Retiree Drug Subsidy, Hardship Distributions, Payroll Tax for Accrual Method Taxpayers, Restricted Stock vs. RSUs

Focus On Employee Benefits

Health & Welfare: Retiree Drug Subsidy Deadlines for Plan Years Ending in 2006 and Q1 2007 Extended

Susan Relland & Patricia Szoeke

Last month the Centers for Medicare and Medicaid Services (CMS) extended the deadline for submitting the Retiree Drug Subsidy (RDS) reconciliation from March 31, 2008 to June 30, 2008, for plan years ending in 2006. In addition, CMS extended by three months the deadlines for plan sponsors with plan years ending in the first quarter of calendar year 2007. However, the deadlines for plan sponsors with RDS applications with plan years ending on or after April 1, 2007 remain unchanged by CMS’ actions. In light of this relief, CMS has stated that requests for additional deadline extensions from plan sponsors with a 2006 or 2007 application affected by this relief will not be considered.

The additional time afforded by CMS’ actions comes after a number of employers and third party administrators had expressed concern over being able to obtain and finalize rebate and other data in time for the existing payment reconciliation deadlines. Despite initially indicating it would address such issue on a case-by-case basis, CMS released a general extension of certain upcoming deadlines, providing plan sponsors with additional time to accurately calculate the final subsidy amounts for plan years ending in 2006 and the first quarter of 2007.


Qualified Plans: 401(k) Hardship Distributions

Elizabeth Drake & Veronica Rouse

In light of the cooling economy and downturn in the housing market, many employers are seeing an increase in 401(k) plan hardship distribution requests. In light of this, plan administrators should ensure hardship distributions are being processed in compliance with IRS rules and plan document provisions.

For a distribution from a 401(k) plan to be on account of hardship, it must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent. Under the provisions of the Pension Protection Act of 2006, the need of the employee also may include the need of the employee’s non-spouse, non-dependent beneficiary. Whether a need is immediate and heavy depends on the facts and circumstances. Certain expenses are deemed to be immediate and heavy, including: (1) certain medical expenses; (2) costs relating to the purchase of a principal residence; (3) tuition and related educational fees and expenses; (4) payments necessary to prevent eviction from, or foreclosure on, a principal residence; (5) burial or funeral expenses; and (6) certain expenses for the repair of damage to the employee’s principal residence. Furthermore, a financial need may be treated as immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee. A distribution is not considered necessary to satisfy an immediate and heavy financial need of an employee if the employee has other resources available to meet the need, including assets of the employee’s spouse and minor children. While, generally, this is a facts and circumstances test, under the IRS rules, the employer may rely on an employee’s representation if certain conditions are met. Furthermore, a distribution will be deemed necessary to satisfy an immediate and heavy financial need if each of the following requirements are met: (1) the employee has obtained all other currently available distributions and loans under the plan and all other plans maintained by the employer, and (2) the employee is prohibited, under the terms of the plan or an otherwise legally enforceable agreement, from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution.


Payroll Tax & Fringe Benefits: IRS Outlines Safe Harbor for Certain Payroll Tax Liabilities for Accrual Method Taxpayers

Dwight Mersereau & Adrian Morchower

The IRS issued Rev. Proc. 2008-25, which provides a safe harbor method of accounting for accrual method taxpayers that incur payroll tax liabilities for compensation, including bonuses and vacation pay, that is accrued in year 1 but payable in year 2.

The IRS previously held in Rev. Rul. 2007-12 that the payroll tax liability associated with such bonuses and vacation pay could be deducted in year 1 even if the liability for the bonuses or vacation pay could not be deducted, because of the application of the 2-1/2 month rule of Section 404, until year 2. In order to satisfy the year 1 accrual of the payroll taxes, however, the taxpayer had to meet the all events test and recurring item exception of Section 461 with respect to the payroll tax liability. This raised the issue of whether the liability for the Social Security tax portion of the FICA tax and the FUTA tax could satisfy these requirements in year 1 because of the possibility that the dollar limitations applicable to these taxes might be satisfied in year 2 before the payment of the accrued bonuses or vacation pay. Rev. Proc. 2008-25 has resolved this issue. Thus, under its safe harbor method of accounting, and solely for the purpose of the recurring item exception, a taxpayer will have satisfied the all-events prong of the recurring item exception for purposes of deducting its payroll tax liability in year 1 without concern for the dollar limitation issue.

A change in the treatment of payroll tax liabilities to conform to the safe harbor method provided by Rev. Proc. 2008-25 is a change in method of accounting generally subject to the automatic change in accounting method procedures of Rev. Proc. 2002-9, with some modifications.


Exec Comp: Taxation of Restricted Stock vs. Restricted Stock Units

Fred Oliphant & Patricia Szoeke

As employers continue to grant equity awards as a part of their overall compensation strategy, the manner in which such awards are taxed increasingly plays a role in determining which type(s) of compensation to award. Two common types of equity compensation awarded to select employees and directors are restricted stock and restricted stock units (RSUs). While these instruments are very similar in economic effect, they are quite different in how they are taxed for federal income tax purposes. Employers should keep these differences in mind in deciding which type of award to grant.

Restricted Stock

Under Code Section 83, unless a special election is made under Section 83(b), restricted stock is generally taxable at the time the shares are no longer subject to a substantial risk of forfeiture (i.e., upon satisfaction of the vesting criteria), even if the shares are not immediately transferable by the recipient. Taxation is based on the fair market value of the shares on the date of vesting, minus the amount (if any) paid by the recipient for such shares; such amount is taxable as ordinary income. Assuming the shares are held as a capital asset, any gain or loss recognized by the recipient upon subsequent sale of the shares is treated as either a short-term or long-term capital gain/loss, depending on the length of the holding period (i.e., the period of time between the vesting of the shares and the subsequent sale of the shares).

However, instead of subjecting restricted stock to taxation upon vesting, a recipient may make a special election under Code Section 83(b) (generally referred to as a “Section 83(b) election”) to subject the shares to taxation at the time of grant. Taxpayers who make a Section 83(b) election trigger inclusion in income of the fair market value of the shares, minus the amount (if any) paid for such shares, at the time of grant. In such cases, the shares are not subject to taxation upon vesting. Upon sale of the shares, any gains or losses recognized by the shares after their date of grant are treated as capital gains/losses. Importantly, however, if an employee does not vest in the restricted shares (e.g., leaves the employment of the employer prior to satisfying the time-based vesting requirement), the employee would forfeit the shares, even though she had elected to include the value of such shares in income upon grant. In such event, the employee is generally treated as incurring a loss, but the loss is limited to the amount (if any) paid for the shares, reduced by the amount (if any) realized on the forfeiture.

Restricted Stock Units

Unlike restricted stock, RSUs do not involve the actual transfer of company stock at the time of grant; instead, RSUs are, in effect, unfunded deferred compensation promises to deliver at a future date an amount valued in terms of the company stock. Generally, upon satisfying the vesting requirement (typically either a time-based or performance-based requirement), the value of the award is distributed to the recipient in the form of either shares of company stock or the cash equivalent of the number of shares. However, some arrangements may provide for the deferral of the distribution amount until after vesting. As unfunded deferred compensation, RSUs will be taxed, for federal income tax purposes, accordingly -- i.e., assuming compliance with Section 409A, they will not be taxed until payments are actually or constructively received by the recipient (and not necessarily when they are vested). Note that if the RSUs do not meet the requirements of Section 409A, they will be subject to tax earlier under Section 409A’s special rules.

In many instances, it is difficult to tell the difference between an arrangement that involves a current transfer of restricted stock where transferability is restricted until a future vesting date, and an arrangement involving RSUs that promises to deliver stock in the future after a vesting date. The difference will frequently turn on whether there has been a transfer of beneficial ownership of the shares at the time of grant. For example, if the arrangement results in the recipient’s having a right to vote the shares and receive dividends during the vesting period, the arrangement will likely be viewed as a transfer of restricted stock, rather than a promise to deliver stock in the future at vesting.

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

Elizabeth Drake,, 202-626-5838

Fred Oliphant,, 202-626-5834

Adrian Morchower

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