Year-End Compliance Alert

Employee Benefits Alert

The following is a summary of year-end compliance issues that you should consider as we approach the end of 2006. Although many of these issues deserve more detailed comment, our intent is to help you see the big picture before you focus on the details.

Qualified Retirement Plans

  • “Interim” Plan Amendments for All Plan Sponsors. Plan sponsors may need to adopt interim plan amendments by year end. Rev. Proc. 2005-66 sets forth comprehensive guidance regarding the deadlines for adopting most plan amendments. A five-year remedial amendment period, during which an individually designed plan can be retroactively amended to correct qualification provisions, will be available to plan sponsors that timely adopt “interim” amendments. The deadline for adopting an interim amendment depends on whether the amendment reflects a tax-qualification change or a discretionary change.

Interim plan amendments that reflect tax-qualification changes must be adopted by the end of the plan year in which they are effective, or if later, the due date of the plan sponsor’s tax return (including extensions). Interim plan amendments that reflect discretionary changes must be adopted no later than the end of the plan year in which they become effective. As always, certain types of amendments, such as the adoption of a safe harbor 401(k) plan and the reduction of future benefit accruals, must be adopted in advance pursuant to specific statutory and regulatory requirements.

There is no one-size-fits-all checklist that identifies each interim plan amendment that must be adopted required amendments depend in large part on the provisions in a particular plan document -- but there is guidance. Notice 2005-101 provides a cumulative list of statutory and regulatory changes that may require plan amendments. An updated list current through the end of 2006 is expected shortly, as the IRS plans to update its cumulative list each November.

One widely applicable change included in Notice 2005-101 applies to all companies with 401(k) plans and any other plans with matching or after-tax contributions. These plans will need to be reviewed to determine the extent to which amendments are required to comply with the 401(k) and 401(m) regulations finalized in late 2004 (and in 2006 with respect to Roth contributions). 

  • Remedial Plan Amendments for “Cycle A” Plan Sponsors. Individually designed plans in Cycle A of the IRS’s new determination letter program must be submitted for letters by January 31, 2007 to have an extended remedial amendment period in which qualification amendments can be adopted retroactively. Cycle A plans include those sponsored by companies with tax identification numbers ending in 1 or 6. The new determination letter program is set forth in Rev. Proc. 2005-66. Note: Plan sponsors may want to evaluate whether any interim amendments have not been timely adopted before the plan is submitted for a determination letter. Non-amender sanctions are significantly lower under the IRS’s VCP program than when the IRS discovers the failure during the determination letter process (see Rev. Prov. 2006-27). 
  • 401(k) Safe Harbor Notice. Plans that intend to make a safe harbor matching or non-elective contribution to avoid the ADP/ACP tests for 2007 must provide a safe harbor notice to participants within a reasonable period before the beginning of the 2007 plan year (final 401(k) regulations deem that at least 30 days notice is reasonable). The notice requirements have changed since last year in that the withdrawal and vesting provisions cannot be incorporated by reference to the summary plan description. The notice may also need to be updated to reflect the new 3-year cliff or 2-6 year graded vesting requirements under the Pension Protection Act for non-elective company contributions made for the 2007 plan year. Note: Plan sponsors that preserved their ability to use the 3% non-elective safe harbor contribution for the plan year ending December 31, 2006 must provide a follow-up notice and adopt a plan amendment by December 2, 2006 (30 days before the end of the 2006 plan year) in order to use the safe harbor for 2006. 
  • Relative Value Disclosures for Optional Benefit Forms. Qualified joint and survivor annuity explanations provided on and after January 1, 2007 must comply with the final “relative value” regulations under Code section 417(a)(3). Initially issued in 2003, the regulations have undergone several revisions. Final regulations issued on March 24, allow good-faith compliance until January 1, 2007, and provide transition relief until then relating to the optional forms of benefit that can be described as approximately equal to the QJSA. 
  • Distribution Notice. The Pension Protection Act also extends the 90-day maximum notice-and-consent period for retirement plan distributions to 180 days effective January 1, 2007, and if applicable, requires the notice to describe the consequences of failing to defer receipt of the distribution. Without further guidance, the scope of this description remains unclear, but legislative history suggests the description should explain how the decision not to defer the distribution affects the taxation and accumulation of a participant’s retirement benefits. 
  • Rollover Notice. The Code section 402(f) written explanation for eligible rollover distributions will need to be updated to reflect expanded rollover provisions under the Pension Protection Act. Effective January 1, 2007, after-tax contributions may be transferred directly into 403(b) annuities that separately account for those amounts, and non-spouse beneficiaries will be able to transfer death benefits into “inherited” IRAs. Note: Distribution forms for non-spouse beneficiaries will also need to be updated to reflect the direct rollover option and the 20% mandatory federal income tax withholding. 
  • Notice of Right to Divest Employer Securities. Defined contribution plans that hold publicly traded employer securities will need to provide participants and beneficiaries notice of their rights to divest those securities effective January 1, 2007. The notice must be provided to each eligible individual no later than 30 days before the date he or she becomes eligible to exercise those rights. The notice must explain the right to divest and reinvest employer securities and must describe the importance of diversifying retirement account assets. Note: Stand-alone ESOPs with no 401(k) or 401(m) component are not subject to the new diversification requirements. 
  • Electronic Notices and Elections. On October 20, 2006, the IRS published final regulations setting forth the standards for electronic notices and elections under ESIGN. These regulations are effective January 1, 2007 and will apply to all of the above communications other than the Notice of Right to Divest Employer Securities. Although the statute directs the Secretary of Treasury to issue model language for the notice, the notice requirement is set forth in ERISA section 101(m), over which the Department of Labor has authority. Thus, it appears that the diversification notice will be subject to the DOL regulations on electronic disclosures.

Health and Welfare Plans

  • Definition of Dependent. Health plan and dependent care assistance plan documents, particularly those that incorporate Code section 152 by reference, should be amended to avoid inadvertent restrictions on dependent coverage. Modifications to Code section 152 in recent years include requirements that do not apply to health and dependent care plans. These plans may treat a “qualifying child” as a Code section 152 dependent, whether or not the child is a dependent of another dependent or married (these are prohibited for dependent status under Code sections 152(b)(1) and (2)), and may treat a “qualifying relative” as a Code section 152 dependent whether or not the relative’s income exceeds the limit described in Code section 152(d)(1)(B). 
  • Subrogation and Reimbursement Provisions. Self-insured health plan documents should be reviewed to ensure that the subrogation and reimbursement provisions are enforceable in light of this year’s Supreme Court decision in Sereboff v. Mid Atlantic Medical Services, Inc. The Sereboff decision enables self-insured health plans to obtain reimbursement from participants who recover from third parties if the plans contain the appropriate provisions. 
  • HSA Eligibility for Participants Covered by Health FSAs and HRAs. Employees cannot contribute to health savings accounts (HSAs) while they are covered by a health FSA unless the scope of the health FSA coverage is limited to preventive care, dental and vision, or high deductible coverage. Thus, employees covered by full-scope calendar-year health FSAs that provide a 2-½ month grace period will not be HSA-eligible until the grace period has expired (i.e., until March 2007), even if the health FSA coverage will be limited for calendar year 2007. Coverage under a health reimbursement plan can also cause an employee to be ineligible for HSA contributions unless the HRA coverage is limited. IRS Notice 2005-86 and Rev. Rul. 2004-45 provide examples of the limited coverage rules for health FSAs and HRAs.

Executive Compensation 

  • Extended Transition Relief for Code Section 409A Compliance. IRS Notice 2006-79 extends the deadline for most plans to be in full compliance with Code section 409A from January 1, 2007 until January 1, 2008. Although final regulations under 409A may be issued by the end of 2006, deferred compensation plans need not be amended until December 31, 2007. Plans must continue to be operated in good-faith compliance with Code section 409A (compliance with the proposed or final regulations will constitute good faith compliance).

Notice 2006-79 also extends until December 31, 2007 the period during which changes may be made through service provider elections or plan amendments to the time and form of benefit payments. Such changes will not violate the subsequent election and anti-acceleration rules under 409A provided that they satisfy the conditions in the Notice.

Although Notice 2006-79 provides relief for most deferred compensation arrangements, deadlines for discounted stock options and stock appreciation rights issued by a public company to a Section 16 officer do not qualify for the extensions if the company has reported or expects to report an expense due to a discount that was not timely reported on the company’s financial statements.

More information about the transition relief in Notice 2006- 79 is in our Employee Benefits Alert, Treasury Extends Transition Relief Under Section 409A.

For additional information, please contact any of the following lawyers:

Jeanette Dayan,, 202-626-6037

Elizabeth F. Drake,, 202-626-5838

Marianna G. Dyson,, 202-626-5867

Michael M. Lloyd,, 202-626-1589

C. Frederick Oliphant,, 202-626-5834

Anthony G. Provenzano,, 202-626-1463

Gary G. Quintiere,, 202-626-1491

Lee H. Spence,, 202-626-5965

Adrian L. Morchower

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