Whether a plan permits hardship distributions is up to the employer when designing the plan.

Last November, the IRS issued proposed regulations incorporating several legislative changes regarding the ability of a 401(k) or 403(b) plan to make distributions to participants to relieve a hardship caused by an immediate and heavy financial need.  Of course, whether a plan permits hardship distributions is up to the employer when designing the plan.  Likewise, these changes give employers discretion in many areas to design their plan as to what, if any, hardship distributions will be allowed. These changes are described below.

Expansion of Safe Harbor Events.  A plan can provide that an immediate and heavy financial need is determined under a facts and circumstances test or it can choose from among a list of safe harbor events that are deemed to meet the immediate and heavy financial need test.  The proposed regulations address the expansion of the safe harbor events by adding three new events that qualify as of January 1, 2018.

  1. Primary Beneficiary. The qualifying medical, educational, and funeral expenses of the participant’s primary beneficiary under the plan has now been added to the safe harbor events to conform to a Pension Protection Act of 2006 change in the law.  Previously such expenses were only included for the participant, spouses, children, and dependents.
  1. Casualty Deduction Limit Eliminated. Safe harbor events include expenses to repair damage to a participant’s principal residence that qualify as a casualty loss deduction under Internal Revenue Code Section 165.  However, the 2017 Tax Act amended Section 165 to provide the deduction may only be taken if the participant’s home is in a federally declared disaster area.  The proposed regulations clarify that this federally declared disaster restriction does not apply for purposes of the safe harbor.
  1. Federal Disasters. Added to the safe harbor list is expenses and loss of income resulting from a federally declared disaster when the participant lives or works in the disaster area.

Expansion of Sources of Distribution.  Previously, hardship distributions could only be made from an employee’s elective deferrals under the plan and not even earnings on those deferrals.  The proposed regulations permit hardship distributions to be made from earnings, QNECs, and QMACs of 401(k) plans beginning in 2019.  However, for 403(b) plans, the restriction earnings remains and hardship distributions may only be made from QNECs and QMACs if they are held in custodial accounts. It should be noted that whether to allow distributions from these sources is discretionary, not required.  Therefore, employers need to decide as a matter of plan design whether to permit them.

Relief Provisions.  The proposed regulations also contain a number of relief provisions aimed at making the consequences of taking a hardship distribution less severe.

  1. Elimination of Six-Month Suspension. The proposed regulations eliminate the required suspension of the employee’s elective deferrals for six months following a hardship distribution. The suspension is prohibited for hardship distributions on or after January 1, 2020.  For 2019, the employer may choose to remove the suspension and may do so retroactively for employers currently under the suspension period.
  1. Elimination of Loan Requirement. Previously to be eligible for a hardship distribution the employee must have first taken all available loans under the plan to try to relieve the financial need.  This requirement may be eliminated beginning in the 2019 plan year. This too is not a required change but permissive.
  1. Substantiation. Beginning in 2020, when applying for a hardship distribution, the employee will have to represent that he or she has insufficient cash or liquid assets to satisfy the immediate and heavy financial need.  Plan administrators may rely on such representation.

Plan Amendments.  The IRS has requested comments on the proposed regulations within 60 days of their publication.  They may change the proposed regulations before finalizing them.  Plan documents will have to be amended to make any of the changes, however, the proposed regulations do not address when they will need to be made.  The preamble only addresses individually designed plan by stating they must be amended after the changes appear on the IRS list of amendments.

Many employers use preapproved plans and the sponsor of these plans may adopt default provisions but allow adopting employers to opt out of the default to design their own changes.  Employers need to decide whether they will make any optional changes and what needs to be done to implement required changes.  Hardship distribution forms and procedures will likely need changing as well as the summary plan description.

The IRS issued Notice 2018-97 (Notice) on December 7, 2018, providing some much needed guidance on interpreting Internal Revenue Code (Code) section 83(i) for qualified equity grants. Section 83(i) was added to the Code as part of the 2017 Tax Cuts and Jobs Act effective at the beginning of this year and permits employees granted stock options or Restricted Stock Units (RSUs) under a “qualified equity grant” to elect to defer the income tax resulting from the receipt of stock from the exercise of an option or the settling of the RSU for up to five years. See New Section 83(i) Provides a New Tool for Allowing Employees to Participate in the Sale of their Private Corporation-Employer, and A More Detailed Look at Section 83(i) Plans. The Notice was issued as a result of stakeholders requesting guidance from the IRS on certain aspects of section 83(i). The Notice provides guidance on calculating the number of employees receiving grants in the year to determine if the 80% test is met; the employer’s obligation to withhold income tax on the deferred income; and how an employer can opt out of a grant being subject to section 83(i) if its provisions are otherwise met.

Annual 80% Test. Section 83(i) provides that if qualified stock is transferred to a qualified employee who makes an 83(i) election, then the income tax on such transfer can be deferred up to five years. Qualified stock is defined as stock received by a qualified employee from the exercise of a stock option or the settlement of an RSU that was granted when the corporation was an eligible corporation. An eligible corporation is one that issues grants of stock options or grants of RSUs to at least 80% of its qualified employees (80% Test).

The Notice clarifies that the 80% Test only counts grants made during the calendar year and does not count grants made in prior years on a cumulative basis. In applying the 80% Test, employers must take into account the total number of non-excluded full time employees employed during the calendar year. This means the 80% Test is only met if the grants are made to at least 80% of the highest number of such employees during the year.

Income Tax Withholding. The Notice also reiterates how the employer is responsible for income tax withholding when the deferred income becomes taxable as wages to the employee. Income tax is to be withheld at the maximum rate which is currently 37%. The employer must make a reasonable estimate of the value of the stock at that time. However, withholding can be a problem if the employee who made the election no longer works for the employer. To remedy this, the Notice provides that the 83(i) election must provide that the employee agrees that stock subject to an 83(i) election must be held in escrow until: 1) the corporation has recovered the income tax withholding amount form the employee; or 2) between the date of income inclusion and March 31 of the following year, the employer retains an amount of stock with a fair market value equal to the amount of income tax withholding.

Opting Out. As soon as section 83(i) became law, the question arose as to whether any qualified employee participating in a stock option plan or RSU plan of an employer could make a valid 83(i) election if the grant met the requirements of section 83(i). The Notice somewhat clarifies this by providing an employer can avoid a plan being subject to section 83(i) by simply declining to offer the required escrow arrangement described above. Further, the terms of the stock option or RSU may provide that no 83(i) election will be available with respect to stock received upon exercise or settlement.

Conclusion. The Treasury Department intends that the guidance under the Notice will be incorporated into regulations in the future and the Notice guidance will be effective as of December 7, 2018, the date of the Notice. Any other future guidance will apply prospectively. The Treasury Department and IRS are requesting comments through February 5, 2019.

While the clarifications under the Notice are helpful, they do add additional complexity to the administration of plans eligible for the 83(i) election. Employers have to count all eligible employees throughout the year of grant to determine whether the stock issued as a result of that grant qualifies for the election. Additionally, 83(i) elections now must contain the required escrow arrangement language. This may require existing election forms to be rewritten. Employers considering adopting a stock option or RSU plan might decide not to offer the 83(i) deferral due to such complexity. Still for start-up companies or smaller employers who want to give a significant number of employees “skin in the game”, a section 83(i) eligible plan could be quite useful.

Plans Must Be Amended for New Disability Claims Procedures

The U.S. Department of Labor’s final disability claims procedures became effective for disability claims filed after April 1, 2018.  See No Fooling: New Disability Claims Procedures are Effective April 1, 2018. Any qualified or nonqualified retirement or deferred compensation plan governed by ERISA (including top hat plans that only cover a select group of management or highly compensated employees) that conditions a benefit on a determination of disability by the plan administrator must include the new procedures. If a plan conditions a benefit on disability as determined by another plan administrator or program, then the plan need not be amended, provided the plan making the determination is amended.  Plan documents generally must be amended by the end of the plan year that includes April 1, 2018.  For calendar year plans that means by December 31, 2018!

There are many hoops to jump through to enjoy the benefits of Section 83(i), but under the right circumstances they may be worth it.

Last February I blogged about new Section 83(i) of the Internal Revenue Code that was added by the 2017 tax reform legislation and provides for up to a five-year deferral of the income tax consequences to an employee when exercising a Non-Statutory Stock Option or settling a Restricted Stock Unit in stock.  See New Section 83(i) Provides a New Tool for Allowing Employees to Participate in the Sale of their Private Corporation-Employer. That article was a brief overview of the new law. For a more detailed discussion click on my article published in the Summer issue of the Journal of Pension Benefits, titled Ay, Ay, Ay, How Do You Comply with Section 83(i) – To Obtain Tax Deferrals on Qualified Equity Grants.  As discussed in the article there are many hoops to jump through to enjoy the benefits of Section 83(i), but under the right circumstances they may be worth it.

On October 30, the California Secure Choice Retirement Saving Investment Board issued yet another notice withdrawing the October 12 proposed regulations.

Last week I reported that the California Secure Choice Retirement Saving Investment Board (Board) posted a Notice of Proposed Emergency Regulation Action twice, once on October 9 and again on October 12 because the October 9 proposed regulations were changed. See CalSavers Files Emergency Proposed Regulations Twice. On October 30, the Board issued yet another notice withdrawing the October 12 proposed regulations, because they were changed yet again, and issuing a new notice of filing proposed regulations with the Office of Administrative Law within five days.  The public comment period for these latest proposed regulations is expected to be November 7 through November 11.

What is frustrating about this process and making following developments difficult is that the notices do not describe what was changed nor does the content of the proposed regulations.  They are not redlined nor otherwise show the changes.  They are not even dated.  However, redlined versions can be found on the agenda for the November 6 meeting of the Board at https://www.treasurer.ca.gov/scib/meeting/index.asp.

On October 9, 2018, the California Secure Choice Retirement Savings Investment Board (Board) posted a Notice of Proposed Emergency Action to issue proposed regulations regarding CalSavers, the California mandated payroll deduction IRA program expected to become effective early next year.  However, on October 12, 2018, the Board filed another notice because it modified the proposed regulations in the October 9th notice.

These proposed regulations replaced those that were initially noticed on March 5, 2018 but then not proposed as the Board decided to wait until after summer.  See California Secure Choice/CalSavers Retirement Savings Program Proposed Regulations Delayed.

The new proposed regulations shed some important light on the details of the CalSavers program (Program).  They provide the last date for covered employers to register for the Program as June 30, 2020 for covered employers employing more than 100 employees; June 30, 2021 for those employing more than 50 employees; and June 30, 2022 for those employing five or more employees.  The proposed regulations also provide for the default options under the Program if a participant does not elect otherwise.  These include a participant contribution rate of 5% which will automatically escalate 1% per year until reaching 8%.  Participants can choose an alternative contribution rate but will still be subject to the automatic escalation unless they opt out of it as well under the proposed regulations.  The default account is a Roth IRA, meaning that after-tax dollars will go into the account.  This is troublesome as there are qualification requirements for being able to make a Roth IRA contribution under federal law. If the Roth IRA owner makes too much income based on his or her filing status, he or she won’t be eligible to make a Roth IRA contribution.

The first $1,000 in contributions will be invested in a capital preservation investment selected by the Board according to the proposed regulations.  Thereafter, contributions will be invested in a Target Date Fund based on the participant’s age.  The Target Date Funds each only cover four years at a time.  Participants can opt out of the default investment options but the proposed regulations do not state what the other investment options are.

Participants can make non-payroll deduction contributions to the account as well.  If they are made on a recurring basis, at least quarterly, they can be as low as $10.  If they are less frequent and non-recurring, each contribution must be at least $50.  Also, under the proposed regulations, individuals who are not required to be automatically enrolled by their employer may elect to contribute to the program outside of an employment relationship.  The recurring and non-recurring minimum contribution rules above apply to such individuals.

It is important to note that these are only proposed regulations at this point.  However, the period to make public comments on these proposed regulations ends October 24, 2018.

Also, the Board is going forward with the Program despite a lawsuit filed in May, demanding an injunction that the Program be stopped.  See Suit Claims CalSavers is Preempted by ERISA.  In July, the Board filed a motion to dismiss.  The parties filed replies and now we are awaiting a decision by the court.

The August 31st Executive Order may make open MEPs more feasible.

On August 31, 2018, President Trump signed an Executive Order directing the Labor Department to consider issuing regulations and guidance that would make it easier for businesses to join together in Association Retirement Plans also known as open multiple employer plans (MEPs).  It is believed that the Labor Department will act to remove the commonality requirement of existing regulations which requires that all employers participating in the MEP must share some commonality such as being members in the same industry trade group.  So called “open” MEPs don’t meet the commonality rule and each employer is currently treated as adopting its own individual plan rather than one single MEP.  This means each employer’s plan has its own administration and must file its own Form 5500.  In addition, the current regulations contain a “one bad apple rule” that says under a MEP, if a single employer fails to meet qualification requirements, the entire MEP is subject to disqualification affecting all employers.

Of course, we will have to see what the Labor Department does in its new guidance, however, a relaxation of these restrictions would encourage more MEPs to be created and adopted, allowing smaller employers to pool together to enjoy economies of scale in the administration of plans like plans of larger employers enjoy.  This should encourage small businesses to provide retirement plans for their employees and help with the low rate of retirement savings.  In my opinion, this would be a better way to encourage small employers to offer retirement plans than state mandated payroll deduction IRAs which may be preempted by ERISA (see Suit Claims CalSavers is Preempted by ERISA).

In a new private letter ruling (PLR 201833012) released August 17, 2018, the IRS approved amendments to a 401(k) plan that effectively permit the employer to treat an employee’s student loan repayments similar to elective contributions under the plan by making a nonelective employer contribution equal to the matching contribution the employer would have made, if instead of making the loan repayments, the employee made elective contributions of the same amount.  The plan at issue provided that if an employee made an elective pre-tax, Roth, or after-tax contribution of at least 2% of compensation during a pay period, the employer would provide a 5% matching contribution.  The employer proposed to amend the plan to provide for a student loan repayment (SLR) benefit whereby if an employee enrolled in the SLR program and paid back student loans in an amount that was at least 2% of compensation during the pay period, the employer would make a nonelective employer contribution of 5% of compensation regardless of whether the employee made elective deferrals under the plan.  However, any elective deferrals also made while participating in the SLR program would not be eligible for matching contributions.  The SLR nonelective contributions would be subject to the same vesting schedule as the matching contributions.

SLR program may help reduce student loan debt.

The employer asked the IRS to rule that the proposed amendment to the plan to add the SLR program nonelective contributions would not violate the prohibition against “contingent benefits” under the 401(k) regulations. Those regulations provide if a benefit is conditioned on an employee electing or not electing to make elective contributions to a 401(k) plan, the plan will not be considered a qualified cash or deferred arrangement under section 401(k) of the Internal Revenue Code.  The IRS ruled the SLR nonelective contributions are conditioned on the employee making student loan repayments, not elective contributions under the plan.  Therefore, the regulations would not be violated.

INSIGHT.

Key facts in the ruling were that the SLR program was subject to all applicable plan qualification requirements such as eligibility, coverage and nondiscrimination testing.  Nevertheless, this ruling authorizes a plan design to help employees who have significant student loan debt that might prevent them from otherwise participating in the employer’s 401(k) plan.  It effectively gives employees credit for student loan repayments as if they were elective contributions.  The ruling does not discuss what constitutes eligible student loan repayments.  For example, does a parent’s loan for his or her child’s college education qualify for either the parent as the employee-participant?  Nor does it address any loan repayment substantiation requirements.

It is also important to note that the employer already had a fairly generous plan formula (5% match on a 2% employee contribution).  Many employers only match employee contributions on a dollar for dollar basis and some provide no match at all.  Additionally, it seems that if the employer had a significant number of employees enroll in the SLR program and not make any elective contributions to the plan because that money was used to make the student loan repayments, the plan could have difficulty passing the ADP test.  Still under the right circumstances this new plan design could be a tremendous benefit for employers to attract recent graduates who are saddled with significant student loan debt.

The Federal Reserve reports that student loan debt in the U.S. reached 1.5 trillion dollars in the first quarter of 2018, which is more than double the credit card debt.  Additionally, the average student loan debt is over $37,000.  This SLR program plan design, as authorized by the ruling, is a welcome tool that may help fight this crisis.  While a private letter ruling is technically only binding on the taxpayer that requested it, they do provide the reasoning of the IRS and there is no reason to believe the IRS would take a different position with respect to a different taxpayer with similar facts.

Last month,  I reported on how California’s mandated payroll deduction IRA program known as CalSavers is being challenged in court as preempted by ERISA. CalSavers is California’s attempt to address the fact that many Americans do not have the opportunity to save for retirement at their workplace because their employer does not offer a retirement plan.  The California Treasurer’s Office reports that 7.5 million Californians work for employers who don’t offer a plan.  Other states such as Oregon and Illinois have also implemented a state mandated payroll deduction IRA program.

As mentioned last month, I have been critical of these programs because of the open issue of ERISA preemption.  I have also been critical because the limits on how much can be contributed to an IRA are so much lower than those of employer sponsored retirement plans.  An individual under age 50 can only contribute $5,500 annually to an IRA compared to $18,500 for a 401(k) plan.  A Savings Incentive Match Plan for Employees (SIMPLE) plan, available for employers with 100 or fewer employees, allows employees to save up to $12,500 annually.  Therefore, in speeches and presentations, I have encouraged retirement industry professionals to use the mandated IRA programs as incentive to persuade employers to adopt employer sponsored plans.

Now federal legislation has been introduced that, if passed, would also encourage small employers to adopt SIMPLE plans by increasing the limits on the amounts that can be contributed by employees.  The SIMPLE Plan Modernization Act, S. 3197 (Act) was introduced in the Senate July 13 by Senators Susan Collins (R-ME) and Mark Warner (D-VA).  The Act would raise the elective contribution limit for SIMPLE plans to $15,500 for employers with 25 or fewer employees.  The catch-up contribution limit for employees over age 50 would also increase from $3,000 to $4,500.  Additionally, employers with more than 25 employees but no more than 100, would have the option to provide these higher limits but it would cost them a corresponding increase to their mandatory employer contributions by one percentage point.  The purpose of this cost is to continue to encourage such employers to consider transitioning to a traditional 401(k) plan.

SIMPLE plans were first created under the Small Business Jobs Protection Act of 1996 as a cheaper, easier retirement savings plan for small businesses.  Through a SIMPLE plan, an employer contributes to the IRAs of participating employees.  The employer must generally provide an employer contribution of either: 1) a 1 for 1 matching contribution up to 3% of the employee’s compensation contributed; or 2) a nonelective employer contribution of 2% of compensation for all eligible employees.  Under the Act, these contribution amounts would increase to 4% and 3% respectively, for employers with between 26 and 100 employees who opt for the higher limits.

The Act is only a bill at this point and these days nobody can predict what will happen in Washington DC, but it does have bipartisan support.  Additionally, it is a sign that Congress is willing to consider action to improve retirement saving.  Federal legislation that encourages small businesses to adopt plans that permit employees to save for retirement at work, such as the Act, seems like a much simpler way to tackle the retirement savings crisis than leaving it to state laws that might be preempted by ERISA.

For the past year or so, I have been speaking and writing about the California Secure Choice Law authorizing the State’s mandatory payroll deduction IRA program named CalSavers (“Program”).  When implemented, the Program will require private employers who don’t otherwise offer employees a retirement plan to automatically enroll their employees and withhold and contribute to the Program a percentage of the employees’ pay to be invested in an individual retirement account for the employee.  Employees can elect to opt out but must be automatically enrolled first.  In particular, I have stressed that there is still an open issue as to whether the statute creating the Program is preempted by ERISA due to the way the statute was enacted and amended.  And, I have pointed out that it is likely going to require litigation to settle the matter.

On May 31, my prediction came true when the Howard Jarvis Taxpayer’s Association (“HJTA”) and two of its employees sued the Program and the Chair of its Board, State Treasurer, John Chiang, in Federal District Court.  As predicted, the suit maintains that the statute creating the Program is void as preempted by ERISA.  The suit also seeks to enjoin the State from spending any further money on the Program.

State Sailed Legislation Through Rough Water Without Safe Harbor

The issue of ERISA preemption exists because of the history of the Secure Choice Law as well as Federal regulatory developments between the Obama and Trump administrations.  The statute creating the Secure Choice Board was enacted in 2016 and the Program’s implementation was contingent upon the Board reporting to the Governor and State legislature that the U.S. Department of Labor (“DOL”) had issued a safe harbor regulation stating that state run mandated employer payroll deduction IRA plans were not subject to ERISA and that the Program met such safe harbor’s requirements.  In August of 2016, the DOL issued the safe harbor.  In November, Trump won the election and took office in 2017.  In May of 2017, Congress repealed the safe harbor regulation under the Congressional Review Act, providing it shall have no force or effect and Trump signed it.

Also in May of 2017, the Secure Choice Board received a legal opinion from a private law firm stating that even without the Obama administration’s 2016 safe harbor, the Program would not create one or more ERISA plans (see www.treasurer.ca.gov/scib/background.asp).  The legal opinion relied on interpretive guidance by the DOL from 1975 (“1975 Safe Harbor”), finding that a payroll deduction IRA plan is not an ERISA plan where:  1) there are no employer contributions to the plan; 2) the only employer involvement is publicizing the program without endorsing it; collecting employee contributions through payroll deductions and remitting them to the IRA sponsor; 3) employee participation is “completely voluntary”; and 4) the employer receives no compensation from the IRA sponsor.

The opinion summarizes how when the 2016 safe harbor was issued, the DOL stated it was necessary because the 1975 Safe Harbor would not cover a program using auto enrollment.  The DOL analyzed that if an employer voluntarily adopted auto enrollment, it may exercise undue influence over an employee’s decision to participate.  This would prevent the employee’s participation from being completely voluntary because it is not “employee initiated”.  Therefore, the employer has established an ERISA plan.  The opinion then states that where an employer is offering the Program because it is required by State law, the employer is not voluntarily acting to establish a plan, or coercing employees to participate.  Therefore, the employee’s participation through auto enrollment with an opt out should be considered “completely voluntary”.

The Program requires covered employers of a certain size to automatically enroll employees into CalSavers and contribute a percentage of the employees’ pay.  However, the employee may opt out of participation in the Program.  In the first year of implementation, covered employers are those with 100 or more employees.  In the second year, the number drops to 50 or more employees and in the third year it drops to 5 or more employees.  The Board will decide when the Program is ready to be implemented and is aiming for 2019.

If the HJTA lawsuit is successful it would be the end of the Program.  Of course, the Program could appeal the initial decision.  And given that other states, such as Oregon, have similar laws, the issue could eventually wind up before the U.S. Supreme Court to decide.  Of course, this will take time.

Currently, the anticipation of CalSavers becoming effective serves as a great opportunity for the California retirement plan industry to market the value of employers adopting other types of retirement plans that would exempt them from the mandate (such as 401k or SEP-IRA plans), and the flexibility of design they offer to meet an employer’s needs.