The Internal Revenue Service announced cost of living adjustments applicable to dollar limitations for pension plans and other items for tax year 2007. Please go to the IRS web site to read the entire article:  http://www.irs.gov/retirement/article/0,,id=96461,00.html.

The Treasury Department and IRS issued Notice 2006-79, which provides an extension of existing transition relief for nonqualified deferred compensation arrangements that will be subject to the requirements of the regulations under section 409A. Final regulations under section 409A are expected to be published later this year. Under the Notice, good-faith operational compliance with the statutory requirements of Section 409A continues to be required.

The extension of transition relief generally applies to all affected arrangements under section 409A, except certain discounted stock options subject to backdating concerns, as specified in the Notice.

The Notice extends the deadline for many aspects of complying with section 409A from January 1, 2007 to January 1, 2008. Full compliance with the operational and documentary requirements of the Section 409A is delayed until January 1, 2008, at which time an adequate opportunity will have been provided for taxpayers to digest and comply with the final regulations.

IRS representatives in September indicated that while work on the final regs is moving forward, the final regulations will contain different rules from the proposed regulations so as to require time for taxpayers to digest, consider alternatives, and draft documents. Please read the following article from CCH Incorporated for more information:  Notice_2006-79.pdf.

Speaking at the ALI-ABA conference, "Retirement, Deferred Compensation, and Welfare Plans of Tax-Exempt and Governmental Employers," held in Washington, D.C., on September 8, 2006, Treasury and IRS representatives discussed how to resolve the apparent disconnect between the deferred payment rules under Code Sec. 457(f) and the new deferred compensation rules under Code Sec. 409A.

If Code Sec. 457 plan eligibility requirements are not met, compensation deferred under the plan is taxable to the employee in the first year there is no substantial risk of forfeiture. In addition, the rules of Code Sec. 409A apply to any requirements already applicable to those plans by virtue of their status as Code Sec. 457 plans. Each section takes a substantively different approach to deferred compensation. For example, under Code Sec. 457(f), the substantial risk of forfeiture rule is fairly strict to the extent that something treated as nonvested may be treated as vested under Code Sec. 409A. In contrast, while a severance agreement is not subject to Code Sec. 457(f), it is presumptively deferred compensation under Code Sec. 409A.

It was suggested that government plans and exempt plans test separately and sequentially for Code Sec. 457(f) and Code Sec. 409A compliance. Generally, if you follow 409A in connection with the substantial risk of forfeiture rule, you probably will meet the 457(f) requirements.

It was also reported that those involved in the Code Sec. 457(f) regulation project now underway have tried, whenever possible, to provide consistency with regard to definitions used in both Code Sec. 457(f) and Code Sec. 409A. However, it was also made clear that, when consistency is not possible, practitioners should remember that it was Congress, not the IRS, that subjected government and exempt entities to both layers (i.e., Code Sec. 457(f) and Code Sec. 409A) when offering deferred compensation to their employees.

The Code Sec. 457(f) regulations project team focused on a number of difficult topics in developing its guidance. That list included:

• Covenants not to compete and Code Sec. 83’s presumption that they do not rise to the level of a substantial risk of forfeiture;
• Consulting service agreements, especially when following full-time employment;
• Goal-oriented conditions related to employment;
• Salary-reduction agreements;
• Rolling risks of forfeiture and their connection to legitimate business purposes;
• Unforeseeable emergencies;
• Defining a permissive service credit under Code Sec. 415(n);
• Defining a government plan for purposes of Code Sec. 414(d);
• Variations on sick and vacation plan deferrals;
• Variations on severance pay plans; and
• Transition rules.

It was also reported that the IRS has an audit initiative on Code Sec. 457(f) plans currently underway.

The failure to afford salary-reduction opportunities to eligible employees when employers are required to do so under the tax code is the top issue facing IRS agents when dealing with public schools and nonprofit organizations, an IRS official told a group of practitioners. The concept of "universal availability" under Code Sec. 403(b) requires that, if institutions make salary-reduction contributions available to some employees, they must be made available to all employees who work at least 20 hours a week. IRS exams have found that failure to adhere to the universal availability rule is generally inadvertent and due to "poor plan design."

During the examination, the IRS sees plans designed that accord individuals the right to make salary-reduction contributions if they are full-time employees. The plan will then incorrectly define a full-time worker as anyone who works at least 2,000 hours. This stipulation causes the failure to provide universal availability. Part of the widespread failure to provide universal availability stems from some organizations' failure to tell their employees that they have the right to make a salary-reduction contribution.

Institution officials (for example, those at public schools, universities, and tax-exempt organizations) have told examining IRS agents that they have plans in place allowing the contributions, but employees are made aware of the plans only upon inquiry, which is insufficient. The IRS looks for some form of notice to participants to complete the universal availability requirement for the salary-reduction opportunity.

Agents continue to see an excess of elective deferral contributions. It has been noted that the problem centers on the misunderstanding of the use of a 15-year catch-up provision provided under Code Sec. 403(b). Under the Code, for elective deferral there is a $15,000 limit for the year 2006. If an individual happens to be 50 or older in the current year, he or she is allowed another $5,000.

Proposed Reg. §1.403(b)-4(c)(3)(i) provides that, in the case of a qualified employee of a qualified organization for whom the basic tax sheltered annuity (TSA) elective deferrals for any year are not less than the elective deferral limit for that year, the TSA elective deferral limitation for the tax year of the qualified employee is increased by the lesser of (a) $3,000; (b) the excess of $15,000 over the total special TSA catch-up elective deferrals made for the qualified employee by the qualified organization for prior years; or (c) the excess of $5,000 multiplied by the number of years of service of the employee with the qualified organization over the total elective deferrals made for the qualified employee by the qualified organization for prior years. Organizations incorrectly assume that if an individual has worked for that specific organization (generally public schools, churches, health care organization) for 15 or more years, he or she may be entitled to another catch-up contribution of up to $3,000. Organizations don't realize that this is a type of a catch-up that is a subject of a special formula; therefore, you cannot say that an individual, because he or she has worked 15 or more years with the organization, is absolutely entitled to an additional $3,000.

Another key concern of agents is that of improper hardship distributions. "Serial hardship" individuals regularly go to multi-vendors and say they have a hardship. The IRS found that the only thing they have to do to certify the hardship to the vendor is check a box. Agents have found situations of people using multiple vendors to get loans in violation of Code Sec. 72(p)'s limits on loan amounts.

Final regulations for that provision are not anticipated before the end of 2007.


For further information on the items above contact: Catherine Bonnes at 269.567.4557 or Forrest Lewis at 517.336.7522.