Under the Inflation Reduction Act of 2022, the tax credit for new energy efficient homes under IRC Section 45L was extended through 2032 (and retroactively through 2022, although the pre-existing rules will continue to apply for 2022). The tax credit is designed to provide an incentive for builders of both residential homes and multi-family dwellings to use materials designed to reduce energy consumption.Beginning in 2023, the credit is also modified by increasing the maximum amount of the credit to either $2,500 or $5,000 (the prior maximum was $2,000 per unit). The new programs also eliminate the height restrictions, so that the previously-existing three-story or less requirement no longer applies beginning in 2023.

Builders must satisfy certain energy-efficient criteria qualify for the $2,500 credit. Beginning in 2023, single-family homes must satisfy the requirements of the Department of Energy’s “Energy Star Single Family New Homes Program,” Version 3.1 for homes constructed before January 1, 2025 and Version 3.2 for later years. It is expected that additional details will be provided. Manufactured homes are required to satisfy the latest Energy Star Manufactured Home National Program requirements that are in effect on the later of (1) January 1, 2023 or January 1 of the year that is two calendar years prior to the date the dwelling is acquired.

If the single-family or manufacture red home is certified as a DOE Zero Energy Ready Home (ZERH) (or meets the requirements of a successor program implemented by the Department of Energy, a higher $5,000 credit is available.

For multi-family dwellings, a $500 credit is available if the home satisfies the criteria of the Energy Star Single Family New Homes Program and a $1,000 credit is available if the building is ZERH certified.¹

Builders must also satisfy prevailing wage standards beginning in 2023. To qualify, workers must be paid wages at rates not less than the prevailing rates for construction, alteration, or repair of a similar character in the locality in which such residence is located as most recently determined by the Secretary of Labor.

To qualify for the tax credit, the taxpayer must obtain an audit that provides an estimate of the energy and cost savings of each energy-efficient home improvement. Beginning in 2024, that audit must be conducted by a Qualified Home Energy Auditor, which is an auditor who has been certified by one of the certification programs listed by the Department of Energy on its certification programs page for the energy efficient home improvement credit. For 2023, a transition rule applies so that the auditor need not be a Qualified Home Energy Auditor.²

Editor’s Note: The Inflation Reduction Act expanded and extended the clean vehicle tax credit for tax years beginning after 2022. See heading below for details. The rules discussed immediately below applied for vehicles placed in service during 2022.

The ARRA modified the credit for qualified plug-in electric drive vehicles purchased after December 31, 2009. To qualify, vehicles must be newly purchased, have four or more wheels, have a gross vehicle weight rating of less than 14,000 pounds, and draw propulsion using a battery with at least four kilowatt hours that can be recharged from an external source of electricity. The minimum amount of the credit for qualified plug-in electric drive vehicles is $2,500 and the credit tops out at $7,500, depending on the battery capacity. The full amount of the credit will be reduced with respect to a manufacturer’s vehicles after the manufacturer has sold at least 200,000 vehicles.¹

ARRA also creates a special tax credit for two types of plug-in vehicles—certain low-speed electric vehicles and two- or three-wheeled vehicles. The amount of the credit is 10 percent of the cost of the vehicle, up to a maximum credit of $2,500 for purchases made after February 17, 2009, and before January 1, 2014. The Protecting Americans from Tax Hikes Act extended this credit for two-wheeled vehicles through 2016, and BBA 2018 extended the credit through 2017. To qualify, a vehicle must be either a low speed vehicle propelled by an electric motor that draws electricity from a battery with a capacity of 4 kilowatt hours or more or be a two- or three-wheeled vehicle propelled by an electric motor that draws electricity from a battery with the capacity of 2.5 kilowatt hours. A taxpayer may not claim this credit if the plug-in electric drive vehicle credit is allowable.

Inflation Reduction Act

The Inflation Reduction Act expands the electric vehicle tax credit for electric vehicles placed into service after December 31, 2022 for ten years, through 2032. Taxpayers who buy qualifying vehicles will qualify for a tax credit of up to $7,500 for new vehicles.

For used electric vehicles, the maximum credit will equal $4,000 or 30% of the vehicle’s cost, whichever is less. Used electric vehicles only qualify if they’re purchased for personal use, rather than for resale.

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Planning Point: Not every electric vehicle will qualify for the clean vehicle credits—meaning that it might be confusing when clients attempt to purchase a clean vehicle. However, the Department of Transportation has provided an online tool so that consumers can enter the vehicle identification number (VIN) to determine whether they would be eligible to claim the credit after purchase.  Sellers of clean vehicles will also furnish seller reports that provide information necessary to claim the credit and verify that the vehicle in question qualifies.
The exact amount of the available credit will depend on various factors, including whether minerals in the vehicle’s battery are sourced from qualifying countries and where the vehicle is assembled. Taxpayers who purchase a vehicle where 40% of the critical minerals used in the battery are sourced from a qualifying country could be eligible for a $3,750 tax credit. Beginning in 2023, 50% of the battery’s components must be assembled or manufactured in North America to qualify for the remaining $3,750 credit.

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Planning Point: The percentage limitations will increase over time, which could make it more difficult to find a qualifying vehicle unless manufacturers modify their processes.

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The clean vehicle tax credit itself was also expanded so that it covers more types of vehicles, to include any new qualified fuel cell motor vehicle. The term “qualifying plug-in electric driver motor” in IRC Section 30D was replaced with the term “clean”. That means qualifying vehicles are expanded to include more than qualified plug-in electric drive vehicles, so that, for example, hydrogen cell fuel cars will qualify.

To claim the tax credit, the taxpayer must include the vehicle’s VIN number on their tax return for the year. The expanded tax credit applies to vehicles placed into service after 2022 (note that clients who have written binding contracts in 2022 will qualify if the vehicle is placed into service in 2023). If the vehicle was purchased in 2022, the old rules for claiming the credit applied.

Taxpayers must ensure that the vehicle was assembled by a qualified manufacturer.  Qualified manufacturers are those that enter into approved agreements with the IRS and supply the IRS with VIN numbers that can be matched to the VIN reported on a taxpayer’s return.

Income Limits and Restrictions. The newly expanded electric vehicle tax credits are intended to provide benefits for lower- and middle-income clients. As such, they come with income restrictions and limitations. The credit is unavailable for single taxpayers who earn more than $150,000 per year, joint filers who earn more than $300,000 per year and heads-of-households who earn $225,000 per year or more.

Certain luxury electric vehicles are also excluded. If the manufacturer’s suggested retail price (MSRP) on an SUV, van or truck is over $80,000, the purchaser is not entitled to the credit. The credit is unavailable if the MSRP on a car is over $55,000. If the vehicle was used (defined as at least two years old), the cost of the pre-owned vehicle cannot exceed $25,000.

There are also restrictions on where the vehicle was manufactured. To qualify, final assembly of the clean vehicle must have occurred in North America. That requirement is effective as of August 16, 2022 (the date the Inflation Reduction Act was signed into law). Further, a certain amount of the minerals used in the vehicle’s battery must be sourced from North America or certain other countries that have free trade agreements with the U.S.

The term “final assembly” is defined to mean the process by which a manufacturer produces a new clean vehicle at, or through the use of, a plant, factory, or other place from which the vehicle is delivered to a dealer or importer with all component parts necessary for the mechanical operation of the vehicle included with the vehicle, whether or not the component parts are permanently installed in or on the vehicle.

Starting in 2023, however, existing sales caps will be removed so that automakers who currently offer electric vehicles can produce more electric vehicles. Prior to the Inflation Reduction Act, manufacturers that produced more than 200,000 electric vehicles did not qualify for the credit.

Transfer of Clean Energy Tax Credits

Beginning in 2024, IRS proposed regulations would allow buyers of eligible green energy vehicles to transfer their tax credits under IRC Sections 30D or 25E to the dealer in return for either (1) cash or (2) for use as a down payment on the vehicle.  

Taxpayers will be permitted to transfer up to two clean vehicle tax credits per year, either in the form of two clean vehicle credits or one clean vehicle credit and one previously owned clean vehicle credit (taxpayers cannot transfer two previously owned clean vehicle credits in the same tax year).  The buyer must also transfer the full amount of the credit.

The buyer will be able to transfer the credit (for both new and previously owned clean vehicles) regardless of their individual tax liability.  However, if the taxpayer is later found to be ineligible for the credit because their income exceeds the income restrictions, the amounts received must be paid to the IRS when the buyer files their federal income tax return (buyers must file a return to claim or transfer their clean vehicle credits).

The amounts received by the buyer (whether in cash or in the form of a down payment) are not included in the buyer’s income.  The amounts are simply treated as an advance payment of the allowable tax credit.  However, the basis of the vehicle must be reduced by the amount of the advance credit.

Buyers can transfer their clean energy credits if the attest that they believe they’re eligible, based on their income falling below the threshold levels in the prior year or the fact that they believe their income will fall below the threshold in the year of purchase.  

According to a news release related to the proposed regulations, the IRS will issue advance payments to the recipient dealer for the transferred credit within 72 hours of the date of purchase if the dealer submits information about the sale to the IRS (a “time of sale report”).  

The advance payment is not included in income, but the dealer also cannot deduct the amount transferred to the buyer.  The amounts are treated as though the buyer paid the amounts to the dealer as part of the purchase price of the vehicle (so will be realized by the dealer in the same way as any other method of purchase).

To allow these transfers, dealers will be required to register with the IRS Energy Credits Online Portal, through which they will submit required information to claim the advance credits (the website is expected to be available late in October).  Dealers will not be able to claim these credits on their tax returns and must instead use the IRS’ advance payment procedures via the IRS Energy Credits Online system.

At the time of sale, the dealer must submit a seller report containing the seller’s identifying information, taxpayer identification number and other valid identification information for the dealer.  The dealer must also have submitted the vehicle identification number for the qualifying vehicle.  These time of sale reports will be required regardless of whether the buyer decides to transfer the credit to the car dealer.  Dealers must also provide copies of the report to the buyer, along with written confirmation that the vehicle qualifies for the credit.

IRS ECO is a free electronic service and requires no special software. The tool is available to any sized business and allows dealers and sellers of clean vehicles to complete the entire process online and receive advance payments within 72 hours. The tool will generate “time of sale reports” that taxpayers will use when filing federal tax returns to claim or report the credit.  Beginning in 2024, clean vehicle sellers and licensed dealers must use the tool for customers to claim or transfer the new or previously owned clean vehicle credit for vehicles placed in service January 1, 2024 or later. 

According to the IRS< the benefits of IRS ECO include: (1) advance payments to dealers will typically occur within 72 hours of an accepted clean vehicle credit transfer time of sale report, (2) the IRS acknowledges receipt and confirmation in real time that a qualified manufacturer has provided the VIN being sold as eligible when a time of sale report is submitted, (3) users can make corrections to information submitted through the tool and (4) the tool keeps issuer information from year to year.  

Initially, only one individual representative of the dealer or seller who is authorized to legally bind the dealer or seller can complete the initial registration through IRS Energy Credits Online.  Starting in December 2023, dealers and sellers will be able to authorize more than one employee to submit time of sale reports and advance payment requests.

To participate in the advance payment program, the dealer must also be in compliance with all federal tax laws and must filed all required returns and paid all federal taxes, interest and penalties due at the time of sale.

1.     IRC  § 30D
2.    REG-113064-23
3.     Rev. Proc. 2023-33

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Editor’s Note: For 2021, employers had the option of amending DCAPs to offer up to $10,500 in tax-preferred benefits ($5,250 for married individuals who file separate returns).An employee may exclude up to $5,000 paid or incurred by the employer for dependent care assistance provided during a tax year.¹ For a married individual filing separately, the excludable amount is limited to $2,500. Furthermore, the amount excluded cannot exceed the earned income of an unmarried employee or the lesser of the earned income of a married employee or the earned income of the employee’s spouse.²

An employee cannot exclude from gross income any amount paid to an individual with respect to whom the employee or the employee’s spouse was entitled to take a personal exemption deduction under IRC Section 151(c) (prior to the suspension of the personal exemption from 2018-2025) or who is a child of the employee under 19 years of age at the close of the taxable year.³  Additionally, the employee cannot reimburse the child’s other parent for child care provided to their qualifying child.

With respect to on-site facilities, the amount of dependent care assistance excluded is based on utilization by a dependent and the value of the services provided with respect to that dependent.⁴

Editor’s Note: The SECURE Act 2.0 created new statutes of limitations (SOLs) for the penalties that apply to excess IRA contributions and missed RMDs.  The SOLs will now start to run immediately while, under prior law, the clock did not begin until the taxpayer filed Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts (meaning that the IRS often had an unlimited amount of time to act if the taxpayer did not file the form).  However, the Tax Court recently ruled that the new SOL on excess contribution penalties was not retroactive (so did not apply for cases where the penalty was incurred prior to the enactment of SECURE 2.0 on December 29, 2022)¹.  The case serves as a warning for clients with missed RMDs or excess contributions from years prior to 2022 that have not yet been corrected.

If contributions are made in excess of the maximum contribution limit for traditional IRAs (Q 3656) or for Roth IRAs (Q 3659), the contributing individual is liable for a nondeductible excise tax of six percent of the amount of the excess for every year the excess contribution remains in the IRA (not to exceed six percent of the value of the account or annuity, determined as of the close of the tax year).² A contribution by a person ineligible to make the contribution is an excess contribution even if it is made through inadvertence.³In the case of an endowment contract described in IRC Section 408(b), the tax does not apply to amounts allocable to life, health, accident, or other insurance.⁴ It also does not apply to premiums waived under a disability waiver of premium feature in an individual retirement annuity.⁵

The penalty tax does not apply to “rollover” contributions to a traditional IRA or “qualified rollover contributions” to a Roth IRA.⁶ It does apply, however, if the “rollover” contribution does not qualify for rollover. The Tax Court did not accept the argument that an IRA created in a failed rollover attempt is not a valid IRA and, thus, the six percent penalty should not apply.⁷ Likewise, a failed Roth IRA conversion that is not recharacterized is subject to the six-percent penalty (the right to recharacterize IRA-to-Roth IRA conversions has generally been eliminated for tax years beginning after 2017, although recharacterizations to correct an excess contribution should remain permissible absent further guidance to the contrary).⁸

The IRS has ruled that earnings credited to an IRA that are attributable to a non-IRA companion account maintained at the same financial institution (a “super IRA”) are treated as contributions to the IRA; when coupled with a cash contribution, these amounts may represent excess contributions subject to the penalty tax.⁹ An interest bonus credited to an individual retirement account, however, is not included in the calculation of an excess contribution.¹⁰

Yes.Taxable distributions from traditional IRAs are subject to income tax withholding. If the distribution is in the form of an annuity or similar payments, amounts are withheld as though each distribution were a payment of wages pursuant to the recipient’s Form W-4. In the case of any other kind of distribution, a flat 10 percent must be withheld by the plan custodian unless a different withholding choice is elected by the owner.¹ A recipient generally can elect not to have the tax withheld; this election will continue until the recipient revokes the election.² Even though distributions from a traditional IRA may be partly nontaxable because of nondeductible contributions, the payor must report all withdrawn amounts to the IRS.³ For states that impose income tax on IRA distributions, state income tax withholding may also be required.

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Planning Point: A recipient of a taxable IRA distribution should project his or her income tax liability for the year and pay in an appropriate amount of estimated tax payments to avoid penalties for under-withholding. Withholding of 10 percent or even 20 percent may be insufficient to cover federal income tax liability. Taxpayers should project their state and local tax liabilities as well. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

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Distributions from Roth IRAs are subject to income tax withholding, but only to the extent that it is reasonable to believe the amount withdrawn would be includable in income.⁴

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Planning Point: IRS withholding guidance, released in Notice 2018-14, could impact individuals who receive retirement benefits in the form of periodic payments (generally those that are annuitized). Individuals receiving periodic payments can use Form W-4P to waive or increase withholding, depending upon their expected income tax liability. With respect to periodic payments, the default method of withholding is based on whether the individual is single or married and the number of withholding allowances the individual could claim were the payments traditional wages. Under Notice 2018-14, the IRS has set the default withholding for periodic payments to equal the wage withholding of a married taxpayer who claims three withholding allowances in order to take the 2017 tax reform law into consideration. Individuals who receive periodic retirement payments may wish to examine their anticipated tax situation and use Form W-4P to modify this default treatment if appropriate. ⁵

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Planning Point: Starting in 2022, withholding elections were to be divided among two forms, Form W-4P and Form W-4R. The IRS delayed the effective date to January 1, 2023. The IRS has also released draft forms and instructions. Form W-4P will be used for withholding tax from periodic payments made from retirement plans and IRAs (the default withholding will be single, with no adjustments, if the taxpayer fails to provide a form). If the taxpayer is already receiving periodic payments, there’s no need to submit a new form if the taxpayer does not wish to make any changes. Form W-4R will be used to withhold federal tax from certain rollover distributions and non-periodic payments.⁶

For 2020, the IRS redesigned Form W-4, which previously mirrored Form W-4P, to account for tax reform changes. The IRS clarified that for 2020, the default rules for withholding from periodic payments under Section 3405(a) when no withholding certificate has been furnished will continue as in prior years (i.e., married with three allowances).

For 2020, the IRS redesigned Form W-4, which previously mirrored Form W-4P, to account for tax reform changes.  The IRS clarified that for 2020, the default rules for withholding from periodic payments under Section 3405(a) when no withholding certificate has been furnished will continue as in prior years (i.e., married with three allowances).

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IRS regulations clarify tax withholding rules for periodic retirement and annuity payments. Pre-tax reform, the default withholding rate was based on a married taxpayer with three withholding exemptions. Post-reform, the personal exemption has been suspended and Congress directed the Treasury to provide updated withholding rules. The regulations add several Q&A to explain that amounts withheld will be treated as though the payment were part of wages paid by an employer. If the payee has not provided a withholding certificate, the withholding amount is determined based on a married taxpayer with three withholding allowances.⁷

Generally, withholding for these types of payments should be determined based on the rules in applicable IRS forms, instructions, publications and other guidance. Rules similar to the wage withholding rules will apply, but the IRS has indicated that further forms, instructions, publications and other guidance will be issued when the rules are finalized. The regulations apply to payments made after December 31, 2020.

A penalty tax is imposed on the participant (IRA owner) if the amount distributed under an IRA for a calendar year is less than the required minimum distribution for the year. The penalty is equal to 25 percent of the amount by which the distribution made in the calendar year falls short of the required amount (the penalty was decreased from 50 percent of the missed RMD for tax years beginning in 2023 and thereafter under the SECURE Act 2.0).¹ The penalty amount is further reduced to 10 percent of the missed RMD if the taxpayer takes all of their missed RMDs and files a tax return paying the required tax and penalty amount before the earlier of (1) receiving a notice of assessment of the RMD penalty tax or (2) two years from the year of the missed RMD.The penalty generally will be imposed in the calendar year in which the amount was required to be distributed. If the distribution was the first required distribution, and thus was due by April 1 following the calendar year in which the IRA owner reached 72 years old (the required beginning date), the penalty will be imposed in the calendar year when distributions were to begin even though the required distribution was technically for the preceding year.²

Example: Joan turned 73 on October 26 of 2023. Her first required minimum distribution for 2023 was due by April 1, 2024. Joan did not receive such amount by the April 1 due date. Consequently, Joan will owe a penalty equal to 25 percent of the amount that should have been distributed, which will be imposed on her 2024 tax return.

The penalty tax may be waived if the payee establishes to the satisfaction of the IRS that the shortfall was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.³

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Planning Point: The SECURE Act 2.0 also contained a new three-year statute of limitations in Section 313.  Under the new law, the penalty only applies for the three years after the year of the missed RMD, after which the penalty cannot be enforced. The language of the SECURE Act leaves room for interpretation and we have yet to receive IRS guidance on the issue.  Some experts argue that the three-year statute of limitations only applies to RMDs that are missed after the law was enacted late in 2022.  That would leave the penalty pending for RMDs missed before SECURE 2.0 became law.

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The minimum distribution requirements will not be treated as violated, and, the 25 percent excise tax will not apply, where a shortfall occurs because assets are invested in a contract issued by an insurance company in state insurer delinquency proceedings.⁴

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Planning Point: To request a waiver of all or part of the 25 percent penalty tax imposed on RMD amounts not distributed on time, a statement of explanation should be filed with Form 5329 for each tax year there is or was a failure to properly take RMDs. The letter must explain the “reasonable error” that caused the failure and the reasonable steps that were taken to correct the error. Although the IRS has not issued guidance on what is a “reasonable error,” possible examples may include illness, death in the family, and notification of RMD not received from the financial institution.

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Editor’s Note: See Q 3691 for a discussion of the substantial changes the SECURE Act made to the distribution rules governing IRAs inherited by non-spouse beneficiaries.

2022 Proposed RMD Regulations

Post-SECURE Act, most non-spouse account beneficiaries will be required to take distributions over a 10-year period unless they are classified as an eligible designated beneficiary (see Q 3903).¹ The law did not change the rules applicable to surviving spouse beneficiaries.

Under regulations proposed in 2022, designated beneficiaries will be required to take annual RMDs throughout the ten-year distribution period if the original account owner died after the required beginning date (it was originally expected that the beneficiary could elect to deplete the entire account in year ten if desired).

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Planning Point: Many clients will jump to take advantage of this relief to avoid increasing their 2023 taxable income. However, skipping the annual RMD is not always a wise move. These taxpayers should be reminded that the original ten-year distribution period still applies, so clients will be required to empty the account by year ten regardless of whether they qualify for relief in years one-three. Those clients may end up with higher distributions in years four-ten, which could increase their overall tax liability in the end.

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Pre-SECURE Act Rules

Prior to 2020, if the owner of an IRA died on or after the date minimum distributions have begun (i.e., the required beginning date), but before the entire interest in the IRA has been distributed, the entire remaining balance generally must be distributed at least as rapidly as under the method of distribution in effect at the owner’s date of death.²

If the IRA owner does not have a designated beneficiary as of the date on which the designated beneficiary is determined (the “determination date;” i.e., September 30th of the year after death, see Q 3696), the IRA owner’s interest was distributed over his or her remaining life expectancy, using the age of the owner in the calendar year of his or her death, reduced by one for each calendar year that elapses thereafter.³

If the owner does have a designated beneficiary as of the determination date, the beneficiary’s interest was distributed over the longer of (1) the beneficiary’s life expectancy, calculated as described under the “Life Expectancy Method,” in Q 3688 or (2) the remaining life expectancy of the owner, determined using the age of the owner in the calendar year of his or her death, reduced by one for each calendar year that elapses thereafter.⁴

For the treatment of multiple beneficiaries and separate accounts, see Q 3696.

Editor’s Note: Under regulations proposed in 2022, designated beneficiaries are required to take annual RMDs throughout the ten-year distribution period if the original account owner died after the required beginning date (it was originally expected that the beneficiary could elect to deplete the entire account in year ten if desired).  The IRS has yet to provide guidance on whether retroactive RMDs will be required for accounts inherited after the SECURE Act effective date and before the proposed regulations were released. Each year, however, the IRS has offered relief by excusing these post-inheritance RMDs.  Most recently, Notice 2024-35 once again excused RMDs in 2024 for beneficiaries of accounts when the original owner died after their required beginning date and the beneficiary inherited the account in 2020, 2021, 2022 or 2023.

Planning Point: Although RMDs for inherited IRA beneficiaries have technically been waived every year since 2020, these beneficiaries may wish to consider taking annual RMDs anyway.  Tax rates are currently at historic lows.  The IRS has also not indicated whether it will extend the 10-year period, meaning that the beneficiary could face a larger tax bill once the IRS begins enforcing their RMD obligations.

Distribution requirements for an inherited IRA for a nonspouse beneficiary will depend on whether the IRA owner died before, on or after the required beginning date. The SECURE Act made substantial changes that eliminate the “life expectancy method” and “five-year method”, discussed under the heading below, for most account beneficiaries. Under the new law, most non-spouse account beneficiaries will be required to take distributions over a 10-year period following the original account owner’s death (the 10-year rule).

The law did not change the rules applicable to surviving spouses who inherit retirement accounts. Exceptions also exist for disabled beneficiaries, chronically ill beneficiaries and children who have not reached “the age of majority”.  Proposed regulations provide that, for defined contribution plans, a child reaches the age of majority on their 21st birthday.  One exception contained in the proposed regulations would continue to allow plans adopted prior to the effective date of the final regulations to continue to use their own definition of “age of majority”.

A trust may be used to secure payments from the inherited account over the life expectancy of a disabled or chronically ill beneficiary. The new 10-year rule also does not apply to an account beneficiary who is not more than 10 years younger than the original account owner.  See Q 3903 for more on eligible designated beneficiary status.

The new rule applies for tax years beginning after December 31, 2019 and applies to all defined contribution-type plans (the rules governing distributions from Roth IRAs were not changed).

Pre-SECURE Act Law: Death Before Required Beginning Date

Prior to 2020, if an IRA owner died before the required beginning date, distributions must be made under either a life expectancy method or the five-year rule (Q 3688).¹ After-death distributions from a Roth IRA also will be determined under these rules because the Roth IRA owner is treated as having died before the required beginning date.²

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Planning Point: The CARES Act provided relief to IRA owners by eliminating the need to take 2020 RMDs. This relief also extends to beneficiaries of inherited accounts. For account beneficiaries subject to the five-year rule, the CARES Act provides that if 2020 is one of those five years, it is not counted—essentially extending the distribution period to six years.

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Under the life expectancy rule, if any portion of the interest was payable to, or for the benefit of, a designated beneficiary, that portion could be distributed over the life (or life expectancy) of the designated beneficiary, beginning within one year of the owner’s death.³ To the extent that the interest is payable to a nonspouse beneficiary, distributions had to begin by the end of the calendar year immediately following the calendar year in which the IRA owner died.⁴ The nonspouse beneficiary’s life expectancy for this purpose was measured as of the beneficiary’s birthday in the year following the year of the owner’s death. In subsequent years, this amount was reduced by one for each calendar year that has elapsed since the year of the owner’s death.⁵

A person who wishes to use the life expectancy method and failed to timely start distributions could make up the missed RMDs and pay the 50 percent penalty on the missed distributions.⁶

Under the five-year rule, the entire interest had to be distributed within five years after the death of the IRA owner (regardless of who or what entity receives the distribution).⁷ To satisfy this rule, the entire interest must be distributed by the end of the calendar year that contains the fifth anniversary of the date of the IRA owner’s death.⁸

Pre-SECURE Act Law: Death On or After Required Beginning Date

If the owner of an IRA dies on or after the date distributions have begun (i.e., generally the required beginning date), but before the entire interest in the IRA has been distributed, the entire remaining balance generally must be distributed at least as rapidly as under the method of distribution in effect as of the owner’s date of death (Q 3689).⁹

If the IRA owner does not have a designated beneficiary as of the date on which the designated beneficiary is determined (i.e., September 30 of the year after death) the IRA owner’s interest is distributed over the remaining life expectancy, using the age of the owner in the calendar year of death, reduced by one for each calendar year that elapses thereafter.¹⁰

If the owner does have a designated beneficiary as of the determination date, the beneficiary’s interest is distributed over the longer of (1) the beneficiary’s life expectancy, calculated as described in Q 3688¹¹ or (2) the remaining life expectancy of the owner, determined using the age of the owner in the calendar year of his or her death, reduced by one for each calendar year that elapses thereafter.¹²

See Q 3690 for the treatment of an IRA that is inherited by a surviving spouse.

In some cases, a plan may reduce the benefits of plan participants and beneficiaries. The Multiemployer Pension Reform Act of 2014¹ (MPRA) created a new type of plan status, known as “critical and declining status” that applies to plans that are projected to become insolvent within either (1) the current plan year, or within 14 subsequent plan years or (2) the current year, or within 19 subsequent plan years if (a) the ratio of inactive to active participants exceeds two to one or (b) the plan is less than 80 percent funded.²

If a plan is in critical and declining status, the plan may temporarily or permanently reduce any current or future payment obligations to plan participants or beneficiaries, whether or not those benefits are in pay status at the time of the reduction.³ Once benefits are suspended, the plan has no future liability for payment of benefits that were reduced while in critical and declining status.⁴

In order to reduce benefits, however, the plan actuary must certify that the plan is projected to avoid insolvency, assuming that the reductions remain in place either indefinitely or until the expiration date set by the plan’s own terms. The plan sponsor must also determine that the plan is projected to remain insolvent unless benefits are reduced, despite the fact that the plan has taken all reasonable measures to avoid insolvency.⁵

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Planning Point: There has been increasing activity to reduce plan benefits under the 2014 law in recent years, so much of an increase that the U.S. Chamber of Commerce described the situation as a “crisis.”⁶ The multiemployer Central States Pension Fund applied to the PBGC to approve benefit reductions but was rejected on the basis the cuts would be insufficient to save the fund. However, the request of the Ironworks Union Local No. 17 Pension Fund was approved by the PBGC and by its members in 2017 to become the first to reduce retiree pension benefits under the law.⁷ More plans have now followed. ⁸

The problem of insolvent multi-employer pension plans recently received study from the GAO as part of its “High Risk Series.” In the report, the GAO assessed the risks of these pension liabilities and made recommendations to Congress in February of 2017. In addition, the head of the PBGC has predicted that based upon current trends the PBGC’s fund could be expended by 2025. This has become a priority for Congress and new legislation, allowing loans to plans and consolidation of plans to increase solvency, might be expected as a consequence.⁹ In light of the rapidly evolving guidance and perhaps new law in this area, practitioners will need to check the status of any legislation and all new PBGC guidance before proceeding to formally request a reduction in benefits for a plan.

In 2021, the American Rescue Plan Act (ARPA) provided relief designed to address the insolvency problem. The PBGC has since issued an interim final rule implementing the special financial assistance (SFA) rule for multiemployer pension plans in the ARPA. Eligible plans may apply to receive a lump-sum payment from a new Treasury-backed PBGC fund. Under the new rules, eligible plans are entitled to amounts that are sufficient to pay all benefits for the next 30 years. According to the PBGC interpretation, that means sufficient funds to forestall insolvency through 2051 (but not thereafter). Plans are entitled to receive the difference between their obligations and resources for the period. “Obligations” are defined to include benefits and administrative expenses that the plan is reasonably expected to pay through the last day of the plan year ending in 2051. “Resources” are defined to include the fair market value of plan assets and the present value of future anticipated contributions, withdrawal payments, and other expected payments.

Surprisingly, the PBGC rule provides that SFA funds will be taken into account when calculating a plan’s withdrawal liability. However, plans are required to use mass withdrawal interest rate assumptions published by the PBGC when calculating withdrawal liability until the later of: (1) 10 years after the end of the year in which the plan received the SFA or (2) the time when the plan no longer holds SFA funds. The PBGC has also stated that it intends to propose a separate rule under ERISA Section 4213(a) to prescribe actuarial assumptions that may be used by a plan actuary in determining an employer’s withdrawal liability.

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Editor’s Note: The SECURE Act has changed the law on mandatory eligibility to include long-term part-time employees. Under prior law, employers were permitted to exclude employees who performed fewer than 1,000 hours of service per year from participation in the employer-sponsored 401(k). The SECURE Act modified this rule in order to expand access for certain part-time employees. Under the new law, nonunion employees who perform at least 500 hours of service for at least three consecutive years (and are at least 21 years old) must be allowed to participate in the employer-sponsored 401(k). The SECURE Act 2.0 reduces the three-year period to two years for tax years beginning after 2024. These long-term, part-time employees may, however, be excluded from coverage and nondiscrimination testing requirements. This SECURE Act provision becomes effective for plan years beginning after December 31, 2020. However, 12-month periods beginning before January 1, 2021 are not taken into account for purposes of determining whether an employee qualifies.¹ Therefore, an employer need only track part time employees on a going forward basis. However, the same is not true for tracking the vesting of employer contributions, based upon Notice 2020-68.

Planning Point: Post-SECURE Act, employers are still permitted to impose certain job-based restrictions on eligibility as long as those restrictions are reasonable and non-discriminatory (i.e., exclusions based on job function or location).  Because the new changes have increased scrutiny on the classifications used by employers, employers should be extra cautious to ensure that any classifications are not a backdoor way to circumvent the service requirements.

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Section 401(k)(15)(B)(iii) provides special vesting rules for an employee who becomes eligible to participate in a CODA solely by reason of having completed three consecutive 12-month periods during each of which the employee completed at least 500 hours of service (long-term, part-time employee). A long-term, part-time employee must be credited with a year of service for purposes of determining whether the employee has a nonforfeitable right to employer contributions (other than elective deferrals) for each 12-month period during which the employee completes at least 500 hours of service.² In addition, Section 401(k)(15)(B)(iii) modifies the break-in-service rules of Section 411(a)(6) for a long-term, part-time employee. The special vesting rules of Section 401(k)(15)(B)(iii) continue to apply to a long-term, part-time employee even if the long-term, part-time employee subsequently completes a 12-month period during which the employee completes at least 1,000 hours of service.³

The IRS has clarified that the rule providing that 12-month periods beginning before January 1, 2021 are not taken into account does not apply for purposes of the vesting rules. Generally, all years of service with the employer maintaining the plan must be taken into account for purposes of determining a long-term, part-time employee’s nonforfeitable right to employer contributions under the special vesting rules. For purposes of determining whether a long-term, part-time employee has a nonforfeitable right to employer contributions (other than elective deferrals), each 12-month period for which the employee has at least 500 hours of service is treated as a year of service. All years of service with the employer maintaining the plan are taken into account for purposes of determining an employee’s nonforfeitable right to employer contributions, subject to certain exceptions. Those exceptions include, for example, years of service before the employee attains age 18.⁴

A plan may not require, as a condition of participation in the cash or deferred arrangement, that an employee complete a period of service beyond the later of age 21 or the completion of one year of service.⁵

A cash or deferred arrangement must satisfy a nondiscriminatory coverage test (Q 3842).⁶ For purposes of applying those tests, all eligible employees are treated as benefiting under the arrangement, regardless of whether they actually make elective deferrals.⁷ An eligible employee is any employee who is directly or indirectly eligible to make a cash or deferred election under the plan for all or a portion of the plan year. An employee is not ineligible merely because he or she elects not to participate, is suspended from making an election under the hardship withdrawal rules, is unable to make an election because his or her compensation is less than a specified dollar amount, or because he or she may receive no additional annual additions under the IRC Section 415 limits (Q 3728, Q 3868).⁸

Employers may apply an early participation test for certain younger or newer employees permitted to participate in a plan. If a plan separately satisfies the minimum coverage rules of IRC Section 410(b), taking into account only those employees who have not completed one year of service or are under age 21, an employer may elect to exclude any eligible nonhighly compensated employees who have not satisfied the age and service requirements for purposes of the ADP test (Q 3802).⁹ This provision is designed to encourage employers to allow newer and younger employees to participate in a plan without having the plan’s ADP results “pulled down” by their often-lower rates of deferral. By making this election, an employer will be able to apply a single ADP test comparing the highly compensated employees who are eligible to participate in the plan to the nonhighly compensated who have completed one year of service and reached age 21.

If an employer includes a tax-exempt 501(c)(3) organization and sponsors both a 401(k) (or 401(m)) plan and a Section 403(b) plan, employees eligible to participate in the Section 403(b) plan generally can be treated as excludable employees for purposes of the 401(k) plan if (1) no employee of the 501(c)(3) organization is eligible to participate in the 401(k) (or 401(m)) plan and (2) at least 95 percent of the employees who are not 501(c)(3) employees are eligible to participate in the 401(k) or 401(m) plan.¹⁰

Guidelines and transition rules for satisfying the coverage requirement during a merger or acquisition are set forth at Revenue Ruling 2004-11.¹¹

Catch-up contributions are defined as additional elective deferrals by an eligible participant in an applicable employer plan, as defined in IRC Section 414(v) and regulations thereunder. Elective deferral for this purpose refers to the amounts described in IRC Section 402(g)(3) (Q 3760), but also includes amounts deferred to eligible Section 457 governmental plans.¹ The provisions allowing catch-up contributions are among the retirement amendments of EGTRRA 2001 that became permanent under the Pension Protection Act of 2006 (“PPA 2006”).²For purposes of IRC Section 414(v), an applicable employer plan means:

(1)    employer plans qualified under IRC Section 401(a) (Q 3838);

(2)    Section 403(b) tax sheltered annuities (Q 4047);

(3)    eligible Section 457 governmental plans (457(b) plans);

(4)    salary reduction simplified employee pensions (i.e., SAR-SEPs (Q 3705)); and

(5)    SIMPLE IRAs (Q 3706).³

For this purpose, qualified plans, Section 403(b) plans, SAR-SEPs, and SIMPLE IRAs that are maintained by a controlled group of corporations, a group of trades or businesses under common control, or members of an affiliated service group (Q 3935) are considered one plan. In addition, if more than one eligible Section 457 governmental plan is maintained by the same employer, the plans will be treated as one plan.⁴

Catch-up contributions permitted under IRC Section 414(v) do not apply to a catch-up eligible participant for any taxable year in which a higher catch-up amount is permitted under IRC Section 457(b)(3) during the last three years prior to the plan’s normal retirement year (Q 3584).⁵

Dollar limit. A plan may not permit additional elective deferrals for any year in an amount greater than the lesser of (1) the indexed amount listed below or (2) the excess (if any) of the participant’s compensation as defined in IRC Section 415(c)(3) (Q 3868, Q 3728) over any other elective deferrals for the year made without regard to the catch-up limits.⁶ An employer that sponsors more than one plan must aggregate the elective deferrals treated as catch-up contributions for purposes of the dollar limit.⁷ An individual participating in more than one plan is subject to one annual dollar limit for all catch-up contributions during the taxable year.⁸

The indexed dollar limit on catch-up contributions to SIMPLE IRAs and SIMPLE 401(k) plans is $3,500 in 2023-2024 and $3,000 in 2015-2022. The SECURE Act 2.0 in-creased the catch-up contribution limit to $5,000 for taxpayers aged 60, 61, 62 or 63 for tax years beginning after 2024.⁹

The indexed dollar limit on catch-up contributions to all other 401(k) plans and to Section 403(b) plans, eligible Section 457 plans, and SAR-SEPs is $7,500 in 2023-2024 and $6,500 in 2020-2022. The SECURE Act 2.0 increased the catch-up contribution limit to the greater of (1) $10,000 or (2) 150% of the regular catch-up limit for 2024 for taxpayers aged 60, 61, 62 or 63 for tax years beginning after 2024 (up from $6,500 in 2020-2022 and $7,500 in 2023-2024).¹⁰

Starting in 2024, if the taxpayer has wages of at least $145,000 from the employer sponsoring the plan in the prior year, the catch-up contribution must be treated as a Roth contribution (the $145,000 limit will also be indexed for inflation). Congress intends to clarify that it only intended this change-and that tax-payers earning less than $145,000 for the prior year can continue to make Roth or pre-tax catch-up contributions. The IRS provided transition relief so that catch-up contributions will satisfy the SECURE 2.0 provisions until at least 2026 even if they are non-Roth contributions made on behalf of high-earning taxpayers.¹¹

The IRS provided transition relief so that catch-up contributions will satisfy the SECURE 2.0 provisions until at least 2026 even if they are non-Roth contributions made on behalf of high-earning taxpayers.  Once the new rule does become effective, the IRS clarified that if an employee who is subject to the Roth catch-up requirement elects to make catch-up contributions on a pre-tax basis, the plan sponsor can disregard that election and treat the catch-up as a Roth contribution.  When multiple employers sponsor the same 401(k) and an employee has wages from more than one of those employers, the amounts will not be aggregated for purposes of determining whether the employee is subject to the Roth mandate.

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Planning Point: As the SECURE Act 2.0 is drafted, once a taxpayer reaches age 64, the lower catch-up contribution limit will once again apply. Additionally, note that the $145,000 limit is a new limit that is not related to the existing definitions for highly-compensated employees. Plans will be required to track this new limit to determine whether any given participant’s catch-up contributions must be treated as Roth contributions (the income limit that applies in the definition for highly-compensated employees is $150,000 in 2023 and $155,000 in 2024).

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Planning Point: Employers who wish to offer high-earning employees a catch-up contribution option must first contact their plan recordkeeper to request the changes. Employers should act now because it can take months for an amendment to be processed and implemented by the recordkeepers and recordkeepers may also limit the number of changes and amendments that they will process in any given year because of staffing constraints. Given the number of employers who will be interested in amending their plans to permit Roth catch-up contribution options this year, it’s important to act early to avoid delays.

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Eligible participant. An eligible participant with respect to any plan year is a plan participant who would attain age 50 before the end of the taxable year and with respect to whom no other elective deferrals may be made to the plan for the plan (or other applicable) year as a result of any limit or other restriction.¹² For this purpose, every participant who will reach age 50 during a plan year is treated as having reached age 50 on the first day of the plan year, regardless of the employer’s choice of plan year and regardless of whether the participant survives to age 50 or terminates employment prior to his or her birthday.¹³

Universal availability. A plan will not satisfy the nondiscrimination requirements of IRC Section 401(a)(4) unless all catch-up eligible participants who participate in any applicable plan maintained by the employer are provided with the effective opportunity to make the same election with respect to the dollar limits described above.¹⁴ This is known as the universal availability requirement. A plan will not fail to satisfy this requirement merely because it allows participants to defer an amount equal to a specified percentage of compensation for each payroll period and permits each catch-up eligible participant to defer a pro rata share of the dollar catch-up limit in addition to that amount.¹⁵

For purposes of the universal availability requirement, all plans maintained by employers that are treated as a single employer under the controlled group, common control, or affiliated service group rules (Q 3933, Q 3935) generally must be aggregated.¹⁶ Exceptions to the aggregation rule apply to Section 457 plans and certain newly acquired plans.¹⁷

Catch-up contributions are excluded from income in the same manner as elective deferrals.¹⁸ The calculation of the elective deferrals that will be considered catch-up contributions generally is made as of the end of the plan year by comparing the total elective deferrals for the plan year with the applicable plan year limit.¹⁹ Elective deferrals in excess of the plan, ADP, or IRC limits, but not in excess of the amount limitations described above, will be treated as catch-up contributions as determined on the last day of the plan year.²⁰

An employer may make, but is not required to make, matching contributions on catch-up contributions. If an employer does so, the contributions must satisfy the ACP test of IRC Section 402(m) (Q 3804).²¹ Reporting requirements for catch-up contributions are set forth in Announcement 2001-93.²²

Editor’s Note: Prior to the SECURE Act 2.0, business owners could not change from a SIMPLE IRA to a safe harbor 401(k) before the end of the year.  By November 2, the employer was required to provide notice of the switch to employees.  The formal termination date was always December 31, and the 401(k) start date was January 1.  SECURE 2.0 relaxed the rules so that employers can terminate a SIMPLE IRA mid-year and replace it with a safe harbor 401(k).  Pursuant to IRS guidance, the employer must take formal written action and specify the termination date.  Employees must be given a 30-day notice before the termination date.  The notice must tell them that no salary reductions to the SIMPLE IRA will be made based on compensation paid after the termination date.  The employer must make matching contributions attributable to employee compensation earned through the termination date.  During the year of transition, the total amount contributed as salary reduction contributions under the terminated SIMPLE IRA plan and as elective contributions under the safe harbor section 401(k) plan cannot exceed the weighted average of the salary reduction contribution and elective contribution limits for each of those plans (based on how many of the 365 days in the transition year each plan was in effect).

The IRC requires that deferrals, matching, and after-tax employee contributions to 401(k) or 401(m) plans satisfy certain nondiscrimination tests. A plan that is designed to meet certain safe harbors is deemed to have met those testing requirements. These tests are referred to as the ADP test for salary deferrals and the ACP test for employee after-tax and matching employer contributions. The requirements for meeting the safe harbors of 401(k) and 401(m) plans include specific plan provisions that generally require a fully vested employer contribution, one or more advance notice requirements (but see the Editor’s Note below), and certain restrictions on the level of discretionary matching contributions.

A plan may be designed to satisfy safe harbors for deferrals but not for the matching employer contribution.

The safe harbor plan requirements prohibit placing restrictions on a participant’s right to receive the match or 3 percent of pay employer contribution. Thus, the contribution must be given to employees who terminate employment in the plan year (Q 3802, Q 3804). The safe harbor does not eliminate the requirement of ACP testing for employee after-tax contributions.¹ In addition, 401(k) plans that meet the safe harbor of 401(k) and 401(m) generally are exempt from the top-heavy requirements (Q 3916 to Q 3922), except as explained below.²

Regulations permit the required safe harbor contributions to be made to the 401(k) plan or other defined contribution plans of the employer.³ Except for the provisions described below, a safe harbor plan generally is subject to the same qualification requirements of IRC Section 401(a) as a traditional 401(k) plan.

The fact that a plan is a safe harbor 401(k) does not prevent certain lower income taxpayers from being eligible to claim the saver’s credit for elective deferrals (Q 3648).

The dollar limit on elective deferrals to a safe harbor plan is the same as for a traditional 401(k) plan (Q 3760).

A safe harbor plan generally may also permit catch-up contributions by participants who are at least age 50 by the end of the plan year.⁴ The limit on catch-up contributions (Q 3761) to safe harbor plans is calculated in the same manner as if made to a nonsafe harbor 401(k) plan.⁵ The dollar limit for salary deferrals is $23,000 in 2024 ($22,500 in 2023, $20,500 in 2022, $19,500 in 2020-2021, $19,000 in 2019) and the catch-up contribution limit is  $7,500 for 2023-2024 ($6,500 for 2020-2022).⁶

Safe harbor 401(k) and 401(m) plans generally are exempt from the top-heavy requirements; where additional employer contributions are made (e.g., profit sharing), that exemption is lost.⁷

Editor’s Note: Under the SECURE Act, beginning in tax years after December 31, 2019, a plan sponsor may switch an existing 401(k) plan to a safe harbor 401(k) with nonelective contributions at any time prior to 30 days before the close of a plan year. An amendment to do this can even be made later than this deadline if it provides (i) a nonelective contribution of at least 4 percent of compensation (versus 3 percent) for all eligible employees for the plan year; and (ii) the plan is amended no later than the last day for distributing plan excess contributions for the plan year, which is the close of the following plan year.

The SECURE Act also eliminates the safe harbor notice requirement for nonelective contributions. However, it retains the requirement to allow employees to make or change a deferral election at least once per year.⁸ In addition, there is a new tax credit for certain small employers that include an automatic enrollment feature (a QACA) in their plan, whether new or existing.⁹ See Q 3776.

SIMPLE 401(k) plans (Q 3778) provide a design-based alternative to the use of a safe harbor plan. Some of the differences between safe harbor plans and SIMPLE 401(k) plans are as follows:

(1)    Employees covered by a SIMPLE 401(k) plan may not be participants in any other plan offered by the employer, although employees participating in a safe harbor plan may be covered by more than one plan.

(2)    SIMPLE 401(k) plans are subject to the lower dollar limits on elective deferrals and catch-up contributions that apply to SIMPLE IRAs, rather than those applicable to traditional 401(k) plans.

(3)    Employers offering a SIMPLE 401(k) plan may not offer any contributions other than those provided under the SIMPLE 401(k) requirements, although employers maintaining a safe harbor plan may do so within the limitations described in Q 3775.

(4)    Safe harbor plans may be offered by any employer, although SIMPLE 401(k) plans are available only to employers with 100 or fewer employees earning $5,000 or more in the preceding year.

(5)    Contributions required under a safe harbor design may be made to a separate plan of the employer, although contributions required under a SIMPLE 401(k) design must be made to the SIMPLE 401(k) plan.

(6)    A SIMPLE 401(k) plan must provide the required notice to employees at least 60 days before the beginning of the plan year while safe harbor 401(k) plans must provide notice at least 30 days before the beginning of the plan year, except in the case of certain nonelective contribution safe harbor plans.¹

(7)    A SIMPLE 401(k) plan cannot be established by completing IRS Form 5304-SIMPLE or IRS Form 5305-SIMPLE. It requires a formal written plan document.

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Planning Point: A SIMPLE 401(k) must file a Form 5500 but SIMPLE IRAs do not. Anyone considering a SIMPLE 401(k) plan can accomplish the same funding in a SIMPLE IRA. Note that the penalties for failing to file a Form 5500 are steep and increase with every day the filing is late. Pre-SECURE Act, the IRS could assess a penalty of up to $25 per day with a cap of $15,000 per year. Effective for years beginning after December 31, 2019, the penalty has increased to $250 per day for late filers and up to $150,000 per plan year (note that the additional DOL penalty exceeds $2,000 per day with no annual cap).²

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Planning Point: The SECURE Act now allows employers to adopt retirement plans after the close of the employer’s tax year (by the due date, including extensions, for filing its tax return). The employer may elect to treat the plan as having been adopted as of the last day of the tax year (the new rule applies after December 31, 2019). If an employer adopts a plan prior to the tax filing deadline and treats the plan as having been adopted as of the last day of the employer’s 2020 tax year, the plan sponsor is not required to file Form 5500 for the plan year that begins during the employer’s 2020 tax year. The first Form 5500 required to be filed instead will be the 2021 Form 5500. The plan sponsor should check a box on the 2021 Form 5500 indicating that the employer elects to treat the plan as retroactively adopted as of the last day of the 2020 tax year.

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Editor’s Note: Under the SECURE Act 2.0, employees may elect to have employer matching or non-elective contributions made on a Roth basis if the plan offers a Roth option starting with the 2023 tax year. The IRS has clarified that participants must be given the opportunity to make a Roth election at least once per year (presumably, that election could cover all employer-matching contributions made throughout the year).  The participant must be fully vested to make the Roth election (only allowing fully vested participants to elect Roth matching contributions will not be treated as a discriminatory plan feature).  The plan is still entitled to have a vesting schedule.  Contributions are subject to income tax in the year of contribution but are not subject to employment taxes.  Contributions are reported as in-plan rollovers in Form 1099-R.  A plan may also be permitted to allow only employer Roth contributions without also allowing employee Roth deferrals.¹

A Roth 401(k) feature combines certain advantages of the Roth IRA with the convenience of 401(k) plan elective deferral-style contributions. The IRC states that if a qualified plan trust or a Section 403(b) annuity includes a qualified Roth contribution program, contributions to it that the employee designates to the Roth account, although not being excluded from the employee’s taxable income, will be treated as an elective deferral for plan qualification purposes.² A qualified plan or Section 403(b) plan will not be treated as failing to meet any qualification requirement merely on account of including a qualified Roth contribution program.³

A qualified Roth contribution program means a program under which an employee may elect to make designated Roth contributions in lieu of all or a portion of elective deferrals that the employee is otherwise eligible to make.⁴ For this purpose, a designated Roth contribution is any elective deferral that would otherwise be excludable from the gross income of the employee, but that the employee designates as not being excludable.⁵ Final regulations set forth the following requirements for designated Roth contributions:

(1)    The contribution must be designated irrevocably by the employee at the time of the cash or deferred election as a designated Roth contribution that is being made in lieu of all or a portion of the pre-tax elective contributions the employee is otherwise eligible to make under the plan.

(2)    The contribution must be treated by the employer as includable in the employee’s gross income at the time the employee would have received the amount in cash, if the employee had not made the cash or deferred election (i.e., it must be treated as wages subject to applicable withholding requirements).

(3)    The contribution must be maintained by the plan in a separate account, as provided under additional requirements set forth below.⁶

A plan with a Roth contribution feature must provide for separate accounts for the designated Roth contributions of each employee and any earnings allocable to the account.⁷ Gains, losses, and other credits and charges associated with the Roth accounts must be separately allocated on a reasonable and consistent basis to the designated Roth account and other accounts under the plan. Forfeitures of any accounts may not be reallocated to the designated Roth account. No contributions other than designated Roth contributions and rollover Roth contributions (as described below) may be allocated to the Roth account. The separate accounting requirement applies from the time the designated Roth contribution is made until the designated Roth contribution account is completely distributed.⁸

The maximum amount an employee may claim as a designated Roth contribution is limited to the maximum amount of elective deferrals permitted for the tax year, reduced by the aggregate amount of elective deferrals for the tax year for which no designation is made.⁹ Only one limit can be split between the Roth and salary deferrals of the employee each calendar year.

Designated Roth contributions generally must satisfy the rules applicable to elective deferral contributions. Thus, for example, the nonforfeitability requirements and distribution limitations of Treasury Regulation Sections 1.401(k)-1(c) and (d) must be satisfied for Roth contributions. Designated Roth contributions are treated as elective deferral contributions for purposes of the Actual Deferral Percentage (“ADP”) test.¹⁰

Beginning in 2024, a designated Roth account will not be subject to the minimum distribution requirements of IRC Section 401(a)(9) (Q 3891 to Q 3909).¹¹ Roth 401(k)s were subject to the RMD rules in 2023, so first-time
RMDs for 2023 that were due by April 1, 2024 were still required. A payment or distribution otherwise allowable from a designated Roth account may be rolled over to another designated Roth account of the individual from whose account the payment or distribution was made or to a Roth IRA of the individual.¹² Rollover contributions to a designated Roth account under this provision are not taken into account for purposes of the limit on designated Roth contributions.¹³ Funds in a Roth IRA are not subject to the lifetime minimum distribution requirements(Q 3686).

The IRC states that any qualified distribution from a designated Roth account is excluded from gross income.¹⁴ A qualified distribution for this purpose is defined in the same manner as for Roth IRAs except that the provision for “qualified special purpose distributions” is disregarded (Q 3673).¹⁵ The term qualified distribution does not include distributions of excess deferrals (amounts in excess of the IRC Section 402(g) limit) or excess contributions (under IRC Section 401(k)(8)), or any income on them.¹⁶

Nonexclusion period. A payment or distribution from a designated Roth account will not be treated as a qualified distribution if it is made within the five-year nonexclusion period. This period begins with the earlier of (1) the first taxable year for which the individual made a designated Roth contribution to any designated Roth account established for that individual under the same retirement plan, or (2) if a rollover contribution was made to the designated Roth account from another designated Roth account previously established for the individual under another retirement plan, the first taxable year for which the individual made a designated Roth contribution to the previously established account.¹⁷

The IRC states that notwithstanding IRC Section 72, if any excess deferral attributable to a designated Roth contribution is not distributed on or before the first April 15 after the close of the taxable year in which the excess deferral was made, the excess deferral will not be treated as investment in the contract and will be included in gross income for the taxable year in which such excess is distributed.¹⁸ Furthermore, it adds that “Section 72 shall be applied separately with respect to distributions and payments from a designated Roth account and other distributions and payments from the plan.”¹⁹

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Planning Point: Even though designated Roth contributions are not excluded from income when contributed, they are treated as elective deferrals for purposes of IRC Section 402(g). Thus, to the extent total elective deferrals for the year exceed the 402(g) limit for the year, the excess amount can be distributed by April 15 of the year following the year of the excess without adverse tax consequences. However, if the excess deferrals are not distributed by that time, any distribution attributable to an excess deferral that is a designated Roth contribution is includible in gross income (with no exclusion from income for amounts attributable to basis under Section 72) and is not eligible for rollover. If there are any excess deferrals that are designated Roth contributions that are not corrected prior to April 15 of the year following the excess, the first amounts distributed from the designated Roth account are treated as distributions of excess deferrals and earnings until the full amount of those excess deferrals (and attributable earnings) are distributed.²⁰

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Amounts held by the trust that are attributable to employer contributions made pursuant to the election to defer may not be distributed to participants or beneficiaries prior to:

(1)    the employee’s death, disability, or severance from employment;

(2)    certain plan terminations, without the establishment or maintenance of another defined contribution plan;

(3)    in the case of a profit sharing or stock bonus plan, the employee’s reaching age 59½;

(4)   experiencing financial hardship (Q 3798) (for years beginning before January 1, 2019, limited to distributions from a profit sharing or stock bonus plan and not permitted from other plans);

(5)    in the case of a qualified reservist distribution, the date of the reservist’s order or call;¹ or

(6)    Under the SECURE Act, withdrawals of up to $5,000 for up to one year following the birth or legal adoption of a child. Adopted children generally include children under age 18, but can also include someone who has reached age 18 but is physically or mentally disabled and incapable of self-support.²

These occurrences are referred to as “distributable events.” Amounts may not be distributable merely by reason of completion of a stated period of participation or the lapse of a fixed number of years.³

Planning Point: Under SECURE 2.0, plans can elect to include an automatic cash-out provision to distribute small retirement plan balances when the employee separates from service. Qualified plans are not required to contain cash-out provisions that provide for immediate distribution of a participant’s benefits without the participant’s consent upon termination of participation if the value of the benefit is less than the statutory limit (under SECURE 2.0, $7,000 starting in 2024).  Plans do have the option of adding a cash-out threshold if the threshold is not more than $7,000.  If the threshold established is less than $1,000, the plan can merely cut a check for the participant’s balance.  If the threshold is $1,000 or higher, the plan must automatically roll the amounts over into an IRA in the former employee’s name (unless the former employee makes an election to receive the amount directly or have the amounts rolled over into another eligible retirement plan).

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The cost of life insurance protection as per Table 2001 or the insurer’s qualifying lower published term rates (Q 3948) provided under the plan is not treated as a distribution for purposes of these rules. Neither is the making of a loan that is treated as a deemed distribution even if the loan is secured by the employee’s elective contributions or is includable in the employee’s income under IRC Section 72(p).

The reduction of an employee’s accrued benefit derived from elective contributions (i.e., an offset distribution) by reason of a default on a loan is treated as a distribution (Q 3953).⁴ The IRS has privately ruled that a transfer of 401(k) elective deferrals or rollovers to purchase service credits would not constitute an impermissible distribution from the plan and are not a violation of the separate accounting requirement.⁵

Restrictions on distributions of elective contributions generally continue to apply even if the amounts are transferred to another qualified plan of any employer.⁶ Amounts transferred to a 401(k) plan by a direct rollover from another plan do not have to be subject to these restrictions.⁷ See Q 3780 for discussion of in-plan Roth distributions. See Q 3787 for a discussion of penalty-free rollovers from 401(k) plan accounts into Roth 401(k) accounts. Final regulations state that rollover amounts may be excepted from the timing restrictions on distributions applicable to a receiving plan, provided there is a separate accounting for such amounts.⁸

If an eligible retirement plan separately accounts for amounts attributable to rollover contributions to the plan, distributions of those amounts are not subject to the restrictions on permissible timing that apply, under the applicable requirements of the Internal Revenue Code, to distributions of other amounts from the plan. Accordingly, the plan may permit the distribution of amounts attributable to rollover contributions at any time pursuant to an individual’s request.

Thus, for example, if the receiving plan is a money purchase pension plan and the plan separately accounts for amounts attributable to rollover contributions, a plan provision permitting the in-service distribution of those amounts will not disqualify the plan.⁹

Editor’s Note: The SECURE Act 2.0 created new rules allowing plan participants to take emergency distributions to cover immediate financial hardships without penalty.  These emergency distributions will be limited to $1,000 each year.  Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period.  Non-highly compensated employees may be entitled to contribute the le sser of (1) 3% of compensation or (2) $2,500 to pension-linked emergency savings accounts (PLESAs) using after-tax dollars if their employer elects to establish a PLESA.  See Q3798.1 for details.
The 2017 tax reform legislation created new rules governing hardship distributions made because of qualified 2016 disasters.  The CARES Act further expanded hardship distribution eligibility in response to the COVID-19 pandemic in 2020. See Q3799-Q3801 for details.

Hardship withdrawals may be made from a 401(k) plan only if the distribution is made on account of an immediate and heavy financial need and the distribution is necessary to satisfy the financial need.² The distribution may not exceed the employee’s maximum distributable amount. Hardship withdrawals generally may not be rolled over (Q 3998).³ Not all plans provide for hardship withdrawals, and plan sponsors must first look to the plan documents before determining whether a hardship distribution can be made. The final regulations cited here took effect for plan years beginning on or after January 1, 2006.⁴

The Pension Protection Act of 2006 called for regulations modifying the hardship requirements to state that if an event constitutes a hardship with respect to a participant’s spouse or dependent, it constitutes a hardship with respect to the participant, to the extent permitted under the plan.⁵

An employee’s maximum distributable amount generally is equal to the employee’s total elective contributions as of the date of distribution reduced by the amount of previous distributions on account of hardship.⁶ Early in 2018, Congress passed the Bipartisan Budget Act of 2018 (BBA 2018), which modified this rule to expand the amounts that may be withdrawn as hardship distributions. Beginning in tax years that begin after December 31, 2018, the following amounts may also be distributed as hardship distributions (1) amounts contributed by the employer to a profit sharing or stock bonus plan, (2) qualified nonelective contributions (QNECs), (3) qualified matching contributions (QMACs) and (3) earnings on any of these types of contribution.⁷

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Planning Point: The changes enacted by BBA 2018 are not all mandatory, meaning that plan sponsors have the option of modifying their plans to implement the new rules. Plan sponsors operating safe harbor 401(k)s may wish to proceed with caution in implementing the changes, as Treasury has yet to issue guidance on whether the regulatory safe harbor will be satisfied if the plan retains (1) the six-month waiting period for contributions following a hardship distribution or (2) the requirement that the participant first take a plan loan before a hardship distribution is available. Plans must also consider the “leakage” problem in allowing participants to withdraw QNECs or QMACs, or in permitting hardship distributions before plan loans (which must be repaid).

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The determinations of whether the participant has “an immediate and heavy financial need” and whether other resources are “reasonably available” to meet the need are to be made on the basis of all relevant facts and circumstances. Beginning for hardship distributions taken on or after January 1, 2020, the employee must provide a written representation stating that the employee does not have cash or other liquid assets reasonably available to satisfy the need (under BBA 2018). An example of “an immediate and heavy financial need” is the need to pay funeral expenses of a family member. A financial need will not fail to qualify as an immediate and heavy financial need merely because it was foreseeable or voluntarily incurred by the employee.⁸

Under the SECURE Act 2.0, beginning in 2023, employers are permitted to rely on written self-certification from employees stating that (1) the hardship exists, (2) the amount requested does not exceed the amount needed to cover permitted expenses and (3) the employee does not have a reasonably available alternative source of funding.

A distribution will be deemed to be made on account of “an immediate and heavy financial need” if it is made on account of any of the following:

(1)    “medical expenses” incurred by the employee, spouse, or dependents that would be deductible as itemized deductions under section 213(d) without regard to the 7.5 percent (10 percent in prior years⁹) of AGI floor;

(2)    the purchase (excluding mortgage payments) of the employee’s principal residence;

(3)    payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, spouse, children, or dependents (note that the educational expenses must be for education incurred in the following 12 months, the IRS has ruled that a participant cannot take a hardship distribution to repay student loans incurred for past education);

(4)    payments necessary to prevent eviction of the employee from his or her principal residence or foreclosure on the mortgage on his or her principal residence;

(5)    funeral or burial expenses for the employee’s parent, spouse, children, or other dependents (as defined prior to 2005); and

(6)    expenses for the repair or damage to the employee’s principal residence that would qualify for the casualty deduction under IRC Section 165 (without regard to the 10 percent floor).¹⁰

This list may be expanded by the IRS but only by publication of documents of general applicability.¹¹ Apparently, to be the taxpayer’s “principal residence” for this purpose, the home must be the residence of the employee, not merely that of his or her family.¹²

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Planning Point: While the rules governing plan hardship distributions were not directly changed by the 2017 tax reform legislation, many plans that follow safe harbor standards and allow participants to withdraw funds to cover losses that are deductible as casualty losses may need to reevaluate their plan provisions. This is because, for 2018-2025, individuals may only treat losses sustained in a federal disaster area as deductible casualty losses under IRC Section 165. Unless subsequent guidance is released to change the safe harbor rules governing hardship distributions, plans may need to change the terms of their plan to comply with the new Section 165 rules.

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A distribution is not necessary to satisfy such an immediate and heavy financial need (and will not qualify as a hardship withdrawal) to the extent the amount of the distribution exceeds the amount required to relieve the financial need. The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.¹³

The distribution also will not be treated as necessary to satisfy an immediate and heavy financial need to the extent the need can be satisfied from other resources that are reasonably available. However, the BBA 2018 eliminated the requirement that a plan participant first take any available plan loan before the distribution could qualify as a hardship distribution.¹⁴

A distribution may be treated as necessary if the employer reasonably relies on the employee’s representation that the need cannot be relieved:

(1)    through reimbursement or compensation by insurance or otherwise,

(2)    by reasonable liquidation of the employee’s assets,

(3)    by cessation of elective contributions or employee contributions,

(4)    by other distributions or nontaxable loans from any plans (the requirement that a participant first take any available plan loan was eliminated by the BBA 2018, but the requirement that the employee consider any ESOP dividend distributions was retained), or

(5)    by loans from commercial sources.

Notwithstanding these provisions, an employee need not “take counterproductive actions” (such as a plan loan that might disqualify the employee from obtaining other financing) if the effect would be to increase the amount of the need.¹⁵

The final regulations governing hardship distributions also provide that with respect to employee representations of financial hardship, the employee can reasonably represent that he or she has no cash or liquid assets reasonably available to satisfy the relevant financial need if the only cash or liquid assets available to that employee are necessary to pay some other expense (such as rent) in the near future.¹⁶ Employees can also make representations of financial need over the phone if the employer records the call.¹⁷ Plan documents were required to be amended by December 31, 2021 to provide for the new written representation provision, although the rule is effective beginning in 2020.¹⁸

Plan sponsors are also entitled to impose a minimum distribution amount for hardship distributions so long as the requirement is not found to be discriminatory.¹⁹

Regulations state that a distribution will be deemed to be “necessary” to meet a financial need (deemed or otherwise) if the employee has obtained all other distributions and nontaxable loans (prior to 2019) currently available under all of the employer’s plans and, prior to 2019, the employee is prohibited from making elective contributions and employee contributions to the plan and all other plans of the employer for a period of at least six months after receipt of the hardship distribution.²⁰ The regulations have been modified to eliminate the prohibition on contributions during the six month period following receipt of a hardship distribution, although the final regulations have clarified that the new rule applies only to contributions to qualified plans. Plan documents must be amended by December 31, 2021 to account for this new rule, which became effective beginning in 2020.²¹ Nonqualified plans, including those subject to IRC Section 409A, may continue to suspend deferrals for six months following the hardship distribution.²²

The IRS has released internal guidance that it will use when examining a 401(k) plan to evaluate whether hardship distributions have been properly substantiated. The new guidance clarifies that, as part of the verification process for determining whether the participant has an immediate and heavy financial need, the employer or plan sponsor must review either the source documents supporting that need (such as contracts or foreclosure notices), or a summary of those documents. If only a summary is provided, an IRS agent reviewing the case will look to whether a notice was provided to the withdrawing participant before he or she is entitled to the hardship withdrawal. The notice must contain a statement that provides the following information:

(1)    the distribution is taxable,

(2)    additional taxes could apply,

(3)    the amount of the distribution cannot exceed the participant’s “immediate and heavy financial need,”

(4)    the distribution cannot be made from earnings on elective contributions or qualified nonelective contributions or matching contributions (QNECs and QMACs) (the prohibition on making the distribution from QNECs, QMACs, and earnings was eliminated for tax years beginning after December 31, 2018)²³, and

(5)    all source documents must be retained and provided to the employer or administrator upon request at any time.

The guidance also provides that specific information should be obtained by the plan administrator to substantiate a summary. If the summary is incomplete or inconsistent on its face, the IRS examining agent may ask for source documents.²⁴

 

The 2019 Tax Certainty and Disaster Relief Act (enacted in conjunction with the SECURE Act) extended the rules governing qualified disaster distributions from retirement accounts, discussed below, for victims of disasters that occurred in 2018 and through 60 days after enactment of the bill (December 20, 2019). With respect to this specific provision, distributions had to be made within 180 days after enactment of the law to qualify.

A 60-day extension now applies in all cases involving federally declared disasters.  Under IRS rules, the 60-day extension will apply automatically (although Treasury often provides for longer extension periods).  As of November 15, 2021, the changes also clarify what will happen if multiple disasters occur within the same disaster area within a 60 day period.  If that’s the case, a separate 60 day period will apply to each disaster declaration.  The IRS has also clarified that the 60-day period will now end 60 days after the later of (1) the earliest incident date or (2) the date FEMA declares the disaster.

Qualified disaster areas generally include any area the President declares as such. The term “qualified disaster area” does not include the California wildfire disaster area, as defined in the 2018 Bipartisan Budget Act.

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Planning Point: Relatedly, Section 7508A(d) was added to the Internal Revenue Code in 2019 to codify a 60-day postponement of certain tax-sensitive acts in situations involving a disaster.

For this purpose, IRS final regulations released in 2021 clarify that a “federally declared disaster” includes both a major disaster and emergencies declared under Sections 401 or 501 of the Stafford Disaster Relief and Emergency Assistance Act.

The regulations also clarify that “time-sensitive acts” include those acts that the Treasury secretary determines should be postponed.  In the case of certain pensions and employee benefit plans, they also include acts described in IRC Section 7508A(d)(4), such as contributions, distributions and rollovers.  The final regulations apply to federally declared disasters after December 21, 2019.

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In general, the benefits of taking a distribution under the SECURE Act’s expansion of the disaster relief option are:

• The taxpayer is exempt from the penalty on early distributions,
• The taxpayer is exempt from withholding requirements on the distribution,
• The taxpayer can elect to treat the distribution as having been distributed over a three-year period (or within the single year of distribution, and
• The taxpayer is able to repay the distribution within three years of receiving the distribution.¹

Individuals affected by a qualified disaster qualify for relaxed rules on loans from qualified plans. The plan administrator may increase the regular $50,000 limit on plan loans to $100,000 and the 50 percent of vested benefit limit to 100 percent. These same benefits were provided for the 2020 tax year in response to the COVID-19 pandemic.

3800.1. What requirements apply to hardship withdrawals from a 401(k) plan after qualified natural disasters for 2021 and beyond?

Under prior law, Congress and the IRS had to proactively take action to provide relief for taxpayers after natural disasters.  The SECURE Act 2.0 created a permanent hardship withdrawal for qualified natural disasters.

If the disaster qualifies as a federally declared disaster, taxpayers can access up to $22,000 in retirement funds per disaster without application of the 10 percent early withdrawal penalty.  Further, the tax liability generated by the retirement account withdrawal can be spread over three years–and taxpayers can be given the option to repay the funds within three years of the withdrawal.  

The maximum loan amount for individuals experiencing a qualified disaster was also increased to $100,000.  

The expanded rules apply to any federally declared disaster occurring on or after January 26, 2021.  Federally declared disasters are those designated by FEMA at  https://www.fema.gov/disaster/declarations.

Planning Point: These provisions are optional.  Taxpayers should check their specific plan terms to determine whether the plan sponsor has included the expanded hardship distribution option.

Editor’s Note: The SECURE Act, enacted on December 20, 2019, made significant changes in required minimum distribution (RMD) rules for all qualified plans. It added a new subsection (H) to IRC Section 401(a)(9) to change the mandatory start date for RMDs from age 70½ to age 72 for distributions made after December 31, 2019 (the change applies only to individuals who attain age 70½ after that date).  The age 72 required beginning date applied in 2020-2022.  Beginning in 2023, SECURE 2.0 raised the required beginning date to age 73.  In 2033, the age is once again set to increase to 75.

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Planning Point: The IRS allowed taxpayers who received RMDs that turned out to be unnecessary due to the change in the RBD age to roll those amounts back into their accounts. The relief applies for taxpayers who took RMDs between January 1, 2023 and July 31, 2023. The amounts were required to be rolled back into the account by September 30, 2023.¹

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In order to be qualified, a plan must provide that the entire interest of each employee will be distributed not later than his required beginning date, or will be distributed beginning not later than the required beginning date over certain prescribed time periods.²

For purposes of the minimum distribution rules (Q 3892 to Q 3908) and the minimum distribution incidental benefit rule (Q 3909), the term “required beginning date” means April 1 of the calendar year following the later of (1) the year in which the employee attains age 73 or (2) the year in which the employee (other than a 5 percent owner) retires from the employer maintaining the plan.³

In the case of a 5 percent owner, there is only one required beginning date: April 1 of the calendar year following the year in which the employee attains age 73.⁴ Under pre-SECURE Act law, the IRS determined that where a 5 percent owner rolls the account balance over to the plan of another employer in which the 5 percent owner was not a 5 percent owner (after receiving the required distribution for the year in question), the individual could delay distributions from the new plan until retiring after age 70½.⁵

Under pre-SECURE Act regulations, a plan was permitted to provide that the required beginning date for all employees was April 1 of the calendar year following the calendar year in which the employee attained age 70½ regardless of whether the employee is a 5 percent owner.⁶ Presumably, this ability to mandate distribution will be available even though the SECURE Act has changed the attained age from 70½ to 72 and SECURE 2.0 once again raised the relevant age to 73.

If distributions began irrevocably (except for acceleration) prior to the required beginning date in the form of an annuity that meets the minimum distribution rules, the annuity starting date will be treated as the required beginning date for purposes of calculating lifetime and after death minimum distribution requirements (Q 3896).⁷

Pre-SECURE Act, if, for example, an employee’s date of birth is June 30, 1939, the employee would reach age 70 on June 30, 2009, and would reach age 70½ on December 30, 2009. Consequently, assuming the employee is retired or a 5 percent owner, the employee’s required beginning date would be April 1, 2010. Because distributions from a defined contribution plan were waived for 2009, a distribution from a defined contribution plan would not be required until December 31, 2010. (See Q 3892.) If the same employee’s birthday were July 1, 1948, the employee would reach age 70½ on January 1, 2019, and the employee’s required beginning date would be April 1, 2020.⁸ Post-2019, if for example, the employee’s date of birth is July 1, 1949, the employee would reach age 70½ on January 1, 2020. Pre-SECURE Act (under prior law), the calendar year for the first required distribution for the employee would be 2020. But, because the employee will have reached age 70½ after December 31, 2019, the new law will apply, and the first calendar year of distribution to the employee will be 2022. Unfortunately, any employee born a day earlier (June 30, 1949) or more is stuck with the first distribution in calendar year 2020 (although RMDs were waived for 2020, see Q 3892).

A qualified plan must provide that benefits under the plan generally may not be assigned, alienated, or subject to garnishment or execution.¹ Limited exceptions are provided, including a Qualified Domestic Relations Order (“QDRO,” see Q 3915), for collection of taxes or certain federal judgments (see Q 3913), or when a participant has committed a breach of fiduciary duty, or a criminal act, against the plan (see Q 3914).²The U.S. Supreme Court has held that, for purposes of the anti-alienation provision, a working business owner and the owner’s spouse are ERISA-protected participants, provided the plan covers one or more employees other than the owner and spouse.³

Bankruptcy Protection

The Supreme Court has held that qualified plan interests generally are protected from the reach of plan participants’ creditors in bankruptcy.⁴ The Supreme Court also has extended the protection offered to qualified plan assets under the federal Bankruptcy Code to an IRA containing a rolled over lump sum distribution from a qualified plan.⁵ Even where it is unclear whether a plan was tax qualified, lower courts have allowed anti-alienation provisions to stand.⁶

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Planning Point: The U.S. Bankruptcy Court for the Western District of North Carolina recently held that inherited 401(k)s may also receive creditor protection in bankruptcy if the funds remain in the inherited account when the bankruptcy petition is filed. The court specifically distinguished this treatment for ERISA-covered plans from the treatment of inherited IRAs, which may not be protected in bankruptcy (in Clark v. Rameker,⁷ the Supreme Court unanimously ruled that inherited IRAs were not “retirement funds,” and were thus not entitled to bankruptcy protection). A key factor in the case was the fact that the funds remained within the inherited 401(k), which was set up by the financial institution in the debtor’s name. However, this case was decided by a lower district court and is apparently a case of first impression. Therefore, clients should proceed cautiously and examine state laws when determining whether inherited 401(k)s can be excluded from a bankruptcy estate.⁸

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Payment of a participant’s accrued benefit to a bankruptcy trustee pursuant to a bankruptcy court order, even with the participant’s consent, is a prohibited alienation for qualification purposes.⁹ If the plan permits and the participant consents, however, a plan administrator may draw a loan check or a hardship withdrawal check payable to the participant and send such checks directly to the bankruptcy trustee, to be endorsed over to the trustee by the participant, without violating the anti-alienation prohibition.¹⁰

A Bankruptcy Code requirement that debtors apply all “projected disposable income to be received … to make payments under the [bankruptcy] plan” does not require a plan participant to take out a plan loan to pay toward his or her debt, because plan loans are not “income” for bankruptcy purposes.¹¹ If a participant has already taken a plan loan and subsequently files for bankruptcy, amounts used to repay the loan do not receive preferential treatment merely because the loans are secured by plan assets. In at least two rulings, the payments were not deemed necessary for the participant’s “maintenance and support.”¹²

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Planning Point: In a 2021 decision, the Sixth Circuit Court of Appeals confirmed that 401(k) contributions made by debtors in Chapter 13 bankruptcy are not always protected if the debtors had not regularly contributed to the account in the six months prior to filing for bankruptcy. In other words, debtors cannot shield assets from bankruptcy by beginning to make contributions after filing for bankruptcy. In this case, the court denied the debtors’ request to exclude $1,375 per month from their disposable income to contribute to a 401(k). The court confirmed the denial even though the debtor had made contributions in the past, but stopped because he accepted a new job that did not offer a 401(k) savings option. However, in a similar case where the debtor had been making regular 401(k) contributions in the six months prior to bankruptcy, the debtors were permitted to withhold their contributions from disposable income.¹³

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QDRO Exception

A plan may not distribute, segregate, or otherwise recognize the attachment of any portion of a participant’s benefits in favor of the participant’s spouse, former spouse, or dependents unless such action is mandated by a QDRO (Q 3915).¹⁴ The voluntary partition of a participant’s vested account balance between the participant’s spouse and the participant in a community property state is an alienation of benefits.¹⁵ The Tax Court ruled that a participant’s voluntary waiver of benefits was a prohibited alienation, despite the PBGC’s approval of the plan’s termination. The waiver resulted in the plan’s disqualification and the participant, who was the sole shareholder, was taxed on benefits the participant did not receive.¹⁶

Other Exceptions

A plan may provide that, after a benefit is in pay status, the participant or beneficiary receiving such benefit may make a voluntary and revocable assignment not to exceed 10 percent of any benefit payment, provided the assignment is not for the purpose of defraying plan administrative costs.¹⁷

Payment, pursuant to a court order that is the result of a judicial determination that benefits cannot be paid to a beneficiary who murdered the plan participant, is permitted if the order conforms to the terms of the plan for directing payments when there is an ineligible beneficiary.¹⁸

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Planning Point: Courts sometimes hold that ERISA preempts state slayer statutes. The U.S. Supreme Court has not yet decided the issue. If faced with this issue, the plan can argue that federal common law precludes payment to a beneficiary who murders the participant.¹⁹

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A disclaimer of qualified plan benefits that satisfies the requirements of state law and IRC Section 2518(b) is not a prohibited assignment or alienation.²⁰

An anti-alienation provision also will not prevent a plan from holding a rolled over distribution from another plan subject to an agreement to repay a part of the distribution in the event of early termination of the other plan.²¹

A loan from a plan made to a participant or beneficiary and secured by a participant’s accrued nonforfeitable benefit is not treated as an assignment or alienation if the loan is exempt from the excise tax on prohibited transactions or would be exempt if the participant or beneficiary were a disqualified person.²²

A participant or beneficiary may direct payment of his or her plan benefit payment to a third party, including the employer, if the arrangement is revocable and the third party files with the plan administrator a written acknowledgement stating that he or she has no enforceable right to any plan benefit other than payments actually received. The written acknowledgement must be filed within 90 days after the arrangement is entered into.²³ After the death of a participant, an assignment made pursuant to a bona fide settlement between good faith adverse claimants to the participant’s pension plan benefits was not invalidated by ERISA’s anti-alienation provision.²⁴

Except as noted below, amounts distributed from qualified retirement plans before the participant reaches age 59½ are early or premature distributions subject to an additional tax equal to 10 percent of the amount of the distribution includable in gross income.¹

To the extent that they are attributable to rollovers from a qualified retirement plan or a Section 403(b) plan, amounts distributed from Section 457 plans (Q 3584) generally will be treated as distributed from a qualified plan, for purposes of the early distribution penalty.²

The 10 percent penalty tax does not apply to distributions:

(1) made to a beneficiary, or the employee’s estate, on or after the death of the employee;

(2) attributable to the employee’s disability;³

(3) that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary, and beginning after the employee separates from the service of the employer (Q 3679);

(4) made to an employee after separation from service during or after the year in which the employee attained age 55, or age 50 for distributions to qualified public safety employees from a governmental plan as defined in IRC Section 414(d);⁴

(5) made to an alternate payee under a qualified domestic relations order (Q 3915);

(6) made to an employee for medical care, but not in excess of the amount allowable as a deduction to the employee under IRC Section 213 for amounts paid during the year for medical care, determined without regard to whether the employee itemizes deductions for the year;

(7) made to reduce an excess contribution under a 401(k) plan (Q 3808);

(8) made to reduce an excess employee or matching employer contribution, that is, an excess aggregate contribution (Q 3808);⁵

(9) made to reduce an excess elective deferral (Q 3760);⁶

(10) that are dividends paid with respect to stock of a corporation described in IRC Section 404(k) (ESOPs) (Q 3824);

(11) made on account of certain levies against a qualified plan;⁷ or

(12) that are qualified reservist distributions, which are distributions of elective deferrals made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to rollover the amount of any distributions to an individual retirement plan for two years following the end of active duty.⁸

(13) made on account of qualified births or adoptions under the SECURE Act (see heading below for more details).

(14) beginning in 2024, qualifies as an emergency distribution under the rules discussed below.

(15) beginning in 2024, made on account of domestic violence if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal (see below).

(16) beginning in 2025, made to cover the costs of long-term care insurance (see below).

(17) made on account of the taxpayer’s being diagnosed with a terminal illness.

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Planning Point: Note that many clients mistakenly believe that the penalty does not apply to certain distributions used to fund the purchase of the taxpayer’s home. This exception applies only with respect to IRA distributions—the 401(k) rules do not provide for a similar exception.

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Planning Point: Early distribution penalties are generally waived in the event of natural disasters, and were waived in response to COVID-19-related distributions for 2020.

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The IRS has approved three methods for determining what constitutes a series of substantially equal periodic payments in the exception discussed in (3) above. If the series of payments is later modified, other than because of death or disability, before the employee reaches age 59½, or if after the employee reaches age 59½, within five years of the date of the first payment, the employee’s tax for the year in which the modification occurs is increased by an amount equal to the tax that would have been imposed in the absence of the exception, plus interest for the deferral period. For an explanation of the calculation under each method, the definition of “modified,” and related rulings, see Q 3679.

The exception for distributions pursuant to a QDRO (see (5) above) was not applicable where a participant took a distribution from the plan following a trade of other marital property rights for his or her spouse’s waiver of rights in his or her plan benefits.⁹

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Planning Point: A participant who separates from service during or after the year he or she attains age 55 but is not yet age 59½ should generally leave plan accounts in the plan if permitted rather than transferring or rolling the accounts to an IRA or other qualified plan. This allows the participant to take distributions from the account as permitted by the plan without being subject to the 10 percent tax. A transfer to an IRA would subject the money transferred to the 10 percent tax while a transfer to another qualified plan would subject it to the new plan’s restrictions on distributions and the 10 percent tax.

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A court determined that a distribution originating from an arbitration award was subject to the 10 percent penalty because the amounts attributable to the award were thoroughly integrated with benefits provided under the state retirement plan.¹⁰ The involuntary nature of a distribution does not preclude the application of the tax, provided that the participant had an opportunity, such as by a rollover, to avoid the tax.¹¹

The IRS has stated that the garnishment of an individual’s plan interest under the Federal Debt Collections Procedure Act to pay a judgment for restitution or fines as discussed in (11) above, will not trigger the application of the 10 percent penalty.¹²

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Planning Point: An individual who is facing an IRS levy against his or her plan benefit and who is not yet age 59½ should allow the IRS to follow through on the levy rather than voluntarily taking a plan distribution and paying it to the IRS in satisfaction of the unpaid taxes. A “voluntary” distribution would be subject to the 10 percent tax, whereas any amount distributed directly to the IRS pursuant to the levy would not. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

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The cost of life insurance protection included in an employee’s income (Q 3948) is not considered a distribution for purposes of applying the 10 percent penalty.¹³ The Civil Service Retirement System is a qualified plan for purposes of the early distribution penalty.¹⁴

A plan is not required to withhold the amount of the additional income tax on an early withdrawal.¹⁵ Distributions that are rolled over (Q 3996 to Q 4019) generally are not includable in income, and, thus, the 10 percent penalty does not apply. In the case of a distribution subject to 20 percent mandatory withholding, the 20 percent withheld will be includable in income, however, to the extent required by IRC Section 402(a) or IRC Section 403(b)(1), even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period (Q 4016). Thus, an employee who rolls over only 80 percent of a distribution may be subject to the 10 percent penalty on the 20 percent withheld.¹⁶

Qualified Birth and Adoption Distributions

The SECURE Act amended the IRC to allow qualified plan participants to withdraw up to $5,000 for a qualified birth or adoption without becoming subject to the 10 percent penalty on early distributions. The distribution must be taken within the one-year period following the birth or adoption.

IRS guidance clarifies that an “eligible adoptee” does not include the child of the participant’s spouse (in other words, step-parent adoptions do not count).¹⁷ Notice 2020-68 also clarifies that each parent is entitled to take a distribution with respect to the same child. Parents are also eligible to take distributions more than once—i.e., for multiple children over time. Parents of twins are entitled to double the $5,000 limit. However, plans are not required to provide the option for qualified birth or adoption distributions. If the plan permits distributions for qualified birth or adoption, it must also permit recontribution of those amounts.

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Planning Point: The SECURE Act 2.0 clarified that taxpayers who take penalty-free withdrawals for qualifying birth or adoption expenses do not have an unlimited amount of time to repay those amounts.  Instead, the repayment must be made within three years of the date of the withdrawal.  For qualifying birth or adoption withdrawals that were taken before the new law was enacted, the repayment period ends December 31, 2025.

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A qualified birth or adoption distribution is not treated as an eligible rollover distribution for purposes of the direct rollover rules of Section 401(a)(31), the notice requirement under Section 402(f), and the mandatory withholding rules under Section 3405. Thus, the plan is not required to offer an individual a direct rollover with respect to a qualified birth or adoption distribution. In addition, the plan administrator is not required to provide a Section 402(f) notice. Finally, the plan administrator or payor of the qualified birth or adoption distribution is not required to withhold an amount equal to 20 percent of the distribution, as generally is required in Section 3405(c)(1).

However, a qualified birth or adoption distribution is subject to the voluntary withholding requirements. If the plan does not permit qualified birth or adoption distributions and an individual receives an otherwise permissible in-service distribution that meets the requirements of a qualified birth or adoption distribution, the individual may treat the distribution as a qualified birth or adoption distribution on the individual’s federal income tax return. The distribution, while includible in gross income, is not subject to the 10 percent additional tax. If the individual decides to recontribute the amount to an eligible retirement plan, the individual may recontribute the amount to an IRA.

In the case of a recontribution made with respect to a qualified birth or adoption distribution from an applicable eligible retirement plan other than an IRA, an individual is treated as having received the distribution as an eligible rollover distribution (as defined in Section 402(c)(4)) and as having transferred the amount to an applicable eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution.¹⁸

Emergency Distributions

Beginning in 2024, the SECURE Act 2.0 will also allow retirement plan participants to take emergency distributions from their retirement savings accounts without penalty (currently, a 10 percent penalty plus ordinary income tax applies if an early distribution does not qualify for an exception).

These emergency distributions will be limited to $1,000 each year.  Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period.  Non-highly compensated employees may be entitled to contribute the lesser of (1) 3 percent of compensation or (2) $2,500 to emergency savings accounts using after-tax dollars.

Long-Term Care Insurance

The SECURE Act 2.0 will allow taxpayers to withdraw up to $2,500 each year to cover the costs of long-term care insurance without triggering the 10 percent early withdrawal penalty (these withdrawals will still be subject to ordinary income taxation).

The funds can be used to pay for standalone long-term care insurance or for certain life insurance or annuity contracts that also provide for meaningful financial assistance in the event that the insured person requires long-term care in a nursing home or home-based long-term care.

This new provision is effective for tax years beginning after December 31, 2024 (the $2,500 annual limit will also be adjusted for inflation).

Domestic Violence

Beginning in 2024, plan participants will be entitled to take penalty-free withdrawals if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal.  The withdrawal will be limited to the lesser of $10,000 (the amount will be indexed for inflation) or 50 percent of the participant’s vested account balance.  Plan participants who take advantage of this withdrawal provision will be permitted to repay the amounts withdrawn within three years.

Terminal Illness

Taxpayers who have been certified by a physician as being terminally ill will also be permitted to take penalty-free withdrawals beginning immediately (the withdrawals can also be repaid within three years).  The distribution is not exempt from income tax.

The IRS clarified that self-certification is not sufficient and the employee must provide evidence and documentation as required by the employer.   That evidence must include the certifying physician’s name and contact information, as well as a description of the evidence used to conclude that the individual suffers from a terminal illness.

The IRS also clarified that terminal illness means that the individual has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of the certification.

While plans are not strictly required to offer the terminal illness exception, the employee may elect to treat an otherwise permissible in-service distribution as a distribution based on terminal illness via Form 5329, filed with their income tax return.¹⁹

Editor’s Note: The IRS has released proposed regulations to replace Notice 2023-02.  Under the proposed regulations, the aggregate fair market value of stock repurchased by a taxpayer during a taxable year is reduced by the aggregate fair market value of stock issued by the taxpayer during the taxable year. Additionally, the regulations would implement the statutory “de minimis” exception that provides that a taxpayer is not subject to the stock repurchase excise tax with respect to a taxable year if the aggregate fair market value of the stock repurchased by the taxpayer during the tax year does not exceed $1,000,000. The stock repurchase excise tax will be reported on Form 720, Quarterly Federal Excise Tax Return, and Form 7208, Excise Tax on Repurchase of Corporate Stock, will be used to calculate the amount owed.  Under the proposed regulations, for taxpayers with a tax year ending after December 31, 2022, but before the publication of final regulations, liability for the excise tax for the tax year must be reported on the Form 720 that is due for the first full quarter after the date the final regulations are published.  The deadline for payment of the tax is the same as the filing deadline. Further, there will be no addition to tax under IRC Section 6651(a) (or any other provision) for failing to file a return reporting the stock repurchase excise tax, or for failure to pay the stock repurchase excise tax, before the time specified in final regulations.  Finally, the IRS has specified that the upcoming regulations will require covered corporations to keep complete and detailed records to accurately establish any amount of stock repurchases (including repurchases made after December 31, 2022, but before the final regulations are published) and to retain these records as long as their contents may become material.¹

The Inflation Reduction Act of 2022 added a new 1 percent excise tax on stock buybacks. Publicly-traded corporations often use a stock buyback strategy when they believe that their shares are undervalued. To increase value, they buy their own corporate shares to decrease the number of shares that are available on the market. The tax applies to the fair market value of stock repurchased by “covered corporations,” which include domestic corporations whose stock is publicly traded on an established securities market. The tax also applies in cases where a corporation purchases stock of an affiliate (defined as a corporation if more than 50 percent of its stock is held, directly or indirectly, by the purchasing corporation).

The excise tax does not apply if the repurchase is part of a reorganization and no gain or loss on the stock repurchase is recognized.² It also does not apply in situations where the repurchased stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan (ESOP) or similar plan (or if an amount of stock equal to the value of the stock repurchased is contributed to such a plan).

The following transactions are also exempt:

• Cases where the total value of the stock repurchased by the corporation during the tax year does not exceed $1 million;
• Cases where the repurchase is by a dealer in securities in the ordinary course of business under regulations prescribed by the IRS;
• Repurchases made by regulated investment companies (RICs) or a real estate investment trusts (REITs); or
• In cases where the repurchase is treated as a dividend.

Until late 2019, the IRS had released very little guidance on the tax treatment of what it refers to as “virtual currency” except Notice 2014-21, which defined virtual currency as “property,” like collectible coins and antiques, which can appreciate in value. Therefore, virtual currency can be included in taxable income and taxed based the sale or exchange of the virtual property. “Convertible virtual currency” is virtual currency that is convertible into real currencies (e.g., U.S. dollars), or as a substitute for a real currency. Notice 2014-21 provides the basic tax rules that currently apply to bitcoin, Ethereum and other cryptocurrency transactions.

Under Notice 2014-21, the IRS generally treats bitcoin and other forms of virtual currency as property (and not currency that is legal tender in the United States or elsewhere). In the IRS’ own words, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” This means that it is typically subject to capital gains treatment upon sale, exchange or other disposition under the general rules applicable to property dispositions, including intangible property (e.g., stocks, bonds, and collectibles).

A taxpayer who receives bitcoin in exchange for goods or services must include the fair market value (measured in U.S. dollars) of the bitcoin received in gross income. Therefore, if the fair market value of property or currency received in exchange for the bitcoin exceeds the taxpayer’s adjusted basis in the bitcoin, the taxpayer will recognize capital gain (or loss if the fair market value of property received is less than that of the bitcoin).¹ The generally applicable holding period rules can be used in determining whether the gain or loss is long-term or short-term (Q 699). Similarly, the $3,000 capital loss limitation that can be applied against ordinary income also applies.

If the bitcoin is held by the taxpayer as inventory or property held for sale to customers in the ordinary course of trade or business (i.e., so that the property is not treated as a capital asset in the hands of the taxpayer), the gain or loss will be treated as ordinary gain or loss in accordance with generally applicable rules. In keeping with this position, the IRS Counsel indicated in a late 2020 internal Tax Advice Memorandum that cryptocurrency paid for providing micro-services, like completing an online survey, processing data or reviewing images, is taxable ordinary income to the recipient, and may even be subject to self-employment taxes, depending on the circumstances.² Every taxable event involving a taxpayer’s cryptocurrency holdings must be reported on IRS Form 8949, Cryptocurrency Tax Form.

While these rules seemed clear-cut, a recent letter from members of Congress to the IRS indicated that there was much uncertainty still remaining in the rules and procedures for taxing bitcoin transactions.³ Perhaps in part as a consequence, on October 9, 2019, the IRS released Revenue Ruling 2019-24 and a set of new FAQs.

Rev. Rul. 2019-24 and FAQ

Revenue Ruling 2019-24 defines and addresses the income recognition of certain crypto-currency transactions/events. In doing so, it introduces two new terms into our tax vocabulary; (1) “hard fork,” and (2) “airdropped.” The ruling outlines the taxability resulting from a hard fork when a new crypto-currency is airdropped to the holders of existing crypto-currency. A “hard fork” for tax purposes occurs when cryptocurrency on a ledger undergoes a protocol change that results in a permanent diversion from the legacy or existing distributed ledger. An “airdrop” is a vehicle of distributing crypto-currency to the distributed ledger addresses of multiple taxpayers.

The IRS outlines two scenarios of hard fork ledger protocol change situations:

(1) A hard fork ledger protocol occurs, but there is no airdrop of new cryptocurrency to current holders as part of the transaction. Hence, the IRS indicated there is no tax event generated because no new property is received increasing a holder’s wealth (see FAQ 21).

(2) A hard fork occurs but there is an airdrop of new cryptocurrency to the holders in connection with the hard fork. As a consequence, there is reportable ordinary income generated for a holder because of the receipt of new cryptocurrency (property) at the time of the airdrop.

Taxability in these situations appears to be based upon the recipient-holder’s “dominion and control” over the property- the receipt of and ability to transfer, sell, exchange, or otherwise dispose of the new cryptocurrency created by the hard fork.⁴ The ruling indicates that “[a} taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency.” Moreover, the ruling indicates that a hard fork is not considered a sale or exchange of a capital asset; therefore, it generates ordinary income and not capital gain.

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Planning Point: A hard fork, coupled with an airdrop, followed by a drop in value of the holder’s existing cryptocurrency has the potential to create a wealth decrease in the aggregate for the holder with ordinary income generated at the front end and capital loss at the back of the transaction. Holders with substantial holdings might find themselves stuck with significant taxable ordinary income but an unusable capital loss. Given the likelihood of more hard forks for cryptocurrency holders, anticipatory planning is in order to prevent or ameliorate this potential outcome for the taxpayer.

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The set of IRS FAQs⁵ that accompanied Revenue Ruling 2019-24 offered some useful information as well on the taxation of cryptocurrency transactions. In general they appear to reinforce the application of the basic income tax principles applicable to cryptocurrency. Although they cover various types of convertible virtual currency that are currently used as a medium of exchange, they do not address the treatment of contracts for the receipt of virtual currency.

Cost Basis Methods: As to some specifics, the FAQs allow only two cost basis assignment methods when selling or exchanging cryptocurrency of the same type that was acquired at different times and for different prices

(1)     They require a taxpayer to use “first-in first-out” (FIFO) cost basis assignment methods; unless,

(2)     The taxpayer can specifically identify the cryptocurrency being sold or exchanged.⁶

Prior to this guidance, taxpayers were potentially using five different methods of cost basis assignment (see Q ).

Fair Market Value: The FAQs clarify that a taxpayer is required to look at the specific exchange for pricing data if the cryptocurrency was purchased on an exchange. As evidence, the IRS will accept the fair market value as determined by a cryptocurrency or blockchain “explorer” that analyzes worldwide indices of cryptocurrency and calculates the value at an exact date and time, if the transaction was not facilitated by a cryptocurrency exchange, or the taxpayer engages in a peer-to-peer transaction not involving an exchange. The FAQ does not specify which index or data source should be used. The FAQ allows the taxpayer to establish the fair market value under general valuation principles in lieu of using an explorer value. Finally, per the guidance, the fair market value of the cryptocurrency is the fair market value of the property or services exchanged for the cryptocurrency in the case of a cryptocurrency not traded on any exchange and that does not have a published value.⁷

It is important to note that in 2019 the IRS announced⁸ that it would begin sending letters to holders of various forms of cryptocurrency, including bitcoin, informing those taxpayers of potential misreporting (or failure to report) on virtual currency transactions. The IRS sent out another set of letters in August 2020.⁹ The IRS advised taxpayers who receive such a letter to review past tax filings to uncover any errors or underreporting, and amend those returns in order to pay back taxes, interest and penalties as soon as possible.

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Planning Point: The IRS has recently been sending out CP2501 letters to individuals with cryptocurrency holdings. If a client receives one of these letters, it’s important to act quickly to avoid potential penalties. The CP2501 letter provides a taxpayer with notice that the IRS has noticed a discrepancy between reported information and other information that the IRS has received. Any client with a discrepancy could receive a CP2501 letter. Employers, cryptocurrency exchanges, and other entities report information to the IRS. When that information varies from what the client reports on a tax return, the IRS may issue a CP2501 letter. These letters do not always include an amount that the taxpayer owes to the IRS. In some cases, the taxpayer may not owe additional tax. However, it’s important to respond by the letter’s due date to avoid a penalty. Clients receiving CP2501 letters should review information, such as Forms 1099-B, 1099-K, 1099-MISC, and any W-2s to determine whether their reporting was correct.

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These letters are part of a larger campaign designed by the IRS to crack down on misreporting or underreporting of virtual currency transactions. The IRS also announced a new Schedule 1 (to Form 1040) with a controversial, prominent Yes/No question about cryptocurrency holdings and transactions for tax year 2019 returns, and doubled down by moving the question to nearly the top of page 1 of Form 1040 for the 2020 tax year and thereafter.¹⁰

This IRS campaign to impose inclusion and taxation on virtual currency transactions has already developed a significant litigation challenge.¹¹ All this activity suggests the high IRS focus on income tax compliance of cryptocurrency transactions, and the need to carefully comply with IRS reporting and tax calculation guidance. Finally, it seems likely that a “yes” answer to cryptocurrency question on Form 1040 will increase a taxpayer’s chances of incurring an audit.

For purposes of determining the value of bitcoin received that must be included in gross income, the fair market value is determined as of the date the bitcoin is received by the taxpayer. As in other property transactions, this fair market value forms the “basis” of the bitcoin as of that date.¹ The taxpayer must determine the value of the bitcoin in U.S. dollars. This means that the basis of bitcoin will typically be its acquisition cost. In the case of a gift or inheritance of bitcoin, the basis of the bitcoin in the hands of the donor will presumably apply (this issue has not yet² been formally addressed in official guidance).

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Planning Point: As of early 2022, proposals would require taxpayers to report cryptocurrency transactions with a fair market value of $10,000 or more. Beginning January 1, 2024, these cryptocurrency transactions will trigger Form 8300 filing requirement if the fair market value of the transaction is $10,000 or more.

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In some cases, virtual currency such as bitcoin will be listed on an exchange, in which case the exchange rate listed on that exchange must be used to convert the value into U.S. dollars (or some other “real” legal tender currency that can be converted to U.S. dollars).

Late in 2019, the IRS released a set of FAQ answering questions about the tax treatment of bitcoin and other virtual currency. One issue that commonly arose was determining how exchanges of virtual currency for other virtual currency or property were taxed. The FAQ provide that when virtual currency is exchanged for other virtual currency, the taxpayer’s gain or loss is the difference between the fair market value of the currency received and the adjusted basis of the property disposed of. If the property exchanged is a capital asset, capital gain or loss tax treatment will apply. If the property exchanged is not a capital asset, ordinary income tax treatment will apply.

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Planning Point: The IRS Office of Chief Counsel (OCC) released a Chief Counsel Advice (CCA) document advising that a charitable contribution deduction for a donation of digital assets without a qualified appraisal should be denied because the value of those assets exceeded $5,000. The taxpayer in this case donated cryptocurrency valued at $10,000.  The $10,000 value was based on the value listed on the cryptocurrency exchange where the assets were purchased as of the date the donation was made.  The taxpayer did partially complete Form 8283, Noncash Charitable Contributions, but did not obtain a qualified appraisal.  The IRS did not agree with the taxpayer’s rationale that she did not need an appraisal because the value of the digital assets was published and readily available.  Under IRC Section 170(f)(11)(C), an appraisal is generally not required when the property has readily available value (including cash, publicly traded securities, etc.).  The OCC noted that while cryptocurrency exchanges may publish valuation information, these assets do not meet the definition of a security.  The IRS further found that a reasonable cause exception would not apply because the taxpayer did not attempt to obtain an appraisal as required in Form 8283.  However, the OCC also noted that the CCA should not be cited as precedent.¹

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When a taxpayer receives virtual currency through an exchange, the fair market value is the amount recorded by that exchange in U.S. dollars. If virtual currency is received in a peer-to-peer transaction, fair market value is determined as of the date and time the transaction is recorded on the distributed ledger. The IRS notes that it will accept as evidence of fair market value certain values determined by a cryptocurrency or blockchain explorer that analyzes worldwide virtual currency values. If the taxpayer does not use an explorer value, the taxpayer is responsible for establishing that the value used is an accurate reflection of the virtual currency’s value.³

Loss Deductions

In 2023, the IRS Office of Chief Counsel addressed a situation where a taxpayer attempted to take a Section 165 loss deduction with respect to worthless or abandoned cryptocurrency on their 2022 federal income tax return.⁴  In the end, the IRS noted that the taxpayer would still have not had a deductible loss because miscellaneous itemized deductions subject to the 2% floor are suspended through 2025.  However, the IRS also addressed the issues as they would have applied had the deduction not been suspended to offer insight to taxpayers going forward.  

The IRS denied the individual’s Section 165 loss deduction claim, finding that the cryptocurrency investment was neither worthless nor abandoned for purposes of the IRC.  The taxpayer purchased cryptocurrency units for $1 in 2022 and the unit value fell to less than 1 cent by year-end.  The assets continued to be traded on at least one cryptocurrency exchange (and the taxpayer maintained control over the digital assets, as evidenced by the fact that the taxpayer was free to sell or exchange the assets).  The taxpayer attempted a Section 165 deduction on their 2022 return.  

The IRS initially determined that the asset did not rise to the level of a “security” for 165(g) purposes.  The court then found that a mere fluctuation in value could not give rise to a loss deduction.  Such a loss must be evidenced by a permanent closing, such as abandonment, sale or exchange.  Here, the units still had some value and could possibly increase in value in the future.  Further, the taxpayer showed no affirmative step to abandon the property because they maintained dominion and control over the assets.

The IRS now asks about cryptocurrency transactions on taxpayers’ Form 1040 federal income tax returns. The IRS’s question asks the taxpayer if they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency at any time during the tax year. Every taxpayer must answer either “yes” or “no”.  Taxpayers must check “yes” if they (1) received digital assets as payment for property or services provided, (2) received digital assets resulting from a reward or an award, (3) received new digital assets resulting from mining, staking and similar activities, (4) received digital assets resulting from a hard fork (which is defined as a branching of a cryptocurrency’s blockchain to split a single cryptocurrency asset into two), (5) disposed of digital assets in exchange for property or services, (6) disposed of a digital asset in exchange for another digital asset, (7) sold a digital asset, or (8) otherwise disposed of any financial interest in a digital asset.¹

However, the IRS also released guidance clarifying that taxpayers who purchased cryptocurrency with “real” currency are not required to answer the question with a “yes” if they had no other cryptocurrency transactions during the tax year because a taxpayer who merely owns cryptocurrency is not taxed on any gains or losses until they sell or otherwise exchange the cryptocurrency. In other words, there has been no realization event that would trigger tax liability.

Dispositions of bitcoin as property must be reported to the IRS in the same manner as any other intangible property transactions, meaning that the taxpayer will be required to complete and file Schedule D and Form 8949, or Form 4797, to report the transaction in accordance with the instructions to those forms. The reporting requirements do not vary because the property transferred is bitcoin.² Each bitcoin trade should be reported separately.

The IRS released proposed regulations³ in August 2023 that, if finalized, would require brokers to report sales and exchanges of cryptocurrency and digital assets to the IRS. Information reporting under IRC Section 6045 would be extended to cover brokers who act as agents, principals or middlemen in selling digital assets to others. The regulations are broad and cover transactions where cryptocurrency is sold for cash, broker’s services or any property that is subject to reporting by brokers. Brokers who handle payments of cryptocurrency via payment card and third-party network transactions would also be subject to reporting under IRC Section 6050W. Under Section 6045, the definition of “broker” includes digital asset trading platforms, digital asset payment processors, digital hosted wallet providers, and parties who regularly offer to redeem digital assets that were created or issued by that person. Brokers will be required to report sales and exchanges of cryptocurrency on new Form 1099-DA beginning January 1, 2025. Depending on the facts, brokers may also be required to provide basis information with respect to gain or loss for sales that take place on or after January 1, 2026 (to allow individuals access to information necessary to report such gain or loss on their federal tax returns).

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Planning Point: Taxpayers who trade in various types of cryptocurrencies should be reminded that each trade is a taxable event. Further, IRS guidance has confirmed that pre-2018 exchanges of bitcoin, ether, and litecoin do not qualify for Section 1031 exchange treatment under pre-2018 law (post-tax reform, Section 1031 is limited only to exchanges of real property). The IRS’s rationale is that these were not exchanges of like-kind property and so were taxable even prior to tax reform. The IRS found that bitcoin and ether each played special roles in cryptocurrency trading because if taxpayers wanted to trade in other types of virtual currency, they had to first exchange the other currency into or from bitcoin or ether. Therefore, exchanges between Litecoin and bitcoin/ether did not qualify as “like kind.” Further, the IRS identified differences in design, intended use and actual use of bitcoin and ether. While this guidance currently only extends to exchanges involving bitcoin, ether, and litecoin, it is possible that the IRS could extend the rationale to other types of cryptocurrencies.

For many taxpayers, the pre-2018 three-year statute of limitations may have expired if the return was filed on time. However, a special six-year limitation period applies if taxpayers fail to report more than 25 percent of their income, meaning that taxpayers with substantial cryptocurrency gains in earlier years may remain exposed to tax liability, interest, and penalties.⁴

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As discussed in Q 7725, employers that pay employees in bitcoin are required to report those payments as taxable compensation on Form W-2, and employers that pay independent contractors in bitcoin are required to report those payments on Form 1099-MISC.

While the treatment of bitcoin or other virtual currencies for U.S. taxpayers with foreign accounts who are required to file FinCen Form 114, Report of Foreign Bank and Financial Account, is unclear following guidance allowing its exclusion in 2013 only, these individuals should include bitcoin unless they have a clear reason to exclude it.

Because a money market fund is a mutual fund, its shareholders are taxed in the manner discussed in Q 7938 through Q 7951.Money market funds ordinarily do not have capital gain dividends because of their general policy of investing in short-term securities. Note that money market fund dividends are not qualified dividends and, thus, do not qualify for the lower tax rates (20%/15%/0%) (see Q 702).

Money market funds (MMFs) that are neither government MMFs nor retail MMFs must value portfolio securities using market-based factors and compute their price per share by rounding the fund’s net asset value (NAV) to a minimum of the fourth decimal place (or, for MMFs with a share price other than $1.0000, an equal or greater level of precision).  

These MMFs have a share price that is likely to change often, but within a narrow range due to the limited types of investments that MMFs may hold (potentially generating a loss).  The wash sale rule disallows a loss realized on a sale or disposition of stock or securities if, within a period beginning 30 days before and ending 30 days after, the taxpayer acquires, or enters into a contract to acquire, substantially identical stock or securities.  Because many MMF shareholders engage in frequent redemptions and purchases of MMF shares (e.g., due to sweep arrangements and automatic reinvestments), a shareholder that realizes a loss on a redemption of MMF shares will often acquire shares in that MMF within 30 days before or after the redemption.  

In Revenue Procedure 2023-35, the IRS extended the wash sale relief that it had already provided to shares in floating-NAV MMFs and will not treat a redemption of a share in any MMF as part of a wash sale.

Editor’s Note: As of September 2023, the IRS has announced that it will stop processing new ERC claims through at least December 31, 2023. Newly submitted claims will be held in reserve until the IRS once again begins processing claims.

The IRS has repeatedly issued warnings about false or overstated ERC claims.  The statute of limitations for IRS challenges to Forms 941 is three years.  However, the three-year period does not start to run until April 15 of the calendar year following the year in which the form is filed (i.e., the statute of limitations for 2020 Forms 941 started to run on April 15, 2021 and will expire April 15, 2024).  However, there is a special limitations period for the third quarter of 2021. That statute of limitations does not expire until April 15, 2027.  Further, proposals would apply the special, longer statute of limitations to any period in which the ERC was available.  Taxpayers who received ERC refunds should also be aware that the IRS can challenge the payment in court within two years of the date the refund was paid (five years if the taxpayer obtained the refund based on fraud or misrepresentation).

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Planning Point: The IRS has provided new details about a withdrawal process for taxpayers who filed employee retention tax credit (ERC) claims that they now believe to be erroneous.  Employers can use the withdrawal process if (1) they made the claim on an adjusted employment return (Forms 941-X, 943-X, 944-X, CT-1X), (2) they withdraw the entire amount of the claim, and (3) the IRS has not paid their claim or they have not cashed/deposited the IRS’ refund check.  Taxpayers who are not eligible to withdraw a claim can still file an amended return to reduce or eliminate the ERC claim.  Taxpayers who filed their ERC claims themselves, have not received, cashed or deposited a refund check and have not been notified their claim is under audit can fax withdrawal requests to the IRS (a special fax line has been set up and details are available at IRS.gov/withdrawmyERC). Taxpayers who are under audit can send the withdrawal request to their examiner or in response to their audit notice.  Claims that are properly withdrawn will be treated as though they were never filed, and no interest or penalties will apply.  However, taxpayers who willfully filed fraudulent claims or assisted in fraudulent claims need to know that withdrawing the claim will not exempt them from criminal investigations. 

Additionally, the agency is working on a program that will allow employers to repay improperly received ERC claims (it is unclear whether these repayments can be made without the threat of criminal investigation).

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Under IRS final regulations released in 2023, erroneous refunds of COVID-19-related credits will be treated as underpayments of tax under IRC Sections 3111(a) or (b).  Both assessment and administrative collection procedures may apply.  The regulations also clarify that if third-party payers claimed tax credits on behalf of common law employer clients, employers against which erroneous refunds of credits can be assessed include anyone treated as an employer under IRC Sections 3401(d), 3405 and 3511.  The common law employer client of the third-party payor remains liable for the erroneous refunds of these tax credits.

Voluntary Repayment Program.

The IRS has announced a voluntary disclosure program that can allow employers with erroneous employee retention credit claims to avoid potential penalties, interest and civil litigation.  The program will first settle the ERC claim for purposes of the employer’s employment tax obligations via eliminating their ERC eligibility while allowing the employer to retain 20% of the claimed ERC amount.  The disclosure also resolves the corresponding adjustment for income tax expense.  Individuals are entitled to participate in the program if (1) they are not under criminal investigation and have not been notified by the IRS of a forthcoming criminal investigation, (2) the IRS has not received information from a third party about the employer’s noncompliance, (3) the individual is not under employment tax examination for any tax period for which the individual is applying for the program and (4) the individual has not already received a notice and demand for repayment for all or a part of the claimed ERC.  If the terms are satisfied, the employer must repay 80% of the amount claimed (including refundable and non-refundable portions) and will not be responsible for repaying overpayment interest received and will not be charged underpayment interest.  The individual will not be deemed to receive taxable income by way of repaying only 80% of the claimed amount.

Editor’s Note: The Infrastructure Investment and Jobs Act of 2021 retroactively ended the employee retention tax credit, so that wages paid after September 30, 2021, were not eligible for the credit. The law did exempt recovery startup businesses from the early termination. Originally, the credit was set to expire after 2021.Editor’s Note: The IRS released guidance on the early termination of the employee retention tax credit, which expired after the third quarter of 2021. Employers who received advance payment of the ERC for fourth quarter wages could avoid penalties for failure-to-pay if they repaid the amount by the due date of their employment tax returns. Employers who reduced employment tax deposits on or before December 20, 2021 for fourth-quarter wages in reliance on the ERC were not subject to penalties for failure-to-deposit if (1) the employer reduced deposits in anticipation of receiving the ERC under the rules in Notice 2021-24, (2) the employer deposited the amounts retained on or before the due date for wages paid on December 31, 2021 (regardless of whether the employer actually paid the wages on that date), and (3) the employer reported tax liability resulting from the end of the ERC on the employment tax return or schedule including the period from October 1, 2021 through December 31, 2021. Failure to deposit penalties were not waived if the employer reduced deposits after December 20, 2021. Employers who did not qualify for relief under these rules can reply to any notice of a penalty with an explanation, and the IRS will consider whether to grant reasonable cause relief.¹

Early in 2022, the IRS provided penalty relief for taxpayers who owed additional income tax because their deduction for qualified wages was reduced by a retroactively-claimed ERTC if the taxpayer was unable to pay the additional tax because the ERTC refund had yet to be received. The IRS acknowledged that this often occurred because of its own backlog in processing Forms 941-X. Taxpayers in this situation were eligible for penalty relief for inability to pay their tax liability if they could show reasonable cause, rather than willful neglect, under Notice 2021-49 provisions.²

ERTC Rules for 2020 and 2021

IRS regulations allow the IRS to recapture any of the tax credits credited to an employer in excess of the amount that the employer was actually entitled to receive. That includes the ERTC, credits for qualified leave wages and credits for qualified health plan expenses under Sections 3131(d) and 3132(d). Those incorrect tax credits are treated as underpayments of taxes and may be administratively assessed and collected in the same manner as the taxes. The temporary regulations also provided that the calculation of any credits erroneously claimed must account for any amounts that were advanced to the employer under the processes established in 2020.

The Consolidated Appropriations Act of 2021 expanded the employee retention tax credit (ERTC), discussed below. Under the CAA, the applicable credit percentage increased from 50 percent to 70 percent of qualified wages. The limit on qualified wages per-employee increased from $10,000 per year to $10,000 per quarter. The “decline in gross receipts” threshold decreased from 50 percent to 20 percent, and a safe harbor rule allowed business owners to use the calendar quarter immediately preceding the current quarter to determine eligibility.

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Planning Point: IRS Revenue Procedure 2021-33 offered a safe harbor that allowed employers to exclude certain amounts from gross receipts for the sole purpose of determining eligibility for the ERTC.

Amounts that could be excluded include: (1) the amount of forgiveness for a PPP loan, (2) Shuttered Venue Operators Grants under the Economic Aid to Hard-Hit Small Businesses, Non-Profits, and Venues Act, and (3) Restaurant Revitalization Grants under the ARPA.

Employees elected to apply this safe harbor by excluding the amounts for purposes of determining whether it was an ERTC-eligible employer on an employment tax return. Employers were required to apply the safe harbor consistently in determining ERTC eligibility (meaning the employer had to exclude the amounts from gross receipts for each calendar quarter when gross receipts were relevant to determining ERTC eligibility). If the employer applied the safe harbor, it was also required to apply the safe harbor to all employers treated as a single employer under aggregation rules.

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The rules discussed below that applied to “large employers” only applied to employers with more than 500 employees under the CAA (as opposed to 100 under the CARES Act). Further, employers that were not in existence for all or part of 2019 became eligible to claim the credit. Businesses with 500 or fewer employees had the option of advancing the credit at any point during the quarter, and the amount of the credit was estimated based on 70 percent of the average quarterly wages the employer paid in 2019.

As long as the wages were not paid with forgiven PPP loan proceeds, PPP loan recipients were entitled to claim the ERTC retroactive to the date of the CARES Act.

Editor’s Note: The ARPA made further changes the ERTC, which remained fixed at 70 percent of qualified wages (up to a $10,000 per-quarter cap) for employers who had experienced a 20 percent year-over-year decline in per-quarter gross receipts (or a qualifying suspension of business). Starting June 30, 2021, certain small businesses that began operations after February 15, 2020 became eligible for a maximum $50,000 per-quarter credit.

Qualifying “recovery startup businesses” were required to have average annual gross receipts for the three-taxable-year period ending with the taxable year that precedes the quarter that did not exceed $1 million. These businesses could qualify to claim the expanded ERTC even if they did not otherwise meet the eligibility requirements for claiming the credit. Beginning in the third quarter of 2021, employers who had suffered a decline of 90 percent or more in gross receipts compared to the same quarter in 2019 could treat all wages paid as qualified wages (up to the $10,000 cap) regardless of the number of employees the business had and regardless of whether the employees provided services (in other words, even employers with more than 500 employees qualified if they were under severe financial distress). Employers could continue to claim the credit even if they had received a PPP loan, but could not claim the credit with respect to wages paid with forgiven PPP funds.

The ERTC was allowed against the Medicare tax only in the third and fourth quarters of 2021. While this procedural shift did not impact the available value of the ERTC, it was often important for business owners who had relied upon taking the credit in advance. Because the Medicare tax is only 1.45 percent, more clients were required to file Form 7200 to receive advance payment of the credit. ARPA also extended the statute of limitations on assessments under the law to five years from the date the return claiming the credit was filed.

CARES Act ERTC

The CARES Act created a refundable tax credit designed to help employers who retained employees during the COVID-19 health crisis. The credit was taken against employment taxes and was equal to 70 percent (originally 50 percent) of the first $10,000 of qualified wages paid to the employee. Wages paid between March 12, 2020 and September 30, 2021 counted in calculating the credit.³ Wages included both cash payments and employer health care payments (see below for allocation rules). Because the credit was refundable, employers were eligible for a refund if the credit amount exceeded the employment taxes due.

Employers were eligible regardless of size if they were in business during 2020.

The credit was available for calendar quarters where either:

(1) operations were either fully or partially suspended because of a government-issued order relating to COVID-19 (see below), or

(2) the business remained open, but gross receipts declined by more than 20 percent (originally 50 percent) when compared to the same calendar quarter in the previous year. Once gross receipts rebounded and exceeded 80 percent when compared to the same quarter in 2019, the employer no longer qualified in the subsequent quarter.

Eligible government issued orders included restrictions on travel, group gatherings or limitations on commerce (such as orders requiring certain businesses to close or limit operations).

Planning Point: The IRS released a generic legal advice memorandum (GLAM) to clarify when and whether a business owner could have properly qualified for the employee retention tax credit (ERC) based on supply chain disruptions.  The GLAM contained five different scenarios where supply chain disruptions did not qualify the business for the ERC.  Under the guidance, some type of governmental order must have caused the supplier to suspend its operations during the pandemic.  That suspension, in turn, must have caused the business claiming the ERC to suspend its own business operations.  It is up to the business to provide documentation to prove that the governmental order applied, and to substantiate the link between that governmental order and the business owner’s own suspension of operations.  If the business cannot substantiate the governmental order, the business will also not be treated as having a partial suspension of operations.  Importantly, business owners should be aware that even dramatic price increases or inability to offer some (but not all) of the business’ goods and services does not equate to a partial suspension.  Business owners who justified ERC claims based on supply chain disruptions should maintain careful documentation in anticipation of a future IRS challenge.⁴

Qualification was calculated every quarter.⁵ If the employer had no more than 500 (originally 100) employees, the amount of qualified wages included wages paid during a quarter where COVID-19 impacted the business, including when the employees continued to provide services for payment during the relevant period and when employees were paid, but not working.

If the employer had more than 500 full-time employees, the wages counted toward the credit included only those paid while the employee was not working for the employer because of a government order or decline in gross receipts. In counting the number of employees, the employer used average employees during 2019.

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Planning Point: For purposes of determining whether a credit-eligible employer is a large eligible employer or a small eligible employer, employers were not required to include full-time equivalents when determining the average number of full-time employees. However, for purposes of identifying qualified wages, an employee’s status as a full-time employee was irrelevant because wages paid to a part-time employee could be treated as qualified wages if all other requirements are satisfied.⁶

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Employers who paid wages with PPP loans that were forgiven could not claim the tax credit for the same wages. Further, the credit did not apply with respect to wages paid under the FFCRA paid sick leave laws (in other words, the employer could not “double dip”).

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Planning Point: Any cash tips treated as wages within the definition of IRC Section 3121(a) or compensation within the definition of IRC Section 3231(e)(3) were treated as qualified wages if all other requirements were satisfied. According to IRS reasoning, eligible employers were not prevented from receiving both the employee retention credit and the Section 45B credit (the FICA tip credit) for the same wages because the CARES Act and subsequent legislation did not reference Section 45B in areas where a “no double dipping” rule applied.⁷

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The amount of wages considered for purposes of the credit could not exceed the wages the employee would have received for working an equal amount of time in the 30-days preceding the applicable period when the credit was available.

Qualified wages also included the employer’s health plan expenses allocated to the wages taken into account for the credit. The health plan expenses must be amounts paid or incurred by the employer to provide and maintain a group health plan, but only if the amounts were excluded from employees’ income under IRC Section 106(a).⁸

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Planning Point: IRS Notice 2021-49 addressed the issue of whether wages paid to majority owners and spouses of majority owners could be treated as “qualified wages”. “Majority ownership”, for these purposes, means more than 50% of the value in a corporation. According to the IRS, if the majority owner of a corporation had no brother or sister (whether by whole or half-blood), ancestor, or lineal descendant as defined in IRC Section 267(c)(4), then neither the majority owner nor the spouse was a related individual within the meaning of Section 51(i)(1) and the wages paid to the majority owner and the spouse were qualified wages for ERTC purposes, assuming the other requirements for qualified wages were satisfied. The notice contains multiple examples that provide guidance on various scenarios and various types of relationships.

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Unless otherwise provided, allocating health expenses pro rata among employees and pro rata based on the periods of coverage (i.e., lining the payments up with the periods to which the wages relate) was sufficient.

Editor’s Note: The SECURE Act expanded the retirement plan start-up credit for small businesses who are eligible. The credit available under IRC Section 45E, available for three tax years, is increased to the greater of (a) $500 or (b) the lesser of (i) $250 per employee of the eligible employer who is not a highly-compensated employee and who is eligible to participate in the eligible employer plan maintained by the employer or (ii) $5,000.

Eligible small employers (under IRC Section 408(p)(2)(C)(1)) who provide an eligible auto-enrollment feature are eligible for an additional $500 per year credit (for the first three years the auto-enrollment feature is offered).

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Planning Point: The credit for auto-enrollment can be claimed even if a new auto-enrollment feature is added to an existing plan.

Planning Point: Starting with the 2025 tax year, the SECURE Act 2.0 will require employers that establish new 401(k) or 403(b) plans to auto-enroll employees in the savings plans.  The minimum auto-enrollment contribution rate will range from 3% to 10%.  Each year, the minimum contribution rate will then increase by 1% until the rate reaches 15%.  Under the law, small business employers with 10 or fewer employees and new businesses will be exempt from the auto-enrollment requirement.

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A tax credit for qualified retirement plan start-up costs is available to small business owners. A small business employer is eligible if, during the preceding tax year, it employed 100 or fewer employees who received at least $5,000 in annual compensation from the employer (the same definition that generally applies for SIMPLE retirement plans).¹ The plan must be available to at least one employee who is a non-highly compensated employee (a highly compensated employee is one who owns 5 percent of the business or who has earned more than $155,000 in 2024).²

Importantly, the small business employer is only eligible for the credit if its employees were not able to participate in another retirement plan sponsored by the employer, a member of a controlled group or a predecessor of either within three years of establishing the new plan (essentially, this requirement ensures that the plan truly is a newly-established retirement plan).³

The credit is equal to 50 percent of the ordinary and necessary costs of starting up the retirement plan, including both the costs of setting up and administering the plan and costs related to educating employees about the plan, up to a maximum credit of $500 per year.⁴ The credit is available for three years, with the option of first claiming the credit in the year before the year in which the plan becomes effective.⁵  

Beginning in 2023, the 50 percent limit was increased to 100 percent under the SECURE Act 2.0 for small employers with 50 or fewer employees.  The law also creates an additional tax credit for a percentage of the employer’s contributions made to employees with compensation that does not exceed $100,000 for the year.  The additional credit cannot exceed $1,000 per employee and will phase out over a five-year period.  The additional credit also phases out for employers with between 51 and 100 employees, and the credit is reduced by 2 percent for each employee that exceeds the 50-employee limit in the prior year.

Employers who join an existing multiple employer plan (MEP) will also now be eligible to receive the tax credit for small employers even if the MEP has been in existence for several years (this provision is effective retroactively, for 2020 and all later tax years).
If the entire value of the plan cannot be maximized in a single year, the small business employer has the option of carrying it back or forward to another tax year, so long as that tax year does not begin prior to January 1, 2002. To claim the credit, the taxpayer must file Form 8881 with the IRS.⁶

A taxpayer who is not considered to be “away from home” for purposes of deducting business-related travel expenses (see Q 8738 to Q 8744) may still be entitled to claim a deduction for business-related transportation expenses. A taxpayer is generally not entitled to deduct the cost of commuting from the taxpayer’s residence to the taxpayer’s primary place of business. However, business-related transportation costs other than commuting costs may be deducted as business expenses. Examples of such expenses include the following:

(1) Travelling from one business place to another business place within the general area that is considered a taxpayer’s “tax home” (see Q 8739 and Q 8738);

(2) Visiting clients and customers;

(3) Travelling to a business meeting outside of the taxpayer’s principal place of business;

(4) Travel from the taxpayer’s residence to a temporary workplace if the taxpayer has one or more regular workplaces. A work location is considered temporary if it is realistically expected to last (and does last) for one year or less, unless the circumstances indicate otherwise.¹

If a taxpayer’s residence is also the taxpayer’s principal place of business, that taxpayer may deduct the costs of commuting between the residence and another place of business, whether or not that second place of business is considered “regular” or “temporary.”²

Example: Brent is a representative for a cheese manufacturing company and works out of his home. He has no permanent office, but regularly must drive to visit clients who have questions about his company’s cheese products. Brent may deduct the cost of driving between his home and client sites, even though these visits occur on a regular basis. If Brent were required to travel outside of his regular area of business on an overnight trip, those costs would be deductible as travel expenses, not transportation expenses. Because Brent travels by car, he can either deduct the actual costs of his car or the standard mileage rate for the year (58 cents in the first half of 2022 and 62.5 cents in the second half of 2022, 65.5 cents in 2023, and 67 cents in 2024).³

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Planning Point: Because all miscellaneous itemized deductions were suspended for 2018-2025, taxpayers who previously deducted business mileage expenses as a miscellaneous itemized deduction will no longer be entitled to do so. However, for taxpayers who were eligible to claim the deduction as an above-the-line deduction, the business standard mileage rate remains relevant.

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As stated above, expenses incurred for commuting from the taxpayer’s residence to place of business are generally nondeductible. This is the case even though the taxpayer works during the commute—for example, by taking work-related calls or discussing business while carpooling with a business associate.

Editor’s Note: In response to the COVID-19 pandemic, the CARES Act allowed HDHPs to cover the cost of telehealth services without cost to participants before the HDHP deductible is satisfied. HDHPs providing telehealth coverage do not jeopardize their status as HDHPs. Plan members similarly retained the right to fund HSAs after taking advantage of cost-free telehealth services. The Consolidated Appropriations Act of 2022 (CAA 2022) extended the CARES Act relief so that HDHPs could provide first-dollar telehealth services from April 2022 through December 2022 (regardless of the plan year) without jeopardizing HDHP status.  The remote services do not have to be related to COVID-19 or preventative in nature to qualify.  Plans and participants should note that if the HDHP is a calendar year plan, the usual rules regarding the plan deductible applied between January 2022 and March 2022.  The 2023 year-end omnibus spending bill extended this relief again, although it should be noted that instead of beginning on January 1, 2023, the relief is effective for plan years beginning after December 31, 2022 and before January 1, 2025 (that means a gap will exist for non-calendar year plans from January 1, 2023 until the date that the plan year begins).  The ability to provide pre-deductible remote health services is optional for employers.

In Notice 2023-37, the IRS confirmed that that the special rules allowing pre-deductible coverage of COVID-related testing and treatment will end as of December 31, 2024.  The guidance also states that the preventive care safe harbor does not include COVID-19 testing as of July 24, 2023.

Under the Inflation Reduction Act, HDHPs will be permitted to cover insulin prior to the participant satisfying the plan deductible effective for tax years beginning after December 31, 2022.  This insulin coverage will not adversely affect a participant’s eligibility to contribute to an HSA.  Going forward, HDHPs will be permitted to cover selected insulin products before the deductible is satisfied regardless of whether the participant has been diagnosed with diabetes. “Selected insulin products” is defined to include any dosage form, including vials, pumps, or inhalers of any type of insulin.

The requirements for a high deductible health plan (HDHP) differ depending on whether individual or family coverage is provided. In this context, family cover-age includes any coverage other than self-only coverage.¹

For 2024, an HDHP is a plan with an annual deductible of not less than $1,600 for self-only coverage ($1,500 in 2023). The family coverage deductible limit is $3,200 in 2024 ($3,000 in 2023). Annual out-of-pocket expenses for an HDHP can-not exceed $8,050 in 2024 ($7,500 in 2023) for self-only coverage. For family cov-erage, the annual out-of-pocket expense limitation is increased to $16,100 ($15,000 in 2023).² These annual deductible amounts and out-of-pocket expense amounts are adjusted annually for cost of living.³

Deductible limits for HDHPs are based on a 12-month period. If a plan deductible may be satisfied over a period longer than twelve months, the minimum annual deductible under IRC Section 223(c)(2)(A) must be increased on a pro-rata basis to take the longer period into account.⁴

An HDHP may impose a reasonable lifetime limit on benefits provided under the plan as long as the lifetime limit on benefits is not designed to circumvent the maximum annual out-of-pocket limitation.⁵ A plan with no limitation on out-of-pocket expenses, either by design or by its express terms, does not qualify as a high deductible health plan.⁶ Beginning in 2016, the CMS has provided guidance stating that the self-only limitation applies to each individual, regardless of whether the individual is enrolled in self-only or family coverage. This is the case even if the limitation for self-only coverage is below the family deductible limit. Family coverage can continue to be offered as long as the self-only limitation is applied separately to each individual under the plan.⁷

An HDHP may provide preventive care coverage without application of the annual deductible.⁸ The IRS has provided guidance and safe harbor guidelines on what constitutes preventive care. Pursuant to the IRS safe harbor, preventive care includes, but is not limited to, periodic check-ups, routine prenatal and well-child care, immunizations, tobacco cessation programs, obesity weight-loss programs, and various health screening services. Preventive care may include drugs or medications taken to prevent the occurrence or reoccurrence of a disease that is not currently present.⁹

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Planning Point: In 2020, the IRS announced that high deductible health plans can cover costs associated with COVID-19. HDHPs can cover coronavirus-related testing and equipment needed to treat the virus. Generally, HDHPs are prohibited from covering certain non-specified expenses before the covered individual’s deductible has been met. Certain preventative care expenses are excepted from this rule. HDHPs will not jeopardize their status if they pay coronavirus-related expenses before the insured has met the deductible, and the insured will remain HSA-eligible. The guidance applies only to HSA-eligible HDHPs. Participants in HDHPs should pay attention to IRS guidance in specific future situations.¹⁰

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Notice 2013-57 clarifies that a health plan will not fail to qualify as an HDHP merely because it provides preventative services under the ACA without requiring a deductible.¹¹

For months before January 1, 2006, a health plan would not fail to qualify as an HDHP solely based upon its compliance with state health insurance laws that mandate coverage without regard to a deductible or before the high deductible is satisfied.¹² This transition relief only applied to disqualifying benefits mandated by state laws that were in effect on January 1, 2004. This relief extended to non-calendar year health plans with benefit periods of twelve months or less that began before January 1, 2006.¹³

Out-of-pocket expenses include deductibles, co-payments, and other amounts that a participant must pay for covered benefits. Premiums are not considered out-of-pocket expenses.¹⁴

An employer may offer employees who are participants in a cafeteria plan a choice among two or more benefits consisting of cash and qualified benefits.¹ A cash benefit is not strictly limited to cash, but includes a benefit that may be purchased with after-tax dollars or the value of which is generally treated as taxable compensation to the employee (provided the benefit does not constitute deferred compensation).²A qualified benefit is a benefit that is not includable in the gross income of the employee because of an express statutory exclusion and because the benefit constitutes deferred compensation. Contributions to Archer Medical Savings Accounts, qualified scholarships, educational assistance programs, or excludable fringe benefits are not qualified benefits. Products that are advertised, marketed, or offered as long-term care insurance similarly do not qualify as qualified benefits.³

When insurance benefits, such as those provided under accident and health plans and group term life insurance plans, are provided through a cafeteria plan, the benefit is the coverage under the plan. Accident and health benefits are qualified benefits to the extent that coverage is excludable under IRC Section 106.⁴ Accidental death coverage offered in a cafeteria plan under an individual accident insurance policy is excludable from the employee’s income under IRC Section 106.⁵

Group term life insurance coverage on employee-participants can be offered through a cafeteria plan. Coverage may be offered through the plan even if it exceeds the $50,000 excludable limit under IRC Section 79.⁶ The application of IRC Section 79 to group term life insurance and IRC Section 106 to accident or health benefits is explained in Q 8789 to Q 8792.

Accident and health coverage, group term life insurance coverage, and benefits under a dependent care assistance program are still counted as “qualified” benefits even if they must be included in income because a nondiscrimination requirement has been violated.⁷

For tax years beginning after 2012, a health flexible spending arrangement (FSA) offered under a cafeteria plan is not a qualified benefit unless the plan limits employees to no more than $2,500 in salary reduction contributions for each tax year (the amount is indexed for later years, to $3,200 in 2024, $3,050 in 2023, $2,850 in 2022 and $2,750 in 2021).⁸ Beginning in 2014, up to $500 ($640 in 2024, $610 in 2023, $570 in 2022 and $550 in 2020 and 2021)⁹ of the balance of a health FSA may be carried forward to the subsequent tax year if the FSA incorporates a provision that permits such a carryover.

A cafeteria plan generally cannot provide for deferred compensation, permit participants to carry over unused benefits or contributions from one plan year to another, or permit participants to purchase a benefit that will be provided in a subsequent plan year. A cafeteria plan, however, may permit a participant in a profit sharing, stock bonus, or rural cooperative plan that has a qualified cash or deferred arrangement to elect to have the employer contribute on the employee’s behalf to the plan.¹⁰ After-tax employee contributions to an IRC Section 401(m) qualified plan are permissible benefits under a cafeteria plan, even if the employer makes matching contributions.¹¹

A cafeteria plan may permit a participant to elect to have the employer contribute to a health savings account (HSA) on the participant’s behalf (see Q 8825 to Q 8837).¹² Unlike other benefits, HSA balances may be carried over from one year to another even if they are funded through a cafeteria plan.

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Planning Point: Notice 2020-29 allowed employers to permit certain mid-year elections made during calendar year 2020 that would otherwise be impermissible, including changes to salary reduction contribution elections. The guidance also allowed participants to revoke (or make) an election with respect to health and dependent care FSAs on a prospective basis during 2020 to respond to changing needs during the COVID-19 pandemic. Further, the guidance clarified that the relief for high deductible health plans (HDHPs) and expenses related to COVID-19 (regarding an exemption for telehealth services) may be applied retroactively to January 1, 2020.

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Generally, life, health, disability, or long-term care insurance with an investment feature, such as whole life insurance, or an arrangement that reimburses premium payments for other accident or health coverage extending beyond the end of the plan year cannot be provided under a cafeteria plan.¹³ Supplemental health insurance policies that provide coverage for cancer and other specific diseases are not treated as providing deferral of compensation and are properly considered accident and health benefits under IRC Section 106.¹⁴

Participants in a cafeteria plan maintained by an educational organization described in IRC Section 170(b)(1)(A)(ii) (i.e., one with a regular curriculum and an on-site faculty and student body) can be permitted to elect postretirement term life insurance coverage. The postretirement life insurance coverage must be fully paid up on retirement and must not have a cash surrender value at any time. Postretirement life insurance coverage meeting these conditions will be treated as group term life insurance under IRC Section 79 (see Q 8681 to Q 8684).¹⁵

Under the Affordable Care Act, plans and issuers that offer dependent coverage must make this coverage available until a child reaches the age of 26.¹⁶ Even if a cafeteria plan has not yet been amended to provide coverage for children under age 27, the ACA allows employers with cafeteria plans to permit employees to immediately make pre-tax salary reduction contributions to provide coverage for these children in order to assist with implementation of the expanded coverage requirements.

Both married and unmarried children qualify for this coverage. This rule applies to all plans in the individual market and to new employer plans, as well as to existing employer plans unless the adult child has another offer of employer-based coverage. Beginning in 2014, children up to age 26 can stay on their parent’s employer plan even if they have another offer of coverage through an employer.

Employees are eligible for the new tax benefit beginning March 30, 2010 and thereafter if the children are already covered under the employer’s plan or are added to the employer’s plan at any time. For this purpose, a child includes a son, daughter, stepchild, adopted child, or eligible foster child. This “up to age 26” standard replaces the lower age limits that applied under prior tax law, as well as the requirement that a child generally qualify as a dependent for tax purposes.

As a general rule, a participant in a cafeteria plan is not treated as being in constructive receipt of taxable income solely because he or she has the opportunity – before a cash benefit becomes available – to elect among cash and “qualified” benefits (generally, nontaxable benefits).¹A participant must elect the qualified benefits before the cash benefit becomes currently available in order to avoid taxation. That is, the election must be made before the specified period for which the benefit will be provided begins—generally, the plan year.²

A cafeteria plan may, but is not required to, provide default elections for one or more qualified benefits for new employees or for current employees who fail to timely elect between permitted taxable and qualified benefits.³

Benefits provided under a cafeteria plan through employer contributions to a health flexible spending arrangement (FSA) are not treated as qualified unless the plan provides that an employee may not elect to have salary reduction contributions in excess of $2,500 (this amount is indexed annually for inflation, see Q 8902) made to the FSA for any tax year.⁴ Under IRS Notice 2012-40:

(1)     the $2,500 contribution limit did not apply for plan years that begin before 2013;

(2)     the term “taxable year” in IRC Section 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made;

(3)     plans could adopt the required amendments to reflect the contribution limit at any time through the end of calendar year 2014;

(4)     in the case of a plan providing a grace period (which may be up to two months and 15 days), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the contribution limit for the subsequent plan year; and

(5)     unless a plan’s benefits are under examination by the IRS, relief is provided for certain salary reduction contributions exceeding the contribution limit that are due to a reasonable mistake and not willful neglect, and that are corrected by the employer.

Under IRS Notice 2013-71, heath FSAs may now be amended so that $500 ($640 in 2024; $610 in 2023 and $570 in 2022) of unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carry forward provision may not also offer the grace period that would otherwise allow FSA participants an additional period after the end of the plan year to exhaust account funds.⁵

Editor’s Note: The Affordable Care Act (“ACA”) imposes an annual limitation on contributions to a health FSA. For taxable years beginning after 2012, FSA contributions will not be treated as a qualified benefit unless the cafeteria plan provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to the arrangement. The limit will be indexed for inflation ($3,200 in 2024, up from $3,050 in 2023, $2,850 in 2022 and $2,750 in 2020 and 2021).¹

A health flexible spending arrangement (FSA) is a program that is established under IRC Section 125 to provide for the reimbursement of certain expenses that have already been incurred. This benefit may be provided as a stand-alone plan or as part of a traditional cafeteria plan.

Health coverage under an FSA is not required to be provided under commercial insurance plans, but the coverage that is provided must demonstrate the risk shifting and risk distribution characteristics of insurance. Reimbursements under a health FSA must be paid specifically to reimburse medical expenses that have been incurred previously.

A health FSA cannot provide coverage only for periods during which the participants expect to incur medical expenses if the period is shorter than a plan year. Further, the maximum reimbursement amount must always be available throughout the period of coverage (properly reduced for prior reimbursements for the same period of coverage).

This must be true without regard to the extent to which the participant has paid the required premiums for the coverage period, and without a premium payment schedule based on the rate or amount of covered claims incurred in the coverage period.² Though there was no statutory limit on contributions to a health FSA prior to 2013, most employers imposed a limit to protect themselves against large claims that had not yet been funded by salary reductions.

The period of coverage must be 12 months, or in the case of a short first plan year, the entire first year (or the short plan year where the plan year is changed). Elections to increase or decrease coverage may not be made during a coverage year, but prospective changes may be allowed consistent with certain changes in family status.

The plan may permit the period of coverage to be terminated if the employee fails to pay premiums, provided that the terms of the plan prohibit the employee from making a new election during the remaining period of coverage. The plan may permit revocation of existing elections by an employee who terminated service.³

As is the case with a cafeteria plan, a health FSA may provide a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement. The grace period must apply to all participants in the plan. Plans may adopt a grace period for the current plan year by amending the plan document before the end of the current plan year.⁴

For tax years beginning in 2014 and beyond, a health FSA may be amended so that $500 ($640 in 2024, $610 in 2023, $570 in 2022 and $550 in 2020 and 2021) of unused amounts remaining at the end of the plan year may be carried forward to the next plan year.  However, plans that incorporate the carry forward provision may not also offer the grace period.⁵

The plan may not reimburse premiums paid for other health plan coverage, but it may reimburse medical expenses of the kind described under IRC Section 213(d).⁶ Beginning in 2011, reimbursements for medicine are limited to doctor-prescribed drugs and insulin. Before 2020, over-the-counter medicines were not qualified expenses unless the participant obtained a doctor’s prescription.⁷ However, beginning in 2020 the CARES Act now allows these over-the-counter medical expenses to be reimbursed by an FSA without a prescription.⁸

The reimbursed medical expenses must be expenses incurred to obtain medical care during the period of coverage. The employee must provide substantiation that the expense claimed has been incurred and is not reimbursable under other health coverage.⁹ The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.¹⁰ On a one-time basis, a plan may allow a qualified HSA distribution (see Q 8834).

An employee must include the value of employer-provided coverage for qualified long-term care services provided through an FSA in gross income.¹¹

Substantiation Requirements.

The IRS has released guidance4 on the types of substantiation that are acceptable for health FSAs offered via IRC Section 125 cafeteria plans.  The IRS is clear that the plan must adopt procedures to ensure that all claims are substantiated.

The IRS guidance approved a system where a plan will only reimburse Section 213(d) medical expenses that are substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents (where the information from the third party describes the service or product, the date of service or sale, and the amount of the expense).  The approved system also reimburses expenses based on information from independent third parties (such as an explanation of benefits from an insurance company) and requires that information from the independent third party include (i) the date of the medical care and (ii) the employee’s share of the cost of the medical care (i.e., coinsurance payments and amounts below the deductible). Employee must also certify that any expense paid by the plan has not been reimbursed by insurance or otherwise and that the employee will not seek reimbursement from any other plan covering health benefits.

Under the guidance, self-certification of claims that are not otherwise substantiated does not ensure that all claims are substantiated, meaning that cafeteria plans are prohibited from adopting a self-certification regime.  Similarly, plans that (1) adopt a “sampling” technique, (2) only require substantiation of claims below a certain dollar threshold or (3) do not require substantiation of claims paid via a debit card to certain preferred dentists, doctors, hospitals, or other health care providers fail to ensure that all claims are substantiated.

For cafeteria plans that adopt prohibited substantiation rules, all amounts paid under their health FSAs will be included in gross income.

[1] IRC OCC Memo 202317020.

Editor’s Note: The 2017 tax reform legislation eliminated the 50 percent deduction for business-related entertainment expenses. Although the 50 percent deduction for meal expenses generally remains in effect (including meals consumed while travelling for business), Congress lifted the 50 percent cap for 2021 and 2022. The 2017 tax reform legislation also expanded the deduction for meals to include expenses associated with meals provided through an eating facility meeting the de minimis fringe benefit requirements discussed below.¹ This deduction for meals provided at the convenience of the employer expires after December 31, 2025.²The “de minimis fringe” exception allows an employee to exclude from income any property or services provided by the employer, if the value of such property or services is so small as to make accounting for it unreasonable or administratively impractical.³

For example, an employer-operated eating facility is considered a de minimis fringe if it is located on or near the business premises and the revenue from the facility equals or exceeds its operating costs. These rules are applicable to highly-compensated employees only if access to the facility is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees (see Q 8905).⁴

The IRS provided specific guidance with respect to meals provided for the convenience of the employer. The IRS has released a technical advice memorandum (TAM) that sheds light on the potential tax implications when employers provide employees with free meals in the office. Post-tax reform, meals provided “for the convenience of the employer” may receive favorable tax treatment. In the TAM, the IRS denied exclusion of the meals’ value from employee compensation. Here, the employer provided free meals to all employees in snack areas, at their desks and in the cafeteria, justifying provision of these meals by citing need for a secure business environment for confidential discussions, employee protection, improvement of employee health and a shortened meal period policy. The IRS rejected these rationales, stating that the employer was required to show that the policies existed in practice, not just in form, and that they were enforced upon specific employees. In this case, the employer had no policies relating to employee discussion of confidential information and provided no factual support for its other claims. General goals of improving employee health were found to be insufficient. The IRS also considered the availability of meal delivery services a factor in denying the exclusion, but indicated that if the employees were provided meals because they had to remain on the premises to respond to emergencies, that would be a factor indicating that the exclusion should be granted.⁵

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Planning Point: Early in 2021, the EEOC released a set of regulations to govern whether employers could permissibly offer certain wellness incentives to employees. Those rules were designed to replace regulations that were vacated by court order in 2018. Under the new regulations, employers would have been permitted to offer certain de minimis incentives to employees who participated in wellness programs, including low value gift cards and other “gifts”. However, employers who also offered a health insurance plan in conjunction with the wellness program would have been permitted to offer incentives valued at up to 30 percent of the cost of coverage.

Importantly, the regulations would have offered guidance for employers interested in offering nontaxable incentives to employees who received the COVID-19 vaccine. Those employers should now exercise caution when using incentives to encourage the vaccine. For example, they should be aware of the need to offer reasonable accommodation for religious beliefs or disability (in other words, they may need to provide an alternative way to earn the incentive for employees who will not get the vaccine because of religious beliefs or disability). Employers should also consider the 30 percent limit when determining whether to impose a health insurance surcharge for employees who elect to remain unvaccinated—as well as the ACA limits on affordability that apply to large employers.

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The frequency with which the employer provides the benefit at issue must be taken into account in determining whether the value is de minimis. The benefits provided must be calculated on a per-employee basis. For example, if an employer provides one meal to only one employee on a daily basis, the value of the free daily meal would not be de minimis to that individual employee, even though the provision of one daily meal to one employee would be de minimis with respect to the employer’s entire workforce.⁶

If, however, it would be administratively difficult to determine the frequency with which the employer provides the fringe benefit to an individual employee, the employer may measure frequency based on the frequency for the provision of the fringe benefit to all employees. The regulations use the example of an employer who uses reasonable means to restrict use of employer-provided copy machines to business-related use and is successful in ensuring that 85 percent of the copying is for business use. Any personal use of the copy machine by a particular employee will be considered a de minimis fringe because it would be administratively difficult for the employer to measure usage on a per-employee basis.⁷

An employer may provide meals, money for meals or local transportation fare as de minimis benefits if the following conditions are satisfied:

(1)     The benefit is provided on an occasional basis, determined by examining the availability of the benefit and the regularity with which the benefit is provided to the employee. If an employer provides one of these benefits, or a combination of the three benefits, on a regular or routine basis, they are not provided on an occasional basis.

(2)     The benefit is provided because of overtime work that requires an extension of the employee’s work schedule, even if the conditions giving rise to the need for overtime are reasonably foreseeable.

(3)     In the case of a meal or meal money, the benefit is provided to enable the employee to work overtime hours.

Meal money and local transportation fare will not qualify as de minimis benefits if the amounts provided are calculated based on the number of hours that the employee works.⁸

The IRS has also issued an FAQ⁹ on the tax treatment of work-life referral services as de minimis fringe benefits.  Work-life referral (WLR) programs are a type of employment benefit that, according to IRS language, provide employers with “guidance, support, information, and referrals in connection with” things like childcare services, medical insurance issues, retirement planning services, government benefits, home professionals who can provide care services for family members with special needs and other personal issues and challenges employees may face.   Programs covered by the FAQ are presumed to charge a “per-eligible-employee monthly fee, regardless of how many employees actually utilize the WLR services”.  The FAQ is intended to clarify that WLR programs may be excludable from employees’ income and exempt from employment taxes as de minimis fringe benefits if they otherwise satisfy the legal requirements established by the IRC and regulations (FAQ are issued as non-binding guidance from the IRS and the law itself actually controls).  The FAQ only applies to referral programs, not to payments for actual resources provided through employee assistance programs (EAPs).

Many employees incurred significant expenses setting up home offices during the COVID-19 pandemic. However, remote workers are only entitled to claim a home office deduction if they qualify as self-employed individuals (for example, independent contractors).Prior to 2018, an itemized deduction was available for work-related expenses associated with the trade or business of being an employee. The 2017 tax reform legislation eliminated the deduction for “employment expenses” for 2018-2025.

Under current law, therefore, traditional W-2 employees cannot deduct their home office expenses regardless of whether they would otherwise qualify for the home office deduction if they were self-employed.

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Planning Point: Under federal FLSA rules, employers cannot require employees to pay for work equipment and other unreimbursed expenses if that would cause the employee’s income to fall below the federal minimum wage or salary thresholds ($7.25 per hour or $684 per week).¹

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Further, many states require employers to reimburse employees for certain remote work expenses.² A federal district court judge in California denied a motion to dismiss a proposed class action lawsuit against Amazon. The lawsuit focuses on whether Amazon was required to reimburse the employees for expenses related to work-from-home requirements. The employee in this case alleged that state employment laws required Amazon to reimburse employees for work-related expenses incurred because of pandemic-related work-from-home requirements after the California governor issued lockdown orders. The expenses at issue here include electricity, Internet and space-related expenses totaling between $50 and $100 per month.³

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Planning Point: While the federal tax deduction is currently unavailable, some states, including California, provide a state-level deduction for unreimbursed employee expenses.

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Self-employed taxpayers can deduct expenses associated with maintaining a home office on Schedule C if the office is used regularly and exclusively as the taxpayer’s principal place of business (if the office is within the dwelling unit). A home office deduction is permitted for self-employed taxpayers with separate structures if the office/workspace is used “in connection with” the trade or business.⁴

See Q 8741 for more information on calculating the value of the home office deduction.

Editor’s Note: The 2017 tax reform legislation eliminated the corporate AMT.¹ Corporate taxpayers with existing AMT credit from a prior year may offset regular tax liability with the credit for any taxable year. Existing AMT credits will be refundable for tax years after 2017 and before 2022 in an amount equal to 50 percent (100 percent before 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability (this basically means that the full amount of the credit was available before 2022).² See heading below for modification of this treatment under the 2020 CARES Act. The discussion below generally applies for tax years beginning before 2018 unless otherwise noted. See Q 8962.1 for a discussion of the Inflation Reduction Act’s corporate alternative minimum tax.

Prior to 2018, a corporate taxpayer was required to calculate its liability under the regular tax and a tentative minimum tax, and then add to its regular tax the amount of tentative minimum tax as exceeds the regular tax. The amount added was the corporate alternative minimum tax (AMT).³

To calculate its AMT, a corporation first calculated its “alternative minimum taxable income” (AMTI), as explained below.⁴ The corporation then calculated its “adjusted current earnings” (ACE), also explained below. The corporation increased its AMTI by 75 percent of the amount by which ACE exceeded AMTI (or reduced its AMTI by 75 percent of the amount by which AMTI exceeded ACE).⁵ The tax itself was a flat 20 percent rate, applied to the corporation’s AMTI after it was adjusted based on ACE.⁶

Each corporation received a $40,000 exemption, similarly to the AMT exemption applicable to individuals (see Q 8578). The corporate exemption amount, however, was reduced by 25 percent of the amount by which AMTI exceeded $150,000 (phasing out completely at $310,000).⁷

AMTI is regular taxable income determined with certain adjustments and increased by tax preferences.⁸ “Tax preferences” for corporations are the same as for other taxpayers. Adjustments to income include:

(1)     property is generally depreciated under a less accelerated or a straight line method over a longer period, except that a longer period is not required for property placed in service after 1998;

(2)     mining exploration and development costs are amortized over 10 years;

(3)     a percentage of completion method is required for long-term contracts;

(4)     net operating loss deductions are generally limited to 90 percent of AMTI (although some relief was available in 2001 and 2002);

(5)     certified pollution control facilities are depreciated under the alternative depreciation system except those that are placed in service after 1998, which will use the straight line method; and

(6)     the adjustment based on the corporation’s ACE.⁹

To calculate ACE, a corporation begins with AMTI (determined without regard to ACE or the AMT net operating loss) and makes additional adjustments. These adjustments include adding certain amounts of income that are includable in earnings and profits but not in AMTI (including income on life insurance policies and receipt of key person insurance death proceeds). The amount of any such income added to AMTI is reduced by any deductions that would have been allowed in calculating AMTI had the item been included in gross income. The corporation is generally not allowed a deduction for ACE purposes if that deduction would not have been allowed for earnings and profits purposes, though a deduction is allowed for certain dividends received by a corporation. Generally, for property placed into service after 1989 but before 1994, the corporation must recalculate depreciation according to specified methods for ACE purposes. For ACE purposes, earnings and profits are adjusted further for certain purposes such as the treatment of intangible drilling costs, amortization of certain expenses, installment sales, and depletion.¹⁰

A corporation subject to the AMT in one year may be allowed a minimum tax credit against regular tax liability in subsequent years. The credit is equal to the excess of the adjusted net minimum taxes imposed in prior years over the amount of minimum tax credits allowable in prior years.¹¹ However, the amount of the credit cannot be greater than the excess of the corporation’s regular tax liability (reduced by certain credits such as certain business related credits and certain investment credits) over its tentative minimum tax.¹² For tax years beginning after 2017, existing AMT credits will be refundable for tax years after 2017 and before 2022 in an amount equal to 50 percent (100 percent before 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability (i.e., the full amount of the credit was available before 2022).¹³

CARES Act

As noted above, the 2017 tax reform legislation generally repealed the corporate AMT, but also permitted corporations to continue claiming a minimum credit for prior year AMT paid. The credit was carried forward to offset corporate tax liability in a later year. The CARES Act eliminated certain limitations that applied to the carryover provision, so that corporations can claim refunds for their unused AMT credits for the first tax year that began in 2018 (i.e., the corporation can take the entire amount of the refundable credit for 2018).¹⁴ The corporation was required to submit the application for refund before December 31, 2020.