Current developments.

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 II focuses on general developments in executive compensation, health and welfare plans and fringe 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, in the last issue, addressed general developments in retirement plan qualification requirements and employee stock ownership plans. Part II, below, focuses on general developments in executive compensation, health and welfare plans and fringe benefits.

Executive Compensation

Sec. 1032 Final Regs.

The IRS issued final regulations(32) on the purchase and sale of stock and other property between a corporation and its corporate shareholder (e.g., a parent). Although they have broader corporate tax implications, the regulations affect the treatment of stock and options when the company issuing them is not the one using them for compensatory purposes (e.g., a parent's issuance of stock or options to subsidiary employees). The tax treatment remains unchanged for a company issuing stock or options to its own employees.

Regs. Sec. 1.83-6(b) provides that, except as provided in Sec. 1032, when property is transferred for the performance of services, the transferor recognizes gain to the extent he received an amount in excess of his basis in the property. Regs. Sec. 1.83-6(d) provides that if a shareholder transferred stock to employees, the transfer is treated as a corporate contribution of capital by the shareholder. Any amount paid to the shareholder for the stock is deemed paid to the company and transferred from it to the shareholder as a distribution. The owner's basis in the shares is transferred with the stock to the company.

Regulations: Regs. Sec. 1.1032-3 is substantially similar to the proposed regulations, but modifications were made in response to comments. The regulations provide a special rule if (1) a subsidiary is obtaining parent stock, (2) it intends to transfer the stock immediately to acquire money or property and (3) no one receiving the stock from the subsidiary will take a substituted basis.

If these conditions are met, the parent is treated as having made a capital contribution to the subsidiary of cash equal to the shares' fair market value (FMV); the subsidiary is treated as having purchased the shares at FMV immediately before they are transferred to the employee. The subsidiary then has a basis equal to the FMV of the shares transferred and is unlikely to have gain or loss on the transfer.

For Sec. 1032 purposes, "money or other property" is defined to include services rendered. Thus, if the company transfers shares to an employee as part of a compensation plan, Regs. Sec. 1.1032-3 considers this a disposition of shares for money or property.

Example: X Corp., a parent, transfers 100 shares of stock to Y Corp., its subsidiary; Y immediately gives 10 of its employees 10 shares each. The FMV of each share is $5. X is deemed to have made a $500 capital contribution to Y; Y is treated as buying the shares from X for $500. Thus, Y recognizes no gain or loss on the transfer of shares to its employees.

Stock received by an acquiring corporation must be immediately transferred to acquire money or other property. The regulations apply to rabbi trust arrangements only if the immediacy requirement is met, not if the issuing corporation's stock is treated as owned for a period by a subsidiary.

Previous rulings have stated that a rabbi trust must be subject to the subsidiary's general creditors.(33) Questions arose as to whether the subsidiary would be the trust grantor, failing the immediacy requirement. The IRS and Treasury determined that subjecting the trust assets to the subsidiary's creditors' claims does not make the subsidiary the trust grantor; thus, the immediacy requirement may still be met. Further, the IRS will not challenge a taxpayer's position that no gain is recognized by an acquiring corporation on the disposition by a rabbi mast, established before June 16, 2000, of issuing corporation stock, if such stock was contributed by the issuing corporation to the trust before May 17, 2001. The IRS is planning to release further guidance on rabbi trust issues.

The final regulations do not apply when options without a readily ascertainable FMV are granted to employees. If the regulations are met when the options are exercised, they apply at that time to determine the issuing and acquiring corporations' treatment.

In an area especially important to corporations with foreign subsidiaries, the regulations address instances in which an acquiring corporation makes an actual payment to the issuing corporation for stock. The final regulations provide that the cash deemed contributed by the issuing corporation to the acquiring corporation equals the difference between the issuing corporation stock's FMV and the cash received by the issuing corporation as payment from the employee.

Example:(34) X Corp. owns all of the outstanding stock of Y Corp. B, an individual, is a Y employee. To compensate B for services provided, Y offers him the chance to purchase 10 shares of X stock (with a $100 FMV) for $80. B transfers $80; Y transfers $10 to X as partial payment for the X stock.

No gain or loss is recognized on the deemed disposition of the X stock by Y. Immediately before Y's deemed disposition of the X stock, Y is treated as having purchased the X stock from X for $100 ($80 of which Y is deemed to have received from B, $10 of which originated with Y and $10 of which is deemed to have been contributed to Y by X). Under Sec. 358, X's basis in its Y stock is increased by $10.

The final regulations have been expanded to apply to partnership transactions. Regs. Sec. 1.1032-3(a) treats an acquiring partnership's disposition of an issuing corporation's stock in the same manner as an acquiring corporation's disposition of stock. Further, Regs. Sec. 1.1032-3(b) applies when an issuing corporation's stock is obtained indirectly by the acquiring entity (through either a Sec. 721 or 351 exchange).

The regulations also apply to a corporate Shareholder's transfer of its own stock to any person in consideration of services performed for another entity, if the conditions are met. Regs. Sec. 1.1032-3 applies instead of Regs. Sec. 1.83-6(d) in such cases.

The preamble provides that Rev. Rul. 80-76(35) is obsoleted by the final regulations. In that ruling, a majority shareholder transferred parent stock to a subsidiary's employee as compensation. This type of stock transfer is now addressed in the regulations, which do not require that the transferring corporation be a majority shareholder.

The final regulations apply prospectively, but the IRS will not challenge a position taken in a prior period if consistent with the final rules.

Foreign Corp's U.S. Subsidiary Not Subject to $1 Million Deduction Cap

In Letter Ruling 200021050,(36) the IRS ruled that compensation paid to top executives of a foreign corporation's U.S. subsidiary was not subject to the Sec. 162(m) $1 million deduction limit, because the parent is not required to file a summary compensation table with the Securities and Exchange Commission (SEC).

In the ruling, A is a U.S. corporation and an indirect subsidiary of B. A is the U.S. parent of numerous U.S. businesses and is the highest employer in B's U.S. corporate chain. Each of B's U.S. subsidiaries is a member of B's affiliated group (under Sec. 1504, without regard to Sec. 1504(b)). A and its U.S. subsidiaries pay U.S. taxes and deduct compensation paid to their highest-paid employees. B's common stock is publicly traded. Under the Securities and Exchange Act of 1934 (Exchange Act), B is considered to be a "foreign private issuer" and, thus, is not required by the SEC to file any documentation listing a summary executive compensation table (as described in Item 402(b) of SEC Regularion S-K).

Law: Sec. 162(a)(1) allows a deduction for all ordinary and necessary expenses paid or incurred in the tax year in carrying on a trade or business, including a reasonable allowance for salaries and other compensation for personal services actually rendered. Sec. 162(m) (1) provides that publicly held companies cannot deduct more than $1 million for applicable employee remuneration for a covered employee. Sec. 162(m)(2) defines "publicly held corporation" as any corporation issuing any class of common equity securities required to be registered under Exchange Act Section 12.

"Covered employee" is defined by Sec. 162(m)(3) as any employee of the corporation if, as of the close of the tax year, such employee is the company's chief executive officer (CEO) or is acting in that capacity, or the employee's total compensation for the year is required to be reported to shareholders, because the employee is among the four highest-paid officers (other than the CEO).

The definition of CEO under Regs. Sec. 1.162-27(c)(2)(ii) is determined by the Exchange Act's executive compensation disclosure rules. The preamble to the Sec. 162(m) proposed regulations states that the legislative history provides that covered employees are defined by reference to the SEC rules. The regulations generally consider an individual to be a covered employee if he is reported on the SEC summary compensation table.

Analysis: The IRS determined that, assuming neither A nor B is required to file an SEC summary compensation table, employees of A's or B's affiliated service group are not covered employees under Sec. 162(m)(3); their compensation is not required to be reported to shareholders under the Exchange Act. Thus, A and its U.S. subsidiaries are not subject to the Sec. 162(m)(1) disallowance rule and can fully deduct CEO compensation in excess of $1 million.

Compensation Plan Was Performance-Based, Despite Immediate Vesting

In Letter Ruling 9949014,(37) the IRS concluded that compensation paid under a performance-based stock award plan was deductible under Sec. 162(m), even though the plan immediately vested executives (1) terminated without cause or (2) terminating for "good reason"

A company maintained a compensation program for its executives (some of whom are covered employees for Sec. 162(m) purposes), consisting of grants of restricted stock. The restricted stock will vest if the employee is still employed on a certain date and if performance targets (e.g., earnings per share, net operating profit, after-tax profit, return on equity or return on invested capital) are met. Vesting also occurred on a change of control, death or disability, or if the executive is terminated without cause or leaves for good reason.

The company defines both "without cause" and "good reason." "Good reason" means the occurrence of any of the following, without the executive's express written consent: (1) assignment of duties materially inconsistent with the executive's current authorities, duties, responsibilities and status; any reduction in rifle, position or reporting lines; or a material reduction in status, authorities, duties or responsibilities; (2) relocation from the company's principal office or relocation of the company's principal office; (3) reduction in base salary; (4) reduction in the overall level of executive participation in company incentive, benefit or retirement plans; (5) failure of the company to obtain assumption of the executive's employment agreement from a successor company; or (6) any other material breach of employment by the company.

In general, employee remuneration in excess of $1 million for the CEO or the four other highest-paid officers of a publicly held corporation is not deductible under Sec. 162(m). "Remuneration" includes benefits (as well as cash), but does not include payments to a qualified retirement plan. However, the Sec. 162(m) limit does not apply to (1) commissions based solely on an individual's performance or (2) performance-based compensation. For compensation to be considered performance-based, the company's performance goals must be determined by a compensation committee of the board of directors comprised solely of two or more outside directors, the material terms of the arrangement must be disclosed to shareholders and approved by a majority vote before payment and the committee of outside directors must certify before payment that the performance goals have been met.

Regs. Sec. 1.162-27(e)(2)(v) states that the facts and circumstances cannot indicate that the employee would receive all or part of the compensation, regardless of whether the performance goal is attained. If the payment is only nominally or partially contingent on meeting the performance goal, none of the compensation paid under the grant will be considered performance-based for Sec. 162(m) purposes. However, compensation does not fail to be performance-based just because it becomes vested on death, disability or a change of control.

Conclusion: The IRS ruled that, because termination by the company without cause or by an executive with good reason are both involuntary terminations similar to terminations as a result of death, disability or a change of control, the compensation will continue to be performance-based for Sec. 162(m) purposes, and deductible.

Seventh Circuit Analyzes "Reasonable" Compensation

In Exacto Spring Corp.,(38) the Seventh Circuit ruled in favor of a closely held corporation's deduction for compensation paid to an executive, rejecting the Tax Court's seven-factor reasonableness test.

Merger Not Ownership Change Under Sec. 280G

In Letter Ruling 9943032,(39) the IRS ruled that a merger of two corporations would not result in a change of ownership or effective control of the acquiring company that would trigger the Sec. 280G golden parachute rules.

Acquirer and Target are both widely held, publicly traded corporations. According to the merger agreement, Acquirer's wholly owned subsidiary would merge with and into Target and cease to have a separate legal existence. Target would then become Acquirer's new wholly owned subsidiary.

Directly after the merger, Acquirer shareholders will own more than 50% of the total FMV and voting power of its outstanding stock. Target shareholders will own more than 20% of the total voting power of Acquirer's outstanding stock. Additionally, Acquirer represented that no current Target shareholder will hold more than 5% of the voting power immediately after the merger and that no Target shareholder has any agreement (written or unwritten, express or implied) to act in concert to control Acquirer following the merger.

Analysis: Prop. Regs. Sec. 1.280G-1, Q&As-27 and -28, provide guidance as to when a corporation experiences a change in ownership or effective control for Sec. 280G purposes after a merger. Q&A-27(a) provides that a change in ownership or control of a corporation occurs on the date that any one person (or more than one person acting as a group) acquires ownership of stock such that, together with stock already held by such person or group, totals more than 50% of the total FMV or voting power. The IRS concluded that Acquirer would not experience a change of control, because its shareholders remain in control of over 50% of its outstanding stock.

Q&A-28 provides that a change in effective control of a corporation is presumed to occur on the date that either (1) any one person (or more than one person acting as a group) acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of 20% or more of the stock's total voting power or (2) a majority of the members of the corporation's board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation's board of directors before the appointment or election date.

This presumption is rebutted by establishing that the acquisition of stock or the replacement of directors does not transfer the power to control the corporation's management and policies from any one person or group to another. The IRS concluded that, because Target would possess more than 20% of Acquirer's voting power, it is presumed under Q&A-28 that Acquirer experienced a change in effective control. However, because Acquirer represented that Target shareholders would not act in concert to control Acquirer management or policies, the presumption was rebutted; no change of effective control had occurred.

Because there was no change in Acquiring's ownership or effective control, the Sec. 280G golden parachute rules will not apply to any payments under management agreements made by Acquirer to its employees (or former employees) contingent on the merger. (Had Sec. 280G applied, a deduction would not be allowed for excess parachute payments made contingent on the merger. Additionally, under Sec. 4999, a 20% excise tax would be imposed on the excess payment.)

SAR Deductions Under Sec. 404

In Letter Ruling 200009013,(40) the IRS discusses the deduction rules for stock appreciation rights (SARs). The ruling highlights the distinction between a short-term compensation deferral and a longer-term deferral under Sec. 404. In addition, the ruling apportions the deductions to different companies (after a change in control), depending on whether the deduction was governed by Sec. 404.

In the ruling, an S corporation had a SAR plan for several employees. The SARs vested after one year of service, but accelerated and were to be surrendered on a change in control. SARs were last awarded on June 15,1998. All SARs awarded before that date were fully vested by June 15,1998; the 1998 SARs vested on June 15,1999.

On June 30,1999, the S corporation experienced a change in control, recapitalized and became a C corporation. Thus, there were two short years: Jan. 1, 1999-June 29, 1999 (the S year) and June 30, 1999-Dec. 31, 1999 (the C year). All nonvested SARs vested and were paid out on June 29, 1999. Employees included the SAR payouts in income for the tax year ending Dec. 31,1999.

Law: Sec. 404 governs deductions for employer-maintained plans that provide for compensation deferral (assuming such compensation is otherwise deductible under Sec. 162 or 212). Sec. 404(a)(5) governs the timing of deductibility for plans that defer compensation (which, for Federal income tax purposes, may include SARs).

Temp. Regs. Sec. 1.404(b)-1T, Q&A-1, provides that if an amount is otherwise deductible, it is deductible by an employer in its tax year in which (or with which) ends the employee's tax year in which the amount attributable to the contribution is included in his taxable income.

Example: An employer's tax year ends March 31, 2000. Its deferred compensation plan makes a distribution to an employee on Feb. 28, 2000. The employer can take a deduction in its tax year ending March 31, 2001, because the employee will take the distribution into income in the tax year ending Dec. 31, 2000; the employer can take the deduction only in the tax year in which the employee's tax year ends. If, however, the employer's tax year is a calendar year, the deduction can be taken in its tax year ending Dec. 31,2000.

However, under Regs. Sec. 1.404(b)-1T, Q&A-2, an amount is deferred if an employee receives the benefit or compensation more than a brief period of time after the end of an employer's tax year in which the services creating the right to the amount were performed (generally, 2 1/2 months). Amounts received by an employee within the 2 1/2 -month period are not subject to Sec. 404. By example, a bonus or other payment earned in December 1999, but paid in February 2000, is not considered "deferred compensation" and is not governed by Sec. 404. If the amount is not deferred compensation under Sec. 404, it is generally deducted in accordance with the taxpayer's method of accounting.

Analysis: In Letter Ruling 200009013, the SARs issued on June 15, 1998 were not governed by Sec. 404(a)(5), because they had a one-year service requirement before they became exercisable. Thus, services creating the right to the amount were being performed until June 15, 1999, which occurred during the taxpayer's year ended June 29, 1999. Because these amounts were paid out within the employer's tax year in which services were rendered that gave rise to the right to payment, the IRS ruled that they were not deferred compensation. Thus, Sec. 404(a)(5) did not apply to these amounts. Instead, the amount paid for the SARs issued in 1998 was deductible to the company in the S corporation's short year ending June 29, 1999, in accordance with its method of accounting.

The SARs issued before June 15, 1998, were exercisable by that date; no services were required by employees in 1999 to benefit from them. Thus, when payment was made for these SARs on June 29, 1999, it was made more than 2V2 months after the employer's tax year in which the employees rendered services creating the right to payment. Thus, these amounts were governed by Sec. 404(a) (5). The amounts paid for these SARs were included in the employees' 1999 income. Thus, the amounts were deductible to the company in its tax year in which (or with which) ends the employees' tax year--i.e., the C corporation could take the deduction for the short year ending Dec. 31,1999.

Thus, the SAR deductions were split between the original company, and the surviving company, depending on whether the amount paid was deferred compensation.

Health and Welfare Benefits

Cafeteria Plan Final Regs.

The IRS released final and additional proposed regulations on Sec. 125 cafeteria plans.(41)

Regs. Sec. 1.125-4(c) (2)(iii) includes as a "change in status" a change in the employment status of an employee, spouse or dependent that affects an individual's eligibility under a cafeteria plan. Under Regs. Sec. 1.125-4(c)(3), a change in an employee's marital status or in a spouse's or dependent's employment status may allow an increase or decrease in group-term life insurance.

Under Prop. Regs. Sec. 1.125-4(f), an employee can make changes in elections due to cost and coverage changes, including (1) the addition or elimination of a new benefit package option, (2) a coverage change made under a plan of the spouse's or dependent's employer and (3) a significant increase in cost of coverage. Further, a change in the number of qualifying individuals will constitute a change in status for dependent care assistance; the commencement or termination of adoption proceedings will constitute a change in status for adoption assistance purposes.

Plan Distributions Used to Purchase Cafeteria Plan Benefits

In an Industry Specialization Program (ISP) paper coordinated for all industries,(42) the IRS held that a distribution from a qualified retirement plan used to purchase accident and health coverage through a cafeteria plan is includible in income under Sec. 402(a). The distribution is not excludible under Sec. 125, which provides that cafeteria plan benefits are available on a pretax basis.

Arrangements have been marketed to allow retirees participating in a qualified retirement plan to use plan distributions to purchase accident and health coverage through a former employer's cafeteria plan. This arrangement was designed to avoid including plan distributions in income.

The industry argues that Sec. 125 was designed to provide accident and health benefits to retirees on a pretax basis, because it allows former employees to participate in the plan. Also, the industry argues that if former employees are allowed to participate in a plan, it must have been contemplated that retirement plans could be used to pay benefits.

Law and analysis: Sec. 125 provides that a cafeteria plan is a plan providing a choice between qualified benefits and cash. Benefits provided under Sec. 106 are among the qualified benefits listed in Sec. 125. Under Sec. 106, an employee can exclude from income amounts used to purchase accident and health coverage, including coverage provided through a cafeteria plan.

Under Sec. 402(a), any amount actually distributed from a qualified retirement plan is taxable to the distributee under Sec. 72, with two exceptions. Sec. 402(e)(1)(A) provides that distributions made under a qualified domestic relations order are not taxed to the participant on receipt (and are taxed to the alternative payee). Sec. 402(c) provides that eligible rollover distributions transferred to an eligible plan within 60 days of distribution are not included in income.

The IRS has addressed similar issues in two rulings. In Rev. Rul. 61-164,(43) the IRS held that, while a profit-sharing plan can purchase accident and health coverage for a participant, the purchase constitutes a distribution to the participant under Sec. 402(a). In Rev. Rul. 69-141,(44) the IRS held that distributions made by a profit-sharing plan to pay for a participant's medical expenses are taxable, not accident and health benefits excludible under Sec. 105.

In the ISP, the IRS stated that while Sec. 125 protects benefits from taxation under Sec. 61, it does not protect qualified plan distributions from taxation under Sec. 402(a). The IRS concluded that the Sec. 402(a) general rule applies; the distributions are included in a retiree's income, because Sec. 402(a) does not provide an exception for Sec. 125 benefits.

Severance Payments

A district court denied a taxpayer's request for a refund of FICA taxes withheld from a severance package he received after being terminated;(45) the lump sum constituted taxable wages subject to FICA.

James Greenwald was involuntarily terminated in 1994 after his employer, KCI, was sold and a new management team hired. He negotiated and entered into a severance agreement with KCI; under the agreement, he was to receive $2,805,583 in exchange for relinquishing all of his future salary and bonus entitlements. KCI withheld $40,680 in FICA taxes on the payment.

Greenwald filed a claim for refund of the FICA taxes, which the IRS rejected, concluding that the lump sum was taxable wages.

Analysis: Under Sec. 3101(a), FICA tax is imposed on wages an individual receives for employment. Under Sec. 3121(a), "wages" are all remuneration for employment. Under Sec. 3121(b), "employment" means any service, of whatever nature, performed by an employee for the person employing him. "Service" means "not only work actually done, but the entire employee relationship for which compensation is paid to the employee by the employer" Regs. Sec. 31.3121(a)-1(c) provides that a payment constitutes wages when given as remuneration for employment, notwithstanding the name (e.g., salary, bonus, etc.).

The government cited Rev. Rul. 75-44,(46) which held that a lump sum given to a railroad employee as consideration for relinquishing employment rights acquired through prior service constituted wages for FICA purposes. The IRS concluded that the rights the employee relinquished constituted remuneration for past services. Additionally, in Rev. Ruls. 71-408(47) and 74252,(48) the IRS concluded that a dismissal payment constituted FICA wages.

In Rev. Rul. 58-301,(49) the IRS ruled (without explanation) that a lump-sum payment a taxpayer received, canceling the remaining three years of a written employment contract, constituted income, but was not FICA wages. Greenwald argued that because the payment he received was in consideration for the release of future contractual rights, it was not subject to FICA, citing Rev. Rul. 58301 and Slotta v. Texas A &M University Systems.(50)

The court concluded that Greenwald's lump sum was wages for FICA purposes. The court reasoned that he agreed to relinquish his future salary and bonus (both clearly wages) in exchange for a lump sum; thus, the payment constituted a "substitute for wages" subject to FICA taxes. Additionally, because the severance agreement contained both confidentiality and noncompete clauses, further duties were bestowed on Greenwald, making the payment "remuneration for employment." Because of his long service to KCI, he was able to negotiate such a payment, making it a payment for service previously rendered and wages subject to FICA.

Finally, the court classified the lump sum as a dismissal payment under Rev. Ruls. 74-252 (a payment made to an employee, following his involuntary termination, that constitutes wages for FICA purposes) and 71-408 (payments made to eligible employees with five or more years of service at termination were wages for FICA purposes). Greenwald received his payment because new management was replacing him, producing a dismissal payment that constituted wages for FICA purposes.

The court found Rev. Rul. 58-301 noncontrolling, because Rev. Rul. 7544 expressly distinguished the unexplained holding in Rev. Rul. 58-301 by pointing out that lump-sum payments "for the past performance of services reflected in the employment rights [an employee] was giving up are wages, whereas the relinquishment of a purely contractual right is not." In addition, the court distinguished Slotta v. Texas A&M, stating that the school granted tenure to a professor who never worked for it; thus, the payment could not have been for services rendered. Moreover, the employment agreement between the professor and the school lacked a provision allowing for tax withholding from the settlement; in Greenwald's case, the severance agreement provided for withholding.

Disability Benefits

In Letter Ruling 200019005,(51) the IRS ruled that when employees choose to pay long-term disability premiums under an employee welfare benefit plan on an aftertax basis, any subsequent benefits received are excludible from income under Sec. 104(a)(3).

The plan provides long-term disability coverage under a group insurance policy for all eligible employees. The employer pays the cost for each employee under the current plan, but proposes to amend it so that employees can pay for such coverage on an aftertax basis. The employer would continue to pay the premiums for employees who do not elect to pay for coverage on an aftertax basis.

The election to pay insurance premiums on an aftertax basis under the amended plan would be made before the beginning of the plan year, before employee payments are made. In addition, the election would be irrevocable once the plan year begins, but could be changed in subsequent plan years.

Analysis: Generally, Sec. 104(a)(3) excludes amounts received through accident or health insurance for personal injury or sickness. However, it does not apply to the extent such amounts are attributable to (1) employer contributions not includible in an employee's income or (2) benefits paid directly by the employer.

Regs. Sec. 1.104-1(d) states that, if amounts for accident or health insurance are paid by employees on an aftertax basis, the Sec. 104(a)(3) exclusion applies. Conversely, Regs. Sec. 1.1051 (b) states that all amounts received by employees through an accident or health plan financed solely by the employer are subject to Sec. 105(a).

Sec. 105(a) provides that amounts received by an employee through accident or health insurance are included in income if attributable to employer contributions not includible in the employee's income or paid by the employer. However, Sec. 105(b) and (c) exclude from that amount reimbursements of medical expenses or amounts paid for the loss of use of a member or function of the body.

Ruling: The IRS determined that the amended plan is financed either by the employer, or by the employee on an aftertax basis. Thus, if an employee has elected to pay long-term disability,. premiums on an aftertax basis for a plan year in which he becomes disabled, the benefits will be excluded from income under Sec. 104(a)(3). However, if the employee chooses to have the employer pay the premiums for such plan year, benefits paid will be includible in the employee's income under Sec. 105(a).

Partnership's Self-Funded Health Plan Was Insurance

In Letter Ruling 200007025,(52) the IRS ruled that a self-funded health insurance plan maintained by a partnership for its partners and employees was "an arrangement having the effect of accident or health insurance." Thus, plan benefits paid to partners were excludible from their income under Sec. 104(a)(3); premium payments the partners made for plan coverage were deductible by them under Sec. 162(1), subject to limits.

Self-funded health plan: A partnership offers a group health plan to both its partners and nonpartner employees. Currently, the plan consists of a self-funded component for the eligible nonpartners and an insured component for eligible partners. More than 200 partners and 900 nonpartners participate; participants may choose either single or family coverage. The premium payments for the insured component are set by the insurer and paid by participating partners.

The partnership proposed to amend the plan to eliminate the insured component and to cover all eligible persons (including partners) under one self-funded health plan. After the amendment, eligible medical expenses will be reimbursed from a dedicated account funded with premium payments from partner and nonpartner participants and partnership contributions. The partnership will determine the premium before the beginning of each plan year, calculated by examining the past claims experience of the entire pool of plan participants, to project future claims and administration expenses.

The partnership will then charge each participant a pro rata share of the projected plan claims and administrative costs. Partners and nonpartners will be charged the same premium, depending on the type of coverage elected (i.e., single or family coverage). Premiums may vary among the various geographical locations in which the partnership maintains offices, but not for any other reason. The partnership will pay a portion of the premium on behalf of nonpartners.

All premium payments (including the portion of the nonpartner premium paid by the partnership) will be deposited into a dedicated account, from which plan administrative expenses and eligible medical expenses will be paid on behalf of all participants. If the total premium payments exceed the claims and expenses incurred for a plan year, the excess will be used to pay claims and expenses incurred in the following plan year, thus reducing premium payments for all participants in such year. If the total premium payments for a plan year are less than the year's claims and expenses, the partnership will contribute to the dedicated account to cover the shortfall. To the extent the shortfall is allocable to partners (and is not de minimis), the partnership will charge a pro rata portion of that amount to each participating partner as additional premium. The partnership will pay the portion of the shortfall allocable to nonpartners and contract with a stop-loss carrier to insure itself against catastrophic health claims.

Arrangement having effect of insurance: Before the Health Insurance Portability and Accountability Act of 1996 (HIPAA), it was uncertain whether self-employed (SE) individuals could exclude from income amounts they received under a self-insured health arrangement. SE individuals were not employees for purposes of the Sec. 105(b) exclusion; their only avenue to an exclusion was Sec. 104(a)(3). Before the HIPAA, Sec. 104(a)(3) provided that amounts received through accident or health insurance for personal injuries or sickness were excludible from income (except to the extent the amount is received by an employee and is either (1) attributable to employer contributions not includible in the employee's income or (2) paid by the employer). The uncertainty centered on the issue of whether a self-insured arrangement was "insurance."

HIPAA Section 311 resolved the issue, by amending Sec. 104(a)(3) to provide that the exclusion is available for amounts received through an arrangement having the effect of accident or health insurance, effective for tax years beginning after 1996. The Conference Report(53) states that, under this provision, payments for personal injury or sickness through an arrangement having the effect of accident or health insurance (and not merely reimbursement arrangements) are excludible from income. The HIPAA provision thus equalizes the treatment of payments under commercial insurance and other arrangements that have the effect of insurance. Under this provision, an SE individual who receives payments from such an arrangement could exclude the payments from income.

According to the IRS, an essential element of accident or health insurance is the shifting of risk. Insurance must shift the risk of economic loss from the insured and his family to the insurance program and distribute the risk of this economic loss among program participants. For this type of insurance, risk-shifting occurs when an insurer agrees to protect the insured (or a third-party beneficiary) against a direct or indirect economic loss rising from a defined contingency involving an accident or health risk. Risk-shifting occurs because the insurer assumes another's risk of economic loss in exchange for the payment of a premium by the insured or other payer.

The IRS found in Letter Ruling 200007025 that, in return for a premium payment, the risk of economic loss in the event of personal injury or sickness is shifted from a partner and his family to the plan and distributed among plan participants. Thus, the plan as amended is "an arrangement having the effect of accident or health insurance"; payments from the plan to or for the benefit of partners and their dependents will be excludible from partners' income under Sec. 104(a)(3).

Deduction: The HIPAA also increased the deduction available under Sec. 162(1)(1)(A) for SE health insurance costs. The deduction is available in the case of self-insurance, as well as commercial insurance. A self-insured plan must in fact be insurance (e.g., there must be appropriate risk-shifting), not merely a reimbursement arrangement.

Having already found that the plan, as amended, is an arrangement having the effect of accident or health insurance, the IRS concluded that premium payments made by partners for coverage under the self-funded plan will be deductible by them under Sec. 162(1), subject to that section's limits.

Use of Excess Assets in Retiree Benefit VEBA

In Letter Ruling 9952094,(54) the IRS ruled that a company may use excess assets in a voluntary employees' beneficiary association (VEBA) it established to provide its employees collectively bargained benefits, as the source for paying benefits to affiliates' employees.

A company established a VEBA to provide the payment of collectively bargained welfare benefits to its union employees; the VEBA trust is tax-exempt under Sec. 501(c)(9), and is overfunded (i.e., has more assets than needed to fund expected postretirement benefit obligations). The VEBA provides postretirement healthcare and life insurance for retired employees.

The company acquired several other companies and is responsible for providing postretirement benefits to their retirees and paying other benefits to their active employees. The acquired companies and the company are members of a controlled group under Sec. 414. The benefit obligations were established under a collectively bargained agreement by unions not associated with the benefits offered by the company's VEBA to its pre-existing employees.

The company wants to amend the VEBA to permit the acquired companies' active and retired employees to receive VEBA benefits. In addition, the VEBA would reallocate excess funds within the trust to provide for the payment of current benefits to all active, eligible employees of the postacquisition group. All the benefits provided through the VEBA would qualify as Sec. 501(c)(9) benefits, established pursuant to a collectively bargained agreement. The IRS concluded:

* The use of any VEBA assets (whether or not excess assets) to pay the company's or the acquired companies' collectively bargained benefit obligations permitted under Sec. 501(c)(9) and by the VEBA's governing agreement would not be a prohibited reversion under Sec. 4976 (subject to the 100% excise tax on any disqualified benefit (e.g., a benefit that reverts to an employer)) and would not adversely affect the VEBA's Sec. 501(c)(9) tax-exempt status.

* The use of VEBA assets (including excess assets) to pay collectively bargained benefit obligations of the company or the postacquisition group permitted under Sec. 501(c)(9) and under the VEBA would not violate Sec. 419A(c)(2), regarding the account limit on reserves in a qualified asset account; under Sec. 419A(f)(5)(A), the account limit is not applicable to VEBAs that provide collectively bargained benefits.

Distribution of VEBA Surplus Does Not Trigger Reversion or UBI

In Letter Ruling 200023052,(55) the IRS ruled that the partial dissolution of an employee-pay-all welfare benefit fund and the distribution of surplus funds to retirees and their surviving spouses will not result in a reversion to the employer, unrelated business income (UBI) or loss of the plan's exempt status.

A company established a healthcare plan funded entirely by retirees. The plan was funded by a tax-exempt VEBA under Sec. 501(c)(9). The retirees made all contributions to the VEBA.

The trust document states that all contributions made to it may only be used to provide healthcare benefits to retirees and their dependents. It also provides that, if the VEBA becomes overfunded through 1996, additional life, sick, accident or other Sec. 501(c)(9) permissible benefits can be provided.

To be covered under the plan, retirees had to make an actuarially determined lump-sum contribution by Jan. 1,1993, for four years of coverage ending on Dec. 31,1996. Retirees who became eligible after Jan. 1, 1993, were required to pay a pro rata portion of the lump sum.

At the end of the four-year coverage period, the VEBA had a sizeable surplus. The retirees requested that the company terminate the portion of the EBA holding the surplus funds and direct the trustee to distribute this excess to them or their surviving spouses. The surplus distributed to each retiree or surviving spouse would be in proportion to each retiree's contribution.

Analysis: To be considered tax-exempt under Sec. 501(c)(9), no part of a VEBA's net earnings may inure to the benefit of any private shareholder or individual (other than through the payment of benefits permitted by Regs. Sec. 1.501(c)(9)-3). The rebate of excess insurance premiums to the person whose contributions were applied to such premiums does not constitute prohibited inurement; however, according to Regs. Sec. 1.501(c)(9)-4(c) and (d), a distribution on dissolution must be determined on the basis of objective and reasonable standards that do not result in unequal payments to similarly situated members.

The IRS concluded that, because the excess funds were the result of favorable investment experience and lower healthcare costs, and because the distributions were determined on the basis of objective and reasonable standards, the VEBA will retain its tax-exempt status under Sec. 501(c)(9).

Nevertheless, unless contributions and earned net income are "exempt-function" income, the VEBA may have UBI on the returned assets. Sec. 512(a)(3)(B) defines exempt-function income as all income (other than income derived from any unrelated trade or business regularly carried on by such organization) set aside (in the case of a Sec. 501(c)(9) organization) to provide for the payment of life, sick, accident or other benefits, including reasonable administration costs.

The IRS concluded in the ruling that, because all VEBA contributions (including the net income earned), were used or set aside to provide medical benefits to retirees and their dependents, and to defray reasonable administrative costs, it is exempt-function income under Sec. 512(a)(3)(B), even though some of it was not used to provide medical benefits. In addition, because the plan is employee-pay-all, Sec. 419A account limits do not apply.

Because the company made no VEBA contributions and will not receive any VEBA surplus, the distribution of the surplus funds to the retirees will not be an employer reversion subject to the Sec. 4976(a) 100% excise tax.

Fringe Benefits

Sec. 79 Trumps Split-Dollar Rulings

The IRS concluded in Letter Ruling (TAM) 200002047(56) that the cost of life insurance provided by an employer to its employees under a split-dollar "group life carveout program" was includible in the employees' incomes under Sec. 79, rather than under the split-dollar insurance rulings, resulting in larger imputed income.

Basic and carveout plan: An employer pays all the premiums for a basic group-term life insurance plan that provides term life coverage of two times compensation. The employer also sponsors a "group life carveout program," under which any employee with five years of service and salary of at least $50,000 can waive coverage above $50,000 under the basic plan, and replace the excess coverage with an individual permanent life insurance policy. As part of the carveout program, an employee must enter into a split-dollar agreement with the employer, under which he is the sole owner of the individual policy and the employer pays the annual premiums. The employee will make a collateral assignment of the policy to the extent of premiums paid by the employer. Otherwise, the employee has full ownership rights in the policy, including the right to designate and change the beneficiary and to sell, assign, transfer, borrow against, surrender or cancel the policy.

The agreement terminates on the earliest of (1) the parties' mutual consent; (2) the date the employee attains a specified age; (3) termination of employment other than for total disability; (4) death; or (5) reimbursement by the employee of the lesser of the total premiums the employer paid or the cash-surrender value of the policy on the termination date. If the agreement is terminated for reasons other than (4) or (5) above, the employer has the right to the lesser of total premiums it paid or the policy's cash-surrender value on the termination date. If the agreement terminates because of the employee's death, the employer is entitled to the death benefits to the extent of total premiums it paid.

For the years involved, the employer reported on each employee's FormW2 imputed income attributable to coverage provided under the carveout program; it determined that amount by using "substitute P.S. 58" rates supplied by the insurer. For most age groups, the substitute P.S. 58 costs reported on the W-2s were four to six times lower than the cost of group-term life insurance as determined under Sec. 79 for the years involved. For those years, no policy had a cash-surrender value exceeding the total premiums the employer paid on the policy.

Group-term life insurance: Generally under Regs. Sec. 1.61-2(d)(2)(ii)(a), premiums paid by an employer for insurance on employees' lives are included in their income if the proceeds of such insurance are payable to their beneficiaries. Sec. 79 provides special rules for amounts includible in an employee's income for employer-provided group-term life insurance. Under Sec. 79(a), an employee must include in income the cost of group-term life insurance provided under a policy (or policies) carried directly or indirectly by his employer (but only to the extent the cost exceeds the sum of the cost of $50,000 of such insurance and any amount the employee pays for the insurance). The cost of the group-term life insurance is generally determined under tables provided in regulations.

Split-dollar life insurance: Rev. Rul. 64-328(57) examined two major types of split-dollar arrangements: (1) endorsement arrangements (in which the employer is named the policy owner); and (2) collateral assignment arrangements (in which the employee is named the policy owner). In the ruling, an employer paid the part of the annual premiums equal to the increase in the policy's cash-surrender value each year; the employee paid the balance (if any) of the annual premiums. The employer was entitled to receive, out of the policy proceeds, the policy's cash-surrender value (or at least a sufficient part thereof to equal the premium payments made). The employee had the right to name the beneficiary of the balance of any proceeds payable because of his death. According to the ruling, the effect of the arrangement is that the earnings on the investment element in the contract are used to provide all (or a portion) of the cost of the employee's insurance protection, an economic benefit the value of which must be included in his income.

Rev. Rul. 64-328 held that the value of the benefit the employee receives equals the one-year term cost of the life insurance protection to which he is entitled from year to year, less the portion (if any) he provided. It also stated that the one-year term cost of life insurance provided through a split-dollar arrangement is determined by using the P.S. 58 cost.(58) Rev. Rul. 66-110(59) provides in part that an employer may substitute for the P.S. 58 cost, if lower, the current published initial issue premium rates charged by an insurer for individual one-year term life insurance available to all standard risks.

Sec. 79 applies: The IRS first concluded in TAM 200002047 that the substitute P.S. 58 rates used by the employer do not satisfy Rev. Rul. 66-110. It also concluded that, because the carveout program meets all the requirements for group-term life insurance, Sec. 79, not the split-dollar rulings, apply in determining the taxation of benefits provided under that program and the basic group-term plan.

Regs. Sec. 1.79-1(a) provides that life insurance is not group-term life insurance for Sec. 79 purposes, unless it meets the following four conditions:

* It must provide a general death benefit excludible from income under Sec. 101(a). The IRS found that the life insurance provided under the carveout program met this requirement.

* It must be provided to a group of employees. Regs. Sec. 1.79-0 defines a "group of employees" as all employees of an employer, or less than all employees if membership in the group is determined solely on the basis of age, marital status or employment-related factors. Generally, a group of employees does not include fewer than 10 full-time employees, under Regs. Sec. 1.79-1 (c)(1). Here, the insurance is provided to at least 10 employees; membership in the carveout group is based solely On factors related to employment--i.e., employees with at least five years of service and a $50,000 or higher salary. Further, the fact the insurance is provided under individual policies does not disqualify it from being provided to a group of employees. Under Regs. Sec. 1.79-0, a group of individual contracts under which life insurance is provided to a group of employees may be a policy, as long as it is offered or available because of the employment relationship.

* It must be provided under a policy carried directly or indirectly by the employer. A policy is carried directly or indirectly by the employer if the employer pays any part of the cost of the insurance directly or through another person. The insurance under the carveout program meets this requirement, because the employer pays the premiums.

* The insurance provided to each employee must be computed under a formula that precludes individual selection. The insurance provided to each employee under the carveout program meets this requirement, because it is based on compensation.

Further, under Regs. Sec. 1.79-1 (b), no part of the life insurance provided under a policy that provides a "permanent benefit" is treated as group-term life insurance, unless certain requirements are met. A permanent benefit is defined as an economic value extending beyond one policy year (e.g., a paid-up or cash-surrender value) that is provided under a life insurance policy. (A feature that provides no economic benefit to the employee other than current life insurance protection is not a permanent benefit.) The IRS found that, for the years involved, the life insurance provided under the carveout program provided no permanent benefit. No individual policy issued under the carveout program had a cash-surrender value that exceeded the amounts to which the employer was entitled. Thus, an employee had no current right to any of the policy's cash value.

Also, if an employee were to transfer the policy to a third party, the transfer would be subject to the employer's rights under the collateral assignment and under the split-dollar agreement; the employee could not receive an economic benefit from the policy's current cash value by transferring the policy. Further, whether an employee would receive any rights in the policy's cash value in the future would depend on his continuing employment; thus, the, employee had no vested rights to future cash value. Thus, current insurance protection was the only economic benefit employees actually or constructively received for the years involved.

Sec. 79 nondiscrimination rules: Unlike the split-dollar rules, the Sec. 79 rules include nondiscrimination requirements. If insurance meets the Sec. 79(d) nondiscrimination requirements, Sec. 79(a) and (c) will apply in determining the amount includible in all employees' income. If the provision of insurance is discriminatory, the exclusion for the cost of $50,000 of insurance will not apply to key employees; the cost of the insurance includible in a key employee's income will be the greater of the cost of the insurance or the uniform premium cost.

According to Temp. Regs. Sec. 1.79-4T, Q&A-5, assuming at least one of the employer's key employees is receiving insurance under the carveout program, the basic plan and carveout program will be considered a single plan for testing purposes under Sec. 79(d)(2), to determine whether the employer maintains a discriminatory plan. Under Q&A-9, a plan does not meet the requirements for nondiscrimination as to the amount of benefits available unless all terms and conditions for all benefits (including permanent benefits) available to any key employee are also available to nonkey employees. Under Q&A-9, the terms and conditions of the employer's plan do not meet the requirements for nondiscrimination as to the amount of benefits available, because only employees with a salary of $50,000 or more can participate in the group carveout program and potentially obtain permanent benefits in the future.

However, the regulations include a special rule that a plan will be considered not to discriminate in favor of key employees, as to the amount of benefits available, if the group receiving the discriminatory benefits, when tested separately, meets the Sec. 79(d) participation requirements. Accordingly, whether the employer's basic group-term plan and its carveout program meet the Sec. 79(d) nondiscrimination requirements will depend on whether the carveout program, when tested separately, meets the Sec. 79(d)(3)(A) requirements for a nondiscriminatory eligibility classification.

Qualified Transportation Fringe Benefits

The IRS issued proposed regulations under Sec. 132(f) on tax-free qualified transportation fringe benefits.(60) Under Sec. 132(f), an employer can provide an employee with a tax-free qualified transportation fringe benefit, including transportation in a commuter highway vehicle, transit passes and qualified parking. These benefits are subject to limits on the amount that can be excluded from income. Further, for tax years after 1997, such benefits can be provided under a salary reduction arrangement.

Notice 94-3(61) provided guidance on Sec. 132(f); the IRS also released proposed regulations on salary reduction rules and other unanswered issues. Issues addressed in the proposed regulations include the following:

* Unused amounts can be carried over to subsequent months and subsequent years.

* A cash reimbursement for a transit pass pursuant to a bona fide reimbursement arrangement can be made only if a voucher exchangeable for a pass is not readily available.

* "Readily available" means an employer can obtain it on terms no less favorable than those available to an individual employee and without incurring a significant administrative cost.

* Determining whether obtaining a voucher would result in a significant administrative cost is made for each transit system voucher.

* Administrative costs are "significant" if the average monthly administrative costs incurred by an employer for a voucher are more than 1% of the average monthly value of the vouchers for a system. Delivery fees imposed by the fare provider are not included in the average monthly administrative cost, to the extent delivery charges do not exceed $15.

* If a receipt is not provided in the ordinary course of business (e.g., when using a parking meter), certification by an employee to the employer regarding the type and amount of the expense incurred will satisfy the substantiation requirement. Substantiation can also be provided if an employee submits a used transit pass to the employer and certifies that he purchased and used it during the month. The employee could also present a transit pass at the beginning of the month and certify that it will be used during the month.

* An employer can impose substantiation requirements in addition to those required by the regulations. There is no substantiation requirement if an employer distributes transit passes directly to an employee.

* Benefits can be provided by a salary reduction arrangement, but the employee election must be made before the employee is currently able to receive the compensation. The election must be irrevocable after the beginning of the period for which the transportation fringe is provided.

* Employers can use a negative election.

* Partners, 2% shareholders and independent contractors are not employees for purposes of a qualified transportation fringe benefit.

* On Jan. 1, 2002, up to $100 per month is excludible from an employee's income for transit passes or transportation in a commuter. highway vehicle.

* There is no requirement that a qualified transportation fringe benefit plan be in writing.

* If an employer provides local transportation other than transit passes to employees, or provides transportation benefits to partners, 2% shareholders or independent contractors, the value of the benefit may be excludible under fringe benefits rules other than the Sec. 132(f) qualified transportation fringe rules.

EXECUTIVE SUMMARY

* The IRS ruled that compensation paid under a performance-based stock award plan was deductible under Sec. 162(m), even though the plan immediately vested executives (1) terminated without cause or (2) terminating for "good reason."

* In an ISP paper, the IRS held that a distribution from a qualified retirement plan used to purchase accident and health coverage through a cafeteria plan is includible in income under Sec. 402(a).

* A district court denied a taxpayer's request for a refund of FICA taxes withheld from a severance package he received after being terminated.

Authors' note: The authors wish to acknowledge the significant contributions of Gary Cvach, Karen Field, Robert Masnik, Donna M. Prestia, Pamela Hobbs and Terri Stecher, of KPMG LLP's Washington National Tax Compensation and Benefits Practice, in compiling information for this article.

(32) TD 8883 (5/11/00, corrected 6/14/00).

(33) IRS Letter Rulings 9305006 (11/6/92), 9309008 (11/20/92) and 9250013 (9/8/92).

(34) Adapted from Regs. Sec. 1.1032-3(e), Example 5.

(35) Rev. Rul. 80-76, 1980-1 CB 15.

(36) IRS Letter Ruling 200021050 (2/29/00).

(37) IRS Letter Ruling 9949014 (9/9/99).

(38) Exacto Spring Corp., 196 F3d 833 (7th Cir. 1999), rev'g TC Memo 1998-220; for a detailed discussion, see Friske and Smith, "The Status of the `Independent Investor' Test in Reasonable Compensation Determinations," 31 The Tax Adviser 406 (June 2000).

(39) IRS Letter Ruling 9943032 (8/2/99).

(40) IRS Letter Ruling 200009013 (11/26/99).

(41) TD 8878 (3/22/00); REG-117162-99 (3/23/00).

(42) ISP Doc. 2000-6975.

(43) Rev. Rul. 61-164, 1961-2 CB 99.

(44) Rev. Rul. 69-141, 1969-1 CB 48.

(45) James Greenwald, SD NY, 1/6/00.

(46) Rev. Rul. 75-44, 1975-1 CB 15.

(47) Rev. Rul. 71-408, 1971-2 CB 340.

(48) Rev. Rul. 74-252, 1974-1 CB 287.

(49) Rev. Rul. 58-301, 1958-1 CB 23.

(50) Slotta v. Texas A&M University Systems, SD TX, 8/10/94.

(51) IRS Letter Ruling 200007025 (11/19/99).

(52) IRS Letter Ruling 200019005 (2/4/00).

(53) H. Rep't No. 104-736, 104th Cong., 2d Sess. (1996), p. 293.

(54) IRS Letter Ruling 9952094 (10/8/99).

(55) IRS Letter Ruling 200023052 (3/10/00).

(56) Letter Ruling (TAM) 200002047 (9/30/99).

(57) Rev. Rul. 64-328, 1964-2 CB 11.

(58) As provided in Rev. Rul. 55-747, 1955-2 CB 228.

(59) Rev. Rul. 66-110, 1966-1 CB 12, amplified by Rev. Rul. 67-154, 1967-1 CB 11.

(60) REG-113572-99 (1/27/00).

(61) Notice 94-3, 1994-1 CB 327.

Peter I. Elinsky, Esq.
Partner
KPMG LLP
McLean,VA

Terrance E Richardson, Esq.
Senior Manager
KPMG LLP
McLean,VA

Betsy K. Rogers, CPA
Manager
KPMG LLP
McLean,VA