COMMONLY CONTROLLED EMPLOYERS | Plan Qualification Requirements

Often an employer organization (incorporated or unincorporated) is owned or controlled in common with other such organizations. The qualified plan designer often must coordinate plan coverage for the first employer with plan coverage for employees of other members of the commonly controlled group of employers.

The Code has several provisions relating to this issue; their basic objective is to prevent a business owner from getting around the coverage and nondiscrimination requirements for qualified plans by artificially segregating employees to be benefited from the plan into one organization with the remainder being employed by subsidiaries or organizations with lesser plan benefits or no plan at all. While this is still technically possible, the controlled group rules restrict this practice considerably.

Controlled Group Rules in General
Because the forms of business ownership can be tangled and complex, the common control rules for qualified plans are appropriately complicated. There are three sets of these rules.

1. Under Code Section 414(b), all employees of all corporations in a controlled group of corporations are treated as employed by a single employer for purposes of Sections 401, 408(k), 410, 411, 415, and 416. The major impact of this comes from the participation rules of Section 410, which require that the participation and coverage tests be applied to the entire controlled group rather than to any single corporation in the group. Code Section 414(c) provides similar rules for commonly controlled partnerships and proprietorships.

2. Code Section 414(m) provides that employees of an affiliated service group are treated as employed by a single employer. This requirement similarly has its major impact in determining participation in a qualified plan; however, it applies to other employee benefit requirements as well.

3. A leased employee is treated as an employee of the lessor corporation under certain circumstances, under Code Section 414(n).

Some examples will give a general idea of the impact of these provisions on plan design; Note that the common thread of these examples is that the related organization's employees must be taken into account in applying the participation rules. This does not mean that these employees must necessarily be covered.

• Alpha Corporation owns 80 percent of the stock of Beta Corporation. Alpha and Beta are members of a parent subsidiary controlled group of corporations. In applying the participation and coverage rules of Code Section 410, Alpha and Beta must be considered as a single employer.

• Medical Services, Inc., provides administrative and laboratory services for Dr. Sam and Dr. Joe, each of whom is an incorporated sole practitioner. Dr. Sam and Dr. Joe each own 50 percent of Medical Services, Inc. If either Dr. Sam or Dr. Joe adopts a qualified plan, employees of Medical Services, Inc., will have to be taken into account in determining if plan coverage is nondiscriminatory.

• Calculators Incorporated, an actuarial firm, contracts with Temporary Services, Inc., an employee-leasing firm, to lease employees on a substantially full-time basis. The leased employees will have to be taken into account in determining nondiscrimination in any qualified plan of Calculators, unless Temporary maintains a minimum (10 percent nonintegrated) money-purchase pension plan for the leased employees.

OVERALL COVERAGE TESTS

In addition to the specific rules relating to age and service eligibility provisions, the second major limitation on the employer's freedom to exclude employees from a qualified plan is a set of two alternative statutory tests (Code Section 410) to be applied to the plan in actual operation to determine if coverage is discriminatory. A qualified plan must satisfy one of two coverage tests:

The ratio percentage test: The plan must cover a percentage of nonhighly compensated employee that is at least 70 percent of the percentage of highly compensated employees covered.

The average benefit test: The plan must benefit a nondiscriminatory classification of employees, and the average benefit, as a percentage of compensation, for all non-highly compensated employees of the employer, must be at least 70 percent of that for highly compensated employees.

In addition, no defined-benefit plan can be qualified unless it covers, on each day of the plan year, the lesser of (1) 50 employees of the employer or (2) 40 percent or more of all employees of the employer [Code Section 401(a)(26)].

Employees Excluded
In applying these tests, certain employees are not taken into account:

• Employees who have not satisfied the plan's minimum age and service requirements, if any

• Employees included in a collective bargaining unit, if there is evidence that retirement benefits were the subject of good-faith bargaining under a collective bargaining agreement

• Employees excluded under a collective bargaining agreement between air pilots and employers under Title II of the Railway Labor Act

• Employees who are nonresident aliens and who receive no earned income from sources within the United States

The coverage tests apply not only at the plan's inception but on an ongoing basis. Generally, all of the nondiscrimination requirements must be met by a plan on at least one day of each quarter of the plan's taxable year [Code Section 401(a)(6)]. Although the IRS does not perpetually monitor a plan's compliance with the percentage coverage requirements, these requirements give the IRS an ongoing weapon to challenge a plan that may have become discriminatory.

Highly Compensated
For purposes of the coverage tests just described (and for many other employee benefit purposes as well), Code Section 414(q) provides a specific definition of a highly compensated employee. A highly compensated employee is any employee who during the preceding year met either of the following tests:

• Was at any time an owner of a more than 5 percent interest in the employer or

• Received compensation from the employer in excess of $80,000 (this nominal $80,000 amount is indexed annually for inflation; the 2000 amount is $85,000).

Features of the Average Benefit Test
In some respects, the average benefit test is the least stringent of the two coverage tests, and many types of plan design will be able to qualify only under this test. For example, a common plan design provides separate plans for salaried and hourly employees. In many cases, neither plan individually—the salaried plan in particular—can meet the ratio percentage test and thus meets the average benefit test.

The average benefit test is two-pronged. First, the plan must cover a nondiscriminatory classification of employees. Because of this aspect of the test, the IRS has a degree of discretion in the determination of whether a classification is nondiscriminatory. However, the IRS has issued detailed regulations as guidance in interpreting whether there is a nondiscriminatory classification.

The second requirement of the average benefit test is that the average benefit, as a percentage of compensation for non-highly compensated employees, must be at least 70 percent of that for highly compensated employees. In making this determination, all employees, whether covered or not under the plan in question, are counted and benefits from all qualified plans are taken into account.

Examples of Plan Coverage Meeting Various Tests

• Acme Trucking Company has ten employees, three of whom are highly compensated. A qualified plan covers the three highly compensated employees and five of the seven nonhighly compensated employees. This plan meets the ratio percentage test because it covers at least 70 percent of nonhighly compensated employees.

• Barpt Products, Inc., has 20 employees, 5 of whom are highly compensated. If a qualified plan covers four of the highly compensated employees (80 percent), then the plan meets the ratio percentage test if it covers at least 56 percent of non-highly compensated employees—70 percent of 80 percent—or, in this case, nine nonhighly compensated employees.

• Flim Company, Inc. has 500 employees, 100 of whom are salaried. Flim has a plan for salaried employees that covers 50 employees. Flim has received a determination from the IRS that the 50 salaried employees covered do not form a discriminatory classification, presumably because some low-paid salaried employees are covered as well as highly paid employees. The Flim Company Plan will qualify, so long as benefits are provided for non-highly compensated employees as a group that are at least 70 percent of those for highly compensated employees as a group. Thus, some kind of retirement plan coverage for the hourly employees would be necessary.

Plans for Separate Lines of Business
If an employer has separate lines of business, the participation tests can be applied separately to employees in each line of business [Code Section 414(r)]. A separate line of business must be operated for bona fide business reasons and must have at least 50 employees. If highly compensated employees constitute more than a specified percentage of the employees in the separate line of business, special guidelines apply or IRS approval may be required to use the separate line of business provision.

The separate line of business provision may allow a larger employer, or a controlled group of employers, to design separate plans—with separate coverage provisions—for its various operations. This increases the flexibility available in plan design to some extent.

AGE AND SERVICE REQUIREMENTS

Although not all plans have age or service conditions for entry, many employers prefer such conditions because they help to avoid the cost of carrying an employee on the records as a plan participant when the employee quits after a short period of service. Generally, a plan cannot require more than one year of service before eligibility, and an employee who has attained the age of 21 must be permitted to participate in the plan if the employee has met the other participation requirements of the plan. Both age and service requirements can be imposed. For example, for an employee hired at age 19, the plan can require that employee to wait until age 21 to participate in the plan. However, an employee hired at age 27 cannot be required to wait more than one year before participating in the plan.

As an alternative to the one-year waiting period, a plan may provide for a waiting period of up to two years if the plan provides immediate 100 percent vesting upon entry. The two-year provision is often used by employers with very few employees and a high turnover rate—for example, a self-employed physician with one or two clerical or technical employees who have high mobility in their labor market. With a two-year provision, few of the employees may ever be covered.

One problem with these age and service requirements is that it is often desirable for a plan to have entry dates—that is, specific dates during the year in which plan participation is deemed to begin—to simplify recordkeeping. The regulations provide that no employee may be required to wait for participation more than six months after the plan's age and service requirements are met. Thus, a plan having entry dates must adjust its eligibility provisions accordingly.

The Blarp, Inc., pension plan wishes to have a one-year, age 21 entry requirement and to use an entry date or dates. Any of the following options will meet the requirement in the regulations:

* Two entry dates in the year, six months apart, with participants entering on the next entry date after they satisfy the one-year, age 21 condition

* One entry date, but a minimum entry age of no more than 20½ and a maximum waiting period of six months

* One entry date, with participants entering the plan on the date nearest (before or after) the date on which the one-year, age 21 requirement is satisfied

All qualified plans are subject to the age 21 requirement, except for a plan maintained exclusively by a tax-exempt educational institution as defined in Code Section 170(b)(1)(a)(ii). To avoid coverage of temporary employees such as graduate teaching assistants, such a plan may provide a minimum age of 26, but the plan must have 100 percent vesting after one year of service.

Definition of Year of Service

The term year of service is used in different ways in the qualified plan rules. It is used to define the age and service rules for eligibility that were just discussed, and is also used in connection with the vesting and benefit accrual rules. Because it plays such an important part in these rules, it has a specific definition under the law.

Generally, a year of service is a 12-month period during which the employee has at least 1,000 hours of service. For purposes of determining eligibility, the initial 12-month period must be measured beginning with the date the employee begins work for the employer. For other purposes, the 12-month accounting period used by the plan (the plan year) can generally be used. For example, suppose the plan uses the calendar year as the plan year. If an employee began work on June 1, 2001, the initial 12-month period for determining whether the 1,000-hour requirement had been met would be June 1, 2001, through May 31, 2002. If the employee did not perform 1,000 hours of service during that period, the plan could begin the next measuring period on January 1, 2002, with subsequent years being determined similarly on the basis of the plan year.

The employer may determine hours of service using payroll records or any other type of records that accurately reflect the hours worked. Alternatively, the regulations allow a plan to use "equivalency" methods for computing hours of service. These equivalencies allow employees to be credited with hours worked based on completion of some other unit of service such as a shift, week, or month of service, without actual counting of hours worked.

Breaks in Service

A larger employer may reduce the cost of a plan somewhat by including a break-in-service provision in the plan's eligibility requirements. Under such a provision, an employee whose continuous service for the same employer is interrupted loses credit (upon returning to work) for service prior to the break and must again meet the plan's waiting period for eligibility. For a smaller employer, breaks in service followed by reemployment are relatively rare and such a provision may have no substantial cost impact other than possibly to complicate plan administration.

The rules under which a plan may interrupt service credits for breaks in service are somewhat complicated. The rules are set out in Code Section 410(a)(5) and regulations thereunder, as well as Labor Regulations Section 2530.200b. A one-year break in service for this purpose is defined as a 12-month period during which the participant has 500 or fewer hours of service. Service prior to a break cannot be disregarded until there is a one-year break in service. If the employee then returns to work, prebreak service may be disregarded (and the participant regarded as a new employee for participation purposes) within the following three limitations:

1. Service prior to the one-year break in service does not have to be counted unless the returned employee completes a year of service. Participation is then effective as of the first day of the plan year in which eligibility was reestablished.

2. If the plan has a two-year, 100 percent vesting eligibility provision, prebreak service need not be counted if the employee did not complete two years of service before the break.

3. If the participant had no vested benefits at the time of the break, prebreak service need not be counted if the number of consecutive one-year breaks in service equals or exceeds the greater of five or the participant's years of service before the break. For example, suppose that participant Arlen works for Maple Corporation for eight months, quits, and then returns seven years later. For purposes of determining eligibility in the Maple Corporation Plan, Arlen's eight months of prebreak service do not have to be counted.

Other Eligibility Criteria Related to Age and Service

Because the age and service limitations must be met by the plan document as drafted, the IRS will scrutinize the plan to ascertain whether there are eligibility criteria that indirectly base eligibility on age and service. For example, the employer may wish to exclude part-time employees. The IRS views an exclusion of part-timers as a service-based eligibility provision. If the plan has a one-year service requirement for entry, it will exclude all employees who never work 1,000 hours or more in any year. However, the plan cannot exclude part-timers who work 1,000 hours or more in a year, but less than a full year, because such a requirement would be seen as a service requirement that violated the one-year, 1,000-hour rule. However, even if some part-timers must be included, the plan is allowed to have a benefit formula that provides smaller benefits for them because of their lesser compensation, or because part-time service is given less credit for benefit purposes than full-time service.

The IRS will also look at how a plan is actually operated to make sure that the age and service limitations are not violated. For example. suppose an employer has a plan for Division B of the business, and employment in Division B requires five years of service in Division A. Division B has a qualified plan and Division A does not. This service requirement, although outside the plan itself, could be seen as an attempt to circumvent the service limitation for the plan maintained by Division B.

ELIGIBILITY AND PARTICIPATION | Plan Qualification Requirements

The employer must decide what group is to be covered by the qualified plan. In a closely held business, the employer will often want to provide a large portion of the plan's benefits to controlling and key employees and minimize benefits for rank and file employees. In larger plans, employers will often want to provide a different qualified plan (or no plan) for different groups of employees for various reasons; for example, the existence of collective bargaining units with separate plans, a desire for different benefit structures for hourly and salaried employees or differences in benefit policy for employees at different geographic locations.

In reviewing the many limitations imposed on the plan designer by the qualified plan rules, note that the overriding purpose for most of these rules is to prevent discrimination by the employer in favor of highly compensated employees. A secondary purpose, related to the first, is to provide and maintain some security of benefits for participants, particularly participants who are not highly compensated. Most of the qualified plan rules can be explained by these rationales; most questions about the meaning of particular rules and how they apply in a particular situation can be resolved by referring to these basic purposes of the law.

The Code imposes two types of limitations on the employer's freedom to designate the group of employees to be covered under the plan. The first limitation applies to the plan as it exists on paper—the eligibility provisions written into the plan. The second type of limitation applies to the plan in operation and provides minimum coverage requirements in the form of three alternative coverage tests. Both limitations are contained in Code Section 410 and its accompanying regulations and rulings.

First of all, as to plan coverage in the document itself, the designer has a good deal of freedom. The plan may cover only employees at a certain geographic location, employees in a certain work unit, salaried employees only, hourly employees only, or almost any other variation. However, when eligibility is restricted on the basis of age or service with the employer, there are specific limits.

GOVERNMENT REGULATION OF QUALIFIED PLANS

Qualified retirement plan receives special federal tax benefits in return for being designed in accordance with rules imposed by the federal government.We will discuss how the federal government imposes these rules. The federal rules are the most important because federal law generally preempts state and local laws in the qualified plan area.

Benefit planners need a basic understanding of the federal regulatory scheme. Planners must often interpret the significance of various official rules and interact with government organizations. These government rules and organizations must be understood in order to be effective in plan design and management.

Government regulation is expressed through the following, in the order of their importance: (1) statutory law, (2) the law as expressed in court cases, (3) regulations of government agencies, and (4) rulings and other information issued by government agencies.

Statutory Law

Theoretically, the highest level of regulatory law is the U.S. Constitution because all regulation must meet constitutional requirements, such as due process of law and equal protection for persons under the law. However, relatively few issues of federal regulation are actually resolved under constitutional law. For practical purposes, the "law" as expressed by statutes passed by the U.S. Congress is the highest level of authority and is the basis of all regulation; court cases, rulings, and regulations are simply interpretations of statutes passed by Congress. If the statute was detailed enough to cover every possible case, there theoretically wouldn't be any need for anything else. But despite the best efforts of Congressional drafting staffs, the statutes can't cover every situation.

Benefit planners should become as familiar as possible with statutory law because it is the basis for all other rules, regulations, and court cases. One of the main causes for confusion among nonexperts is a lack of understanding of the relative status of sources of information. That is, while a rule found in the Internal Revenue Code is fundamental, a statement in an IRS ruling or instructions to IRS forms may be merely a matter of interpretation that is relatively easy to "plan around."

In the benefits area, the sources of statutory law are:

• Internal Revenue Code (the Code). The tax laws governing the deductibility and taxation of pension and employee benefit programs are fundamental. These are found primarily in Sections 401–425, with important provisions also in Sections 72, 83, and other sections.

• ERISA (Employee Retirement Income Security Act of 1974), as amended, and other labor law provisions. Labor law provisions such as ERISA govern the nontax aspects of federal regulation. These involve plan participation requirements, notice to participants, reporting to the federal government, and a variety of rules designed to safeguard any funds that are set aside to pay benefits in the future. There is some overlap between ERISA and the Code in the area of plan participation, vesting, and prohibited transactions.

• Pension Benefit Guaranty Corporation (PBGC). The PBGC is a government corporation set up under ERISA in 1974 to provide termination insurance for participants in qualified defined-benefit plans up to certain limits. In carrying out this responsibility, the PBGC regulates plan terminations and imposes certain reporting requirements on covered plans that are in financial difficulty or in a state of contraction.

• Securities laws. The federal securities laws are designed to protect investors. Benefit plans may involve an element of investing the employees' money. While qualified plans are generally exempt from the full impact of the securities laws, if the plan holds employer stock, a federal registration statement may be required and certain securities regulations may apply.

• Civil rights laws. Benefit plans are part of an employer's compensation policies; these plans are subject to the Civil Rights Act of 1964, which prohibits employment discrimination on the basis of race, religion, sex, or national origin.

• Age discrimination. The Age Discrimination Act of 1978, as amended, has specific provisions aimed at benefit plans.

• State legislation. ERISA contains a broad "preemption" provision under which any state law in conflict with ERISA is preempted—has no effect. If ERISA does not deal with a particular issue, however, there may be room for state legislation. For example, there is considerable state legislation and regulation governing the types of group term life insurance contracts that can be offered as part of an employer plan. There are also certain areas where states continue to assert authority even though ERISA also has an impact, as in the area of creditors' rights to pension fund assets.

Court Cases

The courts enter the picture when a taxpayer decides to appeal a tax assessment made by the IRS. The courts don't act on their own to resolve tax or other legal issues. Consequently, the law as expressed in court cases is a crazy-quilt affair that offers some answers but often raises more questions than it answers. However, after statutes, court cases are the most authoritative source of law. Courts can and do overturn regulations and rulings of the IRS and other regulatory agencies.

A taxpayer wishing to contest a tax assessment has three choices: (1) the Federal District Court in the taxpayer's district, (2) the United States Tax Court, or (3) the United States Claims Court. Tax law can be found in the decisions of any of these three courts.

All three courts are equally authoritative. Most tax cases, however, are resolved by the U.S. Tax Court, because it offers a powerful advantage: The taxpayer can bring the case before the Tax Court without paying the disputed tax. All the other courts require payment of the tax followed by a suit for refund.

Decisions of these three courts can be appealed to the Federal Court of Appeals for the applicable federal "judicial circuit"—the U.S. is divided into 11 judicial circuits. The circuit courts sometimes differ on certain points of tax law; as a result, tax and benefit planning may depend on what judicial circuit the taxpayer is located in. Where these differences exist, one or more taxpayers will eventually appeal a decision by the Court of Appeals to the United States Supreme Court to resolve differences of interpretation among various judicial circuits, but this process takes many years and the Supreme Court may ultimately choose not to hear the case. Congress also sometimes amends the Code or other statute to resolve these interpretive differences.

Regulations

Regulations are interpretations of statutory law that are published by a government agency; in the benefits area, the most significant regulations are published by the Treasury Department (the parent of the IRS), the Labor Department, and the PBGC.

Regulations are structured as abstract rules, like the statutory law itself. They are not related to a particular factual situation, although they often contain useful examples that illustrate the application of the rules. Currently, Treasury regulations are often issued in question-and-answer form.

The numbering system for regulations is supposed to make them more accessible by including an internal reference to the underlying statutory provision. For example, Treasury Regulation Section 1.401(k)-2 is a regulation relating to Section 401(k) of the Internal Revenue Code. Labor Regulation Section 2550.408b-3 relates to Section 408b of ERISA.

Issuance of regulations follows a prescribed procedure involving an initial issuance of proposed regulations followed by hearings and public comment, then final regulations. The process often takes years. Where taxpayers have an urgent need to know answers, the agency may issue temporary regulations instead of proposed regulations. Technically, temporary regulations are binding, while proposed regulations are not. However, if a taxpayer takes a position contrary to a proposed regulation, the taxpayer is taking the risk that the regulation will ultimately be finalized and be enforced against him.

Rulings and Other Information

IRS Rulings

IRS rulings are responses by the IRS to requests by taxpayers to interpret the law in light of their particular fact situations. A General Counsel Memorandum (GCM) is similar to a ruling, except that the request for clarification and guidance is initiated from an IRS agent in the field during a taxpayer audit, rather than directly from the taxpayer.

There are two types of IRS rulings—Revenue Rulings, which are published by the IRS as general guidance to all taxpayers, and Private Letter Rulings (PLRs), which are addressed only to the specific taxpayers who requested the rulings. The IRS publishes its Revenue Rulings in IRS Bulletins (collected in Cumulative Bulletins [CB] each year). Revenue rulings are binding on IRS personnel on the issues covered in them, but often IRS agents will try to make a distinction between a taxpayer's factual situation and a similar one covered in a ruling if the ruling appears to favor the taxpayer.

PLRs are not published by the IRS, but are available to the public with taxpayer identification deleted. These "anonymous" PLRs are published for tax professionals by various private publishers. They are not binding interpretations of tax law except for the taxpayer who requested the ruling, and even then they apply only to the exact situation described in the ruling request and do not apply to even a slightly different fact pattern involving the same taxpayer. Nevertheless. PLRs are very important in research because they are often the only source of information about the IRS position on various issues.

Other Rulings

The Department of Labor and the PBGC issue some rulings in areas of employee benefit regulation under their jurisdiction. DOL rulings include the Prohibited Transaction Exemption (PTEs) which rule on types of transactions that can avoid the prohibited transaction penalties—for example, sale of life insurance contracts to qualified plans.

Other Information

Because of frequent changes in the tax law, the IRS has been unable to promulgate regulations and rulings on a timely basis, and has increasingly used less formal approaches to inform taxpayers of its position. These include various types of published Notices and even speeches by IRS personnel. Finally, many important IRS positions are found only in IRS Publications (pamphlets available free to taxpayers) and instructions for filling out IRS forms. The IRS also maintains telephone question-answering services, but the value of these for information on complicated issues is minimal.

PLANS FOR SPECIAL TYPES OF ORGANIZATIONS

Plans Covering Partners and Proprietors

Under federal tax law, partners and proprietors (sole owners) are not considered employees of their unincorporated business, even if they perform substantial services for the business. By comparison, shareholders of a corporate business who are employed by the business are considered employees for retirement planning and other employee benefit purposes. For many years, there were restrictions on the benefits available from a qualified plan to partners or proprietors. Special plans called Keogh or HR#10 plans were used if partners or proprietors were covered. Since 1983, most of these restrictions no longer apply, and qualified plans can cover partners and proprietors on virtually the same terms as regular employees of the business.

S Corporations

An S corporation is a corporation that has made an election to be treated substantially like a partnership for federal income tax purposes. Certain shareholder employees of S corporations were once subject to qualified plan restrictions similar to those for partners and proprietors; however, after 1983, most of these restrictions do not apply. Thus, as with partners and proprietors, S corporation shareholder-employees are now treated basically like regular employees for qualified plan purposes. However, an S corporation employee who owns more than 2 percent of the corporation's stock is treated as a partner for other employee benefit purposes, such as group life and health plans.

Multiple Employer, Collectively Bargained, and Multiemployer Plans

In this text, if not stated otherwise, it is assumed that any qualified plans referred to are maintained by a single employer or by a group of related employers. It is possible, however, for more than one employer or related group to participate in a single qualified plan. If such a plan is established under a collective bargaining agreement (as is usually the case), it is referred to as a collectively bargained plan. With a collectively bargained plan, the plan is usually designed and maintained by a labor union, and employers who recognize the union as a bargaining agent for their employees agree to contribute to the plan on a basis specified in the collective bargaining agreement. If the plan is not the result of a collective bargaining agreement, it is referred to as a multiple employer plan. Such plans might, for example, be maintained by trade associations of employers in a certain line of business. There are special rules for applying the participation and other requirements to these plans.

There are also provisions for a special type of collectively bargained plan known as a multiemployer plan (Code Section 414(f)). A multiemployer plan is a plan to which more than one employer is required to contribute and that is maintained under a collective bargaining agreement covering more than one employer; the Department of Labor can also impose other requirements by regulation. Presumably, most large collectively bargained plans will qualify as multiemployer plans. Because of the nature of the multiemployer plan, the funding requirements are somewhat more favorable than for other plans. However, the employer may incur a special liability on withdrawing from the plan.

CLASSIFICATION OF QUALIFIED PLANS

There are two broad classifications of qualified plans. The first classification differentiates between pension plans and profit-sharing plans and the second between defined-benefit and defined-contribution plans. These broad classifications are useful in identifying plans that meet broad overall goals of the employee. Once detailed employer objectives have been determined, a specific qualified plan program can be developed for the employer using one or more of the types of plans from a menu of specific plan types. The specific plan types contain a lot of flexibility in design to meet employer needs, and one or more different plans or plan types can be designed covering the same or overlapping groups of employees to provide the exact type of benefits that the employer desires.

Pension and Profit-Sharing Plans

One way of broadly classifying qualified plans is to distinguish between pension plans and profit-sharing plans. A pension plan is a plan designed primarily to provide income at retirement. Thus, benefits are generally not available from a pension plan until the employee reaches a specified age, referred to as the normal retirement age. Some plans also provide an optional benefit at an earlier age (the early retirement age). The design of a pension plan benefit formula must be such that an employee's retirement benefit is reasonably predictable in advance. Because the object of a pension plan is to provide retirement security, the employer must keep the fund at an adequate level. Pension plans are subject to the minimum funding rules of the Code, and these generally require that the employer make regular deposits to avoid a penalty.

By contrast, a profit-sharing plan is designed to allow a relatively short-term deferral of income; it is a somewhat more speculative benefit to the employee because the employer's contribution can be based on profits. Furthermore, a profit-sharing plan can provide for a totally discretionary employer contribution so that even if the employer has profits in a given year, the employer need not make a contribution for that year. The minimum funding rules do not apply. However, there must be substantial and recurring contributions or the plan will be deemed to be terminated.

In a profit-sharing plan, it is difficult to determine the employee's benefit in advance, and the plan is considered more an incentive to employees than a predictable source of retirement income. Because it is not exclusively designed for retirement income, employees may be permitted to withdraw funds from the plan before retirement. The plan may allow amounts to be withdrawn as early as two years after the employer has contributed them to the plan. However, as with any qualified plan, preretirement withdrawals may be subject to a 10 percent penalty. Finally, the deductible annual employer contribution is limited to 15 percent of payroll, an amount less than would usually be deductible under a pension plan.

Defined-Benefit and Defined-Contribution Plans

Qualified plans are also divided into defined-benefit and defined-contribution plans. A defined-contribution plan has an individual account for each employee; defined-contribution plans are, therefore, sometimes referred to as individual-account plans. The plan document describes the amount the employer will contribute to the plan, but it does not promise any particular benefit. When the plan participant retires or otherwise becomes eligible for benefits under the plan, the benefit will be the total amount in the participant's account, including past investment earnings on the amounts put into the account. The participant can look only to his or her own account to recover benefits; he or she is not entitled to amounts in any other account. Thus, the participant bears the risk of bad plan investments.

In a defined-benefit plan the plan document specifies the amount of benefit promised to the employee at normal retirement age. The plan itself does not specify the amount the employer must contribute annually to the plan. The plan's actuary will determine the annual contribution required so that the plan fund will be sufficient to pay the promised benefit as each participant retires. If the fund is inadequate, the employer is responsible for making additional contributions. There are no individual participant accounts, and each participant has a claim on the entire fund for the defined benefit. Because of the actuarial aspects, defined-benefit plans tend to be more complicated and expensive to administer than defined-contribution plans.

Specific Types of Qualified Plans

As Figure 1 indicates, within the broad categories (pension, profit-sharing, defined-benefit, defined-contribution), there are specific types of plans available to meet various retirement-planning objectives.

Figure 1: Types of Qualified Plans

Defined-Benefit Pension Plan

All defined-benefit plans are pension plans; they are designed primarily to provide income at retirement. A defined-benefit plan specifies the benefit in terms of a formula, of which there are many different types. Such formulas may state the benefit in terms of a percentage of earnings measured over a specific period of time, and might also be based on years of service. For example, a defined-benefit plan might promise a monthly retirement benefit equal to 50 percent of the employee's average monthly earnings over the five years prior to retirement. Or instead of a flat 50 percent, the plan might provide something like 1.5 percent for each of the employee's years of service, with the resulting percentage applied to the employee's earnings averaged over a stated period. Employer contributions to the plan are determined actuarially. Thus, for a given benefit, a defined-benefit plan will tend to result in a larger employer contribution on behalf of employees who enter the plan at older ages, because there is less time to fund the benefit for them.

Cash-Balance Pension Plan

In a cash-balance plan (also called a guaranteed account plan and various other titles), each participant has an "account" that increases annually as a result of two types of credits: a compensation credit, based on the participant's compensation, and an interest credit equal to a guaranteed rate of interest. As a result of the guarantee, the participant does not bear the investment risk. Unlike defined-benefit formulas, the plan deposits are not based on age, and younger employees receive the same benefit accrual as those hired at older ages. The plan is funded by the employer on an actuarial basis; the plan fund's actual rate of investment return may be more or less than the guaranteed rate, and employer deposits are adjusted accordingly. Technically, because of the guaranteed minimum benefit, the plan is treated as a defined-benefit plan. From the participant's viewpoint, however, the plan appears very similar to a money-purchase plan, described below.

Target-Benefit Pension Plan

A target plan uses a benefit formula (the "target") like that of a defined-benefit plan. However, a target plan is a defined-contribution plan and, therefore, the benefit consists solely of the amount in each employee's individual account at retirement. Initial contributions to a target plan are determined actuarially, but the employer does not guarantee that the benefit will meet the target level, so the initial contribution level is not adjusted to reflect actuarial experience. Like a defined-benefit plan, a target-benefit plan provides a relatively higher contribution on behalf of employees entering the plan at older ages.

Money-Purchase Pension Plan

A money-purchase pension plan is a defined-contribution plan that is in some ways the simplest form of qualified plan. The plan simply specifies a level of contribution to each participant's individual account. For example, the plan might specify that the employer will contribute each year to each participant's account an amount equal to 10 percent of that participant's compensation for the year. The participant's retirement benefit is equal to the amount in the account at retirement. Thus, the account reflects not only the initial contribution level but also any subsequent favorable or unfavorable investment results obtained by the plan fund. The term money purchase arose because in many such plans, the amount in the participant's account at retirement is not distributed in a lump sum but rather is used to purchase a single or joint life annuity for the participant.

Profit-Sharing Plan

As described earlier, the significant features of a profit-sharing plan are that employer contributions are, within limits, discretionary on the part of the employer and that employee withdrawals before retirement may be permitted. Profit-sharing plans that are designed to allow employee contributions are sometimes referred to as savings or thrift plans.

Section 401(k) Plan

A Section 401(k) plan, also called a cash or deferred plan, is a plan allowing employees to choose (within limits) to receive compensation either as current cash or as a contribution to a qualified profit-sharing plan. The amount contributed to the plan is not currently taxable to the employee. Such plans have become popular because of their flexibility and tax advantages. However, such plans must include restrictions that may be burdensome to the employer or the employees. The most significant restrictions are a requirement of immediate vesting for amounts contributed under the employee election and restrictions on distribution of these amounts to employees prior to age 59½.

Stock Bonus Plan

The stock bonus plan resembles a profit-sharing plan except that employer contributions are in the form of employer stock rather than cash and the plan fund consists primarily of employer stock.

The fiduciary requirements of the pension law forbid an employer to invest more than 10 percent of a pension plan fund in stock of the employer company. This prevents the employer from utilizing pension plan funds primarily for financing the business rather than providing retirement security for employees. However, the 10 percent restriction does not apply to profit-sharing or stock bonus plans.

Stock bonus plans are intended specifically to give employees an ownership interest in the company at relatively low cost to the company. Stock bonus plans are also used by closely held companies to help create a market for stock of the employer.

ESOP

Employee stock ownership plans (ESOPs) are similar to stock bonus plans in that most or all of the plan fund consists of employer stock: employee accounts are stated in shares of employer stock. However, ESOPs are designed to offer a further benefit: the employer can use an ESOP as a mechanism for financing the business through borrowing or "leveraging." Various tax incentives exist to encourage this.

TAX BENEFITS OF QUALIFIED PLANS

The most important tax advantage of a qualified plan is best understood by comparison with the rules applicable to a nonqualified deferred compensation plan. In a nonqualified plan, the timing of the employer's income tax deduction for compensation of employees depends on when the compensation is included in the employee's income. If the employer puts no money aside in advance to fund the plan, there is no deduction to the employer until the retirement income is paid to the employee, at which time the employee also reports the compensation as taxable income. If the employer puts money aside into an irrevocable trust fund, insurance contract, or similar fund for the benefit of the employee, the employer can get an immediate tax deduction, but then the employee is taxed immediately; there is no tax deferral for the employee.

These rules do not apply to a qualified plan. In a qualified plan, the employer obtains a tax deduction for contributions to the plan fund (within specified limits) for the year the contribution is made. Employees pay taxes on benefits when they are received. The combination of an immediate employer tax deduction plus tax deferral for the employee can be obtained only with a qualified plan.

Besides this basic advantage, there are other tax benefits for qualified plans. Four advantages are usually identified:

• The employer gets an immediate deduction, within certain limits, for amounts paid into the plan fund to finance future retirement benefits for employees.

• The employee is not taxed at the time the employer makes contributions for that employee to the plan fund.

• The employee is taxed only when plan benefits are received. If the full benefit is received in a single year, it may be eligible for special favorable "lump sum" income taxation.

• Earnings on money put aside by the employer to fund the plan are not subject to federal income tax while in the plan fund; thus the earnings accumulate tax free.

QUALIFIED PLAN CHARACTERISTICS

The term qualified plan is not amenable to a simple definition; in a sense, it requires all of Part Five of this text to provide an adequate definition. Nevertheless, it is helpful to take a brief overall look at the most significant requirements before getting into the details.

Eligibility and Plan Coverage

The plan can have almost any kind of initial eligibility provision, except for specific restrictions based on age or service. Generally, no minimum age over 21 can be required, nor can more than one year of service be required for eligibility. In addition, the plan in operation must generally cover at least 70 percent of all non-highly compensated employees. These rules have many complex exceptions and limitations.

Nondiscrimination in Benefits and Contributions

Generally speaking, a qualified plan may not discriminate, either in plan benefits or employer contributions to the plan, in favor of highly compensated employees. The law includes a detailed definition of highly compensated for this purpose. However, the plan contribution or benefit can be based on the employee's compensation or years of service, which often will provide a higher benefit for certain highly compensated employees. In addition, the qualified plan can be integrated with Social Security so that a greater contribution or benefit is available for higher-paid employees whose compensation is greater than an amount based on the Social Security taxable wage base. Because of the possibilities for abuse in these areas, the rules for Social Security integration are complex.

Funding Requirements

Generally, a qualified plan must be funded in advance of the employee's retirement. This can be done either through contributions to an irrevocable trust fund for the employee's benefit or under an insurance contract. There are strict limits on the extent to which the employer can exercise control over the plan fund. The fund must be under the control of a fiduciary—the legal designation for a person who holds funds of another—and must be managed solely for the benefit of plan participants and beneficiaries.

Vesting Requirements

Under the vesting rules, an employee must be given a nonforfeitable or vested benefit at the normal retirement date specified in the plan and, in case of termination of employment prior to retirement, after a specified period of service. For example, one common vesting provision grants a fully vested benefit after the employee has attained five years of service, with no vesting until then. If the plan has this vesting provision, an employee who leaves after, say, four years of service with the employer will receive no plan benefit even though the employer has put money into the plan on his behalf over the four-year period. However, an employee who leaves after five or more years of service will receive the entire plan benefit earned up until that time.

These rules are designed to make it more difficult for employers to deny benefits to employees by selectively discharging or turning over employees.

Limitations on Benefits and Contributions

To limit the use of a qualified plan as a tax shelter for highly compensated employees, Section 415 of the Internal Revenue Code contains a limitation on the plan benefit or employer contributions, depending on the type of plan. Under these limitations, a plan cannot generally provide an annual pension of more than $90,000 (as indexed for inflation) or annual employer and employee contributions of more than $30,000. Practically speaking, these limits are high enough so that only highly compensated participants are likely to encounter them.

Benefits for highly compensated employees are further limited by a requirement that only the first $150,000 (as indexed) of a participant's compensation can be taken into account in a plan's contribution or benefit formula.

Payout Restrictions

To ensure that qualified plan benefits are used for their intended purposes, there are various restrictions on benefit payouts. Certain plans (pension plans in particular) do not allow withdrawals of funds before termination of employment. In addition, there is a 10 percent penalty on withdrawal of funds from any qualified plan before early retirement, age 59½, death, or disability, with certain exceptions. Funds cannot be kept in the plan indefinitely; generally, the payout must begin by April 1 of the year after the participant's attainment of age 70½, in specified minimum annual amounts. Loans from the plan to participants are restricted.

Top-Heavy Rules

To reduce the possibility of excessive discrimination in favor of business owners covered under a qualified plan, special rules are provided for top-heavy plans. Basically, a top-heavy plan is one that provides more than 60 percent of its aggregate accumulated benefits or account balances to key employees. A plan that is top-heavy must meet a special rapid vesting requirement and provide minimum benefits for nonkey employees.