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. Port II focuses on recent developments in areas such as stock options, reasonable compensation, voluntary employees' beneficiary associations, health care coverage 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, published in the November 1998 issue, focused on recent developments affecting qualified retirement plans, employee stock ownership plans and individual retirement accounts. Part II, below, focuses on recent developments in areas such as stock options, reasonable compensation, voluntary employees' beneficiary associations, health care coverage and fringe benefits.

Stock Options

Employees of Corporate Partnership

The IRS outlined in Letter Ruling 9822012(32) the tax consequences when a C corporation grants stock options and stock appreciation rights (SARs) to individuals employed by a partnership in which the Corporation and an S corporation are general partners.

C Corp. is engaged in the construction of commercial and industrial buildings; S Corp. is engaged in construction and real estate activities. Neither corporation has employees; each is a general partner in P, a partnership through which they conduct their activities. C wants to establish nonqualified stock option (NQSO) and SAR plans. Under the NQSO plan, selected P employees will be offered nontransferable NQSOs to acquire C stock. The goal is to retain key employees by offering them a stake in C, whose value is directly tied to P's performance. The exercise price will be the stock's book value at the grant date, adjusted for any outstanding NQSOs.

Under the SAR plan, all salaried P employees would be eligible for SAR awards. The SARs will be awarded annually in conjunction with performance reviews conducted by C's executive management committee. On exercise of a SAR, P would pay the employee cash equal to the increase in value of C stock. All SARs are contingent on continuing employment.

The IRS issued the following rulings regarding this arrangement:

* The NQSOs will be treated as not having a readily ascertainable fair market value (FMV) at grant; thus, under Regs. Sec. 1.83-7(a), C's grant of an NQSO to a P employee will not result in a taxable event to the employee.

* A P employee who exercises an NQSO will have ordinary- compensation income equal to the stock's FMV on the exercise date, less the exercise price, under Sec. 83(a) and Regs. Sec. 1.83-7.

* When a P employee exercises an NQSO and includes the spread in income, P will be entitled to a deduction for that amount under its normal method of accounting, under Regs. Sec. 1.83-6(a)(3).

* An employee's basis in stock acquired through the exercise of an NQSO will equal the exercise price plus the income the employee recognizes, under Regs. Sec. 1.83-4(b) and Rev. Rul. 78-182.(33)

* The employee's holding period for the stock acquired through the exercise of an NQSO with cash will begin on the exercise date, according to Regs. Sec. 1.83-4(a).

* Any subsequent sale or exchange of stock acquired through exercise of an NQSO will result in capital gain or capital loss to the employee, under Secs. 1001(a) and 1222.

* The grant of a SAR to a P employee will not require him to include any amount in income, under Regs. Sec. 1.451-2(b) and Rev. Rul. 80-300.(34)

* When a P employee exercises a SAR, the cash he receives is includible compensation income, under Rev. Rul. 80-300.

* When a P employee exercises a SAR, P will be allowed a deduction for the corresponding amount in the tax year in which or with which the employee's tax year of inclusion ends, under Sec. 404(a)(5).

Transferring NQSOs to Charity

The IRS ruled in Letter Ruling 9737014(35) that the transfer of options to a charity should be treated as a non-arm's-length transfer. However, because of the control retained over the exercise of the options, no charitable deduction may be claimed until the options are actually exercised.

A company granted two employees NQSOs. The options did not have a readily ascertainable FMV as defined in Regs. Sec. 1.83-7(b) on the date of grant. The plans under which the options were granted permitted the option holders to donate them anonymously to charity.

The first employee transferred the options to an intermediary, who held them in a combined brokerage and custody account established on the employee's behalf. The intermediary must exercise the options on a specified date, which the employee has reserved the right to change. Once the options are exercised, the intermediary must immediately sell the shares and deposit the proceeds (less the exercise price, taxes and costs of sale) in the employee's account. The employee will then designate a charity to which the intermediary will transfer the amounts attributable to the sale. If the employee dies before the options are exercised, the intermediary is to transfer the options to a charity previously identified by the employee. The charity can then exercise the options at any time.

The second employee intends to donate the options to certain charities, subject to an agreement. There are two possible ways of exercising the options under the agreement. Either the charity can pay cash to exercise the options or a broker will pay the exercise price, plus any taxes. If the broker exercises the options, the broker will sell sufficient stock to cover its expenses. The charity can then choose whether to receive the remaining shares or have the broker sell those shares and remit the proceeds to it.

The agreement will permit the second employee to retain the right to veto a proposed exercise of the options during his life. If he dies before the options are exercised, the charity can exercise the options at any time.

Sec. 83(e)(3) provides that Sec. 83(a) does not apply to the transfer of an option without a readily ascertainable FMV, but Sec. 83(a) and (b) apply when the option is exercised. If the option is disposed of in an arm's-length transaction, Sec. 83(a) and (b) apply as if the option had been exercised. Neither the Code nor the regulations address what happens if an option is disposed of in a transaction that is not arm's-length.

The IRS held that the rules for dispositions of nonvested property not at arm's length, found in Regs. Sec. 1.83-1 (c), apply; accordingly, it ruled that the employees will not recognize income or gain on the transfer of the options. Further, if the options are exercised while the employees are alive, they will recognize compensation income (and the company will receive a corresponding deduction) equal to the excess of the FMV of the optioned shares on the date of exercise over the exercise price. Such compensation will constitute "wages" for Federal income tax withholding purposes. Finally, if the options are not exercised until after the employees die, the compensation income will not be "wages." Under Regs. Sec. 1.83-6(a)(3), the company will be entitled to a deduction under its normal method of accounting for the income recognized by the employees.

The IRS also considered the employees' charitable deductions for these transfers, as well as the gift and estate tax implications. In Letter Rulings 9737015 and 9737016,(36) the IRS held that, because the employees retained control over the exercise of the options, they will not be entitled to charitable deductions until the options are actually exercised. The amount deductible will be the value of the stock received on exercise, less the exercise price and applicable taxes. For gift tax purposes, the employees will not be deemed to have made a completed gift to any charity until the options are exercised. However, assuming the charities are organizations described in Sec. 2522(a), the contributions to them will be eligible for the gift tax charitable deduction. Finally, the value of any options not exercised at the employees' deaths will be included in their gross estates, as will be the value of any options exercised within three years of their deaths.

These rulings illustrate that, when structuring a gift of NQSOs, identifying the donee is critical to achieving the most favorable tax consequences for the donor. For transfers of options to a charity, it is to the donor's advantage to ensure that the transfer is not a completed gift. As in these rulings, if an employee retains sufficient control over options transferred to or for the benefit of a charity so as to prevent the transfer from being a completed gift, he must recognize income when the options are exercised, but will also be entitled to a charitable deduction at that time equal to the value of the shares received at exercise, less the expenses of exercise. If the transfer of the options constituted a completed gift, the employee could claim a charitable deduction only for the value of the options on the date transferred to the charity and would still recognize income when the options were exercised.

Constructive Exchange

In Letter Ruling 9736040,(37) the IRS detailed the tax consequences of an employee's exercising compensatory stock options by constructively surrendering previously acquired employer stock in payment for the shares to be received. The ruling provides a good review of the applicable rules.

Constructive surrender: X Corp. maintains two stock option plans (the Plans). Options granted under the Plans may be either incentive stock options (ISOs) or NQSOs.

The Plans provide that the exercise price may be paid in cash or in shares of common stock transferable to X and having an FMV on the transfer date equal to the exercise price. X wants to allow employees to exercise their options by constructively surrendering shares they already own (Payment Shares) rather than actually tendering the shares to X. If the Payment Shares are held by a registered securities broker for the employee in "street name," the employee will give X a notarized statement attesting to the number of shares owned that are intended to serve as Payment Shares. If the employee actually holds the stock certificates, he will give X the certificate numbers. X will then treat the Payment Shares as being constructively exchanged and will issue the employee a certificate for a net number of shares--the number of shares subject to the option exercise, less the number of Payment Shares.

Constructive delivery: The IRS concluded that X's proposed certification procedure, which eliminates the need to physically deliver Payment Shares to X, will be deemed a constructive delivery of such shares for Federal income tax purposes, resulting in the following tax consequences:

1. An employee who constructively pays the exercise price of an ISO with Payment Shares that were (i) previously acquired through the exercise of an ISO and met the Sec. 422(a) holding requirements (mature ISO stock) or (ii) acquired some other way, such as through the exercise of an NQSO (NQSO stock) or purchased on the open market, will receive the same treatment as if he had physically surrendered shares that had satisfied the holding period, if applicable; specifically:

* The employee will not recognize income on the exercise of the ISO, under Secs. 421(a)(1), 422(c)(4)(A), 424(c)(1)(B) and 424(c)(3). Further, he will not recognize capital gain or loss on the constructive surrender of previously owned shares; see Sec. 1036(a).

* The employee will have a carryover basis for shares deemed to be received equal in number to the Payment Shares. The basis in any stock actually received will be the cash (if any) paid on the transfer, under Secs. 1012 and 1031(d).

* For Sec. 1223(1) purposes, the employee will have a carryover holding period for shares deemed received equal in number to the Payment Shares. The holding period of any additional shares actually received will begin on the date the new ISO is exercised. For Sec. 422(a)(1) purposes, the holding period of all shares (including those deemed and actually received) will begin on the date the new ISO is exercised.

2. An employee who constructively pays the exercise price of an ISO with Payment Shares previously acquired through the exercise of an ISO, but that have not met the Sec. 422(a) holding period requirements (immature ISO stock), will receive the same tax treatment as if he had physically surrendered shares that had not met the holding period; specifically:

* The constructive surrender of the Payment Shares is a disqualifying disposition resulting in the recognition of compensation income under Secs. 421(b) and 422(c)(2); see also Sec. 424(c)(3). Any additional appreciation in the stock's value not taxed as compensation income under the disqualifying disposition rules is subject to the Sec. 1036 nonrecognition rules.

* The basis of the shares deemed to be received that are equal in number to the Payment Shares will be the basis of the Payment Shares increased by any reported compensation income as a result of the disqualifying disposition. Any additional shares actually received will have a basis equal to the amount of cash paid (if any) to exercise the new ISO, under Secs. 424(c)(3) and 1012.

* The employee will not recognize income on receiving the new shares as a result of the exercise of the ISO, under Sec. 422(c)(4)(A).

* For Sec. 1223(1) purposes, the employee will have a carryover holding period for those shares deemed received that are equal in number to the Payment Shares. The holding period of any additional shares received will begin on the date the new ISO is exercised. For Sec. 422(a)(1) purposes, the holding period of all shares (including those deemed and actually received) will begin on the date the new ISO is exercised.

3. An employee who constructively pays the exercise price of an NQSO with Payment Shares that are mature ISO stock, immature ISO stock, NQSO stock or stock that was purchased on the open market will receive the same tax treatment as if he had physically surrendered the shares; specifically:

* The employee will recognize as compensation income the FMV of the shares that exceed the number of Payment Shares used to exercise the NQSO (less any cash paid on the transfer), under Sec. 83 and Regs. Sec. 1.83-7.

* The employee will not recognize income on the constructive exchange of the Payment Shares for stock received equal in number to the Payment Shares, under Sec. 1036(a), Prop. Kegs. Sec. 1.422A-2(i)(4), Example 4 and Rev. Rul. 80-244.(38)

* The employee will have a carryover basis for the stock deemed received equal in number to the Payment Shares. The basis in any additional shares will be the difference between the FMV of the shares received under the NQSO and the exercise price, plus any cash actually paid, under Secs. 1012 and 1031 (d) and Rev. Rul. 80-244.

* The employee will have a carryover period for the stock received equal in number to the Payment Shares. The holding period of any additional share received will begin on the date the NQSO is exercised, under Sec. 1223(1).

No need to amend plans: The IRS also concluded that X'S interpretation of the Plans to permit an employee to use the certification procedure described above to exercise an ISO through constructive surrender of Payment Shares is not a "modification, extension, or renewal" of the ISO under Sec. 424(h). Finally, neither the Code nor the regulations require X to amend the Plans before instituting the certification procedure; the certification procedure need not receive shareholder approval under Sec. 422(b)(2).

Parent Warrants Yield ISOs

In Letter Ruling 9752030,(39) the IRS ruled that a domestic company's stock option program, in which a warrant for the foreign parent's stock is transferred to the employee when he exercises the option and then immediately exercised for stock, qualifies under Sec. 422 as an ISO program.

The U.S. company is a State E corporation that is a wholly owned subsidiary of Company A, a State F Corporation, which, in turn, is a wholly owned subsidiary of the foreign parent, Company B, a Country V Corporation. B's stock is publicly traded on a foreign stock exchange.

The U.S. company adopted a stock option plan for B's stock that it intended to be an ISO plan under Sec. 422(b).

The ruling indicates the simplest approach would have been to have B grant options to purchase its shares directly to the U.S. company's (and its subsidiaries') employees, but Country V's commercial code contains two restrictions that preclude such an arrangement. The first restriction prohibits a corporation and its subsidiaries from owning the corporation's stock. The second restriction requires any sale of newly issued stock to be made available to the public.

To avoid these restrictions, the U.S. company will purchase debentures from B with warrants for B stock attached. Under this arrangement, the exercise price of each option granted under the plan will not be less than the FMV of B stock on the date the option is granted. If the exercise price is less than the subscription price for the corresponding B warrant, the U.S. company will pay the difference to B when the option is exercised. If the option price is greater than the corresponding warrant's subscription price, the U.S. company will retain the excess. In either event, an employee who exercises an option will not pay less than the FMV of B stock as of the date the option was granted, without regard to the exercise price of the corresponding B warrant. The steps of the transaction are as follows:

1. When an option is granted to an employee, an account will be opened with Company C in his name; the exercise price will be expressed in a foreign currency. (Although the ruling does not specify, presumably C is a totally unrelated company, such as a brokerage house.)The employee will pay the exercise price in U.S. dollars.

2. When an employee exercises an option, he will pay the exercise price to the U.S. company.

3. The U.S. company will deliver the warrant subscription price to C.

4. C will transfer the corresponding B warrant to the employee's account.

5. Immediately thereafter, the warrant will be exercised, and B stock will be issued to the employee.

The IRS ruled that this arrangement would meet the Sec. 422(b) requirements, assuming Sec. 422(a) (1), (2) and (d) were met, and further ruled that the options granted under the plan would be eligible for Sec. 421 treatment. The IRS expressed no opinion on other tax aspects of the plan, including the effect of adjustments to the number of shares granted under an option or the exercise price of an option under other plan provisions.

Reduced ISO Price Not Modification

The IRS ruled in Letter Ruling 9743043(40) that a reduction in an ISO's exercise price, to reflect a decrease in the value of the company's shares resulting from a return of capital, will not constitute a modification of the option, if the "spread" and "ratio" tests are met.

Following a public offering of its stock, Company A adopted an ISO plan for its employees. A subsequently determined that the public offering raised more cash than it needed currently and proposed to distribute the excess cash pro rata to its shareholders as a return of capital. To reflect the resulting decrease in the value of A shares, A also proposed to reduce the exercise price of the outstanding ISOs. No shares would be redeemed.

Generally, any modification, extension or renewal of an ISO's terms is treated as the granting of a new option, under Sec. 424(h)(1). For this purpose, a modification is defined by Sec. 424(h)(3) as any change in the terms of an option that gives an employee additional benefits. Regs. Sec. 1.425-1 (e)(5)(ii)(b) states that a change that provides more favorable terms for paying for the option stock is a modification. However, the regulations also state that a change in the number or price of the option shares to reflect a "corporate transaction" is not a modification of the option, if the change meets the "spread" and "ratio" tests.

In Rev. Rul. 71-385,(41) the IRS concluded that a change in the exercise price of outstanding options to reflect a decline in the value of the corporation's stock resulting from a spinoff was a change to reflect a corporate transaction, and therefore was not a modification. Here, the proposed return of capital would result in a reduction in the FMV of the employer's stock. Thus, the IRS concluded that the proposed exercise price reduction will reflect a "corporate transaction"; provided the spread and ratio tests are met, the proposed price reduction will not constitute a modification of the ISOs.

Under the spread test, (1) the excess of the aggregate FMV of the option shares immediately after the change over the new option price cannot be more than (2) the excess of the aggregate FMV of option shares immediately before the transaction over the old aggregate option price. Also, the option after the change cannot give the employee additional benefits he did not have before the change. Under the ratio test, the ratio of (1) the option price immediately after the change to (2) the FMV of the option stock immediately after the corporate transaction, cannot be more favorable to the option holder on a share-by-share comparison than the ratio of(3) the old option price to (4) the FMV of the option stock immediately before the transaction.

Effective Date for Sec. 3121 (v) Regs. Extended

In January 1996, proposed regulations were issued on withholding FICA and FUTA from nonqualified deferred compensation plans. Those regulations had a proposed general effective date of Jan. 1, 1997. However, because the IRS has not finalized the regulations, it moved the proposed general effective date to Jan. 1, 1998.(42)

Sec. 457 Plans

The IRS issued guidance on the effect of recent statutory changes on eligible Sec. 457 plans. Notice 98-8(43) provides guidance on (1) in-service distributions of plan balances of $5,000 or less; (2) an additional election to defer the start of distributions; (3) cost-of-living adjustments to the $7,500 deferral limit; and (4) trust requirements for eligible government Sec. 457 plans.

In-Service Distributions

Benefits under an eligible Sec. 457 plan generally may not be paid or made available to a participant before separation from service with the employer. Before the Small Business Job Protection Act of 1996 (SBJPA), in-service distributions were allowed only if the participant had an "unforeseeable emergency" or had attained age 70 1/2. SBJPA Section 1447(a) and the tax-payer Relief Act of 1997 (TRA '97), Section 1071(a), amended the rules to allow in-service distributions if the total amount payable does not exceed a specified dollar amount. The specified dollar amount is the same as the maximum involuntary cashout amount under Sec. 411 (a)(11)--i.e., $5,000 for plan years beginning after Aug. 5, 1997. This in-service distribution is available only if no amount has been deferred under the plan for the participant during the preceding two-year period. Notice 98-8 lists the following alternative plan provisions in connection with such in-service distributions; the plan may:

1. Provide that a participant with a balance of $5,000 or less may elect an in-service distribution of the entire amount.

2. Provide that the entire amount payable to a participant with a balance of $5,000 or less will automatically be distributed to the participant.

3. Substitute a specified dollar amount that is less than $5,000 for either of the preceding two alternatives.

4. Combine the alternatives; for example, a plan could provide for automatic cashout for balances up to $500 and allow participants to elect a cashout for the balance above $500 but not above $5,000.

A plan does not have to permit inservice distributions under any of these alternatives.

Additional Deferral Election

Amounts are not "made available" under Regs. Sec. 1.457-1(b) if a participant irrevocably elects, before the time the amounts become payable, to defer the payment to a fixed and determinable future time. The time at which amounts become payable (the first permissible payout date) is the earliest date on which a plan allows payments to begin after separation from service (i.e., disregarding in-service distributions). Before the SBJPA, a participant could not change this deferral election after the first permissible payout date.

SBJPA Section 1447(a) amended Sec. 457(e)(9)(B) to provide that the amount payable under an eligible Sec. 457 plan is not treated as made available merely because the plan allows the participant to make an additional election, after the first permissible payout date, to further defer the commencement of distributions, as long as this "additional election" is made before distributions begin. Only one Sec. 457(e)(9)(B) additional election can be made after the end of the period for making the original deferral election. Any elections made before the first permissible payout date are not Sec. 457(e)(9)(B) additional elections, and thus will not preclude a plan from allowing a participant to make a Sec. 457(e)(9)(B) additional election after the first permissible payout date.

Cost-of-Living Adjustments

Sec. 457(e)(15) provides for cost-of-living adjustments to the $7,500 deferral limit for tax years beginning after 1996. For 1997, the maximum deferral amount remained at $7,500; the maximum deferral amount for 1998 is $8,000.(44)

Trust Requirements

SBJPA Section 1448(a) added Sec. 457(g), which requires that all assets and income of an eligible Sec. 457 plan maintained by a state or local government employer be held in trust or in custodial accounts or annuity contracts, for the exclusive benefit of participants and beneficiaries. This rule generally applies to assets and income held by an eligible government plan on or after Aug. 20, 1996. Under a transition rule for government plans in existence on that date, a trust (or custodial account or annuity contract) does not need to be established before 1999.

Notice 98-8 states that to satisfy the requirement that all plan assets and income be held in trust, amounts deferred under a government plan after a trust has been established must be transferred to the trust "within a period that is not longer than is reasonable for the proper administration of the accounts of the participants." According to the notice, a government plan may provide that amounts deferred for a participant under the plan will be transferred to the trust within a specified period after the date the amounts would otherwise have been paid to the participant (e.g., within 15 business days following the month in which the amounts would otherwise have been paid to the participant). (The IRS noted that eligible government Sec. 457 plans are not subject to the Employee Retirement Income Security Act of 1974 (ERISA), and therefore, are not subject to the Department of Labor (DOL) regulations on plan assets.) If any plan assets or income are not held in a trust (or in custodial accounts or annuity contracts) that meets these requirements, the plan is not an eligible Sec. 457 plan.

Custodial Accounts/Annuity Contracts

Under Sec. 457(g)(3), for purposes of the Sec. 457(g)(1) trust requirements, custodial accounts and annuity contracts described in Sec. 401(f) are treated as trusts. Notice 98-8 states that Regs. Sec. 1.401(f)-1(b) generally will be used to determine whether a custodial account or annuity contract meets Sec. 457(g)(3).

A custodial account will be treated as a trust if the custodian is a bank or a person that meets the nonbank trustee requirements outlined below, and if the account meets the trust requirements described above (other than the requirement that it be a trust). An annuity account will be treated as a trust if it (1) is an annuity contract as defined in Sec. 401(g), (2) has been issued by an insurance company qualified to do business in the state and (3) meets the trust requirements described above (other than the requirement that it be a trust). An annuity contract does not include a life, health, or accident, property, casualty or liability insurance contract.

Eligible government plans may use a combination of trusts, custodial accounts and annuity contracts, as long as (1) all such vehicles satisfy the relevant requirements and (2) all plan assets and income are held in such vehicles.

Nonbank Custodians 

The custodian of a custodial account may be a person other than a bank only if the person demonstrates to the IRS's satisfaction that the way it will administer the account will be consistent with the Sec. 457(g) requirements. To the extent a person has already demonstrated that it satisfies Regs. Sec. 1.408-2(e) in connection with a Sec. 401(a) qualified trust (or custodial account or annuity contract), that person will be deemed to satisfy the requirements for being a nonbank custodian.

Reasonable Compensation

Letter Ruling 9811029(45) held that a compensation committee consisting of at least two outside directors, along with a number of non-outside directors, will meet the Sec. 162(m) performance-based compensation requirements as long as the non-outside directors recuse themselves from the performance goal process. This ruling shows how employers with mixed compensation committees can meet the Sec. 162(m) outside director requirement without the administrative burdens and costs of maintaining separate committees or a separate subcommittee.

Performance-Based Compensation

Generally under Sec. 162(m), no deduction is allowed to a publicly held corporation for employee remuneration in excess or $1 million paid to any covered employee (i.e., the chief executive officer or any of the four other highest-paid officers for whom compensation must be reported under SEC rules). However, certain types of remuneration (including qualified performance-based compensation) are exempt from the disallowance rule.

Definitions: Qualified per, finance-based compensation is compensation that meets the following requirements:

1. It is paid solely on account of attaining one or more pre-established, objective performance goals.

2. The performance goal is established by a "compensation committee" comprised solely of two or more "outside directors," according to Sec. 162(m)(4)(C)(i) and Regs. Sec. 1.162-27(e)(3).

3. The material terms of the performance goal under which the compensation is to be paid are disclosed to and approved by the shareholders in a separate vote before the payment is made.

4. Prior to payment, the compensation committee certifies that the performance goals and any other material terms were satisfied.

A compensation committee is the committee of directors (including any subcommittee of directors) of the publicly held corporation that has the authority to set and administer performance goals, and to certify that performance goals are attained, according to Regs. Sec. 1.162-27(c)(4).

An outside director is one who (1) is not a current employee of the corporation; (2) is not a former employee of the corporation and currently receiving compensation for prior services (other than benefits under a tax-qualified retirement plan) during the tax year; (3) has not been an officer of the publicly held corporation; and (4) does not receive remuneration (directly or indirectly) in any capacity other than as a director.

Under Regs. Sec. 1.162-27(e)(2)(vi), compensation from the exercise of stock options or SARs is deemed to satisfy the performance goal requirement if (1) the grant is made by the compensation committee; (2) the plan states the maximum number of shares with respect to which options or SARs may be ,granted during a specified period to any employee; and (3) the compensation received by the employee is based solely on an increase in the value of the stock after the date of grant.

Holding: The employer in the ruling was a publicly held corporation with a shareholder-approved stock option plan. Apart from the outside director requirement, the plan met all the criteria under Regs. Sec. 1.16227(e)(2)(vi), so that compensation under the plan would otherwise qualify, as qualified performance-based compensation. The corporation's compensation committee consisted of at least two directors who qualified as outside directors under Regs. Sec. 1.162-27(e)(3), plus several other individuals who do not qualify as outside directors. The corporation intended to grant stock options in 1998. To comply with the requirements for performance-based compensation, and to ease the administrative burdens and costs of maintaining separate committees or a separate subcommittee, the corporation proposed an abstention or recusal of all directors on the compensation committee who did not qualify as outside directors under the regulations.

The IRS ruled that after such an abstention or recusal, the corporation would effectively have a subcommittee of two or more outside directors under Reg. Sec. 1.162-27(c)(4) that will be considered a compensation committee consisting solely of two or more outside directors for purposes of Sec. 162(m)(4)(C)(i) and the regulations thereunder.

VEBAs

Post-Retirement Reserve

The Second Circuit, in General Sighal Corp.,(46) and the Sixth Circuit, in Parker-Hannifin Corp.,(47) concluded that for contributions to a voluntary employees' beneficiary association (VEBA) to be deductible under Sec. 419A(c)(2) as a reserve funded over the working lives of covered employees for certain post-retirement benefits, the contributions must actually be accumulated for the payment of such benefits.

Under Sec. 419(a), contributions paid or accrued by an employer to a welfare benefit fund are deductible only under Sec. 419 (and subject to the limits therein)for the tax year in which paid. The deductible amount generally is limited to the fund's "qualified cost" for the tax year, which consists of the fund's "qualified direct cost" plus additions to a "qualified asset account" (QAA) for the tax year, minus the fund's "after-tax income" for the tax year.

According to Sec. 419(c)(3), an employer's "qualified direct cost" is the aggregate amount the employer would otherwise be able to deduct for benefits provided directly to employees if the employer were a cash-basis taxpayer. Sec. 419A(a) defines a QAA as an account in which assets are set aside to provide disability, medical, severance pay, supplemental unemployment compensation or life insurance benefits. Sec. 419A(c)(1) provides that additions to a QAA cannot cause the account to exceed an amount reasonably and actuarially necessary to fund incurred but unpaid claims plus administrative costs (account limit). However, the account limit may include, under Sec. 419A(c)(2), an additional reserve for post-retirement medical or life insurance benefits funded over the working lives of employees and actuarially determined on a level basis.

Taxpayers' position: In both General Signal and Parker-Hannefin, the taxpayer claimed deductions for amounts contributed to a reserve for post-retirement benefits, even though those amounts were actually used to pay active employee benefits in years following the contribution year. Both taxpayers argued that the term "reserve" represents a liability., not a fund of assets, and that the phrase "reserve funded over the working lives of the covered employees" is merely a mathematical computation that serves to limit the deduction an employer can take in any tax year for its contributions to a welfare benefit fund. Thus, Sec. 419A(c)(2) does not require that assets actually be set aside or accumulated. In each case, the Tax Court disagreed with the taxpayer's interpretation, and was ultimately upheld on appeal.

Parker-Hannifin: In Parker-Hannifin, the Sixth Circuit stated that the plain meaning of the term "reserve" and the legislative history of Sec. 419A(c)(2) supported the IRS'S interpretation that assets must actually be set aside and accumulated for the payment of post-retirement benefits. According to the court, Sec. 419A(c)(2) establishes a quid pro quo--the employer gets the benefit of a current deduction, and in exchange must accumulate assets in a reserve so that the benefits payable to a retired employee during retirement will be fully funded on retirement.

A consideration of all the facts and circumstances convinced the court that Parker-Hannifin did not accumulate assets in such a reserve: the full contribution was expected to be depleted within 12 to 18 months, and was in fact depleted within 26 months; the taxpayer did not disclose the existence of the VEBA to employees, labor unions, retirees or shareholders; and the disclosures in its financial statements regarding the provision of health care and life insurance benefits were more consistent with an expensing of benefit costs when paid, than with the annual funding of benefits based on estimated accruals. Thus, the court concluded that the taxpayer could not deduct in the year of contribution the amounts it had claimed as contributions for post-retirement benefits.

The Sixth Circuit also denied the applicability of Sec. 419A(f)(5)(A), which provides that no account limit applies to a QAA for a separate welfare benefit fund maintained under a collective bargaining agreement. According to the court, the statute requires not simply separation from the employer and its creditors, but also separation from any other welfare benefit funds maintained for the employer's nonunion employees. The taxpayer failed to make this showing.

The court also decided that the Tax Court's interpretation of "set aside" for QAA purposes was erroneous, and that an employer has set aside assets for Sec. 419A(a) purposes when it makes an irrevocable contribution to a welfare benefit fund that provides the benefits specified in that section.

General Signal: The Second Circuit found that the language "funded over the working lives of covered employees" clearly evokes a gradual accumulation of funds measured with an eye toward complete funding at the time of retirement, as the Service argued. Thus, the court held that, for contributions to a reserve under Sec. 419A(c)(2) to be tax deductible, they must be intended actually to accumulate for the purpose of funding post-retirement benefits. On the other hand, the employer's intent is determined at the time of the contribution. Thus, if later events rendered maintenance of the reserve impossible, evidence of the reason for discontinuing or spending down the reserve could be offered in response to a charge that the employer never intended a reserve to be established in the first place. Here, though, General Signal made no claim that it intended that any portion of any VEBA contribution would be spent in any particular way, other than to pay benefits as expenses were incurred.

Temp. Regs. Sec. 1.419A-1 Valid

In Square D C0.,(48) the Tax Court upheld for the first time the validity of Temp. Regs. Sec. 1.419A-1, Q&A-5 (b)(1), which provides that amounts contributed to a VEBA after its tax year-end but before the employer's tax year-end are treated as included in the VEBA's year-end balance. The temporary regulation also provides that a contribution to a VEBA is deductible only if paid to the fund during the tax year, and only to the extent the contribution does not cause the fund to exceed its account limit for its tax year. Because the employer contributed $27 million between the VEBA's tax year-end (Nov. 30, 1986) and the employer's tax year-end (Dec. 30, 1986), that amount was counted in the VEBA's total year-end amount. The VEBA's year-end account balance had already reached the account limit without the contribution; thus, the court ruled that no part of the $27 million was deductible for the employer's 1986 tax year.

The case also involved two other issues--the use of safe harbors under Sec. 419A, and the appropriate method for establishing a reserve for retiree benefits under Sec. 419A(c)(2). The taxpayer argued that the safe harbor for calculating account limits under Sec. 419A(c)(5) requires no showing of "reasonableness" of the limits used. The court disagreed, holding that the legislative history requires the taxpayer to show that reserves are reasonable,

The court also rejected the taxpayer's argument that it had established a reserve in the VEBAs for funding retirees' claims, relying primarily on the fact that (1) the VEBAs showed no balances reflecting a reserve; (2) the taxpayer gave no notice of such a reserve to shareholders, employees, retirees or disabled employees; (3) the taxpayer hired an auditor to audit the VEBA, but never disclosed to him the existence of a reserve or liabilities for the provision of post-retirement medical benefits; and (4) although disclosure of funding policies is required for financial accounting purposes, the funding policy the taxpayer disclosed was that claims would be expensed as they were incurred. Based on these facts, the court concluded no reserve existed.

Mental Health Parity Act 

The IRS, DOL and the Department of Health and Human Services released interim regulations implementing the Mental Health Parity Act (MHPA) and the Newborns' and Mothers' Health Protection Act.(49)

Alternative Compliance Methods

According to the preamble to the interim regulations, under the MHPA and the interim rules, a group health plan (or health insurance coverage offered in connection with a group health plan) providing both medical/surgical benefits and mental health benefits may comply with the MHPA parity requirements in any of the following general ways:

1. By not including any aggregate lifetime dollar limit or annual dollar limit on mental health benefits.

2. By imposing a single aggregate lifetime or annual dollar limit on both medical/surgical benefits and mental health benefits in a way that does not distinguish between the two.

3. By imposing an aggregate lifetime dollar limit or annual dollar limit on mental health benefits that is not less than the aggregate lifetime dollar limit or annual dollar limit on medical/surgical benefits.

4. In the case of a plan (or coverage) under which aggregate lifetime dollar limits or annual dollar limits differ for categories of medical/surgical benefits, the plan (or coverage) may comply by calculating a weighted-average aggregate lifetime dollar limit or annual dollar limit for mental health benefits. The weighted average must be based on a formula in the interim rules that takes into account the limits on different categories of medical/ surgical benefits.

The interim regulations include examples of permissible ways to comply with the MHPA.

Exemptions

A plan may be exempt from the MHPA if (1) it does not cover mental health benefits; (2) the plan sponsor is a small employer (2-50 employees) or (3) it can show that applying the same caps to mental health benefits as to medical/surgical bills would cause the plan's costs to increase by 1% or more.

The interim regulations do not focus on the first (and most obvious) way to avoid the cap, but instead focus on the 1% method. The MHPA provides no statutory guidance on the measurement period for such calculations or on how to calculate the costs of the increase. The interim regulations state that the costs must be based on a period of at least six consecutive months during the current plan year. The formula for such calculations is:

IE/IE - (CE + AE) [is greater than or equal to] $1.01000

IE represents the incurred expenditures during the base period. CE represents the health care claims incurred during the base period that would have been denied under the plan absent amendments required to comply with the parity requirements of Temp. Regs. Sec. 54.9812-1T(b)(1)(i). AE represents administrative costs related to claims in CE and other administrative costs attributable to complying with the parity requirements.

The exemption cannot be applied until the relevant agencies and the participants have been given at least 30 days' advance notice of the application of the exemption. The interim regulations include a model notice. Participants, beneficiaries and their representatives are entitled to the supporting financial data used to calculate the 1% increase on which the exemption is based.

Substance Abuse/Chemical Dependency

Because substance abuse and chemical dependency are not deemed mental health treatments, an annual cap that counted treatment for such abuse and/or dependency as part of the mental health cap on benefits would not be considered equal to the same dollar amount cap medical/surgical benefits; hence, such a cap would violate the MHPA. For example, a $250,000 annual cap for all benefits involving mental health, substance abuse and chemical dependency treatments, and a $250,000 annual cap for medical/surgical benefits, would not be permissible under the MHPA regulations.

The MHPA does not apply to services furnished after Sept. 29, 2001.

COBRA Issues

Electing CCC 

Notice 98-12(50) provides employers with standard information that can be given to employees and their families regarding factors to take into account in deciding whether to elect Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) continuation coverage (CCC). Employers are not required to provide this notice, nor is it a substitute for any required COBRA notice or other information required by law to be furnished to participants or beneficiaries in employer group health plans.

The notice is in question-and-answer form in three parts. Part I provides an overview of COBRA and the Health Insurance Portability and Accountability Act (HIPAA); Part II addresses whether to enroll in CCC if other health coverage is available; and Part III addresses whether to enroll in CCC if other health coverage is not available. The agencies intend to make the notice available at the following Internet sites: http://www.irs. ustreas.gov, http://www.dol.gov/dol/ pwba and http://www.hcfa.gov.

Supreme Court Rules on CCC

In Geissal v. Moore Medical Corp.,(51) a unanimous Supreme Court ruled that health insurance coverage held prior to a COBRA qualifying event does not allow an employer to deny CCC under ERISA Section 602(2)(D)(i) on a qualifying event. That section permits termination of CCC on the date on which the qualified beneficiary first becomes, after the date of the election, covered under any other group health plan (as an employee or otherwise), if that plan does not contain any exclusion or limit on any preexisting condition of such beneficiary. The Court's decision resolves a split in the lower courts and resolves a longstanding question among employers.

Facts: Moore Medical Corp. fired James Geissal, who had cancer. At the time Geissal was fired, he was covered under his employer's plan, as well as under his wife's employer's plan. At the time of the firing, Moore told Geissal he was entitled to CCC, which Geissal elected. About six months later, Moore told Geissal that it had been mistaken and that Geissal was not entitled to CCC, because on the date of his election, he was covered by his wife's plan. Geissal sued.

The Eighth Circuit held that coverage existing at the time of a qualifying event under a spouse's plan would be cause for denying CCC; however, the preexisting coverage under the spouse's plan must not create a significant gap in coverage as compared with the employer's COBRA plan, as COBRA was intended to prevent coverage gaps due to qualifying events. The Fifth and Eleventh Circuits had held similarly(52); the Tenth Circuit, the first to address the issue, ruled that preexisting coverage would not prevent a qualified beneficiary from seeking CCC, because ERISA required that CCC could be terminated only when the beneficiary "first" became eligible for CCC after the COBRA qualifying event.(53) The Supreme Court granted certiorari in Geissal to resolve the dispute among the circuits.

Surprisingly, Treasury and the IRS recommended that the U.S. Solicitor General file an amicus brief, taking a position contrary to the IRS'S proposed regulations. The Solicitor General argued that the existence of coverage under another health plan at the time one qualifies and elects CCC should not permit the plan sponsor to deny CCC.

The IRS issued Ann. 98-22(54) to explain its paradoxical position. The announcement also provided for continued reliance on Prop. Regs. Sec. 1.162-26, Q&A-38(d), pending a decision by the Supreme Court in Geissal. The IRS warned that the announcement would not affect private rights of action; it merely meant the IRS would not impose the Sec. 4980B excise tax for periods before the Supreme Court issued a decision.

Court's reasoning: Moore argued that Geissal's coverage under his wife's employer's plan defeated his claim for CCC. As Moore interpreted ERISA Section 602(2)(D)(i), it was not relevant when a qualified beneficiary first obtains other health insurance coverage; rather, all that matters is whether, at any time after the date of the CCC election, the beneficiary was covered by another group health plan.

Rejecting Moore's argument, the Court held that, under ERISA Section 602(2)(D)(i), because Geissal was covered by his wife's employer's plan before he made the CCC election, he did not "first become" covered under that plan after the date of election; thus, Moore could not terminate his CCC coverage. The Court also rejected the view that such prior coverage would permit denial of CCC as long as no "significant gaps" in coverage occurred by virtue of the COBRA denial. In the Court's view, the "significant gap" approach is without statutory support; a clear congressional mandate would be needed for courts to decide such issues of social policy.

Employers following the majority view of the circuits and the IRS proposed regulations permitting denial of CCC to qualified beneficiaries with existing coverage at the time of the qualifying event will need to change their policies shortly. The IRS grace period on the imposition of taxes, at least as announced, applied only to instances of CCC denial prior to the Supreme Court's decision. Now that the decision has been issued, employers are on notice that existing insurance is not a reason to deny CCC.

Cafeteria Plan Temp. Regs.

The IRS issued new cafeteria plan temporary regulations(55) that focus on election issues arising out of the HIPAA changes in health benefits and the welfare reform changes to ERISA. These regulations are not effective until Dec. 31, 1998, but can be used by employers before then. Once effective, these changes will almost certainly require small changes in the plan document and administration. The regulations allow a cafeteria plan with health benefits to permit individuals to enroll if they lose other health coverage or if they want to add a family member to the plan (i.e., when the new HIPAA rules require coverage of the employee).

They also permit a cafeteria plan change if a plan receives a "qualified medical child support" court order or if an employee or spouse or dependent becomes eligible for Medicare or Medicaid.

The regulations generally replace the rules on when an employee has the right to change cafeteria plan elections for accident/health coverage or for group-term life insurance coverage. Temp. Regs. Sec. 1.125-4T(c)(2) provides that an employee can be given the right to change an election if any of the following occurs:

1. A change in marital status.

2. A change in number of dependents (including adoption or placement for adoption).

3. A change in employment status (termination or commencement of employment by the employee, spouse or dependent).

4. A change in the work schedule for the employee, spouse or dependent (e.g., change from part-time to full-time employment, strike or lock out).

5. A dependent grows out of coverage (e.g., attains age 24, is no longer a student).

6. A change in residence or work site.

The cafeteria plan can allow a change in coverage for the above events if a change above causes a change in health care or group-term life insurance coverage and the election change corresponds to such change in coverage. Temp. Regs. Sec. 1.125-4T(k) gives several examples of changes that would or would not be consistent with the change in status.

Sec. 401(k) Deferral Changes

The IRS's new rules allow a cafeteria plan with a Sec. 401(k) plan to give employees the option to change their Sec. 401 (k) deferral percentages during the year under the regular Sec. 401(k) and (m) rules. Some employers have been concerned that because a cafeteria plan can allow changes only once a year or for changes in status or family issues, the Sec. 401(k) contribution also had to be locked in. Temp. Regs. Sec. 1.125-4T(j) permits elective deferral elections on a broader basis.

Change in Work Status

The temporary regulations avoid the ongoing questions about change in work status from full-time to part-time. When there is a change from full to part-time status in which the employee is still covered in the benefits plan but must pay significantly more for coverage, employees try to argue that there has been a "significant cost change" that allows the employee a new election. Some employers allow this, as the regulations have not been clear. These regulations do not resolve this issue.

Fringe Benefits

Transit Benefits

Employees will be able to reduce employees' salaries to pay for transit passes and van pooling benefits under the IRS Restructuring and Reform Act of 1998 (IRSRRA '98). Under IRSRRA '98 Section 9010, (1) effective for tax years alter 1997, employees may choose between cash or any qualified transportation fringe benefit, and have to include amounts in income only if they choose the cash; and (2) effective for tax years after 2001, the excludible amount for transit passes and van pooling is increased to $100 and will be indexed for inflation thereafter.

Because these changes allow employees to reduce income to pay for commuting, employers can offer all employees (including those who commute on public transportation) income and FICA tax savings; at the same time, the employer can enjoy the same level of FICA tax saving. Both the employee and the employer get a tax break at no cost to the employer.

Further, up to $175 a month for qualified parking, and up to $65 a month for transit passes and van pooling transportation, is excluded from an employee's income for tax years beginning after 1998, under Sec. 132(f). These amounts will be indexed after 2002.

Because Sec. 132 benefits are exempt from the definition of wages for employment tax purposes under Secs. 3121(a)(20) and 3306(b)(16), no employment taxes will be due on the amounts deferred for qualified transportation.

These amounts cannot be salary-reduced through a Sec. 125 cafeteria plan. Sec. 125(f) specifically states Sec. 132 benefits cannot be included in a cafeteria plan.

Employer-Provided Meals

The IRSRRA '98 provided that all meals furnished to employees on the employer's premises will be nontaxable to the employees and fully deductible to the employer if more than 50% of the employees are provided meals for the convenience of the employer.

The new law provides that if more than 50% of employees receiving meals on an employer's premises are so provided for the convenience of the employer, all meals received by employees on the employer's premises will be treated as being provided for the convenience of the employer. These meals will be nontaxable to employees and fully deductible to the employer. This rule applies to tax years beginning before, on and after July 22, 1998.

Cents-Per-Mile Valuation

The nonbusiness use of employer-provided automobiles is includible in an employee's income. Three special valuation methods are provided for such use: the lease valuation rule (Regs. Sec. 1.61-21(d)), the vehicle cents-per-mile valuation rule (Regs. Sec. 1.61-21(e)) and the commuting valuation rule (Regs. Sec. 1.61-21(f)). Special limits apply to each method.

The vehicle cents-per-mile rule cannot be used if the value of the vehicle in the year it is first placed into use exceeds the automobile deduction limit under Sec. 280F(d)(7). Rev. Proc. 98-30(56) sets the value for deduction limits under Sec. 280F. To use the cents-per-mile method of attributing income to the employee for personal use of employer-provided automobiles, the maximum value of an automobile first placed in service in 1998 may not exceed $15,600.

Rev. Proc. 98-30 also provides tables for calculating the inflation-adjusted depreciation limits for luxury automobiles owned or leased under Sec. 280F and tables for calculating the amount that must be included in income of taxpayers who lease luxury automobiles. Separate tables are included for such calculations for electric cars.

(32) IRS Letter Ruling 9822012 (2/5/98).

(33) Rev. Rul. 78-182, 1978-1 CB 265.

(34) Rev. Rul. 80-300, 1980-2 CB 165.

(35) IRS Letter Ruling 9737014 (6/13/97).

(36) IRS Letter Rulings 9737015 and 9737016 (both dated 6/13/97).

(37) IRS Letter Ruling 9736040 (6/10/97).

(38) Rev. Rul. 80-244, 1980-2 CB 234.

(39) IRS Letter Ruling 9752030 (9/24/97).

(40) IRS Letter Ruling 9743043 (7/29/97).

(41) Rev. Rul. 71-385, 1971-2 CB 215.

(42) REG-209484-87 (1/25/96) and REG-209807-95 (12/24/97).

(43) Notice 98-8, IRB 1998-4, 6.

(44) IR-97-41 (10/22/97).

(45) IRS Letter Ruling 9811029 (12/9/97).

(46) General Signal Corp., 142 F3d 546 (2d Cir. 1998)(81 AFTR2d 98-1763, 98-1 USTC [paragraphs] 50,357), aff'g 103 TC 216 (1994).

(47) Parker-Hannifin Corp., 139 F3d 1090 (6th Cir. 1998)(81 AFTR2d 98-1115, 98-1 USTC [paragraphs] 50,278), aff'g and rev'g TC Memo 1996-337.

(48) Square D Co., 109 TC 200 (1997).

(49) TD 8741 (12/19/97).

(50) Notice 98-12, IRB 1998-5, 12.

(51) James Geissal v. Moore Medical Corp., 118 Sup. Ct. 1869 (1998), rev'g 114 F3d 1459 (8th Cir. 1997).

(52) See, e.g., Brock v. Primedica, 904 F2d 295 (5th Cir. 1990) and National Cos. Health Benefits Plan v. St. Josephs, 929 F2d 1558 (11th Cir. 1991).

(53) Oakley v. City of Longmont, 890 F2d 1128 (10th Cir. 1989), cert. denied.

(54) Ann. 98-22, IRB 1998-12, 33.

(55) TD 8738 (11/6/97).

(56) Rev. Proc. 98-30, IRB 1998-17, 6.

RELATED ARTICLE: EXECUTIVE SUMMARY

* In Geissal v. Moore Medical Corp., a unanimous Supreme Court ruled that health insurance coverage held prior to a COBRA qualifying event does not allow an employer to deny CCC under ERISA Section 602(2)(D)(i) on a qualifying event.

* The Second and Sixth Circuits concluded that for contributions to a VEBA to be deductible under Sec. 419A(c)(2) as a reserve funded over the working lives of covered employees for certain post-retirement benefits, contributions must actually be accumulated for the payment of such benefits.

* Under the IRSRRA '98, if more than 50% of employees receiving meals on an employer's premises are so provided for the convenience of the employer, the meals will be nontaxable to employees and fully deductible to the employer.

Authors' note: The authors acknowledge the significant assistance of Gary Cvach, Karen Field, Martha Priddy Patterson and Denis Yurkovic of KPMG Peat Marwick LLP's Washington National Tax Compensation and Benefits Practice and compiling information for this article.

Peter I. Elinsky, Esq. Partner KPMG Peat Marwick LLP Washington, D.C.

Terrance F. Richardson, Esq. Manager KPMG Peat Marwick LLP Arlington, VA

Eugene M. Holmes, Esq. Tax Specialist KPMG Peat Marwick LLP Arlington, VA