Application of the Federal Insurance
Contributions Act, Federal Unemployment Tax
Act, and Collection of Income Tax at Source to
Statutory Stock Options.

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8948] RIN 1545-AY43 

TITLE: Minimum Cost Requirement Permitting the Transfer of Excess
Assets of a Defined Benefit Pension Plan to a Retiree Health Account

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final Income Tax Regulations
relating to the minimum cost requirement under section 420, which
permits the transfer of excess assets of a defined benefit pension
plan to a retiree health account. Pursuant to section 420(c)(3)(E),
these regulations provide that an employer who significantly reduces
retiree health coverage during the cost maintenance period does not
satisfy the minimum cost requirement of section 420(c)(3). In
addition, these regulations clarify the circumstances under which an
employer is considered to have significantly reduced retiree health
coverage during the cost maintenance period.

DATES: Effective Date: These regulations are effective June 19,
2001. Applicability Date: These regulations are applicable to
transfers of excess pension assets occurring on or after December
18, 1999. See the Effective Date portion of this preamble.

FOR FURTHER INFORMATION CONTACT: Janet A. Laufer or Vernon S.
Carter, (202).Section 420(a)(1) and (2) provide that the trust that
is part of the plan is not 1 treated as failing to satisfy the
qualification requirements of section 401(a) or (h) of the Code, and
no amount is includible in the gross income of the employer
maintaining the plan, solely by reason of such transfer. Also,
section 420(a)(3) provides that a qualified transfer is not treated
as either an employer reversion for purposes of section 4980 or a
prohibited transaction for purposes of section 4975. In addition,
Title I of the Employee Retirement Income Security Act of 1974 (88
Stat. 829), as amended (ERISA), provides that a qualified transfer
pursuant to section 420 is not a prohibited transaction under ERISA
(ERISA section 408(b)(13)) or a prohibited reversion of assets to
the employer (ERISA section 403(c)(1)). ERISA also provides certain
notification requirements with respect to such qualified transfers.
622-6060 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations (26 CFR Part 1) under
section 420 of the Internal Revenue Code of 1986 (Code). These
regulations provide guidance concerning the minimum cost requirement
under section 420. The Revenue Reconciliation Act of 1990 (Public
Law 101-508) (104 Stat. 1388), section 12011, added section 420 of
the Code, a temporary provision permitting certain qualified
transfers of excess pension assets from a non-multiemployer defined
benefit pension plan to a health benefits account. A health benefit
account is defined as an account established and maintained under
section 401(h) of the Code (401(h) account) that is part of the
plan. One of the conditions of a qualified section 420 transfer was
that the employer 1 satisfy a maintenance of effort requirement in
the form of a "minimum cost requirement" under which the employer
was required to maintain employer-provided retiree health
expenditures for covered retirees, their spouses, and dependents at
a minimum dollar level for a 5-year cost maintenance period,
beginning with the taxable year in which the qualified transfer
occurs.

The Uruguay Round Agreements Act (Public Law 103-465) (108 Stat.
4809) (December 8, 1994), extended the availability of section 420
through December 31, 2000. In conjunction with the extension,
Congress modified the maintenance of effort rules for plans
transferring assets for retiree health benefits so that employers
could take into account cost savings realized in their health
benefit plans. As a result, the focus of the maintenance of effort
requirement was shifted from health costs to health benefits. Under
this "benefit maintenance requirement," which applied to qualified
transfers made after December 8, 1994, an employer had to maintain
substantially the same level of employer-provided retiree health
coverage for the taxable year of the transfer and the following 4
years. The level of coverage required to be maintained was based on
the coverage provided in the taxable year immediately preceding the
taxable year of the transfer.

The Tax Relief Extension Act of 1999 (title V of H.R. 1180, the
Ticket to Work and Work Incentives Improvement Act of 1999) (Public
Law 106-170,113 Stat. 1860) (TREA-99) extended section 420 through
December 31, 2005. In conjunction with this extension, the minimum
cost requirement was reinstated as the applicable "maintenance of
effort" provision (in lieu of requiring the maintenance of the level
of coverage) for qualified transfers made after December 17, 1999.
Because the minimum cost requirement relates to per capita cost, an
employer could satisfy the minimum cost requirement by maintaining
the average cost even though the employer defeats the purpose of the
maintenance of effort requirement by reducing the number of people.
covered by the health plan. In response to concerns regarding this
possibility, TREA-99 also added section 420(c)(3)(E), which requires
the Secretary of the Treasury to prescribe such regulations as may
be necessary to prevent an employer who significantly reduces
retiree health coverage during the cost maintenance period from
being treated as satisfying the minimum cost requirement of section
420(c)(3). If the minimum cost requirement of section 420(c)(3) is
not satisfied, the transfer of assets from the pension plan to the
401(h) account is not a "qualified transfer" to which the provisions
of section 420(a) apply.

On January 5, 2001, a notice of proposed rulemaking (REG-116468-00)
was published in the Federal Register (66 FR 1066). Written comments
were received on the proposed regulations. A public hearing
scheduled for March 15, 2001 was canceled because no one had
requested to speak (66 FR 13864). After consideration of all the
comments received on the proposed regulations, the regulations are
adopted as modified by this Treasury decision.

Explanation of Provisions

General Framework

Following the approach taken in the proposed regulations, these
regulations provide that the minimum cost requirement of section
420(c)(3) is not met if an employer significantly reduces retiree
health coverage during the cost maintenance period. Whether an
employer has significantly reduced retiree health coverage is
determined by looking at the number of individuals (retirees, their
spouses, and dependents) who lose coverage during the cost
maintenance period as a result of employer actions, measured on both
an annual basis and a cumulative basis. In determining whether an
employer has significantly reduced retiree health coverage, the
regulations provide that the employer does not satisfy the minimum
cost requirement if the percentage decrease in the number of
individuals provided with applicable health benefits that is
attributable to employer action exceeds 10 percent in any year, or
if the sum of the annual percentage decreases during the cost
maintenance period exceeds 20 percent.

Employer Action

The regulations retain the broad definition of employer action
contained in the proposed regulations. Thus, employer action
includes not only plan amendments but also situations in which other
employer actions, such as the sale of all or part of the employer's
business, operate in conjunction with the existing plan terms to
have the indirect effect of ending an individual's coverage.

The proposed regulations contained no exceptions from the rule that
treats individuals as losing health coverage by reason of employer
action if those individuals' coverage ends by reason of a sale of
all or part of the employer's business, even if the buyer provides
coverage for such individuals (on the implicit assumption that a
buyer of less than an entire corporation rarely undertakes to
provide such coverage to retirees in these transactions). The
preamble to the proposed regulations specifically requested comments
as to (1) the circumstances, if any, in which buyers commonly
provide the seller's retirees, and their spouses and dependents,
with health coverage following a corporate transaction, and (2) in
such cases, criteria that should apply to the replacement coverage
in determining whether to treat those individuals as not having lost
coverage.

Commentators disagreed with the assumption stated in the preamble to
the proposed regulations that a buyer acquiring a portion of a
seller's business rarely undertakes to provide retiree health
coverage to retirees in these transactions and expressed concern
about the approach taken in the proposed regulations concerning
individuals who lose retiree health coverage in such situations. One
commentator stated that in the case of business combinations
involving organizations that contract with the United States
Government, the relevant procurement regulations encourage buyers to
assume a seller's obligations for retirees' pension and retiree
medical benefits. Other commentators expressed a desire to retain
flexibility in structuring future business dispositions so that a
buyer or transferee of a business could undertake to provide retiree
health coverage for the seller's employees.

Generally, commentators requested that the regulations allow an
employer who sells or transfers a business to take into account
health coverage that a buyer or transferee provides to retired
employees of the employer. Various approaches were suggested, most
of them centering around allowing an employer to take credit for
retiree health benefits provided by a buyer or transferee that are
substantially similar to the benefits provided by the employer.

In cases in which a buyer acquires the entire employer sponsoring
the pension plan that is the subject of the maintenance of effort
requirement under section 420(c)(3)(E), no special rule is required,
because the buyer as the successor employer maintaining the plan is
responsible for continuing to satisfy the minimum cost requirements
of section 420(c)(3) with respect to that transfer. However, based
upon comments received, these final regulations include a special
rule that allows the employer responsible for satisfying the
maintenance of effort requirement of section 420(c)(3)(E) to take
credit for a buyer's or transferee's provision of retiree health
benefits in certain other situations.

Under the final regulations, an employer may, but is not required
to, treat retiree health coverage as not having ended for
individuals whose coverage is provided by a buyer. In such a case,
for the year of the sale and future taxable years of the cost
maintenance period, the employer must apply the minimum cost
requirement contained in section 420(c)(3) by treating the
individuals whose coverage is provided by the buyer as individuals
to whom coverage for applicable health benefits is provided during
the year (i.e., including all such individuals in the denominator in
the determination of applicable employer cost) and treating amounts
the buyer spends on health benefits for those individuals as
qualified current retiree health liabilities. After the buyer
commences providing the retiree health benefits, action of the buyer
is attributed to the employer for purposes of determining whether an
individual's coverage ends by reason of employer action.
Accordingly, if a buyer initially provides retiree health benefits
to individuals affected by the sale, but later amends its plan to
stop providing benefits to those individuals, the employer must
treat those individuals as having lost coverage by reason of
employer action.

These final regulations also add a definition of "sale" to clarify
that the rule for sales applies as well to other transfers of a
business. In the case of a transfer, the transferee is treated as
the buyer. Thus, for example, the rule applies in a situation in
which an employer spins off all or part of its business, and also
applies when a contractor that operates a government-owned facility
is replaced by another contractor and the replacement contractor
hires the employees of the prior contractor to operate the facility.

Effective Date

The proposed regulations provided that the 10 percent annual limit
would not apply to a taxable year beginning before February 5, 2001
(30 days after publication of the proposed regulations in the
Federal Register ). However, under the proposed regulations, the 20
percent cumulative limit applied with respect to cost maintenance
periods pertaining to any transfers made on or after December 18,
1999. Thus, if an employer reduced coverage by more than 20 percent
prior to issuance of the proposed regulations, the employer would
have failed the cumulative test.

Several commentators expressed concern about the proposed effective
date of transfers occurring on or after December 18, 1999. None of
the comments indicated that any employers had in fact reduced
coverage by more than 20 percent prior to issuance of the proposed
regulations, and one of the commentators stated that as a practical
matter, the issue of retroactivity is moot. However, a number of the
commentators expressed concern over retroactive effective dates in
Treasury regulations as a matter of principle.

These final regulations, like the proposed regulations, provide that
the 20 percent cumulative test will apply with respect to transfers
of excess pension assets occurring on or after December 18, 1999. In
order to address concerns raised by commentators, however, the final
regulations take into account any reinstatement of coverage that
occurs during the portion of a cost maintenance period that precedes
the first day of the first taxable year beginning on or after
January 1, 2002 (the initial period). Thus, for purposes of the
cumulative test, if an employer reduced retiree health coverage by
more than 20 percent, the employer can, before the end of the
initial period, resume providing coverage for individuals who lost
coverage and treat those individuals as not having lost coverage.
However, if an employer reduces retiree health coverage by more than
20 percent during the initial period and does not "correct" by again
providing coverage for individuals who lost coverage, the employer
would fail the cumulative test. Also, the annual test of significant
reduction applies only to taxable years beginning on or after
January 1, 2002, which reflects a further delay from the date in the
proposed regulation.

Additional changes

The proposed regulations contained a special rule that addresses
situations in which an employer adopts plan terms that establish
eligibility for health coverage for some individuals, but provide
that those same individuals lose health coverage upon the occurrence
of a particular event or after a stated period of time. In those
cases, an individual is not counted as having lost health coverage
by reason of employer action merely because that individual's
coverage ends upon the occurrence of the event or after a certain
period of time, such as when health benefits are provided to
employees retiring as a result of a plant closing only for the
period during which they receive severance pay (see example 2 of the
regulations). As a result of the changes discussed above that
address "corrections" through restoration of coverage during the
initial period and sale transactions, these final regulations
contain two modifications of the special rule for contemporaneously-
adopted plan terms. First, the special rule is not available with
respect to an amendment that restores coverage before the end of the
initial period. Second, in the context of an amendment of a buyer's
health plan to provide retiree health coverage for a seller's
employees, the special rule is available only to the extent that any
terms that have the effect of ending an individual's coverage are
the same as the terms of the plan maintained by the seller, and only
if the terms of the seller's plan that terminate coverage were
adopted contemporaneously with the provision under which the
individual became eligible for retiree health coverage under the
seller's plan.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and,
because the regulations do not impose a collection of information on
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6)
does not apply. Pursuant to section 7805(f) of the Code, the notice
of proposed rulemaking preceding these regulations was submitted to
the Chief Counsel for Advocacy of the Small Business Administration
for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Janet A. Laufer and
Vernon S. Carter, Office of Division Counsel/Associate Chief Counsel
(Tax Exempt and Government Entities). However, other personnel from
the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 - INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
a new entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805***

§1.420-1 also issued under 26 U.S.C. 420(c)(3)(E). Par. 2
Section 1.420-1 is added under the undesignated center heading
"Pension, Profit-Sharing, Stock Bonus Plans, etc." to read as
follows: §1.420-1 Significant reduction in retiree health
coverage during the cost maintenance period.

(a) In general. Notwithstanding section 420(c)(3)(A), the minimum
cost requirements of section 420(c)(3) are not met if the employer
significantly reduces retiree health coverage during the cost
maintenance period.

(b) Significant reduction--

(1) In general. An employer significantly reduces retiree health
coverage during the cost maintenance period if, for any taxable year
beginning on or after January 1, 2002, that is included in the cost
maintenance period, either

(i) The employer-initiated reduction percentage for that taxable
year exceeds 10 percent; or

(ii) The sum of the employer-initiated reduction percentages for
that taxable year and all prior taxable years during the cost
maintenance period exceeds 20 percent.

(2) Employer-initiated reduction percentage. The employer-initiated
reduction percentage for any taxable year is the fraction B/A,
expressed as a percentage, where: A = The total number of
individuals (retired employees plus their spouses plus their
dependents) receiving coverage for applicable health benefits as of
the day before the first day of the taxable year. B = The total
number of individuals included in A whose coverage for applicable
health benefits ended during the taxable year by reason of employer
action.

(3) Special rules for taxable years beginning before January 1,
2002. The following rules apply for purposes of computing the amount
in paragraph (b)(1)(ii) of this section if any portion of the cost
maintenance period precedes the first day of the first taxable year
beginning on or after January 1, 2002--

(i) Aggregation of taxable years. The portion of the cost
maintenance period that precedes the first day of the first taxable
year beginning on or after January 1, 2002 (the initial period) is
treated as a single taxable year and the employer-initiated
reduction percentage for the initial period is computed as set forth
in paragraph (b)(2) of this section, except that the words "initial
period" apply instead of "taxable year."

(ii) Loss of coverage. If coverage for applicable health benefits
for an individual ends by reason of employer action at any time
during the initial period, an employer may treat that coverage as
not having ended if the employer restores coverage for applicable
health benefits to that individual by the end of the initial period.

(4) Employer action--

(i) General rule. For purposes of paragraph (b)(2) of this section,
an individual's coverage for applicable health benefits ends during
a taxable year by reason of employer action, if on any day within
the taxable year, the individual's eligibility for applicable health
benefits ends as a result of a plan amendment or any other action of
the employer (e.g., the sale of all or part of the employer's
business) that, in conjunction with the plan terms, has the effect
of ending the individual's eligibility. An employer action is taken
into account for this purpose regardless of when the employer action
actually occurs (e.g., the date the plan amendment is executed),
except that employer actions occurring before the later of December
18, 1999, and the date that is 5 years before the start of the cost
maintenance period are disregarded.

(ii) Special rule. Notwithstanding paragraph (b)(4)(i) of this
section, coverage for an individual will not be treated as having
ended by reason of employer action merely because such coverage ends
under the terms of the plan if those terms were adopted
contemporaneously with the provision under which the individual
became eligible for retiree health coverage. This paragraph (b)(4)
(ii) does not apply with respect to plan terms adopted
contemporaneously with a plan amendment that restores coverage for
applicable health benefits before the end of the initial period in
accordance with paragraph (b)(3)(ii) of this section.

(iii) Sale transactions. If a purchaser provides coverage for
retiree health benefits to one or more individuals whose coverage
ends by reason of a sale of all or part of the employer's business,
the employer may treat the coverage of those individuals as not
having ended by reason of employer action. In such a case, for the
remainder of the year of the sale and future taxable years of the
cost maintenance period --

(A) For purposes of computing the applicable employer cost under
section 420(c)(3), those individuals are treated as individuals to
whom coverage for applicable health benefits was provided (for as
long as the purchaser provides retiree health coverage to them), and
any amounts expended by the purchaser of the business to provide for
health benefits for those individuals are treated as paid by the
employer;

(B) For purposes of determining whether a subsequent termination of
coverage is by reason of employer action under this paragraph (b)
(4), the purchaser is treated as the employer. However, the special
rule in paragraph (b)(4)(ii) of this section applies only to the
extent that any terms of the plan maintained by the purchaser that
have the effect of ending retiree health coverage for an individual
are the same as terms of the plan maintained by the employer that
were adopted contemporaneously with the provision under which the
individual became eligible for retiree health coverage under the
plan maintained by the employer.

(c) Definitions. The following definitions apply for purposes of
this section: (1) Applicable health benefits. Applicable health
benefits means applicable health benefits as defined in section
420(e)(1)(C).

(2) Cost maintenance period. Cost maintenance period means the cost
maintenance period as defined in section 420(c)(3)(D).

(3) Sale. A sale of all or part of an employer's business means a
sale or other transfer in connection with which the employees of a
trade or business of the employer become employees of another
person. In the case of such a transfer, the term purchaser means a
transferee of the trade or business.

(d) Examples. The following examples illustrate the application of
this section: Example 1.

(i) Employer W maintains a defined benefit pension plan that
includes a 401(h) account and permits qualified transfers that
satisfy section 420. The number of individuals receiving coverage
for applicable health benefits as of the day before the first day of
Year 1 is 100. In Year 1, Employer W makes a qualified transfer
under section 420. There is no change in the number of individuals
receiving health benefits during Year 1. As of the last day of Year
2, applicable health benefits are provided to 99 individuals,
because 2 individuals became eligible for coverage due to retirement
and 3 individuals died in Year 2. During Year 3, Employer W amends
its health plan to eliminate coverage for 5 individuals, 1 new
retiree becomes eligible for coverage and an additional 3
individuals are no longer covered due to their own decision to drop
coverage. Thus, as of the last day of Year 3, applicable health
benefits are provided to 92 individuals. During Year 4, Employer W
amends its health plan to eliminate coverage under its health plan
for 8 more individuals, so that as of the last day of Year 4,
applicable health benefits are provided to 84 individuals. During
Year 5, Employer W amends its health plan to eliminate coverage for
8 more individuals.

(ii) There is no significant reduction in retiree health coverage in
either Year 1 or Year 2, because there is no reduction in health
coverage as a result of employer action in those years.

(iii) There is no significant reduction in Year 3. The number of
individuals whose health coverage ended during Year 3 by reason of
employer action (amendment of the plan) is 5. Since the number of
individuals receiving coverage for applicable health benefits as of
the last day of Year 2 is 99, the employer-initiated reduction
percentage for Year 3 is 5.05 percent (5/99), which is less than the
10 percent annual limit.

(iv) There is no significant reduction in Year 4. The number of
individuals whose health coverage ended during Year 4 by reason of
employer action is 8. Since the number of individuals receiving
coverage for applicable health benefits as of the last day of Year 3
is 92, the employer-initiated reduction percentage for Year 4 is
8.70 percent (8/92), which is less than the 10 percent annual limit.
The sum of the employer-initiated reduction percentages for Year 3
and Year 4 is 13.75 percent, which is less than the 20 percent
cumulative limit.

(v) In Year 5, there is a significant reduction under paragraph (b)
(1)(ii) of this section. The number of individuals whose health
coverage ended during Year 5 by reason of employer action (amendment
of the plan) is 8. Since the number of individuals receiving
coverage for applicable health benefits as of the last day of Year 4
is 84, the employer-initiated reduction percentage for Year 5 is
9.52 percent (8/84), which is less than the 10 percent annual limit.
However, the sum of the employer-initiated reduction percentages for
Year 3, Year 4, and Year 5 is 5.05 percent + 8.70 percent + 9.52
percent = 23.27 percent, which exceeds the 20 percent cumulative
limit.

Example 2.

(i) Employer X, a calendar year taxpayer, maintains a defined
benefit pension plan that includes a 401(h) account and permits
qualified transfers that satisfy section 420. X also provides
lifetime health benefits to employees who retire from Division A as
a result of a plant shutdown, no health benefits to employees who
retire from Division B, and lifetime health benefits to all
employees who retire from Division C. In 2000, X amends its health
plan to provide coverage for employees who retire from Division B as
a result of a plant shutdown, but only for the 2-year period
coinciding with their severance pay. Also in 2000, X amends the
health plan to provide that employees who retire from Division A as
a result of a plant shutdown receive health coverage only for the 2-
year period coinciding with their severance pay. A plant shutdown
that affects Division A and Division B employees occurs in 2000. The
number of individuals receiving coverage for applicable health
benefits as of the last day of 2001 is 200. In 2002, Employer X
makes a qualified transfer under section 420. As of the last day of
2002, applicable health benefits are provided to 170 individuals,
because the 2-year period of benefits ends for 10 employees who
retired from Division A and 20 employees who retired from Division B
as a result of the plant shutdown that occurred in 2000.

(ii) There is no significant reduction in retiree health coverage in
2002. Coverage for the 10 retirees from Division A who lose coverage
as a result of the end of the 2-year period is treated as having
ended by reason of employer action, because coverage for those
Division A retirees ended by reason of a plan amendment made after
December 17, 1999. However, the terms of the health plan that limit
coverage for employees who retired from Division B as a result of
the 2000 plant shutdown (to the 2-year period) were adopted
contemporaneously with the provision under which those employees
became eligible for retiree coverage under the health plan.
Accordingly, under the rule provided in paragraph (b)(4)(ii) of this
section, coverage for those 20 retirees from Division B is not
treated as having ended by reason of employer action. Thus, the
number of individuals whose health benefits ended by reason of
employer action in 2002 is 10. Since the number of individuals
receiving coverage for applicable health benefits as of the last day
of 2001 is 200, the employer-initiated reduction percentage for 2002
is 5 percent (10/200), which is less than the 10 percent annual
limit.

(e) Regulatory effective date. This section is applicable to
transfers of excess pension assets occurring on or after December
18, 1999.

David A. Mader
Acting Deputy Commissioner of Internal Revenue

Approved: June 12, 2001

Mark A. Weinberger
Assistant Secretary of the Treasury (Tax Policy)

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