10211031);
(ii)
Part 2 - participation and vesting (ERISA §§201-211, 29 U.S.C.S. §§10511061);
(iii)
Part 3 - minimum funding standards (ERISA §§301-308, 29 U.S.C.S. §§10811086);
(iv)
Part 4 - fiduciary responsibility (ERISA §§401-414, 29 U.S.C.S. §§1101-1114);
(v)
Part 5 - administration and enforcement (ERISA §§501-515, 29 U.S.C.S.
§§1131-1145);
(vi)
Part 6 - continuation coverage and additional standards for group health plans; and
(vii)
Part 7 - group health plan requirements.
Substantive additions to Title I of ERISA were enacted in the Consolidated Omnibus Budget
Reconciliation Act of 1985 (“COBRA”) imposing continuation coverage requirements under group health
plans. COBRA health care continuation requirements are contained in Part 6 of Title I of ERISA. (ERISA
1
§§601-608, 29 U.S.C.S. §§1161-1168). Corresponding tax provisions are contained in Section 4980B
of the Internal Revenue Code of 1986, as amended (“Code”).
ERISA was further amended by the passage of the Health Insurance Portability and Accountability
Act of 1996 extending federally mandated protection to, among other things, portability, access and
renewability to medical plans.
In addition to participant rights and employer obligations, Title II of ERISA also governs the tax
treatment associated with employee benefit plans. In many instances particular requirements are codified
in both the provisions of the Code and the Labor provisions of the United States Code. This means that
the requirement is imposed as a condition of tax qualification and the employer or the participant has
enforceable duties or rights. Examples include minimum vesting standards (ERISA §203, Code §411), the
exclusive benefit rule (ERISA § 402(c)(1), Code §40 l(c)(1)), written plan requirements (ERISA §402(b),
Code §401(a)), benefit distribution forms (ERISA §205, Code §401(a)(11) and 417), and accrual
requirements (ERISA §204, Code §411).
Title II further establishes registration and information requirements, a declaratory judgement
procedure relating to the qualification of retirement plans and internal operational requirements for the
Internal Revenue Service in monitoring employee benefit issues.
Title III of ERISA governs the jurisdiction, administration and enforcement of employee benefit
plans, establishes a Joint Pension, Profit Sharing and Employee Stock Ownership Plan Task Force,
commissions other Congressional studies involving employee benefit issues, and establishes a Joint Board
for the Enrollment of Actuaries.
A comprehensive federal insurance plan for the termination of defined benefit employee pension
benefit plans is included in ERISA Title IV. Passage of ERISA created the Pension Benefit Guaranty
Corporation, which is charged with the responsibility of monitoring the termination insurance program. Plans
subject to Title IV are required to pay annual premiums and are subject to strict termination procedures.
Additionally, employers maintaining plans subject to Title IV also risk exposure for the under funding of
terminated plans.
B.
[11.3] Plan Types
Most practitioners view ERISA as mandating legal requirements for “qualified” retirement plans.
In fact, employee pension benefit plans providing retirement benefits are governed by ERISA and probably
receive more attention under ERISA than other plans. Employee pension benefit plans can either be
“qualified” or “non qualified.” Qualified retirement plans entitle plan sponsors, the plan and plan participants
to preferential tax treatment. non qualified retirement plans do not afford the same degree of preferential
tax treatment but are generally not subject to the stringent qualification rules otherwise imposed on qualified
plans.
2
Many of the provisions of ERISA also apply to welfare plans, i.e., plans that are established and
maintained for the purpose of providing medical, surgical, or hospital care benefits in the event of sickness,
accident, disability, death, unemployment, vacation, apprenticeship or other training programs, daycare
centers, scholarship funds, or prepaid legal services. During the infancy stages of ERISA employers,
employees and many governmental agencies virtually ignored or were unaware of the application of ERISA
to employee welfare benefit plans. As a result of the developing crisis in the health care industry a national
focus continues to be directed toward welfare benefit plans. Undoubtedly, mounting pressures resulting
from an alarming increase in the number of individuals being denied access to medical care will likely
require that Congress implement far reaching changes in the welfare benefit plan area in the future.
II.
[11.4] Qualified Plans
A.
[11.5] General
In order to establish and maintain the status of an employee pension benefit plan as “qualified” the
plan must satisfy the requirements for qualification set forth in Section 401(a) of the Code. Special rules
in the Code and ERISA apply to different types of employers and plans. It is the intention of this Chapter
to provide an overview of the rules applicable to single employer plans maintained by “for profit” corporate
employers. It should be noted that there are special rules and exemptions for other types of plans and
employers. Examples include
•
church plans (ERISA §§201 and 401, Code §403(b)),
•
plans maintained by Code §501(c)(3) organizations and public schools (ERISA §202,
Code §403(b)),
•
simplified employee pension plans (ERISA §104, Code §408(k));
•
individual retirement accounts (ERISA §§201 and 301, Code §§219 and 408),
•
collectively bargained plans (Code §§410(b)(3) and 413), and
•
partnership and “S” corporation plans (Code §§401(c). and (d).
There are a number of advantages to maintaining and participating in a qualified plan. Perhaps the
greatest advantage for employers is the fact that contributions made by the employer to the plan are
currently deductible for federal income tax purposes. Code §404. Although contributions made by an
employer to a qualified plan on behalf of its employees provide a benefit, amounts contributed to the plan
generally will not be included in the income of a plan participant until such time as the participant actually
receives distributions from the plan. Code §402. This results in savings for employees since a participant
ordinarily will not receive distributions from a qualified plan until actual retirement, at which time the
3
participant's taxable income will generally be less and the participant's tax bracket lower. Finally, the trust
holding the contributions made to a qualified plan will be exempt from federal income tax thereby enabling
the trust's earnings to compound at a much faster rate. Code §501(a).
Despite the decided tax advantages in maintaining a qualified plan, qualified plans are not without
disadvantages. An obvious disadvantage is the fact that a qualified plan is subject to the inflexible
qualification requirements of the Code and ERISA. Compliance with coverage, participation, vesting and
other rules results in the inclusion of more individuals in the plan, in turn increasing the cost to the employer.
For plans subject to the termination insurance provisions of Title IV of ERISA, an employer assumes
additional responsibility as well as additional exposure to liability for an underfunded plan.
B.
[11.6] Qualification Requirements
Achieving and maintaining qualification compels adherence to all requirements of Section 40 l(a)
and other relevant sections of the Code. Certain requirements for qualification are common to all plans
regardless of type, although the application of those requirements may vary depending upon the type of plan
involved. Generally, a qualified plan must satisfy the following:
1.
[11.7] Establishment of A Written Plan and Trust
In order to be qualified a plan must first be of the type that may qualify - that is, it must be a
pension, profit sharing, or stock bonus plan. Code §401(a). The plan must be established pursuant
to a written instrument which
(i)
names one or more fiduciaries having authority to control the management and
operation of the plan;
(ii)
provides a procedure for establishing and carrying out a funding method consistent
with the objectives of the plan and the requirements of ERISA relating to the
protection of employee benefit rights;
(iii)
describes any procedures established for the allocation of responsibilities
concerning the operation and administration of the plan, including the delegation
of responsibility for asset management to an investment manager;
(iv)
provides a procedure for making amendments to the plan; and
(v)
specifies the basis upon which payments will be made to and from the plan.
Assets of the plan are required to be held in trust, pursuant to a written trust document. Limited
exceptions to the trust requirements are provided for plan assets held in insurance contracts, simplified
4
employee pension plan assets, assets held for the benefit of self-employed individuals, and assets held in
plans for Code §501(c)(3) organizations or public schools.
2.
[11.8] Exclusive Benefit
Qualified plans may be maintained solely for the exclusive benefit of employees and beneficiaries
under the plan. Specifically. Section 401(a)(2) of the Code mandates that plan assets not be used for or
diverted to purposes other than providing benefits to employees and beneficiaries. Limited exceptions are
applicable which will permit the return of contributions made by mistake of law or fact. Rarely is the
exclusive benefit rule challenged in its tax application. More frequently, however, challenges are made under
the ERISA exclusive benefit rule where participants allege improper activities with respect to plan assets.
3.
[16.9] Prohibited Discrimination - Coverage, Participation and Vesting
Section 401(a)(4) of the Code contains an encompassing prohibition against discriminating in favor
of highly compensated employees. Material changes to Section 401(a)(4) of the Code were
enacted in the Tax Reform Act of 1986 (“TRA 86"). Since that time final regulations have been
implemented under Section 401(a)(4) of the Code providing better coordination among the overall Section
401(a)(4) non-discrimination requirements and other mandatory standards for minimum coverage,
participation and vesting.
(i)
[11.10] Minimum participation standards
As a general rule a plan may not require as a condition of participation the
attainment of an age greater than 21 or the completion of more than two years of service.
Cash or deferred arrangements sponsored pursuant to Section 401 (k) of the Code may
not impose a service requirement in excess of one year. Code §401(k)(2)(D). Even if a
two-year service requirement is implemented, any waiting period greater than one year will
require immediate vesting of the participant's accrued benefit. Code §410(a)(1)(B). Benefit
vesting may be permitted under a graduated scale if the participant's waiting period does
not exceed one year. Code §411(a)(2). Such deferred vesting cannot exceed maximum
schedules of either 3 to 7 years graduated vesting or a 5 year cliff vesting schedule in which
participants are not vested in their accrued benefits until they have completed 5 years of
service, at which time they will become 100% vested. In the event a plan is “top heavy,”
accelerated vesting may be imposed under Section 416 of the Code.
(ii)
[11.11] Minimum coverage requirements
Minimum participation standards are supplemented by minimum coverage
requirements imposed pursuant to Section 410(b) of the Code. Minimum coverage
standards have been consolidated into concise tests set forth in Treasury Regulation
5
§1.410(b)-2(b) and described as the “ratio percentage test” and the “average benefits
test.” Under the ratio percentage test a plan will meet the minimum coverage requirements
if the percentage of non-highly compensated employees benefitting under the plan divided
by the percentage of highly compensated employees benefitting under the plan is at least
equal to 70%. For example, assume that Plan A benefits 70% of non-highly compensated
employees and 100% of highly compensated employees. In this case the Plan A’s ratio
percentage for the year is 70% (70% divided by 100% = 70%), thus Plan A satisfies the
ratio percentage test. Assume, on the other hand, that Plan B benefits only 40% of nonhighly compensated employees and 60% of highly compensated employees. Plan B then
fails the ratio percentage test because the ratio percentage is only 66.67% (40% divided
by 60% = 66.67%).
The average benefits test requires that the plan must satisfy both a nondiscriminatory classification test and an average benefit percentage test. Treasury
Regulation §1.410(b)-2(b)(3). Because of the complexity of utilizing the average benefits
test, its availability is limited. Nevertheless, in complex multiple employer arrangements it
may frequently be of value.
4.
[11.12] Required Distributions
Section 401 (a)(9) of the Code sets forth minimum distribution requirements for all participants. In
order to avoid the accumulation of retirement benefits after a participant has attained the age of 70 ½,
qualification mandates that benefits be distributed or distribution of benefits commence no later than April
1 of the calendar year following the calendar year in which a participant attains age 70 ½. There are,
however, exceptions for certain participants and distributions. Distributions must then be made no less
frequently than a period of time extending over the life (or life expectancy) of the participant or the lives (or
life expectancies) of the participant and a designated beneficiary. In the event of a participant's death prior
to completion of the distribution scheme, the remaining interest must be distributed to the participant's
designated beneficiary at least as rapidly as would have been required had the participant lived. If the
participant dies before distribution commences, then the entire interest of the participant must be distributed
within 5 years of the participant's death.
Benefits not distributed as required under Code §401(a)(9) are subject to a 50% non-deductible
penalty. Code §4974(a).
5.
[11.13] Top-Heavy Plan Requirements
Top-heavy plans must satisfy minimum vesting and minimum benefit accrual standards. Code §416.
Defined contribution plans are deemed top heavy if the aggregate of the accounts of key employees
exceeds 60% of the aggregate of the accounts of all employees under the plan. Defined benefit plans are
top heavy if the present value of the cumulative accrued benefits under the plan for
6
key employees exceed 60% of the present value of the cumulative accrued benefits under the plan for all
employees. A key employee is determined by reference to compensation, ownership, and status as an
officer. See Code §416(i)(1). Key employee determinations are based upon the current plan year and the
four preceding plan years.
Minimum vesting requirements for top heavy plans are satisfied by utilization of either a three-year
cliff vesting schedule or a six-year graduated schedule. Code §416(b). With respect to minimum benefit
requirements, top heavy defined contribution plans are required to provide a minimum benefits for non-key
employees of not less than 3% of the participant's compensation, unless the contribution percentage for key
employees for that year is less than 3%. In the case of defined benefit plans the applicable percentage is
2% of compensation multiplied by the participant's years of service with the employer, or 20%. If the
benefit accrual for key employees is less than the mandatory level, the mandatory level will be adjusted
accordingly.
6.
[11.14] Distribution Forms
In 1984 Congress amended ERISA with the passage of the Retirement Equity Act of 1984
(“REA”). The provisions of REA were codified in both ERISA and the qualification requirements contained
in Section 401(a) of the Code. The general rule is that plans subject to ERISA and Section 401(a) of the
Code must provide a qualified joint and survivor annuity as the normal form of retirement benefit. In the
event of a participant's death prior to retirement, a plan must provide a preretirement survivor annuity as
the normal form of benefit to the surviving spouse. Alternate benefit forms may be elected but only with the
participant's written waiver of the normal form, and with the written consent of the participant's spouse to
such election. Code §417.
Qualified preretirement survivor annuity and qualified joint and survivor annuity rules are not
applicable to all plans. The rules only apply to defined benefit plans and to defined contribution plans
subject to minimum funding standards under Section 412 of the Code. Defined contribution plans subject
to minimum funding standards include, among others, money purchase pension plans and target benefit
plans. Participants under other defined contribution plans, such as profit sharing plans, will be subject to
the annuity rules unless (1) the plan provides that a participant's vested benefit will be payable in full upon
the participant's death to the participant's surviving spouse (unless appropriate elections have been signed);
(2) the participant does not elect the payment of benefits in the form of a life annuity; and (3) the plan is not
a “transferee” plan.
7.
[11.15] Merger or Consolidation
In the event of a merger or consolidation with, or transfer of assets or liabilities, to any other plan,
each participant in the plan must receive a benefit immediately following the transaction which is equal to
or greater than the benefit the participant would have been entitled to receive immediately before the
transaction.
7
8.
[11.16] Assignment and Alienation
Both the Code and ERISA prohibit the assignment or alienation of benefits under the plan. ERISA
§206(d)(1); Code §401 (a)(13). Exceptions are provided in limited instances. Conflicts between state
domestic relations law and ERISA resulted in special legislation permitting assignments under “qualified
domestic relations orders.” A domestic relations order is defined in Section 414(p) of the Code to include
any judgement, decree or order (including approval of a property settlement agreement) relating to the
provisions of child support, alimony payments or marital property rights of a spouse, former spouse, child
or other dependent of a participant. The order must be made pursuant to state domestic relations law,
including community property law. Domestic relations orders are “qualified” if they create or recognize the
existence of an alternate payee's right, or assign to an alternate payee the right to receive all or a portion
of the benefits payable with respect to a participant under the plan, and if they specify information outlined
in Section 414(p)(2) of the Code. A domestic relations order cannot direct a plan to provide a benefit in
a form that is not otherwise provided under the plan, nor can the order increase the amount of benefits
available under the plan.
Each plan is required to adopt plan procedures necessary to notify participants and alternate payees
of the receipt of a domestic relations order and such procedures must establish a mechanism for determining
whether or not the domestic relations order is a qualified order.
9.
[11.17] Absolute Distribution Date
It was the intention of Congress to establish an absolute date beyond which a plan cannot hold
benefits without the consent of the participant. Section 401(a)(14) of the Code states that benefit
distributions must commence not later than the 60th day following the later of the close of the plan year in
which the participant attains age 65 (or other normal retirement age under the plan), the 10th anniversary
of the year in which the participant commenced participation in the plan, or the date the participant
terminates service with the employer. Delays in distribution after such date will be permitted where the plan
administrator does not possess sufficient information necessary to calculate benefits.
10.
[11.18] Benefit and Contribution Limitations
Plan contribution and benefit accrual limitations are also embodied in the Code. Like similar
provisions of ERISA, these limitations have been enacted in order to limit contributions and benefit accruals
and to enhance revenues for the federal government. Section 401(a)(16) of the Code, in conjunction with
Section 415(c) of the Code, provides that the annual additions to a defined contribution plan participant's
account may not exceed the lesser of $30,000.00 (as indexed) or 25% of a participant’s compensation.
Annual additions to a participant’s account include employer contributions, employee contributions and
forfeitures. The cost of living adjusted limit remains at $30,000 for 2000.
8
Defined benefit plans state the restriction in terms of accrued benefits. The annual benefit accrual
is limited to the lesser of $90,000 (as indexed), or 100% of a participant's average compensation for the
participant's high 3 years. As noted, the $90,000 limit is adjusted for cost of living increases for years after
1987. The $90,000 limitation has gone from its stated dollar level in 1987 to a 2000 limit of $120,800.
11.
[11.19] Compensation Limitations
A qualified plan may not take into account annual compensation in excess of $150,000 (as indexed)
in determining contributions and benefits under the plan. The 2000 dollar limit for annual compensation
under Code §401(a)(17) as indexed for inflation is $170,000.
12.
[11.20] Actuarial Assumptions
Defined benefit plans are now required to provide written actuarial assumptions in the plan
document in order to preclude employer discretion in determining the value of benefits. Code §401(a)(25).
13.
[11.21] Utilization of Net Profits
At one time profit sharing plans permitted discretionary employer contributions based upon an
employer’s current or accumulated profits. Section 401(a)(27)(A) of the Code has been added to allow
discretionary employer contributions without regard to an employer’s net profits. Plans intended to qualify
as a money purchase pension plan or a profit sharing plan must state the intent to qualify as such plans in
the written plan document. Code §401 (a)(27)(B).
14.
[11.22] Limits on Elective Deferrals
In the case of cash or deferred arrangements, the plan is required to limit the amount of elective
deferrals made by a participant in the plan to the dollar limit permitted under Section 402(g)(1) of the Code.
Code §401(a)(30). The stated dollar limit is $7,000, which is indexed annually for cost of living
adjustments. As of 2000 the elective deferral limit has been established at $10,500.
15.
[11.23] Qualification Procedures
Since the inception of ERISA the Internal Revenue Service has established procedures whereby
an employer may submit a plan for determination as to its qualified status. Despite the lack of a requirement
that a plan actually receive a favorable determination letter, it is strongly recommended that all plans be
submitted for favorable determination letters. Due to the extensive tax modifications implemented in recent
legislation, procedures governing qualification are, at best, in a transitional state. In early 2000 the Internal
Revenue Service issued Revenue Procedure 2000-6, I.R.B. 2000-1, outlining the current procedures for
the submission of plans for IRS determination letters. Revenue Procedure 2000-6 sets forth the procedure
9
for submitting plans for a determination letter. The Revenue Procedure governing plan submission is
updated annually.
Submission of a qualified plan for a determination letter must be made on Treasury Form 5300
(Application for Determination Letter). The application must be accompanied by Treasury Form 5300,
Schedule Q (Nondiscrimination Requirements), Treasury Form 2848 (Power of Attorney) and Treasury
Form 8717 (User Fee). The submission must also be accompanied by a user fee check in an amount
determined under the user fee schedule then in effect.
Revenue Procedure 2000-6 contains streamlined submission procedures for employers adopting
prototype, regional prototype and volume submitter plans. Modified procedures are warranted because
the sponsoring organization maintaining the prototype or volume submitter plan has received initial approval
from the Internal Revenue Service.
III.
[11.24] Types of Qualified Plans
Qualified plans can be characterized as defined contribution plans and defined benefit plans. A
participant's retirement benefit in a defined contribution plan is equal to the sum of contributions made for
the participant during the participant's lifetime plus any earnings or loses generated on those contributions.
A separate account is established for each participant in a defined contribution plan to record the amounts
contributed for each participant. Account balances are adjusted periodically to reflect the account's share
of earnings or loses generated by the investment of plan assets. Defined benefit plans, on the other hand,
do not define the contribution that will be made; rather, the plan defines the actual benefit which will be
received by a participant upon attainment of a normal retirement age.
A.
[11.25] Profit Sharing Plans
A profit sharing plan is a defined contribution plan which permits employers to make discretionary
contributions to be allocated among participant accounts. Employer contributions need not be based on
profits, however, the plan may require employer profits before contributions are permitted. Employer
contributions to the plan may not exceed an amount equal to 15% of the compensation of participating
employees for the plan year. Code §404(a) (3). Contributions in excess of that limit will be subject to an
excise tax imposed under Section 4972 of the Code. Once a contribution is made by the employer it is then
allocated among the participant accounts in accordance with a definite allocation formula. The most widely
used formula is simply based upon a comparison of an individual participant's compensation to the
compensation of all participants, Permitted disparity allocations based on factors related to Social Security
levels are authorized pursuant to Section 401(1) of the Code.
B.
[11.26] Cash or Deferred Arrangements - 40l(k) Plans
10
Cash or deferred arrangements (“CODAs”) are intended to permit elective deferrals made by
employees to the plan. CODA must be part of a profit sharing or stock bonus plan maintained by the
employer. However, a CODA may also be sponsored as part of a pre-ERISA money purchase pension
plan or a plan maintained by a rural cooperative. Code 40l(k)(1). CODA participants are entitled to elect
to have the employer make contributions to the plan or to pay that amount to the employee in cash.
CODAs are most commonly operated through payroll deductions from employee's compensation. Caution
must be exercised in designing retirement plans containing employee elections regarding contribution
amounts. In most instances those arrangements will be deemed to be non-qualified, jeopardizing the tax
status of the plan.
CODAS are subject to the elective deferral limits imposed under Section 402(g) of the Code. As
previously discussed, the elective deferral limit for any participant is $7,000 per year, as revised for cost
of living adjustments. Special participation and discrimination standards are imposed for CODA elective
deferrals requiring the comparison of the average deferral percentage for highly compensated employees
and non-highly compensated employees. The average deferral percentage for highly compensated
employees cannot exceed the average deferral percentage for all other eligible employees by more than
1.25%. Alternatively, the average deferral percentage for the highly compensated employees over the
average deferral percentage for all other eligible employees cannot be more than two percentage points nor
more than the average deferral percentage of all other eligible employees multiplied by two.
Distributions to CODA participants or beneficiaries may not be made earlier than the participant's
separation from service, death, disability, or attainment of age 59 ½ or, in certain events, upon the
termination of the plan without the establishment of a successor plan. Hardship distributions are permitted
for elective deferrals consistent with the requirements contained in regulations adopted pursuant to Section
40 l(k) of the Code.
Elective deferrals are treated as employer contributions for most purposes. Each participant must
be 100% vested in the participant's elective deferral accounts at all times. While elective deferrals are not
subject to federal income tax (or state income tax for the state of Kentucky), elective deferrals are,
nevertheless, treated as wages for purposes of FICA (Social Security and Medicare) and FUTA
(Unemployment) taxes. Code §3121(v)(1) and 3306(r)(1).
CODAs may permit participant after-tax contributions and employer non-elective contributions.
Employers frequently make matching contributions as part of the plan arrangement. After-tax contributions
and matching contributions are not subject to the Section 401(k) average deferral percentage limitations,
but they are subject to average contribution percentage limitations contained in Section 401(m) of the
Code.
C.
[11.27] Money Purchase Pension Plans
11
A money purchase pension plan is a form of defined contribution plan requiring a definite
contribution formula. Contributions may be stated as a percentage of participants' compensation. Money
purchase pension plans are permitted to base the contribution percentage on permitted disparity rules
contained in Section 401(l) of the Code. Individual accounts are established and maintained on behalf of
each participant and retirement benefits are equal to the sum of contributions plus earnings and loses
generated on each participant's account. Employers may make contributions up to a maximum of 25% of
aggregate compensation for all participants. Code §404(a)(1). Contributions in excess of that limit are
subject to a non-deductible excise tax. Code §4972.
D.
[11.28] Employee Stock Ownership Plans
An employee stock ownership plan is a defined contribution plan intended to invest primarily in
employer securities. Although ERISA restricts the investment of plan assets in employer securities to 10%
of plan assets, ESOPs are not subject to the 10% limitation. Sections 401(a)(28) and 409 of the Code
impose a number of special ESOP qualification requirements. Because of the lack of asset diversification
inherent in investing primarily in employer securities, Section 401(a)(28)(B) of the Code was added by
TRA 86 to permit employees latitude and diversification as they near retirement. Participants with at least
10 years of participation who have attained age 55 will be permitted to diversify 25% of their account
balance. As the participant nears retirement, the diversification percentage increases to 50%.
Employer securities held by an ESOP which are not readily tradeable on an established market
must be valued, at least annually, by an independent appraiser. Sections 401 (a)(22) and 409 of the Code
require that ESOPs pass through voting rights to participants. ESOPs with registration type securities have
a uniform pass through rule. Registration type securities are those classes of securities required to be
registered under Section 12 of the Securities Exchange Act of 1934. ESOPs without a registration type
class of security are required to pass through voting rights involving the voting of shares with respect to
specified transactions. Each participant is entitled to only one vote with respect to each issue being voted.
ESOP participant votes are in turn communicated to the plan trustee and the plan trustee is then required
to vote all shares in proportion to the votes cast by participants.
E.
[11.29] Defined Benefit Plans
Defined benefit plans specify the actual benefit which a participant will receive at retirement rather
than the contribution level for each participant. Thus, retirement benefits are reflected in accrued benefit
levels, rather than account balances. An example of a typical defined benefit retirement income formula
would be a life annuity equal to 50% of the average annual compensation earned by a participant during
the participant's last three years of employment. Benefit accruals are subject to the annual benefit limitations
imposed under Code §415(b).
The normal retirement date established by a defined benefit plan can be no later than the date the
participant attains age 65 or the 5th anniversary of the date the employee commenced plan participation.
12
Code §411(a)(8). A defined benefit plan may provide for early retirement so that upon completion of a
certain number of years of service, or within a certain number of years of normal retirement age, a
participant will become 100% vested in the participant’s accrued benefit and may require the plan to pay
benefits if the participant actually retires.
No separate account balances are maintained for participants in defined benefit plans. Instead, the
entire trust fund is held for the benefit of all participants and beneficiaries. Plan contributions necessary to
fund retirement benefits are determined on an actuarial basis. Each year actuarial assumptions are measured
against the actual experience of the plan and gains and loses are amortized over a number of years rather
than being immediately applied to the next year's contribution.
IV.
[11.30] Non-Qualified Retirement Plans
Non-qualified retirement plans avoid many of the tax qualification rules applicable to qualified plans.
They may also be exempt from application of many of the ERISA standards for reporting and disclosure,
minimum participation, vesting, and fiduciary responsibility. Avoiding application of ERISA and Code
qualification provisions affords greater design flexibility and, if properly structured, enhance benefit levels
to a select group of highly compensated and management employees.
Utilization of a qualified plan provides a three level protection: current deductibility of contributions,
non-inclusion in income by participants, and exemption of current trust earnings from taxation. The tax
characteristics of a non-qualified plan do not, unfortunately, reflect the same attractiveness. Contributions
to the plan or accruals intended to fund a non-qualified plan will not be deductible by an employer until such
time as the amounts are required to be included in income by the employee. Timing of employee accruals
will be dependant upon the status of the plan as either “funded” or “unfunded.” Taxation of benefits to
employees under non-qualified plans is determined under rules contained in Section 83 of the Code which
govern taxation of “transfers of property” made in connection with the performance of services. Code
§402(b). If the property subject to transfer is subject to a substantial risk of forfeiture, it is non-transferable
and is not currently taxed to the employee until actual distribution. In the case of unfunded plans, the
employer simply makes an unsecured promise to pay a level of benefits upon satisfying c err ain conditions.
With no transfer
of property there is no current taxation to employees. Conversely, with no transfer of property and no
taxation to employees, there is no current deduction for the employer until amounts are actually
paid.
One very unattractive feature of non-qualified plans is the apprehension created for employees.
Qualified plans must be funded and held in trust. Non-qualified plans do not have either a funding or a trust
requirement; yet, recent tax law innovations have brought about an instrument known as a “rabbi trust”
which is intended to provide employee security. Contributions to a rabbi trust correspond to benefit
accruals under the plan. Current guidance by the Internal Revenue Service permits the utilization of rabbi
trusts and does not treat contributions to the trust as a transfer of property by the employer as long as the
13
assets of the trust can be utilized to satisfy the general claims of creditors of the employer in the event of
an insolvency. Subjecting assets to the general claims of creditors means that there is no transfer of property
and thus no tax to the employee at the time of the accrual or at the time that the property is contributed to
the trust. Employee taxation will not occur until such time as actual distributions are made to the participant.
Trust earnings will be taxed to the employer through application of the grantor trust rules contained in
Section 671 of the Code.
Non-qualified plans vary in form and type. One type is an “excess benefit” plan designed solely to
provide benefits to participants in excess of the maximum amount permitted under the Code with respect
to qualified plans. Unfunded excess benefit plans will be exempt from ERISA reporting and disclosure
obligations and enforcement provisions. Funded excess benefit plans will be subject to such requirements
as well as the fiduciary standards of ERISA. Another types, “top hat” plans, are plans of unfunded
deferred compensation maintained primarily for the purpose of providing deferred compensation to a select
group of management or highly compensated employees. Although exempt from the ERISA requirements
pertaining to vesting, funding, and fiduciary responsibility, top hat plans are subject to ERISA's
administrative and enforcement provisions.
V.
[11.31] Fiduciary Responsibility
A.
[11.32] General
Section 402(a)(1) of ERISA provides that every employee benefit plan must be established and
maintained pursuant to a written instrument providing for one or more named fiduciaries who jointly or
severally shall have authority to control and manage the operation and administration of the plan. A named
fiduciary is a fiduciary who is either named in the plan instrument or who may be identified pursuant to a
procedure specified in the plan by the employer and/or employee organization maintaining the plan.
According to Section 405(c)(1) of ERISA, a plan may expressly provide for the allocation of fiduciary
responsibilities (other than trustee responsibilities) among named fiduciaries and for the named fiduciaries
to designate persons other than themselves to carry out their fiduciary responsibilities.
A fiduciary is defined as anyone who exercises discretionary authority or control over the
management of plan assets, renders investment advice for a fee, or has discretionary authority or
responsibility in the administration of the plan.
B.
[11.33] Fiduciary Duties
Certain statutory duties are imposed upon plan fiduciaries requiring them
(i)
to act exclusively for the benefit of plan participants and beneficiaries,
(ii)
to act prudently,
14
(iii)
to diversify plan assets, and
(iv)
to act in accordance with the plan documents so long as the plan documents are
consistent with ERISA.
There are a number of cases challenging fiduciary breaches of the exclusive benefit rule. In many
instances allegations of this nature are asserted in conjunction with violations for the breach of other
fiduciary obligations. Despite the lack of standards as to what constitutes adherence to the exclusive benefit
rule, guidance has been issued by the Internal Revenue Service in the area of investment of plan assets
allowing an employer sponsoring the plan to incidentally benefit from plan investments so long as the
following conditions are satisfied:
C.
(i)
cost of the asset does not exceed the fair market value at the time of purchase,
(ii)
a fair return commensurate with the prevailing rate is provided except with respect
to obligatory investments in employer securities by a stock bonus plan,
(iii)
enough liquidity is maintained for required distributions under the plan, and
(iv)
the investment has sufficient safeguards and diversity to be prudent. Rev. Rul.
69-494, 1969-2 C.B. 88.
[11.34] Fiduciary Liability
A plan fiduciary who breaches any of the fiduciary duties will be personally liable to make good
to the plan any losses resulting from the breach and to restore to the plan any profits the fiduciary made
through the use of plan assets. The plan fiduciary will also be subject to such other equitable or remedial
relief as a court may deem appropriate, including the removal of the plan fiduciary. ERISA §409(a). Plans
may not contain any provision which relieves a fiduciary of personal liability for breach of fiduciary duties.
Plans may, however, purchase insurance to cover liability losses due to acts or omissions by plan
fiduciaries.
A fiduciary will not be liable for a breach of fiduciary duty committed before becoming a fiduciary
or after ceasing to be a fiduciary. Nevertheless, a fiduciary may be liable for the investment decisions of
another fiduciary. In Massachusetts Mutual Life Insurance v. Russell, 473 U.S. 134 (1984), the Supreme
Court refused to find a right under ERISA to contribution and indemnification among plan fiduciaries. Since
Russell, most courts have generally held that no right of contribution or indemnity exists under ERISA. This
does not, however, preclude a separate cause of action against another fiduciary. See Variety Corp. v.
Howe, 516 U. S. 489 (1997). In Chenung Canal Trust Co. v. Sovran Bank/Maryland, 14 EBC 1169 (2d
Cir. 1991), the plan sponsor sued Sovran, a former fiduciary, for lack of prudence and due diligence with
15
respect to investments made by a previous fiduciary and continued by Sovran. Sovran filed a third-party
complaint against the prior fiduciary seeking contribution or indemnification. The court determined that
federal courts are authorized to develop a federal common law under ERISA, guided by the principles of
traditional trust law which clearly provides for a right of contribution among fiduciaries.
Attorneys and accountants are generally not considered fiduciaries merely because they provide
services to a plan. Applying the principle of “knowing participation” prior to the Supreme Court’s decision
in Mertens v. Hewitt Associates, 113 S. Ct. 2063 (1993), courts held nonfiduciaries liable for breaches
of fiduciary duty of which they had knowledge. Liability had been imposed only in situations where
egregious facts have existed. See Whitfield v. Lindemann, 853 F.2d 1298 (5th Cir. 1988); Whitfield v.
Tomasso , 682 F.Supp. 1287 (E.D.N,Y, 1988); Benvenuto v. Schneide, 678 F.Supp. 51
(E.D.N.Y.1988). In the case of Diduck v. Kaszvcki & Sons Contractors Incorporated, No. 83 Civ. 6346
(C.E.S.) (S. N.Y. filed Apr, 24, 1991), the court found evidence of a tacit agreement between plan
fiduciaries and nonfiduciaries to deprive plan participants of benefits and contributions to the plan fund. The
court held the nonfiduciaries jointly and severally liable for the plan fiduciaries’ breach of duty. Since the
decision in Mertens, the positions of most courts has been to avoid assuming or creating causes of action
not specified in ERISA. See Jordan v. Michigan Conference of Teamsters, 207 F. 3d 854 (6th Cir. 2000).
D.
[11.35] Prohibited Transactions
ERISA and the Code prohibit transactions between a plan and a “party in interest” (referred to as
“disqualified persons” in the Code). “Parties in interest” include such individuals as the plan
sponsor, a plan fiduciary, a plan service provider or plan advisor, an employee, officer, director or 10%
or greater shareholder of the plan sponsor, a spouse or descendant of any of the prior parties, and a union
covering plan participants. ERISA §406, Code §4975. Transactions between the plan and a “party in
interest” violate ERISA even though the transaction was operated in good faith and competitively priced.
Violations of the prohibited transaction rules may be penalized by the imposition of liability, as a
breach of fiduciary duty, and the imposition of statutory penalties imposed under Code Section 4975.
Jurisdiction for enforcing penalties rest with the Internal Revenue Service and jurisdiction for enforcing
liability rest with the U.S. Department of Labor. Pursuant to Reorganization Plan No. 4 of 1978 the
Department of Labor has been assigned enforcement responsibility for regulations, rulings, opinions and
exemptions for prohibited transactions. Section 408 of ERISA specifically authorizes the establishment of
procedures permitting the issuance of individual and class exemptions from the application of the prohibited
transaction rules. These exemption procedures are contained in proposed ERISA Regulation §2570, 29
C.F.R. §2570.
VI.
[11.36] Civil Enforcement of ERISA
A.
[11.37] Governmental and Private Enforcement
16
The Department of Labor is authorized to prescribe any regulations necessary to carry out the
provisions of ERISA. ERISA §505. Investigative authority is extended to the Department of Labor
permitting investigation of civil and criminal violations of ERISA and related laws. Violation enforcement
must be referred to the Attorney General for appropriate action. Legal actions may be brought to enjoin
any act or practice which violates the reporting and disclosure requirements of ERISA, or to secure ERISA
compliance. Civil penalties of up to $1,000 per day may be assessed by the Department of Labor for
failure to comply with ERISA reporting and disclosure requirements. If the failure includes failure to file
appropriate tax returns, the Internal Revenue Service may also assess late filing penalties.
Civil actions may also be brought by plan participants and beneficiaries to recover benefits, enforce
ERISA rights or clarify rights to future benefits. Participants, beneficiaries or fiduciaries
may bring a civil action to enjoin ERISA violations, enforce ERISA rights, or for other appropriate
equitable relief. Interference with enforcement is prohibited by Section 510 of ERISA making it
unlawful for anyone to discharge, fine, suspend, expel, discipline or discriminate against a participant or
beneficiary for exercising rights protected by ERISA or taking part in a legal proceeding under its
provisions.
B.
[11.38] Jurisdiction and Venue
With limited exceptions, federal district courts have exclusive jurisdiction over civil actions brought
by participants, beneficiaries or plan fiduciaries. Jurisdiction for actions by participants or beneficiaries to
recover benefits, enforce rights or clarify future rights rest concurrently with federal district courts and state
courts of competent jurisdiction. Venue for federal district court actions will be the district where the plan
is administered, where the breach that is the subject of a suit occurred, or where the defendant resides or
may be found.
C.
[11.39] Administrative Remedies
Each plan subject to ERISA is required to contain a written claims procedure intended to notify
participants and beneficiaries of their rights to claim benefits. ERISA §503. The claims procedure must
provide for adequate written notice to a claimant that a claim for benefits has been denied and it must set
forth specific reasons for the denial which are written in a manner calculated to be understood. Participants
and beneficiaries must also be afforded a reasonable opportunity for a full and fair review of benefit denials.
Reviews must be conducted by the appropriate fiduciary denying the claim.
No legal action may be brought until a participant or beneficiary has exhausted the administrative
remedies provided under the Plan.
17