The Taxpayer Relief Act of 1997: New Rules Affecting Employee Benefits

From Employee Benefits Alert

September 1997

General Tax Law Changes

Reduction of Capital Gains Tax Rates. The tax rate on capital gains has been reduced from 28% to 20% for assets held more than 18 months. The increased differential between maximum tax rates on capital gains and ordinary income will cause more employees to favor incentive stock options over nonqualified stock options. The lower capital gains tax rate may also cause employees to reconsider deferring compensation, which will ultimately be taxed at ordinary income rates, in favor of taking the compensation currently and investing it in assets that will produce capital gains. Retirement Plan Changes Acceptance of Rollover Contributions. The Act directs the Treasury Department to issue regulations to clarify that a plan will not be disqualified for accepting a rollover contribution if the trustee verifies that the distributing plan is intended to be a qualified plan (regardless of whether the distributing plan is actually qualified). It is not necessary that the distributing plan actually have a determination letter. The new rule applies for rollover contributions made after December 31, 1997. This change is intended to encourage employers to accept rollover contributions by insulating the recipient plan from disqualification.

Diversification of 401(k) Plan Investments. Effective for deferrals made in plan years beginning after December 31, 1998, new limitations are imposed on the ability of an employer to require the investment of 401(k) elective deferrals in employer securities and employer real property. This change will only affect plans that require elective deferrals to be invested in employer stock.

Matching Contributions for Self-Employed Individuals. For years beginning after December 31, 1997, matching contributions made for self-employed individuals in 401(k) plans will be treated the same as matching contributions for employees. This means that they will not be elective contributions and will not be subject to the elective contributions dollar limitation. The new rule does not apply to qualified matching contributions that are treated as elective contributions for purposes of satisfying the average deferral percentage test. This change will permit partners in a partnership to increase their contributions to 401(k) plans by adding a deductible matching contribution.

Involuntary Cash-outs. The threshold for requiring lump-sum distributions of small account balances is increased from $3,500 to $5,000 for plan years beginning after August 5, 1997.

SPD Filings With DOL. Beginning August 6, 1997, plan administrators are no longer required to file summary plan descriptions and summaries of material modifications with the Department of Labor. Although these documents must still be distributed to plan participants as required by ERISA, they must be made available to the DOL only when specifically requested. Repeal of Excess Accumulations and Distributions Excise Tax. The 15% excise tax on excess distributions from, and the 15% additional estate tax on excess accumulations in, qualified plans has been repealed for distributions made, or decedents dying, after 1996.

New Technologies.The Act directs the Treasury and DOL to issue guidance to employers regarding the use of new technology for plan purposes. This guidance will interpret the notice, election, consent, disclosure, and time requirements (and related record keeping requirements) under the Code and ERISA relating to retirement plans as they relate to the use of new technologies by plan sponsors and administrators, while maintaining the protection of the participants' and beneficiaries' rights. The guidance will also consider how the writing requirements under the Code will be interpreted to permit or limit paperless transactions. The Act mandates that this guidance be issued by December 31, 1998.

Tax on Nondeductible Contributions. The 10% nondeductible excise tax on qualified plan contributions in excess of the deduction limits has been eased. A new exception has been adopted for tax years beginning after December 31, 1997, which permits employers to avoid the tax to the extent that nondeductible contributions to a defined contribution plan do not exceed the employer's matching contributions plus the elective deferral contributions to a section 401(k) plan. This would permit the employer to avoid the excise tax when it is making nondeductible contributions because it is funding both a defined benefit plan and a defined contribution plan.

Increased Full Funding Limit. The full funding limit for defined benefit plans will be increased for plan years beginning after December 31, 1998. The limit is currently the lesser of the plan's accrued liability based on projected benefits or 150% of the plan's current accrued liability. The 150% threshold will be increased to 155% for plan years beginning in 1999 or 2000, to 160% for plan years beginning in 2001 or 2002, 165% for 2003 and 2004, and 170% thereafter.

Increased Excise Tax on Prohibited Transactions. The initial excise tax on prohibited transactions between a qualified plan and disqualified persons has been increased from 10% to 15% of the amount of the transaction for transactions occurring after August 5, 1997. As under prior law, the excise tax increases to 100% if the transaction is not corrected within specified periods.

Plan Amendments to Comply With the Act. Generally, plans will not have to be amended to comply with the Act before the first day of the first plan year beginning on or after January 1, 1999. In order to qualify for the deferred amendment date, however, plans must be administered in accordance with the required change as of the effective date and the amendment must be retroactive to the effective date.

Fringe Benefit Changes Parking Subsidies. For tax years beginning after 1997, the current $170 per month limitation on the income exclusion for employer provided parking is repealed. Under the Act, an employee may be given a choice of receiving cash or parking, and the amount of cash will be included in income only if the employee actually elects to receive cash.

Employer-Provided Educational Assistance. The current exclusion of up to $5,250 for employer-provided educational assistance has been extended to apply to expenses paid for courses beginning before June 1, 2000. This provision had expired for courses beginning after June 30, 1997, but was reinstated retroactively.

Business Meals. The Act clarifies that for tax years beginning after 1997 employer-provided meals that are excluded from employees' income as a de minimis fringe benefit or because they are for the convenience of the employer are fully deductible by the employer and are not subject to the 50% limitation on business meals. This change codifies Tax Court precedent.

For additional information regarding the Taxpayer Relief Act of 1997, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall.