While many employers are already in the midst of planning for these significant changes, other employers have yet to examine how these new requirements will impact business operations, health coverage costs, benefit plan design, and coverage of employees. Employers are required to notify existing employees of their coverage options by October 1, 2013 (See Technical Release No. 2013-02 for a discussion of this notice requirement). Practically speaking, this means that employers must have a compliance plan in place well before the January 1, 2014 effective date of these changes. Given the significant impact of these requirements, and given the fast-approaching deadlines, we have been urging employers to begin analyzing these issues now so they have a strategy in place that will enable them to continue normal business operations while complying with the myriad of complex new requirements. Key decisions that need to be made well in advance of 2014 include:

1. Whether to continue offering group health coverage on/after 2014. We have not seen a significant push from employers to completely eliminate their health plans. However, the cost increases in 2014 are significant enough that many employers are analyzing this option and considering it for the future.
2. If the employer will continue to offer coverage, what (if any) steps the employer should take to offset the significant cost increases associated with the new requirements. The ACA requirement to provide coverage to all full-time employees will result in a significant cost increase, especially for employers who do not currently provide coverage to these employees. Even if an employer currently provides coverage to all full-time employees, the individual mandate will cause more employees and dependents to enroll, thereby increasing costs by virtue of the “woodwork effect.” There are also significant taxes (e.g., the transitional reinsurance fee and the patient-centered outcomes research fee) that will further raise costs for employers. For many employers, these cost increases are prohibitive. Accordingly, employers should analyze whether it is prudent/necessary to make plan design changes, revise employment practices, implement wellness programs, and/or take other steps to offset cost increases.
3. Whether any action needs to be taken to avoid the pay or play penalties. Generally, the pay or play penalties apply to employers that either (a) do not offer coverage to at least 95% of their full-time employees or (b) offer coverage to at least 95% of their full-time employees, but such coverage is either unaffordable or does not provide minimum value. Accordingly, employers need to analyze issues such as:

• Who qualifies as a full-time employee? To make this determination, employers must look at the hours its employees work during a “standard measurement period” beginning in 2013. Accordingly, employers should already be reviewing this issue.
• Is coverage offered to at least 95% of these employees?
• If not, what plan design or employment practice changes must be made to alter this result?
• Does the current plan offer affordable coverage that provides minimum value?

These are just a few of the issues that employers should be working through before 2014 (see this brief presentation for a more detailed four-step analysis). While many of the new requirements are very complex, we believe there is still time to properly analyze these questions and develop a solid compliance strategy that will help control inevitable cost increases, while still complying with the new requirements. However, time is of the essence because 2014 is right around the corner.

We believe that Sutardja offers a couple of lessons for employers. The first is don’t panic—in most cases, executives will still be able to exercise their options when they see fit and thus retain the flexibility to choose when to recognize taxable income. The second is that in order to grant options that provide this type of flexibility, employers need to follow detailed stock option grant requirements under the Code Section 409A regulations. This lesson may be harsh for the executive in Sutardja considering that most of those requirements hadn’t been written yet, but it gives the rest of us a chance to learn from those mistakes. Accordingly, this blog will focus on the opportunities employers have to correct outstanding plan grants and improve grant practices for future grants. We first will provide background on the case itself, highlighting the option grant practices that the IRS punished. Second, we will explain how employers can comply with the stock option grant requirements of Code Section 409A so that executives may retain the flexibility to choose when to exercise those options.

Background

The key to understanding the Sutardja story is that the employer’s grant date practices were flawed in two respects.  First, the process to grant the options took nearly a month to complete.  On December 26, 2003, the employer’s compensation committee initially approved a grant of options to purchase 1.5 million shares of stock at $36.50/share, which was the closing price of the employer’s stock on the NASDAQ National Market Systems on that date.  On January 16, 2004, the same committee ratified this approval.  The closing price of the stock was $43.64/share, but the exercise price did not change.  That may seem like a red flag under Code Section 409A (and Code Section 162(m) for that matter), but back then, Code Section 409A had not yet been enacted, and the IRS had little other guidance on proper grant procedures.  While it seems strange that the same committee would approve and ratify a stock option grant on separate dates, the employer probably felt that there was not much as a tax risk from this practice.

The second flaw was that the employer and executive did not try to correct (i.e. eliminate) the discount until after the executive exercised the options.  The executive exercised some the options in January 2006.  In May 2006, the employer reviewed its stock option grant practices and concluded that the appropriate grant date was the date that the grant was ratified (i.e. January 16, 2004), meaning that the exercise price should have been $43.64/share.  Soon after that, the executive and the employer entered into an amended stock option agreement that increased the exercised price to $43.64/share, and the executive paid the difference between the prior exercise price and the new exercise price with respect to the options he had already exercised.  Trying to correct an option grant after the options have been exercised may seem a bit clumsy, but that probably was the best strategy available back then. 

Again, Code Section 409A had yet to be enacted when the options were granted.  When the employer and executive tried to correct the options, the only guidance under Code Section 409A that had been published were Notice 2005-1 and proposed regulations, both of  which explained that discounted options were subject to Code Section 409A.  Being subject to Code Section 409A means that the options generally may be exercised only upon certain permitted triggers:  (1) a specified date or year; (2) separation from service, (3) death, (4) disability, (5) change in control, or (6) an unforeseeable emergency.  An option that could be exercised at any time would violate Code Section 409A, and the difference between the exercise price and fair market value of the stock at the end of the year would be taxed currently as ordinary income and be subject to the Code Section 409A penalties.  Any appreciation in the future years would incur similar taxes and penalties.  It is easy to see why an employer and executive would want to remove the discount.

The problem is that the IRS would not publish final regulations until 2007 and the corrections program until the end of 2008.  Further, the IRS had said that until the plan document requirements in the final regulations became effective (January 1, 2009), plan documents were under a “good-faith” compliance period.  Given the sparse guidance that was available and the “good faith” transition period, the attempted correction doesn’t seem so crazy.  Unfortunately for the executive, the IRS claimed that the exercised options were discounted options that were subject to Code Section 409A, and it did not accept the amended option agreement as a valid correction of the exercise price.  Because the discounted option did not limit exercise to Code Section 409A’s permitted triggers, the IRS assessed the executive with an additional 20% income tax (on top of his ordinary income tax), plus interest, which totaled over $5,282,125.  Thus, the executive repaid the discount to the employer and still had to pay the Code Section 409A penalties on top of that!

The executive filed a claim for a refund, and that challenge is now proceeding through the court of claims.  Our companion blog describes the procedural history here.  The next stage is full trial, which will decide the factual issue of whether the executive’s options truly were discounted options, or whether the exercise price was equal to the stock’s fair market value on the date of grant (which would exempt them from Code Section 409A).  While it is possible that the executive could prevail at trial, in many ways, the outcome is irrelevant to most employers.  This case history shows that the IRS is auditing option grant practices, and it will punish executives if the employer has defective grant procedures.  So, how do employers avoid letting their executives fall into a similar situation?  The following discussion will help answer that question.

Procedures for Granting Flexible Stock Options

Employers who want to ensure that their option grant procedures are proper should review (1) their currently outstanding option grants and (2) the procedures for future grants. 

1. Currently Outstanding Options.  Review of current option grants is critical because unlike in Sutardja, the IRS now offers a Code Section 409A corrections program.  The program generally requires the exercise price to be corrected before any options are exercised.  Also, for options granted to insiders, the correction typically must be completed by the end of the year in which the option was granted.  So, while the corrections program exists, employers should realize that they may not always be eligible to use it.  A prompt review will increase the chances of being able to utilize this program.
2. Future Grants.  If the employer is considering a future stock option grant, it should make note of the following procedures:

• Determine whether the options will be discounted.  Code Section 409A does not prohibit the grant of discounted options, but it imposes strict limits on when they can be exercised.  Non-discounted options generally are exempt from Code Section 409A, which gives executives much more flexibility in choosing when to exercise their options and thus when to recognize taxable income.  For these reasons, employers typically grant non-discounted options.
• Establish a process for determining the exercise price and document that process. A non-discounted option means the exercise price is equal to the fair market value of the underlying stock on the date of grant.  Determining fair market value is fairly easy for publicly traded companies.  Fair market value typically equals the closing price on the grant date, although there is some flexibility to use an average of various prices.  Privately held companies have a much more difficult process because they don’t have a readily established market for their shares.  The regulations under Code Section 409A contain safe harbors, which generally require the employer to get an appraisal or consistently use a the same fair market value formula for most other stock transfers involving the employer.  These approaches contain detailed requirements that can make them difficult and expensive.  Alternatively, employers may use a “reasonable application of a reasonable valuation method.”  A “reasonable” valuation method considers several factors, including:  (1) the value of the employer’s assets; (2) the present value of the expected cash flows; (3) the market value of stock of similar businesses; (4) recent arm’s-length transactions involving the sale of employer stock; and (5) other relevant factors.

The lack of clarity in these rules shows how easily the IRS could challenge a private company stock option’s exercise price.  Accordingly, privately held companies either should use one of the safe harbor methods or carefully document the process it used to establish that the exercise price of the option was equal to the fair market value of the underlying stock.

• Establish detailed grant date procedures.  Establishing the exercise price is an important step.  Making sure the exercise price corresponds to the proper grant date is just as important.  Code Section 409A describes the grant date as the date when the granting corporation completes all corporate action necessary to create the legally binding right to purchase shares under the option.  The IRS further explained this rule in a 2009 Chief Counsel Advice Memorandum that applied the Code Section 409A rules to Code Section 162(m)’s grant date standards.  The Memorandum added that it is entirely within an employer’s control to complete and document the steps to affect the grant of the option contemporaneous with or before the intended grant date.  That is a strict standard, and one the employer did not satisfy in Sutardja.  Employers should review their grant date practices and make sure there is no room for challenge.
• Consider granting other awards besides stock options.  If employers have trouble granting options that fit within these rules, they may want to consider granting alternative equity compensation awards.  Restricted stock is exempt from Code Section 409A.  Restricted stock units or phantom stock can be easily designed to comply with Code Section 409A or be exempt from Code Section 409A.  These awards can provide the same incentives to employees as options, and they do not involve the pricing and grant date issues that accompany options.

Final Thoughts.

Sutardja shows that the IRS is auditing stock option grant procedures aggressively.  Employers who want to grant options that give their executives the maximum flexibility in choosing when to recognize taxable income, still need to satisfy the detailed requirements in the Code Section 409A regulations.  Employers should review their option grant date and exercise practices and take any steps necessary to mitigate the risk of the IRS imposing Code Section 409A penalties on their executives.

In a recent blog post, we explained how the HIPAA Omnibus Rule alters business associate agreement requirements.  Unfortunately for plan sponsors, the impact of these new rules extends beyond business associate agreements.  For example, plan sponsors will need to update their Notice of Privacy Practices (“NPP”) to include:

•  A description of the types of uses and disclosures of protected health information (“PHI”) that require an authorization;
• A statement that the covered entity is required by law to notify affected individuals following a breach of unsecured PHI; 
• A statement informing individuals that a covered entity may contact them to raise funds for the covered entity and an individual has a right to opt out of receiving such communications; and
• A statement that the plan is prohibited from using genetic information for underwriting purposes.

NPPs must be revised by September 23, 2013 for compliance with these new requirements.  With respect to the timing and medium of distribution, plan sponsors that generally post NPPs to their websites must (1) post the revised NPP by September 23, 2013 and (2) provide the revised NPP, or information about the material change and how to obtain the revised notice, in the next annual mailing to covered individuals (i.e., during open enrollment).  Plan sponsors that do not post the NPP on their website must distribute the revised NPP (or information about the changes and how to obtain the revised NPP) to individuals within 60 days of the changes.  

Plan sponsors will also need to update their HIPAA Privacy Policies and Procedures to address these new requirements.  For example, you may need to update your HIPAA Privacy Policies and Procedures to:

• Revise the definition of PHI (this should now include genetic information);
• Clarify your policies regarding individuals’ rights concerning their PHI, such as access to records;
• Generally prohibit the sale of PHI (subject to limited exceptions);
• Generally prohibit the use of PHI for marketing purposes (subject to limited exceptions); and
• Generally prohibit the use of PHI for fundraising communications (subject to limited exceptions).

The good news is that the September 23, 2013 deadline is still a ways off, which means you do not have to take your HIPAA compliance materials with you to the beach.  However, you should circle this date on your calendar so that you can address these issues when you return.  Or, better yet, you can address these issues now so that you have one less thing to trouble your mind while you are soaking up the sun.

The new guidance provides that expatriate plans that are fully-insured will not have to comply with certain provisions of the ACA for a limited transition period extending through plan years ending on or before December 31, 2015. For purposes of this transitional relief, an expatriate health plan is defined as an insured group health plan in which enrollment is limited to primary insureds who reside outside of their home country and its associated group health insurance coverage for at least six months of the plan year and any of their covered dependents. No relief is extended to plans that are not insured.

As a result of the guidance, insured expatriate health care plans are not subject to a number of ACA requirements during the transition period, including but not limited to: (a) the extension of coverage for children until age 26; (b) the prohibition of all pre-existing condition limitations; (c) the coverage of preventive health care services on a first-dollar basis; (d) the prohibition against annual and lifetime dollar limits on essential health benefits; (e) the prohibition against waiting periods in excess of 90 days; and (f) the new internal and external claims appeals procedures.

As noted above, this transitional relief is available for plan years ending on or before December 31, 2015. In order to take advantage of the transitional exemption, plans must be in compliance with the applicable requirements of the Public Health Service Act, the Employee Retirement Income Security Act and the Internal Revenue Code in effect before the enactment of the ACA.

The FAQ also provides that the Departments will treat coverage provided under an expatriate group health plan to be a form of minimum essential coverage under the ACA. Therefore, individuals enrolled in such coverage should satisfy the individual health care coverage mandate and thus avoid potential tax penalties.

The Departments have requested comments by May 8, 2013 on the challenges that expatriate health care plans face in complying with provisions of the ACA.

Any such comments can be sent to the Departments at e.ohpsca-expat.ebsa@dol.gov.

Corporations generally do not receive a corporate income tax deduction for dividends paid to shareholders.  As an exception to this general rule, C corporations are allowed a deduction for dividends paid with respect to employer stock held in an ESOP if certain conditions are met.  To be eligible for the deduction, the dividend must be an “applicable dividend.”  A dividend will be treated as an applicable dividend if the ESOP provides that the dividend is (a) paid directly to plan participants or their beneficiaries, (b) paid to the plan and distributed to participants or their beneficiaries not later than 90 days after the end of the plan year, or (c) at the election of the participants or their beneficiaries, paid directly to the participants or their beneficiaries or paid to the ESOP and distributed in accordance with (a) and (b) above or paid to the plan and reinvested in qualifying employer securities.  In addition, a dividend generally qualifies as an applicable dividend if the ESOP provides that it may be used to repay a loan originally used to purchase the stock with respect to which the dividend is paid.  For this purpose, the dividend qualifies as an applicable dividend only to the extent that employer securities with a fair market value of not less than the amount of the dividend are allocated to the accounts to which the dividend otherwise would have been allocated.

The budget proposal points out that current law extends several tax benefits to ESOPs that are in addition to those applicable to other tax-qualified retirement plans.  The dividend deduction certainly is one of these benefits.  Thus, it can be argued that this difference in tax treatment creates an additional incentive for employers to encourage investment in employer stock through ESOPs.  As others have done before, the Obama administration here is arguing that concentration of employees’ retirement savings in company stock subjects those savings to increased risk without necessarily offering a commensurate return.  Moreover, the administration believes that to the extent current payments of dividends to ESOP participants can spur a productivity incentive effect, the effect may be more likely in small employer settings.  Thus, given the way the administration seems to see it, providing an exception from elimination of the ESOP dividend deduction for smaller corporations makes good sense.

 It is too early to determine whether this proposal will be enacted.  I would point out that this is projected under the Obama budget to raise approximately $6.5 billion over the 2014-23 window.  This number, while perhaps not huge in overall budget terms, might be attractive, if Congress, as appears likely, embarks on a mission to find sources of revenue that do not require changes in income tax rates (or that even permit some lowering of those rates).  Accordingly, this one is worth watching.

We discussed the facts and prior decisions in this case in considerable detail in a prior blog. You might want to review that blog to put this decision in context. To summarize, a health care plan provided that it would cover expenses caused by a third-party, subject to the condition that the plan be reimbursed from any monies recovered from a third party. (This is a common provision in ERISA health care plans, intended to control costs for all participants and to avoid costly litigation over recovery.) Mr. McCutchen was in an auto accident with another vehicle, and the plan paid $66,866 of health care plan expenses he incurred due to that accident. After Mr. McCutchen recovered funds from the other driver and his own insurer for underinsured motorist coverage, the plan sought reimbursement of expenses it had paid, in accordance with plan terms. He refused to repay anything, and the case headed to court.

Eventually, the U.S. Supreme Court agreed to hear the case to resolve a circuit split on whether “equitable defenses” could override an ERISA plan’s reimbursement provision. Justice Kagan delivered the opinion, joined by four other justices. Applying prior case law (Sereboff v. Mid Atlantic Medical Services, Inc.), the Court first held that in a Section 502(a)(3) action based on equitable lien by agreement, the ERISA plan’s terms govern. Neither general unjust enrichment principles nor specific doctrines reflecting those principles can override the applicable contract. Accordingly, the plaintiff’s argument that double-recovery rules prevailed over plan terms was rejected. The participant was being held to the agreement to reimburse in the event of recovery.

The Court next rejected the Department of Labor’s argument that the common-fund rule has a special capacity to trump a conflicting contract. The common-fund rule provides that “a litigant or lawyer who recovers a common fund for the benefit of persons other than himself or his client is entitled to a reasonable attorney’s fee from the fund as a whole.” The Court found that this rule was treated the same as any other rule: ERISA plan terms prevail.

Then, the Court took a somewhat surprising next step. It found a “contractual gap” in the plan document regarding the cost of recovery. The Court found that the common-fund doctrine provided the best indication of the parties’ intent, requiring the attorney’s fees to be paid before the plan was reimbursed. The Court’s majority thought it was unfair that plaintiff would have been “in the hole” for $866 if the common-fund doctrine had not been applied.

The $866 arose based on four agreements the plaintiff entered into: with the plan, attorney, and two other parties. Another view of the $866, from the other plan participants’ perspectives, is that the $866 was not a hole, but was plaintiff’s gamble that he could pay an attorney a 40% contingency fee on the entire recovery, and keep the approximately $66,000 remaining, rather than repaying anything to the plan.

In a dissent, Justice Scalia (joined by three other justices, including Chief Justice Roberts) agreed with the majority on the primary issues, but disagreed regarding the “contractual gap.” In the dissent’s view, the parties had conceded that the plan provided for full reimbursement, without any contribution to attorney’s fees and expenses. Therefore, the issue of whether the plan was ambiguous as to attorney’s fees was not before the Court, and the Court should not have applied the common-fund doctrine.

What does this decision mean for plan sponsors? U.S. Airways, Inc. v. McCutchen informs us that ERISA plan provisions prevail: health care plan sponsors can write provisions regarding reimbursement from recovery, and participants who accept payment of expenses under those conditions are expected to honor the agreement. The decision also leaves plan sponsors with a decision to make regarding whether to explicitly disclaim the common-fund doctrine in their plan documents. The Court’s majority explained that where a plan rejects the common-fund doctrine, people like the plaintiff would make different judgments. Whether such a change in judgment is a bad thing, or a good thing, is something for plan sponsors to consider as they redesign their health care plans to comply with health care reform.

While the new requirements are not a significant departure from the old BAA content requirements, covered entities must review and update their existing BAAs to ensure compliance with the new HIPAA Omnibus Rule. Required changes include:

• Updating the BAA to state that if the business associate is to carry out the covered entity’s obligations under the Privacy Rule (e.g., the provision of Notices of Privacy Practices), the business associate must comply with the requirements of the Privacy Rule that apply to the covered entity in the performance of such obligations; and
• Adding a provision stating that the business associate is directly subject to the Security Rule.

Even more significant is the new requirement that a business associate must enter into a BAA with subcontractors to whom the business associate has delegated a function, activity, or service the business associate has agreed to perform for a covered entity, and such function, activity, or service involves the creation, receipt, maintenance, or transmission of PHI. For example, if a business associate serving as a third party administrator for a covered entity hires a company to handle document and media shredding to securely dispose of paper and electronic PHI, then the shredding company would be considered a subcontractor, and the parties would have to enter into a written BAA to govern the subcontractor’s HIPAA responsibilities. Previously, business associates were contractually required through the terms of their BAAs with covered entities to ensure that their subcontractors agreed to the same restrictions that applied to the business associates with respect to PHI. However, written BAAs were not specifically required under HIPAA. Now, HIPAA’s written BAA requirements directly apply to business associates and their subcontractors. And, to the extent a subcontractor discloses PHI to one of its subcontractors, the written BAA requirements would apply there as well (and so on down the line).

Some business associates and subcontractors might be ahead of the curve and already have BAAs in place with their subcontractors. However, we expect that the majority do not. Accordingly, most business associates and subcontractors will need to take the following steps:

• Business associates and subcontractors must first evaluate their business relationships to determine where BAAs are required (i.e., evaluate which subcontractors create, receive, maintain, or transmit PHI or electronic PHI).
• Where a BAA is required, business associates and subcontractors must prepare and negotiate the terms of the BAAs.
• As part of the BAA preparation and negotiation process, business associates and subcontractors need to make certain that they fully understand their responsibilities under HIPAA and the BAAs, and they must ensure that they actually have the systems and procedures in place to comply with these responsibilities.
• After the parties have completed the previous steps, they must execute the BAA.

The good news is that covered entities, business associates, and subcontractors still have time to comply. The HIPAA Omnibus Rule became effective on March 26, 2013, but the new BAA requirements are generally not effective until September 23, 2013. This means that parties that do not currently have a BAA in place have until September 23, 2013 to execute a BAA that complies with these new requirements. Parties that had a BAA in place on January 25, 2013 that complied with the pre-HIPAA Omnibus Rule BAA requirements have additional time to update their BAAs. While these parties must comply with the substance of these new rules as of September 23, 2013, because they had a compliant BAA in place on January 25, 2013, these parties can wait until the earlier of the following to update their existing BAAs:

• The date the BAA is renewed or modified on or after September 23, 2013 or
•  September 22, 2014.

The other piece of good news is that the HHS issued a model BAA that addresses these new legal requirements. While this model BAA is a decent start, it does not contain certain “best practices” provisions that we would typically recommend. For example, we generally recommend that BAAs include specific provisions outlining the parties’ responsibilities in the case of a breach of unsecured PHI (e.g., timing of notice, content of notice, who is responsible for informing affected individuals, steps the parties must take to mitigate harmful effects, etc.). The HHS does not address these types of important issues in its model BAA. Additionally, the model BAA contemplates a covered entity and a business associate as the relevant parties. Accordingly, for business associates who need BAAs for their subcontractors, the model BAA would need to be modified significantly to reflect the relationship between the parties. So, while the model BAA may be a good starting point, we recommend revising this model BAA so that the agreement complies with all relevant legal requirements, accurately reflects the relationship between the parties, and adequately protects your interests.

Plan Document Issues.

We encourage any 403(b) plan sponsor who was late in adopting a written plan to take advantage of this 2013 relief period. A sponsor can only take advantage of other relief regarding administrative and operational errors if it has timely adopted a plan or taken advantage of this relief.

Generally, 403(b) plan sponsors use the model plan document provisions set forth in Revenue Procedure 2007-71. These provisions have not been updated for law changes such as the Pension Protection Act and “HEART.” As this Procedure reminds us, the IRS is developing a determination letter program for 403(b) plans. Once this program is introduced, the IRS will provide a remedial amendment period to allow plan sponsors to amend their plans retroactively. This guidance suggests that late adopters can likewise use the model provisions, without worrying about subsequent guidance. (Plans must nonetheless be operated in accordance with any statutory or regulatory changes.)

In theory, vendor cooperation could also be an issue in the context of a plan document correction, but we doubt this will be a problem, as a practical matter.

Administrative or Operational Errors.

The sponsor of a 403(b) plan faces a correction hurdle not faced by qualified plan sponsors: the plan may consist of contracts between individual participants and various vendors. Those contracts may prohibit certain forced distributions, yet such distributions may be required under EPCRS. The Voluntary Compliance Program requires sponsors to submit a statement affirming that it contacted all other entities involved with the plan, and has been assured of their cooperation to implement the correction. The sponsor may have difficulty identifying all vendors, including some of whom may be no longer receiving participant contributions. Further, a vendor may refuse to cooperate on the basis that the proposed correction would violate a contract provision, or state insurance law. This vendor issue first arose when the IRS issued guidance regarding 403(b) plan termination, where some vendors balked at employers’ attempts to terminate plans. The IRS has yet to issue guidance to alleviate vendors’ potential concerns, or to assist employers in getting beyond this hurdle. In requiring a statement regarding cooperation, the IRS appears to acknowledge that this hurdle could stand in the way of achieving compliance, without offering any assistance to surmount that hurdle.

Next Steps.

We recommend the following next steps for all 403(b) plan sponsors:

1. Confirm that the sponsor adopted a plan document by December 31, 2009. If not, adopt a document and utilize the Voluntary Compliance Program by December 31, 2013.
2. Review the IRS list of common 403(b) plan errors, and consider whether this plan may have committed any of these errors.
3. Discuss a self-audit of plan procedures, to reduce the likelihood of errors and mitigate risk to the employer in the event of an audit, with legal counsel.
4. Apply the guidance in Revenue Procedure 20013-12 to address any errors that are identified.

The vendor problem may make addressing errors challenging. But as Coach Wooden would say, “Don’t let what you cannot do interfere with what you can do.”

The IRS recently updated the EPCRS with the release of Revenue Procedure 2013-12 (“the Procedure”). The Procedure is effective April, 2013, but plan sponsors may follow its procedures immediately. The Procedure gives plan sponsors the ability to correct a greater variety of plan errors than they could in the past. It also clarifies correction methods described under prior versions of the EPCRS. Administratively, the Procedure proscribes new forms to file with the IRS and changes some of the fees. Overall though, the Procedure gives plan sponsors a great opportunity to correct plan document and administrative failures before the IRS discovers such errors on audit. We will briefly describe of the major changes or additions in the Procedure below.

Revised Correction Methods

• 403(b) Plan Corrections. Perhaps the biggest change is that the EPCRS now is available to correct errors in 403(b) plan documents. Prior versions of the EPCRS generally allowed corrections only of certain operational errors, but not documentation errors. While the correction procedures for 403(b) plans generally are similar to those used to correct qualified plan errors, plan sponsors should be careful because some corrections could be significantly different due to the different natures of 403(b) and qualified plans (e.g., the need of 403(b) plans to coordinate with their vendors).
• Code Section 436 Restriction Errors. If a defined benefit plan’s funded status falls below certain thresholds, Code Section 436 imposes restrictions on the accrual and payment of benefits. The Procedure explains how to correct errors arising from violations of Code Section 436. In certain cases, a plan sponsor may need to make contributions to the plan to make it whole.
• Correction of Matching Contribution Errors. A common mistake we see is that plan sponsors failed to implement matching contributions. The correction method typically has been for the plan to make a qualified non-elective contribution (“QNEC”). In general, QNECs are required to be fully and immediately vested. They also are subject to certain distribution restrictions. The Procedure allows corrective matching contributions to be subject to the plan’s vesting and distribution rules.
• Correction of ADP/ACP Failures. The Procedure states that for purposes of correcting a failed ADP or ACP test, the amount used to fund the QNEC must satisfy the definition of QNEC in Treas. Reg. Section 1.401(k)-6. That means that amounts in the plan’s forfeiture account may not be used to correct ADP and ACP test errors.
• Locating Missing Participants. In August of 2012, the IRS suspended its letter forwarding program that assisted plan sponsors with locating missing participants. The Procedure states that if a correction requires distributions to missing participants, full correction will not be required with respect to those participants so long as the plan sponsor takes “reasonable” steps to locate the missing participants.

Procedural and Administrative Changes

• New Forms and Schedules. The Procedure requires plan sponsors to submit a new Form 8950 and Form 8951 when submitting written correction filings to the IRS. In addition, the Procedure creates new schedules to be included with such filings, depending on the type of error the plan sponsor is correcting.
• Fees. The fees under the Voluntary Correction Program (“VCP”) generally are unchanged, ranging from a low of $750 to a high of $25,000, depending on the number of plan participants. If the IRS discovers an error on audit, the fees under the Audit Cap program have increased, with a new low of $2,500 to a new high of $88,000.
• New Address. VCP submissions now must be sent to the IRS office in Covington, KY, rather than Washington, D.C.
• 457(b) Plan Correction Filings. The Procedure states that the IRS will accept submissions related to governmental employer sponsored 4579b) plans outside of the EPCRS, but through procedures similar to those under the EPCRS. The IRS generally will not review 457(b) plan filings from tax-exempt employers.

These items may look daunting, but the lesson, as always, is that it is better to be diligent with respect to plan documentation and administration rather than to let things slide and create a mess that will need to be cleaned up later. Still, mistakes will happen, and the new EPCRS provides plan sponsors with a greater opportunity than ever to correct these mistakes at a fraction of the cost of dealing with them on audit. Accordingly, plan sponsors should consider reviewing or auditing their qualified plans or 403(b) plans to determine whether they should take advantage of these new procedures.

Some of the more significant provisions in the bill are as follows:

1. the 10% individual income tax bracket, scheduled to expire at the end of 2012, was extended permanently;
2. the 25%, 28%, and 33% income tax rates, also scheduled to expire at the end of 2012, were extended permanently for income at or below $400,000 for individual filers and for income at or below $425,000 for heads of households and $450,000 for married taxpayers filing jointly, and a new 39.6% income tax rate will be imposed above those limits;
3. the personal exemption phase-out is permanently repealed for all taxpayers at or below certain income levels ($250,000 for individual filers, $275,000 for heads of households and $300,000 for married filing jointly);
4. the itemized deduction limitation is permanently repealed for all taxpayers at or below certain income levels ($250,000 for individual filers, $275,000 for heads of households and $300,000 for married filing jointly);
5. the bill permanently extends the 2001 modifications to the child tax credit;
6. the bill permanently extends marriage penalty relief;
7. the bill permanently extends expanded Coverdell accounts;
8. the bill permanently extends the expanded $5,250 exclusion for employer-provided educational assistance;
9. the bill permanently extends the expanded student loan interest deduction;
10. the bill permanently extends the exclusion from income of amounts received under certain scholarship programs;
11. the bill permanently extends the expanded dependent care credit;
12. the bill permanently extends the adoption tax credit and the adoption assistance programs exclusion;
13. the bill permanently extends the credit for employer expenses for child care assistance;
14. the bill continues to provide a $5 million exception for estate tax liability, which is inflation adjusted, and will apply a top tax rate 40 percent to estates of decedents dying after December 31, 2012;
15. the bill permanently extends the current capital gains and dividends rates on income at or below $400,000 (individual filers), $425,000 (heads of households) and $450,000 (married filing jointly) for taxable years beginning after December 31, 2012, and applies a 20 % rate on income in excess of those limits;
16. effective for years beginning after December 31, 2011, the bill increases the AMT exemption amounts (from $33,750 to $50,600  individuals and from $45,000 to $78,750 for married filing jointly), and allows nonrefundable personal credits against the AMT;
17. the bill extends through 2013 the increase (from $125 to $240) in the exclusion from income for employer-provided mass transit and parking benefits, so that it is the same as the exclusion for employer-provided parking benefits;
18. the bill extends for two years the provision that permits annual tax-free distributions to charity from an IRA held by someone age 70 1⁄2 or older of up to $100,000 per taxpayer, per taxable year (and includes a provision under which an individual can make a rollover during January of 2013 and have it count as a 2012 rollover);
19. the bill extends for two years, through 2013, the research tax credit equal to 20 percent of the amount by which a taxpayer’s qualified research expenses for a taxable year exceed its base amount for that year and provides an alternative simplified credit of 14 percent; and
20. the bill permits any amount in a non-Roth account in eligible retirement plans to be converted to a Roth account in the same plan, whether or not the amount is distributable with the  amount so converted being subject to regular income tax (plans currently can allow participants to convert their pre-tax accounts to Roth accounts but only with respect to money the participants have a right to take out of the plan).

The bill extends for one year the availability of benefits under the Emergency Unemployment Compensation Program, and continues for one year the benefits under the extended benefit program with a 3-year look-back.  The 2% payroll tax holiday was not extended under the bill.

It appears that the only significant employee benefit plan matter covered in the bill is the expanded in-plan Roth conversions (discussed above).  This change produces a $12 billion revenue offset, and thus the reason for its inclusion is obvious.  Most of the employee benefits industry supports this change, although the hope for many was that it could be held back for the next wave of fiscal cliff negotiations, which essentially starts right after the new Congress is sworn in, as a way to defend against efforts to raise revenue by increasing contribution limits.  Employee benefits issues likely will draw some attention in the continuing fiscal negotiations.

Next up are the budget, the expiration of the debt limit and the sequestration (mandatory spending cuts) under the Budget Control Act. In a classic case of kick the can, the bill moves sequestration forward a mere two months.  To make things more interesting, the debt limit will expire at about the same time.  Battle sides are forming.  In comments after passage of the bill, President Obama indicated he plans to seek additional tax revenue through tax reform to partially fund sequestration relief and deal with deficit.  Republicans are likely to oppose such a move (some already have said this publicly).  There still are more cliffs ahead of us.