The 1997 Tax Act: Pension and Other Employee Benefits

Chapter 7
Pension and Other Employee Benefits
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

Guide to
Promises Kept

Tax Cuts for Individuals

Principal Tax Increases

Other Key Provisions

Table of Contents

The Act makes numerous changes in the rules governing pension plans and other employee benefits; the more important of these are described below. The significant revisions affecting pensions can be grouped into three categories: (1) provisions that will make it easier for certain organizations to establish or maintain plans; (2) provisions that will affect the compliance burden of plans; and (3) provisions that will affect distributions to participants. Finally, the Act contains a number of other minor technical provisions, as well as technical corrections to the changes enacted last year by the Small Business Job Protection Act.

Significant Revisions Affecting the Availability of Plans

The Act makes three significant changes that will make it easier for certain types of employers to maintain certain qualified plans. These relate to ESOPs established by an S Corporation, 401(k) plans of partnerships, and governmental qualified plans.

ESOPs for S Corporations: The Act contains three provisions, which together will make it easier for an S Corporation to establish and maintain an Employee Stock Ownership Plan (ESOP). Last year's tax bill allowed S Corporations to maintain ESOPs for the first time. However, significant burdens remained in the law. The Act contains three provisions that will remove these burdens that make ESOPs unattractive to S Corporations.

First, ESOPs maintained by S Corporations will be permitted to make distributions solely in cash. ESOPs generally are required to offer participants the opportunity to receive a distribution in the form of employer securities. For S Corporations, such a distribution could result in the S corporation exceeding the maximum number of 75 shareholders allowed. By changing the ESOP distribution rules, the risk of having an S Corporation's S election terminated as a result of such a distribution is eliminated.

Second, certain prohibited transaction rules applicable to S Corporation shareholders are repealed. Before the Act, if an S Corporation shareholder sold his stock to an ESOP, the transfer would be treated as a prohibited transaction and the shareholder would be liable for an excise tax, equal to 10% of the value of the stock or the amount received from the plan. The Act provides that such a transaction is not considered a prohibited transaction, and, therefore, the shareholder would not be subject to the tax. S Corporation shareholders would remain subject to other prohibited transaction rules.

Third, the Act repeals a provision added in the 1996 Act that imposed Unrelated Business Income Tax on the distributable share of S Corporation income attributable to S Corporation stock held by an ESOP. Other qualified plans that hold S Corporation stock continue to be subject to UBIT.

Effective date: Taxable years beginning after Dec. 31, 1997.

Elective deferrals of partners and self-employed individuals: The Act allows partners who participate in Section 401(k) plans to receive matching contributions on their own contributions on the same basis as employees of the partnership. Under prior law, matching contributions made for partners counted against the maximum annual dollar limit on the partner's 401(k) contributions ($9500 in 1997). Matching contributions of employees who are not partners have not been counted against this limit.

The Act may make it more attractive for a partnership to sponsor a Section 401(k) Plan. However, the Act does not change the maximum amount that can be allocated to any employee (including a partner) under other qualified plan limits, or the maximum contribution that may be deducted. The Act includes a similar provision applicable to SIMPLE plans.

Effective date: For 401(k) plans, years beginning after 1997. For SIMPLE Plans, years beginning after 1996.

Nondiscrimination rules for governmental plans: The Act makes permanent a current IRS moratorium on applying "nondiscrimination" rules to qualified plans and tax-deferred annuities maintained by state and local governments. This change will eliminate uncertainty concerning the future and may encourage plan design changes.

Effective date: Retroactively effective for state and local governmental plans, for all years.

Changes Affecting The Compliance Burdens of Plans

The Act contains a number of changes that will affect the paperwork and compliance burdens of pension and 401(k) plans. Some changes ease the compliance burden; others will make compliance more difficult.

Elimination of paperwork burdens on plans: The Act eliminates the need for pension and 401(k) plans to file Summary Plan Descriptions and Summaries of Material Modifications with the Department of Labor on a periodic basis. The Act instead requires the plan administrator to furnish these reports, along with others, to the Department of Labor on demand.

The Act provides for civil penalties to be imposed on the plan administrator for failure to furnish these documents to the Department of Labor within 30 days of the request.

Effective date: None specified.

Electronic reporting: The Act requires the IRS and the Department of Labor to issue guidance by December 1998 on the use of electronic transmission and other new technologies for certain reporting requirements applicable to pension plans. The DOL and the IRS would have to take into account necessary participant protections, and the IRS would further be required to provide guidance that clarifies which "writing" requirements under the Code may authorize paperless transactions.

Effective date: Guidance will be effective for the first plan year 6 months after guidance is issued.

Increase in annual funding limit: The Act increases one of the limits on an employer's annual funding of a defined benefit pension plan. Prior to the Act, one of the limits disallowed deductions for contributions that increased the plan's funding level above 150% of the present value of the accrued benefits. The Act increases this limit gradually over the next few years, as follows:

Limits on employer contributions to defined benefit pension plan
Plan Year	Funding Limit
1999-2000	155%
2001-2002	160%
2003-2004	165%
2005 and later	170%

Effective date: Plan years beginning after Dec. 31, 1998.

Protection from disqualification for accepting rollovers in good faith: The Act adds a provision that protects plans that accept rollover contributions. Prior to the Act, if a plan accepted a rollover contribution from a plan that was not qualified at the time of the rollover, the recipient plan's qualified status would be jeopardized. IRS regulations provide limited protection for the recipient plan accepting rollover contributions believed in good faith to be qualified, but require the rollover to be distributed if the recipient plan later learns that the other plan was not qualified. The Act would broaden this protection, so that the recipient plan would be protected if it receives notice that the distributing plan was intended to be qualified. The distributing plan would not be required to have an IRS letter as to its qualified status. The Act requires the IRS to issue revised regulations to this effect.

Effective date: Rollover contributions made after Dec. 31, 1997.

Limits on employer stock in 401(k) plans: The Act would restrict the amount of employer stock that could be held in a Section 401(k) plan. Under the Act, a 401(k) plan could not hold more than 10% of its assets derived from employees' 401(k) elective deferrals in employer stock, as a general rule.

The Act provides for a number of exceptions to this limit. The Act would not apply if the 401(k) plan allows employees to direct the investment of their accounts, if 401(k) contributions not over one percent of an employee's compensation are required to be invested in stock, or if the plan is also an Employee Stock Ownership Plan.

Effective date: Effective for elective deferrals made after Dec. 31, 1998.

Increased excise tax on prohibited transactions: The Act would increase the initial excise tax on prohibited transactions from 10% to 15% of the amount involved. A prohibited transaction is a transaction between the plan and the employer, a plan fiduciary, or a substantial owner of the employer, involving a sale, exchange, lease, or loan of assets of the plan. Although some prohibited transactions are obvious, many occur inadvertently due to misunderstandings as to the subtleties of the law. In addition, many prohibited transactions do not actually harm the plan.

This increase would be the second increase in two years. Last year's Act increased the tax to 10%, from 5%. Before last year's increase, the excise tax on prohibited transactions had not increased since it was first added to the Code in 1975.

Effective date: Prohibited transactions occurring after enactment.

Revisions Affecting Plan Participants and Distribuitions

A third major set of revisions affects how participants in pension and 401(k) plans will receive distributions from plans, and how those distributions will be taxed to recipients.

Changes to forced distribution rules

The Act increases the maximum benefit that can be distributed without a participant's consent from $3,500 to $5,000. The Act will allow employers to cash out a larger number of small accrued benefits of employees terminating employment.

Effective date: Plan years beginning after enactment.

Permanent repeal of excess distribution and accumulation excise taxes: The Act permanently repeals the 15% excise tax on distributions from retirement plans (including both IRAs and qualified plans) that exceed $150,000 in any year and the 15 % special estate tax on excess IRA and plan accumulations remaining at death. A provision in last year's tax bill provided individuals with a three-year "holiday" from the excess distribution excise tax, for 1997, 1998, and 1999.

Effective date: Excess distributions received after Dec. 31, 1996, and decedents dying after Dec. 31, 1996.

Basis recovery rules: The Act simplifies the rules for determining the tax-free, or basis, portion of distributions from qualified plans, and Section 403(b) annuity plans, attributable to recovery of basis. Basis is recovered in equal installments over the recovery period. Under the Act, if an annuity payment is made over joint lives, then the tax-free portion is determined under a simplified rule, based on the combined age of the annuitants, as follows:

Recovery of Basis
Combined Age (years)	Recovery Period (months)
110 or less	410
110-120	360
120-130	310
130-140	260
More than 140	210

Prior to the Act the recovery period was based solely on the age of the primary annuitant.

Effective date: Annuity payments that commence after Dec. 31, 1997.

Miscellaneous Provisions

The Act also provides for minor additional revisions, related to pension plan rules, fringe benefit rules, and technical corrections to the Small Business Job Protection Act of 1996.

The Act includes the following additional minor revisions to rules affecting pension and 401(k) Plans:

A provision allowing plans to provide for increased early retirement benefits for police officers and firefighters.
Additional rules governing the participation in church plans of self-employed ministers.
A provision authorizing the reduction of a participant's benefits to satisfy liabilities to a plan that result from his criminal conduct or breach of fiduciary duty.
Modifications of the limit on contributions to Section 403(b) plans to harmonize with changes made for qualified plans by last year's tax act.
A partial exemption from an excise tax on nondeductible contributions to plans, if the employer exceeds the deductible limit as a result of 401(k) or matching contributions.
Modified pension plan funding rules for certain bus companies.
A provision to allow certain state-sponsored water districts to maintain 401(k) plans.
A provision to make it easier for state employees to purchase additional pension benefits.
A provision allowing gratuitous transfers to certain ESOPs from qualified charitable remainder trusts established for decedents dying prior to Jan. 1, 1999.
A provision that allows beneficiaries of police officers and firefighters killed in the line of duty to receive distributions tax-free from the decedent's qualified plan benefit attributable to his service as a police officer or firefighter.

The Act also includes the following additional provisions that affect the taxability of non-pension fringe benefits:

A provision that allows an employer to offer all employees a choice between employer-provided parking and taxable cash.
A provision that allows former police officers and firefighters to exclude from income disability payments received for heart disease and hypertension during 1989-1991, and to recover taxes paid on those payments.

Finally, the Act includes a number of technical corrections to the Small Business Job Protection Act of 1996. Most of the technical corrections are applicable to SIMPLE Plans.

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Tax News & Views is produced by the Financial Counseling Specialists and the Legislative & Regulatory Services Group at Deloitte & Touche LLP.