There have been many recent changes in the area of employee benefits and executive compensation. Employers will want to focus on recent developments - including fiduciary and plan fee developments, issues involving tax-qualified plans, executive compensation issues, further guidance on health care, proxy reporting for public companies, and international plan developments. In some cases immediate action may be necessary; in other cases, there may be planning opportunities. The following is a brief summary of some important issues that may affect employers in 2011.
Fiduciaries And Plan Fees
1. Know Who Your Fiduciaries Are
The Department of Labor ("DOL") is poised to finalize regulations that significantly broaden the scope of fiduciary status under the Employee Retirement Income Security Act of 1974 ("ERISA") for those who provide individualized investment-related services or advice for which they are compensated directly or indirectly. Among other things, the proposed regulations will cover as "fiduciaries":
- Persons who give advice, appraisals, and fairness opinions that are the basis for the plan purchasing, holding, selling, or otherwise managing, plan assets. Real estate appraisers and proxy voting advisors, for instance, would be covered under the revised regulations. This extends to people who merely provide year-end asset valuation information if the resulting valuation is the basis for participant distributions.
- Persons who give individualized investment advice to participants, as well as to plan trustees.
- Persons who give such advice on a one-time basis. The existing requirement that advice be provided on a regular or continuing basis would be deleted.
- Persons whose advice will be "considered" in connection with the plan’s (or participants’) investment decisions, even if the advice is not (as under current regulations) the "primary basis" for those decisions.
The proposed regulations continue the rule that providing general investment education is not investment advice. There are a few other carve-outs from the expanded scope of fiduciary functions. For instance, a person whose interests are obviously adverse (such as the seller of securities being bought by the plan), and who does not otherwise claim to be an ERISA fiduciary, does not become a fiduciary by recommending the investment. Persons who provide investment alternatives under a platform without regard to individualized needs of the plan or participants, and persons providing data to enable fiduciaries to monitor investment alternative, will not be fiduciaries, provided they disclose in writing that they are not undertaking to provide impartial investment advice.
Decisions by the new fiduciaries are subject to the usual standards of ERISA for "prudence" and avoiding a conflict of interest. More importantly, the new fiduciaries become clearly liable under ERISA to make good any losses to the plan from any breach of those duties. In addition, the new fiduciaries (and a long list of parties related to them) will become "parties in interest" subject to the ERISA prohibited transaction rules in other dealings with the plan. Service providers who would become fiduciaries under the proposed regulations must be aware of their new status; and plans must re-evaluate who their fiduciaries are so as to understand their respective duties and obligations.
2. Plan Fees and Fee Disclosure
The DOL has increased its focus on plan fees and fee disclosure. Recently issued DOL regulations on fee disclosure to participants of a self-directed defined contribution plan are effective for plan years beginning after October 31, 2011. Previously the DOL issued rules regarding required fee disclosures by plan service providers originally to be effective July 16, 2011 but now effective January 1, 2012. Previously the DOL also has issued guidance currently in effect on requirements for reporting plan investments and fees on Schedule C to the annual Form 5500. This increased focus on fees and fee disclosure has also been the focus of plaintiffs bringing lawsuits on plan investment performance. While plan sponsors and fiduciaries typically heavily negotiate fees when entering into new investment arrangements or adding a new fund, it is important that they continue to monitor investment fees and the effect on investment risk and return.
Plan sponsors and fiduciaries will need to review their methods and forms of disclosure to participants. The DOL regulations on fee disclosure to participants in self-directed plans require comprehensive information on investment-related performance, including a description of features of each investment and the types of fees that are charged. The format must be in a format that allows participants to compare different alternatives for each type of investment, and the DOL has issued a model table for disclosure. The separate service provider fee disclosure rules place a duty on plan sponsors and fiduciaries to insure that service and fee information from plan providers satisfies the new requirements.
In addition to monitoring compliance with these disclosure requirements, plan sponsors and fiduciaries will want to be sure that their plan documents allocate responsibility for communication for preparation and timely availability and delivery of communications to participants, especially if an outside vendor’s website or portal is used. It is also important to review the plan and related documents relating to the plan investments, including agreements with service providers and fee schedules, to make sure that the fees disclosed are those actually authorized by the agreements.
3. 409A Issues in Corporate Transactions
Deferred compensation rules under Internal Revenue Code ("Code") Section 409A continue to merit a watchful eye, particularly in the context of corporate transactions. Here is a partial list of items deserving vigilance:
- Change in control definition. Be sure the change in control ("CIC") definition qualifies under Code Section 409A if it could trigger a payment.
- Intersection of Code Section 409A and Code Section 280G. The rules for determining whether a payment is "contingent on a change" in control for purposes of the golden parachute taxes apply a different definition of CIC than the Code Section 409A rules. Parachute taxes can be triggered even when there has been no CIC for Code Section 409A purposes. Conversely, there can be a CIC under Code Section 409A (for example on sale of a subsidiary) where there is no CIC under the golden parachute rules.
- No double toggles. Be sure that CIC toggles (different time or form of payment before and after a CIC or upon separation within 2 years after CIC) are entirely separate from other toggles, e.g., different time or form of payment before and after age 55. The age 55 toggle cannot apply at the same time as the CIC toggle. The toggles must be the same in all deferred compensation plans of the same type (e.g., employment agreement, CIC plan or agreement, severance plan or agreement).
- Change in control as a payment trigger. Generally, it is not practical to add a CIC payment trigger to an existing arrangement because of the subsequent deferral rules. For example, the addition of a CIC trigger to a deferred compensation arrangement that otherwise provides for payment on separation from service could not take effect for 12 months and would have to provide for payment on the later of the CIC or 5 years after separation.
- Discretionary Plan Liquidation. A better approach would be to consider Code Section 409A’s discretionary plan liquidation rules. If the employer takes irrevocable action to terminate the plan (and all plans of the same type) within 30 days before or 12 months after the CIC and the entire plan (and all other plans of the same type) is liquidated within 12 months after the employer’s action, the subsequent deferral rules do not apply. The employer taking the liquidation action is identified immediately after the transaction, and for asset deals, the entity maintaining the plan post-closing is the relevant employer. The employer must be able to take this action without employee consent, so watch out for plan provisions requiring employee consent for any changes.
- Transaction-based compensation. The limited exception to the Code Section 409A rules for payments related to stock or stock value in a CIC permits deferred compensation payments to be made at the same time as other shareholders receive payments. It requires that such payments be completed no later than 5 years after the CIC. To make this work, it is permissible, before the CIC, to add a substantial risk of forfeiture to amounts that would otherwise vest on a CIC. But the 5-year limit can be problematic, for example, if a post-closing escrow lasts longer.
- Special CIC vesting rules. In connection with a CIC it is permitted to extend or modify substantial risks of forfeiture (or to add new substantial risks of forfeiture) to amounts that would otherwise become vested because of a CIC other than an asset sale.
- Treatment of equity awards. Be careful where an equity plan or award agreement provides for cash out on a CIC (or separation following a CIC) "unless the purchaser assumes" the award. For equity awards subject to Code Section 409A (such as restricted stock units but not most options and restricted stock), there is a risk that the employer, by negotiating for the purchaser not to assume the awards, will be deemed to be exercising impermissible discretion under Code Section 409A.
4. Taxation of Nonqualified Deferred Compensation Payable by Foreign Subsidiaries and Certain Partnerships Under Internal Revenue Code Section 457A
Code Section 457A imposes special timing rules for the taxation of nonqualified deferred compensation that is payable by (i) foreign corporations that are not subject to comprehensive foreign income tax or (ii) partnerships that allocate 20% or more of their net income to partners who are tax-exempt or foreign persons who are not subject to comprehensive foreign income tax. A foreign corporation or other person will generally be treated as subject to "comprehensive foreign income tax" if the foreign corporation or other person resides in a country (other than Bermuda or the Netherlands Antilles) that has an income tax treaty with the United States.
Under these special timing rules, nonqualified deferred compensation that is subject to Code Section 457A must be included in a service provider’s gross income in the year it becomes substantially vested. For purposes of Code Section 457A, compensation will be treated as vested only when the service provider is no longer required to perform any additional services. Performance vesting triggers will be disregarded. These special rules operate in addition to the restrictions imposed under Code Section 409A.
Taxpayers have until the end of 2011 to amend or modify nonqualified deferred compensation arrangements under Code Section 457A that are attributable to services performed before January 1, 2009. Under this transition relief:
- The modification of nonqualified deferred compensation will not be treated as a violation of Code Section 409A if the arrangement is amended to provide for distribution of deferred compensation when such compensation becomes taxable under Code Section 457A.
- If nonqualified deferred compensation is exempt from Code Section 409A under the Code Section 409A grandfather rules, the amendment of this arrangement to provide for payment of the deferred compensation when it becomes taxable under Code Section 457A will not be treated as a "material modification" that would cause the loss of "grandfather" status.
Tax Qualified PLAN Compliance Issues
5. EPCRS Non-Amender Correction
For tax-qualified plans that have not adopted timely amendments, the employer may apply under the IRS Employee Plans Compliance Resolution System ("EPCRS") Voluntary Compliance Program ("VCP") component, to correct the failure to amend. Non-amender failures generally arise from the failure to timely adopt interim amendments that are required for plans to maintain compliance with the changes to the Code and Treasury Regulations.
One key advantage to filing a VCP non-amender application with IRS is that the fee for such filing is significantly less than the penalties that would be assessed if the non-amender plan defect was discovered on audit or during an IRS determination letter review. The VCP non-amender compliance fee is the normal VCP fee that applies for correcting plan failures. This fee ranges from $750 to $25,000 depending on the number of participants in the plan.
It is also important to note that the above VCP fee is reduced by 50% if the non-amender failure is corrected and filed with IRS under EPCRS within the one-year period following the applicable amendment’s required adoption date. For plan sponsors who failed to timely adopt pre-approved defined contribution plan restatements for EGTRRA (this deadline was April 30, 2010), the discounted 50% VCP fee ends on April 30, 2011. However, since April 30 falls on a Saturday, the deadline for filing a discounted VCP application is May 2, 2011.
6. 2010 Cumulative List of Changes in Plan Qualification
The IRS recently issued Notice 2010-90 which sets forth the Cumulative List of Changes in Plan Qualification Requirements. Retirement Plans that will file for determination letters in the current Cycle A (February 1, 2011 - January 31, 2012) will need to incorporate the changes listed in the Notice.
The most recent changes to be aware of in the Cumulative List are the following: the HEART Act provisions, the minimum distribution suspension from 2009, provisions for plans that have implemented in-plan Roth rollovers, special vesting rules (Code Section 411(a)(13)) and changes under Code Section 411(b)(5) for cash balance and other applicable defined benefit plans, benefit restrictions in defined benefit plans required by Code Section 436, and provisions under Code Section 401(a)(35) regarding a participant’s right to divest publicly traded employer securities.
7. IRS Issues Regulations Providing Guidance for Cash Balance Plans
On October 19, 2010, the IRS issued final and proposed regulations providing much needed guidance for sponsors of cash balance plans. The final regulations clarify the rules governing cash balance plans added by the Pension Protection Act of 2006 ("PPA"), and are generally effective for plan years beginning on or after January 1, 2011. The proposed regulations generally would apply to plan years beginning on or after January 1, 2012, but can be relied upon generally now.
When reviewing their cash balance plans in 2011, plan sponsors should realize first that it is very likely that amendments for the final regulations will be required this year. As they consider those amendments, sponsors should focus on the following provisions of the final regulations: (1) the fact that the special three year vesting requirement is broader than it appears on the face of the statute, (2) the age discrimination guidance in the final regulations and whether to attempt to use the PPA’s safe harbor, (3) the detailed and counter-intuitive guidance about the market rate of return requirements, and (4) guidance regarding conversions from a traditional defined benefit pension plan to a cash balance plan. These four principal components of the final regulations shed some light on issues that were uncertain after the PPA. For example, one provision deals with the vesting of accrued benefits. Under the PPA, a cash balance participant’s benefit must be fully vested after three years of vesting service. Plan sponsors, however, were unsure of how the rule would apply to other plans with longer vesting schedules if those plans were converted into cash balance plans. In this regard, the final regulations clarify that the three year vesting requirement generally applies to employees who earn benefits under both plan designs.
The proposed regulations provide sponsors of cash balance plans with important clues regarding acceptable interest crediting rates and changing those rates. As a matter of background, a cash balance plan is a defined plan that specifies an employer contribution along with an interest crediting rate that cannot exceed a "market rate of return," which was defined in the final regulations. Among other things, the proposed regulations allow several new interest crediting rate options as acceptable market rates of return. Since the IRS has indicated that the proposed regulations may be relied on immediately, cash balance sponsors may want to take advantage of the new interest crediting rates now before they become finalized. 8.
8. Correcting Plan Documents Based on Scrivener’s Error Doctrine
In Young v. Verizon, 615 F.3d 808 (7th Cir. 2010), the court issued a welcomed opinion letting plan sponsors correct clear and unequivocal mistakes in plan documents, mistakes often known as scrivener’s errors. The mistake in the Verizon case involved the calculation of the value of a pension benefit. The value of the opening balance of a participant’s hypothetical account was to be determined by multiplying by a factor. But the plan did not say that factor was to be multiplied only once as was intended. It said the factor was to be multiplied twice. This scrivener’s error could have cost the plan sponsor approximately $1.6 billion.
The 7th Circuit agreed with the district court that equitable reformation of the plan to delete that second use was a form of "appropriate equitable relief" under section 502(a)(3) of ERISA. The 7th Circuit set a high standard for future scrivener’s error cases in its circuit. The court reserved to the courts the right to allow an equitable reformation and emphasized that "only those that can marshal clear and convincing evidence the plan language is contrary to the parties’ expectations will have a viable claim." The impact of Verizon will depend on how future courts allow the scrivener’s error doctrine to develop within ERISA’s unique environment, and how the IRS lets this result and the court’s commentary impact its future willingness to accept scrivener’s error arguments under its EPCRS program.
9. Update on the Patient Protection and Affordable Care Act
Reimbursement of Over-the-Counter Medications. Effective January 1, 2011, FSAs, HSAs and HRAs may no longer reimburse participants for the cost of over-the-counter medicines, other than insulin, unless such medicines are actually prescribed by a doctor. The IRS clarified in Notice 2010-59 that these rules do not apply to items that are not medicines, including equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits. Note that employers have until June 30, 2011 to amend their plans as necessary to comply with these new over-the-counter medicine restrictions.
Debit cards may be used to purchase over-the-counter medicines in some limited circumstances. Concerned with substantiation difficulties, the IRS in Notice 2010-59 originally limited the use of debit cards for over-the-counter medications to "90% pharmacies" (i.e., 90% of the store’s gross receipts consist of items that qualify as expenses for medical care under Code Section 213(d)). In Notice 2011-5, the IRS expanded its position, however, to provide that debit cards may also be used to purchase over-the-counter medicines at drug stores and pharmacies, at non-health care merchants that have pharmacies, and at mail order and web-based vendors that sell prescription drugs, if:
- prior to purchase:
- the prescription for the medicine is presented to the pharmacist,
- the over-the-counter medicine is dispensed by the pharmacist in accordance with applicable law and
- an Rx number is assigned;
- the pharmacy or other vendor retains a record of the Rx number, the name of the purchaser (or the person for whom the prescription is obtained), and the date and amount of the purchase in a manner that meets IRS recordkeeping requirements;
- all of these records are available to the employer or agent upon request;
- the debit card system will not accept a charge for an over-the-counter medicine unless an Rx number has been assigned; and
- normal debit card substantiation requirements are met. Debit cards may also be used to purchase over-the-counter medicines from other vendors that have health care related merchant codes if certain requirements are met.
Employers maintaining FSAs or HRAs should confirm that their outside vendors have procedures in place to comply with these new limitations.
Form W-2 Reporting Changes Delayed to 2012. The Affordable Care Act imposed a new requirement on employers that Forms W-2 issued for 2011 and later years include the value of certain employer-sponsored group health coverage. The value to be reported is generally to be determined under rules similar to those for determining premiums for COBRA continuation coverage under Code Section 4980B(f)(4). In Notice 2010-69, however, the IRS has delayed this requirement until 2012 so that employers are not required to include the value of group health coverage on 2011 Forms W-2. The IRS has issued a draft Form W-2 for 2011, however, for employers that wish to voluntarily provide such information.
10. Self-reporting of Health Plan Violations Filing Requirements Begin in 2011
While most employers are well-aware that they may be subject to penalties for failure to comply with legal requirements applicable to their group health plans, many employers are not aware that they now have an affirmative duty to self-report such violations and pay applicable excise taxes. Failure to timely comply with this new self-reporting requirement can subject an employer to layers of additional interest and penalties. Thus, it is important that employers understand their self-reporting obligations and make informed decisions regarding what and when to report.
Violations of the following requirements are now subject to this self-reporting requirement:
- Continuation of coverage requirements under the Consolidated Omnibus Budget Reconciliation Act ("COBRA").
- Portability and nondiscrimination requirements under the Health Insurance Portability and Accountability Act ("HIPAA").
- Mental Health Parity and Addiction Equity Act ("MHPAEA") requirements.
- Mothers’ and Newborns’ Health Protection Act ("MNHPA") requirements.
- Michelle’s Law requiring continued coverage of dependent students on medically necessary leaves of absence.
- Health Savings Account ("HSA") and Archer medical savings account ("MSA") contribution comparability requirements.
In the past, the IRS has not actively examined plans for compliance with these requirements. The IRS issued final regulations in 2009, however, requiring employers to self-report violations of the above laws for plan years beginning on or after January 1, 2010 (or with respect to HSA or MSA contributions made for calendar years beginning on or after January 1, 2010).
Violations must be reported on new Form 8928, Return of Certain Excise Taxes Under Chapter 43 of the Code, and applicable excise taxes must be paid at the time of filing. With respect to COBRA, HIPAA, MHPAEA, MNHPA and Michelle’s Law violations, the form is due by the due date of the employer’s tax return (or, if the filer is a multiemployer or multiple employer plan, the last day of the seventh month following the end of the plan year). Extension of the employer’s federal tax return does not extend this filing deadline. With respect to violations of the HSA and MSA contribution comparability requirements, the form is due on or before the 15th day of the fourth month following the calendar year in which the non-comparable contributions were made. An extension of time to file Form 8928 may be requested on Form 7004, but a filing extension does not extend the time to pay applicable excise taxes.
Violations of COBRA, HIPAA, MHPAEA, MNHPA and Michelle’s Law generally subject the employer (or other responsible party) to an excise tax of $100 per day of noncompliance. Violations of the HSA or MSA contribution comparability requirements subject the employer to an excise tax of 35% of the aggregate employer contributions made to all HSAs or MSAs during the applicable calendar year.
Although no excise tax is due if it is established that no one liable for the tax knew, or exercising reasonable diligence would have known, that such a failure occurred, or if the failure was due to reasonable cause and was corrected within 30 days of the date any such person knew, or exercising reasonable diligence would have known, that the failure existed, the violation must still be reported on Form 8928.
Employers should carefully assess each potential violation to determine whether a filing is warranted. Employers may also wish to review their contractual arrangements with outside vendors to ensure that potential violations are reported to the employer in a timely manner to determine what actions should be taken.
11. Mandatory UK Pensions
Rules for non-US plans also change frequently and employers with operations or employees outside of the US will need to review these rules. Beginning in October 2012, UK employers will be required to enroll most employees into a pension arrangement with a compulsory 3% employer contribution. The enrollment requirement is being rolled out over a 4-year period, starting with the largest employers first. Employer contribution rates are also being phased in, starting at 1% and gradually increasing to 3%. The additional pension costs will need to be considered carefully by any employer looking to establish or acquire a UK business. They will have the greatest impact on companies which make a zero or low contribution towards employee pensions now, or where take-up for current pension arrangements is low. The UK Pensions Regulator can impose significant penalties for non compliance.