Fiduciary Liability Insurance Considerations

We have previously discussed the differences between Fiduciary Liability Insurance and ERISA Fidelity Bonding. We have also discussed D&O Insurance Trends. Fiduciary Liability Insurance vs. ERISA Fidelity Bonds – What's the Difference? explains the differences between fidelity bonding and fiduciary liability insurance and uses an excellent illustration of how the two work together. It discusses the various kinds of fiduciary liability coverage that plans can purchase and the coverage that fiduciaries can personally purchase, recommending that fiduciaries negotiate the latter as part of their compensation if it isn't already included:

Several companies offer fiduciary liability insurance designed to cover claims and losses arising out of claimed breaches of fiduciary duty. The coverages provided by those policies, like other policy features, can differ significantly. The plan itself can purchase liability insurance for its fiduciaries as long as the policy allows the insurer to seek recourse against the fiduciary if the fiduciary is determined to have breached his duty to the plan. Otherwise, the employer or the fiduciary himself can purchase insurance. (Executives who are expected to assume some responsibility over the company's benefit plans should consider incorporating fiduciary liability insurance as part of their overall compensation package.)

It also stresses the exposure to personal liability and discusses issues to consider when choosing your fiduciary liability insurance.

There are several issues to think about in considering fiduciary liability insurance. Among them: the annual premium cost; the amount of coverage needed; the amount of any deductible; whether the deductible is charged any time a claim is made or only if there is a settlement or judgment, and; whether the limits of liability under the policy are reduced by attorneys fees and costs incurred in defending against a claim.

Fiduciaries are personally liable for losses incurred by a plan due to their breach. Although it isn't required by ERISA – as is a bond – every fiduciary of an ERISA plan should seriously consider obtaining fiduciary liability insurance.

Avoiding Us vs. Them, Employee Recognition, and 460% Revenue Growth

Last year we discussed the Employee Engagement Practices of King Arthur Flour Co., an ESOP company and one of the 2008 Top Small Workplaces.



A Two-Century Commitment to Quality and Community reviews the success of King Arthur, noting that revenues have increased from $14.5 million when the ESOP was established in 1996 to over $67 million today:

In 1996 legacy owner Frank Sands felt like the company needed to make another big change. In a move to avoid the classic model of union-management relations in which a union must protect the workers against a management drive solely to maximize value to the owners, papers were drawn up to sell the 200-year-old company to its staff. Revenues at the time were $14.5 million.

"The classical model," explains Voigt, "does not include the workers. So when you have a model that is 100 percent owned by an ESOP, it isn't an 'us-them' situation."

It took until 2004 for the company to become completely bought up by its associates, but it's a move that has cemented success for the organization: Revenues jumped 124 percent from the start of the sale, to $32.5 million. After being named a Winning Workplaces/Wall Street Journal Top Small Workplace in 2008, King Arthur made this year's list of America's fastest-growing private companies in Inc. magazine, and has remained one of the fastest-growing companies in Vermont since going ESOP.

Accolades and sales growth have naturally translated to employee recognition – something the company takes pride in and does in a way that fits their culture. "Knighting" ceremonies honor long-term employees and "Vesting" ceremonies mark an employee's vested stake in the ESOP account. Even the stationery awarded for a job well done has the image of a knight on horseback and the stamp, "A message from an owner."

Travis Oman calls the Knighting ceremonies a "truly unique and terrific experience," and P.J. Hamel, a Senior Editor with 19 years tenure at the company, says such activities, though whimsical, are worthwhile.

"I love to see a colleague celebrated. The ceremonies themselves are touching, funny, and memorable," Hamel says. "Bottom line, they're an opportunity for us all to say thanks to one another."

…As Hamel puts it simply, "It reinforces our 200-plus-year history of doing the right thing." And doing the right thing has continued to pay handsomely: from 2004, when the sale of the company to its employees was completed, to today, revenues have increased over 100 percent to $67 million.

Share Distributions, Promissory Notes, and Adequate Security

Our post on a recent Technical Advice Memorandum (TAM) shared some best practices when making share distributions. It also discussed the put option (participant's right to demand a stock distribution) and the net unrealized appreciation (NUA) tax benefits of making share distributions.

Some ESOP companies have opted to pay their participants with a lump sum share distribution, with the shares immediately put to the company in exchange for a promissory note. Reasons for doing this include:

• To provide NUA treatment;
• To comply with the share distribution requirements;
• To protect the participants from the fluctuations in company stock when they are no longer with the company;
• To reduce the number of shares in the trust; and/or
• For other repurchase planning reasons

In order to use a promissory note and spread the payments over a period of time, you have to satisfy the put option requirements of IRC Section 409(h)(5) - Right to demand employer securities; put option - Payment requirement for total distribution:

(h) Right to demand employer securities; put option

(5) Payment requirement for total distribution

If an employer is required to repurchase employer securities which are distributed to the employee as part of a total distribution, the requirements of paragraph (1)(B) shall be treated as met if—

(A) the amount to be paid for the employer securities is paid in substantially equal periodic payments (not less frequently than annually) over a period beginning not later than 30 days after the exercise of the put option described in paragraph (4) and not exceeding 5 years, and

(B) there is adequate security provided and reasonable interest paid on the unpaid amounts referred to in subparagraph (A).

For purposes of this paragraph, the term "total distribution" means the distribution within 1 taxable year to the recipient of the balance to the credit of the recipient's account.

29 CFR 2550.408b-3(l) - Loans to Employee Stock Ownership Plans provides additional guidance:

(l) Other put option provisions—

(1) Manner of exercise. A put option is exercised by the holder notifying the employer in writing that the put option is being exercised.

(2) Time excluded from duration of put option. The period during which a put option is exercisable does not include any time when a distributee is unable to exercise it because the party bound by the put option is prohibited from honoring it by applicable Federal or State law.

(3) Price. The price at which a put option must be exercisable is the value of the security, determined in accordance with paragraph (d)(5) of 26 CFR 54.4975-11.

(4) Payment terms. The provisions for payment under a put option must be reasonable. The deferral of payment is reasonable if adequate security and a reasonable interest rate are provided for any credit extended and if the cumulative payments at any time are no less than the aggregate of reasonable periodic payments as of such time. Periodic payments are reasonable if annual installments, beginning with 30 days after the date the put option is exercised, are substantially equal. Generally, the payment period may not end more than 5 years after the date the put option is exercised. However, it may be extended to a date no later than the earlier of 10 years from the date the put option is exercised or the date the proceeds of the loan used by the ESOP to acquire the security subject to such put option are entirely repaid.

(5) Payment restrictions. Payment under a put option may be restricted by the terms of a loan, including one used to acquire a security subject to a put option, made before November 1, 1977. Otherwise, payment under a put option must not be restricted by the provisions of a loan or any other arrangement, including the terms of the employer's articles of incorporation, unless so required by applicable state law.

The promissory note must have a reasonable interest rate and provide adequate security. One of the ways that many ESOP companies used to attempt to provide adequate security was by purchasing surety bonds to serve as collateral. As of 2002, "the principal issuer of surety bonds in this market…indicated it will no longer issue the surety bonds."

Another way some ESOP companies have tried to satisfy the requirement is by pledging the stock of the company. Purchasing a Participant's ESOP Stock With a Promissory Note: Is Your "Adequate Security" Really Adequate? explores the problems with the stock pledge and adequate security requirement:

First, a question arises as to whether the stock is really "adequate security." Some will argue that pledging the stock of the employer is not "adequate security" because if the employer runs into financial difficulty and cannot make payments on the note, the value of its stock will undoubtedly decrease as well. However, if the employer is the purchaser, the company's assets are often given as collateral for the original ESOP loan, and there may be no other available assets to use as collateral, other than the stock purchased from the participant.

Second, IRS and Department of Labor ("DOL") regulations provide that the only collateral the ESOP may give as security is the stock purchased with the loan (in this case, the promissory note). If pledging the stock as collateral is not "adequate security," the result would be the ESOP cannot use a promissory note to purchase the participant's stock at all, which appears contrary to the statutory authority.

Third, neither the IRS nor the DOL has issued formal guidance regarding whether the pledge of employer stock will be considered "adequate security." Therefore, the plan sponsor and the ESOP is pretty much on its own in attempting to determine what will pass as "adequate security."

It notes that little guidance and case law is available, but does cite an IRS ruling that "a company's "full faith and credit" is not adequate security". It also cites two cases, including Craig v. Smith, 2009 WL 438635 (S.D. Ind. Feb. 20, 2009), a case where the company issued 10-year promissory notes with an acceleration clause requiring payment in full if there is a default in payments, and ponders whether that constitutes adequate security. Putting the shares to the ESOP instead of the company may also provide a stronger case of adequate security since the ESOP will own the security.

Using Promissory Notes to Repurchase ESOP Stock Becomes More Difficult also cites TAM 9438002 and Internal Revenue Manual Part 4. Examining Process, Chapter 72. Employee Plans Technical Guidelines, Section 4. Employee Stock Ownership Plans (ESOPs) as additional guidance:

1. Check that employer securities not readily tradeable on an established market can be put to the employer.
   
   
2. Make sure the put is exercisable for two 60 day periods: 60 days following the date the employer securities were distributed and 60 days in the following plan year.
   
   
3. If the employee puts shares to the employer received in a total distribution, make sure the employer provides adequate security and pays reasonable interest on the unpaid portion. A put option is not adequately secured if it is not secured by any tangible assets.
   
   
   • For example, adequate security may be an irrevocable letter of credit, a surety bond issued by a third party insurance company rated " A" or better by a recognized insurance rating agency, or by a first priority perfected security interest against company assets capable of being sold, foreclosed upon or otherwise disposed of in case of default. Promissory notes secured by a company's full faith and credit are not adequate security. Nor are employer securities adequate security.

ESOPs Increase Employee Wealth and Wages

A review of existing research on ESOPs found that, in addition to the equity benefits of the ESOP, overall wages of employees of ESOP companies are "at least as high as—and may be higher than" the wages of their non-ESOP counterparts. Steven Freeman of the University of Pennsylvania asserts that this "may partly reflect higher average productivity levels in employee ownership companies, the use of high wages in combination with employee ownership to motivate workers, the influence of workers in setting wages, or beneficence on the part of management that adopts ESOPs."

UPDATE 10/27/09: The NCEO website discusses research on The Impact of ESOPs on Employee Compensation that finds that, rather than replacing wages or benefits with stock, employees are “significantly better compensated in ESOP companies than are employees in comparable non-ESOP companies.” One study found that the median hourly wage is 5% to 12% higher, and another found that total compensation is 5.2% higher for companies with more than 5% ESOP ownership in the company.

H. Con. Res. 204: Expressing continued support for employee stock ownership plans

H. Con. Res. 204: Expressing continued support for employee stock ownership plans was introduced on September 22, 2009, by Rep. Maurice Hinchey [D-NY22] and co-sponsored by Eric Cantor [R-VA7], Howard Coble [R-NC6], Walter Jones [R-NC3], Dana Rohrabacher [R-CA46], Edward Royce [R-CA40], and Mark Souder [R-IN3]. It has been referred to the House Committee on Education and Labor. The ESOP Association supports the bill:

H. Con. Res. 204 cites the Congressional history of ESOPs, references the 35 years of data evidencing that the vast majority of ESOP companies are high performing companies, with better benefits than non-employee owned companies. It concludes that Congress expresses its continued support for ESOPs… "A commitment by Congress to a fair and more equitable form of ownership is important in the 21^st century. On behalf of the nearly 2,500 members of The ESOP Association, I urge all members of Congress to co-sponsor this resolution," said J. Michael Keeling, president of The ESOP Association. "Research has consistently shown that employee owned companies are high performing, have better sales, and provide more retirement savings compared to their non-ESOP counterparts. To have Congress express its continued support for ESOPs is important in the current economic climate."

Here is the full text:

HCON 204 IH 111th CONGRESS 1st Session H. CON. RES. 204 Expressing continued support for employee stock ownership plans. IN THE HOUSE OF REPRESENTATIVES October 22, 2009 Mr. HINCHEY (for himself, Mr. ROHRABACHER, Mr. CANTOR, Mr. COBLE, Mr. JONES, Mr. ROYCE, and Mr. SOUDER) submitted the following concurrent resolution; which was referred to the Committee on Education and Labor CONCURRENT RESOLUTION Expressing continued support for employee stock ownership plans. Whereas in the Employee Retirement Income Security Act of 1974, Congress codified a technique of corporate finance which utilizes employee stock ownership, officially named an employee stock ownership plan (ESOP); Whereas in the 35 years since the statutory recognition of ESOPs, there have been ample data collected by objective research indicating that the vast majority of corporations sponsoring employee stock ownership through ESOPs are high performing companies that, among other indicia of high performing companies, have better sales, are more sustainable, pay better, and provide more retirement savings compared to similar companies that are not employee-owned; and Whereas Congress, in more than 15 laws since 1974, has made it explicit that ESOPs are to serve the dual purpose of providing retirement savings and stock ownership for employees, as well as being a financing technique for corporations: Now, therefore, be it Resolved by the House of Representatives (the Senate concurring), That Congress expresses its continued support for employee stock ownership plans.

New Guidance on 2009 Schedule C Reporting Requirements

The DOL has published new guidance to help service providers comply with the new Schedule C reporting requirements effective for plans beginning on or after January 1, 2009: EBSA issues additional guidance on 2009 Form 5500 Schedule C

2009 Required Minimum Distributions (RMDs)

As a result of the economic downturn that occurred in the second half of 2008, a provision was included in the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) to provide a waiver of the requirement to take RMDs in 2009. IRS Notice 2009-09 – Required Minimum Distributions for 2009 provided some initial guidance. Now that we are into the last quarter of 2009 and the 2009 RMD deadlines of 12/31/09 and 4/1/10 are coming closer, you may be dealing with questions such as:

• Can I still pay a required minimum distribution if the participant would like to take it?
• Do participants have to opt out or do they opt in?
• Are 2009 RMD amounts eligible for a rollover?
• What about the plan document?

IRS Notice 2009-82 – Guidance on 2009 Required Minimum Distributions provides some additional guidance:

• The plan document generally must be amended to account for how you are treating 2009 RMDs. However, the amendment is generally not required to be adopted until the last day of plan year beginning in 2011.
  
  
• The Notice provides two sample amendments that can be used or modified to meet your particular RMD procedures. The two sample amendments provide that participants can 1) "default to continue 2009 RMDs" or 2) "default to discontinue 2009 RMDs".
  
  
• You will need to choose whether participants have to elect to receive a 2009 RMD or whether they will need to elect NOT to receive one.
  
• You will need to choose one of the following options about whether or not 2009 RMDs are eligible for rollover:
  
  
  • 2009 RMDs are eligible for rollover (generally subject to mandatory 20% federal withholding if the amount is not rolled over per IRC Section 3405 - Special rules for pensions, annuities, and certain other deferred income)
    
    
  • 2009 RMDs are eligible for rollover (generally subject to mandatory 20% federal withholding if the amount is not rolled over per IRC Section 3405 - Special rules for pensions, annuities, and certain other deferred income) ONLY if paid with an additional amount that is an eligible rollover distribution.
    
    
  • 2009 RMDs are NOT eligible for rollover (generally subject to voluntary 10% federal withholding if the amount is not rolled over per IRC Section 3405 - Special rules for pensions, annuities, and certain other deferred income)
    
    
• If a participant has already received a 2009 RMD, the Notice provides that the participants have until the later of November 30, 2009 or 60 days after the date the distribution was received to roll it over.
  
  
• 2009 distributions are considered to first consist of prior unpaid RMDs and then 2009 RMDs.

Here is some background information on RMDs:

What are Required Minimum Distributions?

IRC Section 401(a)(9) - Qualified pension, profit-sharing, and stock bonus plans - Required distributions provides statutory guidance on RMDs. An IRS Retirement Plans FAQs regarding the Required Minimum Distributions also provides a definition:

Required Minimum Distributions (RMDs) generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires. However, if the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, the RMDs must begin once the account holder is age 70 ½, regardless of whether he or she is retired.

Retirement plan participants and IRA owners are responsible for taking the correct amount of RMDs on time every year from their accounts, and they face stiff penalties for failure to take RMDs.

When a retirement plan account owner or IRA owner dies before RMDs have begun, different RMD rules apply to the beneficiary of the account or IRA. Generally, the entire amount of the owner's benefit must be distributed to the beneficiary who is an individual either (1) within 5 years of the owner's death, or (2) over the life of the beneficiary starting no later than one year following the owner's death. See Publication 590 - Individual Retirement Arrangements (IRAs) for complete details on when beneficiaries must start receiving RMDs.

The IRS RMD information page also answers the following questions

1. What types of retirement plans require minimum distributions?
2. When is the deadline for receiving a RMD from an IRA?
3. How is the amount of the RMD calculated?
4. Can an account owner just take a RMD from one account instead of separately from each account?
5. Who calculates the amount of the RMD?
6. Can an account owner withdraw more than the RMD?
7. What happens if a person does not take a RMD by the required deadline?
8. Can the penalty for not taking the full RMD be waived?
9. Can a distribution in excess of the RMD for one year be applied to the RMD for a future year?
10. How are RMDs taxed?
11. Can RMD amounts be rolled over into another tax-deferred account?
12. Is an account owner who turned 70½ in 2008 and had planned to take his or her first RMD by the April 1, 2009 deadline still required to take that 2008 RMD?
13. How does the 2009 RMD waiver affect an account owner who may turn 70½ in 2009?
14. If an account owner does receive a 2009 RMD, can he or she roll it over into an IRA?
15. Does the 2009 RMD waiver also apply to defined benefit plans?

Required Beginning Date

Generally, all participants must receive their first RMD by the April 1 of the year following the year they meet both of the following requirements: attain age 70½ and terminate employment. This date is referred to as the participant's required beginning date.

Here is an example of a participant that met both requirements in 2007:

• Required Beginning Date – Since the participant met both requirements in 2008, the required beginning date is April 1, 2009.
  
• RMD #1 - The participant must receive their first RMD by April 1, 2009. This RMD is the participant's 2008 RMD and is calculated using the 2007 balance.
  
• RMD #2 - The participant must receive their second RMD by December 31, 2009. This RMD is the participant's 2009 RMD and is calculated using the 2008 balance. As discussed above, the 2009 RMD has been waived and is subject to special rules.
  
• Each subsequent RMD - Each subsequent RMD will be due on each subsequent December 31 (calculated using the prior year's balance).

Some plans provide eligible participants with the option to take their first RMD in the year they satisfy both requirements. Using the example, the participant would take their first RMD in 2008.

Another option is for the participant to take both their first and second RMDs before April 1 of the year the RMDs are due. Using the example, the first two RMDs would be taken in 2009 by April 1, 2009.

RMD Calculators

Here are two online RMD calculators you may find useful.

1. Required Minimum Distribution Calculator – This calculator requires you to enter the age as of December 31, 2008, and the balance as of December 31, 2007.
   
2. Financial Calculators – Required Minimum Distribution (RMD) – This calculator has more factors to input and is able to handle the beneficiary scenario discussed above. The calculator will also estimate future RMDs and account balances based on the future estimated rate of return. It appears that this is now a premium feature of the site.
   
3. Calculate Your Minimum Required Distribution calculator – This is a basic calculator that only requires your age at the end of this year and the balance.

I previously tested some of the calculators using this Uniform Lifetime Table and my calculation agreed with the online calculators. Most RMD calculators will not be able to handle the scenario of a spouse beneficiary that is more than ten years younger than the participant, as this scenario requires the usage of the Joint Expectancy tables.

Do you have enough cash in the ESOP to pay RMDs?

Another factor to consider for RMDs is that the plan may not have enough cash to pay to the participant(s) to satisfy the RMD requirements. If this is the case, the plan will most likely have three options:

• The stock will be repurchased (recycled) in the plan to other participants - cash will need to be contributed to the plan.
• The stock will be sold and the proceeds used to pay the participants – a stock appraisal on the date of the sale will need to be obtained.
• The stock will be distributed and put back to the company (or the ESOP). It is important to note that as it gets closer to December 31, it becomes more likely that the stock value may be "stale" (see above discussion) and not an accurate reflection of the actual stock value.

This situation can be avoided if you have identified RMDs ahead of time and have a well-planned distribution policy.

What value should be used to determine the number of shares to distribute?

The value of the distribution is calculated using the fair market value of the stock as of the date of the distribution, and the value of the distribution must be at least equal to the amount required to be distributed to satisfy the RMD requirements. RMDs – How many shares to distribute? discusses an example.

Proposal to Repeal ESOPs

Yesterday the Employee Ownership Blog discussed how an Influential Tax Journal Features Respected ERISA Expert Saying "Kill ESOPs".

The Tax Notes's Shelf Project is a column to report "proposals to help Congress when it is ready to raise revenue in the coming years." According to the ESOP Association the Tax Notes publication has “influence in the tight circles of tax law decision makers.” In January 2009 the project announced they had completed 27 proposals and announced they were working on a proposal to repeal ESOPs. They are also working on projects like returning the Estate tax and repealing the step up in basis, implementing a $2/gallon tax or a Carbon auction, and expanding Rangel's Corporate Tax Proposal.

According to the Employee Ownership Blog, the Shelf Project published "Repeal Tax Incentives for ESOPs" on October 19, 2009:

While a close read of the article reveals more of a dislike, or debunking if you will, of the economic theories of ESOP originator Louis O. Kelso, its bottom line is ESOPs do not improve company performance, do not increase wealth consistently, and therefore do not deserve to be ERISA plans nor have tax benefits.

According to their particular proposal, all qualified retirement plan would have to be well-diversified investments. Meaning that ESOPs would and should be subject to diversification rules and all ESOPs tax incentives should be repealed because as the authors state, "ESOPs represent bad public retirement policy…"

They provide four reasons for changing the tax policy to repeal ESOP tax incentives: (1.) ESOPs are not necessary to, and do not, increase workers' wealth; (2.) Stock ownership does not improve worker productivity; (3.) The pain of underdiversification; and (4.) No reason to subsidize ESOPs.

The Employee Ownership Blog post goes on to address the same stale anti-ESOP arguments that the ESOP community has countered with facts in the past.

One of the authors of the Shelf Project article, Andrew W. Stumpff, has also authored Fifty Years of Utopia: A Half-Century After Louis Kelso's The Capitalist Manifesto, a Look Back at the Weird History of the ESOP, 62 Tax Law. 419 (2009). I have not read the article, but observed that the introduction compares Louis O. Kelso to Karl Marx and has an overall negative tone towards ESOPs.

According to the ESOP Association, Norman Stein, the second professor who authored the article, is “a sought after advisor to the Congress on retirement savings policy, and is highly respected by staff policy makers in the Administration and the key Congressional tax committees” and “probably called to testify before Congress on ERISA more than any other person in America.”

Steve Sheppard addressed the article on his blog:

Academics and some politicians don't see the solutions residing there, instead relying upon their own inexperience and often untested ideas to throw rocks. The latest attack on ESOPs comes from Andrew Stumpff, an employee benefits law professor at the University of Michigan Law School and the University of Alabama Law School, along with Norman Stein, a Douglas Arant Professor of Law at the University of Alabama Law School. Their article published in the October 19, 2009 issue of Tax Notes posits four arguments against current ESOP law, arguments which likely would never have even been made had either of these pundits actually been part of an ESOP or even seriously studied ESOP performance. Nonetheless, they have taken their best shot out of some egalitarian and/or short-sighted perspectives, views that have always been killers of creativity, innovation and change. While the ESOP community implores business and government entities to look at the realities of ESOPs, the academics argue from theory and supposition.

2009 Safe Harbor Notice of Tax Treatment (402(f) Notice)

IRC Section 402(f) - Written explanation to recipients of distributions eligible for rollover treatment requires that a plan administrator provide a participant receiving an eligible rollover distribution with a written notice of tax treatment between 30 and 180 days before a distribution (the minimum 30-day period can be waived):

(f) Written explanation to recipients of distributions eligible for rollover treatment

(1) In general

The plan administrator of any plan shall, within a reasonable period of time before making an eligible rollover distribution, provide a written explanation to the recipient—

(A) of the provisions under which the recipient may have the distribution directly transferred to an eligible retirement plan and that the automatic distribution by direct transfer applies to certain distributions in accordance with section 401 (a)(31)(B),

(B) of the provision which requires the withholding of tax on the distribution if it is not directly transferred to an eligible retirement plan,

(C) of the provisions under which the distribution will not be subject to tax if transferred to an eligible retirement plan within 60 days after the date on which the recipient received the distribution,

(D) if applicable, of the provisions of subsections (d) and (e) of this section, and

(E) of the provisions under which distributions from the eligible retirement plan receiving the distribution may be subject to restrictions and tax consequences which are different from those applicable to distributions from the plan making such distribution.

(2) Definitions

For purposes of this subsection—

(A) Eligible rollover distribution

The term "eligible rollover distribution" has the same meaning as when used in subsection (c) of this section, paragraph (4) of section 403 (a), subparagraph (A) of section 403 (b)(8), or subparagraph (A) of section 457 (e)(16).

(B) Eligible retirement plan

The term "eligible retirement plan" has the meaning given such term by subsection (c)(8)(B).

IRS Notice 2009-68 – Safe Harbor Explanation — Eligible Rollover Distributions provides updated guidance and describes what must be in the safe harbor notice:

The written explanation must describe the direct rollover rules, the mandatory income tax withholding rules for distributions not directly rolled over, the tax treatment of distributions not rolled over, and when distributions may be subject to different restrictions and tax consequences after being rolled over. Section 402(f) provides that this explanation must be given within a reasonable period of time before the plan makes an eligible rollover distribution. Under § 1.402(f)-1, A-5, of the Income Tax Regulations, the requirements of § 402(f) are satisfied if this explanation (§ 402(f) notice) is provided through the use of an electronic medium that complies with the requirements of § 1.401(a)-21. This explanation should be provided only to participants who are eligible to receive distributions that are eligible rollover distributions.

The updated guidance splits the previous model safe harbor notice into two separate model notices, one for "Payments From a Designated Roth Account" and one for "Payments Not From a Designated Roth Account". Both notices should be provided if you have both accounts. The notices can be combined or modified as appropriate or you can even develop your own notice as long as it satisfies the legal requirements.

The previous model Safe Harbor Explanation was provided in IRS Notice 2002-3 - Safe Harbor Explanation - Certain Qualified Plan Distributions and had fallen out of date as a result of EGTRRA, PPA, TIPRA, HEART, and WRERA changes and could not be relied upon. The updated guidance provides that the 2002 guidance (adjusted with law changes) will be a safe harbor until December 31, 2009 and reiterates that the notice will need to modified as the relevant laws change:

If the law governing the tax treatment of distributions or other provisions described in a safe harbor explanation in this notice is amended after September 28, 2009, the safe harbor explanation will not satisfy § 402(f) to the extent that the safe harbor explanation no longer accurately describes the relevant law. The safe harbor explanations in Notice 2002-3, appropriately modified to reflect statutory changes since Notice 2002-3 was published, will continue to be safe harbor explanations with respect to notices provided through December 31, 2009.

Here is the sample notice for "For Payments Not From a Designated Roth Account":

For Payments Not From a Designated Roth Account
YOUR ROLLOVER OPTIONS
You are receiving this notice because all or a portion of a payment you are receiving from the [INSERT NAME OF PLAN] (the "Plan") is eligible to be rolled over to an IRA or an employer plan. This notice is intended to help you decide whether to do such a rollover.
This notice describes the rollover rules that apply to payments from the Plan that are not from a designated Roth account (a type of account with special tax rules in some employer plans). If you also receive a payment from a designated Roth account in the Plan, you will be provided a different notice for that payment, and the Plan administrator or the payor will tell you the amount that is being paid from each account.
Rules that apply to most payments from a plan are described in the "General Information About Rollovers" section. Special rules that only apply in certain circumstances are described in the "Special Rules and Options" section.
GENERAL INFORMATION ABOUT ROLLOVERS
How can a rollover affect my taxes?
You will be taxed on a payment from the Plan if you do not roll it over. If you are under age 591/2 and do not do a rollover, you will also have to pay a 10% additional income tax on early distributions (unless an exception applies). However, if you do a rollover, you will not have to pay tax until you receive payments later and the 10% additional income tax will not apply if those payments are made after you are age 591/2 (or if an exception applies).
Where may I roll over the payment?
You may roll over the payment to either an IRA (an individual retirement account or individual retirement annuity) or an employer plan (a tax-qualified plan, section 403(b) plan, or governmental section 457(b) plan) that will accept the rollover. The rules of the IRA or employer plan that holds the rollover will determine your investment options, fees, and rights to payment from the IRA or employer plan (for example, no spousal consent rules apply to IRAs and IRAs may not provide loans). Further, the amount rolled over will become subject to the tax rules that apply to the IRA or employer plan.
How do I do a rollover?
There are two ways to do a rollover. You can do either a direct rollover or a 60-day rollover.
If you do a direct rollover, the Plan will make the payment directly to your IRA or an employer plan. You should contact the IRA sponsor or the administrator of the employer plan for information on how to do a direct rollover.
If you do not do a direct rollover, you may still do a rollover by making a deposit into an IRA or eligible employer plan that will accept it. You will have 60 days after you receive the payment to make the deposit. If you do not do a direct rollover, the Plan is required to withhold 20% of the payment for federal income taxes (up to the amount of cash and property received other than employer stock). This means that, in order to roll over the entire payment in a 60-day rollover, you must use other funds to make up for the 20% withheld. If you do not roll over the entire amount of the payment, the portion not rolled over will be taxed and will be subject to the 10% additional income tax on early distributions if you are under age 591/2 (unless an exception applies).
How much may I roll over?
If you wish to do a rollover, you may roll over all or part of the amount eligible for rollover. Any payment from the Plan is eligible for rollover, except:
Certain payments spread over a period of at least 10 years or over your life or life expectancy (or the lives or joint life expectancy of you and your beneficiary) Required minimum distributions after age 701/2 (or after death) Hardship distributions ESOP dividends Corrective distributions of contributions that exceed tax law limitations Loans treated as deemed distributions (for example, loans in default due to missed payments before your employment ends) Cost of life insurance paid by the Plan Contributions made under special automatic enrollment rules that are withdrawn pursuant to your request within 90 days of enrollment Amounts treated as distributed because of a prohibited allocation of S corporation stock under an ESOP (also, there will generally be adverse tax consequences if you roll over a distribution of S corporation stock to an IRA).
The Plan administrator or the payor can tell you what portion of a payment is eligible for rollover.
If I don't do a rollover, will I have to pay the 10% additional income tax on early distributions?
If you are under age 591/2, you will have to pay the 10% additional income tax on early distributions for any payment from the Plan (including amounts withheld for income tax) that you do not roll over, unless one of the exceptions listed below applies. This tax is in addition to the regular income tax on the payment not rolled over.
The 10% additional income tax does not apply to the following payments from the Plan:
Payments made after you separate from service if you will be at least age 55 in the year of the separation Payments that start after you separate from service if paid at least annually in equal or close to equal amounts over your life or life expectancy (or the lives or joint life expectancy of you and your beneficiary) Payments from a governmental defined benefit pension plan made after you separate from service if you are a public safety employee and you are at least age 50 in the year of the separation Payments made due to disability Payments after your death Payments of ESOP dividends Corrective distributions of contributions that exceed tax law limitations Cost of life insurance paid by the Plan Contributions made under special automatic enrollment rules that are withdrawn pursuant to your request within 90 days of enrollment Payments made directly to the government to satisfy a federal tax levy Payments made under a qualified domestic relations order (QDRO) Payments up to the amount of your deductible medical expenses Certain payments made while you are on active duty if you were a member of a reserve component called to duty after September 11, 2001 for more than 179 days Payments of certain automatic enrollment contributions requested to be withdrawn within 90 days of the first contribution.
If I do a rollover to an IRA, will the 10% additional income tax apply to early distributions from the IRA?
If you receive a payment from an IRA when you are under age 591/2, you will have to pay the 10% additional income tax on early distributions from the IRA, unless an exception applies. In general, the exceptions to the 10% additional income tax for early distributions from an IRA are the same as the exceptions listed above for early distributions from a plan. However, there are a few differences for payments from an IRA, including:
There is no exception for payments after separation from service that are made after age 55. The exception for qualified domestic relations orders (QDROs) does not apply (although a special rule applies under which, as part of a divorce or separation agreement, a tax-free transfer may be made directly to an IRA of a spouse or former spouse). The exception for payments made at least annually in equal or close to equal amounts over a specified period applies without regard to whether you have had a separation from service. There are additional exceptions for (1) payments for qualified higher education expenses, (2) payments up to $10,000 used in a qualified first-time home purchase, and (3) payments after you have received unemployment compensation for 12 consecutive weeks (or would have been eligible to receive unemployment compensation but for self-employed status).
Will I owe State income taxes?
This notice does not describe any State or local income tax rules (including withholding rules).
SPECIAL RULES AND OPTIONS
If your payment includes after-tax contributions
After-tax contributions included in a payment are not taxed. If a payment is only part of your benefit, an allocable portion of your after-tax contributions is generally included in the payment. If you have pre-1987 after-tax contributions maintained in a separate account, a special rule may apply to determine whether the after-tax contributions are included in a payment.
You may roll over to an IRA a payment that includes after-tax contributions through either a direct rollover or a 60-day rollover. You must keep track of the aggregate amount of the after-tax contributions in all of your IRAs (in order to determine your taxable income for later payments from the IRAs). If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions. If you do a 60-day rollover to an IRA of only a portion of the payment made to you, the after-tax contributions are treated as rolled over last. For example, assume you are receiving a complete distribution of your benefit which totals $12,000, of which $2,000 is after-tax contributions. In this case, if you roll over $10,000 to an IRA in a 60-day rollover, no amount is taxable because the $2,000 amount not rolled over is treated as being after-tax contributions.
You may roll over to an employer plan all of a payment that includes after-tax contributions, but only through a direct rollover (and only if the receiving plan separately accounts for after-tax contributions and is not a governmental section 457(b) plan). You can do a 60-day rollover to an employer plan of part of a payment that includes after-tax contributions, but only up to the amount of the payment that would be taxable if not rolled over.
If you miss the 60-day rollover deadline
Generally, the 60-day rollover deadline cannot be extended. However, the IRS has the limited authority to waive the deadline under certain extraordinary circumstances, such as when external events prevented you from completing the rollover by the 60-day rollover deadline. To apply for a waiver, you must file a private letter ruling request with the IRS. Private letter ruling requests require the payment of a nonrefundable user fee. For more information, see IRS Publication 590, Individual Retirement Arrangements (IRAs).
If your payment includes employer stock that you do not roll over
If you do not do a rollover, you can apply a special rule to payments of employer stock (or other employer securities) that are either attributable to after-tax contributions or paid in a lump sum after separation from service (or after age 591/2, disability, or the participant's death). Under the special rule, the net unrealized appreciation on the stock will not be taxed when distributed from the Plan and will be taxed at capital gain rates when you sell the stock. Net unrealized appreciation is generally the increase in the value of employer stock after it was acquired by the Plan. If you do a rollover for a payment that includes employer stock (for example, by selling the stock and rolling over the proceeds within 60 days of the payment), the special rule relating to the distributed employer stock will not apply to any subsequent payments from the IRA or employer plan. The Plan administrator can tell you the amount of any net unrealized appreciation.
If you have an outstanding loan that is being offset
If you have an outstanding loan from the Plan, your Plan benefit may be offset by the amount of the loan, typically when your employment ends. The loan offset amount is treated as a distribution to you at the time of the offset and will be taxed (including the 10% additional income tax on early distributions, unless an exception applies) unless you do a 60-day rollover in the amount of the loan offset to an IRA or employer plan.
If you were born on or before January 1, 1936
If you were born on or before January 1, 1936 and receive a lump sum distribution that you do not roll over, special rules for calculating the amount of the tax on the payment might apply to you. For more information, see IRS Publication 575, Pension and Annuity Income.
If your payment is from a governmental section 457(b) plan
If the Plan is a governmental section 457(b) plan, the same rules described elsewhere in this notice generally apply, allowing you to roll over the payment to an IRA or an employer plan that accepts rollovers. One difference is that, if you do not do a rollover, you will not have to pay the 10% additional income tax on early distributions from the Plan even if you are under age 591/2 (unless the payment is from a separate account holding rollover contributions that were made to the Plan from a tax-qualified plan, a section 403(b) plan, or an IRA). However, if you do a rollover to an IRA or to an employer plan that is not a governmental section 457(b) plan, a later distribution made before age 591/2 will be subject to the 10% additional income tax on early distributions (unless an exception applies). Other differences are that you cannot do a rollover if the payment is due to an "unforeseeable emergency" and the special rules under "If your payment includes employer stock that you do not roll over" and "If you were born on or before January 1, 1936" do not apply.
If you are an eligible retired public safety officer and your pension payment is used to pay for health coverage or qualified long-term care insurance
If the Plan is a governmental plan, you retired as a public safety officer, and your retirement was by reason of disability or was after normal retirement age, you can exclude from your taxable income plan payments paid directly as premiums to an accident or health plan (or a qualified long-term care insurance contract) that your employer maintains for you, your spouse, or your dependents, up to a maximum of $3,000 annually. For this purpose, a public safety officer is a law enforcement officer, firefighter, chaplain, or member of a rescue squad or ambulance crew.
If you roll over your payment to a Roth IRA
You can roll over a payment from the Plan made before January 1, 2010 to a Roth IRA only if your modified adjusted gross income is not more than $100,000 for the year the payment is made to you and, if married, you file a joint return. These limitations do not apply to payments made to you from the Plan after 2009. If you wish to roll over the payment to a Roth IRA, but you are not eligible to do a rollover to a Roth IRA until after 2009, you can do a rollover to a traditional IRA and then, after 2009, elect to convert the traditional IRA into a Roth IRA.
If you roll over the payment to a Roth IRA, a special rule applies under which the amount of the payment rolled over (reduced by any after-tax amounts) will be taxed. However, the 10% additional income tax on early distributions will not apply (unless you take the amount rolled over out of the Roth IRA within 5 years, counting from January 1 of the year of the rollover). For payments from the Plan during 2010 that are rolled over to a Roth IRA, the taxable amount can be spread over a 2-year period starting in 2011.
If you roll over the payment to a Roth IRA, later payments from the Roth IRA that are qualified distributions will not be taxed (including earnings after the rollover). A qualified distribution from a Roth IRA is a payment made after you are age 591/2 (or after your death or disability, or as a qualified first-time homebuyer distribution of up to $10,000) and after you have had a Roth IRA for at least 5 years. In applying this 5-year rule, you count from January 1 of the year for which your first contribution was made to a Roth IRA. Payments from the Roth IRA that are not qualified distributions will be taxed to the extent of earnings after the rollover, including the 10% additional income tax on early distributions (unless an exception applies). You do not have to take required minimum distributions from a Roth IRA during your lifetime. For more information, see IRS Publication 590, Individual Retirement Arrangements (IRAs).
You cannot roll over a payment from the Plan to a designated Roth account in an employer plan.
If you are not a plan participant
Payments after death of the participant. If you receive a distribution after the participant's death that you do not roll over, the distribution will generally be taxed in the same manner described elsewhere in this notice. However, the 10% additional income tax on early distributions and the special rules for public safety officers do not apply, and the special rule described under the section "If you were born on or before January 1, 1936" applies only if the participant was born on or before January 1, 1936.
	If you are a surviving spouse. If you receive a payment from the Plan as the surviving spouse of a deceased participant, you have the same rollover options that the participant would have had, as described elsewhere in this notice. In addition, if you choose to do a rollover to an IRA, you may treat the IRA as your own or as an inherited IRA.
	An IRA you treat as your own is treated like any other IRA of yours, so that payments made to you before you are age 591/2 will be subject to the 10% additional income tax on early distributions (unless an exception applies) and required minimum distributions from your IRA do not have to start until after you are age 701/2.
	If you treat the IRA as an inherited IRA, payments from the IRA will not be subject to the 10% additional income tax on early distributions. However, if the participant had started taking required minimum distributions, you will have to receive required minimum distributions from the inherited IRA. If the participant had not started taking required minimum distributions from the Plan, you will not have to start receiving required minimum distributions from the inherited IRA until the year the participant would have been age 701/2.
	If you are a surviving beneficiary other than a spouse. If you receive a payment from the Plan because of the participant's death and you are a designated beneficiary other than a surviving spouse, the only rollover option you have is to do a direct rollover to an inherited IRA. Payments from the inherited IRA will not be subject to the 10% additional income tax on early distributions. You will have to receive required minimum distributions from the inherited IRA.
Payments under a qualified domestic relations order. If you are the spouse or former spouse of the participant who receives a payment from the Plan under a qualified domestic relations order (QDRO), you generally have the same options the participant would have (for example, you may roll over the payment to your own IRA or an eligible employer plan that will accept it). Payments under the QDRO will not be subject to the 10% additional income tax on early distributions.
If you are a nonresident alien
If you are a nonresident alien and you do not do a direct rollover to a U.S. IRA or U.S. employer plan, instead of withholding 20%, the Plan is generally required to withhold 30% of the payment for federal income taxes. If the amount withheld exceeds the amount of tax you owe (as may happen if you do a 60-day rollover), you may request an income tax refund by filing Form 1040NR and attaching your Form 1042-S. See Form W-8BEN for claiming that you are entitled to a reduced rate of withholding under an income tax treaty. For more information, see also IRS Publication 519, U.S. Tax Guide for Aliens, and IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.
Other special rules
If a payment is one in a series of payments for less than 10 years, your choice whether to make a direct rollover will apply to all later payments in the series (unless you make a different choice for later payments).
If your payments for the year are less than $200 (not including payments from a designated Roth account in the Plan), the Plan is not required to allow you to do a direct rollover and is not required to withhold for federal income taxes. However, you may do a 60-day rollover.
Unless you elect otherwise, a mandatory cashout of more than $1,000 (not including payments from a designated Roth account in the Plan) will be directly rolled over to an IRA chosen by the Plan administrator or the payor. A mandatory cashout is a payment from a plan to a participant made before age 62 (or normal retirement age, if later) and without consent, where the participant's benefit does not exceed $5,000 (not including any amounts held under the plan as a result of a prior rollover made to the plan).
You may have special rollover rights if you recently served in the U.S. Armed Forces. For more information, see IRS Publication 3, Armed Forces' Tax Guide.
FOR MORE INFORMATION
You may wish to consult with the Plan administrator or payor, or a professional tax advisor, before taking a payment from the Plan. Also, you can find more detailed information on the federal tax treatment of payments from employer plans in: IRS Publication 575, Pension and Annuity Income; IRS Publication 590, Individual Retirement Arrangements (IRAs); and IRS Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans). These publications are available from a local IRS office, on the web at www.irs.gov, or by calling 1-800-TAX-FORM.