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CCH® BENEFITS — 11/26/07

Sec. 125 All-Or-Nothing Penalties Criticized

From Spencer's Benefits Reports: The all-or-nothing penalties in the proposed Sec. 125 regulations are overly burdensome, according to several speakers at a November 15 IRS hearing on the regulations. “Any slip up will cause a plan to be disqualified,” John Hickman, partner at Employers Council of Flexible Compensation said, and his comments were echoed by other speakers at the hearings, including Scott Mezistrano, senior manager at American Payroll Association, and Aliya Wong, director of pension policy at the U.S. Chamber of Commerce. Other issues discussed, in addition to plan failures, were correction programs, highly compensated employees, and substantiation requirements.

Plan Failures

The proposed regulations provide that if a plan fails to satisfy the requirement of Sec. 125 and the regulations, the employees will be taxed for all the benefits elected under the plan. Christine Keller, benefits attorney at Groom Law Group testified that “any mistake no matter how small will disqualify the cafeteria plan.” Mr. Mezistrano echoed that criticism, commenting that “it is an all-or-nothing proposition.” It seems “overly broad” to tax all employees for plan failures and it is inconsistent with congressional intent, Ms. Keller explained. If there is a de minimis error, the plan should not be disqualified and employees should not be taxed, Ms. Keller added.

Mr. Hickman suggested a correction plan for minor errors in plan design and administration. “We need a method to correct mistaken elections. There should be a limited period of time, for example, 30 days for correction of errors.” Ms. Wong said the regulations should allow for “self correction within a reasonable period of time.” Ms. Wong also added that all employees should not be taxed but only the employee that makes the mistake.

According to Scott Sims, legal consultant with Hewitt Associates, a self correction program should address three categories of errors:

Nondiscrimination, Substantiation

“New hires should not be included in the definition of highly compensated employees, since they are not considered highly compensated employees under the qualified plan regulations,” Mr. Hickman commented. “Unless the law says otherwise, the regulations should mirror as much as possible the qualified plans regulations” Borrowing from the qualified plan regulations also would ease plan administration for employers, Mr. Hickman added.

Mr. Sims also testified that new hires should be deleted from the definition of highly compensated employees under the nondiscrimination rules. It “skews the results” of the “preliminary tests” conducted by employers earlier in the year for nondiscrimination testing. Further, Mr. Sims remarked, “it compromises the ability of employers to design a plan that would pass the discrimination tests.”

The substantiation requirements are overly burdensome, Ms. Wong commented. “Such strict rules will impede implementation with technological advances.” Ms. Keller similarly explained that the substantiation regulations will force the IRS to give up flexibility as technology improves. “Once the regulations become final, it is very hard to change them.” Ms. Keller recommended that the proposed regulation be replaced with something more general. The general regulation should provide that the “employer has an obligation to follow rules the IRS has set forth” as well as any substantiation guidance issued.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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