Employee Benefits Legislation Proposed (But Not Passed) by the Obama Administration
This article was originally published by Jim Griffin as a series on LinkedIn over the three weeks leading up to Inauguration Day.
In February of 2015, the Department of Treasury issued a reported entitled “General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals” (the “General Explanation”). The General Explanation is several hundred pages long and includes detailed proposals for new Federal tax legislation. If adopted, many of these proposals would have been effective in years beginning after December 31, 2016. With a sharply divided Congress and a lame duck President, however, it is not a surprise that none of the proposals have become law.
Now, as we move to a new Congress and new President, there is much speculation about what legislative changes we should expect starting in 2017. In the area of employee benefits, little of this speculation is based on any concrete ideas or proposals from President-elect Trump, other than, of course, the promise to repeal ObamaCare.
We may not know what the Trump Administration will bring in the way of employee benefits legislation, but I, for one, am confident that the ideas of the Obama Administration will be left behind. Whatever the proposals are for 2017, it seems reasonably clear they will be quite different from the proposals in the General Explanation.
I thought it might be useful (and fun) to take one final look at the employee benefits legislation proposed in the General Explanation. These ideas might not see the light of day for the next four years, or ever.
Mandatory Payroll Deduction IRAs
According to the General Explanation, employers that have been in business for at least two years and have more than ten employees would be required to offer a payroll deduction IRA savings plan. The required IRA plan would have an automatic enrollment feature with a default savings rate of three percent. Employers that offer a qualified retirement plan, SEP, or SIMPLE would not be subject to this requirement.
Contributions would be invested in a “low-cost, standard type default investment” and a “handful of standard, low-cost investment alternatives would be prescribed by statute or regulation.” In addition, a national website would provide information and basic educational material regarding savings and investing for retirement. Tax credits would be expanded to encourage plan formation by employers and contributions by employees.
At least five states (including California, Connecticut, Illinois, Maryland and Oregon) have recently adopted their own versions of mandatory payroll deduction IRAs for state government employees who are not covered by a public pension system. It seems unlikely to me, however, that the Trump Administration will move to burden small business with the requirement to adopt payroll deduction IRAs.
The General Explanation contains an ominous note that no more than about half of the total work force participates in employer-sponsored retirement plans. That statistic may end up in a policy maker’s cost-benefit analysis when trying to find ways to raise revenue in Washington.
Expansion of the Exception to the 10% Early Distribution Penalty Tax for the Long-Term Unemployed
The tax law imposes a 10% penalty tax on early distributions from IRAs and qualified plans. The penalty tax is intended to encourage taxpayers to use assets in those accounts for retirement purposes. For the unemployed, however, current needs take precedence over long term retirement savings. In those situations, the 10% penalty tax erodes limited resources available to the unemployed without having a substantial deterrent effect.
Congress created an exception to the 10% penalty tax for distributions from IRAs for individuals who are unemployed, but that exception does not apply to qualified plan distributions. The Obama Administration proposed to expand the exception for the unemployed to cover potentially larger distributions from IRAs and to cover qualified plan distributions. The General Explanation describes the complicated rules and limits that would apply to the proposed new exception. The proposal would exempt IRA and qualified plan distributions of up to $50,000 per year for each of two years during a single period of long-term unemployment. New codes would also be added to Form 1099-R to facilitate taxpayer compliance and reporting for the new exception.
The proposal would serve a useful purpose to lessen the tax burden on unemployed individuals. However, the details of the proposal limit its usefulness and increase the compliance burden on taxpayers. Assuming that President Trump is successful in his plan to “make America great again”, unemployment will decline and the need for the exception will go away. Regardless, I don’t expect to see this proposal again in the next four years.
401(k) Plan Eligibility for Part-Time Employees
The General Explanation suggests that retirement savings may be improved if part-time employees are given the opportunity to contribute to their employer’s 401(k) plan. Based on that premise, the Obama Administration proposed to change the retirement plan rules to require employers to allow 401(k) contributions by part-time employees.
Not all part-time employees would be eligible to make 401(k) contributions. Employers would have to track hours of service for part-time employees. Only those part time employees who worked at least 500 hours per year with the employer for at least three consecutive years would be eligible. Accordingly, short service part-time employees would continue to be excluded.
Matching contributions would not be required. Top heavy and nondiscrimination testing rules would be amended to exclude the newly eligible part-time employees.
Separate from the Obama proposal, employers should know that the IRS does not allow part-time employees to be excluded from a 401(k) plan. The IRS interprets the 1,000 hour of service requirement as the only mechanism for excluding part-time employees from 401(k) plan participation. Accordingly, a 401(k) plan should not be drafted or administered to categorically exclude part-time employees from 401(k) plan eligibility. If part-time employees are excluded from a 401(k) plan, the 401(k) plan may have a plan document and/or operational error that would need to be corrected in the Employee Plans Compliance Resolution System (EPCRS).
Aside from the practical question about how much money a part-time employee could or would be willing to save in a 401(k) plan, there is the question of whether this proposal is worth the additional recordkeeping burden that would be imposed on employers. Also, the proposal would make 401(k) plans even harder for employees to understand.
With annual contribution limits of more than $5,000 per year, IRAs provide a reasonable alternative to this proposal. My prediction is that expanded 401(k) plan eligibility for part-time employees will not come back around for consideration in the next four years.
Facilitating Annuity Portability
One of the important policy initiatives of the Department of Treasury has been to reduce or eliminate barriers to offering lifetime income options inside 401(k) plans. This would make it possible for participants to view their 401(k) accounts in terms of an income stream rather than as an account balance. Officials inside the Treasury believe that this change would make it easier for participants to avoid either under- or over- spending in retirement.
According to the General Explanation, the Treasury believes that the distribution restrictions in Section 401(k) discourage employers from including annuity investments in their 401(k) plans. The General Explanation observes that there is no good option for handling an annuity if the employer wants or needs to remove the annuity investment option from the 401(k) plan. This may result in surrender charges or penalties if the annuity investment option is discontinued due to a change in recordkeeper, custodian or trustee.
Under the proposal, participants would be permitted to roll over an annuity investment option if the annuity is no longer authorized to be held by the 401(k) plan. This rollover option would be available even when the participant would not be eligible to receive a distribution from the 401(k) plan.
This proposal would be favored by the insurance industry and would promote lifetime income planning with 401(k) plan assets. It is possible that, with some revisions, this proposal may find its way into a round of benefits legislation within the next four years.
Simplification of Minimum Required Distribution Rules
The Obama Administration proposed to exempt small retirement and IRA balances from the minimum required distribution (“MRD”) rules. In the case of IRAs, those rules require that annual distributions begin after the account holder reaches age 70½. In the case of 401(k) plans and other retirement plans, annual distributions must begin after the participant reaches age 70½ or retires, whichever is later.
The General Explanation describes a proposal to aggregate all of a taxpayer’s retirement accounts to determine whether the total value is more than $100,000. The MRD rules would only apply to taxpayers with large retirement balances. This makes a great deal of sense without jeopardizing the tax collection system and allows older citizens to defer distributions without the stiff 50% penalties that backup the MRD requirement.
Another part of the same proposal would be much more controversial by imposing the MRD rules on Roth IRA balances.
I’ll call the first part of this proposal a toss-up. It is possible that we might see legislation that exempts small balances from the MRD requirements. The Roth IRA proposal, however, will generate some very stiff opposition and be unlikely to pass, especially in the next four years.
Simplification of IRA Rollover Rules for Surviving Non-Spouse Beneficiaries
The Internal Revenue Code currently differentiates between spouse and non-spouse beneficiaries in the mechanics of processing a rollover. A beneficiary who is not a surviving spouse may rollover assets from a tax-favored retirement plan into an IRA only by using a direct rollover. A 60-day rollover is not available to a surviving non-spouse beneficiary.
A similar problem is that a surviving non-spouse beneficiary may treat inherited IRA assets as a non-spousal inherited IRA and may move the assets to another non-spousal inherited IRA only by using a direct trustee-to-trustee transfer. Rollovers from a deceased owner’s IRA to another IRA are not allowed for a surviving non-spouse beneficiary.
The General Explanation recognizes that this amounts to nothing more than a game of Trivial Pursuit (my words) that creates “traps for the unwary.” The Obama Administration proposal would allow the 60-day rollover in each of these situations.
This is a reasonable proposal that would clean up the Internal Revenue Code and make it more workable and understandable for taxpayers. Accordingly, it should be quite likely that any reasonable administration would seek to put this change forward at the next opportunity.
Death of the Stretch IRA
The words “Stretch IRA” have emerged over the last few years to apply to beneficiary designation planning for IRA account holders to defer income tax by extending an IRA’s distribution period over the life expectancy of a beneficiary after the death of the participant.
The General Explanation points out that the preference for retirement savings in the Internal Revenue Code exists primarily to provide retirement security for individuals and their spouses. These preferences were not created with the intent of providing tax preferences to the non-spouse heirs of individuals.
The Obama Administration proposal would have changed the distribution rules to provide that non-spouse beneficiaries of retirement plans and IRAs would generally be required to take distributions over no more than five years. Extended payments would be allowed for eligible beneficiaries who are disabled, chronically ill, or not more than 10 years younger than the participant or a minor child of the participant.
This provision would simplify tax administration and planning for individuals and would raise some revenue by shortening permissible deferral periods. It is hard to know whether the amount of revenue that could be raised would be significant. Certainly, eliminating extended IRA payouts for non-spouse beneficiaries would be unpopular with some, but it is doubtful that this provision would attract a significant amount of vocal adverse attention.
For that reason, I suspect that it is possible we might see this provision in a proposal again within the next four years.
Limitation on Tax Deferred Accumulations
The Obama Administration proposed to limit the amount that taxpayers may save in their tax deferred accounts. The proposed limit would apply to the combined balance in a taxpayer’s defined benefit plans, defined contribution plans, IRAs, 403(b) plans, and 457(b) plans.
According to the General Explanation, imposing a limit on tax deferred accumulations would reduce the deficit, make the income tax system more progressive, and distribute the cost of government more fairly among taxpayers of various income levels. Initially, the limit would be $3.4 million, along with fairly generous grandfathering rules.
Taxpayers who have saved more than $3.4 million in their tax deferred accounts would not be allowed to make further contributions. Any excess contributions would be taxable to the individual both at the time of contribution and at the time of distribution.
In 1986, President Reagan enacted a similar limit as part of the Tax Reform Act of 1986. The limits were contained in the excise tax provisions of Internal Revenue Code Section 4981A which applied to large accumulations and distributions. The Reagan limits in Section 4981A were repealed in 1997.
Politicians in both parties seem to be attracted to limits on tax deferred savings so it is hard to predict whether savings limits may be enacted in the next four years. My bet on this one is that we will not see similar legislation in the Trump Administration.
SECA Tax Parity for Professional Service Businesses
This proposed change is not a pure benefits issue but is important enough to be included here.
The General Explanation notes that the imposition of employment taxes on owners of pass through entities is outdated, unfair, and inefficient. According to the General Explanation, employment taxes are imposed as follows:
- general partners and sole proprietors pay employment taxes on nearly all of their earnings
- S corporation owner-employees pay employment taxes on only a portion of their earnings
- limited partners and many LLC members pay little employment tax at all
To even the playing field and eliminate employment tax as a choice of entity decisional factor, the Obama Administration proposed that individual owners of professional service businesses that are organized as S corporations, limited partnerships, general partnerships, and LLCs that are taxed as partnerships would all be treated as subject to self-employment tax in the same manner and to the same degree.
Professional service businesses include those engaged in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. Material participation would be determined under rules similar to the passive activity loss rules.
This change has a lot of ripple effects, especially in the area of fringe benefits, cafeteria plans, and qualified plans. I am not sure whether all of those issues have been fully explored. For now, I’d bet we will not see this change in the next four years. However, this is an area that may be subject to review and reclassification by IRS on audit.
Closing the Backdoor on Roth IRA Conversions
Roth IRAs first became available in 1997 and since then have become an important tool in retirement planning. Congress initially imposed limits that kept the Roth IRA out of reach of high income taxpayers. But in 2010, Congress opened a backdoor to Roth IRAs by permitting non-Roth IRAs to be converted to Roth IRAs. The backdoor is made even larger if the funds in the non-Roth IRA are from after-tax contributions because then the conversion to Roth IRA can be accomplished virtually income tax-free.
The General Explanation does not describe why this is an abuse and does not provide any policy reasons for the change suggested. Nonetheless, the General Explanation sets forth a proposal to permit conversions to Roth IRA only for funds that are includable in income. This change would close the backdoor on Roth IRA conversions.
This is a fairly technical change that has a small impact on a small number of taxpayers who are all high-income earners. I think it is quite possible that this change could be included in a tax code clean-up bill during the next four years.
Eliminating the Dividend Deduction for Public Company ESOPs
The Internal Revenue Code contains numerous provisions designed to encourage the formation of employee stock ownership plans (“ESOPs”). One of those benefits is a provision that allows a corporation to claim a federal income tax deduction for the amount of dividends paid on its own stock held in an ESOP. To qualify for the deduction, the dividend must meet several complex requirements.
The General Explanation reveals the Obama Administration’s concern that ESOPs pose a risk to workers by concentrating their retirement savings in a single, undiversified investment. Accordingly, the Obama Administration proposed to repeal the deduction for dividends paid to an ESOP but only with respect to publicly traded corporations.
While this proposal may initially seem to be fairly limited in its application, the need for broader corporate tax reform may eliminate any interest in this as a stand-alone proposal. The only way this idea can move forward in the next four years is if it is politically sold as a part of a broader corporate tax reform proposal. Even then, it seems unlikely to me that this proposal will see serious consideration in the Trump Administration.
Repeal of NUA in Employer Securities
The net unrealized appreciation (NUA) rules provide a special tax benefit for participants in plans that invest in employer stock. Employees who receive a lump sum distribution in the form of employer stock may pay income tax at the time of distribution only on the amount that they paid for the stock inside the plan that is distributed to them. The NUA is taxed later at capital gains rates when the stock is sold.
The General Explanation maintains that the NUA rule encourages the undiversified investment in a single stock which subjects participants to an increased risk of loss. Accordingly, the Obama Administration proposed to eliminate the NUA rules for distributions to participants who had not reached age 50 by December 31, 2015.
This change might be embraced by tax advisors as a blessing in the form of simplification from the countless exceptions upon exceptions in the Internal Revenue Code. That alone, however, is not a sufficient reason for this change to be adopted. I don’t believe that we will see this change included in a tax change in the next four years.
W-2 Reporting for Defined Contribution Plan Employer Contributions
The Obama Administration proposed legislation in Congress to require employers to report the amount of their contributions to their profit sharing and 401(k) plans on an employee’s Form W-2. This provision serves no apparent useful purpose, especially given it is redundant of ERISA requirements to provide annual statements to participants. Moreover, there is growing opposition to increased reporting and disclosure obligations imposed on employers by all agencies at all levels.
The General Explanation timidly explains that a W-2 reporting obligation would provide workers with a better understanding of their overall retirement savings and compensation. The General Explanation also asserts that such a requirement would facilitate compliance with the tax code’s annual addition limits.
My bet? Don’t look for this proposal to come back around any time soon.
And finally, we finish with a topic that deserves more certainty and finality than it actually receives.
Where the law is not clear and uniform, opportunities for unfair advantage and eventual disregard of the law will replace an orderly system of self-enforcement. That is precisely what has happened for years on the issue of worker classification.
Worker classification is the most important consideration that affects the relationship between a business and its workers. In its simplest form, the determinative question is: Who has the right to direct and control the manner and means by which the work is performed? If the answer is the business, then the worker is an employee. If the answer is the worker, then the worker is an independent contractor. From this simple test, the regulatory and protective effect of numerous laws and regulations naturally follows; including such things as tax withholding, employee benefits, and workplace safety.
According to the General Explanation, Section 530 of the Revenue Act of 1978 has precluded the IRS from issuing general guidance addressing worker classification and from taking enforcement action in certain cases.
The Obama Administration proposal would give the IRS more flexibility to correct worker classification issues prospectively. In addition, the proposal would provide for reduced employment tax liabilities for businesses that voluntarily reclassify their workers before being contacted by the IRS.
While the theme for the next four years seems to be less regulation, worker classification is an issue that deserves continued attention. Competition among businesses can be made more fair by a uniform set of worker classification rules that are clear and consistently applied. I believe that in the next four years we will see continued efforts to legislate and bring fairness to this important area.
Stay tuned over the next few weeks and months as the new administration begins to settle in and define its legislative goals. The details will be filled in by the lobbyists and the Congressional staffs. With the power to lead, it is reasonable to expect that changes in the Trump Administration are on the horizon. Now, we need to wait and see what those changes might be and whether any of the ideas that are part of the unfinished business of the Obama Administration will have another chance to make it to the finish line.