APPENDIX

SMALL BUSINESS JOB PROTECTION ACT OF 1996:
Analysis of Qualified Plan Provisions
(Sections 1316, 1401-1461)

Qualified plan design through and after the year 2000 will be significantly affected if not dominated by the provisions summarized here, which were adopted as part of the 1996 tax legislation. Note that effective dates vary over this period, with some provisions becoming effective in later years and some phased in over the period through 2000. In addition to this summary, many of the most significant provisions are discussed in the main text.

Subject	Act Section(s)	Code Section(s)	Effective Date(s)
Qualified plan trust can hold S corp stock	1316(a)(2)	1361(c)(7)	Taxable years beginning after December 31, 1997

Prior Law: A trust established under a qualified plan (Code Sec. 401(a) trust) was not a permitted shareholder in an S corporation. For qualified plan purposes, the primary consequence of this was that a qualified plan sponsored by an S corporation could not invest in company stock. This precluded the use of such stock in the company’s profit-sharing plan and prohibited the adoption of stock bonus plans or ESOPs by the S corporation.

New Law: A Sec. 401(c) trust will be a permitted shareholder in an S corporation. This will open the door to qualified plan techniques not formerly available to S corporations.

Subject	Act Section(s)	Code Section(s)	Effective Date(s)
Repeal of 5-year averaging	1401	402	Taxable years beginning after 1999

Prior Law: Certain lump-sum distributions from qualified plans were eligible for special 5-year averaging, which reduced the tax on the amount by allowing it to be taxed in lower tax brackets as if received over a 5-year period. Ten-year averaging, permitted under pre-1986 law, continued to be available to taxpayers who attained age 50 before January 1, 1986.

New Law: Five-year averaging is repealed effective after 1999. Taxpayers eligible to elect 10-year averaging under prior law will continue to be able to do so.

Commentary: This provision will primarily affect small-to-moderate qualified plan accumulations. Taxpayers in this category should consider taking lump-sum distributions now, while this provision is still available. For larger distributions, deferral generally has been and will be more advantageous than current withdrawal and taxation. However, see the discussion of Act Section 1452, below.

Subject	Act Section(s)	Code Section(s)	Effective Date
Repeal of $5,000 employee death benefit	1402	101(b)	Deaths after August 20, 1996

Prior Law: Death benefits (insured or noninsured) payable by an employer to an employee’s beneficiary were free of income tax up to $5,000.

New Law: This provision is repealed.

Commentary: This provision dates from many decades ago, and because the amount was never increased to reflect inflation, it had already become largely irrelevant in planning employee death benefits.

Subject	Act Section(s)	Code Section(s)	Effective Date
Rules for recovery of basis from qualified annuity payments	1403	72(d)	Annuity starting dates after 90th day following August 20, 1996

Prior Law: If a participant in a qualified plan had a basis in the plan accumulation, as would be the case, for example, if he had made after-tax contributions to the plan, this basis was recovered under one of two ways: an "exact" method and a safe-harbor method.

New Law: Under the new law the safe harbor method is the primary way to recover basis. The law provides that the total basis is to be divided by a number from a prescribed table, and the resultant amount is the amount of each payment that is nontaxable. The table is as follows:

 

Subject	Act Section(s)	Code Section(s)	Effective Date
Minimum distribution beginning date	1404	401(a)(9)	Years beginning after December 31, 1996

Prior Law: Qualified plan, IRA, and 403(b) plan distributions had to begin by April 1 of the year following the year in which the participant attained age 70 ½ even if the participant continued working (and thus in some cases the employer had to continue contributions to the plan).

New Law: The new law reverts to a pre-1986 rule under which distributions do not have to begin at age 70 ½ if the participant continues working; distributions are required in that case by April 1 of the year following the year of actual retirement. The "actual retirement" provision, however, is not available to 5 percent owners as defined in the top-heavy rules (an owner of more than 5 percent of the business).

Commentary: While this provision eliminates an awkward feature of prior law, for plan participants who continue to work after age 70 ½ , delaying distributions until retirement will mean that the annual distribution then required under the minimum distribution rules will be considerably larger. For large account balances this delay could therefore push the required minimum distribution above the $155,000 (indexed) threshold amount for the 15 percent excess-distribution penalty. In such situations, the participant should consider the advisability of taking distributions even before retirement.

Existing plans will have to be amended to permit deferral of distributions to actual retirement. However, the IRS has indicated that during the transition employees other than 5 percent owners who attain age 70 ½ after 1995 can defer distributions to actual retirement even though the plan has not been formally amended. Ann. 97-24, 1997-11 IRB.

Subject	Act Section(s)	Code Section(s)	Effective Date
SIMPLE Plans	1421, 1422	408(p), 401(k)	Taxable years beginning after December 31, 1996

Prior Law: No provision for such plans. However, the Code included provisions whereby SEPs (Simplified Employee Pensions) could be funded through employee salary reductions (SARSEPs).

New Law: The provision for SARSEPs is repealed, but existing SARSEPs may continue, as in effect on December 31, 1996. The provisions for regular SEPs (employer-funded only) remain unchanged.

The new law provides for plans referred to as "savings incentive match plans for employees" (SIMPLE), with the following major features:

• available to employers with 100 or fewer employees (only employees with at least $5000 in compensation for the prior year are counted) on any day in the year
• available only to employers who do not sponsor another qualified plan, 403(b) plan, or SEP
• contributions can be made to each employee’s IRA or to the employee’s 401(k) account
• employees who earned at least $5000 from the employer in the preceding 2 years, and who are reasonably expected to earn at least $5000 in the current year, can contribute (through salary reductions) up to $6,000 (indexed) annually
• required employer contribution equal to either:

(a) a dollar-for-dollar matching contribution up to 3 percent of the employee’s compensation (the employer can elect a lower percentage, not less than 1 percent, in not more than 2 out of the past 5 years), or

(b) 2 percent of compensation for all eligible employees earning at least $5,000 (whether or not they elect salary reductions)

Further detailed rules are included in the instructions with new IRS forms for adopting these plans, forms 5304-SIMPLE and 5305-SIMPLE.

Commentary: The new SIMPLE plans are somewhat simpler to administer and explain than the SARSEPs available under prior law, and SIMPLEs are available to a broader range of employers (up to 100 employees instead of 25). However, the benefits to employees are potentially somewhat lower than from SARSEPs because of the $6,000 limitation (the 1996 SARSEP limitation was $9,500). Also, from the employer viewpoint, contributions to a SIMPLE are less flexible than for SARSEPs.

In general most practitioners believe that the 401(k)/SIMPLE option will be little used since it offers few if any advantages over a regular 401(k) plan. SIMPLE/IRAs will be advantageous primarily for very small businesses that want to adopt the simplest possible pension arrangement funded through employee salary reductions. Note that regular SEPs (without the salary reduction feature) are still available and continue to be attractive as an alternative for small businesses seeking a simple plan.

See detailed discussion in chapter 5.

Subject	Act Section(s)	Code Section(s)	Effective Date
401(k) plans for tax exempts	1426	401(k)(4)	Plan years beginning after December 31, 1996

Prior Law: Governments and tax-exempt organizations could not maintain 401(k) plans, except for certain plans grandfathered under prior law.

New Law: Tax-exempt organizations and Indian tribal governments (but not other state or local governments or governmental organizations) may adopt 401(k) plans.

Commentary: This provision expands the choices available to tax-exempt organizations for their retirement plans. Some tax exempts, primarily those exempt under Section 501(c)(3) (educational, charitable, and health organizations) continue to be eligible to adopt 403(b) plans as well as now having the opportunity to adopt 401(k) plans. Total salary reductions, however, are limited to $9,500 (indexed) per employee. See detailed discussion in Chapter 5.

Subject	Act Section(s)	Code Section(s)	Effective Date
Spousal IRA limitation increased	1427	219(c)	Taxable years beginning after December 31, 1996

Prior Law: An individual filing a joint return, whose spouse had no compensation for the taxable year, was allowed to make a contribution to an IRA for the spouse; the total individual and spousal contribution could not exceed $2,250.

New Law: The limit on the total individual and spousal contribution has been increased to $4,000, so long as the combined compensation of both spouses exceeds that amount. The contribution for each spouse, as under prior law, cannot exceed $2,000 for the year.

Under the new law, a spousal IRA is available for the (joint return) spouse whose compensation is the lesser (including a spouse with no income), rather than, as under prior law, only for the spouse with no compensation income at all.

Subject	Act Section(s)	Code Section(s)	Effective Date
Definition of highly compensated; family aggregation rules	1431	414(q)	Years beginning after December 31, 1996

Prior Law: Highly compensated. For purposes of various nondiscrimination rules relating to qualified plans, "highly compensated employee" was defined as an employee who, during the year or any preceding year

• owned more than 5 percent of the business
• received compensation from the employer of more than $100,000 (1996)
• received compensation from the employer of more than $66,000 (1996) and was in the most highly paid 20 percent of employees of the employer
• was an officer and received compensation from the employer of more than $60,000 (1996)

Family aggregation. For purposes of the $150,000 limit on compensation used in determining qualified plan limitations, all members of a family were considered a single employee. For example, if a husband and wife operated a business and each earned $100,000 from the business, total qualified plan benefits for both would have to be based on a total salary of $150,000 rather than the actual total of $200,000.

New Law: Highly compensated. A highly compensated employee is defined as an employee who

• owned more than 5 percent of the business at any time during the year or the preceding year
• for the preceding year had compensation from the employer in excess of $80,000 (to be indexed for inflation) and, if the employer elects, was in the most highly paid 20 percent of employees of the employer for the preceding year

Family aggregation. The family aggregation rule is repealed.

Commentary: The new definition of highly compensated simplifies plan administration and in many cases will reduce the number of employees deemed highly compensated, making it easier to comply with nondiscrimination rules. The employer election to add the top-paid 20 percent limitation to the $80,000 limit will generally be made if it reduces the number of highly compensated employees. This may be the case if the employer’s workforce is highly paid.

The repeal of family aggregation removes a rule that, though it rarely applied, produced very harsh and unjust results when it did. (See discussion in chapter 5.)

Subject	Act Section(s)	Code Section(s)	Effective Date
50/40% participation rule	1432	401(a)(26)	Years beginning after December 31, 1996

Prior Law: In addition to all the other applicable participation rules of the Code, every qualified plan had to cover a minimum of the lesser of 50 employees or 40 percent of the employer’s employees. The purpose was to eliminate a former practice under which an employer adopted a separate plan with generous benefits that covered only a few highly compensated employees.

New Law: The 50/40% rule has been modified so that it covers only defined-benefit plans. Apparently Congress has determined that the abuse described above is significant only in the case of defined-benefit plans covering a few employees.

Commentary: This provision expands the options available in designing qualified plan arrangements that provide significant benefits for key employees and executives.

Subject	Act Section(s)	Code Section(s)	Effective Date
Alternative methods of satisfying 401(k) nondiscrimination tests	1433	401(k); 401(m)	Years beginning after December 31, 1998, except provisions relating to use of prior year for ADP computation effective for years beginning after December 31, 1996

Prior Law: A special nondiscrimination test, the ADP test, applies to 401(k) plans. This test limits the salary reduction contributions available to highly compensated employees under a formula based on actual deferrals made by nonhighly compensated employees. Matching contributions by employers are subject to a similar test, the ACP test.

New Law: The new law simplifies these tests in several ways:

• The test is based on deferral percentages for nonhighly compensated employees for the preceding rather than the current year, which allows predictability and reduces the need to distribute excess contributions after the year-end.
• An additional "safe harbor" ADP test is provided. Under this test, the nondiscrimination requirements are satisfied if the employer (a) satisfies a matching contribution requirement (100 percent of the employee contribution up to 3 percent of compensation, plus 50 percent from 3 to 5 percent ) or (b) the employer makes a nonelective (nonmatching) contribution for all eligible nonhighly compensated employees equal to at least 3 percent of compensation.
• A safe harbor for the ACP test is also provided. Under this safe harbor, no match can be made for employee deferrals in excess of 6 percent of compensation, and the rate of match must not increase as the employee deferral rate increases. Also, matching contribution rates for highly compensated employees must not be greater than those for nonhighly compensated employees.

Commentary: These improvements are an attempt to improve compliance by 401(k) plans, especially by smaller plans which have had difficulty in dealing with the complexity and administrative costs of the prior rules. See detailed discussion in
chapter 5.

Subject	Act Section(s)	Code Section(s)	Effective Date
Definition of compensation	1434	415(c)(3)	Years beginning after December 31, 1997

Prior Law: For purposes of the Section 415 limit on annual additions to a participant’s account (limited to the lesser of 25% of compensation or $30,000, as indexed), compensation did not include elective deferrals such as salary reductions in a 401(k) plan.

New Law: Compensation for purposes of the annual additions limit is "grossed up" to include elective deferrals in 401(k) plans, 403(b) plans, 457 plans, and Section 125 (flexible-benefit) plans.

Commentary: The effect of this provision is to increase the base for the Section 415 limitation, which could allow some employees to contribute more to qualified defined-contribution and 403(b) plans than under prior law.

For example, suppose an employee’s gross salary is $40,000 and he contributes $4,000 of this by salary reduction (elective deferral) to a Section 125 plan. The maximum annual addition that could be made to his account in the employer’s defined-contribution plan under prior law was $9,000 (25 percent of $36,000). Under the new law (after 1997) the maximum is $10,000 (25 percent of $40,000).

Subject	Act Section(s)	Code Section(s)	Effective Date
Aggregation rules for unincorporated businesses	1441	401(d)	Years beginning after December 31, 1996

Prior Law: There are (and remain) general rules requiring aggregation of commonly controlled businesses for purposes of applying the nondiscrimination tests. In addition, prior law included a special additional rule that applied to plans covering owners of unincorporated businesses such as proprietorships and partnerships.

New Law: The special aggregation rules for unincorporated businesses are repealed. These entities continue to be subject to the general aggregation rules applicable to all businesses.

Commentary: This provision eliminates an obsolete and complex provision that was a trap for the unwary.

Subject	Act Section(s)	Code Section(s)	Effective Date
Elimination of special vesting rule for multiemployer plans	1442	411(a)	Years beginning on or after January 1, 1997, with transition provisions

This provision eliminates the ability to use 10-year cliff vesting in multiemployer plans.

Subject	Act Section(s)	Code Section(s)	Effective Date
Distributions under rural cooperative plans	1443	401(k)(7)	Distributions after August 20, 1996; public utility provisions effective for plan years beginning after December 31, 1996

This provision permits hardship distributions and distributions after age 59 ½ by rural cooperative plans.

Subject	Act Section(s)	Code Section(s)	Effective Date
Treatment of governmental plans under Section 415	1444	415(b)(10)	Generally, years beginning after December 31, 1994

Under this provision, defined-benefit plans of governmental employers will be subject only to the dollar limit of Sec. 415 ($125,000 annually, as indexed) and not to the 100 percent of compensation limit.

Subject	Act Section(s)	Code Section(s)	Effective Date
Social Security retirement age as uniform retirement age	1445	401(a)(5)	Years beginning after December 31, 1996

This provision conforms certain provisions in the qualified plan law (those requiring a "uniform retirement age") to the recent changes in social security that provide a range of retirement ages.

Subject	Act Section(s)	Code Section(s)	Effective Date
Contributions on behalf of disabled participants	1446	415(c)(3)(C)	Years beginning after December 31, 1996

Prior Law: Contributions to a qualified plan on behalf of disabled highly compensated employees were not permitted. An employer election was required for contributions on behalf of other disabled employees.

New Law: These restrictions are eliminated if a defined-contribution plan provides for contributions on behalf of all disabled participants.

Subject	Act Section(s)	Code Section(s)	Effective Date
Changes in rules for 457 plans	1447, 1448	457	Taxable years beginning after December 31, 1996, except trust require-ment effective to assets and income held by a plan on and after August 20, 1996 (existing plans, January 1, 1999)

Prior Law: Section 457 governs nonqualified deferred-compensation plans of governmental organizations and tax-exempt employers. In an eligible Section 457 plan, the annual amount deferred by an employee was limited to the lesser of $7,500 (unindexed) or one-third of compensation. Plans were required to be unfunded, with no assets set aside in trust for employees.

New Law: These provisions make the following reforms:

• Plans can permit involuntary cashouts of up to $3,500 if no amount has been deferred by the participant for 2 years, and there has been no prior distribution.
• The $7,500 limit will be indexed for inflation.
• In the case of governmental plans, assets must be held in trusts or custodial accounts.

Commentary: These provisions of the act do not resolve the current conflict between the funding requirements of ERISA applicable to certain plans of tax-exempt organizations and the requirement of Section 457 that such plans must be unfunded. Thus 457 plans continue to be of very restricted usefulness to nongovernmental tax-exempt organizations.

Subject	Act Section(s)	Code Section(s)	Effective Date
GATT interest and mortality rate assumptions	1449	415(b)(2)(E)	As if included in GATT, with transitional rule

This provision makes it possible to delay, until plan years beginning after 1999, the effectiveness of the 1994 GATT provisions that prescribed interest and mortality assumptions for calculating lump-sum payments from defined-benefit plans. This may make it possible for participants to receive larger lump-sum distributions from defined-benefit plans during the transition period than GATT would have allowed. Formal amendment of the defined-benefit plan may be required in order to take advantage of this transitional rule.

Subject	Act Section(s)	Code Section(s)	Effective Date
Section 403(b) changes	1450	403(b)	Years after December 31, 1995

The act makes the following changes applicable to 403(b) tax-deferred annuity plans:

• The rules for making elections are conformed to those applicable to 401(k) plans. This eliminates an awkward rule under which only one 403(b) election could be made each calendar year.
• Indian tribal governments are deemed eligible to sponsor 403(b) programs for contracts purchased in a plan year beginning before January 1, 1995, and such contracts may be rolled over to a 401(k) plan sponsored by the tribal government. This provision in effect rescues these contracts from being disqualified.
• 403(b) contracts must explicitly incorporate the $9,500 (indexed) salary reduction limit. There is a 90-day period after the date of enactment to make changes to existing contracts.

Subject	Act Section(s)	Code Section(s)	Effective Date
Joint and survivor notice period	1451	417(a)	Plan years beginning after December 31, 1996

The Code and ERISA require that a written explanation of the joint and survivor annuity option must be given no less than 30 nor more than 90 days before the beginning date. Treasury regulations allow the participant and spouse to waive this requirement. This provision codifies the provision in the regulations.

Subject	Act Section(s)	Code Section(s)	Effective Date
Repeal of combined fraction and suspension of 15% excess-distribution tax	1452	415(e) (repealed)	Limitation years beginning after December 31, 1999; excise tax suspended 1997 through 1999

Prior Law: Code Section 415 (enacted as part of ERISA in 1974) provides limits on annual additions to a defined-contribution plan (the lesser of 25 percent of compensation or $30,000, as indexed) and limits on benefit under a defined-benefit plan (the lesser of 100 percent of average compensation or $120,000, as indexed). Under Section 415(e), if a participant was covered under both a defined-benefit plan and a defined-contribution plan of the same employer, a complex computation involving a "combination fraction" had to be made each year to limit total benefits so that it was not possible to maximize both the defined-benefit and defined-contribution amounts.

The Tax Reform Act of 1986 added another provision aimed at preventing excessive qualified plan accumulations by highly compensated employees, the 15 percent excess-distribution tax. Under this provision, an excise tax of 15 percent is enacted on annual plan distributions exceeding $155,000 (indexed), in addition to the regular income tax. There are provisions exempting accrued benefits in excess of $562,500 as of August 1, 1986 (the grandfathered amount). There is also an additional 15 percent estate tax on excess accumulations at death.

New Law: Congress has apparently determined that the existence of both the provisions described above constitutes overkill and has repealed one of these, the combination fraction computation of Section 415(e), effective after 1999. To provide relief during the interim, the 15 percent excess-distribution tax (but not the excess-accumulation tax) is suspended for years beginning after December 31, 1996, and before January 1, 2000. Distributions during this period are deemed to be made first from non-grandfathered amounts.

Commentary: The repeal of Section 415(e) is welcome and will simplify administration of plans covering owners and executives, as well as open new opportunities for creative plan design.

The suspension of the 15 percent excise tax is something of a Trojan horse, since it may encourage some participants to take distributions (and pay income taxes) earlier than they otherwise would have. In many cases, deferral of distributions and taxes would save participants more money than the 15 percent excise tax saving involved in taking a distribution during the suspension period. Advisors will have to evaluate this decision based on the age and health status of the participant and spouse. If their joint life expectancy is relatively limited, current withdrawals may be beneficial. Note that 5-year averaging continues to be available through 1999 to further reduce the impact of any total distribution taken during this period.

The need for money may be another factor. If money has to be withdrawn over a relatively short-term period, making long-term deferral impossible, then distributions should probably be made during this interim period if the 15 percent excise tax is a factor.

Fundamentally, however, for the vast majority of plan participants who are aged 70 or less and whose qualified accounts total less than $1 million, the amount of 15 percent excise tax imposed on regular minimum distributions will be small or zero and the 3-year moratorium provides no significant benefit.

 

Subject	Act Section(s)	Code Section(s)	Effective Date
Prohibited transaction penalty	1453	4975	Prohibited transactions occurring after August 20, 1996

The initial prohibited transaction penalty has been raised from 5 percent to 10 percent.

Subject	Act Section(s)	Code Section(s)	Effective Date
Leased employee definition	1454	414(n)	Years beginning after December 31, 1996

Prior Law: A leased employee is treated as the service recipient’s employee for pension purposes if the leased employee does work "historically performed by employees."

New Law: The "historically performed" provision has been replaced by a provision covering services that "are performed under primary direction or control by the recipient."

Commentary: This change reduces uncertainty in application of the leased employee rules. It will facilitate contracting out of various jobs such as maintenance, by reducing concern that the leased employees will have to be taken into account for purposes of the service recipient’s pension plans.

Subject	Act Section(s)	Code Section(s)	Effective Date
Uniform penalty provisions	1455	6724, 6047	Returns, etc., with due date after December 31, 1996

This provision makes certain pension-related penalties more uniform.

Subject	Act Section(s)	Code Section(s)	Effective Date
Retirement benefits of ministers not subject to self-employment tax	1456	1402	Years beginning before, on, or after December 31, 1994

This provision exempts the rental value of parsonages or any other retirement benefit from a church plan after the clergyman retires.

Subject	Act Section(s)	Code Section(s)	Effective Date
Sample language for spousal consent and QDRO forms	1457	417(a), 414(p)	Not later than January 1, 1997

The Treasury is directed to develop the sample language referred to. This will affect an increasingly important legal practice issue, the procuring of informed consents from spouses who relinquish spousal rights in qualified plans.

Subject	Act Section(s)	Code Section(s)	Effective Date
Awards to volunteer firefighters, etc.	1458	457	Accruals and amounts paid after December 31, 1996

Length-of-service awards paid to volunteer firefighters or emergency medical or ambulance volunteers will not be considered deferred compensation subject to the limitations of Section 457.

Subject	Act Section(s)	Code Section(s)	Effective Date
Special ADP testing for pre-21 401(k) participants	1459	401(k)(3)	Plan years beginning after December 31, 1998

Prior Law: Many employers would have liked to extend 401(k) eligibility to younger workers (those aged under 21). However, this was rarely done because these younger workers were less likely to participate and this low participation would make it harder to meet the ADP or ACP tests for the overall plan, thus reducing the salary reduction amounts available to highly compensated employees.

New Law: In performing the ADP tests of Section 401(k) or the ACP tests of Section 401(m), the employer may elect to exclude eligible employees who have not attained age 21 or one year of service. The plan must meet Section 410(b) tests with respect to these under-21/one-year participants.

Subject	Act Section(s)	Code Section(s)	Effective Date
Application of ERISA to insurance company general accounts	1460	ERISA Section 401	Not later than June 30, 1997

The Department of Labor is directed to issue regulations providing guidance in determining when assets held by an insurance company on behalf of insurance policies issued to a pension plan constitute plan assets. These regulations are intended to clarify the issues raised by the Supreme Court in John Hancock v. Harris Trust, 510 U.S. 86 (1993), which held that certain such assets held in an insurance company’s general account should be considered plan assets. The outcome of this regulatory project could have significant impact on the marketing of insurance contracts to pension plans.

Subject	Act Section(s)	Code Section(s)	Effective Date
Church plan changes	1461	401 et seq.	Years beginning after December 31, 1996

This provision allows self-employed ministers, or ministers employed by non-501(c)(3) organizations, the benefit of the favorable church plan rules for their retirement plans and adds various other provisions favoring the clergy.

Chapter 15

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