USING EMPLOYER STOCK IN QUALIFIED PLANS

For a number of years, the Internal Revenue Code has included special provisions for qualified plans that invest primarily in employer securities. Congress wants to encourage these plans on the premise that it is desirable to give employees some ownership interest in the company for which they work. The most important special benefit is the leveraging technique for ESOPs, described below, that allows the employer to use the ESOP as a means of financing corporate growth. There are also provisions that encourage the use of a stock plan to help create a market for employer stock.

There are two types of qualified plans that invest primarily in employer securities, the traditional stock bonus plan and the employee stock ownership plan (ESOP). In addition, a regular profit-sharing plan may invest in employer stock without limit, and profit-sharing plans are sometimes used, formally or informally, for this purpose. Qualified pension plans may not invest more than 10 percent of their assets in employer stock, so pension plans are not very useful as employer stock plans.

Advantages of Investing in Employer Stock

There are certain employer and employee advantages to any plan that invests in employer stock, including a regular profit-sharing plan, a stock bonus plan, or an ESOP.

• A market can be created for employer stock. This has many planning implications and is discussed in detail below.

• The employer can obtain a deduction for noncash (that is, employer stock) contributions to the plan.

• Employees receive an ownership interest in the company, which may act as a performance incentive.

• As described below, unrealized appreciation of stock is not taxed to the employee at the time of distribution.

Deduction of Employer Contributions

Under Code Section 404(a)(3), the maximum amount that an employer can deduct for contributions to a profit-sharing plan is 15 percent of the compensation paid or accrued during the taxable year to all employees who participate in the profit-sharing plan. This is an employer deduction limit based on compensation of all covered employees; it is not a rule stating that allocations to individual participants' accounts are limited to 15 percent of their compensation. The limitation on annual additions to individual accounts, the Section 415 limit, is discussed below.

An employer can contribute to a profit-sharing or a stock bonus plan in excess of the 15 percent limit, but the excess is not deductible and is subject to a 10 percent penalty under Section 4972. The excess amount can be carried over to a future year and deducted then, but deductions in the future year for current contributions plus carryovers are still subject to the 15 percent of payroll limit.

Combined Profit-Sharing and other Plans

If an employer has both a defined-benefit plan and a profit-sharing or other defined-contribution plan covering a common group of employees, the total contribution for both plans cannot exceed 25 percent of compensation of the common group of employees. However, if a greater contribution is necessary to satisfy the minimum funding standard for the defined-benefit plan, the employer will always be able to make and deduct this contribution.

Section 415 Limits

The Section 415 limits that apply to profit-sharing plans are those applicable to all defined-contribution plans. The annual addition to any participant's account cannot exceed the lesser of 25 percent of the participant's compensation or $30,000 (as indexed for inflation). For a profit-sharing plan, the annual addition includes the participant's share of any forfeitures as well as employer and employee contributions. This means that when forfeitures are allocated to a participant's account, the amount of employer contributions that can be allocated may be reduced. The Section 415 limits usually affect only highly compensated employees covered under the plan.

Investment Earnings and Account Balances

As a defined-contribution plan, a profit-sharing plan must provide separate accounts for each participant. However, unless the plan contains a provision permitting participants to direct investments (discussed below), the plan trustee or other funding agents will generally pool all participants' accounts for investment purposes. The plan must then provide a mechanism for allocating investment gains or losses to each participant. Most methods for doing this effectively allocate such gains and losses in proportion to the participant's account balance.

IRS revenue rulings require accounts of all participants to be valued in a uniform and consistent manner at least once each year, unless all plan assets are immediately invested in individual annuity or retirement contracts meeting certain requirements. The plan usually will specify a valuation date or dates on which valuation occurs. Investment earnings, gains, and losses are allocated to participants' accounts as of this date.

Participant-Directed Investments

Under ERISA Section 404c, any "individual account" plan (such as a profit-sharing, stock bonus, or money-purchase pension plan) can include a provision allowing the participant to direct the trustee or other funding agent as to the investment of the participant's account.

If the plan administrator provides a broad range of investment choices—so that the participant's choice has real meaning—then the trustee and other plan fiduciaries are not subject to fiduciary responsibility for the investment decision.^[1] A plan can technically allow unlimited choice of investments, but this increases the plan's administrative burdens. Often, a family of mutual funds is offered as an investment option to increase the administrative feasibility of participant direction. At least three investment alternatives must be included.

Investment direction gives the participant a considerable degree of control over the funds in his or her account. It is frequently used in profit-sharing plans, particularly those for closely held businesses where the controlling employees have by far the largest accounts. On the other hand, to the extent that participant direction of investments removes the security provided by the fiduciary rules, such a provision is at odds with a plan objective of providing retirement security, and it would not be appropriate if this were a major objective of the plan for a particular employee group.

To prevent certain abuses associated with participant-directed investments, the Code provides that an investment by a participant-directed qualified plan account in a collectible will be treated as if the amount invested were distributed to the participant as taxable income to the participant. A collectible is defined in Code Section 408(m) as a work of art, rug or antique, metal or gem, stamp or coin (excluding certain federal and state-issued coins), alcoholic beverage, or any other tangible personal property designated as a collectible by the IRS.

Withdrawals during Employment and Loan Provisions

The incentive (rather than retirement security) focus of profit-sharing plans tends to dictate that participants be given the opportunity to control or benefit from their accounts even before retirement or termination of employment. There are various ways to do this. One such provision is a participant-directed account, as discussed above. Another is a special feature permitted in profit-sharing plans but not in pension plans—a provision for account withdrawals from the plan during employment.

The regulations require that employer contributions under a profit-sharing plan must be accumulated for at least two years before they can be withdrawn by participants.^[2] However, in some revenue rulings, the IRS has permitted a plan provision allowing employees with at least 60 months of participation to withdraw employer contributions, including those made within the previous two years. Also, revenue rulings have permitted a plan provision for withdrawal in the case of "hardship," including contributions made within the previous two years. Hardship must be sufficiently defined in the plan and the definitions must be consistently applied. All these limitations apply only to amounts attributable to employer contributions to the plan. If the plan permits employee contributions, the employee contributions can be withdrawn at any time without restriction.

In considering the design of withdrawal provisions, it is important to keep in mind that the taxation and early-withdrawal penalty rules act as disincentives for participants to withdraw plan funds. These rules indirectly reduce the advantages of using a qualified plan as a medium for preretirement savings.

Many plan designers prefer to have a prohibition or at least restrictions on withdrawals from the employer-contributed portion of the account. This is because favorable investment results sometimes depend on having a pool of investment money that is relatively large and not subject to the additional liquidity requirements imposed by the possibility of participant withdrawals. Some typical restrictions found in profit-sharing plans include a requirement that the participant demonstrate a need for the money coming within a list of authorized needs either set out in the plan or promulgated by the plan administrator and applied consistently. Such needs might include educational expenses for children, home purchase or remodeling, sickness or disability, and so forth. Another method of restricting plan withdrawals is to provide a penalty on a participant who withdraws amounts from the plan (in addition to the 10 percent federal penalty tax, which also applies). A plan penalty might include suspension of participation for a period of time, such as six months after the withdrawal. The plan penalty cannot, however, deprive a participant of any previously vested benefit.

Loan provisions are appropriate for profit-sharing plans. Again, however, a generous loan provision in a plan may have the effect of reducing the amount of funds available for other plan investments.

Incidental Benefits

The regulations permit profit-sharing plans to provide as an incidental benefit life, accident, or health insurance for the participant and the participant's family. Incidental life insurance is the only one that is commonly provided. If employer contributions are used to provide insurance, the incidental benefit limitations must be met.

If the plan provides incidental whole life insurance, the usual test is that aggregate premiums for each participant must be less than 50 percent of the aggregate of employer contributions allocated to the participant's account. If the plan purchases term insurance or accident and health insurance, the aggregate premiums must be less than 25 percent of the employer contributions allocated to the participant's account. The current IRS position is that universal life premiums also must meet the 25 percent limit. Note that these tests apply to the aggregate—that is, the total contributions made for all years at any given time. If either of these limits is exceeded, the plan could be disqualified. However, insurance premiums paid with employer-contributed funds that have accumulated for at least two years are not subject to these limitations.

If the employee dies before normal retirement age, the plan can provide that the face amount of the policies plus the balance credited to the participant's account in the profit-sharing plan can be distributed to the survivors without the life insurance violating the incidental benefit requirement. This can be done even though the amount of life insurance might be more than 100 times the account balance expressed as an expected monthly pension.

If life insurance is provided by the plan, the term insurance cost is currently taxable to the employee or the insurer's term insurance rates. Accident and health insurance provided by an employer under the plan might not be taxable because of the exclusion provided for employer-provided health insurance. However, there usually is no particular benefit in providing accident and health insurance under a profit-sharing plan. It is usually provided in a separate plan not connected with the profit-sharing plan.

QUALIFIED PROFIT-SHARING PLANS

The basic profit-sharing plan is a defined-contribution plan in which employer contributions are typically based in some manner on the employer's profits, although there is no actual requirement for the employer to have profits in order to contribute to the plan. Even a nonprofit organization may have a "profit-sharing" plan. The general characteristics are as follows:

• The employer contribution may be specified as a percentage of annual profits each year or, for even more flexibility, the plan may provide that the employer determines the amount to be contributed on an annual basis, with the option of contributing nothing even in years in which there are profits or, conversely, making contributions in unprofitable years.

• The plan must have a nondiscriminatory formula for allocating the employer contribution to the accounts of employees.

• Because the plan is a defined-contribution plan, the benefit from it consists of the amount in each employee's account, usually distributed as a lump sum at retirement or termination of employment.

• The plan may permit employee withdrawals or loans during employment.

• Eligibility and vesting are usually liberal because of the incentive nature of the plan.

• Forfeitures from employees who terminate employment are usually reallocated to the accounts of remaining participants, thus making the plan particularly attractive to long-service employees.

• The main price for the advantages of the design is that the employer's annual deduction for contributions to the plan is limited to 15 percent of the payroll of employees covered under the plan.

Eligibility and Vesting

Profit-sharing plans are typically designed with relatively liberal eligibility and vesting provisions, compared with pension plans. This is because the employer generally wishes the incentive objective of the plans to operate for short-term as well as long-term employees, and also because the simplicity of administering a profit-sharing plan makes it less necessary to exclude short-term employees to reduce plan administrative costs. Thus, many profit-sharing plans permit employees to enter the plan immediately upon becoming employed, or after a short waiting period—for example, until the next date on which the plan assets are valued. A great variety of vesting provisions are used, and they are typically tailored to the employer's specific needs.

As a qualified plan, a profit-sharing plan is subject to the restrictions on eligibility and vesting provisions. In summary, a minimum age requirement greater than 21 is not permitted, nor can a waiting period for entry be longer than one year, or up to 1½ years if entry is based on plan entry dates. Under the age discrimination law, no maximum age for entry can be prescribed (and contributions must continue for as long as the employee continues to work).

A profit-sharing plan is more likely to discriminate in favor of highly compensated employees as a result of high employee turnover and the use of forfeitures, as discussed below. Therefore, the IRS may require the more stringent three- to seven-year vesting schedule in new profit-sharing plans. Most profit-sharing plans use a vesting schedule that is at least as generous as this schedule. Even more stringent vesting is required if the plan is top-heavy.

Employer Contribution Provision

There is great flexibility in designing an employer contribution provision for a profit-sharing plan. The contribution provision can be either discretionary or of the formula type.

With the discretionary provision, the company's board of directors determines each year what amount will be contributed. It is not necessary for the company actually to have current or accumulated profits. Many employers will wish to contribute the maximum deductible amount each year, but a lesser amount can be contributed.

Although employers are permitted to omit contributions under a discretionary provision, the IRS requires that contributions be "substantial and recurring." If too many years go by without contributions, the IRS is likely to find that the plan has been terminated, with the consequences (basically 100 percent vesting for all plan participants and distribution under a specified payment schedule). No specific guidelines are given by the IRS as to how many years of omitted contributions are permitted, so the decision to skip a profit-sharing contribution must always be made with some caution.

With a formula contribution provision, a specified amount must be contributed to the plan whenever there are profits. Typically, the amount is expressed as a percentage of profits determined under generally accepted accounting principles. There are no specific IRS restrictions on the type of formula, so flexibility is possible. For example, the plan might provide for a contribution of 7 percent of all current profits in excess of $50,000, possibly with a limitation on the amount deductible for the year. There is also considerable freedom in defining the term profit in the plan. For example, profit before taxes or after taxes can be used, with before-tax profits being the most common. Profit as defined in the plan can also include capital gains and losses or accumulated profits from prior years. Even an employer that is organized under state law as a "nonprofit" corporation can have a profit-sharing plan funded from a suitably defined surplus account.

The advantage of the formula approach is that it is more attractive to employees than the discretionary approach and more definitely serves the incentive purpose of the plan. However, if a formula approach is adopted, the employer must remember that the formula amount must always be contributed to the plan; the formula constitutes a continuing legal and financial obligation for the business as long as the plan remains in effect. It is possible to draft formulas that take into account possible adverse financial contingencies. Without such provisions, the formula may have to be amended in the future in the event of financial difficulty.

Allocations to Employee Accounts

The plan's contribution provision determines the total amount contributed to the plan for all employees. The plan must also have a formula under which appropriate portions of this total contribution are allocated to the individual accounts of employees. Here there is less flexibility because the allocation provision must meet nondiscrimination requirements. The law provides that contributions must be allocated under a definite formula that does not discriminate in favor of highly compensated employees. Any formula that meets these requirements can be acceptable, but most formulas allocate to participants on the basis of their compensation, compared with the compensation of all participants. That is, after the total employer contribution is determined, the amount allocatable to a given participant is

If compensation is used in the allocation formula, the plan must define compensation in a way that does not discriminate. Compensation might include only base pay or might be total compensation including bonuses or overtime. Only the first $150,000 (as indexed for inflation) of each employee's compensation can be taken into account in the plan formula.

Service is another factor often used in the formula for allocating employer contributions. However, since highly compensated employees are likely to have long service, the IRS will probably require a showing that any service-based formula will not produce discrimination.

Age-Based Allocation Formula and Cross-Testing

Under IRS regulations, it is possible for a profit-sharing plan's allocation formula to take the participant's age at plan entry into account. That is, the plan can provide a greater allocation percentage of compensation to a participant who entered the plan at, say, age 55 than to a participant who entered at age 25. The purpose of this allocation method is to provide the late entrant with a more adequate benefit at retirement, given the fact that the late entrant has fewer years to accumulate plan contributions. Compared with a target plan, the age-based profit-sharing plan has the additional advantage that the employer is not "locked-in" to an annual contribution obligation, which may make this approach attractive to smaller or less stable businesses.

Age-based profit-sharing allocation formulas and target plans are examples of a method of discrimination testing known as cross-testing. A cross-tested defined-contribution plan is tested for discrimination in favor of the highly compensated as if it were a defined-benefit plan. That is, projected benefits at retirement age are determined for all participants in the defined-contribution plan (by assuming that the current level of contributions to each participant's account continues each year until that participant's retirement age). These projected benefits, as a percentage of each participant's compensation, are then tested for discrimination. If lower-paid employees are generally younger than highly compensated employees, cross-testing may allow relatively low contribution levels (percentages of compensation) for the lower-paid employees because the contributions for the younger employees are projected over a longer period of time than those for the older employees. Cross-tested plans are often used by smaller businesses to provide substantial contributions for highly compensated employees, with relatively low costs for coverage of other employees.

Forfeitures

A forfeiture is an unvested amount remaining in a participant's account when the participant terminates employment without being fully vested under the plan's vesting schedule. Thus, forfeitures can occur in any defined-contribution plan that does not have 100 percent immediate vesting. Forfeitures can be reallocated to accounts of other participants or used to reduce future employer contributions. In a profit-sharing plan, forfeitures are usually reallocated to participants to provide an additional incentive for continuing service.

Forfeitures must be allocated in a nondiscriminatory manner. In most plans, forfeiture allocations are made in the same manner as allocations of employer contributions—on the basis of compensation or a combination of compensation and service. The IRS usually will not accept a forfeiture allocation provision based on account balances of remaining participants because such a provision may provide substantial discrimination.

Analysis of profit-sharing plans of smaller employers that have existed for a number of years generally shows that by far the largest account balances are those for highly compensated participants. This is because the combination of higher compensation, longer service (and therefore more years in the plan), and low turnover among the highly compensated group eventually produces a great disparity in account balances. This phenomenon is, in fact, one of the reasons why closely held businesses adopt profit-sharing plans. As such, they are not deemed to be discriminatory. However, if a plan contains any features designed to multiply this inherent discrimination (such as forfeiture allocation based on account balance), the IRS generally will not approve it.

CURRENT QUALIFIED PLAN TRENDS | Profit-Sharing and Similar Plans

Although only the traditional types of pension plans involve an employer commitment to adequate retirement income for employees, trends in management, the economy, and the workforce have produced a gradual erosion in qualified pension plan coverage and a movement toward "nonretirement" plans—that is, defined-contribution plans that provide a form of savings and incentive benefits for employees without a specific funding commitment by the employer. The reasons for this trend include the following:

Figure 1: Pension Coverage

• Competition and cost pressures to minimize wage and benefit costs

• Increasing acquisition, dissolution, and reorganization of business enterprises discourage employer long-term commitment to employees

• Decline in collective bargaining; labor unions have traditionally favored the defined-benefit plan

• Increased mobility in the workforce; the 40-year career with one employer has become a rarity

• Employers are using more part-time employees, leased employees, and independent contractors who would generally receive little benefit from a traditional pension plan

• Increase in families with two wage earners; traditional pension plans tend to duplicate benefits in such cases

We will discuss the following:

• Qualified profit-sharing plans

• Savings or thrift plans

• Employer stock plans (stock bonus plans and ESOPs)

Increasingly, the trend in qualified planning is toward salary savings plans such as 401(k) plans, which are primarily funded through employee salary reductions that are contributed to the plan. These plans are typically combined with the traditional employer-funded profit-sharing plans, or with those in which employer contributions match the employee salary reductions. First, to fully understand how salary savings plans work, the basic profit-sharing plan and its variants

RETIREMENT AGE| Plan Qualification Requirements

A plan's normal retirement age is the age at which a participant can retire and receive the full specified retirement benefit. A defined-benefit plan must specify a normal retirement age in order to fully define the benefit. Defined-contribution plans do not need a normal retirement age for this purpose, but they may have a normal retirement age in order to specify an age at which participants can retire and begin to receive benefits or, as discussed below, an age beyond which no further employer contributions will be made.

Under Code Section 411(a)(8), a plan's normal retirement age can be no greater than the latest of:

• age 65 or

• the fifth anniversary of plan entry if a participant entered within five years of normal retirement age.

Thus, for example, a plan having a normal retirement age of 65 could provide normal retirement at age 67 for a participant entering at age 62.

Although most plans use 65 as the normal retirement age, the plan may specify an earlier normal retirement age. The use of an earlier normal retirement age in a defined-benefit plan requires that funding be accelerated—larger amounts must be contributed to the plan each year to fund each employee's benefit because the benefit will become payable at an earlier date. For plans in which tax sheltering is a primary consideration, such as plans oriented toward key employees in a closely held business, the use of the earliest possible normal retirement age can provide significant additional tax benefits by increasing the deductible plan contributions each year. However, if the normal retirement age is less than the Social Security retirement age, the Section 415 limitations are reduced. This tends to provide some limit on the use of unrealistically low normal retirement ages.

The IRS considers a plan's retirement age to be an actuarial assumption. Therefore, the requirement of "reasonableness" for actuarial assumptions, also puts some limit on the use of unrealistically low normal retirement ages.

Early Retirement
A qualified plan may designate an early retirement age at which an employee may retire and receive an immediate benefit. The early retirement benefit is usually reduced below that payable at normal retirement. The plan may have some service requirement for early retirement, such as ten years of service, or it may permit early retirement simply upon attainment of the early retirement age.

Under most defined-benefit plans, the monthly early retirement benefit is reduced below the monthly normal retirement benefit payable at age 65 because of two factors. First, the early retirement benefit will usually be limited to the participant's accrued benefit, and the participant will often have not accrued the full benefit at early retirement. Second, most plans require an actuarial reduction. The actuarial reduction is a mathematical adjustment based on (1) longer life expectancy at early retirement, (2) loss of investment earnings to the plan fund due to payments beginning earlier, and (3) loss of the possibility that the participant might die before payments begin—mortality.

Most plans do not require employer consent for early retirement. If employer consent is required, the IRS limits the early retirement benefit to the vested accrued benefit that would be payable if the employee terminated employment unilaterally, in order to avoid the possibility that the employer will favor highly compensated employees in granting early retirement benefits.

For defined-contribution plans, early retirement is usually treated the same as a termination of employment, and the benefit payable at early retirement is simply the amount of the participant's account balance as of that date. Thus, many defined-contribution plans do not specify an early retirement age.

Some employers offer a "subsidized" early retirement benefit—one that is reduced by less than the full amount dictated by the three factors discussed above—as an incentive for retirement. The subsidized benefit is often offered during a limited "window" period, during which the employee must either choose the benefit or lose the opportunity to receive it forever (or at least until the employer decides to offer another window benefit). There are specific legal protections under the Age Discrimination Act for employees in this situation.

Late Retirement
A qualified plan design should also cover the possibility of late retirement—retirement after the normal retirement age. Under the age discrimination rules discussed below, the plan must continue benefit accruals for employees who continue working after the normal retirement age unless the plan's benefit formula stops benefit accruals after a specified number of years and the employee has enough years of service to cease accruals for that reason. Benefit formulas must be designed carefully to ensure appropriate treatment of older employees. In smaller businesses, older participants are often owners or key employees who will want the plan to provide substantial benefits. On the other hand, many larger employers want to encourage earlier retirement and will want to provide only the minimum late retirement benefit required under the law

WHO WILL PAY FOR THE PLAN? | Plan Qualification Requirements

Most qualified pension plans are funded entirely by the employer. Pension plans requiring contributions by employees, referred to as contributory plans, were once popular but are currently of diminishing importance. There are two reasons for this. First, employee contributions to a qualified plan other than "salary reductions" (see below) are after-tax contributions—the employee receives no tax deduction or exclusion for the contribution. Also, employee contributions involve administrative complications such as Code Section 401(m).

Many employers believe that retirement plan benefits are appreciated more by employees if the employees themselves contribute (or feel that they are contributing) toward their cost. In most cases, of course, most of an employee's income comes in the form of compensation from the employer, so there is some degree of illusion in this approach. Some employers may also believe that a contributory approach lowers plan costs, but this is not actually true. To the extent that a contributory approach results in the loss of tax benefits (in effect, losing a contribution to the plan by the U.S. Treasury), a contributory plan actually costs the employer more for the same level of benefits. A better justification for contributory plans is that they give the employee some degree of choice in allocating his or her compensation between cash and deferred benefits.

Currently, the most favorable contributory plan design is to use salary reductions in a plan that is permitted to use salary reductions—a Section 401(k) plan, a Section 403(b) plan, a Section 457 plan, or a SIMPLE plan. Qualified pension plans cannot use salary reductions, except for some older plans that were "grandfathered" (permitted to use older law) when current law was enacted. Salary reductions are subject to FICA and FUTA (Social Security and federal unemployment) taxes but not to federal income tax. Thus, the tax benefits of qualified plans are not completely lost to the employee if the salary reduction approach is used.

VESTING | Plan Qualification Requirements

A qualified plan must provide a minimum nonforfeitable, or vested, benefit for participants who attain certain service requirements. Once vested, the participant cannot forfeit this minimum vested benefit. For example, the plan cannot require that an employee forfeit part or all of the vested benefit required by the Code even if the employee commits an act of misconduct, such as embezzlement or going to work for a competitor. The strictness of the vesting rules was designed to provide additional benefit security and to protect employees against arbitrary acts of the employer.

Vesting at Normal Retirement Age and Termination of Employment
The plan must provide a fully vested benefit at the normal retirement age. The plan must also provide that benefits are vested under a specified "vesting schedule" during the participant's employment, so that if the participant terminates employment prior to retirement age, he or she is entitled to a vested benefit with some stated minimum amount of service. The vested benefit can be payable immediately on termination or deferred to the plan's normal retirement age.

If the plan provides for employee contributions, the participant's accrued benefit is divided between the part attributable to employee contributions and the part attributable to employer contributions. The part attributable to employee contributions must at all times be 100 percent vested. The part attributable to employer contributions must be vested in accordance with a vesting schedule set out in the plan.

There is some flexibility in designing a vesting schedule in order to meet various employer objectives. However, the vesting schedule must be at least as favorable as one of two alternative minimum standards, five-year vesting or three-to seven-year vesting.

Five-Year Vesting
The vesting schedule satisfies this minimum requirement if an employee with at least five years of service is 100 percent vested in the employer-provided portion of the accrued benefit. This rule is satisfied even if there is no vesting at all before five years of service. This rule is sometimes referred to as cliff vesting.

Years of Service - Vested Percentage

3 - 20

4 - 40

5 - 60

6 - 80

7 or more - 100

Three-to Seven-Year Vesting
A vesting schedule satisfies this minimum standard if the vesting is at least as fast as in the following table on the right:

In applying the vesting rules, all of a participant's years of service for the employer must be taken into account, even years prior to plan participation, except that years of service prior to age 18 may be excluded. The plan's vesting schedule may also ignore service prior to a break in continuous service with the employer; however, there are elaborate restrictions on how this may be done [Code Section 411(a)(6)].

Probably the most common vesting provision in defined-benefit plans is the five-year provision, because of its simplicity and because it is generally the most favorable to the employee. Defined-contribution plans are often designed with a more generous (to the employee) vesting schedule using the three- to seven-year schedule or one that is even faster.

Top-Heavy Vesting
To complete this discussion, it should be mentioned that plans that are top-heavy, as defined in the Code, are required to provide faster vesting than under most of the schedules previously mentioned. The top-heavy minimum vesting schedule is shown in the table at the left:

Years of Service - Vested Percentage

2 - 20

3 - 40

4 - 60

5 - 80

6 or more - 100

A 100 percent vesting provision with two years' eligibility also meets the top-heavy minimum vesting requirement. As discussed below, the top-heavy requirements have a significant impact in designing a vesting schedule for plans of smaller employers.

Choosing a Vesting Schedule
Choosing an appropriate vesting schedule is an important plan design decision. When a pension plan participant terminates employment, invested funds contributed to the plan for that participant in excess of any benefits paid to the participant on termination (forfeitures) are generally used to reduce future employer costs for the pension plan. Strict vesting, therefore, can reduce a pension plan's cost to the employer. In a defined-contribution plan, forfeitures also can be reallocated to remaining participants' accounts. Thus, there should be a reason for adopting more than a strict minimum vesting schedule. Some reasons for using liberal vesting include the need to provide employee incentive and involvement in situations where a five-year vesting schedule might appear too remote and therefore of no value to employees. Also, a simplified liberal vesting schedule may reduce administrative costs.

Vesting on Plan Termination
The final vesting rule relates to a plan that has terminated. The IRS will regard a plan as having terminated either if it is formally terminated or if the employer permanently ceases to make contributions to the plan. When a plan is terminated, all benefits must be fully vested to the extent funded. Therefore, when a defined-contribution plan terminates, all participants are immediately 100 percent vested in their account balances. When a defined-benefit plan terminates, participants are 100 percent vested in their accrued benefits; however, if the plan funds are insufficient, they are vested only to the extent that the plan is funded. Many terminated qualified defined-benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC).

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.