Reality Check on IRA Investments in Real Estate

Multiple times each year I am asked by prospective clients whether, and how, they can invest traditional IRA assets in real estate.  In this time of distressed real estate and very low interest rates, many investors have maxed out on their after-tax investments in real estate, and their IRA account balances beckon as a new source of investment capital.  If these folks look online, they will find many sources of purported “advice” on how to get rich through IRA investments in real estate.  Unfortunately, the information available online usually obscures or overlooks altogether some significant practical and tax hurdles to making IRA investments in real estate work from both the technical/legal and “return on investment” perspectives. 

Below I summarize those obstacles.  They are not barriers, per se, but prospective investors should assess them carefully, preferably in consultation with their attorneys, CPAs, or other tax advisors, before committing IRA assets to an investment in real property.    Failure to steer clear of them could result in immediate taxation of the entire IRA account – including conventional investments.

1. Understand How the IRS Views Your IRA

A very important concept that much of the online marketing around IRAs overlooks is that, from the perspective of the IRS:

• the IRA is solely meant to provide a source of retirement income and is not a ready source of capital for an investment opportunity; and
• You are a fiduciary with regard to your IRA account. 

The IRS applies a term – prohibited transaction or “PT” – to any use of IRA assets for personal gain other than preservation of a retirement income stream.  The prohibited transaction rules disallow a number of specific transactions, such as selling real estate to or buying it from your IRA, or personal or immediate family member use of real estate owned by an IRA, but they also generally prohibit “self-dealing” which is defined to include any act of a fiduciary (i.e., you) by which IRA income or assets are used for the fiduciary’s own interest.   Examples of self-dealing could include purchase of real estate built on speculation by a son in law, purchase of real estate adjoining your own property or that of a family member in order to control how the property is used and who lives there, or , outside the real estate context, use of IRA assets alongside personal assets in order to meet a minimum investment account threshold.

If your IRA investment in real estate constitutes a prohibited transaction of any stripe, the total account balance of the IRA will be treated as if it were distributed to you on the first of the year in which the investment is made, and thus included in your taxable income for that year.  If you are under age 59 ½, you also may have to pay an early distribution penalty equal to 10% of the prohibited investment. 

Even if the purchase transaction satisfies PT rules, management of the IRA-owned real estate can also trigger violations, as is discussed in section 4, below.

2. Analyze the Tax Consequences:  Income Tax Rates, versus Capital Gains (plus deductions)

Investing IRA assets in real estate means that gains on your investment  -  when realized through sale of the real estate and distributed from the IRA – will be taxed at regular income tax rates, rather than the lower capital gains rates that apply to after-tax real estate investments.  Also, during the time that your IRA holds the real estate, depreciation and the many deductions for property expenses claimed on Schedules C or E will not apply as they would to after-tax real property investments. 

3. Pay Cash – Avoid Unrelated Debt Financed Income

Your IRA must pay cash for the real estate, otherwise tax will be owed on “unrelated debt financed income” under Internal Revenue Code Section 514 if the leveraged property generates income (such as rents) or if it is sold for a profit while the mortgage is still outstanding (or within 12 months of paying it off).   The IRA trustee or custodian must pay the tax. 

In determining how much your IRA can afford to pay for a parcel of real estate, you must arrange ahead of time, preferably with the help of a CPA or other tax advisor, to maintain liquid investments in the IRA to pay off certain recurrent costs and expenses, and for other reasons outlined in 5 – 7, below.

4. Follow Correct Procedures (the Natalie Choate 4-Step Test)

As mentioned, the IRS views you as a fiduciary with regard to your own IRA.  Because the PT rules prohibit an IRA fiduciary from engaging in business transactions with the IRA itself, you will need to use third parties both to purchase the real estate, and to manage the real estate.  Natalie Choate, a nationally recognized authority on the estate planning aspects of IRAs and qualified retirement plans, specifically recommends the following four steps:

• Find a specialized IRA  custodian.  Not all IRA custodians are well versed in the intricacies of the prohibited transaction rules, and how real estate investments may trigger violations.  You will want to find a bank custodian who has experience in this area.  Work through trusted contacts such as your CPA or other tax advisor until you have found the right match.
• Custodian engages in purchase transaction, not you.  The PT rules require that the IRA custodian, not you as IRA fiduciary, uses your IRA assets to purchase the real estate.  You cannot buy the real estate and transfer it to your IRA, or sell it to your IRA.  The latter transaction would be a PT; the transfer would not work because generally only cash may be contributed to an IRA.
• The Custodian engages a third party property manager. This step is recommended if your real estate has residential tenants or commercial tenants in anything other than a “triple net” lease requiring that they assume costs the landlord otherwise would pay.  The property manager, not you, should run the property (e.g., make repairs, collect rent, pay expenses and property taxes, etc.) and send the IRA custodian a check each month that is net of all such costs.  This arrangement makes it unlikely that you will intermingle your personal assets with the IRA assets, for instance by directly hiring a painter or gardener, or by paying a bill associated with the IRA owned property.
•  No family use or sweat equity.  For the same reasons that a third party property manager is recommended, you must avoid any personal use of the IRA-owned real estate, or use by direct family members.  Even use by extended family members or family friends could comprise a “self-dealing” type of PT as described above.  You must also resist the urge to work on the property yourself, show apartments, or have family members fill any of these roles.  Ideally, your property manager will anticipate and take care of such needs on an arms-length basis, without involving you.

5. Set Aside Liquid IRA Investments for Required Minimum Distributions

When you reach age 70 ½, the IRS requires that you begin taking annual minimum required distributions from your traditional (i.e., non-Roth) IRA.  If you have multiple traditional IRAs, you can choose one from which to take distributions, but you must pool all IRA account balances together to determine the minimum required amount you must withdraw each year.  Failure to timely take out a sufficient amount could result in a 50% tax, based on what you should have withdrawn.  Needless to say, minimum required distributions can only be made from liquid IRA investments – stock that can be sold, money market accounts, etc.  Before investing IRA assets in real estate, make sure that you preserve sufficient liquid IRA investments from which to take required minimum distributions.  You CPA or other tax advisor can help you do some advance planning in this regard, to determine the principal amount you should set aside for this purpose, and income you can expect it to generate.

Failure to preserve liquid investments for this purpose will make it very hard to take minimum required distributions.  You might have to distribute fractional interests in the IRA-owned real estate, which would be an expensive process (both in determining the value of the fractional interests, and in documenting the interest transfer).

6. Set Aside Liquid IRA Investments for Annual Valuations of the RE Investment

Most reputable IRA custodians will require annual valuations of real estate investments or other non-traditional investments (privately held stock, etc.)  The valuation may cost several thousand dollars, possibly more.  The IRA must pay for this expense; you cannot use personal funds.  Before committing IRA assets to the real estate purchase, you need to determine how much in liquid IRA investments you need to aside in order to pay this recurrent expense from either the liquid investments themselves and/or anticipated investment income they generate.

7. Set Aside Liquid IRA Investments for Property Taxes, Expenses, Insurance Improvements, Management Fees

As mentioned, your third party property manager will be using IRA funds to pay property taxes, maintenance and other expenses, insurance, improvements, and will also draw on the IRA to pay its own management fees.  Before committing IRA assets to the real estate purchase, you will need to determine how much in liquid IRA investments you need to set aside in order to pay these expenses from the investments themselves and/or anticipated investment income they generate.  Some amounts will be predictable and recurring; others, such as large repairs (roof replacement, etc.) are not predictable and you will have to use good judgment in estimating a set-aside.

Bottom line, IRA investments in real estate can be done, but there are many rules that must be followed to avoid disqualification of the IRA and immediate taxation of the entire IRA account. The availability of required minimum distribution amounts, the loss of capital gains treatment, and the self-dealing restrictions, generally make an IRA investment in real property unsuitable and problematical at best.  For investors who are still “game,” some advance financial and tax planning strongly is advised both before the transaction occurs, during the life of the real estate investment, and well in advance of any minimum required distribution start date.

Finally, you will note that this post does not discuss strategies using business entities within an IRA, such as IRA-owned single member limited liability companies (“LLCs”).   Often marketed as “checkbook control” IRAs, these arrangements raise a host of compliance issues over and above the ones discussed below.  The Groom Law Group has an excellent article debunking this and a number of other questionable IRA strategies that you can read here.

Wrap Up on Constitutional Challenges to the ACA

A tremendous amount has been written already on the three days of Supreme Court oral argument on the Affordable Care Act’s constitutionality (or lack thereof), so I will keep my comments brief. For more in-depth coverage, www.scotusblog.com features both technical, lawyers-only posts as well as “plain English” summaries for lay readers.

At stake in the Court’s ultimate decision, in addition to the fate of the ACA and the larger issue of the reach of the federal government, is the balance in the division of powers between the nation’s legislative and judicial branches. Keep in mind that the Supreme Court’s review of the ACA is taking place in the midst of a remarkably lengthy and costly primary campaign season that in part was made possible by the Court’s prior ruling in the Citizens United case. Without the Super PAC support authorized by the Citizens United case, neither Newt Gingrich nor Rick Santorum would still be in the race, however nominally. With the Supreme Court’s decision on the ACA, the Citizens United decision will either be seen as an anomaly, or as an earlier step on the Court’s path away from deference to Congress, and towards a more assertive counterbalance to the legislative branch.

No matter how sweeping the underlying issues, however, the Justices will decide the ACA case just like any other case, by casting preliminary votes, lobbying for said votes, and by drafting opinions. As volatile as the oral argument was at times, and as plainly as a few of the Justices displayed their apparent support of, or skepticism about, the ACA’s constitutionality, the deliberations and drafting process may temper some of the more polarized views displayed in open court.
A few things to keep in mind between now, and late June (when a decision in the ACA case should occur):
• Former Solicitor General Paul D. Clement, arguing for the 26 states opposing the ACA, appears to have succeeded in getting Justice Kennedy, a crucial swing vote, to frame the Commerce Clause issue from the states’ perspective – i.e., that the federal government cannot create commerce in order to legislate it. For that reason alone, the individual mandate may not survive the Constitutional challenge. The outcome of the whole case may turn on whether Kennedy maintains his apparent view that Congress cannot “create commerce,” or realizes during the deliberation and opinion drafting process that the commerce clause issue is much more nuanced and cannot be boiled down to so simple a premise.
• Much of the Justices’ decision making process occurs in review of the parties’ written briefs, and questions on oral argument are not reliable predictors of how a particular Justice will rule on a case. Some of the questions may be aimed at lobbying other Justices.
• Chief Justice Roberts is believed to be unlikely to be the first to side with the four more liberal Justices supporting the Act (Kagan, Ginsburg, Sotomayor, Breyer) but it is not impossible that he would do so. Much more so than his “brethren” on the Court, the Chief Justice is driven by concerns outside the scope of this one case, however momentous – such as maintaining the consistency of the Court’s rulings on major legislation (which generally have deferred to Congress) and avoiding (or reducing) public perception of the Court as activist or politicized.
• If the individual mandate is deemed to be unconstitutional it is fairly certain that the Court also will strike down insurance market reforms that would otherwise be unaffordable for insurers: community rating, prohibition on lifetime and annual dollar limits on coverage, and the prohibition on pre-existing condition exclusions.
• What will happen to the balance of the ACA is uncertain. However, alternatives to the individual mandate do exist – an early post from this blog discusses some of the options.
• Major insurance carriers already have invested so much in ACA implementation that undoing compliance likely will be more expensive and disruptive than continued compliance through the watershed 2014 year. Employers will experience turbulence in the group market in the latter half of this year and into 2013.
• In a highly charged presidential election year, there likely will be significant political ramifications from the ACA ruling, and they may be counter-intuitive; i.e., striking down the ACA may better mobilize the Democratic base and convert independent voters to their cause, than would an obvious “victory” – a decision upholding the Act.

Much more remains to be said about the pending challenges to the ACA. I will continue to post on significant developments as they occur.

SCOTUS on ACA, Day 1: Supreme Court Signals Reluctance to Postpone ACA Decision on Procedural Grounds

The Supreme Court of the United States (SCOTUS) yesterday heard oral argument from three attorneys on a procedural issue that, if found worthy by the Court, would postpone any ruling on the constitutionality of the Patient Protection and Affordable Care Act (ACA) until 2015 at the earliest. Audio tapes and a written transcript of the session were released yesterday afternoon, and the consensus of Court watchers is that the Justices seemed disinclined to use the procedural issue to postpone a decision on the ACA.

The procedural question before the court concerns financial penalties that the ACA will impose on individuals who do not purchase insurance for themselves and their dependents, starting in 2014. The financial penalties will range from the greater of (i) $95 per person/$285 max per family or (ii) 1% of household income in 2014, to the greater of (i) $695 (capped at $2,085 per family) or (ii) 2.5% of household income in 2016, after which the $695 amount periodically will be adjusted for inflation in $50 increments, and the family cap limited to three times that amount. Persons who do not obtain insurance in 2014 must pay the applicable penalty with their federal income taxes beginning on April 15, 2015.

Federal law contains provisions that prevent taxpayers from challenging a tax at any time before they have actually paid the tax, and unsuccessfully requested a refund from the IRS. The legal term for this law is the “anti-injunction act” or more specifically the “tax anti-injunction act,” codified at 26 U.S.C. § 7421(a).

Neither the federal government nor Florida and the 25 other states opposing the ACA planned oral argument on the impact, on the case, of the tax anti-injunction act, so the Supreme Court appointed a prominent appellate lawyer, Robert A. Long, to argue this issue before them. The Solicitor General, for the federal government, and a third attorney on behalf of Florida and the 26 other states opposing the ACA, also presented oral argument on the issue. Only the Solicitor General, Donald B. Verrilli, Jr., argued that the tax anti-injunction act did not prevent the Court from ruling on the individual mandate. In other words, the attorney the Court appointed to argue the issue asserted that the tax anti-injunction act did bar Court evaluation of the individual mandate until after financial penalties first are paid in 2015.

The Court, however, seemed disinclined to view the anti-injunction act as “jurisdictional” – i.e., an obstacle to ruling on the mandate and the ACA. Of the nine Justices, only one – Justice Clarence Thomas – refrained from questioning counsel on the issue. And of the many questions that other members of the Court posed, most suggested a view that the individual mandate was a self-standing law that it could rule on, independent of the financial penalty/tax issue. This appeared to be the case across the board, with skeptical questions coming from conservative Justice Scalia and Chief Justice Roberts, not only from the more “liberal” Justices Ginsberg, Sotomayor and Kagan. This skepticism was perhaps bolstered by the Court’s own inconsistent prior rulings on the tax anti-injunction act.

A decision from the Court will not likely appear until June 2012, and the most important oral argument is occurring today, March 27, on the constitutionality of the individual mandate.

California Expands Domestic Partner Health Insurance Coverage to Out of State Providers

Last year California Governor Jerry Brown signed into law a provision that, if it successfully can be implemented, will close a loophole in the California Insurance Equity Act which exempts out of state employers from having to offer domestic partner health insurance coverage to employees residing in this state.

Originally enacted in 2004, the California Insurance Equality Act (AB 2208) amended the California Insurance Code to require that insurance policies that were “marketed, issued, or delivered” to a California resident treat registered domestic partners equal to lawfully-married, opposite sex spouses. Similarly the Health & Safety Code required domestic partner coverage to be offered by California HMOs. For group health coverage this rule generally went into effect as of January 1, 2006. This rule still applies to all manner of insurance contracts within California, not just those providing group health coverage.

The original Act, however, did not apply to insurance coverage issued “outside of California to an employer whose principle place of business and majority of employees are located outside of California.” Cal. Ins. Code § 10112.5. It also did not specifically apply to HMO contracts formed outside of California.

This meant that California residents employed by certain out-of-state companies could not extend group health coverage to their domestic partners lawfully registered with the California Secretary of State.
Effective January 1, 2012, SB 757 closes that loophole, but only with regard to group health insurance and HMOs issued outside of California to any employers. Other types of insurance coverage are not affected.

The law requires that a domestic partner be registered with the California Secretary of State in order to be covered and also that, if the employer require proof of such registration for coverage, it must also require that opposite-sex couples provide proof of their marriage in order to obtain spousal coverage. Written documentation also is required for proof of the end of a marriage or domestic partnership.

It is not clear how the California Insurance Department or the California Department of Managed Health Care will enforce this rule against insurers and HMOs that are not licensed under California law and whose contract is with an out-of-state employer. The office of California Senator Ted Lieu, who sponsored the bill, is working with those agencies towards an enforcement mechanism. It is also possible that the “full faith and credit” clause of the U.S. Constitution could be invoked to require other states to conform to California law. If the law can be enforced it will impact the terms of coverage for non-California companies with California employees. It would not likely be preempted by ERISA, however, because it directly governs insurers and HMOs, and only indirectly impacts employer-sponsored group health plans.

Looking Ahead to the Supreme Court’s Health Care Reform Hearings (March 26 – 28)

In three weeks, the U.S. Supreme Court will begin hearing oral argument on the constitutionality of certain provisions of the Patient Protection and Affordable Care Act (“ACA”).  Almost three years to the day after the ACA was enacted, it will become the most significant piece of legislation reviewed by the Court since the Voting Rights Act in the 1960s.   In anticipation of the major news coverage that will surely ensue, this post outlines the legal issues at stake, and takes a look at how the Court’s voting might line up.

Of the numerous (over 30) federal cases challenging the ACA, the Supreme Court agreed to hear three that had been appealed from the 11^th Circuit, one of which is Florida v. U.S. Department of Health and Human Services, a case originally filed by Florida’s attorney general, who later was joined by 25 additional states as plaintiffs.  Six hours of time (the longest amount of argument time allocated since the 1960s) has been reserved for oral argument before the Supreme Court on March 26, 27 and 28, 2012, on the following points:

a)      The Tax Anti-Injunction Act

The tax anti-injunction act is a federal statute codified at 26 U.S.C. §7421(a) that, in relevant part, prohibits federal courts from enjoining enforcement of a federal tax unless and until the tax is actually being collected.  The tax in question under the ACA is the monetary fine – called a “shared responsibility payment” –  that would be required to be paid by individuals who don’t purchase insurance.  In this instance, the individual mandate will not apply until 2014 and the penalty for failing to comply with the mandate will not be collected until April 2015.  Neither the government, nor ACA opponents, are arguing that the anti-injunction act prevents the Court from hearing the case, so the Supreme Court has appointed independent counsel to argue the issue.  This raises the possibility that the Court will use the anti-injunction act to “punt” a decision on the individual mandate into 2015, well past the presidential election.  The Supreme Court has allocated ninety minutes to oral argument on this issue.

b)     Commerce Clause/Individual Mandate

The Commerce Clause of the U.S. Constitution allows the federal government to regulate commerce among the states. Proponents of the ACA argue that our national health care system is in the midst of a huge crisis, with cost-shifting from uninsured to insured individuals creating a burden on interstate commerce that is well within the powers of the federal government to address.  Opponents argue that the federal government has no right to reach into the pockets of state citizens and force them to purchase health insurance.  They claim that this is a slippery slope of government intrusion into our personal lives that ultimately will result in mandated purchases of health food, etc.  One additional problem is that the Commerce Clause permits the federal government to monitor active commerce among the states, but in this instance it would be monitoring inactivity – the refusal to purchase insurance.  The Supreme Court has allocated 2 hours of argument to this key issue.

c)      Severability

If the Court finds that the individual mandate exceeds Congress’s powers under the Commerce Clause, will this require invalidation of the entire ACA or may the individual mandate be severed from the rest of the massive law?  The government asserts that loss of the mandate would eliminate only the prohibition on pre-existing exclusion clauses, and community rating restrictions (which limit insurer’s ability to peg  health insurance premiums to a number of factors including health history), and that the rest of the ACA could be enforced.  Opponents argue that the mandate – which will bring many young, healthy people into the insurance rolls – is intrinsic to the rest of the law, particularly insurance market reforms, and that the ACA cannot stand without it.    Because neither side is expressly arguing that only the individual mandate be severed, the Supreme Court has appointed outside counsel to make that particular argument.

d)     Federalism/Expansion of Medicare

Effective in 2014 the ACA extends Medicaid eligibility to all citizens and certain legal residents with incomes of up to 133% of the poverty level.  This change will add 16 million people to the Medicare rolls and is a large part of the ACA’s means of increasing access to health coverage.  States not complying with the expansion risk losing all federal Medicaid funds, which generally exceed 50% of states’ health care budgets. From 2014 through 2016, the federal government will pay 100% of Medicaid coverage for the new enrollees, then gradually will reduce its contribution to 90% in 2020.  States, whose budgets are already stretched to the limit, argue that they cannot afford even 10% of the cost of the expanded Medicare access but that neither can they afford to opt out, and lose all federal Medicaid subsidies.  Therefore they argue that Congress’s expansion of Medicare on these terms violates states’ 10^th amendment rights to sovereignty.  The Supreme Court has allocated one hour to oral argument on this issue.

Timing of Ruling

A decision on the March 2012 hearing may be made as soon as the end of the Court’s 2012 spring term, on June 28, 2012.   In this scenario, the ruling could have a major impact on the US presidential election, which by then will be in full swing.  Of course, as mentioned, the decision may postpone the constitutionality issue until April 2015 under the anti-injunction argument.

Possible Outcomes

On balance it is thought to be more likely than not that the Supreme Court will uphold the constitutionality of the ACA, but there is no certainty to that prediction.  The Court is dominated 5 to 4 by conservative Justices with Chief Justice John Roberts and Justices Antonin Scalia, Clarence Thomas, Anthony Kennedy, and Samuel Alito on the conservative side, and Justices Stephen Breyer, Ruth Bader Ginsburg, Sonia Sotomayor and Elena Kagan on the more liberal side.  Possible voting outcomes include a 5-4 decision striking down the mandate, or a 6-3 vote upholding it.  Justices Bader Ginsburg, Sotomayor, Kagan and Breyer are almost certain to vote to uphold the mandate, whereas Justices Thomas and Alito are almost certain “no” votes on the mandate.  That leaves three potential swing votes:  Chief Justice Roberts, Justice Kennedy, and surprisingly Justice Scalia, who reportedly is being “courted” by government attorneys briefing the ACA issues for the Court, by liberally quoting prior Scalia opinions.   It is thought to be unlikely that Chief Justice Roberts will be the only conservative justice to uphold the mandate, but he might support it if, for example, Justices Scalia or Kennedy led the way.  For an even more detailed assessment of the “odds,” check out this article by Andrew Cohen for The Atlantic.

If the Court upholds the individual mandate, it will take effect in 2014.  If it finds the mandate to be unconstitutional it will address the severability issue, which could in turn impact survival of other ACA provisions not currently under review, such as employer pay-or-play provisions, the state exchanges, and could even result in a ruling that the entire ACA is unconstitutional.  Inevitably the Supreme Court’s decision on the ACA will have broader implications for Congress’s power to regulate interstate commerce, and more generally for the balance of power between the federal government and the states.

Final Regulations Ease SBC Compliance Duties

The three federal agencies charged with implementing the Affordable Care Act (Treasury, Labor, and HHS) jointly issued final regulations on February 9, 2012 governing the content and distribution of “Summaries of Benefits and Coverage” (SBCs), sometimes called “mini-SPDs.” Unlike SPDs, the SBC is distributed to persons applying for coverage, not just to current participants and beneficiaries. The final regulations include several changes that will make compliance less burdensome on employers and insurers, including a six-month extension of the original compliance deadline, from March 23, 2012 to September 23, 2012. Specifically SBCs must be made available with the first open enrollment period beginning on or after September 23, 2012, which may not be until November or December 2012 for a calendar year plan. However SBCs will also need to be provided as of September 23, 2012 for participants who join a plan outside of open enrollment, such as new hires and dependents acquired through birth or marriage under HIPAA special enrollment rules. In addition to final regulations on the SBC the agencies also published a final template SBC and model completed SBC as well as a final glossary of key terms that have standardized definitions in the SBC context.

Basic background information on the SBC is set forth in this earlier post. This post focuses on the changes made in the final regulation that apply to group, rather than individual health coverage, as follows:
• As mentioned, the compliance deadline was pushed out six months in response to public comments requesting more time to adapt to this new disclosure requirement.
• The SBC may be distributed electronically to plan applicants, including by posting online, so long as the format is readily accessible (e.g., Adobe Acrobat), and the employer/plan sponsor or insurer timely provides written or email notice to the enrollee of how to find the SBC online, and of their option to receive a hard copy free of charge. (Current plan participants may receive electronic SBCs under the same DOL rules that apply to SPDs, which differ depending on whether or not the participant regularly uses a computer as part of his or her job, or does not do so.)
• The SBC does not need to disclose health premium costs. Removing premium costs from the SBC eliminates the need to provide updated documents when premiums increase or otherwise change between the time the application is submitted, and commencement of coverage.
• The SBC does not need to be a self-standing document but may be incorporated into a Summary Plan Description (SPD) so long as it is conspicuously set apart, in its entirety, from SPD language. The preamble to the final regulations recommends placing it immediately after the table of contents for the SPD.
• Because both insurance carriers and employer plan sponsors must each provide SBCs, the final rule expands on the anti-duplication rule set forth in the proposed regulations, pursuant to which an insurer’s timely provision of SBCs for an insured group health plan fulfills both its own, and the employer’s, disclosure duties. Under the final regulation the insurer or employer need only provide one SBC to a participant and beneficiaries known to reside at the same address, and upon renewal of coverage with multiple benefit packages the employer or insurer need only provide a new SBC for the package that automatically is renewed; SBCs for other benefit packages need only be provided upon request.
• The SBC does not need to be provided for certain “excepted benefit” plans such as self-standing dental, vision plans, HSAs, and health Flexible Spending Accounts which are funded solely by employee salary deferrals or which receive employer contributions not exceeding $500. Health Reimbursement Accounts (HRAs) likely will require SBCs.
• To more accurately apply to self funded plans, terms such as “policy period” have been changed to “coverage period.”
• The “coverage examples” used to illustrate in concrete terms how the plan’s deductible and cost-sharing provision apply to a specific medical situation have been reduced from three to two – childbirth (normal delivery) and well-controlled Type 2 diabetes. A third example for breast cancer treatment was dropped.
• The original 4-page limit for the SBC, which the proposed regulations interpreted as 8 pages (4 double-sided pages) has been liberalized further. Now, plan sponsors and insurers may exceed the page limitation when the plan terms “cannot reasonably be described” in the existing space limits.
• The time period in which to provide an SBC upon individual participant or beneficiary request, and on other select instances, is increased from seven calendar days to seven business days.

The final regulations, template and glossary will be published in the Federal Register on February 14, 2012.

401(k) Fee Disclosure Deadlines Extended Three Months; Other Changes Made in Final Regulations Under ERISA 408(b)(2)

On February 2, 2012 the Department of Labor issued a final rule under ERISA Section 408(b)(2), governing disclosures that plan service providers must make to plan fiduciaries to allow them to confirm that the providers receive only “reasonable” amounts of compensation from plan assets in exchange for their services. The types of providers affected include Registered Investment Advisors, certain broker-dealers, third party administrators, and other service providers receiving $1,000 or more in direct or indirect compensation from plan assets. The rule extends the deadline for the initial disclosure three months, from April 1, 2012 to July 1, 2012.

The plan-level fee disclosure rules originally issued in July 2010 with a one-year deadline for implementation deadline, but that deadline was extended to April 1, 2012 last July. This is probably the last such extension (though anything is possible in an election year).

There is no prescribed manner of providing the required disclosures other than that it is in writing. Because compensation information may be conveyed through multiple or complex documents, the final rule includes a placeholder for rules on a “guide or similar tool” that would help fiduciaries locate information in disparate sources. An appendix to the final rule also includes a Sample Guide to get service providers working towards a disclosure roadmap.

Another significant change in the final rule is that it carves out, from plans that are covered by the disclosure rule, “pre-2009” 403(b) annuity contracts or custodial accounts that meet all the requirements set forth in DOL Field Assistance Bulletins 2009-02 and 2010-1 providing limited relief from Form 5500 reporting duties. More information on how to identify a pre-2009 contract or account is found in the FABs.

Failure to comply with the fee disclosure requirements constitutes a prohibited transaction (PT) for the responsible fiduciary, whereas compliance qualifies the fiduciary for a PT exemption. The final rule changes one of the conditions for the PT exemption when a service provider has failed to provide compensation information and also has not responded to the fiduciary’s written request for the information within 90 days. If the information relates to futures services and is not disclosed promptly after the 90-day period, the final rule requires the fiduciary to terminate the service arrangement “as expeditiously as possible.”

The final rule cuts service providers some slack, however, allowing them to provide “reasonable and good faith estimates” of compensation or cost amounts that are difficult to itemize, so long as the service provider explains the methods and assumptions it used to arrive at the estimate.

Additionally, disclosures of indirect compensation paid by third parties to the service provider must be accompanied by a description of the arrangement between the service provider and the third party pursuant to whom the payments are made.

The three-month extension of the plan-level fee disclosure rule triggers an equal extension of the participant-level fee disclosure rules under ERISA Section 404(a)(2). Technically plan sponsors (employers) must make these disclosures to plan participants, but for practical purposes institutional investment providers will provide most of the content. The deadline to distribute the initial written disclosure has moved from May 31, 2012 to August 30, 2012, and the deadline to distribute the first quarterly statement under the rule has moved from August 14, 2012 to November 14, 2012.