Actuarial Assumptions for Withdrawal Liability

 Withdrawal Liability and Actuarial Best Estimate Assumptions – Recent Case-Law

Charles C. Shulman, Esq.
Teaneck, NJ
 201-357-0577 212-380-3834
cshulman@ebeclaw.com

Actuarial assumptions for ERISA withdrawal liability must use the actuary’s best estimate of anticipated experience under the plan. Plan actuaries have divergent ways of measuring unfunded vested benefits for purposes of a participating employer withdrawal from a multiemployer pension plan, sometimes using: (i) ongoing minimum funding assumptions of the plan (a higher rate yields lower withdrawal liability), (ii) termination assumptions (e.g., insurance company annuity close-out rates) (a lower rate yields greater withdrawal liability) or (iii) a blend of the two rates (such as the Segal blend).  Withdrawal liability often causes disproportionate liability on companies that remain in the multiemployer plan after most other employers have withdrawn, the "last man standing" problem, particularly if ongoing minimum funding assumptions have been used for earlier withdrawals.  A 2022 D.C. Circuit Court case held that ongoing funding rates should have been used.  A 2021 Sixth Circuit case held that termination assumptions should be used.  Two 2018 cases held that a blended rate would be appropriate.  This issue is likely to continue through the courts.  Also, the PBGC may be issuing guidance on this issue.

Under ERISA, withdrawal liability is imposed on an employer that withdraws from an underfunded multiemployer pension plans based on its allocated share of the plan's unfunded vested benefits.  ERISA § 4201.  Often, withdrawal liability results in disproportionate liability on companies that remain in the union plan after most other employers have withdrawn—the last man standing problem.

Actuary's Best Estimate of Anticipated Experience of the Plan – ERISA § 4213.  Multiemployer plan withdrawal liability is based on the multiemployer plan's unfunded vested benefits (UVBs) which are the value of vested benefits minus the value of plan assets.  ERISA § 4211.  Under ERISA § 4213, the actuarial assumptions used by the plan actuary to calculate withdrawal liability must be reasonable in the aggregate, based on the experience of the plan and reasonable expectations, and are the actuary's "best estimate" of anticipated experience under the plan.  Once the estimated benefits payments and administrative costs are determined, the actuaries must determine the present value of future liabilities, which are a determination of how much the plan needs in assets today in order to pay those liabilities in the future.  ERISA § 4213(b) provides that in determining the unfunded vested benefits of a pension fund for purposes of determining an employer’s withdrawal liability, the plan actuary may (i) rely on the most recent complete actuarial valuation used for purposes of  IRC § 412 and reasonable estimates for the interim years of the unfunded vested benefits, and (ii) in the absence of complete data, rely on the data available or on data secured by a sampling which can reasonably be expected to be representative of the status of the entire plan.    

Methods Used by Plan Actuaries.  In practice, plan actuaries have divergent ways of measuring unfunded vested benefits.  When there is a withdrawal liability of one participating employer and the fund is ongoing, it would appear reasonable to use ongoing plan minimum funding assumptions or other assumption based on expectation of the plan returns, pension plan minimum funding requirements are typically determined at a higher interest rate, thus yielding a lower withdrawal liability and is more favorable to withdrawing employers.  (Of course, if a multiemployer plan is terminating (a mass termination), the PBGC termination rate assumptions would typically be used.) On the other hand, actuaries sometimes use termination assumptions or insurance company annuity close-out rates, which uses a lower interest rate, thus yielding a higher withdrawal liability and is more favorable to the multiemployer pension fund. 

The plan funding requirements are typically determined at a higher interest rate, thus yielding a lower withdrawal liability and is more favorable to withdrawing employers.  On the other hand, the annuity close-out rates use a lower interest rate, thus yielding a higher withdrawal liability which and is more favorable to the multiemployer pension fund. 

Using Ongoing Plan Assumptions Leads to Backloading – Last Man Standing Problem. Although a multiemployer plan is generally not terminating in a withdrawal liability case, withdrawal liability is different than funding an ongoing plan because it represented, not an ongoing funding relationship, but a one-time transfer of risk from the withdrawing employer to the continuing employers and participants.  Using ongoing funding rates would likely have the result of backloading withdrawal liability obligations to be largest for those who withdraw from the fund the latest.  This disproportionate liability on companies that remain in the union plan after most other employers have withdrawn (the last man standing) causes uneven backloading of liabilities.

D.C. Circuit Court 2022 Case – Ongoing Minimum Funding Rates Should have been Considered.  In a 2022 case the D.C.  Circuit court held that where the multiemployer fund actuary used termination interest assumption of 2.7-2.8% (yielding a very high withdrawal liability) even though the actuary was using a 7.5% assumption for funding purposes, the valuation assumptions must represent the actuary’s best estimate of anticipated experience under the plan, and therefore the withdrawal liability calculations were not reasonable.  United Mine Workers of America 1974 Pension Plan v. Energy West Mining Company, 39 F.4th 730 (D.C.  Cir. 2022) (a multiemployer pension fund brought action under ERISA against a withdrawing employer seeking to enforce arbitrator's award upholding the pension fund actuary's calculation of withdrawal liability through use of a risk-free discount rate; the Circuit Court overturned the arbitrator's ruling since the termination assumption used by plan actuary, which was not chosen based on the plan's projected performance, was not reasonable and instead the actuary should have considered the pension funding discount rate assumptions taking into account anticipated projected investment returns as is applicable for pension minimum funding).

Segal Blend.  Some actuaries use the blend of insurance company annuity close-out rates and plan funding assumptions.  For example, the "Segal Blend" method determines a plan's unfunded vested benefits for withdrawal liability based on a blend of (i) the lower insurance company annuity purchase rates used by the PBGC at current market rates; and (ii) the actuary's assumption of future investment returns used for determining the plan funding requirements.  Although the multiemployer plan is generally not terminating in a withdrawal liability case, withdrawal liability is different than funding an ongoing plan because it represented, not an ongoing funding relationship, but a one-time transfer of risk from the withdrawing employer to the continuing employers and participants.   

Cases Upholding Segal Blend.  Some courts have ruled that blended rates are reasonable, so long as it was the actuary, not the plan's trustees, has chosen to use them.  See, e.g., Manhattan Ford Lincoln Inc. v. UAW Local 259 Pension Fund, 331 F. Supp. 3d 365 (D.N.J. 2018) (arbitrator was not incorrect in allowing the reliance on the Segal Blend as a withdrawal liability is different than merely funding an ongoing plan because it represented, not an ongoing funding relationship, but a one-time transfer of risk from the withdrawing employer to the continuing employers and participants), 2018 WL 10759131 (3d Cir. 2018) (appeal dismissed because parties settled). 

Cases Challenging Segal Blend.  Other cases, however, have held that using a blended rate of the minimum funding interest rate and insurance company annuity close-out rates in a case where the multiemployer plan is not terminated could violate ERISA.  In a 2021 case, Sofco Erectors, Inc. v. Trustees of the Ohio Operating Engineers Pension Fund, 15 F.4th 407 (6th Cir. 2021), the Fund's actuary used a 7.25% growth rate on assets for minimum funding purposes, and only for withdrawal-liability purposes used the Segal Blend taking the interest rate used for minimum-funding purposes (7.25%) and blending it with the PBGC's published interest rates on annuities (2–3%), even though the actuary conceded that the PBGC annuity close-out rates would be what is used in settling up a multiemployer plan.  The court ruled that this blended formula violated ERISA in this case, as using the Segal Blend in an ongoing plan violated ERISA's mandate under ERISA § 4213(a)(1) that the interest rate for withdrawal liability calculations be based on the anticipated experience under the plan). 

Likewise, a 2018 Southern District of New York district court case invalidated the use of the Segal Blend.  New York Times Company v. Newspaper and Mail Delivers’ Publishers Pension Fund, 303 F. Supp. 3d 236 (S.D.N.Y. 2018) (in a withdrawal from an ongoing plan where the minimum funding rate would be the actuary's best estimate, blending with a lower no-risk PBGC bond rates should not be accepted as the anticipated plan experience).

Watch for Future Cases and Future PBGC Guidance.  As shown above, courts are split on whether to use ongoing funding assumptions or termination assumptions or a blend of the two.  This issue is worth following to see how other Circuit Courts or the Supreme Court will rule.  Also, the PBGC has not yet issued regulations or other guidance on what the actuary's best estimate of anticipated experience should be based on, and if the PBGC issues guidance this may change the direction of the courts.

If you have any questions, please contact me at cshulman@ebeclaw.com or 201-357-0577.

Carried Interest Holding Periods

Carried Interest Holding Periods

Charles C. Shulman, Esq.
Teaneck, NJ, 201-357-0577
cshulman@ebeclaw.com

 As discussed in my earlier post on Profits Interest at https://ebeclaw.blogspot.com/2022/03/profits-interests.html , profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met. However, in 2017 this was limited in the case of profits interests (carried interest) for professional investors and real estate development for rental or investment to where the holding period is three years. A 2020 legislative proposal in the pending Inflation Reduction Act to increase the holding period for such carried interest from three years to five years and to only begin only once substantially all the partnership interest subject to IRC § 1061 are acquired by the partnership. However, in further negotiations this proposal was taken out of the final bill. 

Pre-2017 Holding Period for Profits Interests – Two Years from Grant and One Year from Vesting. Prior to the enactment of the Tax Cuts & Jobs Act of 2017, generally long-term capital gain treatment for profits interest would require the general one-year holding period requirement (from the date the profits interests are vested). In addition, Rev. Proc. 93-27 would require that the profits interests be held for at least two-years after the date of grant.

Extended Holding Period for Professional Investors and Real Estate Investment to Three Years Under TCJA of 2017. Legislative changes imposed by the Tax Cuts & Jobs Act of 2017 (effective January 1, 2018) enacted a new IRC § 1061, which imposes a three-year holding period (instead of one year for ordinary capital gains) for an "applicable trade or business," if the partnership owns real estate for rental or investments, since IRC § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on "carried interest" use of long-term capital gains tax rates for fund managers, provides that "applicable partnership interests" which includes professional investors as well as those developing real estate for rental or investment (IRC § 1061(c)(2)), have an increased holding period for long-term capital gains treatment for three years instead of one year. IRC § 1061(a).

2022 Proposed Legislation to Further Extend Holding Period for Such Carried Interest to Five Years, was Removed from the Bill to Win Approval from Sen. Krysten Sinema. Further legislative changes had been proposed in the Inflation Reduction Act in July 2022, H.R. 5376, as agreed to by Senator Charles Schumer and Senator Joe Manchin to amend IRC § 1061 in the following ways: (i) the holding period for "applicable partnership interests" which, under IRC § 1061(c)(2), includes carried interest for professional investors (e.g., private equity firms and hedge funds) and real estate development for rental or investment, would be increased from three years to five years (except with respect to taxpayers with adjusted gross income of less than $400,000); (ii) the five-year holding period would begin only once substantially all the partnership interest subject to § 1061 are acquired by the partnership; and (iii) the holding period would now apply not just to profits interest but also to other income taxed as long-term capital gains, including qualified dividend income included in net capital gain for purposes of IRC § 1(h)(11), gain from the sale of active business assets under IRC § 1231 and regulated futures contracts subject to IRC § 1256. However, it has now been reported on August 4, 2022 that Democrats are revising their Inflation Reduction Act in order to will approval from Senator Kyrsten Sinema (D. Arizona), which, among other things, would drop the proposed tax increase on carried-interest income. However, the carried interest tax change may appear in future legislation.

If you have any questions, please contact me at cshulman@ebeclaw.com or 201-357-0577.

 

Cryptocurrency – An Imprudent 401(k) Investment?

 Cryptocurrency – An Imprudent 401(k) Investment?

 Charles C. Shulman, Esq.

Teaneck, NJ
201-357-0577
cshulman@ebeclaw.com

CAR No. 2022-01: Presumption of Imprudence on Cryptocurrency for 401(k) Plans. On March 10, 2022, the Department of Labor ("DOL") issued Compliance Assistance Release ("CAR") No. 2022-01, cautioning plan fiduciaries to exercise extreme care before they consider adding a "cryptocurrency" option to a 401(k) plan's investment menu for plan participants, and if they do add the cryptocurrency option, they should be prepared for a possible DOL investigation. CAR No. 2022-01 noted that when a 401(k) plan offers a menu of investment options to plan participants, the responsible fiduciaries have an obligation to ensure the prudence of "each" options on an ongoing basis.[1]

CAR No. 2022-01 cited the recent Supreme Court case of Hughes v. Northwestern University, 142 S.Ct. 737, 742 (2022), which held that even in a participant directed plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine whether "each" investment should be prudently included in the plan's menu of options.

CAR No. 2022-01 states that in this early stage in the history of cryptocurrencies, the DOL has serious concerns about the prudence of a fiduciary's decision to expose 401(k) plan participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies, as these are speculative and volatile investments and they present significant risks and challenges to participants' retirement accounts, including significant risks of fraud, theft, and loss, and also raise custodial and recordkeeping concerns. 

DOL Expecting to Investigate Plans that Offer Cryptocurrency – CAR No. 2022-01 noted that the DOL expects to conduct an investigative program aimed at plans that offer participant investments in cryptocurrencies and related products, and to take appropriate action to protect the interests of plan participants and beneficiaries with respect to these investments. Plan fiduciaries responsible for overseeing such investment options or allowing such investments through "brokerage windows" should expect to be questioned about how they can square their actions with their duties of prudence and loyalty in light of the risks described above, according to CAR No. 2022-01.[2]

Fidelity April 2022 Introduction of a Bitcoin Fund in its Core Lineup of 401(k) Investments – Less than two months after the issuance of CAR No. 2022-01, on April 26, 2022 Fidelity Investments announced that it is adding a digital asset fund holding Bitcoin to their core investment lineup for 401(k) funds (although it had been available under its brokerage account for a number of years), and if agreed to by employers for their individual plans, participants will be able to invest up to 20 percent or more of their 401(k) contributions in the Bitcoin fund. This is certainly not congruous with CAR No. 2022-01. However, a DOL official commented on May 23, 2022 that in his view retirement plans that are clients of financial institutions marketing cryptocurrency products will not automatically be subjected to a Department of Labor audit. Reported in Bloomberg Daily Labor Report (May 24, 2022).

Lawsuit Alleging DOL Had no Authority to Issue These New Rules without Administrative Rulemaking and Review – On June 2, 2022, the DOL was sued by ForUsAll, Inc., which was the first 401(k) platform to provide access to cryptocurrency, in the District Court in Washington, D.C., alleging that the DOL violated the Administrative Procedure Act by issuing new fiduciary rules in CAR No. 2022-01 without following the correct procedures.[3] Perhaps in response to this litigation and other pushback on CAR No. 2022-01, DOL Secretary Marty Walsh told a House panel on June 14, 2022 that the DOL is looking at potentially going through a rulemaking process on the cryptocurrency industry as a whole. See Bloomberg Daily Labor Report, June 15, 2022.

Surprises in CAR No. 2021 – CAR No. 2022-01 surprised many practitioners for a number of reasons: (i) CAR No. 2022-01 appears extreme in labeling a cryptocurrency fund from amongst other diverse 401(k) funds as having a presumption of "imprudence;" even if cryptocurrency is volatile and speculative, that contributes not only on the downside but also on the upside; (ii) one would have expected that offering, e.g., a Bitcoin fund as part of a wide variety of diversified funds, and limiting the Bitcoin fund to for example not more than 20% of the account balance, as Fidelity did, should NOT be deemed to be imprudent as a rule or giving rise to an audit for that reason alone; (iii) CAR No. 2022-01 also stated that fiduciaries allowing cryptocurrencies in 401(k) plans even if just though "brokerage windows" should expect to be questioned about how they can square their actions with their ERISA fiduciary duties. Many practitioners were surprised with this added statement, because brokerage windows (which have been around for at least 20 years)[4] have been and continue to be offered in many 401(k) plans, and fiduciaries cannot possibly evaluate each trade in the brokerage accounts.[5]

If you have any questions on this or any other matters, please call me know at 201-357-0577.

Charlie

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[1]       DOL EBSA Compliance Assistance Release No. 2022-01 - 401(k) Plan Investments in "Cryptocurrencies" (March 10, 2022), https://tinyurl.com/DOL-2022-01.  

[2]       DOL EBSA Compliance Assistance Release No. 2022-01.

[3]       ForUsAll, Inc. v U.S. Department of Labor and Martin J Walsh Secretary of Labor Complaint, filed with U.S. Dist. Ct. for D.C. (June 2, 2022), resources.forusall.com/Dkt.%20001%20ForUsAll%20Complaint.pdf

[4]           Field Assistance Bulletin No. 2012-02R (July 30, 2012) in FAB No. 39 notes that the DOL does not prohibit the use of a platform or a brokerage window, self-directed brokerage account, or similar plan arrangement in an individual account plan. In 2014 the DOL solicited comments regarding standards for brokerage windows in participant directed account plans, although no regulations were issued to date. On occasion, an employer might have to file a Form S-8 registration statement for employer stock if the stock may be purchased by 401(k) plan participants through a brokerage account window. 

[5]       It is true, though, that some plans have shied away from brokerage windows because of the increased investment risk and the inability to monitor the investments. 

More MEPs - Less Bad Apples

                                             Multiple Employer Plans under the SECURE Act of 2019 
                                                and Proposed Regulations re  Exemption from One Bad Apple Rule

Charles C. Shulman, Esq.,
Teaneck, NJ
201-357-0577
cshulman@ebeclaw.com

Multiple Employer Retirement Plan Generally

Multiple employer plans, i.e., plans that are maintained by more than one employer that are not collectively bargained, are subject to the more restrictive requirements under Code §413(c). Under Code §413(c), a multiple employer plan is treated as if all the employees were employed by a single employer for the following purposes: age and service requirements of Code §410(a), the exclusive benefit rule of Code §401(a)(2); the vesting rules of Code §411; and the limit on contributions and benefits under Code §415. For other purposes, multiple employer plans are treated as if each employer were maintaining a separate plan, for example: the participation requirements of Code §410(b); the nondiscrimination requirements of Code §401(a)(4); the ADP and ACP tests of Code §§401(k) and 401(m); the vesting requirements upon termination or partial termination; the funding and deductions limits for plans established after 1988; the limit on annual compensation of Code §401(a)(17) and the top-heavy rules of Code §416.  Code § 413(c); Treas. Reg. §1.413–2 and related regulations.

Allowing Unrelated Employers to form a Valid ERISA Multiple Employer Plan (referred to by the SECURE Act of 2019 as a Pooled Employer Plan.

Open MEPs as Separate Employee Benefit Plans Under Pre-SECURE Act Law. Where a service provider sets up a retirement plan for multiple "unrelated" employers with no connection to each other and no connection to the service provider other than the provision of retirement services, the DOL had ruled in a 2012 advisory opinion that this arrangement was not a single multiple-employer plan under ERISA but rather separate employee benefit plans for each employer.

Pre-SECURE Act Efforts to Expand MEPs. There had been efforts even prior to the SECURE Act of 2019 (discussed below) to expand access to workplace retirement plans by small employers, who may not wish to bear the difficulty or expense of setting up their own plans, by allowing such employers to join with certain other employers in a multiple employer defined contribution plan ("MEP").  

Two significant impediments have made setting up MEPs difficult. The first impediment has been that a MEP may be treated by the DOL as separate plans for each employer, especially for non-affiliated employers, requiring separate reporting and disclosure. (The second impediment is the one bad apple rule discussed below.) The DOL in 2019 issued guidance in DOL Reg. § 2510.3-55 to address the above concerns regarding MEPs, with expanded rules as to when separate employers who participate in a defined contribution plan would be considered a single ERISA plan rather than multiple ERISA plans.

SECURE Act of 2019 Expansion of Open MEPs (PEPs). The SECURE Act of 2019, P.L. 116-94 (Dec. 20, 2019), expands the use of multiple employer plans by allowing totally unrelated companies to use a single shared defined contribution "pooled employer plan" (PEP), provided the third-party plan administrator is a "pooled plan provider" that has registered with the DOL and acknowledges that it is a named fiduciary of the plan.

The SECURE Act defines ''pooled employer plan'' in new ERISA § 3(43)(A) as a qualified defined contribution plan or IRA with two or more employers that meets certain additional requirements. Employers in the pooled employer plan need not have a common non-plan-related interest. The plan must designate a pooled plan provider, provide that there will be no unreasonable fees for ceasing participation and to provide for certain disclosure.  Note that the Internal Revenue Code does not use the term "pooled employer plan," but rather refers to a section 413(e) multiple employer plan that has a pooled plan provider.

"Pooled plan provider" is defined in ERISA § 3(44)(A) as (i) a named fiduciary, and plan administrator responsible to perform all administrative duties reasonably necessary to ensure that the plan meets the qualification requirements of Code § 401(a) (or IRA that meets the requirements of Code § 408) and other ERISA requirements, and requiring participating employers to takes actions necessary for the plan to meet the such requirements; (ii) which must register with the DOL as a pooled plan provider; (iii) which must acknowledge its status as a named fiduciary and as the plan administrator; and (iv) which is responsible for ensuring that all persons who handle plan assets or are plan fiduciaries are bonded in accordance with ERISA § 412.

DOL November 2020 Regulations on Registration Requirement for Pooled Plan Providers. The DOL issued regulations in November, 2020, Prop. DOL Reg. § 2510.3-44, effective November 16, 2020, pursuant to ERISA § 3(44)(A)(ii), for registration required 30 to 90 days before beginning operations as a pooled plan provider with certain information about the pooled plan provider on DOL Form PR. Reporting on Form PR is also required if there are changes to the initially reported information or any government agency action or finding of fraud or criminal conduct relating to the assets or the operation of the plan. In addition, a final Form PR is filed on termination or cessation of operations of the pooled plan provider. Form PR must be filed electronically. DOL Reg. § 2510.3-44; Instructions to DOL Form PR.

Increased maximum amount of bond for pooled employer plan. With regard to a fiduciary or person holding assets of a pooled employer plan, the maximum bond amount under ERISA § 412(a) as amended by the SECURE Act of 2019 is $1 million instead of $500,000.

Form 5500 reporting. Form 5500 for all multiple employer plans must include a list of the employers in the plan, a good faith estimate of the percentage of total contributions made by each employer, and the aggregate account balances attributable to each employer.  For pooled employer plans, the Form 5500 now requires identifying information for the pooled plan provider. In addition, the limited scope audit exemption for plans with fewer than 100 participants, which also avoids the need for plan audited financial statements, is modified by the SECURE Act of 2019 to provide that simplified reporting can be used for multiple employer plans that cover fewer than 1,000 participants if no single employer in the plan has 100 or more participants. 

Effective date. These provision applies to plan years beginning after December 31, 2020.

Multiple Employer Plans – "One Bad apple" rule and MEPs Exception

Background. As referenced above, the second impediment to establishing and maintaining MEPs has been the unified-plan rule (also called the "one bad apple" rule) under which if one employer's portion of a multiple employer plan is disqualified the entire multiple employer plan will be disqualified. See, e.g., Treas. Reg. § 1.413-2(a)(3)(iv). The IRS in 2019 gave some relief in Prop. Treas. Reg. § 1.413-2, which would permit an exception to the one bad apple rule if one employer refuses to correct its qualification errors or fails to provide information to the plan administrator regarding a potential disqualification. 

Further Relief in SECURE Act from the One Bad Apple Rule Under Code § 413(e). The SECURE Act of 2019 added Code § 413(e), which provides relief for multiple employer qualified plans or multiple SEP/SIMPLE IRA plans of unrelated employers administered by a pooled plan administer from the ''one bad apple rule'' (also referred to as the uniform rule), that the entire plan will not be disqualified merely because one or more participating employers fail to take actions required by Code §§ 401(a) or 408(a) with respect to the qualified plan or IRA plan. Such relief will only apply if the plan provides that plan assets attributable to employees of the noncompliant employer will be transferred to a plan maintained only by that employer or to an individual tax-favored plans or IRAs and the noncompliant employer would be liable for any plan liabilities due to noncompliance. Code § 413(e) defines "pooled plan provider" substantially the same as ERISA § 3(44).  The DOL and Treasury are directed it issue guidance regarding these provisions. These provision applies to plan years beginning after December 31, 2020.

2022 Proposed Regulations Regarding Exemptions from the One Bad Apple Rule for Section 413(e) Defined Contribution Plans or IRA Plans

Proposed Regulations. On March 28, 2022 the IRS issued proposed Treas. Reg. § 1.413-3 regarding the exception to the one bad apple (uniform plan) rule under Code § 413(e) for multiple employer defined contribution plans or IRA plans that are maintained by employers that have a common interest (other than the sharing of the plan) or  have a common pooled plan provider (a "section 413(e) plan").

Conditions. For the 413(e) plan to be entitled to the exception from the one bad apple rule, the following conditions must be met:  (i) the section 413(e) plan must describe the first, second and final notices that will be sent for a participating employer failure, the actions the section 413(e) plan administrator will take if  an unresponsive participating employer does not either take appropriate remedial action or initiate a spinoff, and that if the unresponsive employer does not act by the 60 days after the final notice, participants of that employer will become fully vested in their accounts;  (ii) the section 413(e) plan administrator must satisfy the notice requirements regarding the participating employer failure, implement the plan spinoff if initiated by the unresponsive employer and take the actions set forth in the regulations if the unresponsive participating employer fails to take appropriate remedial action or initiate a spinoff by 60 days after the final notice; and (iii) if the section 413(e) plan has employers that do not have a common interest and a "pooled plan provider" is required, the pooled plan provider must perform substantially all of the administrative duties that are required of the pooled plan provider under the regulations, as stated below. Prop. Treas. Reg. § 1.413-3(a)(2).

Pooled Plan Provider. A pooled plan provider is a person (an individual or entity) that: (i) registers as a pooled plan provider with the DOL pursuant to ERISA; (ii) is designated by the plan and acknowledges that it is a named fiduciary and the plan administrator; (iii) ensures that those who handle assets or are fiduciaries are bonded in accordance with ERISA § 412. A pooled plan provider must: (i) perform all administrative duties reasonably necessary to ensure that the plan remains qualified/in compliance with the Code and ERISA; (ii) monitor compliance with the terms of the plan, the Internal Revenue Code and ERISA; (iii) maintain accurate data and up-to-date participant and beneficiary information; (iv) conduct nondiscrimination, minimum coverage and top-heavy tests under the Internal Revenue Code, as applicable; (v) process all employee investment changes, loans and distribution transactions; (vi) satisfies reporting and notice requirements of the Code and ERISA; and (vii) amends the plan for all statutory-required changes.  Prop. Treas. Reg. § 1.413-3(a)(3).

Certain Section 1.413-3 Definitions.  (i) "Participating employer failure" means failure to provide information or a failure to take action required of it by the regulations. (ii) "Section 413(e) plan" is a defined contribution plan IRA plan that either (A) has a common interest other than having adopted the plan or (B) has a pooled plan provider. (iii) "Section 413(e) plan administrator" means a plan administrator designated by the section 413(e) plan. (iv) "Unresponsive participating employer" means a participating employer that has a participating employer failure. Prop. Treas. Reg. § 1.413-3(a)(4).

Notices. A section 413(e) plan administrator must provide a "first notice" to an unresponsive participating employer describing its failure, the actions the employer must take to remedy the failure, and that employer's option to initiate a spinoff of a separate plan of the unresponsive employer, and consequences if the employer does not comply.  If, after 60 days, the employer does not take appropriate remedial action or initiate a spinoff, the section 413(e) plan administrator must provide a "second notice" which must state that if within 60 days the unresponsive participating employer does not takes appropriate remedial action or initiate a spinoff, then a "final notice" describing the participating employer failure and the consequences of not correcting the failure will be provided to participants employed  by the employer, their beneficiaries and the DOL. A "final notice" provided within 30 days to participants employed the unresponsive participating employer and their beneficiaries and to the Office of Enforcement of the DOL EBSA must specify the final deadline for an unresponsive participating employer to take remedial action or initiate a spinoff. Prop. Treas. Reg. § 1.413-3(b).

Final Deadline. The final deadline for an unresponsive participating employer to take appropriate remedial action or plan spinoff is 60 days after the final notice. Prop. Treas. Reg. § 1.413-3(c)(1).

Appropriate Remedial Action. If the participating employer's fails to provide required information, appropriate remedial action is by providing the data, documents, or other information requested by the section 413(e) plan administrator. If the participating employer fails to take required action, appropriate remedial action is by taking all actions requested by the section 413(e) plan administrator, such as making corrective contributions. Prop. Treas. Reg. § 1.413-3(c)(2).

Implementing an Employer-Initiated Spinoff. An unresponsive participating employer can initiate a spinoff by directing the section 413(e) plan administrator to spin off the amounts attributable to its employees to a separate qualified plan or IRA plan maintained it. The section 413(e) plan administrator must complete the spinoff as soon as reasonably practicable, which is deemed to be met if the spinoff is completed within 180 days from when the spinoff was initiated. Prop. Treas. Reg. § 1.413-3(d)(2). 

Required Actions Following an Employer's Failure to Meet the Deadline – Stop Contributions, Fully Vest Participants and Allowing Each Affected Participant an Individual Rollover to Another Qualified Plan or IRA. If by the time of the final deadline discussed above, the participating employer fails to take appropriate remedial action or initiate a spinoff, then as soon as reasonably practicable, the section 413(e) plan administrator must (i) stop accepting contributions from the unresponsive participating employer and its employees; (ii) give notice that no further contributions will be made and that additional information will follow; (iii) fully vest the employees; and (iv) give the each employee an option for an individual rollover to a qualified plan or IRA. Prop. Treas. Reg. § 1.413-3(e)(1) & (2).

As stated in the previous paragraph, an election must be given to employees of an unresponsive participating employer (following a failure to meet the deadline to take remedial action or initiate a spinoff) to have their account rolled over directly to another qualified plan or an individual IRA, or alternatively the participant's account will remain in the original section 413(e) plan. If no election is made, the default is to remain in the section 413(e) plan. Prop. Treas. Reg. § 1.413-3(e)(3). The option to remain in the plan does not exist if the participant's account is less than $200, in which case such amount will be mandatorily distributed. § 1.413-3(e)(4).  Also, if there is a required minimum distribution under IRC § 401(a)(9), such amount must be distributed and cannot be rolled over or remain in the plan. § 1.413-3(e)(4).  

Reliance Permitted Beginning March 28, 2022: These proposed regulations may be relied upon beginning March 28, 2022.

Comments

It is not entirely clear to what extent pooled plan providers can delegate their functions to outside third-party administrators, e.g., record-keepers.

The proposed rules only apply to defined contribution plans and it is unclear if similar rules will be adopted for  defined benefit MEPs.

A public hearing on the proposed regulations was set for June 22, 2022.

The above proposed regulations, by implementing the unified plan rule for unrelated-employer MEPs, should eliminate a potential barrier to an employer joining such MEPs.

Profits Interests

 A Primer on Profits Interests

Charles C. Shulman, Esq.,
Teaneck, NJ, 201-357-0577
cshulman@ebeclaw.com

Profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met.

      a.   Description
            i.    A profits interest is an interest in the value of a partnership or LLC taxed as a partnership. It has upside potential but no downside protection.

            ii.   The granting of profits interests has become a preferred way of compensating management in buyouts or as partnership incentives.

            iii.   Profits interests may be structured as a separate class of ownership interests.

            iv.  Profits interests typically provide a share of profits only once the original LP investors have received a return of their full capital investment and a certain rate of return (e.g., IRR).

            v.   The profits interests must be held for a certain period to receive favorable tax treatment, as discussed below.

      b. Tax Treatment of Profits Interests

            i.    Revenue Procedure 93-27 provides that the IRS will treat the receipt of a profits interest as non-taxable if the following conditions are met: (a) the profits interests do not relate to a substantially certain and predictable stream of income from partnership assets, (b) for two years after receipt of the profits interest the partner does not dispose of the profits interest, and (c) the partnership or LLC is not a publicly traded partnership as defined in Internal Revenue Code §7704(b). In addition, the profits interest cannot be a capital interest, which, according to Proc. 93-27 means that if the partnership’s assets would be sold at fair market value, and the proceeds would be distributed in a complete liquidation of the partnership, the profits interest holder would not receive a share of the proceeds.

            ii.   Rev. Proc. 2001-43 provides that even if the profits interest is nonvested at the time of grant, the profits interests will be non-taxable at the time of grant and at vesting, provided that: (a) the partnership treats the recipient as a partner from date of grant, and the partner must take into account its distributive share of partnership income or loss, and (b) the partnership and other partners do not deduct such amounts as wages.

            iii.   Some make a Code § 83(b) “protective” election on nonvested profits interests so that even if they are found to be taxable profits interests, there would be no tax in any event until vested.

            iv.  Upon the sale or liquidation of the profits interest (after the two-year hold period), the proceeds are taxed at the lower long-term capital gains rate.

      c.   Holding Periods for Profits Interests

            i.    Generally long-term capital gains require a one-year holding period. However, with regard to profits interests, Rev. Proc. 93-27 requires that the profits interest be held for at least a two-year period.

            ii.   If there is a Code § 83(b) protective election, there may not be a need for a two-year holding period, since even a capital interest with a § 83(b) election can utilize long-term capital gains rates if held for one year or longer.

            iii.   There may be a three-year holding period if the partnership owns real estate for rental or investment, since Code § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on carried interest use of long-term capital gains tax rates for fund managers, provides that "applicable partnership interests" which includes professional investors as well as those developing real estate for rental or investment, have an increased holding period for long-term capital gains treatment for three years instead of one year.  In this regard, a § 83(b) election would not help to shorten the period.

      d.   Setting Up Separate Entities so that Employer Pays Wages and Partnership Distributes Profits Interests.

            i.    Grantees of profits interests would ordinarily become partners of the entity granting the profits interests with taxes based on Form K-1 partnership returns, and could not be both partners and employees, and therefore the grantees would lose the ability to participate in the cafeteria plan or other flex benefits and would owe self-employment social security tax. 

            ii.   To allow the grantees to continue to be employees, often a subsidiary of the partnership can serve as the employer, while the main partnership grants the profits interest.  For example, the main partnership grants the profits interest; an Employer LLC subsidiary (typically a partnership) is set up as the employer entity that pays wages and employee benefits (with a services agreement with the main partnership); and there is typically a need for a holding company, Employer Holdings taxed as a corporation, which needs to own a small amount (e.g., 1%) of the Employer LLC subsidiary for tax purposes so that the Employer LLC partnership is regarded as a separate entity.    

            iii.   Alternatively, sometimes the profits interests are passed through a feeder entity to the grantees so that they can still be employees of the entity.

            iv.  Keep in mind that setting up these structures does involve extra work to set up and administer.

      e.   Advantages of profits interests                 

            i.    Non-taxability at grant (or on vesting) until the grantee ultimately sells or liquidates the profits interests, and then generally only at the long-term capital gains rate.

            ii.   As equity, the profits interest should not be subject to Code § 409A, and instead it is governed by § 83 principles.

            iii    Profits interests can have a flexible payout.

            iv.  Profits interests can be granted without voting rights.

      e.   Disadvantages of profits interests

            i.    Profits interests must be held at least two years to receive favorable tax treatment (or likely one year if a § 83(b) election is made).

            ii.   The employer will not receive any deduction from the profits interest.

            iii.   The payout formulas are often complicated to administer.

            iv.  There is no downside protection if there are not sufficient profits, and in this way profits interests are more similar to stock options than to restricted stock.

            v.   Grantees may become partners instead of employees of the entity granting the profits interests unless separate structures are set up to separate the employer from the entity granting the profits interests (see above).

      f.    Accounting Treatment for Profits Interests – Profits interests, depending on the facts, would be treated for accounting purposes as either performance compensation or stock compensation. Performance compensation costs may be expenses when the payment is probable and reasonably estimable. Stock compensation is expensed based on its fair value over the period of service (but sometimes revalued each accounting period).

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As discussed in my earlier post on Profits Interest at https://ebeclaw.blogspot.com/2022/03/profits-interests.html , profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met. However, in 2017 this was limited in the case of profits interests (carried interest) for professional investors and real estate development for rental or investment to where the holding period is three years. A 2020 legislative proposal in the pending Inflation Reduction Act to increase the holding period for such carried interest from three years to five years and to only begin only once substantially all the partnership interest subject to IRC § 1061 are acquired by the partnership. However, in further negotiations this carried interest tax proposal is apparently being taken out of the legislation. 

Pre-2017 Holding Period for Profits Interests – Two Years from Grant and One Year from Vesting. Prior to the enactment of the Tax Cuts & Jobs Act of 2017, generally long-term capital gain treatment for profits interest would require the general one-year holding period requirement (from the date the profits interests are vested). In addition, Rev. Proc. 93-27 would require that the profits interests be held for at least two-years after the date of grant.

Extended Holding Period for Professional Investors and Real Estate Investment to Three Years Under TCJA of 2017. Legislative changes imposed by the Tax Cuts & Jobs Act of 2017 (effective January 1, 2018) enacted a new IRC § 1061, which imposes a three-year holding period (instead of one year for ordinary capital gains) for an "applicable trade or business," if the partnership owns real estate for rental or investments, since IRC § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on "carried interest" use of long-term capital gains tax rates for fund managers, provides that "applicable partnership interests" which includes professional investors as well as those developing real estate for rental or investment (IRC § 1061(c)(2)), have an increased holding period for long-term capital gains treatment for three years instead of one year. IRC § 1061(a).

2022 Proposed Legislation to Further Extend Holding Period for Such Carried Interest to Five Years, was Removed from the Bill to Win Approval from Sen. Krysten Sinema. Further legislative changes had been proposed in the Inflation Reduction Act in July 2022, H.R. 5376, to amend IRC § 1061 in the following ways: (i) the holding period for "applicable partnership interests" which, under IRC § 1061(c)(2), includes carried interest for professional investors (e.g., private equity firms and hedge funds) and real estate development for rental or investment, would be increased from three years to five years (except with respect to taxpayers with adjusted gross income of less than $400,000); (ii) the five-year holding period would begin only once substantially all the partnership interest subject to § 1061 are acquired by the partnership; and (iii) the holding period would now apply not just to profits interest but also to other income taxed as long-term capital gains, including qualified dividend income included in net capital gain for purposes of IRC § 1(h)(11), gain from the sale of active business assets under IRC § 1231 and regulated futures contracts subject to IRC § 1256. However, it has now been reported on August 4, 2022 that Democrats are revising their Inflation Reduction Act in order to will approval from Senator Kyrsten Sinema (D. Arizona), which, among other things, would drop the proposed tax increase on carried-interest income.