Month: May 2021

Unless you’ve been living under a rock, you must have heard about ESG Investing. The concept of investing while assessing the Environmental, Social and Governance aspects of underlying companies has become a major focus of the SEC, Department of Labor and Investment Advisors recently. The concept is now working its way into the investment portfolios of America’s most common retirement program: the 401(k) Plan.

The ESG concept, also known as Corporate Socially Responsible Investing takes action to protect the environment as well as promote human rights and equal employment opportunities. It has long been established that businesses and corporations should act responsibly in the communities and environments they operate in. These actions essentially established Socially Responsible Investing (SRI) screens, but it was not until the 1960s that SRI vaulted forward as an investment discipline in the United States.

• 1960s – Protests of the Vietnam War led to boycotts of companies that provided weapons used in the war. Community development banks were established in low-income communities to provide financing opportunities that were otherwise not available.
• 1970s – Social activism spread to labor-management issues at many corporations, while the protection of the environment also became a consideration for many investors.
• 1980s – While Jesse Owens was imprinted on and made advertisements for the South African Krugerrand, many churches, universities, and organizations protested to force US Companies to divest themselves from operations in South Africa due to apartheid. Some of the first SRI mutual funds were marketed as investments. The Calvert Social Investment Fund not only restricted investment away from weapons, alcohol, tobacco, and gambling, but also examined more modern issues including nuclear energy, environmental pollution, and the treatment of workers.
• 1990s – Sufficient proliferation of SRI mutual funds and growth in popularity as an investment approach led to the creation of an index to measure performance. The Domini Social Index, made up of 400 primarily large cap US Corporations launched in 1990 and over time, helped to disprove the argument that investors were settling for lower returns by limiting the companies they included in their portfolios.

So, how do these SRI practices relate to a 401(k) Plan? In November 2020, the Department of Labor published regulations billed as the final rule on “Financial Factors in Selecting Plan Investments”. This rule amended the investment duties under Title I of ERISA requiring Plan Fiduciaries to select investments and investment courses of action solely on “pecuniary factors”, which were defined as factors a fiduciary prudently determines are expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy. In other words, the amended rules would require plan fiduciaries to select investments based solely on financial considerations of the investment. The DOL specifically indicated this was an effort to set limits on SRI investing (or as they referenced it, ESG Investing), stating that the only factors in fund selection should be three ERISA duties – prudence, diversification, and loyalty. The DOL felt that if decisions were made based on other factors, the Plan Fiduciaries may be in breach of their fiduciary duties. But is ESG Investing a breach of fiduciary duty?

When selecting investments in a qualified plan, ERISA dictates that a Plan Fiduciary must act rationally for the exclusive benefit of all participants and must ensure diversification among asset classes. The rule of loyalty requires that securities be purchased at a fair market value, not just what they are willing to pay for the security but ensuring they are paying the value of the security. This is especially true when preparing a menu of funds for participants to direct their investments. The initial DOL regulation assumed that socially responsible investing is somehow less prudent, less diversified or has less value. However, in March of 2021. the DOL released an enforcement policy statement that they will not enforce the recently published final rules and would be investigating the matter further. It may have been due to the public comments, it may have been due to the change in leadership, but the DOL is discussing the future consideration of these funds and their ability to be part of a prudent investment line-up.

New surveys suggest that many workers are not aware of ESG options but would likely invest in them if offered the choice. The success of companies such as Bombas, Toms and DIFF, who donate socks, shoes, or glasses to under-served communities with each purchase, proves there is a strong desire and market for this type of investing. If a fund menu provides acceptable ESG investing options as well as sufficient non-ESG alternatives, and the participant can construct a well-diversified portfolio either way, there is no problem under ERISA. There is no requirement to offer these funds, but if participants want to invest this way, the plan may find increased participation, greater participant engagement and more successful retirement outcomes. Ultimately, isn’t this why a company establishes a retirement plan to begin with?

The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) generally allows parents to take an early distribution (up to $5,000) from an employer sponsored retirement plan or IRA during the 12-month period beginning on the date a child is born or legally adopted. The distribution is not subject to the 10% additional income tax for early withdrawals (generally, distributions made prior to attainment of age 59 ½). In addition, the new law permits repayment of such distributions (which are treated as rollover contributions) to an employer sponsored plan or IRA. The new law is effective for distributions made after December 31, 2019.

This new law, however, leaves several unanswered questions regarding these types of distributions – particularly, the permissible timeframe for “repaying” such a distribution to an eligible retirement plan. The IRS did issue preliminary guidance in Notice 2020-68, addressing some of the provisions of the law, but regulations will ultimately need to be issued before it is clear how all of the provisions will apply.

How does the new law define “qualified birth or adoption” (QBA) distributions?

A QBA distribution is defined as any distribution made from an eligible retirement plan to an individual during the one-year period beginning on the date a child was born or legally adopted. Note that legal adoption of a child under the age of 18 or a disabled individual (as defined under IRC section 72(m)(7)) would qualify provided the child (or disabled person) is not the individual’s stepchild.

What types of retirement plans can allow QBA distributions?

Eligible retirement plans include defined contribution plans, e.g., 401(k) plans, 403(b) plans, governmental 457(b) plans, and IRAs.

Are plans required to offer this distribution option?

No. This is an optional provision, not a required one. Based on the preliminary guidance in Notice 2020-68, however, if a plan permits QBA distributions, the plan will also be required to permit repayment of such distributions (up to the amount distributed from the plan) if the participant would otherwise be eligible to make a rollover contribution.

Is this a new type of hardship distribution?

No. It is an entirely new type of in-service distribution. It is permissible to make QBA distributions from restricted accounts (e.g., 401(k), Roth, and safe harbor accounts), and unlike hardship distributions, QBA distributions may not be “grossed up” for income taxes, and there is no requirement that a participant demonstrate a financial need or even how the funds will be used. Rather, the only requirement is that the participant has had a child (or adopted a child or disabled person) within the last 12 months. Notice 2020-68 states that the plan administrator can rely on the participant’s representation that he or she qualifies for a QBA distribution, unless the plan administrator has specific knowledge to the contrary.

Are there limits that apply to QBA distributions?

Yes. There is an individual and plan limit. The individual limit that applies to each parent, i.e., there is not a “family” limit. Additionally, the $5,000 individual limit is determined separately for each child. For example, assume a couple has twins. Each parent could withdraw up to $10,000 ($5,000 x two children) from his or her eligible retirement plan accounts.

With respect to QBA distributions made from plans, the $5,000/per child limit applies to all plans maintained by the employer, e.g., all plans sponsored by a controlled group. As a result, plan administrators must limit the amount distributed under the new rules to the maximum an individual could receive (taking into consideration all plans sponsored by the employer). Plan administrators are not, however, required to determine whether the participant would qualify for the QBA distribution based on QBA distributions made from other plans (sponsored by unrelated employers), or the individual’s IRA(s). The participant (or IRA owner) is ultimately responsible for reporting QBA distributions on their individual income tax return.

If a plan permits QBA distributions, what are the withholding and reporting requirements?

QBA distributions are not treated as eligible rollover distributions for purposes of the special tax notice (required under IRC section 402(f)) or the withholding rules (which generally require 20% federal withholding on eligible rollover distributions). Rather, they are subject to a 10% default withholding rate for federal income taxes, unless elected otherwise by the participant.

The Form 1099-R instructions have been updated for QBA distributions and indicate that such a distribution generally should be reported as a taxable distribution, using Code 1 (early distribution, no known exception). This is presumably because the plan administrator would have no way of knowing whether the distribution made from the plan would ultimately qualify since all QBA distributions taken by the individual (which would include distributions made from other plans and IRAs) must be considered.

Also, in order for the distribution to qualify as a QBA distribution, the participant must report the name, age, and taxpayer identification number of the child (or disabled person) on his or her individual income tax return.

If a plan does not permit QBA distributions, and a participant is otherwise eligible for a distribution, can they treat the distribution as a QBA distribution?

Yes, to the extent it does not exceed the individual’s limit, i.e., $5,000 per child. Keep in mind, the plan would process the distribution without regard to how the participant handles it on their income tax return. For example, a plan could not waive mandatory 20% federal withholding (at the participant’s request) if a participant indicates they will be treating the distribution as a QBA distribution on their personal income tax return.

How can a participant repay a QBA distribution?

First, as mentioned above, the law did not provide the timeframe for repaying such distributions, so the regulations will need to be issued before the rules are clear (or rather, hopefully clear). Presumably, there may be a requirement that the distribution be repaid within three years (similar to disaster and coronavirus-related distributions) since an individual’s income tax return is generally “open” for three years.

If a plan permits QBA distributions, the plan must also permit repayment of those distributions (up to the amount distributed from the same plan), provided the participant would otherwise be eligible to make rollover contributions to the plan at the time of the repayment. For example, most 401(k) plans do not allow terminated participants to make rollover contributions, so a terminated participant generally would not be allowed to repay a QBA distribution to the distributing plan. If the participant is not eligible to make a rollover contribution to the distributing plan, it would appear they will be able to repay the amount to an IRA, though.

Further, it may be that such repayments are treated in the same manner as disaster and coronavirus-related distributions, meaning that an individual will be able to use Form 8915 series to report the repayment and claim the deduction. Again, the IRS will need to issue regulations (and possibly other guidance) to address the repayment rules for QBA distributions.

If a plan sponsor wants to permit QBA distributions, what actions must be taken?

A plan can permit QBA distributions now, as long as the plan adopts the conforming amendment by the deadline provided under the SECURE Act, i.e., December 31, 2022 for calendar year plans. Note that collectively bargained and governmental plans generally have until the last day of the 2024 to adopt the conforming amendment.

How can I learn more about the new rules?

When the IRS issues the regulations (or other guidance), we will provide an update. In the interim, please contact EJReynolds to learn more about these rules and how they may impact your plan and plan participants.

Under the controlled group rules, related employers are treated as a single employer for plan purposes. This means that employers who are part of a controlled group may (or may not) be able to maintain separate plans because ALL employees of the employer, i.e., the controlled group, must be considered when determining what plan design options are available. In other words, certain plan testing requirements apply to the group of related employers on a combined basis.

What is a controlled group?

Controlled group companies can be related under either the “brother-sister” or “parent-subsidiary” rules. A brother-sister relationship exists between two (or more) companies when five or fewer owners have common ownership of 80% or more and identical ownership of more than 50%. A parent-subsidiary relationship exists when a company owns at least 80% of another company. In either case, the stock attribution rules under IRC section 1563 must be applied when determining who has ownership (direct or indirect) in the companies.

Example: assume Bill owns 100% of ABC Company and 80% of DEF Company. The two companies are related under the brother-sister rules since Bill owns more than 50% of each company and at least 80% of both companies. Alternatively, assume ABC Company owns 80% of DEF Company. In that case, a parent-subsidiary relationship exists since ABC Company owns at least 80% of DEF Company. Under either scenario, the employers form a controlled group and must be treated as a single employer for plan purposes.

What are stock attribution rules?

Stock attribution rules require certain family members (and other entities) to be considered when determining whether an individual (or entity) has ownership in a company. Under these rules, ownership is attributed from the actual owner(s) of a business to another party(parties), i.e., the other party is considered to own the same percentage of the company as the business owner for this purpose.

These rules often hit the employer from left field because they do not exactly follow common sense. For example: assume an individual owns a construction company and his wife owns a dental practice. Even though the companies are in completely different industries, they would be considered related under the controlled group rules since ownership is generally attributed between spouses, unless a limited exception applies.

Who are related parties under these rules?

Related parties under these rules suggest certain family members must be considered for this purpose including spouses, children, parents, grandparents, and grandchildren. There are, however, specific rules that apply when determining whether ownership is attributed to a particular family member. There are also attribution rules that apply to corporations, partnerships, estates, and trusts. Lastly, there are attribution rules that apply to stock options.

What are the attribution rules that apply to spouses?

Attribution rules that apply to a spouse’s ownership is attributed to the other spouse unless all of the following conditions are satisfied:

• The spouse has no direct ownership interest in the company; and
• The spouse is not an employee or director; and
• The spouse does not participate in the management of the business; and
• No more than 50% of the company’s gross income is derived from rents, royalties, dividends, interest, or annuities; and
• The interest in the company is not subject to restrictions that would limit the spouse’s ability to dispose of the stock.

Caution: Even when all of the above conditions are satisfied, if a couple resides in a community property state, that state’s laws could result in the spouse having actual ownership in the company. Additionally, if the couple has minor children, ownership is attributed to the children which could result in businesses being related under these rules.

What attribution rules apply to minor children?

Attribution rules that apply to minor children is attributed to the parent’s ownership interest in a company (minor children are under age 21). From a plan perspective, this rule could result in an unexpected “surprise” when a couple has a baby or adopts a child.

For example, if each spouse owns his or her own business and met the exception (described above) prior to the birth of their child, the companies would not have been related under the controlled group rules. After the birth of their child, however, they would be related, i.e., a controlled group, since the child would be considered to own 100% of both companies under these rules (never mind the fact an infant generally could not own a business).

What attribution rules apply to other family members?

Attribution rules applying to other family members are limited with respect to parents, grandparents, grandchildren, and adult children. An individual who owns more than 50% of a company is also considered to own any interest owned (directly or indirectly) by his or her parents, grandparents, grandchildren, and any adult children. Otherwise, there is no attribution.

For example, assume Bill owns 51% of XYZ Company and his adult son owns the remaining 49%. In this situation, Bill is considered to own 100% of XYZ Company since he is attributed his son’s ownership interest. His son, however, is not attributed his father’s ownership interest since he owns less than 50% of the company. This would matter if Bill owned 80% (or more) of another business – in that case, the businesses would form a controlled group.

Note: There are special rules that limit stock attributed to an individual under these rules from being attributed to another family member, i.e., there isn’t “double attribution”, and similar rules that apply with respect to ownership interests held by other entities.

What rules apply to ownership interests held by other entities?

The rules that apply to ownership interests held by other entities is generally attributed to the underlying owners of that entity (or beneficiaries, in the case of a trust or an estate). For example, assume ABC Company (owned 100% by Sally) owns 50% of DEF Company. In that case, Sally is considered to own 50% of DEF Company under these rules.

Are there rules that apply when a person has options to buy an interest in a company?

Yes. When an individual (or entity) has options to purchase an ownership interest in a company, they are normally considered to own that interest under these rules.

Can companies who are members of a controlled group sponsor different 401(k) plans for each company?

It depends. Usually, it is permissible for an employer, i.e., controlled group, to sponsor different 401(k) plans covering different groups of employees. In that case, if each plan can pass coverage on its own after considering all employees of the employer (i.e., the controlled group), the plans could have different features and would not be aggregated for nondiscrimination testing (including ADP/ACP testing and other required nondiscrimination testing).

Alternatively, if each plan cannot satisfy coverage on its own, the plans could be aggregated, i.e., combined, for coverage and nondiscrimination testing provided they have same plan year and use the same ADP/ACP testing method, e.g., prior year or current year testing method, the same safe harbor formula, etc. Also, each plan would generally need to have the same features to avoid additional testing requirements.

Lastly, when an employer sponsors multiple 401(k) plans, the plans generally must be aggregated for top-heavy purposes. There is a limited to exception to this rule, however, when an employer sponsors a plan that does not cover any key employees if that plan is not aggregated with any other plan for coverage and nondiscrimination testing purposes.

That said, depending on the situation, it may make more sense to cover all companies under a single plan than to maintain separate plans. It really will depend upon the demographics of the employer’s workforce, goals of the employer, specific testing requirements, and other factors.

The Bottom Line

Determining whether employers are related under the controlled group rules can be complex, but it is critical in determining what options are available from a retirement plan perspective. Not getting this right can result in unintended and costly mistakes!

For example, assume Bill and Sally are married have three minor children. Each of them owns a business, and since they have children, their companies are related under the controlled group rules.

Bill is an IT consultant and self-employed. He does not have any employees. His business sponsors a 401(k) plan. Sally owns an established and successful dental practice that has 10 employees. Her practice sponsors a safe harbor 401(k) plan.  When Bill set up his 401(k) plan several years ago, he never mentioned to his advisors that his wife owns a dental practice because he didn’t see how that would be relevant.

Bill has been making 401(k) deferrals to his plan and a 25% profit sharing contribution. Sally’s practice, however, has not been making profit sharing contributions for the last few years.

So, what is the problem here? Bill cannot operate his plan without taking into consideration the employees in his wife’s practice. As a result, there are a number of issues that would require correction in order to preserve the qualified status of Bill’s plan, but let’s just look at the profit sharing contribution.

Since Bill has been making a 25% profit sharing contribution for the last several years, and none of the wife’s employees have received a profit sharing contribution for those same plan years, Bill’s plan fails coverage.

The correction would need to amend his plan to provide for profit sharing contributions for a sufficient number of Sally’s employees (at 25% of their compensation) so that coverage is satisfied. To make things worse, the correction would generally have to be made by seeking IRS approval under the applicable IRS plan correction program.  Clearly, this could be a very expensive mistake to fix!

How can I learn more?

Please contact EJReynolds, Inc. to learn more about these rules and how they may impact your plan and plan participants. Our Administrators are here to help.