Under Internal Revenue Code section 83(b), taxpayers who receive property, such as stock, in exchange for services that is subject to forfeiture, or is unvested for a certain period, may elect to pay income tax on the fair market value of the property as if it were not subject to forfeiture, or fully vested, in the year transferred instead of the year or years in which it vests (83(b) Election). For example, an employee may be issued 100 shares of employer stock at the beginning of 2025 that vests 20% on each December 31 that the employee remains employed from 2025 to 2029. Without the 83(b) Election, the employee recognizes taxable income on the fair market value of the 20 shares that vest each December 31, if still employed. This means that the stock must be valued each year and if it increases in any vesting year, the employee pays more tax in that year than if he or she filed the 83(b) Election. On the other hand, if the 83(b) Election is made, the employee recognizes income in 2024 on the fair market value of all 100 shares of stock on the date of transfer. In this manner, if the stock appreciates during the vesting period, the employee saves taxes. For this reason, the 83(b) Election is tax advantageous for employees receiving property for services in growing companies, such as start-ups.

To be effective an 83(b) Election must be filed by mail with the IRS office where the taxpayer making the election files his or her income tax return no later than 30 days following the date the property is transferred to the taxpayer. The election must contain certain information as provided in regulations, including: the name and Taxpayer Identification Number of the taxpayer making the election; a description of the property subject to the election; the date of transfer of the property; the fair market value of the property on the initial transfer; the type of restrictions on the property; and the amount, if any, paid for the property. The taxpayer must also provide a copy of the election to the transferor of the property.

The 83(b) Election has been in the Internal Revenue Code since 1969 and, until recently, there has never been an IRS Form for making the election. A sample election form was provided in 2012, in Revenue Procedure 2012-29. On November 7, 2024, the IRS released Form 15620 providing a uniform form for taxpayers to make the section 83(b) election. Form 15620 differs from the guidance in the Revenue Procedure as it asks for the name, address and Taxpayer Identification Number of the person transferring the property in exchange for the services (e.g., the employer). It also must be signed by the taxpayer under penalties of perjury. Importantly, taxpayers are not required to use the Form 15620 but can still file their own statement based on the sample from the Revenue Procedure or from the regulations. 

As of now, the Form 15620 or any other 83(b) Election cannot be filed electronically. However, the creation of Form 15620 may be the first step in allowing it to be filed electronically in the future.

On October 3, 2024, the IRS issued guidance on applying the Long-Term, Part-Time Employee (LTPT) rules to 403(b) plans beginning in 2025, as enacted in the legislation known as SECURE 2.0 in IRS Notice 2024-73 (Notice). The LTPT rules were first enacted to apply to 401(k) plans in the legislation known as the SECURE Act. LTPTs are part time employees who work more than 500 hours of service for a consecutive period. Originally for 401(k) plans that was three years for plan years beginning after December 31, 2020, but SECURE 2.0 changed it to two consecutive years beginning for plan years after December 31, 2024. SECURE 2.0 also extended the LTPT rules to 403(b) plans. LTPTs must be eligible to make elective deferrals to the plan but do not have to be eligible for matching or nonelective employer contributions. LTPTs also do not need to be included in discrimination tests for matching contributions. The Notice addresses how the LTPT rules coordinate with other exclusions from 403(b) plans.

Non-ERISA 403(b) Plans. First, the Notice confirms that the LTPT rules do not apply to non-ERISA 403(b) plans. For example, a governmental 403(b) plan is not subject to the LTPT rules because it is not a plan subject to ERISA. This eliminates plans of public schools.

Part-Time Employee Exclusion. While 403(b) plans are subject to the Universal Availability rule that basically says all employees of the employer sponsoring the plan must be eligible to make elective deferrals to the plan if any employee is eligible to make such deferrals, there is an important exception for part-time employees. Generally a 403(b) plan can exclude employees who normally work less than 20 hours per week. The Notice confirms that a 403(b) plan may continue to have the 20 hours per week exclusion. However, if an employee who normally works less than 20 hours per week nonetheless works 500 hours in two consecutive years, the employee becomes eligible to make elective deferrals. Additionally, if after becoming eligible as an LTPT, the employee meets the plan’s general eligibility requirements (e.g., 1,000 hours of service), the employee cannot be excluded from employer contributions.

Student Employee Exception. Another exclusion allowed under a 403(b) plan is students who are performing services at the school, college, or university at which they are enrolled and regularly attending classes. The Notice confirms that because this exclusion is not dependent upon service, such student employees are not affected by the LTPT rules. That is, they will not become eligible if they render 500 hours of services as a student employee for two consecutive years.

Effective Date. The Notice is effective for plan years beginning after December 31, 2024. Additionally, the Notice provides that the Treasury Department and IRS anticipate issuing proposed regulations for LTPTs in 403(b) plans that will be similar to the not yet finalized final regulations relating to LTPTs for 401(k) plans. The Notice also provides that the final 401(k) plan LTPT regulations will not be effective until plan years beginning after January 1, 2026. However, the law is still effective. Comments are requested by December 20, 2024.

Conclusion. Although plan amendments for LTPT rules are not required until the end of the 2026 plan year, 403(b) plan operations must be compliant by January 1, 2025. It should also be noted that employers can amend their plan by January 1, 2025, to provide that all part-time employees are immediately eligible for deferrals, and avoid having to administer the LTPT rules.

SECURE 2.0 codified that for plan years beginning after 2023, 401(k), 403(b), governmental 457(b) and SIMPLE IRA plans can provide matching contributions based on a participant’s repayment of student loan obligations that meet the requirements to be a qualified student loan repayment (QSLP). The Internal Revenue Service (IRS) had previously blessed such a plan design in a private letter ruling in 2018. On August 19, 2024, the IRS issued interim guidance in Q & A format, on such plan design to assist employers in implementing such programs in Notice 2024-63 (Notice).

QSLP. To be a QSLP, the employee-participant must be legally obligated to make the payment of the loan to pay for attendance at an educational institution by the employee, employee’s spouse, or employee’s dependent. The Notice states that a co-signer is legally obligated but a guarantor is only legally obligated when the primary borrower defaults. The employee must certify the payment is a QSLP.

The Notice provides that the plan cannot limit matching contributions to repayments of student loans for only certain employees or for pursuing only certain degrees, or for attending only certain schools. Also, a plan cannot prevent participants who are eligible to receive QSLP matching contributions from also making elective deferrals. Likewise, if a participant makes elective deferrals the participant can’t be precluded from being eligible to receive QDLP matching contributions. In addition, the QSLP matching contributions cannot have requirements stricter than those for matching contributions on elective deferral. A QSLP matching contribution for a plan year may be made omly with respect to QSLP loan repayments made in the same plan year.

Certification. The employee must annually certify the following items (1) the amount of the loan payment; (2) the date of the loan payment; (3) that the payment was made by the employee; (4) that the loan being repaid is a qualified education loan and was used to pay for qualified higher education expenses of the employee, the employee’s spouse, or the employee’s dependent; and (5) that the loan was incurred by the employee.

All items that must be certified can be done through the affirmative certification of the employee. Alternatively, items 1-3 can be certified by independent verification by the employer. An example provided in the Notice is where the loan payments are made through payroll deduction and the employer has all the information. Items 1-3 must be certified annually. Items 4 and 5 can only be certified by affirmative certification. However, an employee registering the loan with the plan satisfies this and need not be repeated annually.

The certification requirements can also be met by registering the loan with the plan to certify items 4 and 5, followed by passive certification of items 1-2 to the plan or employer by the lender, and the plan notifying the participant that it assumes item 3 has been satisfied (unless the employer has actual knowledge to the contrary), with the employee given a reasonable amout of time to correct the information in the notice.

Importantly, the notice provides that if an employee’s certification of a QSLP is determined to be erroneous, the match based on that certification need not be corrected.

Matching Procedures. Plans may establish any reasonable administrative features to implement a QSLP match feature. Whether procedures are reasonable depends on all facts and circumstances including whether the matches are effectively available to all eligible employees and whether employees have a reasonable opportunity to collect and furnish claim submission documentation. A plan may establish a single QSLP match claim deadline or multiple reasonable deadlines, such as quarterly.

ADP Testing. A plan that includes a QSLP match feature that is subject to ADP testing may elect to test the QSLP match feature separate from the rest of the plan. There are two methods to test the QSLP match feature separately. Under method 1, all employees who receive QSLP matches are tested separately. If such employees also make elective deferrals, those are taken into account in the separate test and are excluded from the main ADP test. Under method 2, if an employee that receives a QSLP match also made elective deferrals, those elective deferrals are included in the main ADP test and are excluded from the separate test. The two methods are designed to give employer’s flexibility in passing the ADP test. For a safe harbor plan not subject to the ADP test, a QSLP match feature can be added as a mid-year change, provided the notice and election opportunity conditions are satisfied.

Conclusion. The notice applies to plan year beginning after December 31, 2024. For plan years beginning before January 1, 2025, an employer may rely on a good faith, reasonable interpretation of section 110 of SECURE 2.0. The guidance in the Notice is a good faith, reasonable interpretation of that section. Therefore, following the Notice before 2025 will meet the standard. However, it should be noted that the Notice does not se forth the only reasonable, good faith interpretation of the section 110.

As reported in previous posts, on April 23, 2024, the Federal Trade Commission (FTC) issued a final rule that generally prohibits covenants not to compete (Rule). The rule was set to become effective September 4, 2024. See FTC’s Non-Compete Rule Affecting Executive Compensation Challenged in Courts. The Rule was immediately challenged in courts. On July 3, 2024, the United States District Court for the Northern District of Texas issued a preliminary injunction preventing the rule from being enforced against the Plaintiff in that case before the merits of the case were decided. However, the court refused to expand the injunction to all employers nationwide on a motion for reconsideration on July 10, 2024. See Court Denies Expanding Preliminary Injunction on FTC Non-Compete Rule. The court stated it would provide its decision on the merits of the case by August 30, 2024.

Meanwhile, two other cases had been filed, challenging the Rule. One was filed in a Pennsylania District Court and the other in a Florida District Court. On August 15, 2024, the Florida court agreed with the Northern District of Texas and issued a preliminary injunction against enforcement of the Rule against the Plaintiff until the court decides the merit. Like in Texas, the injunction only applies to the Plaintiff in the case. However, on July 23, 2024, the Pennsylvania District Court denied a preliminary injunction, finding that the Rule was likely valid.

On August 20, 2024, the Texas court issued its decision on the merits, finding that the FTC over stepped its authority in issuing the rule and that the Rule was arbitrary and capricious. Importantly, the court ruled that the Rule is set aside on a nationwide basis. The court rejected the FTC’s argument that the decision should be limited to the Plaintiffs bringing the case.

Employers can breathe a sigh of relief that the Rule will not go into effect on September 4. However, the FTC is likely to appeal the Texas court decision. Additionally, once the Pennsylvania District Court decides the merits, it is likely to uphold the Rule. If that decision is then appealed, there could be a split in the Appellate Circuit Courts that could set up the matter for review by the U.S. Supreme Court. California Employers should also remember that California state law prohibits covenants not to compete, with certain exceptions.

As reported in my previous article, Court Grants Preliminary Injunction Against FTC Ban on Non-Compete Agreements, the District Court granting the preliminary injunction from the FTC enforcing its ban on non-compete agreements limited the relief to only the plaintiff bringing the case, Ryan LLC, and not all business nationwide. I predicted that the Plaintiff would ask that the injunction be given nationwide effect when the court heard the merits of the case in August. On July 10, the Plaintiff and Plaintiff-Intervenors (Plaintiffs) filed a motion to reconsider the preliminary injunction ruling to expand it nationwide. Alternatively, they sought to apply the preliminary injunction to the members of the Plaintiff-Intervenor business associations in the case, the Chamber of Commerce of the United States, the Business Roundtable, the Texas Association of Business, and the Longview Chamber of Commerce, on associational standing grounds. The Plaintiffs reasoned that by limiting the preliminary injunction, all affected businesses must bear the expenses of preparing to comply with the FTC ban when it becomes effective on September 4, 2024, until the court decides the merits by August 30, 2024. Further, they noted, the court already ruled that the Plaintiffs have a likelihood of prevailing on their position that the FTC exceeded its authority in adopting the ban.

On July 11, 2024, the court denied the motion to reconsider in a one paragraph Order simply stating that the Plaintiff and Plaintiff-Intervenors “have not shown themselves entitled to the respective relief requested.” The Order doesn’t prevent the Plaintiff and Plaintiff-Intervenors from seeking a nation-wide permanent injunction when the court hears the merits of the case.

Another Challenge. In a separate case filed in a Pennsylvania district court in April, challenging the FTC ban, ATS Tree Services v. FTC, the court is expected to issue its ruling on the plaintiff’s motion for a preliminary injunction by July 23, 2024.  That court could issue a nationwide preliminary injunction if it chooses.

Supreme Court to Decide? Ultimately, both cases are likely to be appealed by the losing party to the United States Court of Appeals for their respective judicial circuits (the Fifth and Third Circuits, respectively), once the merits are decided. Should the circuit courts have opposing opinions the cases might wind up before the United States Supreme Court to decide the fate of the FTC ban.

As I wrote in April, a lawsuit filed by Ryan, LLC in the United States District Court for the Northern District of Texas, challenged the recently adopted Federal Trade Commission’s (FTC) rule making most non-compete agreements unenforceable (Rule). See FTC’s Non-Compete Rule Affecting Executive Compensation Challenged in Courts. On July 3, 2024, the court granted a preliminary injunction against enforcement of the Rule against the plaintiffs in that case (Plaintiffs), pending a decision on the merits. The court issued the preliminary injunction because it found the Plainiffs had a likelihood of succeeding on the merits that (1) the FTC exceeded its statuory authority in enacting the Rule; (2) the Rule was arbitrary and capricious; and (3) the Rule would cause irreparable harm to the Plaintiffs if a preliminary injunction were not issued.

FTC Exceeded Authority. Plaintiff’s claimed that the Rule exceeds the FTC’s statutory authority because the statute creating the FTC (FTC Act) does not authorize substantive rulemaking. The court stated the FTC Act grants the FTC the power to “classify corporations and to make rules and regulations for the purpose of carrying out the provisions” of the FTC Act. However, the judiciary remains the final authority with respect to questions of statutory construction and courts must reject administrative agency actions which exceed the agency’s statutory mandate. The court stated the question is whether the FTC’s ability to promulgate rules concerning unfair methods of competition include the authority to create substantive rules regarding unfair methods of competition. It concluded that the FTC Act gives the FTC authority to issue rules of agency organization procedure or practice not substantive rules. The court agreed with the Plaintiffs who pointed to the lack of a statutory penalty for violating rules promulgated by the FTC as demonstrating the lack of substantive rulemaking power. The court concluded that the text and structure of the FTC Act reveal the FTC lacks substantive rulemaking authority with respect to unfair methods of competition. Therefore, when adopting the Rule, the FTC exceeded its authority and the Plaintiffs are likely to succeed on the merits.

Arbitrary and Capricious. The court also found that there is a substantial likelihood that the Rule is arbitrary and capricious because it is unreasonably overbroad without a reasonable explanation as to why the FTC chose to impose such a sweeping prohibition. Further, the FTC did not sufficiently consider alternatives to the general ban.

Irreparable Harm. The court found that if a preliminary injunction were not issued, Plaintiffs would suffer immediate irreparable harm because they would not be able to rely on existing non-compete agreements or enter into new ones and would be required to notify workers that existing non-compete provisions are now invalid. This would increase the risk that departing workers might take intellectual property and proprietary methods to competitors. Further, significant time and resources would have to be spent to counteract the effect of the Rule.

No Nation-Wide Relief. While the court granted a preliminary injunction to prevent the FTC from enforcing the rule against the named Plaintiffs, it refused to make the preliminary injunction apply nation-wide. The main reason for limiting the injunction was that the Plaintiffs did not argue for nation-wide application in their briefs. The court stated it intended to issue a decision on the merits on or before August 30, 2024.

Stay Tuned. This preliminary decision indicates that the court is likely to issue a permanent injunction when it decides the case on the merits in August. Plaintiffs will likely ask for the decision to have nation-wide effect. Given the Supreme Court’s recent decision in Loper Bright Enterprises v. Raimondo, overturning Chevron‘s deference to administrative agencies, this could be the end of the FTC Rule.

On April 23, 2024 the Federal Trade Commission (FTC) issued its final rule that prohibits most non-compete clauses. The rule is effective 120 days after its publishing in the Federal Register (scheduled for May 7). However, lawsuits challenging the rule have already been filed.

Prohibition on Non-Compete Clauses.

Clauses preventing employees, especially higher-paid executives, from leaving their employer and going to or starting a competing business (Noncompete) have been a feature of many employment agreements, severance plans, and incentive compensation for a long time. Court rulings and state legislation have limited the scope of enforceable Noncompetes over the years. For example, in California a Noncompete is only enforceable where it prohibits the seller of a business interest from competing with the sold business. In January of 2023, the FTC proposed a nationwide ban on Noncompetes for all workers, including executive and other highly paid employees or independent contractors.

The final rule deems Noncompetes an unfair method of competition. It prohibits employers from entering into Noncompetes in the future and voids existing Noncompetes. It also requires employers to notify applicable employees and former employees that their Noncompetes are no longer enforceable. A change from the proposed rule is that there is an exception for existing Noncompetes with “senior executives”. A senior executive is an individual earning more than $151,164 in the preceding year (which is the top 15 percentile for full-time salaried workers in the nation) who is in a “policy-making position”. This is quite narrow as to be in a policy-making position one must be: the president, CEO or equivalent of the business; an officer of the business who has policy-making authority; or a non-officer of the business who has policy-making authority similar to an officer. Policy-making authority means final authority to make policy decisions that control significant aspects of a business entity. It does not include authority to only advise or exert influence over policy decisions or authority to make policy decisions for a subsidiary but not the entire common enterprise. This narrow definition excludes many highly paid employees such as sales and investment professionals or executives without policy-making authority.

Similar to California law, the rule does have an exception for a Noncompete entered into by the seller of a business entity or that persons interest in a business entity or the sale of all or substantially all the assets of a business entity. The final rule expanded the proposed rule which limited the exception to sales by substantial owners of the business only.

Open Questions.

The rule defines a Noncompete as a contractual term between an employer and worker that: prevents the worker from seeking or accepting work in the United States with a person; or operating a business in the United States after the conclusion of the worker’s employment. Questions remain as to whether nonsolicitation clauses prohibiting the solicitation of customers or employees would constitute a Noncompete under the rule.

Court Challenges.

As soon as the FTC issued the final rule, two lawsuits were filed challenging it. The Chamber of Commerce of the United States was joined by the Business Round Table in a suit filed in the federal district court for the Eastern District of Texas. Another suit was filed in the Northern District of Texas by the business tax services firm of Ryan LLC. Other suits are expected. The suits argue that the agency exceeded its administrative authority when issuing such a broad prohibition. The suits ask for a stay of enforcement and preliminary injunction preventing the FTC from enforcing the rule before the litigation is concluded.

The FTC believes it has clear legal authority to issue the ban. It set forth its position in the lengthy preamble to the final rule.

Conclusion.

If not affected by the court cases, the rule would not be effective until this September. Employers with existing Noncompetes should stay tuned to the litigation. However, employers should also begin to review all of its Noncompete agreements including those in employment agreements, severance plans, and incentive bonus plans to determine which are excepted as involving senior executives and which would not be enforceable if the rule stands. Additionally, if the rule stands, employers will have to reconsider whether changes to its benefit programs are warranted.

This article is the fifth in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. The third article addressed guidance on the Act’s requirement that new 401(k) and 403(b) plans after December 31, 2024 must provide for automatic enrollment. See New Plan Automatic Enrollment Guidance Under IRS Notice 2024-02. The last article addressed guidance under the Notice for the Act’s safe harbor for self-correcting reasonable administrative errors in administering automatic enrollment and automatic escalation features in 401(k), 403(b) and other plans with such features. See When Automatic Isn’t Automatic: Notice 2024-02 Guidance on Self-Correcting Auto-Enrollment And Auto-Escalation Failures. This article discusses guidance on the Act’s allowing penalty-free distributions to terminally ill participants.

Distributions to the Terminally Ill.

The Act provides that after the date of enactment (December 29, 2022), a qualified retirement plan may provide that an employee under the age of 59 1/2 that has been certified by a physician as being terminally ill can receive a distribution (Terminally Ill Distribution) from the plan and such distribution is not subject to the 10% additional penalty tax for early withdrawals. The distribution is still taxable income. The Notice clarifies that the types of plans that can provide for Terminally Ill Distributions are both defined contribution and defined benefit qualified plans under Code section 401(a), annuity plans under both 403(a) and 403(b), and IRAs. It also points out that eligible deferred compensation plans under Code section 457(b) sponsored by state or local governments are not eligible to provide Terminally Ill Distributions because they are not considered qualified retirement plans. While not stated in the Notice, 457(b) plans sponsored by tax exempt organizations are not considered qualified retirement plans either.

Physician Certification Required. To be eligible for a Terminally Ill Distribution, an individual must be certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of certification. The physician generally must be a doctor of medicine or osteopathy legally authorized to practice medicine and surgery by the State in which the doctor performs such function. This definition is in keeping with the definition under the Social Security Act. The certification must contain the following information:

  1. A statement that the illness or condition can reasonably be expected to result in death in 84 months or less from the date of certification;
  2. A narrative description of the evidence used to support the above statement;
  3. The name and contact information of the certifying physician;
  4. The date the physician examined the individual or reviewed the evidence provided by the individual; and
  5. A signed and dated attestation from the physician that by signing the statement, the physician confirms that the physician composed the narrative description based on an examination of the individual or review of the evidence provided by the individual.

The employee must provide the certification to the Plan Administrator before receiving the Terminally Ill Distribution. However, the employee need not provide the Plan Administrator with the underlying documentation on which the certification is based. The Notice points out that a Plan Administrator may not rely on a self-certification that the employee is terminally ill even if the employee is a physician.

Terminally Ill Distribution Is Optional But In-Service Distribution Required. The Notice makes clear that whether to permit Terminally Ill Distributions is voluntary in the discretion of the employer. However, the Terminally Ill Distribution provision of the Act is an exception to the 10 percent additional tax, not the distribution restriction requirements of 401(k) or 403(b) plans. For such a plan to allow Terminally Ill Distributions, it must first permit in-service distributions or hardship distributions. If a plan does not permit Terminally Ill Distributions and an employee otherwise receives a permissible in-service distribution, the employee may treat the distribution as a Terminally Ill Distribution on their federal income tax return using Form 5329. In this case, the employee must still obtain the physician’s certification prior to the distribution and retain it with their tax files in case the IRS requests it later. The Notice provides an example where the employee receives a hardship distribution after obtaining the physician certification and avoids the 10% penalty tax by filing Form 5329.

Ability to Pay Back. Similar to qualified birth or adoption distributions, any or all of the Terminally Ill Distribution amount may be re-contributed by the employee. It can be re-contributed to the same plan or another qualified retirement plan in which the employee is a beneficiary and to which rollovers may be made, including an IRA. In the case of a situation where the distributing plan did not permit Terminally Ill Distributions, but the employee treated an allowed distribution as such, the employee can recontribute to an IRA. This means Terminally Ill Distributions may be recontributed at any time during the 3-year period beginning on the date of the distribution the same as qualified birth or adoption distributions.

Conclusion.

It remains to be seen whether employer’s will adopt provisions allowing Terminally Ill Distributions. They have until the deadline for amendments required by SECURE 2.0 to adopt written amendments. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. However, given that terminally ill employees participating in 401(k) and 403(b) plans that already permit in-service or financial hardship distributions can treat such a distribution as a Terminally Ill Distribution on their income tax return, employers may not want to amend such plans and have the increased burden of administering requests for such distributions.

This article is the fourth in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. The last article addressed guidance on the Act’s requirement that new 401(k) and 403(b) plans after December 31, 2024 must provide for automatic enrollment. See New Plan Automatic Enrollment Guidance Under IRS Notice 2024-02. This article will now address guidance under the Notice for the Act’s safe harbor for self-correcting reasonable administrative errors in administering automatic enrollment and automatic escalation features in 401(k), 403(b) and other plans with such features.

Expired EPCRS Safe Harbor.

The Employee Plans Compliance Resolution System set forth in Rev. Proc. 21-30 (EPCRS), contains a self-correction safe harbor for correcting the excluding of eligible employees in automatic enrollment or automatic escalation failures (Automatic Failures) in 401(k) and 403(b) plans. It permits Automatic Failures to be self-corrected within the earlier of the first payment of compensation after: 1) 9.5 months of the end of the plan year in which the Automatic Failure occurred; or 2) being notified by the affected employee of the failure (Correction Deadline). The safe harbor allows employers to begin making the correct automatic enrollment elective deferrals by the above Correction Deadline without having to make-up the missed elective deferrals by making QNEC contributions of 50% of the missed deferrals otherwise required under EPCRS. All affected employees have to be corrected and if they also missed out on applicable matching contributions, the employer had to make corrective matching contributions, adjusted for earnings, as if the deferrals were timely made. The employer is required to provide a notice of the failure to all affected employees within 45 days after correct deferrals begin. The notice has to include a statement that the correct deferrals have begun and that the employee may increase their elective deferrals to make up for the missed deferrals. However, this safe harbor expired on December 31, 2023.

SECURE 2.0 Safe Harbor.

The Act codified, made permanent, and expanded the expired safe harbor in EPCRS. It expanded it to include governmental 457(b) plans and certain SEP and SIMPLE plans that can have automatic enrollment. It also clarified that the safe harbor correction could be made after an employee has terminated employment and even after the failure was identified under an IRS examination.

Notice Guidance.

The Notice generally provides that to self-correct under the Act, employers would follow the rules under the expired safe harbor of EPCRS. However, it provides guidance on: the effective date of the Act’s safe harbor correction; how to self-correct for failures relating to terminated employees; and when corrective matching contributions must be made.

Effective Date. The Notice clarifies that the safe harbor correction is available for Automatic Failures which began before 2024, so long as the Correction Deadline for the failure is after December 31, 2023. The Notice provides an example where the employer failed to automatically enroll an eligible employee in a calendar year 401(k) plan on January 1, 2023, and the employee did not inform the employer of the error. Therefore, the Correction Deadline is the first compensation payment date after October 15, 2024 (9.5 months after 2023). Since the Correction Deadline is after December 31, 2023, the employer can use the safe harbor.

Terminated Employees. The Notice provides an employer would correct Automatic Failures for terminated employees in the same manner as active employees, including making matching contributions and earnings. However, while still having to provide a notice of the failure, the notice to such terminated employees would not have to include a statement that correct amounts have begun to be deducted from compensation as elective deferrals or that the employee could increase elective deferrals.

Matching Contributions. The Notice provides that corrective matching contributions and earnings (Matching Contributions) must be made within a reasonable period after the correct elective deferrals begin (or would’ve begun for terminated employees). If the Matching Contributions are made within six months after the correct elective deferrals begin (or would’ve begun if not terminated) they are deemed made within a reasonable period. In addition, with respect to an Automatic Failure in a 401(k) or 403(b) plan that begins before December 31, 2023 and qualifies under the expired EPCRS safe harbor, the employer could make the Matching Contributions by the end of the third plan year following the year in which the failure occurred.

Conclusion.

The Act’s safe harbor correction for Automatic Failures is a welcomed extension of the expired EPCRS provision. The guidance under the Notice also provides some important and beneficial clarification as more employers are going to be dealing with automatic enrollment when it becomes mandatory for plans established after 2024.

This article is the third in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. This article will address guidance on the Act’s requirement that any 401(k) plan or 403(b) plan (collectively, Plans) established on or after December 31, 2024, must provide automatic enrollment. However, Plans that are established prior to the date of enactment of the Act, December 29, 2022, are exempt from such requirement (Grandfathered Plans). The Notice discusses when a Plan is established in order to be a Grandfathered Plan. It also discusses how the new requirements affect mergers and acquisitions, multiple employer Plans, spun off Plans and the new deferral only Plans created by the Act. These are addressed below.

Establishment of a Plan. Under the Notice, a 401(k) plan is established on the date plan terms providing for the cash or deferred arrangement are initially adopted. It is important to note, that it is the adoption date and not the effective date that governs. The Notice provides an example where a 401(k) plan is adopted on October 3, 2022, but not effective until January 1, 2023. The Notice concludes that the 401(k) plan is a Grandfathered Plan because it was established prior to December 29, 2022, even though not effective until afterward.

A 403(b) plan is a Grandfathered Plan if the Plan was established prior to December 29, 2022, regardless of whether it provided for salary reduction contributions when initially adopted. Presumably this means that if the 403(b) plan were adopted January 1, 2022, and only provided for employer contributions, it could be amended in 2025 to permit salary reduction contributions and still be exempt from the automatic enrollment requirement.

Mergers and Acquisitions. If two Grandfathered Plans of single employers are merged, the surviving Plan remains grandfathered. Likewise, if a single employer Grandfathered Plan merges with a multiple employer Grandfathered Plan, the surviving Plan remains a Grandfathered Plan. However, if a single employer Plan that is not a Grandfathered Plan is merged into a multiple employer Plan that is a Grandfathered Plan, then the single employer Plan that merged would not be considered a Grandfathered Plan but the remaining employers in the grandfathered multiple employer Plan remain grandfathered.

If a single employer Plan that is not a Grandfathered Plan is merged into a single employer Plan that is a Grandfathered Plan, the Grandfathered Plan will generally lose its Grandfathered Plan status unless, the transaction uses the Code section 410(b)(6)(C) transition relief for meeting coverage. In that case, the ongoing Plan will continue to be considered a Grandfathered Plan, provided the merger occurs by the end of the Code section 410(b)(6)(C) transition period.

Spun Off Plans. The Notice provides that, generally, if a new Plan is spun off from a single employer Grandfathered Plan, the spun off Plan will be considered a Grandfathered Plan. However, if the Plan was spun off from a multiple employer Grandfathered Plan, then the spun off Plan will only be considered a Grandfathered Plan if it were so considered while part of the multiple employer Plan.

Deferral Only Plans. SECURE 2.0 created two new types of deferral only Plans beginning after December 31, 2023. These are the starter 401(k) deferral-only arrangement and the safe harbor deferral-only 403(b) plan. These plans allow employers who do not otherwise offer a retirement plan to permit employees to make elective deferrals only. The Notice provides that the automatic enrollment rules will generally apply to such plans for plan years beginning after December 31, 2024, unless another exception applies. There are exceptions from the automatic enrollment rules for small employers with less than 11 employees and new plans that have been in existence for fewer than 3 years.

Stay tuned for future articles on more guidance under the Notice such as correcting autoenrollment failures, distributions for the terminally ill, and the increased tax credit for adopting plans.