In Announcement 2015-19, issued on July 21, 2015, the Internal Revenue Service said it was eliminating the staggered five-year determination letter remedial amendment cycles for individually designed tax-qualified retirement plans effective Jan. 1, 2017.
Employers depend on these determination letters to ensure both their defined benefit and defined contribution plans remain in compliance with the tax code. While not required to do so, most plan sponsors take advantage of the opportunity to have their plan reviewed not only on adoption and termination but at five-year intervals, particularly if documents are extensively amended during that period.
To better understand the impact of this announcement on pension plan sponsors and how in future they can ensure their plans remain compliant, EBA spoke with Brian Pinheiro, an employee benefits attorney and partner at Ballard Spar LLP in Philadelphia to explain the significance of these changes.
EBA: What are determination letters and why does the Internal Revenue Service issue them?
Pinheiro: Every employer that has a retirement plan for its rank and file employees in the United States has set up that plan so it is tax qualified. This means that employee contributions can go into the plan on a pre-tax basis. Employees can be fully vested in these amounts but they're not taxed on them until years later when they get a distribution. In order to get that tax treatment – which is one of the biggest tax incentives in the Internal Revenue Code – the plan itself has to satisfy a whole list of statutory requirements.
The IRS runs what's called a determination letter program for these plans where it reviews the plan and confirms the plan document does indeed contain all of the necessary requirements for tax qualification.
The determination letter acts sort of like an insurance policy. If the IRS audits the company and the plan, the company will show the determination letter to the auditor and the terms of the plan document will not be audited because they are covered by this determination letter.
EBA: Why is there a five-year determination letter? Isn't it enough to get one when your plan is first filed?
Pinheiro: You can get a determination letter when plans are first drafted and adopted, but the plan gets amended every year or couple of years either because the company decides to make plan design changes or because the law has changed and the terms of the plan document must be modified to catch up with the new legal requirements.
Rather than having plans ask the IRS to provide a determination letter every time there’s an amendment, the IRS currently does this in five year cycles. That's just a way to allocate resources so that the IRS can deal with a more predictable flow of these submissions.
EBA: Why are they making the change now?
Pinheiro: Basically the IRS has cut back on staff and no longer even has the ability to keep up with the steady flow of determination letter applications based on five-year cycles. It’s important to note that they are getting rid of the determination letter program for continuing plans, but plan sponsors can still submit a plan when it’s first established for a determination letter. They can also submit a plan upon termination of the program. They just can't submit plan documents for review in between.
EBA: Why is this a problem for your clients?
Pinheiro: It’s really a problem because these plans contain millions and in some cases billions of dollars in pretax money predicated on the notion that the plan has satisfied the tax qualification requirements. It’s a pretty significant insurance policy for the IRS to say your plan satisfies the qualification requirements. In future, even if a plan got a determination letter at the outset but it has been amended several times, that insurance policy is gone.
Quote"It’s really a problem because these plans contain millions and in some cases billions of dollars in pretax money predicated on the notion that the plan has satisfied the tax qualification requirements."
Now when companies are involved in a merger or acquisition and have to represent that their pension plans meet the requirements for tax qualification, they just have to provide the other side with a copy of the IRS determination letter. But that’s not going to happen anymore. Plan sponsors will have to find other ways to satisfy this obligation.
EBA: Can you give me examples of ways plan sponsors can ensure their plans are in compliance for the purposes of M+As or other business transactions?
Pinheiro: They may be able to move to a pre-approved plan or a volume submitter plan used by some financial institutions or law firms. But a lot of plans that have very customized designs can’t fit within the perimeters of a pre-approved document.
EBA: What effect will the curtailment of the determination letter program have on plan sponsors?
Pinheiro: Within the next year everybody’s still going to have a fresh determination letter from the just concluded five year cycle. Five years out, the question is going to be what a company has to show to prove that its plan is tax qualified.
One possible answer is that they will go to their lawyers and ask them to write an opinion letter stating the plan is compliant. Our firm can certainly do that. It's not going to bind the IRS, but it’s something to show the IRS in case they do an audit. It’s probably how M+A transactions are going to work going forward.
EBA: Do you think the net impact of these changes, will be another nail in the coffin of DB plans because it will just make them too risky to maintain?
Pinheiro: I think DB plans are probably dead already, but this certainly does not help. DB plans are generally a lot more customized than DC plans so they don’t lend themselves to prototype or volume submitter plans. You've got to wonder, whether employers are going to be willing to have DB plans without some protection from the IRS.
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