Cypen & Cypen
AUGUST 30, 2007
Stephen H. Cypen, Esq., Editor
We recently retained Robert Friedman, of Holland & Knight, to provide advice to the trustees of one of our municipal defined benefits pension plans with regard to application of Section 415 of the Internal Revenue Code to the plan and the plan’s DROP. As a service to our clients, Mr. Friedman has recast his opinion in general terms, and authorized us to make it available to our other public pension clients.
The full text of Mr. Friedman’s opinion follows:
Stephen Cypen, Esquire
Re: Application of Section 415 to Fire Fighter and Police Pensions
We recently provided advice to the trustees of a Florida municipal defined benefit fire fighter and police pension plan (the "Plan") with regard to the application of Section 415 of the Internal Revenue Code of 1986, as amended (the "Code"), to the Plan and the Plan's DROP program. The trustees were seeking clarification on certain issues raised by the city that sponsors the Plan and the trustees asked us to respond to a list of questions. The application of Section 415 of the Code to such plans has drawn new attention since the Internal Revenue Service issued final regulations under Section 415 in April.
I thought you might be interested in the issues that are raised about Section 415 and our responses to the questions provided by the trustees. The questions and responses are set forth below.
1. In the case of a participant who enters the DROP program under the Plan, how is the Section 415 limit applied to the payment into the DROP account and to the payment to the participant from the DROP account?
For purposes of the application of the Section 415 limit, the payment into the DROP account will not be subject to testing under Section 415(b) or 415(c). However, as discussed below, depending on the way in which the payment to the DROP account is invested, the payment from the DROP account may be subject to the Section 415(b) annual benefit limit.
For defined benefit pension plans, such as the Plan, Section 415(b) of the Code limits the employer-provided portion of the benefit to be paid to a participant in any limitation year. The limit is the lesser of a specific dollar amount indexed for inflation ($180,000 for 2007) or 100% of the participant's average compensation for the highest three consecutive years. Governmental plans are exempt from the limit related to average compensation. Therefore, the Plan's Section 415 limit is the applicable dollar amount for the year.
As described below, under certain circumstances, a DROP account will be treated as a defined contribution plan for purposes of the application of the Section 415 limit. For defined contribution plans, Section 415(c) of the Code limits "annual additions" to a participant's account to the lesser of a specific dollar amount indexed for inflation ($45,000 for 2007) or 100% of the participant's compensation for the year.
If a defined benefit pension plan pays a benefit in a form other than a straight life annuity, the benefit must be actuarially adjusted to a value equivalent to a straight life annuity beginning at the same age for testing under Section 415(b). The additional value of a qualified joint and survivor annuity is not taken into account. However, benefits that must be adjusted include those paid as full or partial lump sum distributions and nonqualified joint and survivor annuities.
Under the Section 415 regulations, the determination of whether a benefit under a plan must be adjusted is a two-step process. First, the plan must determine whether the benefit is in a form that must be adjusted. Second, the plan must determine if the benefit is in a form subject to Section 417(e)(3) of the Code. If the benefit is determined to be in a form that is not subject to Section 417(e)(3), then the process for adjusting the form of benefit is much simpler than the process for adjustment of a benefit that is subject to Section 417(e)(3). A lump sum distribution is a form of benefit that is subject to Section 417(e)(3).
The Plan includes a DROP program. If an eligible Plan participant elects to enter the DROP, the participant is deemed retired and the Plan pays the participant's monthly pension into a separate Plan account as if the participant actually separated from service. After the participant begins to participate in the DROP program, the participant does not accrue any additional compensation and years of service under the Plan.
Under the DROP program, the participant may elect to have the participant's DROP account invested in two ways. One way is for the account to accrue interest at a fixed rate established from time to time by the Plan. The other way is for the account to accrue a rate of return based upon the rate of return on Plan assets.
To the extent that a participant's DROP account accrues a rate of return based upon the rate of return on Plan assets ("Variable Investment DROP"), the DROP account will be treated as a defined contribution plan for purposes of the limit imposed under Section 415(c) of the Code. This means that the benefit from the DROP is not aggregated with the regular payments from the Plan in applying the annual limit on benefit payments under Section 415(b). Furthermore, because the amounts deposited into the DROP account are not considered "annual additions" to a defined contribution plan for purposes of Section 415(c), the limit on "annual additions" under Section 415(c) will not apply to such deposits to the DROP account. Therefore, in the case of a Variable Investment DROP, the DROP program benefit will not be subject to the participant's Section 415(b) limit and the amounts to be deposited into the DROP account will not be subject to the "annual additions" limit under Section 415(c).
On the other hand, to the extent that a participant's DROP account accrues interest at a fixed rate set by the Plan ("Fixed Investment DROP"), the DROP account will be treated as a defined benefit plan for purposes of Section 415. Because contributions to a defined benefit plan are not limited under Section 415, in the case of a Fixed Investment DROP the payments into the DROP account will not be tested under Section 415(b) (and the Section 415(c) limit on "annual additions" to a participant's account will not be applicable). However, the benefit from the DROP will be calculated as a monthly benefit when the participant finally terminates employment which will be aggregated with the regular payments from the Plan in applying the annual limit on benefit payments under Section 415(b). Therefore, in the case of a Fixed Investment DROP, the participant's DROP account benefit may cause the participant's annual benefit payment to exceed the Section 415(b) limit.
2. If the participant's benefit from the Plan exceeds the Section 415(b) limit and is thereby reduced to meet the limit, can the city (the "City") fund the excess benefit arrangement prior to the participant's separation from service?
Under Section 415(m) of the Code, state and local governments may establish a "qualified excess benefit arrangement" and use such arrangement to pay the portion of a pension plan benefit in excess of the Section 415 limit. Section 415(m)(3)(C) requires that the funds used by the excess benefit arrangement to pay benefits in excess of the Section 415 limit must be held separately from the pension plan.
Section 415(m)(2) of the Code provides that the taxable year or years for which amounts in respect of the excess benefit arrangement are includible in gross income by a participant are determined as if the arrangement were a nonqualified deferred compensation plan of a nonexempt corporation. An item of compensation generally is includible in gross income for the taxable year in which such compensation is actually or constructively received by the employee. Compensation is constructively received in the taxable year during which it is credited to an employee's account, set apart or otherwise made available so that the employee may draw on it at any time. An unfunded, unsecured promise to pay compensation to an employee in a later taxable year does not constitute receipt of income. In general, a participant in a deferred compensation plan that is an unfunded, unsecured promise to pay compensation in a later year does not have gross income from benefits promised to him or her under the plan until such benefits are paid. Additionally, under the economic benefit doctrine, an employee has currently includible income from an economic or financial benefit (other than in cash form) received as compensation. Economic benefit applies when assets are unconditionally and irrevocably paid into a fund to be used for the employee's sole benefit. Generally, a "pay as you go" funding arrangement under a deferred compensation plan avoids the transfer of an economic benefit.
Because of the application of the foregoing rules to the taxability of the amount payable to a participant under a qualified excess benefit arrangement, governmental employers do not prefund such arrangements.
In the case of a participant whose annual benefit from the Plan must be reduced to comply with the limit under Section 415(b), there is a question of whether the Plan must reduce the participant's monthly payment to 1/12th of the annual limit or the Plan may make the regular monthly payments to the participant each month until the limit is reached. Under Section 415, either arrangement for reducing the participant's annual benefit would be permitted. However, the terms of the Plan should be reviewed to determine if a rule for reducing the participant's payments is already provided. In the absence of a Plan provision, the Plan may choose the arrangement for reducing the participant's annual benefit.1 The City's funding of the excess benefit arrangement, and the payments to the participant from the excess benefit arrangement, would have to be coordinated with the arrangement used by the Plan to reduce the annual benefit to comply with Section 415(b).
3. How does the Plan correct benefit payments that exceeded the Section 415 limit?
If the Plan made benefit payments to participants that exceeded the Section 415 limit, the Plan should correct such overpayments in accordance with the IRS's employee plan compliance resolution system ("EPCRS"). Essentially, the Plan may use the "return of overpayment" method provided under EPCRS to correct an overpayment error by taking
4. If the Plan has a BACK DROP feature and for purposes of applying the Section 415(b) limit the BACK DROP must be converted to a straight life annuity, then what interest rate should be used in calculating the amount of such annuity?
Because a BACK DROP involves the payment of a lump sum distribution into the DROP account, a BACK DROP is a form of benefit to which Code Section 417(e)(3) applies. Accordingly, for purposes of actuarially adjusting a BACK DROP to a straight life annuity as required for testing under the Section 415(b) limit, the final Section 415 regulations provide that such annuity is determined as the greatest annual straight life annuity commencing at the annuity starting date that has the same actuarial present value as the form of benefit payable computed using:
Therefore, the Plan must apply the three specified interest rates in performing the required actuarial adjustment of the BACK DROP.
5. What is the best practice for the Plan with respect to the withholding of FICA taxes on payments from the excess benefit arrangement?
In several Private Letter Rulings, the IRS concluded that it would not provide a ruling on the question of the FICA tax treatment of a qualified excess benefit arrangement until a regulation or other prohibited guidance is issued. Accordingly, at the current time, the IRS is not certain whether contributions to an excess benefit arrangement or payments from an excess benefit arrangement should be subject to FICA taxes.
In our view, unless the Plan or the City is prepared
to defend and indemnify the retirees who receive payments
from the excess benefit plan with respect to FICA tax assessments
by the IRS in the future, the best practice is to withhold
FICA taxes on excess benefit payments as each payment is
Very truly yours,
HOLLAND & KNIGHT LLP
Robert J. Friedman
Trustees should make the opinion available to the actuary, to ensure that Section 415 of the Internal Revenue Code is not violated.
The United States Court of Appeals for the 3rd Circuit upheld an Equal Employment Opportunity Commission regulation that would exempt from the Age Discrimination in Employment Act (as amended by the old Workers Benefit Protection Act) employer coordination of retirement benefits with, inter alia, medicare benefits (see C&C Newsletter for June 21, 2007, Item 1). Subsequently, American Association of Retired Persons sought en banc rehearing to review the unanimous 3-judge panel’s decision. In an 11 to 1 vote, the court denied AARP’s request. AARP has announced it will seek Supreme Court review of the 3rd Circuit’s decision.
This piece from PLANSPONSOR.com is apropos of nothing, but it is so ludicrous we had to include it. Believe it or not, China has banned Buddhist Monks in Tibet from reincarnating without government permission, according to a statement issued by the State Administration for Religious Affairs. The law strictly sets forth the procedures by which one is to reincarnate, and is “an important move in institutionalized management of reincarnation.” More insidiously, by barring any Buddhist Monk living outside China from seeking reincarnation, the law effectively gives Chinese authorities the power to choose the next Dalai Lama, whose soul, by tradition, is reborn as a new human to continue the work of relieving suffering. Any reader who has been to Tibet, as has your editor, can appreciate how serious an assault the Chinese have launched.
Employees have stated a claim that school board has failed to pay them FLSA overtime, as they were allegedly told not to record their overtime hours. It is not relevant that the employer did not ask the employee to do the work. However, bus drivers and their attendants failed in their argument that the board violated FLSA in paying different rates for regular and other routes, and in calculating overtime through use of a blended rate. FLSA does not require that different types of work be performed in order for employers lawfully to pay different rates. The regulations do not mandate that different types of work be performed if different rates are paid. Allen v. Board of Public Education for Bibb County, Case No. 06-12131 (U.S. 11th Cir., August 17, 2007).
The Internal Revenue Service has issued a consumer alert regarding a new, two-step e-mail scam that falsely promises recipients they will receive $80 for participating in an online customer satisfaction survey. In the scam, an unsuspecting taxpayer receives an unsolicited e-mail that appears to come from IRS. The e-mail contains a URL linking to an online “Member Satisfaction Survey.” The e-mail notifies the recipient that he has been randomly selected to participate in a survey. In return, IRS will credit $80 to the taxpayer’s account. There are references to IRS in the “from” line and the “subject” line of the e-mail. The link to the survey and a copyright statement at the bottom also reference IRS. The survey form features the IRS logo. In addition to standard customer satisfaction survey questions, the survey requests the name and telephone number of the participant, and also asks for credit card information. Once the fraudsters have the name and phone number, they will presumably call the participant and attempt to retrieve other financial information. The apparent objectives of this scam are to use the participant’s name and financial data to withdraw funds from the taxpayer’s bank account, run up charges on a credit card or take out loans in the taxpayer’s name. Taxpayers should be aware that IRS does not send unsolicited e-mail. In addition, IRS never asks taxpayers for PIN numbers, passwords or similar secret access information for credit, bank or other financial accounts. Recipients of questionable e-mail that appears to come from IRS should not open any attachments or click on any links contained in the e-mail, but should forward it to email@example.com. IR- 2007-148 (August 28, 2007).
The U.S. Department of Labor, U.S. Bureau of Labor Statistics, has issued its National Compensation Survey of Employee Benefits in Private Industry in the United States, March 2007. More workers had access to medical plans (71%) than to retirement plans (61%), but workers were more likely to participate in the latter. Nearly all workers who had access to a defined benefit retirement plan took advantage of the opportunity to participate in it. A summary of this survey presents information on the incidence and key provisions of these and other employee benefit plans by a variety of worker and establishment characteristics and for various and geographic areas. The summary also marks the first release of data on employee benefits under new industry and occupational classifications. Here are some major findings:
The entire report is available at www.bls.gov/ncs/ebs/sp/ebsm0006.pdf.
Johnson sought review of a final order of the Florida Division of Retirement, which determined she was not entitled to Deferred Retirement Option Program or monthly retirement benefits. She contended that the Division erred in determining that she was an “employee” of the Caring and Sharing Learning School in determining she was not entitled to benefits. Concluding that the Division erred in making such determination, the First District Court of Appeal reversed and remanded. One seeking DROP benefits and retirement benefits must terminate all “employment” with any and all Florida Retirement System employers for the next calendar month. Therefore, whether one is an “employee” of an FRS employer during the next calendar month is a dispositive issue regarding whether that person may receive those benefits. In the recommended order, the administrative law judge expressly declined to determine whether Johnson was an “employee” in determining if she was entitled to benefits. The Division, deciding on a different basis than the ALJ, found that Johnson was an employee and not entitled to benefits. On appeal, the Division argued that even if the finding was not made by the ALJ, whether one is an “employee” is a conclusion of law, so the Division had authority to modify or reject that conclusion of law in the final order. However, the reviewing court had previously decided that whether one is an “employee” in this context is a factual finding, not a conclusion of law. Therefore, the Division erred in independently concluding Johnson was an employee, because factual determinations are to be made by the hearing officer and only altered if they lack competent, substantial evidence to support such finding. The order was reversed, and the case was remanded to the Division with instructions for the ALJ to make the necessary factual finding as to whether Johnson was an “employee” of the Caring and Sharing Learning School. Johnson v. Department of Management Services, Division of Retirement, 32 Fla. L. Weekly D1929 (Fla. 1st DCA, August 14, 2007).
As part of its Finance and Economics Discussion series, the Federal Reserve Board’s Divisions of Research & Statistics and Monetary Affairs have issued a study conducted by three prominent economists. According to the abstract, even risky pension sponsors could offer essentially riskless pension promises by contributing a sufficient level of resources to their pension trust funds and by investing those resources in fixed-income securities designed to deliver their payoffs just as pension obligations are coming due. However, almost no firm has chosen to fund its plan in this manner. The authors studied the optimal funding choice for plan sponsors by developing a simple model of pension financing in which the total compensation offered to workers must clear the labor market. They found that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all things being equal. Indeed, in the authors’ model, pension sponsors maximize their value by making their pension promises free of risk. The authors close by positing some explanations for why no real-world firm follows the prescription of their model. A very interesting read. The entire scholarly 23-page report can be accessed at www.federal/reserve.gov/pubs/feds/2007/200736/200736pap.pdf (2007-36, June 13, 2007).
Most famous people were not always famous. In fact, some of them had down-right lowly jobs, according to Book of Lists. Here are a few examples:
How come there are no women on the list?
“Work is fine for killing
time, but it’s a shaky way to make a living.” Pappy
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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.