On June 17th, President Bush signed the Heroes Earnings Assistance and Relief Tax Act of 2008 (the "HEART Act"), which Congress passed in late May. The HEART Act addresses the treatment of payments made to individuals who are called to active military service, provides mandatory and optional changes to the treatment of reservists on active military duty under retirement plans, and permits special distributions from health flexible spending arrangements to employees who are called to active military service.

Differential Wage Payments

Some employers voluntarily continue paying compensation that a service member would have otherwise earned during a period of active duty. This compensation is typically referred to as "differential wages." Under prior law, the Service took the position that these payments were not subject to tax withholding and were not required to be treated as compensation for retirement plan purposes.

The HEART Act, however, provides beginning January 1, 2009 that these differential wage payments are wages subject to income tax withholding and must be treated as compensation of the participant for retirement plan purposes. Plan amendments relating to differential pay must be made on or before the last day of the first plan year beginning on or after January 1, 2010.

Retirement Plan Impact

The HEART Act imposes a number of mandatory and optional changes under the Code to the treatment of participants in retirement plans who are on qualified military service.

Unless otherwise provided, employers are required (or may in the case of optional provisions) to administer their plans to implement these changes effective January 1, 2007. However, plans do not need to be formally amended until the last day of the 2010 plan year.

Death Benefits. If a tax-qualified retirement plan offers certain benefits to survivors of participants who die while actively employed, such as an incidental death benefit or accelerated vesting, the plan must offer these same benefits to survivors of participants who die while performing qualified military service.

Benefit Accruals. Under USERRA, qualified plans must credit service for vesting and benefit accrual purposes for employees who return to active employment from qualified military service. The HEART Act provides that retirement plans may credit service for benefit accruals to participants who were unable to return from active military service due to death or disability. This provision is optional beginning January 1, 2007 and is available only if the plan provides this benefit accrual on reasonably equivalent terms to all participants who die or become disabled during qualified military service.

Tax Treatment of Distributions. The HEART Act makes permanent the exemption from the 10% early distribution penalty for distributions to individuals called to active military service for a period of at least 180 days or indefinitely.

Flex Plan Changes

The HEART Act permits health flexible spending arrangements ("FSA") to provide "qualified reservist distributions." A qualified reservist distribution is a distribution of the account of a participant who was called to active military service for a period of at least 180 days or indefinitely as a result of being a reservist. The qualified reservist distribution may be paid at any time beginning on the date of the order calling the individual to active military service and ending on the last date that reimbursements could otherwise be made for the plan year which includes the date of the order. This is an exception from the "use-or-lose" requirement that all amounts contributed to a health FSA must be used for qualified medical expenses or the amounts will be forfeited at the end of the year.

If you would like additional information about the items in this Legal Alert, please contact Tom Hughes at 612-373-8516 or thughes@felhaber.com or contact Ruth Marcott at 612-373-8435.