IRS PROVIDES ADDITIONAL GUIDANCE ON QUALIFIED PLAN ROLLOVER, 20- PERCENT WITHHOLDING RULES.

Notice 93-3

I. Purpose

This notice provides additional guidance on the direct rollover, 60-day rollover, and 20-percent income tax withholding provisions of sections 401(a)(31), 402(c), 403(b)(8) and (10), and 3405(c) of the Internal Revenue Code of 1986, as amended by the Unemployment Compensation Amendments of 1992 (UCA). In particular, this notice addresses the treatment of distributions attributable to plan loans from qualified plans and section 403(b) annuities, the treatment of payments required under section 401(a)(9), and the application of withholding to net unrealized appreciation. This notice is intended to clarify and supplement the guidance provided in the proposed and temporary regulations under sections 401(a)(31), 402(c), 403(b)(8) and (10), and 3405(c) published in the Federal Register on October 22, 1992 (57 FR 48163), and may be relied upon as if it were incorporated in those regulations.

II. CHANGES TO THE CODE BY THE UCA

The UCA significantly changes the treatment of distributions from qualified plans and section 403(b) annuities made on or after January l, 1993. First, the UCA amends section 402 of the Code to expand the distributions from qualified plans and section 403(b) annuities that are eligible rollover distributions. Under section 402(c), as amended, all distributions (including in-service distributions) are eligible rollover distributions, except certain periodic payments, amounts required to satisfy section 401(a)(9), and amounts not includible in gross income (determined without regard to the exclusion for net unrealized appreciation). Second, the UCA adds section 401(a)(31) to the Code, which requires qualified plans to permit a distributee to elect to have any eligible rollover distribution paid directly to an eligible retirement plan in a direct rollover. Third, the UCA amends section 3405 of the Code to impose mandatory 20-percent income tax withholding on any designated distribution that is an eligible rollover distribution that the distributee does not elect to have paid in a direct rollover.

III. TREATMENT OF DISTRIBUTIONS ATTRIBUTABLE TO PLAN LOANS FROM QUALIFIED PLAN AND SECTION 403(b) ANNUITIES

a. Background

Loans to a participant from a qualified plan or a section 403(b) annuity can give rise to two types of distributions: (1) a deemed distribution pursuant to section 72(p) and (2) a distribution of an offset amount. A deemed distribution occurs when the requirements of section 72(p)(2) are not satisfied, either when the loan is made or at a later time, such as when the loan is in default because it is not repaid in a manner that satisfies section 72(p)(2). A deemed distribution is treated as a distribution to the participant only for federal income tax purposes and is not a distribution of the participant's accrued benefit. A distribution of an offset amount occurs when, under the terms governing a plan loan, the participant's accrued benefit is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the participant's accrued benefit). A distribution of an offset amount could occur in a variety of circumstances, such as where the terms governing the plan loan require that, in the event of the participant's termination of employment or request for a distribution, a loan be repaid immediately or treated as in default.

b. Additional guidance

1. When is a distribution attributable to a plan loan an eligible rollover distribution?

The only type of distribution related to a plan loan that cannot be an eligible rollover distribution is a deemed distribution based on the provisions of section 72(p). See paragraphs (c) and (d) Q&A-4 of section 1.402(c)-1T. In contrast, Q&A-8 of section 1.402(c)-1T provides that when a participant terminates employment and the participant's accrued benefit is offset by the amount of an unpaid plan loan balance, the offset amount is an eligible rollover distribution if it satisfies Q&A-3 of section 1.402(c)-1T, which provides the basic definition of the term "eligible rollover distribution."

Pursuant to this notice, an offset amount to repay a plan loan can be an eligible rollover distribution whether or not the offset occurs after the participant's employment has terminated. Similarly, pursuant to this notice, an offset amount can be an eligible rollover distribution even if the offset occurs because, under the terms governing the plan loan, the loan is accelerated or is treated as if it were in default (e.g., where the plan treats a loan as in default upon an employee's termination of employment or within a specified period thereafter). (Of course, an offset amount is an eligible rollover distribution only if it satisfies Q&A-3 of section 1.402(c)- 1T.)

2. Must a direct rollover option be provided for an offset amount that is an eligible rollover distribution?

A plan will not fail to satisfy section 401(a)(31) merely because the plan does not permit a participant to elect a direct rollover of an offset amount that is an eligible rollover distribution. Nevertheless, as discussed above, the amount by which a participant's accrued benefit is offset to repay a plan loan can be an eligible rollover distribution. Thus, an amount equal to the offset amount can be rolled over by the participant to an eligible retirement plan within 60 days, pursuant to section 402(c)(3) unless the offset amount fails to be an eligible rollover distribution for another reason. See EXAMPLE 6 in section III. b. 6 for one situation in which an offset amount fails to be an eligible rollover distribution for another reason.

3. Is there any limitation on the amount of withholding required for an offset amount that is an eligible rollover distribution?

Pursuant to this notice, income tax withholding under section 3405(c) with respect to an offset amount that is an eligible rollover distribution is limited in the same manner as in the case of a distribution of employer securities within the meaning of 402(e)(4)(E). (See section 3405(e)(8) and Q&A-9 of section 31.3405(c)-1T.) In other words, although the offset amount must be included in the amount that is multiplied by 20 percent, the total amount required to be withheld for an eligible rollover distribution does not exceed the sum of the cash and the fair market value of property received by the participant, excluding any amount of the distribution that is an offset amount or that is distributed in the form of employer securities.

4. Will a plan violate section 401(a) if an amount is withheld from a participant's undistributed accrued benefit or direct rollover amount during 1993 that the plan administrator reasonably believed was necessary to satisfy section 3405(c)?

As published, the proposed and temporary regulations required that an amount greater than that described in section III. b. 3. be withheld for an offset amount that is an eligible rollover distribution. Plan administrators and payors may have developed systems to withhold that amount from a participant's undistributed accrued benefit or from the amount that the participant elects to have paid in a direct rollover.

This notice provides a transition rule for distributions made before January l, 1994, under which a plan will not fail to satisfy section 401(a) merely because an amount is withheld with respect to an offset amount from the participant's undistributed accrued benefit or from an amount that the participant elects to have paid in a direct rollover. (The "amount withheld" referred to in the preceding sentence also includes any "gross-up" withholding, i.e., any withholding on the amount withheld for the offset amount.) To use this transition rule, the plan administrator or payor must have believed the amount withheld was required to be withheld based on a reasonable, good faith interpretation of section 3405(c), and the proposed and temporary regulations thereunder, without regard to the additional guidance in this notice.

If the plan administrator or payor establishes that it satisfies the requirement for this transition rule, prior approval from the Internal Revenue Service is not required to use the transition rule and approval should not be requested. The transition rule described in this section III. b. 4 applies only to withholding for distributions that are made before January 1, 1994.

5. Is there additional relief from withholding with respect to an offset amount if withholding would cause undue hardship?

This notice also provides a transition rule under which a plan administrator or payor will not be subject to liability for tax, interest or penalties for failure to withhold the amount required under section 3405(c) with respect to an offset amount. This transition rule is available only for distributions during 1993 and applies only to the extent that the following two requirements are met. First, immediate compliance with the withholding requirements of section 3405(c) in a manner consistent with the additional guidance provided in this notice would cause undue hardship for the plan administrator or payor. Whether there is undue hardship is determined under the principles provided in the voluntary withholding regulations under Q&A G-6 of section 35.3405-1. Second, the failure to withhold must be based on a reasonable, good faith interpretation of sections 401(a)(31), 402(c) and 3405(c), and the proposed and temporary regulations thereunder, without regard to the additional guidance in this notice.

If the plan administrator or payor establishes that it satisfies the two requirements for this transition rule, prior approval from the Internal Revenue Service is not required to use the transition rule and approval should not be requested. The transition rule described in this section III. b. 5 applies only to failure to withhold for distributions that are made before January 1, 1994.

6. Examples

The guidance in this notice on distributions attributable to plan loans is illustrated by the following examples:

EXAMPLE 1. In 1993, Employee A has an account balance of $10,000 in Plan Y, of which $3,000 is invested in a plan loan to Employee A that is secured by Employee A's account balance in Plan Y. Employee A has made no after-tax employee contributions to Plan Y. Plan Y does not provide any direct rollover option with respect to plan loans. Upon termination of employment in 1993, Employee A, who is under age 70 1/2, elects a distribution of Employee A's entire account balance in Plan Y, and Employee A's outstanding loan is offset against the account balance on distribution. Employee A elects a direct rollover of the distribution.

In order to satisfy section 401(a)(31), Plan Y must pay $7,000 directly to the eligible retirement plan chosen by Employee A in a direct rollover. When Employee A's account balance was offset by the amount of the $3,000 unpaid loan balance, Employee A received an offset amount (equivalent to $3,000) that is an eligible rollover distribution. However, under the terms of this notice, Plan Y satisfies section 401(a)(31), even though a direct rollover option was not provided with respect to the $3,000 offset amount.

No withholding is required under section 3405(c) on account of the distribution of the $3,000 offset amount because no cash or other property (other than the offset amount) is received by Employee A from which to satisfy the withholding. Employee A may roll over $3,000 to an eligible retirement plan within 60 days, as permitted by section 402(c)(3).

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that the terms governing the plan loan to Employee A provide that, upon termination of employment, Employee A's account balance is automatically offset by the amount of any unpaid loan balance to repay the loan. Employee A terminates employment but does not request a distribution from Plan Y. Nevertheless, pursuant to the terms governing the plan loan, Employee A's account balance is automatically offset by the amount of the $3,000 unpaid loan balance.

The $3,000 offset amount attributable to the plan loan in this example is treated in the same manner as the $3,000 offset amount in EXAMPLE 1.

EXAMPLE 3. The facts are the same as in EXAMPLE 2, except that, instead of providing for an automatic offset upon termination of employment to repay the plan loan, the terms governing the plan loan require full repayment of the loan by Employee A within 30 days of termination of employment. Employee A terminates employment, does not elect a distribution from Plan Y, and also fails to repay the plan loan within 30 days. The plan administrator of Plan Y declares the plan loan to Employee A in default and executes on the loan by offsetting Employee A's account balance by the amount of the $3,000 unpaid loan balance.

The $3,000 offset amount attributable to the plan loan in this example is treated in the same manner as the $3,000 offset amount in EXAMPLE 1 and in EXAMPLE 2. The result in this EXAMPLE 3 is the same, even though the plan administrator treats the loan as in default before offsetting Employee A's accrued benefit by the amount of the unpaid loan.

EXAMPLE 4. The facts are the same as in EXAMPLE 1, except that Employee A elects to receive the distribution of the account balance that remains after the $3,000 offset to repay the plan loan, instead of electing a direct rollover of the remaining account balance.

In this case, the amount of the distribution received by Employee A is $10,000, not $3,000. Because the amount of the $3,000 offset attributable to the loan is included in determining the amount that equals 20 percent of the eligible rollover distribution received by Employee A, withholding in the amount of $2,000 (20 percent of $10,000) is required under section 3405(c). The $2,000 is required to be withheld from the $7,000 to be distributed to Employee A in cash, so that Employee A actually receives a check for $5,000.

EXAMPLE 5. The facts are the same as in EXAMPLE 4, except that the $7,000 distribution to Employee A after the offset to repay the loan consists solely of employer securities within the meaning of section 402(e)(4)(E). In this case, no withholding is required under section 3405(c) because the distribution consists solely of the $3,000 offset amount and the $7,000 distribution of employer securities. This is the result because the total amount required to be withheld does not exceed the sum of the cash and the fair market value of other property distributed, excluding offset amounts and employer securities. Employee A may roll over the employer securities and $3,000 to an eligible retirement plan within 60 days, as permitted by section 402(c)(3).

EXAMPLE 6. Employee B, who is age 40, has an account balance in Plan Z. Plan Z is a section 401(k) plan that provides for no after- tax employee contributions. In 1990, Employee B receives a loan from Plan Z, the terms of which satisfy section 72(p)(2), and which is secured by section 401(k) elective contributions. In 1993, the loan fails to satisfy section 72(p)(2) because Employee B stops repayment. In that year, pursuant to section 72(p), Employee B is taxed on a deemed distribution equal to the amount of the unpaid loan balance. Under Q&A-4 of section 1.402(c)-1T, the deemed distribution is not an eligible rollover distribution. Because Employee B has not separated from service or experienced any other event that permits the distribution under section 401(k) of the elective contributions that secure the loan, Plan Z is prohibited from executing on the loan. Accordingly, Employee B's account balance is not offset by the amount of the unpaid loan balance at the time Employee B stops repayment on the loan. Thus, there is no distribution of an offset amount that is an eligible rollover distribution in 1993. However, Employee B has basis in the account balance to the extent of the deemed distribution.

In 1995, Employee B separates from service and is eligible to receive a distribution from Plan Z. Upon separation from service, Employee B elects to receive a total distribution of the account balance. As part of the distribution to Employee B, Employee B's account balance in Plan Z is offset by the amount of the unpaid loan balance in satisfaction of the unpaid loan obligation. Although an offset amount can generally be part of an eligible rollover distribution under Q&A-8 of section 1.402(c)-1T, the portion of the distribution to Employee B that equals the amount of the prior deemed distribution under section 72(p) will not be eligible for rollover because it is not includible in Employee B's gross income.

IV. THE TREATMENT OF AMOUNTS REQUIRED UNDER SECTION 401(a)(9)

In accordance with Q&A-3 and Q&A-7 of section 1.402(c)-1T, a distribution is not an eligible rollover distribution to the extent that it is a required distribution under section 401(a)(9). Thus, for example, if a participant in an individual account plan is required under section 401(a)(9) to receive a minimum distribution for a calendar year of $1,000 and the participant receives four quarterly distributions in that year of $400 each, then the first two distributions and $200 of the third distribution are not eligible rollover distributions. However, the remaining $200 of the third distribution and all of the fourth distribution are eligible rollover distributions because this is the amount by which the total of the distributions exceeds the required minimum distribution.

In the case of annuity payments from a defined benefit plan or under an annuity contract purchased from an insurance company, a literal reading of Q&A B-5 and C-1 of proposed section 1.401(a)(9)-1, published in the Federal Register on July 27, 1987 (52 FR 28070), implies that such annuity payments cannot be eligible rollover distributions. Those questions and answers have been read to imply this result even for annuity payments that are paid before the employee attains (or would have attained) age 70 1/2 and that are for a period certain of less than ten years.

Pursuant to this notice, for purposes of sections 401(a)(31), 402(c), and 3405(c), two rules apply to annuity payments from a defined benefit plan or under an annuity contract purchased from an insurance company. The first rule is that the entire amount of any such annuity payment made on or after January 1 of the year in which an employee attains (or would have attained) age 70 1/2 will be treated as an amount required under section 401(a)(9) and, thus, cannot be an eligible rollover distribution. The second rule is that any such annuity payment that is paid before January l of the year in which the employee attains (or would have attained) age 70 1/2 will not be treated as required under section 401(a)(9) and, thus, can be an eligible rollover distribution if it otherwise qualifies. This second rule applies despite any contrary implication in the proposed regulations under section 401(a)(9). In addition, this second rule applies not only to annuity payments from defined benefit plans or under annuity contracts but also to distributions from individual accounts.

V. APPLICATION OF MANDATORY WITHHOLDING TO NET UNREALIZED APPRECIATION

An eligible rollover distribution can include net unrealized appreciation from employer securities, within the meaning of section 402(e)(4), even if the net unrealized appreciation is excluded from gross income under section 402(e)(4). See Q&A-3 of section 1.402(c)- 1T. To the extent that net unrealized appreciation is excludible from gross income pursuant to section 402(e)(4), net unrealized appreciation is not a "designated distribution" because it is reasonable to believe that it is not includible in gross income. See section 3405(e)(1)(B), which defines the term "designated distribution." Thus, to the extent that net unrealized appreciation is excludible from gross income pursuant to section 402(e)(4), net unrealized appreciation is not included in the amount of an eligible rollover distribution that is subject to 20-percent withholding. (Of course, if the distribution received by the participant consists solely of employer securities, no withholding is required even if the distribution is a designated distribution.)

VI. RELIANCE ON THIS GUIDANCE

This document serves as an administrative pronouncement as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling, a revenue procedure, or temporary regulation.

VII. COMMENTS

The Service and Treasury invite comments on the additional guidance in this notice. Comments will be considered in the development of final regulations under sections 401(a)(31), 402(c), and 3405. Comments should be submitted in writing and addressed to --

     Internal Revenue Service

The principal author of this notice is Marjorie Hoffman of the Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations). For further information, contact Ms. Hoffman at 202- 622-4606 (not a toll-free number).