IRS

Retirement Spotlight: IRS Regulations Address Tax on Unrelated Businesses in Plans

The IRS has released final regulations on computing unrelated business taxable income (UBTI) for a tax-exempt organization. This guidance may affect only a relatively small portion of tax-exempt retirement plans. For those plans that invest in certain types of assets, however, knowing the rules will be important. As explained later, these final regulations may help simplify administration and reporting requirements for what are usually considered to be more complex investments.

The final regulations pertain to Internal Revenue Code Section (IRC Sec.) 512(a)(6), added by the Tax Cuts and Jobs Act of 2017. The regulations are generally effective for taxable years starting on or after December 2, 2020. Tax-exempt organizations may choose to apply the final regulations to taxable years that start on or after January 1, 2018. Alternatively, they may rely on a “reasonable, good-faith interpretation” of IRC Sec. 512(a)(6) for such taxable years.

Rationale for the Unrelated Business Tax

IRC Sec. 501(c) contains the list of exempt organizations that receive special tax benefits. Perhaps most familiar to many are IRC Sec. 501(c)(3) entities, which are organized and operated for religious, charitable, scientific, educational, and other similar purposes. Because of the societal benefits that these organizations confer, they are exempt from federal taxation. Hence the name “exempt organizations”.

Because these exempt entities operate free from most taxation, they can devote more of their resources to their purpose. Some organizations own or operate businesses outside this purpose, usually to raise money to further the organization’s goals. But this could allow them to have an advantage over for-profit organizations conducting the same kind of business.

  • Example: Misty Meadows Arboretum is an IRC 501(c)(3) exempt organization whose primary purpose is to educate the community about various ecosystems. It relies primarily on charitable contributions from its members. It always has a spring plant sale, which is open to the public and brings in a modest profit. Misty Meadows’ new director sees potential in creating a larger plant sale. Eventually, the arboretum builds multiple greenhouses to meet the huge demand. Before long, the annual plant sale is by far Misty Meadows’ biggest revenue source. Unfortunately, Misty Meadows’ director wasn’t aware that the arboretum was prohibited from using its tax-exempt status to run the almost year-round plant-sales operation without paying any tax.

Exempt organizations that operate a business enterprise outside their tax-exempt purpose are required to pay taxes on profits from that enterprise. This levels the playing field so that not-for-profit entities do not have an unfair advantage, which would be contrary to public policy.

Retirement Plans as Exempt Organizations

In addition to the UBTI rules applying to IRC 501(c)(3) organizations, they also apply to trusts under IRC Sec. 401(a). This includes pension plans, profit sharing plans, and 401(k) plans. The IRS also applies the UBTI rules to IRAs.

In the vast majority of plans and IRAs, UBTI will not be a factor. Generally, most assets in these types of plans are invested in mutual funds or time deposits (i.e., certificates of deposit). Even participants in plans that permit greater investment latitude will often invest in individual securities. Only those plans that permit true investment self-direction will normally become subject to the UBTI rules. The plans most often associated with unrelated taxable businesses are truly self-directed owner-only 401(k) plans and IRAs. These types of accounts are referred to as self-directed accounts or SDAs. And while some financial organizations may permit SDA owners to place assets in investments that generate UBTI, many SDA investments (e.g., precious metals, promissory notes) do not.

How Does the Tax on UBTI work?

The rules on UBTI can be complex, but here are some of the basics.

  • Annual income of $1,000. Form 990-T: Exempt Organization Business Income Tax Return, must be filed for plans with gross income of $1,000 or more from an unrelated trade or business. Form 990-T must normally be filed for qualified plans and IRAs by the trust’s tax return due date (generally April 15 for calendar-year tax filers).
  • Tax rates. A filer gets a $1,000 “specific deduction.” So an IRA with exactly $1,000 in gross income from an unrelated business would have to file Form 990-T, but it doesn’t pay tax on the income unless there is UBTI after the $1,000 deduction (and any other deduction) is applied. The tax rate schedule for trusts then applies for any taxable unrelated business income. This rate starts at 10 percent—but quickly rises to 37 percent (on taxable income over $12,950).
  • Filing Form 990-T. This is one of the biggest concerns surrounding SDAs: who is responsible for actually filing Form 990-T? The Form 990-T instructions state that the exempt organization (e.g., the 401(k) plan) and the trustee or custodian of the IRA must file. Practically, the financial organization may address this requirement by clarifying (in a service agreement) that the account owner must prepare any Form 990-T that is needed, while the financial organization (as trustee or custodian) will file it with the IRS. It is important that both parties understand their roles. The financial organization may not know enough of the details about the underlying investments to prepare Form 990-T, but the account owner may assume that, because the financial organization is allowing self-directed investments, it is also taking care of every aspect of such investments. Unless financial organizations are charging for providing this service, it is unlikely that they will volunteer to do it. And if they agree to prepare Form 990-T, they must have access to sufficient information. This is but one reason that financial organizations must carefully consider whether they wish to offer self-directed accounts. If they do, they should ensure that their clients clearly understand their respective roles and duties.

NOTE: Any financial organization allowing—and any individual owning—retirement plan investments that require Form 990-T filing should consult with a competent tax adviser.

Specific Provisions in the Final Regulations

The regulations contain provisions that may affect how unrelated businesses operate within a retirement plan.

  • Multiple unrelated businesses are treated separately. The final regulations require an exempt organization subject to the unrelated business income tax—if it has more than one unrelated trade or business—to calculate UBTI separately for each one. But the rule also prohibits offsetting the income of one unrelated business with the net operating loss of another. Using the example above, let’s consider how the new rules would dictate how the arboretum would report UBTI if it decided to build and operate a restaurant to increase its income.

The final regulations require an exempt organization to identify each separate business using the first two digits of the North American Industry Classification System (NAICS) code. The NAICS code (pronounced “nākes”) is a six-digit system that classifies over one thousand industries. The first two digits identify the general sector of the business (e.g., construction, manufacturing, education). Each successive digit narrows the business definition. In our example, for instance, the arboretum’s greenhouse operation could be classified with the first two digits “45,” which identifies “Retail Trade”; the restaurant would be classified under “Accommodation and Food Service,” which is “72.” If multiple businesses have the same first two digits, they are not considered separate businesses of the exempt organization. If the digits are different, they must file a separate Form 990-T schedule for each business with gross income of at least $1,000. In addition, one unrelated business cannot reduce its tax obligation by using the net operating loss (NOL) of another. So if the arboretum’s greenhouse made a profit, it could not reduce its taxes by using the restaurant’s NOL. Each “separate” unrelated business must stand on its own.

  • Unrelated businesses in the nature of investments. An exempt organization may be permitted to treat various investments that are subject to UBTI as one distinct unrelated trade or business. This allows the organization to invest in multiple unrelated businesses that can be combined for UBTI purposes into one “business” classified as investment activity. The regulations limit such investments to
    • qualifying partnership interests (QPI),
    • qualifying S corporation interests (QSI), and
    • debt-financed properties.

An exempt organization may identify “investment activities” on its Form 990-T (Schedule A)—using a six-digit non-NAICS code rather than the two-digit NAICS code. But it can classify multiple unrelated investments as investment activity on one Schedule A only if each of the investments is one of the types just mentioned. The organization has a QPI in an unrelated trade or business if the organization

  • is not a general partner in the partnership, and
  • either holds no more than a 2 percent interest in the profits or capital, or holds no more than 20 percent of the capital interest and does not significantly participate in the partnership.

The regulations contain similar rules for a QSI. But instead of using the term “profits or capital interest,” the tern “stock ownership” is used. So for investments in both partnerships and S corporations, exempt organizations with limited ownership and involvement can combine such investments into one unrelated business classified as “investment activity.” This approach gives exempt organizations more investment flexibility by reducing their need to obtain information from entities they invest in—information that may be harder for a small investor to readily obtain.

Debt-financed properties are likely to be included in this investment activity category because special UBTI rules already apply to such properties. Grouping other investments together may be a practical way for the IRS to simplify Form 990-T filing, thus ensuring greater compliance.

Practical Impact on Retirement Plans

The only specific plan provision in the final regulations—adopted without change from the proposed regulations—merely codified a rule that the IRS has operated under for years. This addition clarifies that the definition of unrelated trade or business for trusts (such as qualified retirement plan trusts) also applies to IRAs.

Other than that, the effects on plans, if they apply at all, are likely minor. But they are still important. Consider a self-directed account owner, for example, who has invested in a debt-financed rental property and has also bought (at arm’s length) a very small interest in a partnership (a QPI). Historically, if each investment generated at least $1,000 in gross income, each would be reported as a separate business (with a separate Form 990-T schedule). Now it is clear that multiple investments can be more easily grouped into one classification: investment activities. And to the extent that different investments in a plan can be aggregated, there is less concern about the new limitation on NOLs reducing profits in another unrelated business. Most SDAs will simply require a Form 990-T with a single Schedule A that accounts for all their unrelated business investments.

Conclusion

Although these regulations may have little effect on retirement plans, those who work with self-directed retirement plans should consider the following questions.

  • Do any of my plans contain investments that may generate UBTI?
  • If so, do I know who is responsible for filing IRS Form 990-T? While a financial organization that operates in the self-directed account sector may file this form routinely (when needed), it may be worth verifying what the trust agreement or other controlling documents state.
  • Does the entity filing Form 990-T know about the details of the final regulation? While the implications of the final regulations are relatively minor, knowing the details can still be helpful.

The IRS has released a draft version of the updated Form 990-T (and instructions), which contain details on the filing requirements mentioned in the final regulations.

Please visit ascensus.com for the latest news and developments.

 

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IRS Details Additional Temporary Guidance for Cafeteria Plans

The IRS has issued Notice 2021-15, providing additional guidance and flexibility to employee benefit plans offering health FSA and dependent care arrangements. Because of COVID-19, employees participating in these programs are more likely to have unused amounts in these accounts as a result of changes in anticipated expenses during the pandemic. To qualify as a cafeteria plan under IRC Section 125, funds remaining at the end of the plan year generally cannot be carried over to future plan years, and restrictions apply when modifying elections after the start of the plan year.

While initial temporary relief was made available for 2020, the Consolidated Appropriations Act of 2021, enacted in December 2020, provides the following additional flexibility for 2021 and 2022 plan years.

  • Permits post-termination reimbursements through the end of the plan year that participation ceased for health and dependent care FSAs.
  • Creates special rule for dependent care programs, allowing the plan to substitute “under age 14” for “under age 13” as the maximum age for qualifying dependents.
  • Provides carryover of unused funds into the subsequent plan year from the 2020 and 2021 plan years.
  • Allows health and dependent care FSAs to offer a grace period extension of 12 months after the end of the plan year.
  • Permits mid-year election changes by plan participants of health and dependent care FSAs for plan years ending in 2021 without a change in status.

Notice 2021-15 provides illustrative examples of these provisions, details on interaction with COBRA continuation coverage, and timing of plan amendments. The notice also provides additional relief that allows employers to retroactively amend their

  • cafeteria plans to permit mid-year election changes for employer-sponsored health coverage, and
  • health reimbursement arrangements to permit reimbursement of over-the-counter drugs without a prescription and menstrual care products.

IRS Confirms Late Mailing of Notices for 2019 Forms 5500 Series Extension Approvals

The IRS has announced in an Employee Plans News bulletin that processing requests for an extension of time to file 2019 Forms 5500 series returns were delayed in 2020, resulting in delayed mailing of Notice CP 216F.

Form 5500 is generally due by the last day of the seventh month following the end of the plan year being reported. But plan sponsors can request a 2½ month extension by filing Form 5558, Application for Extension of Time to File Certain Employee Plan Returns. Notice CP 216F confirms approval of the requested extension and is typically mailed before returns are due. Notices for 2019 Form 5500 extensions, however, are being mailed months after this timeframe.

Plan sponsors that are just receiving the Notice CP 216F for 2019 Form 5500 filings can be assured that the extension has been approved and that no further action is necessary.


Retirement Spotlight: IRS Aims to Clarify 60-Day Postponement Rule for Federally Declared Disasters

At the end of 2019, the Internal Revenue Code (IRC) was amended to create a mandatory 60-day postponement for certain federal tax-related deadlines in the event of a disaster. This new provision was designed to ensure that affected taxpayers would have guaranteed relief while recovering from a natural disaster or other emergency. But this measure didn’t seem to affect how the IRS had already been responding to such events. In fact, the new law created some ambiguity. In an effort to address this uncertainty, the IRS has released proposed regulations. These regulations provide more information about

  • what time-sensitive tax acts are covered;
  • how the 60-day postponement is determined; and
  • how the phrase, “federally declared disaster,” is defined for purposes of this 60-day period.

These regulations make it clear that the practical applicability of the automatic 60-day rule still ultimately depends on the IRS’s granting of deadline relief when disasters happen. And because the IRS has already been doing this—typically granting more than 60 days—there may not be a noticeable change.

60-Day Postponement Rule

The mandatory 60-day postponement rule was added (as IRC Sec. 7508A(d)) by the Taxpayer Certainty and Disaster Tax Relief Act of 2019. (This act was part of the Further Consolidated Appropriations Act, which also contained the SECURE Act.) It requires the IRS to automatically postpone for 60 days certain time-sensitive, federal tax-related deadlines—including those related to retirement savings plans—in response to federally declared disasters that occur on or after December 21, 2019.

The rule applies to taxpayers

  • who reside in or were injured or killed in a disaster area,
  • who have principal places of business in the disaster area,
  • who are relief workers providing assistance in a disaster area, or
  • whose tax records necessary to meet a tax deadline are located in a disaster area.

The IRS already had the authority under IRC Sec. 7508A to extend certain tax-related deadlines for up to one year in response to presidentially declared disasters or terroristic or military actions. The IRS typically makes disaster declarations through news releases, describing the counties affected and the length of the deadline postponement. Extensions typically are 120 days. Some are less. But the 60-day postponement rule ensures at least a minimum time to complete the acts covered by the guidance.

Time-Sensitive Tax Acts

The 60-day postponement statute contains a list of specific time-sensitive, tax-related acts. Those that pertain to retirement plans are

  • making IRA or retirement plan contributions,
  • removing excess IRA contributions,
  • recharacterizing IRA contributions, and
  • completing rollovers.

The proposed regulations point to other time-sensitive acts—specified under IRC Sec. 7508, Treasury Regulations, and IRS Revenue Procedure 2018-58—such as filing IRS Form 5500 for retirement plans and making retirement plan loan payments. Thus, the proposed regulations do not limit the mandatory 60-day postponement to only those acts listed in new IRC Sec. 7508A(d). Instead, they reinforce the IRS’s discretion in identifying which tax-related acts will be postponed.

So, despite the seemingly automatic nature of the new 60-day extension, individuals must still wait for the IRS to grant relief that applies to a specific disaster and to a specific area. If the IRS decides not to postpone a time-sensitive act, the 60-day postponement statute simply doesn’t apply. On the other hand (for disasters with incident dates), if the IRS postpones an act, the postponement must be for at least 60 days.

60-Day Postponement Period

The mandatory 60-day postponement period generally begins on the earliest “incident date” specified in a Federal Emergency Management Agency (FEMA) disaster declaration and ends on the date that is 60 days after the latest incident date. For example, consider a hurricane battering a coastal state for several days. FEMA announces a disaster declaration that is approved by the president. It specifies the earliest incident date for the affected counties as August 15 and the latest incident date (when the flooding ends) as August 19. The deadline postponement begins on August 15 and ends 60 days from August 19.

Under the 60-day postponement statute, however, it is unclear how the 60-day period is calculated when the disaster declaration either does not contain an incident end date or does not contain any incident dates. This happened with the president’s March 13, 2020, emergency coronavirus declaration: no incident date was specified, and no latest incident date has yet been determined. The proposed regulations simply state that in such a case no mandatory postponement period applies. Rather, the IRS will determine the postponement period—under its discretionary authority under IRC Sec. 7508A(a)—not to exceed one year.

Federally Declared Disaster

The 60-day postponement statute uses the phrases “disaster area” and “federally declared disaster” and cites the definitions found in IRC Sec. 165(i)(5). There, “federally declared disaster” is defined as ‘‘any disaster subsequently determined by the President of the United States to warrant assistance by the Federal Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.’’ But the words “federally declared disaster” are not used in the Stafford Act. Instead, the Stafford Act uses the terms ‘‘emergency,’’ ‘‘major disaster,’’ and ‘‘disaster (used to refer to both emergencies and major disasters).”

This language difference between IRC Sec. 165(i)(5) and the Stafford Act has led to some misunderstanding. For this reason, the IRS has also amended the regulations under IRC Sec. 165 to clarify that the term “federally declared disaster” includes references to both “major disaster” and “emergency,” as defined in the Stafford Act.

The Takeaway

The IRS is accepting comments on all aspects of the proposed regulations before they are adopted as final. Written or electronic comments and requests for a public hearing must be received by March 15, 2021.These regulations—when made final—may clarify the interplay between the new mandatory 60-day postponement rule and existing disaster relief. But practically, not much is likely to change. The IRS will continue to exercise its considerable authority to postpone tax-related deadlines. Postponements will generally continue to exceed 60 days. And individuals will still rely on the IRS to identify which disasters and tax-related items will qualify for deadline postponement.

Visit ascensus.com for further developments on this and other guidance.

 

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Washington Pulse: IRS Releases Final QPLO Regulations

Plan participants have more time to roll over certain plan loan offsets under the Tax Cuts & Jobs Act of 2017 (TCJA). These are known as qualified plan loan offsets (QPLOs). In response to this legislative change, the IRS released proposed regulations in August 2020. The IRS finalized the regulations in December 2020, with only one modification: the applicability date.

The IRS had previously stated that the regulations, once finalized, would apply to plan loan offset amounts treated as distributed on or after the date the final regulations were published in the Federal Register. Plan administrators and service providers were concerned that, if the final regulations were published in 2020, then they would not have enough time to implement the required changes for reporting distributions on the 2020 IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

To help alleviate this concern, the IRS revised the applicability date. The final regulations apply to plan loan offsets treated as distributed on or after January 1, 2021. The new applicability date will affect how QPLOs are reported on 2021 Forms 1099-R, which won’t be sent to taxpayers until January 2022. Taxpayers—including Form 1099-R filers—may, however, choose to rely on these final regulations for plan loan offset amounts that were treated as distributed on or after August 20, 2020—the date the IRS released the proposed regulations.

Overview

A plan loan offset is generally described as the process by which a participant’s accrued benefit is reduced (offset) in order to repay an outstanding plan loan. The offset can occur only when the participant has a distributable event, such as a severance from employment. Often, plan loan policies require loan repayments to be made through payroll withholding, so former employees cannot continue previously scheduled loan payments. In this case, a loan default occurs when a participant leaves the employer. At that point, the participant can cure the default by paying off the loan balance.

More likely, however, is that the participant will request a total distribution, and the plan administrator will offset the loan amount, removing it as a plan asset. This cancelled loan amount—the offset amount—is not simply “forgiven.” It is considered an actual distribution and is taxable to the former participant for the year in which it is offset, unless it is rolled over. But often participants will not do this. It could be that they don’t have the out-of-pocket funds to roll over the offset amount. Or perhaps they don’t understand their options.

Before the TCJA was enacted, participants had to complete the rollover within 60 days of the loan offset. While this may be enough time for some participants, others might not understand that the offset amount is taxable until they receive a Form 1099-R, which may be well after the 60-day time frame. More fundamentally, 60 days doesn’t provide much time to come up with the money to roll over the offset amount. If a participant cannot repay the loan to the plan, it’s also unlikely that the participant can make up the offset amount by rolling over the loan amount into another eligible plan within 60 days. Under the TCJA, participants have a much longer time period to complete a rollover of certain loan offsets.

Existing Rules Still Apply

Many of the familiar rollover rules pertaining to offset amounts remain intact. For instance, the final regulations still contain a definition of “plan loan offset amount,” which is eligible to roll over within 60 days. And Treasury Regulation (Treas. Reg.) 1.401(a)(31)-1 Q&A-16 still applies. This provision exempts offsets from the requirement that a plan administrator must offer a direct rollover option on all eligible rollover distributions. Although offset amounts are eligible for rollover treatment, they cannot be rolled over directly because the outstanding loan assets are no longer in an account that can be paid to another eligible plan. Instead, participants can indirectly roll over offset amounts.

Another rule, under Treas. Reg. 31.3405(c)-1, Q&A-11, provides that offset amounts alone are not subject to 20 percent mandatory federal withholding. But if the offset is processed along with a cash distribution that is also an eligible rollover distribution, then the plan administrator must calculate the 20 percent withholding based on the sum of the cash distribution plus the offset amount.

Example: A participant quits his job and requests a lump-sum distribution of his entire account balance. This balance includes $7,000 in cash and a $3,000 unpaid loan amount, which is offset in accordance with the plan’s loan policy. The total distribution eligible for rollover is $10,000. Therefore, the plan administrator must withhold $2,000 on the lump-sum distribution, which is equal to 20 percent of the total $10,000 eligible rollover distribution. The plan administrator withholds $2,000 from the $7,000 cash portion of the distribution and sends the participant a $5,000 check. If the participant had requested a direct rollover of the $7,000, no withholding would apply, and the $3,000 QPLO could be rolled over from the participant’s other assets.

QPLO Requirements

While “regular” plan loan offset amounts still exist, a QPLO describes offsets that occur only upon plan termination or severance from employment. Plan participants and spousal beneficiaries have until their tax filing deadline (including extensions) for the taxable year in which a QPLO occurs to indirectly roll over all or part of the loan offset amount to another eligible retirement plan or IRA. This rule applies to QPLOs from 401(a) plans (such as profit sharing plans, 401(k) plans, and defined benefit plans), 403(a) plans, 403(b) plans, and governmental 457(b) plans.

Two “Qualifying” Conditions

The proposed regulations define a QPLO as a plan loan offset amount that meets the following two conditions.

  • The loan amount is treated as distributed from an eligible employer plan to a participant or spousal beneficiary either because the eligible employer plan was terminated or because the participant incurred a severance from employment that caused a failure to meet the loan repayment terms.
  • The loan offset amount must relate to a plan loan that met the requirements of Internal Revenue Code Section (IRC Sec.) 72(p)(2) immediately before the plan termination or the participant’s severance from employment.

IRC Sec.72(p)(2) contains the plan loan conditions that must be met to avoid treating a loan as a distribution. Such conditions normally include the $50,000 limitation, the five-year term maximum, and the level repayment requirement. If these loan requirements are not met immediately before the loan offset occurs, the offset amount cannot be treated as a QPLO.

Example: Participant B and Participant C both take loans in 2019 from Plan X. Participant B’s loan meets all of the conditions of IRC. Sec. 72(p)(2), and she has not missed any payments on her loan when her plan is terminated on August 1, 2021. Any offset amount may be considered a QPLO because all loan requirements were satisfied immediately before plan termination.

On January 1, 2021, Participant C defaulted on his loan payments. The employer provided a cure period until June 30, 2021, during which Participant C made no repayments. When the plan terminates on August 1, 2021, Participant C’s loan offset amount will not be a QPLO because the loan did not satisfy the level repayment requirement immediately before plan termination. It will, however, still be eligible to be rolled over within 60 days.

Automatic Six-Month Rollover Extension

In the final regulations, the IRS has clarified that the automatic six-month extension under Treas. Reg. 301.9100-2(b) also applies to the deadline by which a QPLO must be rolled over, provided that

  • the taxpayer files a timely tax return, and
  • the taxpayer takes corrective action within the six-month period.

If these requirements are met, taxpayers will normally have until October 15 of the year following the QPLO distribution to roll over that amount.

Example: On June 1, 2020, Participant D has a $10,000 QPLO amount that is distributed from her plan. The automatic six-month extension applies if Participant D timely files her tax return (generally by April 15, 2021), rolls over the QPLO amount, and if necessary, amends her tax return by October 15, 2021, to reflect the rollover.

12-Month “Bright-Line” Test

Both the proposed and the final regulations contain a test that is designed to help plan administrators identify QPLOs after a severance from employment. A plan loan offset amount will meet the severance-from-employment requirement if the plan loan offset 1) relates to a failure to meet the loan’s repayment terms solely because of the severance, and 2) occurs within the period beginning on the date of the participant’s severance from employment and ending on the first anniversary of that date.

As a result, plan administrators must not report an offset as a QPLO if the offset occurs more than 12 months after the participant’s severance from employment. Offsets occurring after the 12-month period will be treated like regular loan offset amounts, which are subject to the 60-day indirect rollover deadline.

Form 1099-R Reporting Requirements

Plan administrators must report whether a distribution is a regular offset amount or a QPLO on Form 1099-R. The 2021 Form 1099-R instructions provide that if a participant’s accrued benefit is offset to repay a loan (a regular offset amount), the plan administrator should report the distribution as an actual distribution (code 1 for an early distribution or code 7 for a normal distribution) in Box 7 and not use code L, which is used only for deemed distributions. But for a QPLO, the plan administrator should enter code M in Box 7, along with any other applicable code.

Next Steps

Because the delayed applicability date is the only change contained in the final regulations, plan administrators, recordkeepers, and service providers have received additional time to comply with the new regulations. Plan administrators should start working with their service providers, if applicable, to create procedures for tracking severance of employment dates and to ensure that their systems can report QPLOs properly on Form 1099-R.

Please visit ascensus.com for the latest news and developments.

 

 

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IRS Signals Compatibility of Pre-Approved Plan Documents and PEPs

The IRS in its January 20, 2021 edition of Employee Plans News has revealed that pre-approved qualified retirement plan documents may be used to establish arrangements known as pooled employer plans, or PEPs. These arrangements are a type of multiple employer plan (MEP) in which several employers may participate in this common plan structure. But PEPs are less likely to have common interest or common ownership among participating employers than is required of conventional MEPs.

The IRS indicated in Employee Plans News that it is creating language that can be used to amend current pre-approved qualified retirement plan documents to add a PEP feature. Document providers are not required to use IRS-drafted amendment language, but if drafting their own they “will not have reliance on those provisions,” the IRS states.

The PEP structure was created by provisions of the Setting Every Community up for Retirement Enhancement (SECURE) Act of 2019. PEPs are intended to consolidate plan administration functions, and these functions are to be carried out by a pooled plan provider that must register as a named fiduciary with the Department of Labor’s Employee Benefits Security Administration.


Retirement Spotlight: IRS Gives SECURE Act Guidance on Traditional and QACA Safe Harbor Plans

The SECURE Act makes it easier for employers to adopt ADP/ACP safe harbor plan provisions. These plans, which include both “traditional” safe harbor plans and qualified automatic contribution arrangements (QACAs), have proven popular with many employers. This is because such plans are usually deemed to pass several nondiscrimination tests. IRS Notice 2020-86 provides guidance on some of the details of these SECURE Act provisions, including direction on amendments and notices. But while this notice gives important direction, we await more comprehensive regulatory guidance.

 

Background

Retirement plans, such as 401(k) plans, are subject to various nondiscrimination tests. The ADP test1 applies to employee deferrals and the ACP test2 applies to matching and after-tax contributions. The top-heavy test helps ensure that key employees’ accounts do not contain a disproportionate share of overall plan assets. Failing these tests can result in certain employees having to remove deferrals or in employers having to make additional—and at times substantial—contributions. But Internal Revenue Code Sections (IRC Secs.) 401(k)(12) and 401(k)(13) contain provisions that allow employers to avoid the ADP test. And if certain other conditions are satisfied, they can also avoid the ACP and top-heavy tests. Plans known as traditional safe harbor plans and QACA safe harbor plans must meet the requirements of IRC Secs. 401(k)(12) and (13), respectively. Employers that have these plans must make the proper matching or nonelective contributions to non-highly compensated employees.

Employers with traditional safe harbor 401(k) plans must make either a matching contribution to those who defer income into the plan, or a nonelective contribution of 3 percent, which goes to all employees that are eligible to participate in the plan. Employers with QACA safe harbor plans must make similar contributions and must enroll eligible employees in the plan automatically. These employees must have at least 3 percent of their compensation deferred into the plan in the first year—unless they opt out or choose a different deferral amount. Each year, the deferral percentage is increased by at least 1 percent. When an employee’s deferral percentage reaches 6 percent, it can remain there, or it can continue to increase until the percentage cap is reached. Before the SECURE Act, the cap was set at 10 percent.

For all the benefits of adopting a traditional or a QACA safe harbor plan, there have been some concerns about the requirements that apply to these plans.

  • Employers must generally maintain the plan under the traditional or QACA safe harbor rules for the entire plan year.
  • Detailed notice requirements—in addition to other 401(k) notices—accompany these plans.
  • The QACA 10 percent automatic deferral cap may not provide employers with enough plan design flexibility or may not encourage a high enough savings rate.

 

SECURE Act Provisions

The SECURE Act, generally effective for plan years beginning on or after January 1, 2020, provides relief from some of the restrictions of the previous rules.

QACA plans now have a higher cap on deferral percentages Instead of the previous 10 percent cap on automatic deferrals, QACAs now have a maximum 15 percent default deferral rate. During the initial plan year, employers may automatically enroll eligible employees at a default rate ranging from 3 percent to 10 percent of their compensation. Employers may then automatically increase the deferral rate to 15 percent in the second year. Most employers, however, will likely increase the deferral rates more gradually. (The QACA rules still require the automatic deferral amount to be at least 4 percent in the second year, 5 percent in the third year, and 6 percent in the fourth year.)

Employers that make nonelective contributions may have reduced notice requirements and more opportunities to adopt a safe harbor feature – Under the old rules, an employer could amend an existing 401(k) plan to add a safe harbor nonelective contribution up to 30 days before the end of the plan year. But this was only allowed if the employer provided a contingent notice before the start of the plan year and a follow-up notice 30 days before the end of the plan year. Now, an employer may more easily adopt a safe harbor nonelective contribution design mid-year—without first providing notices—but only if the contribution is made on employees’ full-year compensation. This change allows employers to amend their plans, for example, if they discover that they are failing the ADP test for the current year. By adopting a safe harbor nonelective contribution feature, an employer may avoid the ADP test—and usually the ACP and top-heavy tests, as well. But specific contribution and timing rules apply.

  • As before, an employer may amend the plan up to 30 days before the end of the current plan year. Eligible participants must still receive a 3 percent nonelective contribution based on their full-year compensation. But in some cases, the SECURE Act removed the need to provide a contingent and follow-up notice.
  • The SECURE Act now allows an employer to amend the plan up to the end of the following plan year, but only if eligible participants receive a 4 percent nonelective contribution based on full-year compensation. For example, an employer could add a safe harbor feature to a calendar-year plan for 2020 up until December 31, 2021.

 

Notice 2020-86 Provides Details

Notice 2020-86 offers guidance on both the QACA default deferral cap and on electing safe harbor 401(k) status. The notice also acknowledges that more complete guidance is needed, stating that the notice “is intended to assist taxpayers by providing guidance on particular issues while the Treasury Department and the IRS develop regulations to fully implement these sections of the SECURE Act.”

While more than half of the notice deals with a variety of specific notice issues, the following items are the most relevant.

The 15 percent cap on QACA default deferrals – Employers may choose to amend their QACA plans to reflect the increase in the maximum automatic deferral percentage to 15 percent. For example, an employer with a plan that expressly limits the default deferral percentage to 10 percent may retain this provision.

But the notice also addresses other plans that may incorporate the maximum default percentage by reference to the statute. Because the SECURE Act raised the statutory cap to 15 percent, those employers that apply the statutory limit in the plan will raise the plan’s cap to 15 percent by default. On the other hand, for a plan that incorporates the statutory limit, the employer could keep the cap at 10 percent. But the employer would have to document this decision, continue to consistently apply this cap, and amend the plan by the deadline (discussed below).

Notice requirements – Traditional and QACA safe harbor regulations have allowed a safe harbor provision to be added to a 401(k) plan mid-year if the employer 1) gives the nonelective safe harbor contribution (versus a matching contribution) and 2) provides the proper notices. The regulations required two distinct notices: a contingent notice and a follow-up notice. The contingent notice was required to be given a reasonable time before the beginning of each plan year, specifying that the plan may be amended mid-year to provide a nonelective contribution to satisfy the safe harbor rules. A follow-up notice would be required—at least 30 days before the end of the plan year—if the employer amended the plan mid-year to adopt the safe harbor provision.

  • The SECURE Act eliminated the notice requirements in IRC Secs. 401(k)(12) and 401(k)(13) for employers that adopt a nonelective safe harbor feature. For example, consider a 401(k) plan that has only a deferral feature and no employer contributions. If an employer determines during the year that the plan will fail the ADP test, providing a 3 percent nonelective contribution will allow the plan to be treated as passing the test. (If no other contributions are made, the plan is also deemed to pass the ACP test and the top-heavy test.)
  • The SECURE Act did not, however, eliminate the notice requirements of IRC Sec. 401(m)(11), which address the ACP test requirements for plans that provide for matching (or after-tax) contributions. Consequently, plans that allow for matching contributions that fall within the ACP test safe harbor limitations (e.g., no match on deferrals that exceed 6 percent of a participant’s compensation) are still subject to the notice requirements that normally apply to traditional safe harbor plans. The result is different for QACA arrangements where employers are making safe harbor nonelective contributions. This is because the SECURE Act did eliminate the safe harbor notice requirement under IRC Sec. 401(m)(12) for those plans. QACA arrangements are, however, still subject to annual notice requirements that allow plan participants to opt out of automatic contributions.
  • Notice 2020-86 uses several examples to illustrate when various notices are required. Some of these examples also show the complexities of the notice requirements. In Q&A 4, the notice uses an example of a 401(k) plan that meets the ADP safe harbor nonelective contribution requirement and also provides matching contributions that are not intended to satisfy ACP safe harbor rules. The plan does not need to satisfy the ADP or ACP safe harbor notice requirements, but it must satisfy the ACP test.
  • Notice 2020-86 points out that the requirements for permissible reduction or suspension of safe harbor contributions have not changed. For example, if an employer wishes to amend a plan to remove the safe harbor contribution requirements during a plan year, it either 1) must be operating at an economic loss, or 2) must have included in the notice a statement that the plan may be amended during the year to reduce or suspend contributions. While certain notice requirements have been eliminated, employers wishing to retain the option to reduce or suspend contributions should continue providing this language to participants.
  • Notice 2020-86 addresses numerous combinations of nonelective and matching contributions for both traditional and QACA safe harbor plans. But because the IRS is expected to release additional guidance, employers may choose to continue providing the same safe harbor notices that they have been providing—even if they may not be required to in every case.
  • To assist with providing notices in general, Q&A 7 contains further relief. For the first plan year beginning after December 31, 2020, safe harbor notices will be considered timely if given to each eligible employee 30 days before the beginning of the plan year or January 31, 2021, whichever is later. For calendar-year plans, this gives employers approximately 60 days more than normally allowed.

Amendment requirements – Throughout Notice 2020-86, the IRS points out that employers must generally amend their plans for SECURE Act provisions by the end of the plan year that starts on or after January 1, 2022. (Governmental plans have two additional years to amend.) Of course, plans must operationally comply with whatever plan provision is in effect before the formal amendment. In addition, a plan may be amended after the applicable SECURE Act plan amendment deadline, in accordance with the plan amendment provisions that apply to adopting the nonelective safe harbor provisions in the SECURE Act. So if adopting a 3 percent nonelective contribution in the current year, the employer must amend the plan before the 30th day before the end of the plan year. If adopting a 4 percent nonelective safe harbor contribution for the previous plan year, the employer must amend the plan by the end of year following the year to which the amendment applies.

Contribution deductibility – The notice also addresses contribution deductibility when a plan adopts the 4 percent nonelective safe harbor feature. It clarifies that, to claim a deduction for the year for which the contribution is made, the contribution must be made by the tax return due date, plus extensions, for the business. If the employer makes the safe harbor contribution after that date, the deduction may be taken for the taxable year in which the contribution is made, to the extent otherwise deductible under IRC. Sec. 404.

 

Looking Ahead

While Notice 2020-86 provides needed guidance on a few particular issues, the IRS has indicated that more comprehensive regulatory guidance is coming. Ascensus will continue to follow any new guidance as it is released. Visit ascensus.com for further developments on this and other guidance.

 

Click here for a printable version of this issue of the Retirement Spotlight.

 

 

 

1The ADP test—or the actual deferral percentage test—compares the highly compensated employees’ (HCEs’) deferral percentage with the nonHCEs’ average deferral percentage. This test helps ensure that HCEs do not contribute a disproportionate percentage of deferrals in relation to nonHCEs.

2The ACP test—or the actual contribution percentage test—is like the ADP test. But the ACP test compares the HCEs’ percentage of matching and after-tax contributions with the nonHCEs’ percentages of such contributions.


Washington Pulse: IRS Issues Final Life Expectancy Regulations

On November 12, 2020, the IRS published final regulations updating life expectancy tables that are used for required minimum distributions (RMDs) and for other purposes. These new tables reflect an increase in life expectancies since the last tables were issued nearly 20 years ago. Although the updated tables do not apply until distribution years beginning in 2022, financial professionals should learn how the new life expectancy figures may affect their clients and should assess how their administrative systems will accommodate the changes.

 

Background

Two years ago, President Trump issued Executive Order 13847, which (among other things) directed the IRS to examine the life expectancy tables and to “determine whether they should be updated to reflect current mortality data and whether such updates should be made annually or on another periodic basis.” On November 8, 2019, the IRS published proposed regulations in response to the executive order. The IRS received numerous comments, but the only substantial change made in creating the final regulations was pushing back the applicability date to the 2022 calendar year.

Internal Revenue Code Section (IRC Sec.) 401(a)(9) and associated RMD regulations require “employees” to begin distributing their accumulated retirement assets by their required beginning date. (In this article, we will use the term “employee” because that is the term found in the Internal Revenue Code. It includes qualified plan participants, IRA owners, and all those who must take RMDs (e.g., beneficiaries).) The RMD rules help ensure that employees start taking distributions, and they permit payments over their life expectancy to avoid outliving their retirement savings. The IRS life expectancy tables determine the distribution period over which defined contribution-type retirement plans must be paid. The regulations specifically apply to RMDs taken from

  • qualified trusts (such as a 401(k) trust);
  • individual retirement accounts and annuities described in IRC Secs. 408(a) and (b);
  • eligible deferred compensation plans under IRC Sec. 457; and
  • IRC Secs.403(a) and §403(b) annuity contracts, custodial accounts, and retirement income accounts.

The life expectancy tables determine the distribution period for RMDs. The final regulations revise the three life expectancy tables found in Treasury Regulation (Treas. Reg.) 1.401(a)(9)-9. The Uniform Lifetime Table is used to determine the distribution period for those employees who must take RMDs during their lifetime. This table begins at age 72, which is the age at which RMDs must first be calculated under the SECURE Act rules. The distribution periods listed are simply the joint life expectancy of the employee at a certain age and a beneficiary who is exactly 10 years younger. Years ago, the IRS simplified the RMD process by allowing all employees—regardless of their beneficiary’s actual age—to use the Uniform Lifetime Table.

The Joint and Last Survivor Table reflects the life expectancy of two individuals. The ages in the table range from 0 to 120 years, and it shows the likely number of years that at least one of the two individuals will live. Despite listing all combinations of ages up to 120, this table is used in the RMD context for one purpose: to determine the distribution period for an employee who has named the spouse as the sole designated beneficiary—when the spouse is more than 10 years younger than the employee. This allows the employee to calculate the RMD using a longer life expectancy than under the Uniform Lifetime Table, resulting in a smaller RMD.

The third life expectancy table, the Single Life Table, is required in several situations. Perhaps the most common use is for determining the distribution period that a beneficiary must use when an employee dies. For example, assume that an IRA owner dies this year at age 75 and has named his 70-year-old sister as the sole beneficiary. Next year, his sister will determine her distribution period using the Single Life Table. The life expectancy for a (now) 71-year-old is 16.3 years under the current table.

The tables are also used for “substantially equal periodic payments” under IRC Sec. 72(t)(2)(A)(iv). The Internal Revenue Code contains an exception to the 10 percent early distribution penalty tax for certain pre-59½ distributions. Payments must be properly structured using the life expectancy tables contained in the regulations—and they must continue for at least five years and until the recipient reaches age 59½. This payment stream permits access to retirement funds while also preventing excessive fund depletion. The details of setting up such equal periodic payments are found in Revenue Ruling 2002-62, which the IRS expects to update to reflect the changes in the final life expectancy regulations.

 

The Transition Rule

The one provision that will likely create the most activity—and questions—is the final regulation’s “transition rule.” The IRS states that this rule is “designed to recognize that the general population has longer life expectancies than the life expectancies set forth in the formerly applicable Treas. Reg. 1.401(a)(9)-9.” The transition rule allows a beneficiary who has already locked into a life expectancy for RMD payouts to use a “one-time reset” to take advantage of the longer life expectancies in the new tables. This situation occurs when the employee died before January 1, 2021, and the beneficiary was using the old life expectancy tables to determine the RMD. Starting in 2022, the beneficiary’s RMD is based on the new tables, using the age for which the life expectancy was originally determined. An example may help.

Example: Frank died at age 80 in 2018. Frank’s nonspouse beneficiary, Rose, was 75 in the year he died. In 2019, the distribution period that Rose must use is 12.7 (the single life expectancy of a 76-year-old). For her distribution in 2021, Rose reduces that figure to 10.7 years: one year for 2020 and one year for 2021. Normally, Rose would then reduce her distribution period by one more year for 2022, to 9.7. But the transition rule permits Rose to reset her distribution period based on the new tables. Rose still uses her age in the year following Frank’s death, but she simply replaces the old life expectancy, 12.7, with the new one, which is 14.1. She then reduces that figure one year for each subsequent distribution year (2020, 2021, and 2022) to arrive at 11.1 instead of 9.7 (under the old tables).

Although this transition rule makes only incremental decreases in the amount that beneficiaries must distribute, this reset provides some relief for those who wish to distribute the smallest amount required in order to preserve assets. On the other hand, redetermining the distribution periods for beneficiaries who had commenced required distributions before 2022 will entail additional effort by financial organizations, plan administrators, and other advisers.

Note: The proposed regulations seemed to limit the circumstances under which a beneficiary could use the one-time reset. This apparent limitation was likely unintentional. But the final regulations revised the transition rule wording enough to verify a more expansive interpretation of the rule. So irrespective of how a beneficiary came to use the old Single Life Table, the new table can now be used. For those required to use “nonrecalculation” (by reducing the life expectancy by one year for each successive distribution year), the starting age remains the same. Spouse beneficiaries, who may use the “recalculation” method, simply start using the new tables in 2022.

 

Key Takeaways

The final regulations are nearly identical to the proposed regulations. While these new regulations are straightforward, there are still some important points to remember.

  • The new tables apply for distribution calendar years beginning on or after January 1, 2022.
  • The transition rule allows certain beneficiaries a one-time reset to use the longer life expectancies.
  • The IRS expects to review these tables every 10 years (or when new mortality studies are published).
  • The final regulations will require a significant number of individual RMD payout redeterminations.
  • Software platform providers and others may face sizeable programming tasks.

 

Looking Ahead

Fortunately, the IRS heeded commenters’ requests and delayed the final regulations’ applicability date to 2022. This will allow more time for all affected parties to integrate the new tables into their processes. The IRS will also release guidance regarding SECURE Act provisions, such as the rule that replaces certain beneficiary life expectancy payments with a requirement to deplete beneficiary accounts after 10 years. As guidance is released, rely on Ascensus to monitor developments and to publish helpful analysis.

 

 

Click here for a printable version of this issue of the Washington Pulse.


IRS Clarifies Extended Due Date for Single-Employer DB Plan Contributions

The IRS clarified today in IRS Notice 2020-82 that contributions to single-employer defined benefit plans due January 1, 2021, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act are considered timely if they are made no later than Monday, January 4, 2021.

The CARES Act delayed both the annual and quarterly minimum funding contributions for single-employer defined benefit plans to January 1, 2021. While plan sponsors appreciated this delay, this raised a concern, as January 1, 2021, is a federal holiday falling on a Friday. While tax deadlines falling on a federal holiday generally are considered performed timely if they are performed on the next day that isn’t a Saturday, Sunday, or legal holiday, it was unclear if this extension to January 1, 2021, would be considered performed timely if completed on January 4, 2021.

 


Federal Agencies Jointly Issue Final Rule on Transparency In Healthcare Coverage

In response to President Trump’s Executive Order, Improving Price and Quality Transparency in American Healthcare to Put Patients First, the IRS, Department of Labor, and Department of Health and Human Services have jointly issued a Transparency In Coverage final rule. This guidance is intended to make healthcare price information accessible to consumers and other stakeholders to permit comparison-shopping.

The final rule requires that most healthcare plans make available to participants, beneficiaries, and enrollees (or their authorized representative) personalized out-of-pocket cost information, and the underlying negotiated rates for all covered healthcare items and services, including prescription drugs, through an Internet-based, self-service tool and in paper form upon request.

The guidance also requires most healthcare plans to make available to the public, including stakeholders such as consumers, researchers, employers, and third-party developers, three separate machine-readable files that include detailed pricing information. The detailed pricing information is to include 1) negotiated rates for all covered items and services between the plan or issuer and in-network providers; 2) historical payments to, and billed charges from, out-of-network providers; and 3) in-network negotiated rates and historical net prices for all covered prescription drugs by plan or issuer at the pharmacy location level.