The situation involved in Private Letter Ruling 201407027 illustrates that a participant can be caught between a rock and hard place when a qualified plan loan must be repaid upon termination of employment.
Administering qualified plan loan repayments following a participant’s termination of employment can be burdensome for employers. Most plans provide that a qualified plan loan must be repaid upon termination of employment to avoid a situation in which the employer must arrange for loan repayments other than through payroll deduction. Some plan recordkeepers provide post-termination loan administration services, but since loan administration errors can be costly and time-consuming to fix, employers tend to prefer requiring repayment upon termination of employment.
A plan loan which satisfies all the requirements under Section 72(p) of the Internal Revenue Code does not cause a taxable event at the time the loan proceeds are distributed from the plan. In addition, if loan repayments are remitted in accordance with the loan terms and the requirements of Code Section 72(p), no taxable event occurs during the term of the loan. However, if a loan is defaulted during the term for non-payment or any other reason, the tax rules treat the outstanding loan balance as a deemed distribution, meaning that the entire amount is treated for tax purposes as a distribution. A deemed distribution of a plan loan is not eligible for rollover. Therefore, when a participant defaults on a loan during employment, she has a deemed distribution which is taxable, but the amount of the deemed distribution is not eligible for rollover.
However, under Treasury Regulation Section 1.402(c)-2 Q&A-9, when a participant’s account is reduced to repay the loan, this plan loan offset amount is an eligible rollover distribution. If the terms of the plan require that a loan be repaid upon termination of employment or a request for a distribution, a plan loan offset occurs at these times. At that time, a participant may also rollover the amount of the loan offset (by coming up with the plan loan offset amount from other funds and contributing it to the IRA or other employer plan) to keep that amount from being taxable.
Confusing? We think so too. If a participant is not able financially to repay a plan loan on termination of employment, it’s unlikely she is able financially to come up with the funds to contribute the loan offset amount into an IRA or other employer plan. In Private Letter Ruling 201407027, the financial institution providing administrative services for the plan did not inform the participant of the tax consequences of the loan default. Therefore, the IRS granted him a waiver of the 60-day rollover requirement to allow him to rollover the loan offset amount. That’s good news for this taxpayer, but it still leaves many participants caught in a tough spot when they terminate employment with an outstanding plan loan.
Last month, the Supreme Court heard oral arguments in Sebelius v. Hobby Lobby Stores, Inc., and Conestoga Wood Specialties Corp., two highly anticipated cases that deal with the Affordable Care Act (“ACA”), religious freedom, and women’s access to contraception.
Hobby Lobby and Conestoga, each a closely-held family-owned corporation, have challenged the ACA’s preventive care requirement mandating coverage of all FDA-approved contraceptive drugs, devices, and related services. Although the companies’ owners do not object to most contraceptives, they oppose emergency contraception and certain devices on religious grounds. They contend that the required coverage of certain contraceptives violates their rights under the Religious Freedom Restoration Act (“RFRA”) and the Free Exercise Clause of the First Amendment. Generally, the RFRA is aimed at providing exceptions to laws that substantially burden a person’s free exercise of his or her religion. The question before the Court was whether secular for-profit companies can exercise religion.
While it will be a few months before a decision is issued, the dialogue during oral arguments posed many compelling questions. Justice Sotomayor asked Paul D. Clement, who represented the corporations, how courts are to determine whether a corporation holds a particular religious belief: whose beliefs control, the majority of shareholders; the corporate officers; what happens to the minority? She and Justice Kagan asked how far corporation’s religious objections might extend. Would blood transfusion and vaccines be objectionable? What should occur if other employers in the future claim that they have religious objection to sex discrimination laws, minimum wage laws, family leave, and child labor laws? Clement responded that the Courts are able to evaluate free exercise claims.
Justice Kennedy asked Clement whether an employer’s religious belief should trump an employee’s belief and whether employers should be required to pay for abortions. Justices Kagan and Ginsburg also asked about balancing third party interests. Justice Alito queried whether there are ways of accommodating the interests of the employees without imposing a substantial burden on the employer who has the religious objections. Clement responded that, in this case, it is a matter of who pays for the services and suggested that the government could pay.
Donald B. Verilli, the Solicitor General, argued on behalf of the Federal Government. He opened his argument by quoting Justice Robert Jackson’s statement that limitations on religious freedom begin to operate whenever activities collide with the liberties of others and that adherence to this principle is what makes possible the harmonious functioning of a society in which people of every faith live and work side by side. Justices Roberts challenged this statement as inconsistent with RFRA and stated that the purpose of RFRA was to provide exceptions to laws which would otherwise infringe on the religious beliefs of proprietors and individuals. General Verilli responded that “in any RFRA case, including this one, you have to consider the impact on third parties.” Justice Scalia stated that there is no reference to third party interests in RFRA at all.
Justice Roberts suggested that Congress could have crafted an exception to RFRA if it was not intended to extend its protection to corporations. General Verilli noted that a for-profit corporation has never been successful in seeking the protections of RFRA, to which Justice Roberts essentially replied that there is no case law on this point.
The arguments and the Justices’ questions touched on several issues, including whether a corporation is a “person” within the meaning of RFRA; whether a corporation can have religious beliefs; the complexities of judicial review in this area, balancing the rights of the religious objectors and the rights of third parties; and the consequences of a decision, either way, on other issues that are touched by religious belief.
It appears that the court is divided, with Justice Kennedy potentially being the deciding vote. The decision is expected by Summer 2014.
On March 25, 2014, the United States Supreme Court issued its unanimous (8-0) decision in U.S. v Quality Stores, 572 U.S. ____ (2014). In its opinion authored by Justice Kennedy, the Court held that the severance payments at issue constituted taxable wages for FICA purposes. The severance payments in question were made to employees in connection with an involuntary termination, were varied based on job seniority and time served, and were not linked to the receipt of state unemployment benefits. In so holding, the Supreme Court reversed the decision of the Sixth Circuit Court of Appeals and resolved a split in the courts. See CSX Corp. v. United States, 518 F. 3d 1328 (Fed. Cir. 2008).
The Court reasoned that severance payments of the type described fit plainly within the definition of “wages” under Section 3121 of the Internal Revenue Code, which defines “wages” for FICA tax purposes broadly as “all remuneration for employment” and defines employment as “any service, of whatever nature, performed by an employee for the person employing him.” According to the Court, common sense dictates that severance payments are remuneration that is received by employees in consideration for employment because severance payments are made only to employees. In addition, the Court noted that the fact that severance payments often vary according to the function and seniority of a particular employee was a further indication that the payments are made to reward employees for their service.
The Supreme Court considered the arguments made by the taxpayer under Code section 3402(o) but found them to be erroneous and concluded that Code section 3402(o), which relates to income tax withholding, does not narrow the term “wages” under FICA to exempt all severance payments. The Court noted that the taxpayer’s position would result in severance payments not being subject to FICA taxation while they would be deemed wages for purposes of income tax withholding. The Court concluded that such a result would be inconsistent with the broad principle set forth by the Supreme Court in Rowan Cos., Inc. v. United States, 452 U.S. 247 (1981) that simplicity of administration and consistency of statutory interpretation instruct that the meaning of “wages” should be in general the same for income-tax withholding and for FICA calculations.
The Court noted in its decision that the IRS still provides, in Rev. Rul. 90-72, that supplemental unemployment benefit (“SUB”) payments tied to the receipt of state unemployment benefits are exempt from income tax withholding and from FICA taxation. Because the severance payments at issue in Quality Stores were not linked to state unemployment benefits, the Court expressly declined to reach the question of whether the IRS’ current exemption is consistent with the broad definition of wages under FICA.
As a result of the Supreme Court’s decision, the IRS will not need to refund an estimated $1 billion in FICA taxes previously paid in connection with severance payments. Protective claims that have been filed by taxpayers will be denied. Going forward, employers must continue to treat severance payments as “wages” subject to FICA taxes unless they are linked to state unemployment compensation and otherwise qualify for the SUB pay exemption recognized by the IRS under Rev. Rul. 90-72.
See our prior blog posts for additional information regarding this case.
Recently, the IRS released a Chief Counsel Advice Memo describing the interaction of the health FSA carryover feature we previously discussed and HSAs. This memo addresses some of the important questions left open by prior guidance. However, readers should know that CCA Memos are not binding guidance, so while this memo is helpful, employers should recognize that subsequent IRS guidance may take a different approach.
The question raised was whether an employee in a general purpose FSA with a carryover feature can contribute to an HSA. The answer (a good legal answer) is, “it depends.”
The CCA starts out by noting, correctly, that an individual who is covered under a general purpose health FSA (i.e. one that reimburses for more than just dental, vision, preventive care, and post-HDHP deductible expenses) is not eligible to contribute to an HSA. So a general purpose carryover makes the individual HSA-ineligible. This applies even after the entire $500 (or other amount) carried over is spent. So if a participant who carried over $500 from a prior year goes for laser eye surgery in January and uses up the general purpose carryover amount, he or she is still ineligible for the entire year. So far, this is consistent with guidance involving the grace period, so there is no real surprise here.
But then the CCA goes on to say that an individual who elects a limited purpose, HSA-compatible FSA (i.e. one that reimburses only for dental, vision, preventive care, or post-deductible expenses, or some subset of those) can carryover the $500 from a general purpose FSA into the limited purpose FSA. In other words, if I have a general purpose FSA in 2014 and want to contribute to an HSA in 2015, I can take my carryover amount from my 2014 general purpose FSA and elect to treat it as a limited purpose FSA in 2015. A plan can also automatically provide this result, without the requirement for a participant election. The CCA also says the participant can elect to waive the carryover entirely.
That is where the carryover diverges from the grace period. (The CCA even alludes to this in a footnote.) Under an IRS-created rule, any rules that apply to grace period reimbursements must apply uniformly all participants. The IRS has interpreted this to mean that the grace period has to be either general purpose or limited purpose for all participants, regardless of which type of FSA they utilized during the plan year. There are structuring alternatives that may serve to limit the scope of this rule, but it nevertheless constitutes a trap for the unwary since it does not allow variations on a participant-by-participant basis, as this new (admittedly, informal, non-binding) guidance does for the carryover. Note this grace period rule is an IRS-created rule, so the IRS could change it, but has chosen not to (for reasons known only to themselves).
While this new rule on the carryover is good news for employers wanting to implement the carryover, it also only serves to highlight the very trap for the unwary that the grace period rules create. Employers weighing the choice between having (or keeping) a grace period or implementing the carryover should take this into account, as it would be significantly simpler for employees to understand. Employers should also consider that this rule is informal and non-binding, so the IRS could take a different position in formal guidance. However, to the extent the IRS does so, we expect any different interpretation would be prospective-only.
The very day after we posted about the IRS’s delay in issuing guidance on the application of the Windsor decision (and guidance previously provided by the IRS under Rev. Rul. 2013-17) to qualified retirement plans the IRS issued Notice 2014-19 (the “Notice”) addressing those very issues. The brief seven page Notice took the form of a Q&A and weighed in on many of the issues facing plan sponsors:
- The Basics – The Notice reconfirms the basic principle (which arguably was not questioned by anyone at this stage of the game) that any retirement plan qualification rule that applies because a participant is married must be applied with respect to a participant who is married to an individual of the same sex. The Notice provides the example of a participant in a plan subject to the rules of IRC 401(a)(11) who is married to a same-sex spouse and notes that such participant cannot waive a qualified joint and several annuity without obtaining his or her same-sex spouses consent as required by IRC 417.
- Retroactive Application of Windsor – Moving on to the “meaty” questions, the IRS indicated that qualified retirement plans are required to reflect the outcome of Windsor as of June 26, 2013. This effective date may come as a surprise to some who expected September 16, 2013 to be the magic date given the effective date contained in Notice 2013-17. However, it is a welcome development to others who worried that a retroactive effective date preceding the Windsor decision might be forthcoming.
Qualified status of a plan will not be impacted merely because it did not recognize the same-sex spouse of a participant as a spouse before June 26, 2013. Additionally, a plan may (permissively) be amended to reflect the outcome of Windsor for some or all purposes as of a date prior to June 26, 2013, if the amendment complies with the applicable qualification requirements (e.g., the discrimination rules under IRC 401(a)(4)). For example, a plan could apply only the QJSA and QPSA requirements to same sex spouses before June 26, 2013 solely with respect to participants with annuity starting dates or dates of death on or after a specified date. However, as the IRS warns, amending a plan retroactively to a date prior to June 26, 2013 may trigger requirements that are difficult to implement retroactively (such as the ownership attribution rules) and may create unintended consequences.
- Plans That Must be Amended – If a qualified plan defines a marital relationship by reference to Section 3 of DOMA (or is otherwise inconsistent with Windsor, Rev. Rul. 2013-17 or the Notice), then the Notice provides that an amendment to such plan to reflect all three sources is required. However, if a plan’s terms are not inconsistent with these sources (e.g., the plan’s definition is simply “spouse,” “legally married spouse” or “spouse under Federal law” without any distinction between a same-sex spouse and an opposite-sex spouse), an amendment is generally not required – although may still be helpful for clarification. Finally, if a plan sponsor chooses to apply the rules with respect to married participants in qualified retirement plans in a manner that reflects the outcome of Windsor for a period before June 26, 2013, an amendment to the plan that specifies the date as of which (and the purposes for which) the rules are applied in this manner is required. In the event the plan is amended, a summary of material modifications must be provided to inform plan participants of the change. Even if a plan amendment is not required, a plan sponsor may want to provide a communication to educate participants about the right of same-sex spouses under the plan to facilitate participant planning and minimize potential costly controversy.
- Due Date for Plan Amendments – Generally, a plan sponsor who has not adopted a plan amendment in line with the Notice already will have through at least December 31, 2014 (or the applicable deadline under Rev. Proc. 2007-44) to adopt such an amendment, with additional guidance provided for governmental plans. Rev. Proc. 2007-44 provides, in relevant part, that when there are changes to the plan qualification requirements that affect provisions of the written plan document, the adoption of an interim amendment generally is required by the later of (1) the end of the plan year in which the change is first effective or (2) the due date of the employer’s tax return for the tax year that includes the date the change is first effective.
- Special IRC 436(c) Rule – For purposes of IRC 436(c), regarding limitations on single-employer plan amendments increasing liability for benefits, the Notice provides a special rule for a plan amendment consistent with the Notice that takes effect on June 26, 2013 and provides that such amendment is not treated as an amendment to which IRC 436(c) applies. However, this special rule does not apply to an amendment that reflects the outcome of Windsor for a period before June 26, 2013.
Here are the answers from our three National Employee Benefits Day crossword puzzles! We hope you enjoyed them.
Update (4/11): See our post here on the recently released guidance.
The employee benefits community continues to wait with baited breath on IRS guidance regarding the amendments necessary to qualified retirement plans in the wake of last Summer’s Windsor decision determining that Section 3 of the Defense of Marriage Act is unconstitutional. (Recall that Section 3 of DOMA defines “spouse” and “marriage” to exclude same sex spouses and marriages.) The IRS 2013-2014 Priority Guidance Plan for the period running through June 2014 includes issuance of this guidance as a top priority. In December 2013, a Treasury Department official said that guidance was expected “fairly imminently.” In February, such guidance seemed very imminent. Yet, here we sit in the second quarter of 2014 with no guidance yet issued….
Notwithstanding the absence of guidance, to administer retirement plans in operational compliance with the Windsor decision, employers must currently treat same sex spouses as spouses for purpose of determining rights and benefits thereunder. Such operational compliance is necessary to avoid exposure both under the Internal Revenue Code and in the courts. Courts have been acknowledging the decision in Windsor and awarding same sex spouses “surviving spouse” status under qualified plans since last summer. See, e.g., Cozen O’Connor, P.C. v. Tobits, CIV.A. 11-0045, 2013 WL 3878688 (E.D. Pa. July 29, 2013).
Although employers must operate retirement plans in compliance with Windsor at this time, we generally recommend that they postpone amendment of any qualified plan pending issuance of additional guidance from the Service regarding amendment timing, any necessary corrections relating to plan operations for periods before future guidance is issued and the retroactive effect of Windsor for federal tax purposes.
In the meantime, employers should gather the information necessary to bring the plan into compliance upon issuance of the guidance. Specifically, employers should determine who is married and to whom, update and review beneficiary designations forms, and review plan administration documents and processes to ensure compliance with these new rules. Documents such as HR manuals, policies, procedures, and payroll systems should also be earmarked where a change to reflect similar treatment of both opposite-sex and same-sex married couples may be necessary.
Stay tuned folks!
In honor of National Employee Benefits Day, we’re taking a break from guidance updates and commentary and providing a little fun. Over the next few days, we will be posting some crossword puzzles focused on the fascinating and complex world of benefits. We will post the answers on Saturday so you can check your work. Enjoy!