In June of 2008, the Heroes Earnings Assistance and Relief Tax (“HEART”) Act became law. The Act made a number of significant changes to the treatment of military reservists under employee benefit plans. In an August 2008 article, we summarized those changes as they applied to qualified defined benefit and defined contribution plans, Section 403(b) plans, and Section 457(b) plans. In January of 2010, the IRS issued Notice 2010-15 (the “Notice”), which contains guidance on a number of the Act’s provisions. This article summarizes the most significant and surprising elements of that guidance, which apply to differential wage payments, “in-service” distributions on a reservist’s deemed severance from employment, and the Act’s mandatory death benefit provisions.
DIFFERENTIAL WAGE PAYMENTS
Some employers continue to pay part or all of a reservist’s wages when the reservist is called to active duty. As we reported in our earlier article, the HEART Act changed the tax treatment of these “differential wage” payments. Prior to the Act, differential wage recipients were usually treated as independent contractors. Accordingly, differential wages were usually reported on Form 1099, rather than Form W-2. The HEART Act required that such payments not only be treated as W-2 wages, but that they be treated as “compensation” for retirement plan purposes.
Based on the language of the statute (and the conference committee report on the new statutory language), most employers and commentators concluded that differential wage payments must be included as compensation for benefit accrual purposes under retirement plans covered by the Act. In the Notice, however, the IRS has taken a contrary position.
According to the Notice, differential wage payments must be treated as compensation only for purposes of applying the annual Code Section 415 limits. They may — but need not — be treated as compensation for benefit accrual purposes.
In fact, the Notice states that differential wage payments need not be included in a plan’s accrual definition of compensation, even if that definition is intended to satisfy a nondiscrimination safe harbor under Code Section 414(s). This is a surprising interpretation because such safe-harbor definitions must be based on a definition of compensation that could be used for Section 415 testing. The Notice does not explain (or cite any authority for) this interpretation.
DISTRIBUTIONS UPON DEEMED SEVERANCE FROM EMPLOYMENT
As we discussed in our August 2008 article, the HEART Act includes a rule intended to facilitate “in-service” distributions from defined contribution plans. Such plans are required to treat participants who have been on active duty in the uniformed services for more than 30 days as having severed their employment for purposes of determining whether they are eligible for a distribution of the following amounts: 401(k) elective deferrals; salary reduction amounts under Section 403(b) plans; contributions to 403(b)(7) custodial accounts; and deferrals under eligible Section 457(b) plans. Recipients of such “in-service” distributions are not permitted to make elective deferrals or employee contributions to the plan for the six months following the distribution.
The statutory language raised three questions with respect to this rule. The first was based on the statutory heading under which the provision appeared, which reads: “Treatment of Differential Wage Payments.” This caption led some commentators to conclude that the “in-service” distribution provisions applies only to differential wage recipients. The Notice clarifies that the rule applies to any participant who has been on active duty for a period of more than 30 days.
The second question was whether plans are required to permit “in-service” distributions once the participant has satisfied the 30-day active-duty requirement. The Notice answers this question in the negative: although plans are required to treat such participants as having experienced a severance from employment, they are not required to provide “in-service” distributions on account of such severance, even if the participant would be entitled to such a distribution upon a true severance from employment.
In other words, affected plans are free to impose two separate rules — one for “true” severances, and another for “deemed” severances. Plan sponsors may wish to amend their plans to clarify when distributions will be permitted based on the two different types of severance.
The final question concerned how to coordinate two closely related types of special distributions to reservists on active duty: qualified reservists distributions (“QRDs”) and “in-service” distributions upon a deemed severance from employment. As discussed in our earlier article, QRDs were created by the Pension Protection Act of 2006 (the “PPA”) to allow certain participants in Section 401(k) and Section 403(b) plans to receive special distributions while on active duty. QRDs are exempt from the 10% penalty that usually applies to distributions made before the participant has attained age 59½, and reservists may “repay” them to an IRA (during a specified two year period), without regard to the usual IRA contribution limit.
The HEART Act eliminated the PPA’s sunset provision, which restricted QRDs to reservists activated before December 31, 2007. The Act did not clarify, however, how QRDs would interact with the newly created “in-service” distributions discussed above. The Notice answers this question: if a plan provides for both QRDs and “in-service” distributions, the distribution is deemed to be a QRD, to the extent possible. Thus, to the extent the distribution can be treated as a QRD, the participant is not subject to the six-month suspension that would apply in the case of an “in-service” distribution, need not pay the 10% penalty even if the amount is received before age 59½, and may repay the amount to an IRA under the QRD repayment rules.
VESTING RULE CLARIFIED FOR MANDATORY DEATH BENEFIT
As discussed in our earlier article, the HEART Act imposed a new requirement when a participant dies on or after January 1, 2007, while performing qualified military service. This rule requires qualified plans, Section 403(b) plans, and governmental Section 457(b) plans to pay any death benefit under the plan as if the participant had returned to work and then terminated employment on account of his or her death.
It was clear under the Act that this rule required such plans to fully vest any participant who died while in military service if the participant would have automatically become fully vested upon death while an active employee. It was also clear that this rule required the plan to provide ancillary life insurance benefits to participants who died in-service, if such benefits would be provided to participants who died while actively employed.
The Notice explains that this rule applies to vesting service, as well. That is, covered plans must provide participants who die while performing qualified military service with vesting credit for that period of military service. Under this rule, if a participant enters qualified military service while nonvested, then dies on or after the date he or she would have become vested had he or she remained an active employee, the plan must vest him or her — even if the plan does not automatically vest active employees on death.
ACTION ITEMS
Sponsors should carefully review their plan documents to ensure compliance with the clarifications (and new rules) included in the Notice.
Plan amendments for the HEART Act’s mandatory provisions are generally not required until the end of the 2010 plan year (2012 for governmental plans). Plan sponsors who have already amended their plans to ensure compliance will need to review those amendments in light of the Notice.
In particular, plan sponsors who amended their plans to include differential wage payments in the plan’s benefit accrual definition of compensation will want to consider whether to change course now that the Notice has provided the option of excluding such payments. Such amendments must, however, be carefully drafted. They might need to be prospective only because anti-cutback rules may apply to benefits already accrued.