Plan sponsors can now use forfeitures to fund safe harbor contributions, according to new proposed regulations.  The Internal Revenue Service (“IRS”) issued eagerly anticipated guidance earlier this year, in the form of proposed regulations, that would permit plan sponsors to use forfeitures to fund qualified nonelective contributions (“QNECs”) and qualified matching contributions (“QMACs”) made to 401(k) plans either as safe harbor contributions or to pass nondiscrimination testing.  The proposed regulations bring the IRS’s formal position into alignment with what plan sponsors and industry practitioners have long considered the common sense reading of the current regulations to be.

The IRS has historically interpreted the regulations to require QNECs and QMACs to satisfy the applicable nonforfeitability and distribution requirements at the time the amounts are originally contributed to the plan.  Since contributions made to satisfy ADP or ACP safe harbors are considered to be QNECs and/or QMACs, this interpretation has meant that plan sponsors could not use amounts in plan forfeiture accounts to fund safe harbor contributions or corrective contributions.

The proposed regulations amend the definition of QNECs and QMACs to permit employer contributions to qualify as QNECs or QMACs as long as the contributions satisfy the applicable nonforfeitability and distribution requirements at the time they are allocated to participants’ accounts, instead of when they were originally made to the plan.  As a result, employers may now use money in their plans’ forfeiture accounts to fund safe harbor contributions or other QNECs and QMACs.  Plan sponsors who wish to use their plans’ forfeiture accounts to fund QNECs and QMACs should confirm that their plan documents permit this use of amounts in the forfeiture account.

The proposed regulations become effective after they are finalized; however, taxpayers may rely on the proposed regulations beginning immediately.  Additionally, any changes to the rules in the final regulations will be applied prospectively only.

We encourage plan sponsors to determine whether a plan amendment may be needed in order to use forfeitures to fund safe harbor contributions or other QNECs and QMACs, keeping in mind that the forfeiture language in many plan documents can be complex and nuanced.

IRS Releases an Updated Audit Technique Guide for Golden Parachute Payments

On January 20, 2017, the IRS released an updated Golden Parachute Payments Audit Technique Guide (“ATG”) that covers the examination of golden parachute payments under Internal Revenue Code (“IRC”) sections 280G and 4999.

Golden parachute payments are payments of compensation to “disqualified individuals” (i.e., certain officers, shareholders, or highly-compensated individuals), the payment of which is contingent upon a change in control.  To the extent these payments are “excessive” under IRC section 280G, the corporation may not, as a general rule, deduct them from its taxable income, and IRC section 4999 imposes an excise tax on the disqualified individuals equal to 20% of the excess payments.

The ATG includes: 1) a review of the golden parachute rules and a discussion of potential audit adjustments; 2) a list of documents to review in connection with a golden parachute examination; and 3) a list of nine steps to perform in a parachute payment examination.  While similar to the 2005 version of the ATG, the current guide makes two key updates.

First, the newly updated ATG expands the scope of documents that IRS agents will review during an examination of golden parachute payments to include the following:

• Schedules 14A and 14C – The Dodd-Frank Act requires the disclosure of golden parachute payments in proxy statements and informational statements filed on Schedule 14A and 14C.
• Forms S-4 and F-4 – These forms provide disclosures relating to mergers, acquisitions, or the exchange of securities between companies.

In addition, the ATG discusses the intersection between IRC sections 280G and 162(m).
Specifically, it notes that, under IRC section 162(m), the $1 million limitation on deductible compensation is reduced by the amount of any excess parachute payments.

Although the ATG is for internal use by IRS auditors and is not binding authority, it is nonetheless a helpful document in understanding the IRS’s position with respect to golden parachute payments.  Accordingly, we recommend that compensation committee members as well as management keep the ATG in mind when setting severance and change in control payments.

IRS Provides Substantiation Guidelines for Safe-Harbor Hardship Distributions

On February 23, 2017, the IRS issued a memorandum addressing the substantiation guidelines for safe-harbor hardship withdrawals from 401(k) plans, and followed with a March 7th memorandum extending the substantiation guidelines to 403(b) plans. The memoranda are of particular importance because they outline the steps that IRS examiners are to take in determining whether safe-harbor hardship withdrawals from 401(k) and 403(b) plans are being made on account of an immediate and heavy financial need when supporting source documents are not being collected.  As such, they provide plan sponsors with a much-needed road map as to a minimum standard of substantiation.

Safe-harbor hardship withdrawals may be made from 401(k) and 403(b) plans only if the distribution is deemed to be on account of an immediate and heavy financial need.  To meet this safe harbor definition, the reason for the hardship withdrawal must be limited to certain medical expenses, costs directly related to the purchase of a principal residence, payment of tuition and certain educational expenses, payments necessary to prevent eviction or foreclosure, burial or funeral expenses, and expenses for the repair of certain damage to a principal residence.

For plans that utilize the safe-harbor hardship rules, it is the plan sponsor’s responsibility to confirm that the reason for the hardship withdrawal satisfies one of the safe-harbor reasons before issuing the distribution.  Some plan sponsors and recordkeepers allow participants to “self-certify” the reason for the safe-harbor hardship withdrawal without also providing substantiating documentation.  There has long been a concern as to whether participant self-certification alone is in fact sufficient to demonstrate compliance with the regulations, as the IRS had not formally addressed the issue previously.  The IRS has, however, indicated in informal guidance that self-certification, without more, would not be sufficient.

The memoranda specifically provide that an IRS examiner may evaluate this by reviewing either source documents or a summary of information contained in the source documents (the accuracy of which must be certified to by the participant), depending on which is being obtained by the plan sponsor (or its recordkeeper).  If a summary of information is being obtained, the memoranda instruct IRS examiners to review the summary to determine whether the hardship withdrawal reason has been substantiated.

The IRS examiner may still require source documentation if the summary information is incomplete or inconsistent, or with respect to participants who receive more than two hardship withdrawals in a plan year.  In addition, where a plan’s recordkeeper is obtaining the summary information, the recordkeeper is expected to provide a report, or other access to data, to the plan sponsor at least annually, describing the hardship withdrawals made during the plan year.

The memoranda are for internal use by IRS examiners and are not binding authority, but they are an important tool in clarifying the level of documentation needed to substantiate hardship withdrawals if the plan were under IRS examination.  Plan sponsors who currently allow participants to self-certify, without obtaining either source documents or the applicable summary information from the source documents, should consider revising their procedures to minimize the likelihood of an adverse IRS finding.