Current developments in employee benefits.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, published in the November issue, focused on current developments affecting qualified retirement plans (excluding changes made by the Small Business job Protection Act of 1996 (SBJPA)). Part II, below, focuses on recent changes related to welfare benefits and executive compensation (excluding changes enacted by the SBJPA).

Employer-Provided Meals

In Boyd Gaming Corp.,(22) the Tax Court ruled that a casino can deduct 100% of the cost of meals provided free to employees if such meals meet the de minimis fringe benefit exception of Sec. 274(n)(2)(B).

Boyd Gaming Corp. and three related casinos (collectively, "taxpayers") operated casinos in Las Vegas. Each maintained and operated a cafeteria that provided free meals to employees on a nondiscriminatory basis. The cafeterias were separate from the public restaurant facilities located on the properties. The taxpayers provided their employees with free meals to remain competitive in the market and to keep employees on the business premises during their shifts.

For 1987 and 1998, the IRS disallowed 20% of the taxpayers, claimed deduction for the meals under Sec. (which currently disallows 50%); in Tax Court, it moved for partial summary judgment on this issue. The taxpayers argued in response that 100% of the cost was deductible under the Sec. 274(n)(2)(B) de minimis fringe benefit exception and that the applicability of said exception was a factual determination. They also sought partial summary judgment, contending that 100% of the cost was deductible under the Sec. 274(e)(8) bona fide sale exception.

The Tax Court first addressed the Sec. 274(n)(2)(B) de minimis fringe benefit exception. Employee meals provided on a nondiscriminatory basis satisfy the exception if the following conditions under Regs. Sec. 1.132-7(a) are met:

1. The eating facility is owned or leased by the employer. 2. The facility is operated by the employer. The facility is located on or near the employer's business premises. 4. The meals furnished at the facility are provided during, or immediately before or after, the employee's workday. 5. The annual revenue derived from the facility normally equals or exceeds the facility's direct operating costs (the revenue/operating cost test).

The parties' only dispute was whether the revenue/operating cost test was met. Regs. Sec. 1.132-7(a)(2) provides that an employer may disregard the cost and revenue of any employee meal that the employer reasonably determines is excludible from gross income under Sec. 119. Sec. 119(a)(1) allows an employee to exclude from income the value of meals furnished by an employer for the employer's convenience and on the employer's premises. Regs. Sec. 1.119-1(a)(2)(i) states that meals provided to employees without charge on the employers, premises are within Sec. 119 if the employer furnished the meals for a "substantial noncompensatory business reason" (the presence of which is a factual determination).

The IRS argued that the revenue/operating cost test was not met, because the taxpayers did not earn revenue from the employee meals; Regs. Sec. 1.132-7(a)(2) applies only when employees pay for meals, some of which are excludible from gross income under Sec. 132(e) and the rest under Sec. 119. The IRS further asserted that Congress intended to allow a full deduction for employee meals only when they are provided in a facility that normally makes an overall profit, and did not intend for Sec. 274(n)(2)(B) to apply to meals covered by Sec. 119.

The IRS cited as support the legislative history to Sec. 274(n)(1), which provides that "20% of an otherwise allowable deduction for food and beverages...is disallowed. Similarly, the cost of a meal furnished by an employer to employees on the employer's premises is subject to the rule."(23) "The bill generally reduces to 80% the amount of any deduction otherwise allowable for meal expenses, including meals...furnished on an employer's premises to its employees (whether or not such meals are excludible from the employee's gross income under Sec. 119)."(24)

The Tax Court rejected the Service's argument that the taxpayers could not qualify for the Sec. 274(n)(2)(B) de minimis fringe benefit exception merely because they did not charge their employees for the meals; according to the court, the taxpayers could deduct the cost of the meals if it could reasonably determine that the meals were excludible from the employees, incomes under Sec. 119.

The court found that the provisions of the legislative history relied on by the IRS were only the general rules, not the exceptions, and were taken out of context. Under the legislative history, the cost of a meal...is fully deductible if the full value...is excludable under Section 132, pursuant to either the subsidized eating facility exclusion or the exclusion for de minimis fringe benefits."(25)

The court stated that, taken in its entirety, the legislative history does not foreclose the complete deduction of employee meals in 100% of the cases. For example, the taxpayers' deduction for employee meals would not be limited by Sec. 274(n)(1) if Sec. 119 allows their employees to exclude the value of the meals from gross income. In such a case, the Secs. 132(e) and 274(n)(2)(B) de minimis fringe benefit exceptions allow the taxpayers to claim a complete deduction for the meals because the cafeterias' revenues and expenses will both be zero for purposes of the revenue/operating cost test.

The court concluded that Sec. 274(n)(2) allows the taxpayers to deduct the entire cost of the meals if they are a Sec. 132(e) de minimis fringe benefit. Thus, it denied the IRS's motion for partial summary judgment and set the case for trial to determine if the taxpayers qualified for the Sec. 274(n)(2)(B) de minimis fringe benefit exception.

The Tax Court then addressed the taxpayers' motion for summary judgment, which asserted that Sec. 274(n)(1)(B) does not limit the deduction, because the meals fall within the Sec. 274(n)(2)(A) exception, which cross-references Sec. 274(e)(8). Sec. 274(e)(8) provides an exception for expenses for goods or services sold by the taxpayer in a bona fide transaction for adequate and full consideration in money or money,s worth. The taxpayers argued that they sell the meals to their employees in consideration for the employees, services and their promise not to leave the business premises during breaks. In rejecting this argument, the court concluded that the taxpayers merely presented the meals to their employees in connection with their employment.

Boyd could prove extremely favorable for employers providing eating facilities to their employees. With the effective elimination of the revenue/operating cost test, the possibility of amending prior years' tax returns exists if employers meet the Sec. 119 requirements; however, the primary hurdle is that the meals must be provided for the convenience of the employer.

Split-Dollar Life Insurance

In Letter Ruling (TAM) 9604001,(26) the IRS ruled that a corporate officer whose life was insured under policies purchased through a split-dollar arrangement (SDA), is taxable on any cash surrender buildup in the policies that exceeds the amount returnable to the employer on discontinuance of the arrangement. This ruling could have a significant effect on insurance and estate planning techniques using SDAs.

Under a typical SDA, an employer and an employee join in purchasing a whole life insurance policy (or a similar type of policy - e.g., variable life or universal life, containing an investment element) on the employees life. The employer agrees to pay a portion of the insurance premium (often equal to the annual increase in cash surrender value); the employee pays the balance. If the employee dies, the employer receives an amount equal to the cash surrender value from the policy proceeds.

Under an equity SDA, the employer's interest is limited to a return of cumulative contributions (i.e., premium payments). The employee thus owns any equity build-up in excess of cumulative contributions. Prior to TAM 9604001, it was unclear how the IRS would treat the employee as to the excess of the cash surrender value over the employers cumulative contributions.

In the TAM, the taxpayer was chairman and CEO of Holding, of which he owned 51% Holding owned 98% of Subsidiary. In 1991, Subsidiary, two insurance companies, and Trust entered into the following transaction: (1) Subsidiary paid a premium to each of the insurance companies for two paid-up $500,000 life insurance policies on the taxpayers life (2) the insurance companies issued the life insurance policies to Trust as owner of the policies; (3) Trust entered into SDAs with Subsidiary; and (4) Trust's assigned the policies to Subsidiary as collateral for Trust's obligation under the SDAs to repay the premiums Subsidiary had paid to each insurance company.

Under the SDAs, Trust was the owner of the policies and the beneficiary, and possessed all incidents of policy ownership. Subsidiary had an unqualified right to receive a portion of the death benefits equal to the total premiums paid; no amount could be paid from the death benefit proceeds to the beneficiary until the full amount due Subsidiary has been paid.

The SDAs may be terminated for various reasons, including (1) Subsidiary's bankruptcy or cessation of operations; (2) termination of the taxpayers employment; and (3) written notice by Trust or the taxpayer. If the SDAs are terminated before the taxpayer's death, Trust must reimburse Subsidiary before the collateral will be returned to Trust. If the policies are canceled or surrendered, Subsidiary is to be reimbursed from the cash surrender proceeds.

The insurance documents indicated that in the policies, fourth year, the cash surrender value would exceed the premiums paid. The SDAs and the collateral assignment agreements also provided that (1) any policy dividends were to be applied to purchase paid-up additional insurance on the taxpayer's life and (2) the owners of the policies could borrow from or pledge or assign them, but only to the extent the cash surrender value of a policy exceeded the premiums paid by Subsidiary.

The Service's analysis began with Secs. 61 and 83; it also noted that its position on traditional SDAs is set out in Rev. Rul. 64-328.(27) In that ruling, the employer and the employee both paid a portion of the cost of the insurance; the practical effect was that, although the employee paid a substantial part of the first premium, after the first year, his share of the premium decreased rapidly, and in some cases even became zero after relatively few years. Rev. Rul. 64-328 concluded that the amount to be included in income each year an SDA is in effect is the annual value of the benefit the employee receives under it; this equals the one-year term cost of the declining life insurance protection to which the employee is entitled] from year to year, less the portion (if any) paid for by the employee.

In amplifying Rev. Rul. 64-328, Rev. Rul. 66-110(28) concluded that any benefit received from an SDA in addition to current insurance protection (e.g., dividends) is also includible in the employee's gross income. The IRS acknowledged that the facts in TAM 9604001 differed from those in Rev. Rul. 64-328; in the TAM, Subsidiary paid a single premium sufficient for the earnings thereon to cover the annual premiums for death protection. However, this difference was ruled to be insignificant, because in both the TAM and Rev. Rul. 64-328, the employee was not required to make further payments after a after period.

EXECUTIVE SUMMARY

* Employers who provide free meals to employees may be able to fully deduct the cost, according to the Tax Court in Boyd Gaming Corp. * The tax consequences of life insurance SDAs were explored in TAM 9604001, which held that the employee whose life was insured had to recognize income each year the SDA was in effect. * Under the HIPAA, COBRA continuation coverage can be terminated on the date a beneficiary first becomes covered by another health plan, as long as said plan has no preexisting condition limitation or exclusion that applies to the beneficiary.

(14) See the discussion under "Elective Retroactivity" for the conditions that must be met for the consolidated group to apply the 1996 TRs retroactively. If a group has consistently used the 1991 PRs in determining its SRLY limit, apparently, it may now choose to revert to use of the existing regulations, although the 1996 TRs do not so state; see also notes 3 and 12. (22) Boyd Gaming Corp., 106 TC 343 (1996). (23) S. Rep. No. 99-313, 99th Cong., 1st Sess. 70 (1985), 1986-3 CB (Vol. 3) 70; H. Rep. No. 99-426, 99th Cong., 1st Sess. 123 (1985), 1986-3 CB (Vol. 2) 123. (24) H. Rep. No. 99-841, 99th Cong., 2d Sess. II-24 (1986), 1986-3 CB (Vol. 4) 24. (25) S. Rep. No. 99-313, note 23, p. 71, 1986-3 CB (Vol. 3) 71; H. Rep. No. 99-426, note 23, p. 124, 198603 CB (Vol. 2) 124; H. Rep. No. 99-841, note 24, p. II-25, 1986-3 CB (Vol. 4) 25. (26) IRS Letter Ruling (TAM) 9604001 (9/8/95). (27) Rev. Rul. 64-328, 1964-2 CB 11, amplified by Rev. Ruls. 66-110, 1966-1 CB 12; 67-154, 1967-1 CB 11; and 78-420, 1978-2 CB 67. (28) Rev. Rul. 66-110, id.

TAM 9604001 concluded that, each year the SDA is in force, the taxpayer must include in income (1) the one-year term cost of declining life insurance and (2) any cash surrender build-up in the policies that exceeds the amount returnable to Subsidiary when the SDA is discontinued. The TAM left to the District Director the issue of the value of the amount includible in income; however, in addressing this question of fact, the following considerations are to apply: the rates used must be (1) those of the same insurer and not those of a parent or brother/sister corporation in the same related group of corporations and (2) for one-year term insurance available for all standard risks.

The TAM also concluded that the taxpayer made a gift (subject to gift tax) to Trust each year of the amount included in his income under the SDAs with Subsidiary.

Practitioners have speculated for some time as to the proper income tax treatment of equity SDAs. TAM 9604001 indicates the IRS will treat them as creating taxable income for the employee-corporate officer, a ground-breaking ruling that may have negative implications for all life insurance SDAs. Although TAM 9604001 involves single-premium policies, a controlling shareholder executive, and trust-owned policies under collateral assignment to the corporation, the ripple effect may go beyond this narrow set of circumstances. The serious income and gift tax consequences must be analyzed.

Frequent-Flier Miles

Letter Ruling (TAM) 954700129 explored the IRS's long-threatened position on frequent-flier miles. In the TAM, the IRS examined an employer's business expense reimbursement program for business travel, including air travel. The Air Travel Allowance and Reimbursement Arrangement required return of excess amounts, including any finds received by an employee denied boarding on an overbooked flight. The arrangement did not require an employee to turn in or otherwise account for frequent-flier miles earned on business trips. Because there was no accounting for such mileage, the TAM deemed the arrangement a "nonaccountable" plan.

Under Sec. 62, an employee is not taxed on amounts reimbursed by the employer for business travel expenses if the employer reimburses only the actual expenses and requires substantiation and return of amounts in excess of substantiated expenses. Such arrangements are "accountable" plans, the rules for which are set out in Regs. Sec. 1.62-2. If an arrangement fails to meet any of the requirements, amounts paid are treated as paid under a nonaccountable plan.

According to the TAM, the employer's arrangement allowed employees to retain mileage and awards accumulated on business travel. Mileage accrued toward awards constitutes a rebate in consideration of flying on a particular airline; a rebate is a purchase price adjustment that reduces the purchaser's cost of the property acquired. Such purchase price adjustments constitute mounts in excess of the substantiated expenses covered under the arrangement; accordingly, the arrangement's failure to require the return of such excess means that the arrangement is a "nonaccountable" plan under Regs. Sec. 1.62-2(c)(3)(i).

The TAM stated in footnote 4 that the IRS has suggested several acceptable alternatives for the taxpayer to consider in rendering its plan "accountable." First, the employer could require all

r employees to turn in frequent-flier miles earned on business trips. Second, the employer could count the mileage awards as taxable compensation and calculate the mileage, using a set cents-per-mile formula. Third, the employer could monitor the employees' use of the mileage and count the value of tickets actually issued in taxable compensation. Each of these corrections has distinct disadvantages and requires a great deal of employer involvement.

The IRS subsequently announced that it is reconsidering the analysis in TAM 9547001, in part because it does not address the full range of regulations that potentially could be applicable to employee reimbursement plans involving frequent-flier miles. The IRS is concerned about taxpayers reading too much into the TAM, which is specific to the particular taxpayer. IRS officials have also stated that the IRS has no compliance activities geared toward frequent-flier miles, and does not anticipate any.(30)

HMO Employer Contribution Rules

The Health Care Financing Administration (HCFA) of the Department of Health and Human Services issued final regulations (effective July 1, 1996) governing employer contributions for health maintenance organization (HMO) coverage.31 These rules implement changes made to Section 1310(c) of the Public Health Service Act (PHSA) by Section 7(a)(2) of the HMO Amendments of 1988 (HMOA). Previously, equal employer contributions to HMOs and other plan were required; the HMOA changed this to a nondiscriminatory contribution standard and eliminated the requirement that employers offering health care benefits also offer an HMO option if an eligible HMO so requested.

The PHSA required certain public and private employers that offered employee health benefits plans to include the option of enrollment in qualified HMOs if such HMOs requested inclusion and their requests met specified conditions as to content and timing (the "employer mandate" provision). Part 417, Subpart E, of the HCFA rules implementing the PHSA required the employer to offer the HMO option on terms no less favorable (with respect to the employer's monetary contribution or the designee's cost) than the terms on which the other alternatives are included; an employer's contribution to the HMO had to be equal (in dollar amount) to the largest contribution made bY that employer, on behalf of a particular employee, to a non-HMO alternative included in plan offering.

The burgeoning HMO market made the employer mandate provision unnecessary; consequently, it was repealed by HMOA, effective Oct. 24, 1995. The PHSA was also amended to provide:

* If an employer offers a health benefits plan to its employ, and includes an HMO as required by the employer mandate provision, any employer contribution under the plan must "not financially discriminate" against an employee who enrolls in the HMO.

* The employer's contribution does not discriminate if the "method of determining the contribution on behalf of all employees is reasonable and is designed to assure employees a fair choice among health benefits plans."

Employers that voluntarily include HMOs after the repeal of the employer mandate provision must meet a nondiscrimination standard for contributions; the new final regulations outline this standard. The legislative history of this provision makes clear that, while Congress agreed that the current "dollar for dollar" test was consistent with prior law, it now intends to give employers greater flexibility.

HCFA Regs. Section 417.157(a)(1), Contributions for the HMO alternative, states as a general principle that:

The employer contribution to an HMO must be in an amount that does not discriminate financially against an employee who enrolls in an HMO. A contribution does not discriminate financially if the method of determining the contribution is reasonable and is designed to ensure that employees have a fair choice among health benefits plan alternatives.

HCFA Regs. Section 417.157(a)(2) provides that an employing entity or designee is not required to pay more for health benefits as a result of offering the HMO alternative than it would otherwise be required to pay under a collective bargaining agreement or contract that provides for health benefits and is in effect at the time the HMO alternative is included.

HCFA Regs. Section 417.157(a)(3)(i)-(iv) lists examples of acceptable employer contributions; the following methods are deemed nondiscriminatory:

* The employer contribution to the HMO is the same, per employee, as the contribution to non-HMO alternatives.

* The employer contribution reflects the composition of the HMO's enrollment in terms of enrollee attributes that can reasonably be used to predict utilization, experience, costs or risk. For each enrollee in a given class established on the basis of those attributes, the employer contributes an equal amount, regardless of the health benefits plan chosen by the employee.

* The employer contribution is a fixed percentage of the premium for each of the alternatives offered.

* The employer contribution is determined under a mutually acceptable arrangement negotiated by the HMO and the employer. In negotiating the arrangement, the employer may not insist on terms that would cause the HMO to violate any of the HCFA requirements.

HCFA Regs. Section 417.157(a)(4) provides that an employer contribution determined by an acceptable method may in some cases be adjusted if it would result in a nominal (or no) payment by HMO enrollees because the HMO premium is lower than the premiums for the other alternatives offered). If, for example, the employer has a policy of requiring all employees to contribute to their health benefits plan, the employer may require HMO enrollees who would otherwise pay little (or nothing) to make a payment that does not exceed 50% of the employee contribution to the principal non-HMO alternative. The principal non-HMO alternative is the one that covers the largest number of enrollees from the particular employer.

In addition, adjustments may be made for certain other benefits provided as part of the HMO or other plans. The employer must retain data sufficient for the HCFA to examine and determine the accuracy and lawfulness of the employer's contribution for HMO benefits.

Health Care Discounts

In McConocha v. Blue Cross and Blue Shield of Ohio,(32) a district court ruled that Blue Cross and Blue Shield of Ohio (BCBSO) violated Employee Retirement Income Security Act of 1974 (ERISA) fiduciary obligations by not passing on to plan participants secretly negotiated volume discounts. At issue was whether an insured's co-payment should be based on the health care provider's standard charges or on the actual discounted price negotiated by BCBSO with the provider. Presumably, the same issue arises in employers' self-insured plans; but in self-insured plans, it may be even more complicated by possible violations of prohibited transaction rules.

In McConocha, Jeffrey McConocha, president and 80% shareholder of ISDN, purchased group health insurance from BCBSO for himself and ISDN employees. McConocha and other employees received an explanation of benefits (EOB) from BCBSO after they received hospital services that stated that the employees were responsible for 20% of the hospitals' charges. The employees' obligations stemmed from the schedule of benefits included in the certificate of insurance, under which BCBSO agreed to pay "80% of the provider's reasonable charge" and the beneficiaries were to pay the remaining 20%.

However, BCBSO negotiated with area hospitals to pay less than 800/o of the billed hospital charges in full satisfaction of an insured's bill. Thus, an insured paid more than 20% of the total amount the hospital actually received.

The ISDN employees sued BCBSO under ERISA Sections 1132(a)(1)(b) and 1106(b), claiming that (1) BCBSO was liable them for the difference between the co-payment actually made (i.e., 20% of the total bill) and 20% of the actual charges and (2) BCBSO breached its fiduciary duties by failing to disclose the discounts and by using the discount scheme for its own benefit at the expense of plan participants. The district court granted summary judgment in favor of the employees on all counts.

BCBSO argued that the insurance certificate's language allowed it to negotiate discounts without disclosing them to insureds. BCBSO asserted that the co-payment, as provided in the certificate, could only be interpreted as being based on the provider's actual bill and that the provider's reasonable charges do not include any agreed-on discount. The employees countered that the certificate bound them to pay only 20% of the actual hospital charges. Although the court recognized that both interpretations were equally plausible, it found the provision ambiguous and requiring application of contract construction rules.

The court stated first that the contract should be construed against the drafter under the doctrine of contra proferentum. The doctrine of construing insurance contracts against their drafters arises out of a concern for fairness, particularly in night of the disparity of expertise and resources between insurers and insureds. Under this doctrine, the court held that BCBSO was required to pay 80% of the total amount received by the hospital, and that the claimants' obligation was 20% of that amount.

Second, the court ruled that the insureds should prevail under the doctrine of reasonable expectation of coverage, which provides that limitation on m insurance company's liability should be set forth clearly enough for nonlawyers to understand. Applying this doctrine, the court determined that the insureds had no reason to know from the certificate or EOBs that BCBSO paid less than 80% of the hospital charges. The insureds had no way of knowing that the charge reflected on the EOBs overstated the amount that the hospitals would receive. The court stated that the only expectation the insureds could have had was that they would pay no more than 20% of the amount actually to be received by the hospital.

The court also decided that the discounting scheme did not conform to the language of the agreements between BCBSO md the insureds. The contract language implied that there was a single list of charges that applied to all payors (including insureds and insurers), but there was no such list once a discount had been applied. The court thus ordered BCBSO to refund the co-payment differential.

The court further found that BCBSO, as an ERISA fiduciary, had breached a duty not to misinform plan participants about the actual percentage of their co-payments, by not disclosing the discounting scheme. The court also ruled that BCBSO violated ERISA Section 404(a)(1), which requires a fiduciary to act solely in the interests of participants and beneficiaries. In addition to causing the employees to pay a greater percentage of their hospital bills than they had anticipated, the nondisclosure reduced the plan sponsor's ability to make an informed decision whether to insure with BCBSO or to contract with another insurer. The court noted that the nondisclosure protected the insurer's market position at the expense of the insureds. To the extent BCBSO lowered its premiums not only by paying less, but also by paying a smaller percentage, it enhanced its ability to compete with other insurers.

McConocha did not address the Eleventh Circuit's decision in Hoover v. Blue Cross and Blue Shield of Alabama.(33) Hoover involved similar facts, except that the employer, USX, also a defendant, had drafted the plan. The Eleventh Circuit stated that under ERISA, a fiduciary's actions must be sustained as a matter of law unless a claimant can prove that such actions were arbitrary and capricious. USX asserted that the plan was written so that participants were responsible for 20% of the charges and USX was responsible for the balance. Hoover offered no evidence rebutting the defendant's position; thus, the court ruled that the practice of obtaining discounts was reasonable as a matter of law. The outcome in Hoover might have been different had the plaintiff offered evidence similar to that offered in McConocha.

The McConocha case raises difficult issues. Employers with insured plans may want to discuss with their insurers the treatment of discounts and suggest sharing them with insureds. Self-insured employers that have negotiated discounts should consider that employees may question whether their co-payment is based on the provider's bill or the actual discounted charges. According to Hoover, employers have the right to design their plans to provide that employee co-payments reflect standard fees. Employers who have designed their plans in this manner should examine their plan documents, summary plan descriptions and other employee communications to ensure that these documents reflect that fact. Also, for self-insured plans containing plan assets, potential prohibited transaction issues could arise if plan documents state that employees are responsible for a percentage of the providers' actual (i.e., discounted) charges, but in fact, employees are paying a percentage of the provider's standard fees.

COBRA Continuation Coverage

Section 421(c) of the Health Insurance Portability and Accountability Act of 1996 (HIPAA) amends Sec. 4980b(f)(2)(b)(iv)(I), effective Jan. 1, 1997, to provide that Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) continuation coverage (CCC) can be terminated on the date a beneficiary "first becomes covered by another health plan," provided said plan has no preexisting condition limitation or exclusion (other than a limitation or exclusion that does not apply to (or is satisfied by) the beneficiary). Three circuits have previously addressed whether the employer has to offer CCC at aR if, at the time of the CCC qualifying event, the employee was covered by a spouse's plan.

Typically, a former (or soon to be former) employee is a qualified beneficiary, and a qualifying event has occurred (or is about to occur) that entitles him to CCC. Sec. 4980B(f)(2)(B) enumerates the events that permit CCC to be terminated. Post-HIPAA Sec. 4980b(f)(2)(b)(iv) provides that CCC can terminate on the date the qualified beneficiary first becomes, after the date of election, "covered under any other group health plan (as m employee or otherwise)...."

While the "first becomes, after the date of the election" language appears to be straightforward - that the coverage sufficient to terminate or deny CCC is new coverage first available to the qualified beneficiary after the qualifying event - three circuits have differed on the issue.

In Oakley v. Longmont,(34) the Tenth Circuit held that CCC had to be offered to a terminated employee, even though he was covered under his spouse's health plan at the time of termination. According to the court, the Sec. 4980b(f)(2)(b)(iv) requirement that CCC ends when a qualified beneficiary first becomes "covered under any other group health plan (as an employee or otherwise)..." only applies to subsequent events related to the employee's own employment or marital status and not to the then-existing coverage of the employee's spouse.

On the other hand, both the Fifth Circuit in Brock v. Primedica(35) and the Eleventh Circuit in National Cos. Health Benefits Plan v. St. Joseph's Hospital, Inc.,(36) held that CCC can terminate when, at the time of the qualifying event, the employee was covered under his spouse's health plan. However, each decision also provides that the preexisting spousal coverage must not create a "significant gap" in coverage as compared with the CCC. The intent of the CCC rides is to ensure that there are no significant gaps in an individual's health coverage. If there is preexisting coverage, the terminating event is simultaneous with the election of CCC, since there is no gap in coverage.

The problem with the standard created by Brock and National Cos. is that it requires the employer to examine and evaluate every spouse's (and domestic partner's) plan for significant gaps in coverage when a qualified beneficiary also covered under the other plan requests CCC. For example, if the CCC available to the qualified beneficiary offers a low deductible and little (or no) co-payments and the other coverage has a high deductible and co-payments, there may be a "significant gap" in coverage.(37) Of course, if the other cover age limits or excludes preexisting conditions, and the qualified beneficiary has not yet fulfilled the rules for preexisting condition coverage, Sec. 4980B(f)(2)(b)(iv)(I) clearly requires that CCC not terminate. Because most employers do not deny medical coverage to current employees simply because they are covered under another plan, denying cover to a CCC-qualified beneficiary would appear to violate Sec. 4980B(f)(2)(A). This point was not addressed by any of the three cases. Prudent business planning would indicate offering CCC even if the employee is covered by another plan at the time of the qualifying event.

Medical Coverage for

Terminated/Retired Employees

Defining "Employee"

In Letter Ruling 9612008,(38) the IRS ruled that terminated employees are "employees" for purposes of Secs. 105 and 106 when the former employer's plan pays for 12 months of medical coverage under COBRA. The employer's contributions for medical coverage for such employees and their dependents is excludible from income under Sec. 106. The IRS refused to opine in the ruling on whether the benefits received under the medical plan would be excludible under Sec. 105(b) or whether the plan satisfied the Sec. 105(h) nondiscrimination rules.

The IRS's analysis began with Rev. Rul. 82-196,(39) which held that employer contributions to an accident or health plan that provides (1) coverage for m employee and his spouse and dependents before and after his retirement and (2) benefits for a deceased employee's surviving spouse and dependents, are excludible from the employee's and survivor's gross incomes under Sec. 106. Rev. Rul. 82-196 also provides that the taxation of health benefits paid to survivors of a deceased employee-participant in such a plan is determined under Sec. 105. In effect, the ruling considers an employee-participant in an employer-funded accident or health plan to continue to be an "employee" for Secs. 105 and 106 purposes, even after the nation of employment. Letter Ruling 9612008 also refers to Rev. Ruls. 62-199(40) and 75-539,(41) Which held that an employer's contributions to an accident and health plan that provides benefits for a retired employee are excludible from his gross income.

The ruling then discusses Rev. Rul. 85-121,(42) in which an employee was temporarily laid off. During the layoff, the employer made contributions to its accident and health plan on behalf of the laid off worker and the worker received health benefit payments from the plan. That ruling states that (as in the of retired or deceased employees) the employer's plan contributions on behalf of the laid-off worker were based solely on the employment relationship; thus, the laid-off worker's treatment should be the same as that of the retired or deceased employee in Rev. Rul. 82-196. Accordingly, Rev. Rul. 85-121 held that, during the period of layoff, the laid-off worker was an "employee" for Secs. 105 and 106 purposes.

In Letter Ruling 9612008, the IRS concluded that the employer's contributions under the severance plan for medical coverage for terminated employees was related solely to and based solely on the terminated employee's prior employment relationship with the employer. Thus, the basis for the payments is the same as the basis for the payments on behalf of the laid-off employee in Rev. Rul. 85-121 and on behalf of the retired or deceased employee in Rev. Rul. 82-196.

State-required Contributions

The IRS also ruled on the status of employee and employer state-required contributions to fund retiree medical benefits. Letter Ruling 9625012(43) held that if an employee's required contribution is deducted from his after-tax salary on his paycheck, the employee's contribution is taxable; but if the employer "grosses up" the employee's salary for the required contribution and then deducts the identical amount from his after-tax salary, the deducted amount is an employer contribution excludible from gross income under Sec. 106.

In the ruling, a state law required a participant to contribute 0.005 of his salary to the state-operated retiree health benefit fund. The contributions are deducted by the employer and paid into the fund; alternatively, an employer can agree to pay the required employee contributions.

Taxpayer A's contribution to the fund was deducted from A's after-tax salary on each paycheck, while Taxpayer B's employer "grossed up" B's salary by the amount of the contribution, then deducted the identical amount from B's after-tax salary and contributed that amount to the fund. The issue was whether amounts contributed to the fund for A and B were includible in their gross incomes.

The IRS's analysis noted Secs. 105 and 106; the Service then cited Rev. Rul. 72-191,(44) in which state-required employee contributions to a nonoccupational disability plan were paid by the employer. That ruling concluded that because the employer voluntary assumed and paid the employees' portion of contributions, those contributions were employer contributions excludible from the covered employees' gross incomes under Sec. 106.

Letter Ruling 9625012 also cites Rev. Rul. 61-146,(45) which held that an employer's reimbursement for medical coverage purchased by an employee outside the employer's plan or through an employer check directly to the employee's insurance company was excludible under Sec. 106.

VEBAs

Letter Ruling 9622001

The IRS concluded in Letter Ruling (TAM) 9622001(46) that Sec. 419 governed a corporation's timing of deductions for contributions made to a voluntary employees' beneficiary association VEBA) to fund vacation pay benefits. The contributions were ruled to be deductible for the tax year in which paid to the VEBA. The IRS rejected the taxpayer's argument that it could deduct contributions accrued in a particular tax year as long as they were made within 2 1/2 months of the close of that year.

In the ruling, in January 1990, the taxpayer, an accrual-basis, calendar-year corporation, made payments into Trust I, representing earned and vested vacation pay of hourly employees as of Dec. 31, 1989, to be paid in 1990 as employees took vacation. In February 1990, the taxpayer made payments into Trust II, representing the same thing. Each trust received a determination letter confirming its status as a VEBA under Sec. 501 (c) (9). The taxpayer deducted the payments made into the two trusts on its 1989 return. The IRS disallowed the deduction for 1989 (the year of accrual), but allowed it in 1990 (the year of payment).

Sec. 419(a) provides that otherwise deductible contributions paid or accrued by an employer to a "welfare benefit fund" are deductible (subject to the Sec. 419(b) limit) for the tax year in which paid. Under Sec. 419(e)(1), a "welfare benefit fund" is any fund part of an employer plan, through which the employer provides welfare benefits to employees or their beneficiaries. Sec 419(e)(2) defines "welfare benefits" as any benefit other than a benefit with respect to which Sec. 83(h), 404 determined without regard to Sec. 404(b)(2)) or 404A applies. Sec. 419(e)(3)(A) provides that an organization described in Sec. 501(c)(9) (i.e., a VEBA) is a "fund"

The IRS thus determined that the trusts were welfare benefit funds under Sec. 419(e). First, the trusts were "funds" under Sec. 419(e)(3)(A) because they were VEBAs. Second, the vacation pay benefits provided through the trusts were welfare benefits under Sec. 419(e)(2). Applying Sec. 419, the IRS concluded that the contributions made in January and February 1990 to the trusts were not deductible in 1989, because they were not paid to the trusts that year; rather, the contributions were deductible in 1990, the tax year in which paid. Moreover, the taxpayer's 1990 deduction under Sec. 419 for amounts contributed to the trusts was limited to the "qualified cost" for 1990. Under Sec. 419(c)(3), the qualified cost for 1990 includes only amounts that would have been allowable as a deduction to the taxpayer for benefits provided during 1990, if such benefits were provided directly by a cash-method taxpayer.

The taxpayer argued that the legislative history to Section 10201(b)(4) of the Revenue Act of 1987s (RA '87) repeal of Sec. 463 and amendment of Sec. 404(a)(5) supported the view that Sec. 419 does not apply to VEBA contributions to fund vacation pay; rather, the timing of the deduction for such contributions should be governed by the 21/2-month rule in Temp. Regs. Sec. 1.404(b)-1t The IRS responded that the argument that Sec. 419 does not apply to VEBA contributions to fund vacation pay is not supported by Sec. 419. Prior to its repeal by the RA '87, Sec. 463 had provided that an actual-basis employer could elect to deduct vacation pay for pre-1987 tax years if paid in the year for which the deduction was sought or within 8 1/2 months after the close of that year. Before the RA '87 amendments, Sec. 419(e)(2)(D) had provided an exception to the application of Sec. 419 for benefits to which an election under Sec. 463 applied. According to the IRS, the only amendment the RA '87 made to Sec. 419 removed the exception previously contained in Sec. 419(e)(2)(D). The IRS concluded that, in the absence of such exception, Sec. 419 governs the timing of deductions for contributions to a welfare benefit fund (e.g., Trust I or Trust II) to fund vacation pay benefits such as those provided to the taxpayer's employees.

Connecticut Mutual

In a second V-EBA deduction case, Connecticut Mutual Life Insurance Co.,(47) the Tax Court ruled that an employer's $20 million 1985 contribution to a VEBA was a capital expenditure, not a current business expense; thus, the employer could not deduct the entire amount in the year contributed, even though the contribution predated the enactment of the Secs. 419 and 419A deduction limits for payments to welfare benefit plans.

Although the case is now mostly of historical value, it indicates that, even before enactment of the Secs. 419 and 419A deduction limits, employers did not have an unrestricted ability to prefund welfare benefits and deduct them currently.

Connecticut Mutual was a calendar-year, actual-basis, mutual life insurance company. For 150 years, the company had provided its employees an annual fixed number of paid holidays, and had funded the holiday pay on a "pay-as-you-go" basis. In 1985, the company decided to fund its holiday pay obligations through a VEBA, believing it would yield substantial tax savings and allow it to provide the benefits more efficiently. In December 1985, it created a VEBA and contributed $20 million to fund holiday pay commencing with Memorial Day 1986. The taxpayer retained the right to amend or terminate the plan and the trust; however, the plan documents barred any reversion of trust assets to the company. Between 1986 and 1994, the company's annual holiday pay expenses ranged from approximately $1.5 million to $2.3 million. The original $20 million contribution produced earnings sufficient to cover over 800% of the expenses.

The taxpayer deducted the $20 million contribution on its 1985 tax return under Sec. 162; the IRS denied the deduction, contending that the contribution was a nondeductible capital expenditure.

The Tax Court's analysis began with the Supreme Court's opinion in INDOPCO, Inc.,(48) which states that capitalization is required when an expenditure provides the taxpayer with significant benefits beyond the year incurred. Here, through its $20 million VEBA contribution, Connecticut Mutual effectively prefunded a substantial portion of its anticipated holiday pay obligations for many future years.

The taxpayer nevertheless argued, citing Moser(49) and Schneider,(50) that its contribution was currently deductible because the employees, not the company, had benefited from the VEBA, and that any future benefit to the company, had merely incidental. In both Moser and Schneider, the Tax Court had held that the funded benefits provided the employer with only incidental or indirect future benefits that did not have to be capitalized prior to the enactment of Secs. 419 and 419A. The court noted that, prior to the enactment of Secs. 419 and 419A, it had analyzed the deductibility of employer contributions to a welfare benefit plan by taking into consideration, among other things the degree (1) of control the employer maintained over the plan and (2) to which employees benefited.

The court also noted that it had concluded in both Moser and Schneider that an employer does not retain too much control over plan funds merely because it retains the right to amend or terminate the plan, as long as the plan funds cannot revert to the employer. Although Connecticut Mutual retained the right to amend or terminate the VEBA, the reversion of VEBA assets was prohibited in the plan documents; thus, its control over the plan was not excessive.

However, the Tax Court concluded that Moser and Schneider were distinguishable from the present case on the basis of the nature of the benefits funded, and their permanence and extent. The plans in Moser and Schneider funded death, disability and severance benefits, benefits that were payable on the occurrence of an event that would terminate an employee's services. In such plans, the employer's only benefit is the expectation that employees are more likely to remain loyal. Moreover, the employees in those cases generally had a vested right to severance, disability or death benefits at the time the employer made the contribution. On the occurrence of a qualifying event, the employee would be entitled to benefits even if he was no longer providing services to the employer.

In contrast, Connecticut Mutual's VEBA was a medium for funding obligations contingent on the future performance of services. The right to holiday pay did not vest unless an employee was employed on the working days immediately preceding and following the holiday. Thus, the prefunding of the holiday pay obligation was "inextricably linked" to acquiring the future benefits Connecticut Mutual would reap from its employees' services in subsequent years.

Finally, in both Moser and Schneider, the court found that the employer's contribution was based on the amount necessary to fund the plans' benefits for one year. Connecticut Mutual's contribution, on the other hand, was not calculated to fund benefits for a specific period; rather, it established the VEBA to prefund holiday pay for many years, and the future benefits from such prefunding were far from incidental.

(29) IRS Letter Ruling (TAM) 9547001 (7/11/95). (30) See "IRS Says Frequent Flier Miles Ruling Not New Policy. But Practitioners Worried," BNA Daily Tax Report (11/25/95), p. G-4. (31) 61 Fed. Reg. 27282 (5/31/96). (32) Jeffrey McComocha v. Blue Cross and Blue Shield of Ohio, 898 F Supp 545 (N.D. Ohio 1995). (33) James W. Hoover v. Blue Cross and Blue Shield of Alabama, 855 F2d 1538 (11th Cir. 1988). (34) Oakley v. Longmont, 890 F2d 1128 (10th Cir. 1989), cert. denied. (35) Brock v. Primedica, 904 F2d 295 (5th Cir. 1990). (36) National Cos. Health Benefits Plan v. St. Joseph's Hospital, 929 F2d 1558 (11th Cir. 1991). (37) For cases discussing "significant gap," see e.g., Daniel v. Master Health Plan, 864 F Supp 1399 (S.D. Ga. 1994), Liberty Life Assurance Co. v. Toys "R" Us, 901 F Supp 556 (E.D. NY 1995), McGee v. Funderburg, 17 F3d 1122 (8th Cir. 1994), and Geissal v. Moore Medical Corp., E.D. Mo., 1996. (36) IRS Letter Ruling 9612008 (12/18/95). (39) Rev. Rul. 82-196, 1982-2 CB 53. (40) Rev. Rul. 62-199, 1962-2 CB 38. (41) Rev. Rul. 75-539, 1975-2 CB 45. (42) Rev. Rul. 85-121, 1985-2 CB 56. (43) IRS Letter Ruling 962501 (no date given). (44) Rev. Rul. 72-191, 1972-2 CB 45. (45) Rev. Rul. 61-146, 1961-2 CB 25. (46) IRS Letter Ruling (TAM) 9642001 (12/20/95). (47) Connecticut Mutual Life Insurance Co., 106 TC 445 (1996). (48) INDOPCO, Inc., 503 US 79 (1992)(69 AFTR2d 92-694, 92,-1 USTC [paragraph]50,113). (49) Wade L. Moser, TC Memo 1989-142. (50) Joel A. Schneider, M.D., S.C., TC Memo 1992-24.