Katrina Guidance
Rev. 12/15/05, E-mail Alert 2005-25

The IRS has issued Notice 2005-92 providing guidance on the Katrina Emergency Tax Relief Act.

Notice 2005-92 — Hurricane Katrina Relief Under Sections 101 and 103 of the Katrina Emergency Tax Relief Act of 2005 (KETRA)

BACKGROUND AND DEFINITIONS
On September 23, 2005, KETRA became a law. The IRS issued Notice 2005-92 to provide clarifications and operational guidance with examples for implementing KETRA. Here is our write-up on this detailed notice.

KETRA Definition of a “qualified individual”
A qualified individual is an individual whose principal place of abode on August 28, 2005, is located in the Hurricane Katrina disaster area as defined by KETRA and who has sustained an economic loss by reason of Hurricane Katrina. For purposes of the relief provided under KETRA, the term "Hurricane Katrina disaster area" means the entire states of Louisiana, Mississippi, Alabama, and Florida. (This definition applies to KETRA and not necessarily to other IRS guidance.)

Definition of Katrina Distribution (Section 101)

• Qualified individuals may make a distribution of up to $100,000 from an eligible retirement plan and designate it as a Katrina distribution.
  
• Katrina distributions rules only apply to those made between August 25, 2005 and before January 1, 2007.
  
• Katrina distributions are not subject to the 10% additional tax under Code § 72(t) nor, in the case of SIMPLE IRAs, the 25% additional tax under § 72(t)(6).
  
• Generally, Katrina distributions are includible in income over a 3-year period.
  
• To the extent the Katrina distributions are eligible for tax-free rollover treatment, it may be “recontributed” to an eligible retirement plan within a 3-year period from the day after the date of distribution.

Hardship Distribution Or Katrina Distribution
Distributions made as a hardship withdrawal under the terms of a qualified plan are not eligible for rollover. However, if such a distribution satisfies the definition of a Katrina distribution, then the distribution is not treated as a hardship withdrawal for purposes of this guidance.

Definition of Principal Place of Abode
A principal place of abode is where the individual lives, unless temporarily absent due to special circumstances such as illness, education, business, vacation or military leave. If an individual’s principal place of abode was in a Hurricane Katrina disaster area immediately before August 28, 2005, and the individual evacuated because of Katrina, the individual’s place of abode is considered to be in the Katrina disaster area on August 28, 2005.

Katrina distributions are generally treated as satisfying certain plan distribution restrictions.

• A Katrina distribution is a distributable event that satisfies the distribution restrictions for cash-or-deferred arrangements. Thus, deferrals, QNECs and QMACs are permitted to be distributed without violating the distribution restrictions for such sources. Money purchase and DB plans are not eligible for this special tax treatment.

Direct rollover and 20% withholding requirements are not applicable to Katrina distributions. The 402(f) notice is also not required.

Treatment of distributions as Katrina distributions.

• The employer is permitted to choose whether to treat distributions under its plan as Katrina distributions.
  
• The employer may develop reasonable procedures for identifying Katrina distributions.
  
• If a plan permits funds subject to Cash or Deferral Arrangement (CODA) withdrawal restrictions, to become Katrina distributions, the plan must be consistent in its treatment.

Distribution limits on Katrina Distributions.

• The employer may only make Katrina distributions of up to $100,000 from all the employer’s retirement plans.
  
• A plan will not fail this requirement because a qualified individual exceeded $100,000 of Katrina distributions by taking distributions from IRAs or other employer’s eligible retirement plans.
  
• Example 1 If a plan designated a distribution of $90,000 as a Katrina distribution upon reasonable representation by the qualified individual who was under age 59½ and the individual also withdrew $40,000 from an IRA and designated that as a Katrina distribution, the individual would only be eligible to exempt $100,000 from the 10% additional tax. If the individual designated the $40,000 from the IRA and $60,000 from the plan as the Katrina distributions, the plan would have not failed any requirement.

Reliance on reasonable representations.

• A plan sponsor or plan administrator may rely on reasonable representations of a qualified individual with respect to the individual’s principal place of abode on August 28, 2005 and whether the individual suffered an economic loss from Katrina, unless the plan administrator has actual knowledge to the contrary.

An employer retirement plan will be treated as operating in accordance with its terms if certain requirements are satisfied.

• A plan operating under KETRA is not treated as failing to operate in accordance with its terms provided an amendment is made by the last day of the first plan year beginning on or after January 1, 2007 for all qualified plans and by the last day of the first plan year beginning on or after January 1, 2009 for governmental plans.
  
• The IRS may provide a “sample” amendment. (as of the date of this article, a “sample” amendment was not available.)

GUIDANCE FOR ELIGIBLE RETIREMENT PLANS MAKING, OR ACCEPTING RECONTRIBUTION OF KATRINA DISTRIBUTIONS

Form 1099-R Tax Reporting on Katrina Distributions, Box 7 Codes:

• Code 2 (early distribution, exception applies) is to be used if the payor is treating the distribution as a KATRINA distribution and no other code applies. This would signify that the 10% (or 25% for a SIMPLE IRA) additional tax does not apply.
  
• Code 1 (early distribution, no known exception applies) is permitted to be used by a payor. Perhaps the Service is leaving this option open for payor’s who are unsure of the recipient’s qualification under KETRA.
  

Recontribution of a Katrina distribution may be accepted based on relying on the representations received from the qualified individual (as defined above).

This section provides guidance on tax treatment and reporting for:

• 10% additional tax (25% for SIMPLE IRAs) not applying to Katrina distributions to qualified individuals under KETRA.
  
• Katrina distribution being included in income over 3 year.
  
• Katrina distribution being recontributed, via a direct rollover concept to an eligible retirement plan, within three years from the day after the day the distribution was received.

IRS Form 8915
IRS Form 8915 Qualified Hurricane Katrina Retirement Plan Distributions and Repayments has been created for qualified individuals to report any recontributions during the tax year and to determine the taxable amount to include in income for any remaining distributions. (Form 8915 was not yet available as of the date of this article though it was mentioned in the new Form 1040 Instructions.)

Election to designate a distribution as a Katrina distribution.

• A qualified individual is permitted to designate any distribution that meets the definition of a Katrina Distribution (in this notice) as a Katrina distribution, provided the individual’s total Katrina distributions do not exceed $100,000.
  
• The exception to the 10% early distribution additional tax only applies to $100,000 of Katrina distributions. Amounts above that are subject to the 10%. For example, using the information from example 1 above in which the individual took an IRA distribution of $40,000 and a qualified plan distribution of $90,000. Only the $100,000 includible in income would be exempt from the 10% additional tax. The additional $30,000 above $100,000 would be subject to the 10% additional tax.

Income inclusion for Katrina Distributions.

• A qualified individual may include the taxable portion of a Katrina distribution in the year received or ratably over three years, starting with the year it is received.
  
• All Katrina distributions received by an individual in a year must be treated consistently as three year ratable or as taxed in one year.
  
• Once the individual’s tax return, reflecting use of the three-year method, has been timely filed (including extensions); the three-year method cannot be changed.

Tax Treatment of Recontributions.

• A Katrina distribution may be recontributed at any time during the 3-year period beginning the day after the Katrina distribution is received.
  
• The Katrina recontribution will not violate the once a year IRA-to-IRA rollover rule.

Tax treatment of recontributions of a Katrina distribution using the 1-year inclusion method.

• All reporting to be in the one tax year in which the distribution is reported for tax.
  
• Form 8915 to be used.
  
• If the recontribution is made after the year of distribution, an amended tax return for the year of the distribution and an amended Form 8915 is to be filed to reflect the recontribution.
  
• Examples 1, 2 and 3 (page 11 and top of page 12) of the notice illustrate the options.

Tax treatment of recontributions of a Katrina distribution using the 3-year ratable income inclusion method.

• An individual using the 3 year ratable tax method who makes a recontribution will offset the taxation of the current tax year’s ratable amount provided the recontribution is made no later than the filing date of the individual’s tax return(including extensions).
  
• If the amount of the recontribution exceeds the taxable amount for a given year, the recontributions may be carried back or forward. Specifically, the excess above the one year’s taxable amount may be used to reduce a future year’s 1/3 of the ratable income or a past year’s 1/3 of the 3-year ratable income inclusion. Examples are in the notice.
  
• Death of qualified individual before full taxable amount included in gross income will require the remainder to be included in the individual’s taxable year of death.
  Katrina distributions will not be treated as a change in the substantially equal periodic payments.
  

APPLICATION OF SECTION 103 OF KETRA TO PLAN LOANS
Increase in loan amount

• For loans made to a qualified individual on or after September 24, 2005 and before January 1, 2007.
  
• Limit on the Maximum Loan is increased from $50,000 to $100,000.
  
• Maximum loan amount is increased from 50% of the employee’s vested accrued benefit to 100% of the vested accrued benefit. Thus, the full account balance, up to $100,000, can be used as loan collateral (not just 50%).

Suspension of payments and extension of term of loan for a period equal to the length of the suspension

• This section applies to a qualified individual who has an outstanding participant loan(s) from a qualified plan on or after August 25, 2005.
  
• With respect to such loans, repayments due between August 25, 2005 and December 31, 2006 may be delayed for one year.
  
• Subsequent repayments shall be adjusted for interest accrued during such delay.
  
• The period of the delay shall be disregarded when determining the 5-year maximum loan period.
  
• The employer is permitted to choose to allow the delay. Thus, this is an optional plan provision which the employer may or may not opt to select.

IRS Safe Harbor Provisions for Satisfying the KETRA Loan Delay

• Loan repayments must resume at the end of the suspension period.
  
• The term of the loan may be extended by the duration of the suspension period.
  
• Interest added during the suspension must be added to the principal of the loan.
  
• The loan is to be re-amortized to provide substantially equal payments over the remaining period of the loan.
  
• The employer may choose a suspension period that is less than the one provided in the law. If the employer decides to offer a shorter suspension period and then wishes to extend the period, that may be done, provided the extension does not go beyond December 31, 2006.

IRS Example. "On March 31, 2005, a participant with a nonforfeitable account balance of $40,000 borrowed $20,000 to be repaid in level monthly installments of $394 each over 5 years, with the repayments to be made by payroll withholding. The participant makes 8 monthly payments until December 1, 2005. The participant’s home is in the Hurricane Katrina disaster area and the participant sustained an economic loss. The participant’s employer takes action to suspend payroll withholding repayments, for the period from December 1, 2005, through the end of 2006, for loans to qualified individuals that are outstanding on or after August 25, 2005, but only for its employees who have a principal place of abode in the Hurricane Katrina disaster area and sustained an economic loss. Because the participant is an employee of the employer who has a principal place of abode in the Hurricane Katrina disaster area and notifies the employer that he or she has sustained an economic loss, no further repayments are made on the participant’s loan until January 1, 2007 (when the balance is $19,045). At that time, repayments on the loan resume, with the amount of each monthly installment increased to $423 in order to repay the loan by April 30, 2011 (which is the date the loan originally would have been fully repaid, plus the 13-month loan suspension period that resulted from Hurricane Katrina)."

Qualified employer plan may rely on reasonable representations.
A participant’s reasonable representations that he or she is a qualified individual and thus able to use the loan provisions of KETRA may be relied upon by the plan administrator, unless actual knowledge to the contrary is known.

--------------------------------------------------------------------------------
Prior McKay Hochman Article Entitled Hurricane Guidance Scorecard (with links to other articles).

Bill Grossman, QPA