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<nobr>Feb 16, 2005</nobr>

Treasury Response To ERIC Letter on March 15 Deadline

On February 4, ERIC, joined by the Profit Sharing/401(k) Council of America (PSCA), wrote the Treasury Department to ask for a delay in the March 15, 2005, deadline for deferral elections, especially regarding issues related to 401(k) spillover plans and 415 excess plans.

As a result of recent informal discussions with a Treasury Department official, ERIC has learned that the Treasury and the Internal Revenue Service are unlikely to grant ERIC’s February 4th request for an extension of the March 15th deadline in Q&A-21 of Notice 2005-1. ERIC’s request, which was joined in by The Profit-Sharing/401(k) Council of America (“PSCA”), asked the Treasury and the Service to give employers and employees more time to conform the operation of their defined contribution mirror and excess plans (“spill-over plans”) to the advance election requirement in section 409A(a)(4)(B) by extending the March 15th deadline in Q&A-21 until December 31st.

The Treasury’s inclination not to extend the March 15th deadline appears to be based on the view that Notice 2005-1 already grants adequate relief. First, as ERIC recognized in its request, Q&A-20 provides relief for decreases in deferrals during 2005. As far as increases in deferrals are concerned, the Treasury appears to believe that the Notice provides adequate relief even beyond the March 15th deadline in Q&A-21. If an employee’s deferrals under a spill-over plan increase after March 15th because the qualified plan bumps up against the ADP limit or some other Internal Revenue Code limit, the increase in the amount deferred could reasonably be viewed as the result of the employee’s original election (to defer any amount that the qualified plan limits prevent the employee from deferring under the qualified plan) and not as a change in that election. In this respect, the advance election requirement might apply in the same way as it applies when an employee receives a mid-year pay increase: if the employee elected to defer 10% of pay, the increase in the amount deferred that results from the mid-year pay increase should be viewed as consistent with the employee’s original deferral election and not as a change in that election. The result should be the same when the qualified plan limits cause an employee’s deferrals under the spill-over plan to increase.

While the Treasury’s analysis seems to be sound and constructive as far as it goes, it does not solve the problem identified by the ERIC/PSCA request: many spill-over plans permit participants to change their deferral elections after the year starts, and many qualified plans also allow participants to change their section 401(k) elections (or their after-tax contribution elections) after the year starts – which can indirectly affect the deferrals under the related spill-over plan. For example, where the spill-over plan provides that it will accept all deferrals to the related section 401(k) plan that the section 401(k) plan cannot accept because of an Internal Revenue Code limit, and where the section 401(k) plan allows a participant to change his or her deferral rate at any time, a mid-year increase in a participant’s deferral rate under the section 401(k) plan from 6% to 15% can have the effect of a mid-year increase in the participant’s deferral rate under the spill-over plan.

The Treasury’s position appears to be based on its view that, under prior law, deferral elections generally had to be made before the beginning of the year in which the compensation was earned; because of this view, the Treasury does not appear to be inclined to extend the March 15th deadline. In the Treasury’s view, elections that were impermissible under prior law should not be granted generous transition relief.

Although this view of the advance election requirement has often been asserted by the IRS in rulings and litigation, the courts have generally rejected the IRS’s position and have adopted a much more flexible approach toward the tax treatment of deferred compensation than the IRS has. It is not surprising that many employers designed their plans in the past to conform to what the courts have said to be the law rather than to what the IRS has asserted it to be.

If the Treasury and the Service do not extend the March 15th deadline, plans with flexible deferral election features will continue to have great difficulty in complying with the advance election requirement in 2005. ERIC intends to continue to pursue its case vigorously with the Treasury and the Service.

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