Employee Benefits Law Report

Fiduciaries in stock-drop suits should be evaluated on real-time conduct, not 20-20 hindsight—Sixth Circuit decision Pfeil, et. al. v. State Street Bank & Trust Co.

ERISA fiduciaries of employee stock ownership plans (ESOPs) and plans with employer stock funds increasingly find themselves in a Catch-22. If they continue to invest in employer stock and the stock price falls, the fiduciaries could be sued for violating their duty of prudence. If they stop investing in employer stock and the price rises, the fiduciaries could be sued for failing to follow plan terms. Many circuit courts previously addressed this situation by applying the Moench presumption of prudence to fiduciaries of ESOPs and other plans that required an employer-stock fund. That is, fiduciaries of plans that required investment in employer stock were presumed to have acted prudently, and that presumption generally was overcome only if plaintiffs could demonstrate that the fiduciaries abused their discretion by continuing to invest plan assets in employer stock. The Supreme Court in Fifth Third Bancorp v. Dudenhoeffer, however, held last year that no special presumption of prudence applied in these circumstances. Instead, fiduciaries of these types of plans were subject to the same ERISA prudence standards that applied to fiduciaries of any other plan. The Court did acknowledge that the separate standard of asset diversification did not apply top ESOPs (although it would apply to other plans with employer stock funds).

After Dudenhoeffer, many commentators expressed concern about what the loss of the presumption of prudence would mean for ESOP fiduciaries.  The Sixth Circuit, however, may have restored a sense of calm in a recent decision.  In Pfeil, et al. v. State Street Bank & Trust Co., the Sixth Circuit held that an ESOP fiduciary’s investment decisions satisfy the ERISA duty of prudence so long as the fiduciary uses a prudent process when the decisions are made. Further, a public company stock’s current market price is deemed to be a reliable indicator of the stock’s value, absent a showing of special circumstances by the plaintiffs as to why that price is not reliable. This is true even if in hindsight stock losses occur.

This case represents good news for fiduciaries of plans that require investment in employer stock—even though the days of a presumption of prudence are gone. This case demonstrates that if fiduciaries use a prudent process then attacks from plaintiffs will be much tougher to sustain even if hindsight shows the outcome of the decision to be a bad one. This blog will explore the decision and its implications.

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Nonqualified deferred compensation plan guidance from the IRS appears to be on the horizon

Ever since the series finale of “Mad Men,” I’ve been thinking a lot about old commercials. One commercial in particular involves Heinz ketchup. In the ad, someone would turn the bottle upside down, and the ketchup would take an extremely long time to pour out of the bottle and onto a sandwich. An announcer would then say the slogan: “The best things come to those who wait.” Apparently, Heinz wanted us to believe that patience was a virtue—rewarded by its ketchup.

Marketing gimmicks aside, the IRS has taken a similar view (towards patience, not ketchup) with respect to tax guidance that impacts executive compensation arrangements. In a notice published in 2007, the IRS announced its intent to issue new regulations under Code Section 457(f) in an attempt to harmonize Code Sections 457(f) and 409A. Over eight years later, we are still waiting for that guidance. The wait may soon be over, however, because IRS officials informally have indicated that this guidance is “very, very close” to be released, probably by the end of this year or early in 2016. The two pieces of guidance presumably will not be issued at the same time. Continue Reading

The view from Washington — we have a budget!

In perhaps the last big legislative push of 2015, the Bipartisan Budget Act of 2015 (the “Act”) was passed by the House of Representative on a 266-167 vote on Wednesday, October 28, 2015 — in the waning moments of outgoing Speaker John Boehner’s tenure. In the vote, 79 Republicans joined 187 Democrats to pass the package — which means a fairly large number of Republicans voted against the Act suggesting the days of the political turbulence in the House may not completely be over.  Subsequently, the Senate also voted to approve the Act by a 64-35 vote (overcoming objections from a group of conservative senators, including a few presidential candidates). On Monday, November 2, 2015, President Obama signed the bill into law at a brief ceremony at the White House.

The Act encompasses a compromise two-year budget bill that was negotiated between House leadership and the White House, and it raises spending caps on domestic and defense spending over the next two years by an aggregate amount of $80 billion. Generally, the additional spending is split evenly between domestic and defense concerns — thus allowing all participants in the negotiations to declare themselves winners. The Act also makes changes to the Social Security disability program. In addition, the Act extends the federal borrowing limit through March 15, 2017 — at which time there will be a new Congress and a new president. The days of crisis governing in Congress may be over—at least we are taking a welcome break.

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New IRS Equity-Based Compensation Audit Guide Highlights Importance of Documenting Compensation Practices

The IRS recently released an audit techniques guide (the “Guide”) to advise its internal auditors who are examining cases involving equity-based compensation (i.e., compensation based on the value of specified stock). Examples include stock transfers, stock options, stock warrants, restricted stock, restricted stock units, phantom stock plans and stock appreciation rights paid to an employee, director or independent contractor. The Guide provides a general discussion of potential tax issues that could arise with respect to these arrangements (e.g., disqualifying dispositions of incentive stock options, Code Section 83(b) elections for restricted stock). Interestingly, the Guide devotes a fair amount of detail to explaining where auditors may find these documents, encouraging them to review Securities and Exchange Commission (“SEC”) filings as well as internal documents. As such, the Guide serves as an important reminder to employers to be mindful that the IRS (or other third parties) someday could seek to review their corporate documents. That will be the focus of this blog.

SEC Documents.

The Guide advises auditors that a good place to start an examination is by reviewing SEC documents (at least with respect to publicly-held entities). In particular, the Guide explains that a public company’s annual report (Form 10-K), definitive proxy statement (DEF 14A), and Statement of Changes in Beneficial Ownership (Form 4) can be particularly pertinent. These documents will identify the types of plans an employer sponsors and provide compensation data under the plans for the named executive officers and the directors. The Guide directs the IRS auditors to compare the compensation data on the SEC forms with information reported on the individual’s Form W-2 or 1099-MISC, as applicable, and confirm that the appropriate amount of taxes has been withheld and paid. If the information on the tax documents and SEC forms do not reconcile, the Guide recommends that the auditor consider expanding the scope of the audit.

Internal Documents.

The Guide also instructs auditors to review an employer’s internal corporate documents, including employment contracts, Board of Director meeting minutes and Compensation Committee meeting minutes. The Guide adds that auditors should request reports “issued by the compensation committee and presented to the board of directors” because these reports may provide additional insight into equity compensation practices.

Employers should be aware of these instructions. Often times, it is easy for someone to prepare internal documents using jargon or short-hand that is familiar among people at the company but that may be difficult to explain to a third party or worse could be misleading. The Guide demonstrates that internal documents may not be restricted to internal personnel. Instead, the IRS very well could review these internal documents. As such, employees and advisers who prepare these documents should be mindful of both the information contained in the documents and how they present that information.

Key Takeaways for Employers.

While the IRS prepared the Guide to assist its internal auditors, the Guide also helps employers understand how the IRS could conduct a potential audit of equity-based compensation plans. One takeaway for employers is to review its compensation practices and make sure that as a matter of substance they comply with the applicable tax rules. The other takeaway is a matter of form or style. Specifically, when employees of a company or its outside advisers prepare internal documents or documents to be filed with the SEC, they should keep in mind that the IRS very possibly will review some or all of these documents (particularly the SEC filings). Thus, when preparing these documents, they should do so in a way that demonstrates compliance with the applicable tax rules and that avoid any ambiguities. Doing so will help make a potential audit less burdensome and less risky.

Bright lines getting blurrier: Recent Ohio Supreme Court decision changes factors for determining who is an Ohio resident for state tax purposes

Cunningham v. Testa, Slip Opinion No. 2015-2744 (July 8, 2015)

Recently, the Supreme Court of Ohio issued an opinion in Cunningham v. Testa which significantly alters the application of a statute for determining non-Ohio domicile for state tax purposes. Prior to the ruling, the statute seemed to set forth two factors which, when verified, would create an irrebuttable presumption of non-residency for state income tax purposes:

  1. too few contact periods; and
  2. an abode outside of Ohio.

Following this ruling, a taxpayer may now be forced to prove sufficient additional facts to show that he would legally be considered domiciled outside the state. The change represents a partial reversion back to a prior structure which existed at common law, a structure which was amended over 20 years ago due to its complexities. The case of Cunningham v. Testa casts serious doubt on the future validity of any bright-line test for determining Ohio domicile and will create uncertainty for taxpayers in the coming years.

The taxpayer, Kent Cunningham, owned homes in both Ohio and Tennessee for the entirety of the 2008 tax year. Also, Cunningham undisputedly had fewer than 182 contact periods with the state of Ohio for that year. He filed a Form IT-DA, an “Affidavit of Non-Ohio Domicile,” for the 2008 tax year. In the affidavit, he declared that he “was not domiciled in Ohio at any time during taxable year 2008” and affirmed that he “had fewer than 183 contact periods in Ohio during the taxable year.”

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Like old soldiers, Employee Plans Determination Letter Program fades away

The Internal Revenue Service (the “IRS”) issued Announcement 2015-19 on July 21, 2015, in which the agency announced that its long-standing and widely used retirement plan determination program for individually designed plans was being significantly curtailed. The IRS indicated that this curtailment, which has been rumored for months and now becomes official, is attributable to a need to more efficiently direct its limited resources in an era of budget cutbacks for the agency.

Under the announcement, and effective as of January 1, 2017, the currently-available staggered 5-year determination letter remedial amendment cycles for individually designed plans generally will be consigned to history. As of that date, the IRS no longer will accept determination letter applications based on the 5-year remedial amendment cycles. Sponsors of Cycle A plans will continue to be permitted to submit determination letter applications during the period beginning February 1, 2016, and ending January 31, 2017. Presumably, all pending applications filed in earlier cycles will be processed. After January 1, 2017, the scope of the determination letter program for individually designed plans will be limited to submissions related to qualification upon initial plan qualification (i.e., regardless of when the plan was adopted, any plan for which a Form 5300, Application for Determination for Employee Benefit Plan, has not been filed or for which such a Form 5300 has been filed but a determination letter was not issued) and qualification upon plan termination. Generally, effective July 21, 2015 and through December 31, 2016, the IRS no longer will accept off-cycle determination letter applications (except for determination letter applications for new plans and for terminating plans). In addition, the IRS indicated in Announcement 2015-19 that plan sponsors will be permitted to submit determination letter applications in other limited circumstances that will be determined by Department of the Treasury (the “Treasury”) and the IRS in the future. The Treasury and the IRS will identify those limited circumstances through periodic published guidance.

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The Supreme Court rescues Obamacare one more time

President Obama might want to invite Chief Justice John Roberts to the White House for a “thank you” dinner!

The United States Supreme Court today issued an opinion in King v. Burwell that upholds the Obama administration’s interpretation of language in the Affordable Care Act (the “ACA”) that concluded government subsidies to underwrite the cost of health care coverage are available to all qualifying Americans–and not just to those living in states that maintain their own heath care exchanges under the ACA.  In a 6-3 decision, Chef Justice Roberts authored the opinion of the court (just as he did in the Court’s landmark opinion in 2012 in National Federation of Independent Business v. Sebelius).  Specifically, the Court’s opinion upholds a ruling by the Internal Revenue Service that subsidies should be available both in states that have set up their own exchanges and in other states in which residents must purchase coverage through the federal government exchange.  Five other justices joined Chief Justice Roberts in his opinion, including Justices Anthony Kennedy, Ruth Bader Ginsburg, Stephen Breyer, Sonia Sotomayor and Elena Kagan.  Justice Antonin Scalia wrote a typically scathing dissent, and was joined in that dissent by Justices Clarence Thomas and Samuel Alito Jr.

The case centered on an interpretation of a phrase in the ACA that offers tax credits to individuals who purchase health care coverage on exchanges that are “established by the state.”  Chief Justice Roberts wrote that even though the language was problematic, the intent of Congress to provide the subsidies to all individuals was clear.  In perhaps the core (and ultimately most-quoted) statement in the opinion, Roberts wrote that “Congress passed the Affordable Care Act to improve health insurance markets, not to destroy them.  If at all possible we must interpret the Act in a way that is consistent with the former, and avoids the latter.”

In his dissent, Justice Scalia forcefully expressed his view that the actions of majority were not designed to interpret the ACA but rather to save it—a job he believes is rightfully reserved to the legislature.  Scalia closed his dissent with a statement that is sure to gain much notice and notoriety when he wrote that “We should start calling this law SCOTUScare.”

This case does not deal with complicated constitutional principles, and at the end of the day simply preserves the status quo.  Having said that, most observers believed that a contrary ruling would have dealt a devastating blow to the essential operations of the ACA.  While other legal challenges to the ACA are being litigated, none of those cases seem to present such an existential threat to the ACA.  Still, the challenges are not over.  The ACA surely will be a centerpiece issue during the 2016 presidential campaign, and legislative efforts to repeal, defund or revise all or parts of the ACA will continue.  Although the battlefield may have changed, the battles will continue.


IRS issues 409A guidance—need to correct before the year of vesting

The Office of Chief Counsel of the Internal Revenue Service (the “IRS”) recently confirmed that violations of Section 409A of the Internal Revenue Code (the “Code”) could be corrected without penalty in any taxable year before the taxable year in which an arrangement became vested. However, the IRS went on to clarify that the Code would require immediate recognition of taxable income of the amounts deferred and the assessment of an additional 20% tax if taxpayers waited until the taxable year of vesting to correct an error.

In Chief Counsel Advice 201518013 (the “CCA”),the IRS clarified what some perceived to be an ambiguity under previously issued proposed regulations describing Code Section 409A income inclusion issues. The proposed regulations explained that an employer generally could correct a Code Section 409A error before the arrangement vests without immediate income tax and additional taxes being imposed on the participant. Most practitioners agreed that an arrangement could be corrected without the risk of penalty so long as the compensation under the arrangement became vested no earlier than the taxable year after the taxable year of correction, and the IRS has confirmed that view in the CCA. What was less clear was whether a correction could be made without the risk of penalty if compensation became vested after the date of correction but still within the same taxable year in which the correction was made. In the CCA, the IRS explained that the correction technique works only when the compensation remains unvested throughout the entire taxable year in which the correction is made and vests no earlier than the taxable year after the taxable year of that correction.

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Supreme Court says give credit where credit is due

In Comptroller of Treasury of Maryland v. Wynne, 135 U.S. 1787 (2015), the Supreme Court held that Maryland’s tax scheme was unconstitutional because it discouraged interstate commerce in violation of the Dormant Commerce Clause of the U.S. Constitution. Maryland’s tax scheme gave taxpayers credit for taxes paid to other states against the Maryland state income tax, but did not provide a credit against the county income tax. Therefore, out-of-state income was subject to double taxation, a tax burden not imposed on in-state income.

The Dormant Commerce Clause only gives Congress the ability to regulate interstate commerce, not intrastate commerce. However, shouldn’t activity prohibited at the state level also be prohibited at the municipal level? In Ohio, municipalities are given authority to impose taxes on personal income of both residents and non-residents. In effect, personal income made by an Ohio resident living in one municipality and working in another is taxed twice. In wake of Wynne, Ohio residents should look to a number of Constitutional and fairness arguments to consider whether Ohio’s municipal tax scheme could also be unconstitutional.

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Protection of ERISA’s statute of limitations is narrowed by the Supreme Court

The United States Supreme Court yesterday issued a unanimous opinion in Tibble et al. v. Edison International et al. vacating a Ninth Circuit Court of Appeals ruling that claims by employees of Edison International against the company over allegedly imprudent 401(k) plan investments were time-barred under applicable ERISA statute of limitation rules. The issue before the Court was whether a fiduciary breach claim can be brought under ERISA based on such an allegedly imprudent retirement investment when that investment initially was selected outside of ERISA’s applicable six-year statute of limitations. Writing for the Court, Justice Stephen Breyer stated that since plan fiduciaries have a continuing duty to monitor plan investments, any claims falling within that duty’s statute of limitations would be valid.

In this case, individual beneficiaries of the Edison International 401(k) Plan filed a lawsuit on behalf of the 401(k) Plan and similarly situated beneficiaries against Edison International and other related parties. The petitioners sought to recover damages for losses suffered by the Plan in addition to other equitable relief based on alleged breaches of the respondents’ fiduciary duties. Specifically, the petitioners argued that the respondents violated their fiduciary duties with regard to mutual funds added to the Plan in 1999 and in 2002. The action was filed by the petitioners in 2007. The underlying fiduciary claim was that the respondents imprudently selected six higher priced retail-class mutual funds as plan investments when materially identical but lower priced institutional-class mutual funds were available. Since ERISA generally requires a breach of fiduciary duty complaint to be brought no more than six years after the date of the last action that constitutes a part of the breach, the lower courts ruled that the petitioners’ complaint with respect the 1999 funds was barred under ERISA’s statute of limitations because those funds were added to the 401(k) Plan more than six years before the complaint was filed (the lower courts concluded that the attendant circumstances had not changed enough to require that review of the selected mutual funds by the respondents). On the other hand, the lowers courts concluded that the respondents’ failed to satisfy their fiduciary obligations with respect to the selection of the three funds in 2002 (and that portion of the lower court opinions may yet prove to be problematic in other similar situations).  While the rulings of the lower courts with respect to the 1999 funds likely cheered plan sponsors temporarily, the Court did not embrace the position of the lower courts and instead vacated the previous rulings and remanded the case back for further examination of the proper application of fiduciary obligations to the facts at hand.

Justice Breyer notes that the District Court in this case allowed the petitioners to argue that the complaint was timely with respect to the funds added in 1999. The petitioners argued that the respondents should have commenced a review and conversion of the higher priced retail-class mutual funds to lower priced institutional-class mutual because the previously selected funds incurred significant changes within the 6-year statute of limitations period. The District Court concluded, and the Court of Appeals later agreed, that the petitioners failed to show that changing circumstances would have required a prudent fiduciary to undertake a review of the funds within the 6-year statute of limitations period.

Breyer began his review by focusing on the language contained in ERISA’s statute of limitations rule. In that regard, he stated that ERISA Section 1113 reads, in relevant part, that “[n]o action may be commenced with respect to a fiduciary’s breach of any responsibility, duty, or obligation” after the earlier of “six years after (A) the date of the last action which constituted a part of the breach or violation, or (B) in the case of an omission the latest date on which the fiduciary could have cured the breach or violation.” Breyer noted that both prongs of the rule require that a breach or violation occurs within the applicable 6-year period. The petitioners contend that the respondents breached the duty of prudence by offering higher priced retail-class mutual funds when the same investments were available as lower priced institutional-class mutual funds. While in Breyer’s view, the Ninth Circuit Court of Appeals correctly focused on whether the last action that constituted a part of the breach occurred within the relevant 6-year period, he wrote that the lower court inappropriately concluded that only a significant change in circumstances could cause a new breach of a fiduciary duty.

The Court ultimately concluded that the lower courts erred by applying a statute of limitations bar to such a claim of a breach of fiduciary duty without considering the nature of that duty. The opinion states that the lower courts failed to recognize that under applicable trust principles a fiduciary is required to conduct a regular review of plan investments with the nature and timing of the review contingent on the circumstances. Citing a by-now familiar standard, Breyer noted that an ERISA fiduciary must discharge his or her responsibility “with the care, skill, prudence, and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use. When examining the range of that fiduciary duty, courts often look to the law of trusts. The Court went on to note that under trust law a fiduciary has a continuing duty to monitor plan investments and to remove imprudent ones (this continuing duty is in addition to the trustee’s duty to exercise prudence in selecting investments).  Since under trust law a fiduciary has a continuing duty of some kind to monitor investments and to remove imprudent ones, a petitioner should be permitted to allege that a fiduciary breached the duty of prudence by failing to properly monitor investments. In such a case, Breyer concluded that “so long as the alleged breach of the continuing duty occurred within six years of suit, the claim is timely.”

The Court in this decision expressed no view on the scope of the respondents’ fiduciary duty in this case.[1]  In effect, the case has been remanded so that the Ninth Circuit Court of Appeals can consider claims by the petitioners that the respondents breached their duties within the relevant 6-year statute of limitations period.  Breyer noted that on remand the Court of Appeals may conclude that the respondents did indeed conduct the sort of review that a prudent fiduciary would have conducted absent a significant change in circumstances.  Either way, the Court may well see this case again.

[1] The respondents argued that the petitioners failed to raise in the lower courts a claim that the respondents committed new fiduciary breaches due to a failure to monitor their investments. Given its decision to remand the case back to the Ninth Circuit Court of Appeals, the Court opted to let the Ninth Circuit resolve this ancillary issue.