Employee Benefits Developments - January 2019

Hodgson Russ LLP

The Employee Benefits Practice is pleased to present the Employee Benefits Developments Newsletter for the month of January 2019.


Second Circuit Overrules District Court Dismissal of Stock-Drop Case

In a significant departure from the stock drop case rulings coming out of other courts, including other U.S. Courts of Appeals, the U.S. Court of Appeals for the Second Circuit overturned a district court’s dismissal of a claim for breach of ERISA fiduciary duties brought by a participant whose accounts in IBM’s 401(k) plan were invested in an IBM stock fund and suffered losses as a result of a decline in the market price of IBM shares.  Prior to this Second Circuit ruling, plaintiffs in other stock drop cases have struggled to defeat plan defendants’ motions to dismiss.

The plaintiff in this case alleged that plan fiduciaries knew or should have known that IBM’s microelectronics division was overvalued, and then failed to disclose that fact to plan participants.  That failure, according to the plaintiff, artificially inflated IBM’s stock price, and ultimately resulted in a $12 share price drop when IBM had to pay $1.5 billion to sell the struggling microelectronics division and also had to take a $4.7 billion pre-tax charge that in-part reflected an impairment in the stated value of the microelectronics business.  Among other things, the plaintiff alleged that the plan fiduciaries knowledge of undisclosed financial trouble for the microelectronics division violated the ERISA fiduciary duty of prudence.  The district court (i.e., the federal trial court), however, dismissed the claim, based on pleading standards prescribed by the Supreme Court in Fifth Third Bancorp v. Dudenhoeffer,  because the plaintiff’s pleadings lacked allegations sufficient to demonstrate that a prudent fiduciary could not have determined that each of the plaintiff’s proposed alternative actions for avoiding an ERISA breach (for example, making public disclosures or halting the plan from making further investments in IBM stock) might have caused more harm than good.

On appeal, the Second Circuit disagreed with the district court, and concluded that the plaintiff plausibly pleaded that the plan defendants violated the fiduciary duty of prudence.  The Second Circuit devoted some attention to assessing the Dudenhoeffer “more harm than good” pleading standard, which is susceptible to multiple interpretations.  But, the Second Circuit ultimately declined to decide which interpretation is correct, and instead ruled that the plaintiff plausibly pleaded a duty of prudence claim even under a more restrictive application of the “more harm than good” standard.  The Second Circuit identified several allegations in the plaintiff’s amended complaint that “plausibly establish that a prudent fiduciary in the IBM plan defendants’ position could not have concluded that [early] corrective disclosure [of the microelectronics division’s impairment] would do more harm than good,” including allegations that the plan defendants knew the IBM stock was artificially inflated, that the Plan defendants had the power to disclose the truth to the public and correct the artificial inflation, that failure to promptly disclose the actual value of the microelectronics division hurt the long-term prospects of IBM stock as an investment due to reputational harm that could lead to greater stock drops, that a prudent fiduciary need not fear overreaction by the market to disclosure of the microelectronics division’s impairment because IBM stock is traded in an efficient market, and that disclosure of the truth regarding IBM’s microelectronic business was inevitable.  Thus, the Second Circuit reversed the district court’s grant of the defendant’s motion to dismiss the complaint, and remanded the case for further proceedings.

The rarity of this type of victory for plaintiffs in a stock drop case is particularly noteworthy, and potentially signals future opportunities for plaintiffs in stock drop cases to survive a plan defendant’s motion to dismiss.  In the meantime, this case warrants further monitoring – the case certainly is not over and further appeals, perhaps even to the Supreme Court, will need to play out before the influence of this decision on future stock drop cases can be fully assessed.  Jander v. IBM (2nd Cir. 2018).


ACA Currently Remains In Effect, Despite Texas District Court’s Ruling

On December 14th, the US District Court for the Northern District of Texas held that the Patient Protection and Affordable Care Act (ACA) is unconstitutional.  By way of background, in Nat’l Fed’n of Indep. Business v. Sebelius (NFIB), 567 U.S. 519 (2012), it was Congress’s authority to impose a tax under the Interstate Commerce Act that the Supreme Court upheld the constitutionality of the individual mandate and the ACA.  In the present case, the district court reasoned that the “zeroing out” of the individual mandate tax penalty (effective January 1, 2019, as part of the Tax Cuts and Jobs Act) means that the individual mandate will no longer be a valid exercise of Congress’s taxing authority.  The district court further reasoned that the entire ACA will become invalid because the individual mandate is an essential component of the law and is “inseverable from the ACA’s remaining provisions.”  However, because this ruling does not grant injunctive relief, employers and plan sponsors will continue to be responsible for complying with the ACA until trial court proceedings and appellate review are complete.  (Texas v. United States (N.D. Tex. 2018))


IRS Issues Transition Relief For Application of the 403(b) Plan “Universal Availability” Rule to Part Time Employees

On December 4, 2018, the IRS issued a notice offering transition relief to retirement plan sponsors who have incorrectly excluded part-time employees under the “universal availability” requirements of Code Section 403(b).

Tax exempt and educational organizations that sponsor 403(b) retirement plans must comply with the “universal availability” nondiscrimination requirement.  Under this rule, all employees of the employer must be permitted to make elective deferrals, with the exception of the certain categories of employees, including those who normally work less than 20 hours per week.  However, once such a part-time employee gains eligibility by working 1,000 hours in a plan year or anniversary year, the employee may not be excluded from making elective deferrals in a subsequent year on the basis that they did not work enough hours. 

Many employers fail to conform to this Once-In-Always-In condition on 403(b) plan eligibility, excluding part-time employees from year to year based on the hours worked in any given plan year or anniversary year.  In response to comments regarding the widespread nonconformity with the Once-In-Always-In condition, the IRS issued a notice providing transition relief for 403(b) plans that were not operated in accordance with the Once-In-Always-In condition, or lacked necessary plan language. 

The transition relief is available to 403(b) plan sponsors who consistently applied an incorrect eligibility rule, excluding all part-time employees from year to year (plan year or anniversary year).  The transition relief encompasses errors in both plan operations and plan language, and offers a “fresh start” when the transition period expires.  The IRS defines a “Relief Period” as commencing after December 31, 2008 and expiring before December 31, 2019, depending on the last year the employer improperly excluded a part-time employee based on either plan year or anniversary year hours of service.  For employers using the calendar year to measure hours of service, the Relief Period expires December 31, 2018.

During the Relief Period a 403(b) plan will not be treated as failing to satisfy the Once-In-Always-In condition merely because the plan was not operated in conformity with the rule.  In addition, any 403(b) plan document which omits the Once-In-Always-In exclusion condition has until March 31, 2020 to be amended to include the required language.  Finally, employers are allowed a “fresh start” for 2018 and may exclude a part-time employee who previously worked more than 1,000 hours, but did not do so in 2018.  Thus, employers may act as though the Once-In-Always-In condition first became effective January 1, 2018.

A plan must conform to the Once-In-Always-In condition for plan years or anniversary years beginning on or after January 1, 2019.  Sponsors of 403(b) plans should carefully examine their plan operations regarding the exclusion of part-time employees and ensure that any individually designed plans are amended appropriately during the remedial amendment period or restated on a pre-approved plan document. (Notice 2018-95, 2018-52 IRB)


IRS Provides Guidance on New Private Company Equity Grants

The 2017 Tax Cuts and Jobs Act included a new provision on the tax treatment of certain stock options and restricted stock units (RSUs).  After 2017, privately held companies may make grants of stock options or RSUs to certain non-executive employees, and those employees may elect to defer income tax inclusion on those grants for up to 5 years, provided certain requirements are met.  The deferral election will not be available to 1% owners, current or former chief executive officers and chief financial officers (as well as their family members), or certain highly compensated officers.  The IRS has issued guidance on this new Section 83(i) of the Internal Revenue Code. 

One requirement that is addressed is that options or RSUs must be granted to at least 80% of the company’s U.S. workforce.  The 80% requirement must be satisfied on the basis of a single calendar year (a multi-year approach is not permitted) and the workforce must be measured over the entire calendar year (a snapshot date test is not permitted).  Also addressed is the mechanism for tax withholding on the deferred income.  The IRS guidance requires the establishment of an escrow account which would hold the shares until the time the tax obligation is triggered. 

The use of these qualified equity grants has not seemed to generate much interest for private companies.  Some companies were concerned that they could inadvertently fall within these rules.  Under the IRS guidance, this concern can be avoided by not establishing the escrow account; by not having an escrow account, the options and RSUs would then not meet the requirements of Section 83(i).

The IRS anticipate that the guidance in the Notice will be incorporated into future regulations that, with respect to issues addressed in the Notice, will apply to any taxable year ending on or after December 7, 2018.  IRS Notice 2018-97  https://www.irs.gov/pub/irs-drop/n-18-97.pdf


IRS Issues Interim Guidance on The Excise Tax Imposed on Executive Compensation Arrangements of Tax-Exempt Organizations

On December 31, 2018, the IRS issued Notice 2019-09 regarding the interpretation of Code Section 4960.  Enacted as part of the Tax Cuts and Jobs Act, Code Section 4960 imposes a 21% excise tax on an applicable tax-exempt organization (“ATEO”) that pays remuneration in excess of $1 million for a taxable year or any excess parachute payment to a covered employees of a tax-exempt organization.

Using a question and answer format, Notice 2019-09 provides interim guidance on a number of issues arising under Code Section 4960, including which taxable year is to be used for calculating the excise tax, the determination of an ATEO’s covered employees, the treatment of related organizations, the limited and medical service exceptions, and the timing and nature of remuneration, the allocation of excise tax liability among related organizations, and excess parachute payments subject to the excise tax.

Taxable Year

As more generally set forth above, Code Section 4960(a)(1) provides that the 21% excise tax applies to remuneration paid by an ATEO to a covered employee in excess of $1 million for a taxable year.  Code Section 4960 did not specify whose taxable year is to be used, the ATEO’s or the covered employee’s.  Notice 2019-09 clarifies that the relevant taxable year will be the calendar ending with or within the ATEO’s taxable year.  This approach aligns more closely with how remuneration is reported on Form W-2 and Form 990.

Covered Employee Status

A covered employee includes any individual who is among an ATEO’s five highest paid employees for the current taxable year or in any preceding taxable year beginning after December 31, 2016.  Notice 2019-09 provides that covered employee status is determined based on remuneration for services performed as an employee of the ATEO or a related organization.  The remuneration used for this purpose is the remuneration paid to an employee by the ATEO or any related organization during the taxable year (as defined above). 

The Notice provides limited relief where an ATEO pays less than 10% of an employee’s total remuneration for services performed as an employee of the ATEO or any related organization.  In that circumstance, the employee is generally disregarded in determining the ATEO’s covered employees for the taxable year.

It is recommended that ATEOs develop a system for tracking covered employees.


For purposes of the excise tax, “Remuneration” generally has the same meaning as Code Section 3401(a) wages for income tax withholding purposes, except that it excludes designated Roth contributions, and includes amounts required to be included in gross income under Code Section 457(f).

In determining covered employee status and whether there is Remuneration subject to the excise tax, “Remuneration” does not include remuneration paid to a licensed medical professional for the performance of medical (including nursing) or veterinary services.   ATEO’s with highly paid medical professionals that serve in dual capacities must make a reasonable, good faith allocation between remuneration for medical services and other services.

When is Remuneration Considered to be Paid?

Remuneration is considered to be paid when it is no longer subject to a substantial risk of forfeiture within the meaning of Code Section 457(f) (but without regard to whether the remuneration is actually subject to Code Section 457(f)).  Thus, in general, remuneration is considered paid if an employee’s right to the remuneration is not conditioned on the future performance of substantial services or the occurrence of a condition that is related to a purpose of the remuneration – for example, the achievement of performance goals.

In a departure from the Code Section 457(f) rules, the Notice provides that earnings on remuneration previously considered to be paid are treated as paid at the close of the taxable year in which they accrue.  Thus, in the case of an account-based deferred compensation arrangement, any earnings on previously vested amounts would be treated as paid during the year they accrue, even though not currently taxable under Code Section 457(f).

Since the rule views remuneration as being paid when it is vested, the present value of any remuneration that became vested, but was not actually received, before January 1, 2018 escapes the Code Section 4960 excise tax.  Accordingly, even though there is no formal grandfathering rule under Code Section 4960, certain deferred amounts that remain to be paid nonetheless escape the excise tax.  It is recommended that ATEOs inventory any deferred compensation arrangements they maintain and evaluate whether any amounts under those arrangements are “grandfathered.”

What is the Amount of Remuneration Treated as Paid?

If there is remuneration that is considered to be paid currently, but that is not actually paid currently, the amount of remuneration treated as paid currently is the present value of the future payments owed to the employee.

Related Organizations

If an individual performs services as an employee for an ATEO and organizations related to the ATEO, all remuneration paid to the individual is generally aggregated in determining covered employee status and whether more than $1 million in remuneration was paid to the individual during the taxable year.  In this regard, whether organizations are related to one another is determined using a 50% control threshold.  Thus, organizations may be considered related even though they may not represent a controlled group for retirement plan purposes.  That said, the methodology set forth in the Notice is generally consistent with Form 990 reporting.

Allocation of Excise Tax Liability

If a covered employee is paid remuneration in excess of $1 million for service performed for an ATEO and related organizations, the excise tax must be allocated between the ATEO and each related organization based on relative remuneration paid by each organization.  The Notice provides guidance on (i) an ATEO determining whether excess compensation is paid to its covered employees and, if so, how to allocate the excess tax liability with respect to the excess compensation, and (ii) obtaining information from another ATEO as to whether the first ATEO is subject to excise taxes based on remuneration paid by the first ATEO as a related organization with respect to a covered employee of the other ATEO.

Excess Parachute Payments

Generally, excess parachute payments subject to the excise tax are determined using rules similar to those applied under Section 280G.  However, Section 4960 differs somewhat in imposing the excise tax only if the excess parachute payment is contingent upon an involuntary separation.  The notice provides detailed information about how to calculate the base amount and makes clear that parachute payments may include accelerated vesting of deferred compensation as a result of an involuntary separation, even if such amounts remain unpaid. 

Excise Tax Reporting

If an organization owes excise taxes under Code Section 4960, the excise tax is to be reported using Form 4720.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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