ESOPs & Employee Benefits Update – Q1 2022 Client Update
Happy Spring from the K&C ESOPs & Employee Benefits practice group. We’ve compiled a short list of employee benefits updates from the first quarter of 2022. Please feel free to contact us if you would like to discuss them in more detail.
401(k) Plan Restatement and Amendment Reminder
Sponsors of pre-approved 401(k) plans probably are aware that we are nearing the end of another six-year “restatement” cycle mandated by the IRS. As a result, all pre-approved 401(k) plan documents must be entirely updated for the so-called “Cycle 3” restatement by July 31, 2022. The update is required even if you haven’t changed any terms of the plan, and is unrelated to the recent legislation discussed below. If you sponsor a pre-approved plan and have not heard from your plan document provider, it’s important to contact them to ensure the restatement is in process. Failing to complete the restatement by the deadline will result in IRS penalties.
Additionally, most plans will also require two separate amendments by the end of 2022. These amendments will update plan documents for the SECURE Act (December 2019) and the CARES Act (March 2020). The SECURE Act covered several topics such as raising the required minimum distribution age to 72, changing the required minimum distribution rules to eliminate “stretch” distributions for most beneficiaries, allowing qualified birth or adoption distributions, allowing more flexibility for safe harbor 401(k) plans, allowing 401(k) deferrals by “long-term, part-time” employees, and various other matters. The CARES Act, on the other hand, addressed very specific COVID-related relief during the 2020 plan year.
Because of the timing involved with prior IRS approval of plan documents, the “Cycle 3” restatement documents do not include provisions for these two new laws. Many plans have not yet been amended for the SECURE Act and the CARES Act, in part because clarifying guidance is still needed from the IRS on some aspects, so expect to see amendments from your document provider later this year.
IRS Issues Proposed RMD Regulations
Closely related to the major provisions of the SECURE Act, the IRS recently released proposed required minimum distribution (RMD) regulations. Although they are not yet finalized, they give us a good look at the IRS’s thought process on the updated RMD rules following the SECURE Act. The regulations, among other things, implement the elimination of “stretch” distributions that previously allowed younger beneficiaries of deceased plan participants or IRA holders to take RMDs over the younger beneficiaries’ lifetimes.
These rules often allowed children or grandchildren of deceased participants or IRA holders to take distributions, and therefore spread taxes, over many decades. The SECURE Act eliminated that option for all but a handful of types of beneficiaries, including a participant’s spouse, child under age 21 (but only until age 21), a disabled or chronically ill individual, or anyone else less than 10 years younger than the participant. All other designated beneficiaries, including most children and grandchildren, will now instead be required to distribute the entire account within 10 years of the participant’s death.
The proposed RMD rules also implement the delay in the RMD starting age from 70 ½ to 72 and generally update the RMD regulations. These new rules likely will be incorporated into the SECURE Act amendments to be completed later this year, although operationally the new rules are already in effect.
DOL Weighs in on Crypto Investments in 401(k) Plans
Meanwhile, the Department of Labor issued a “Compliance Assistance Release” directed at plans that are, or are considering, allowing participants to direct their accounts into cryptocurrencies (Bitcoin, “tokens,” and similar assets). The DOL did not mince words—it is adamantly opposed to any form of cryptocurrency being offered to plan participants. Although the Release does not prohibit such investments outright, the DOL guidance has strong words for plan fiduciaries who allow them. It has several concerns, some technical but primarily oriented toward protection of participants in volatile assets that it deems inappropriate for retirement savings accounts.
Interestingly, the guidance also appears to apply to plans that allow cryptocurrency investments through self-directed brokerage windows, arguably expanding plan sponsors’ responsibilities to monitor brokerage window investment alternatives, as well as investments in “other products whose value is tied to cryptocurrencies,” leading to unanswered questions about whether indirect investments are a risk to plan sponsors as well.
Plan sponsors should consider this guidance very carefully—and be prepared to explain their actions in light of the DOL’s warnings—before allowing participants to invest in these asset classes.
New Legislation on the Horizon
Although far from final, the House recently passed H.R. 2954, the Securing A Strong Retirement Act (SECURE 2.0), another comprehensive retirement plan bill covering an enormous amount of ground, including mandating automatic enrollment in 401(k) plans, further increasing the RMD age, allowing matching contributions for student loan repayments, increasing catch-up contribution limits, creating further tax incentives for plan establishment and contributions, and many other substantive and technical updates.
The bill also includes two provisions that would assist employee stock ownership plans (ESOPs) and business owners seeking to establish ESOPs.
Section 117 of SECURE 2.0 modifies Internal Revenue Code Section 1042 to modestly expand eligibility on the deferral of capital gains recognition from the sale of stock to an ESOP for “all domestic corporations”, including S corporations, rather than just C corporations under the current law. However, it should be noted that the deferral is limited to no more than 10% and does not take effect until after December 31, 2027. The S corporation must otherwise meet all other requirements for 1042 deferral, including the requirement that at least 30% of the company must be owned by the ESOP after the sale.
In addition, Section 118 of SECURE 2.0 provides the opportunity for ESOPs to offer shares on certain SEC-regulated interdealer quotation systems. This section could assist some ESOPs in establishing valuations for their stock as well as potentially creating a market where ESOPs could invest in other ESOPs to meet diversification requirements.
SECURE 2.0 still needs to pass the Senate and then head to President Biden for enactment, so there is a strong likelihood that there will be additional changes before the bill does ultimately become law.
Fourth Circuit Issues Favorable Decision for ESOPs
Finally, at the end of 2021, the Fourth Circuit issued an opinion in Walsh v. Vinoskey providing a favorable damages mitigation pathway for ESOPs, ESOP-owned companies and selling shareholders in cases where the ESOP is alleged to have overpaid for the stock it acquired. The Fourth Circuit ruled that the $4.6 million in debt owed to the selling shareholder, which he forgave after the challenged transaction, counts toward the determination of damages such that the amount of damages due was reduced by $4.6 million. The court noted that if the debt forgiveness was not counted toward damages that the award would have resulted in a windfall for the ESOP that is prohibited by ERISA and court precedent. This is a favorable ruling for ESOPs as it provides an additional tool to use when claims are made that the ESOP paid more than adequate consideration for the stock it acquired. The decision can help to mitigate not only the damages determination but also could reduce the cost and time involved in an investigation or suit challenging an ESOP’s purchase of stock.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.