Current developments.

EXECUTIVE SUMMARY

* The Ninth Circuit reversed the Tax Court in Boyd Gaming; the employer can deduct 100% of meals furnished to employees.

*IRS coordinated issue papers examined tax-free reimbursements under self-insured medical plans and the deduction of family medical coverage provided to an employee spouse.

* In Alpha Medical, the Sixth Circuit decided the age-old question of reasonableness of compensation.

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.

Welfare Benefits

COBRA Regs.

Twelve years after the first Consolidated Omnibus Reconciliation Act of 1985 (COBRA) healthcare continuation proposed regulations were released under Sec. 4980B, the IRS issued final regulations and more proposed regulations.(18) The IRS has "caught up" the regulations to Congress's frequent changes in the COBRA statute. The final regulations are effective for COBRA qualifying events occurring in plan years beginning after 1999.

VEBAs

The IRS ruled in Letter Ruling 9915059(19) that a voluntary employee benefits association (VEBA) must include in unrelated business taxable income (UBTI) investment income it earned on amounts set aside to pay insurance premiums for employees with "banked" hours.

Banked hours: In the ruling, a VEBA paid premiums to insurance carriers that provide medical benefits to employees who participate in the employer's medical plan. Employees must work a specified minimum number of hours to be eligible for benefits; employees who work more than the minimum number of hours can "bank" them to cover periods when they do not work the minimum. The VEBA proposed to set aside, in a separate bank account, investment income to pay future insurance premiums and trust expenses resulting from the use of banked hours. It requested a ruling that this investment income would not be included in its taxable income, on the basis that its obligation to pay future premiums for banked hours constitutes "claims incurred but unpaid."

Account limit: Tax is imposed on a VEBA's UBTI for each tax year, under Sec. 511 (a) (1). A VEBA's UBTI equals its gross income (excluding exempt-function income (EFI)), minus the deductions attributable thereto. A VEBA's EFI is its gross income from employee contributions to provide the VEBA benefits, plus employer contributions and passive investment income (other than UBTI) set aside for exempt purposes. Sec. 512(a) (3) (E) provides that the set-aside cannot exceed the account limit determined under Sec. 419A. Generally under Sec. 419A(c)(1), the account limit is the amount reasonably and actuarially necessary to fund incurred but unpaid claims, plus related administrative costs.

Zero account limit: Citing the legislative history of Sec. 419A and the Sixth Circuit's decision in Parker-Hannifin Corp.,(20) the IRS found that claims are incurred only when an event (such as a medical expense) actually occurs; a contractual obligation to pay benefits does not meet that requirement. Thus, according to the IRS, a fully insured plan has a zero account limit. Because a set-aside cannot exceed the account limit, no part of the VEBA's proposed set-aside could be treated as EFI; rather, all of the investment income earned on amounts set aside to pay insurance premiums on behalf of employees with banked hours was includible in the VEBA's UBTI.

Tax-Free Reimbursements Under Self-Insured Medical Plans

The IRS has taken the position in a coordinated issue paper(21) that employees cannot exclude from income employer reimbursements under a self-insured medical plan for medical expenses incurred before the employer adopted the plan. Such retroactive adoption of medical plans often arises when a self-employed (SE) individual hires his spouse as an employee and seeks to cover the family's medical expenses.

Sec. 105(b) excludes from gross income amounts an employee receives through accident or health insurance as reimbursement for expenses incurred for medical care for himself, his spouse or dependents. Sec. 105(e) provides that, for purposes of the exclusion, amounts received under an accident or health plan for employees will be treated as received through accident or health insurance. Thus, the Sec. 105(b) exclusion is available for self-insured medical plans.

The IRS stated that, for there to be a "plan" under Sec. 105(e), the employer must be committed to certain rules and regulations governing payment; these rules must be made known to employees as a definite policy and be determinable before the employee's medical expenses are incurred. Accordingly, the IRS position is that payments of medical expenses incurred before plan adoption are not paid or received under an accident or health plan; thus, they are includible in an employee's income under Sec. 61, not excludible under Sec. 105(b). On the other hand, as long as the expenses are ordinary and necessary business expenses, they are deductible under Sec. 162(a).

The industry's argument in favor of the exclusion is based on Kegs. Sec. 1.105-5(a), which provides that an accident or health plan may be either uninsured or insured, and that the employee's rights under the plan may or may not be enforceable. However, if the employee's rights are not enforceable, an amount is deemed to have been received under a plan only if, on the date the employee became sick or injured, he was covered by a plan providing for the payment of amounts to employees in the event of personal injuries or sickness, and notice or knowledge of such plan was reasonably available.

According to the IRS, this language has been misread by tax advisers to mean that, if an employee's right to payment is enforceable, there is no requirement that the (1) plan be in effect when the medical expenses are incurred or (2) employee have notice of the plan. The IRS's position is that Sec. 105 does not address the retroactivity issue and that Regs. Sec. 1.105-5(a) is open to other interpretations.

Family Coverage Provided to Employee Spouse

The IRS has concluded in a coordinated issue paper(22) that an SE individual can deduct the cost of accident and health coverage provided to his spouse as an employee, if the spouse is a bona fide employee in the business. In appropriate circumstances, this position would allow SE individuals to escape the Sec. 162(1) limits on the deductibility of medical insurance premiums.

This issue arises when an SE individual hires his spouse as an employee, then provides the spouse family coverage through a self-insured (or an insured) medical plan. The SE individual is covered by the plan as a member of the employee-spouse's family. This arrangement allows the SE individual to deduct the cost of providing medical coverage to himself and his family as a Sec. 162(a) business expense (i.e., as part of a reasonable allowance for compensation); the employee-spouse excludes from income both the cost of the coverage and the benefits paid under the plan.

Deduction: The IRS's position, based on Rev. Rul. 71-588,(23) is that the cost of the coverage (including medical expense reimbursements) is deductible by the SE individual under Sec. 162 if the employee-spouse (1) is a bona fide employee under common-law rules or (2) otherwise provides services to the business for which the coverage constitutes reasonable compensation.

If the employee-spouse does not meet that standard, the coverage is a personal expense under Sec. 262(a) and nondeductible under Sec. 162(a). The cost of health insurance purchased by the SE individual would be deductible up to the applicable percentage limit under Sec. 162(1); any excess would be deductible only to the extent allowed under Sec. 213 (i.e., in excess of 7.5% of adjusted gross income). Amounts paid by an SE individual for reimbursement under a self-insured plan for himself, his spouse and dependents would be deductible only to the extent allowed under Sec. 213.

The IRS noted that if a health insurance policy is purchased in the SE individual's name, the Sec. 162(1) limits would apply, even though coverage is provided for the employee-spouse and dependents in addition to the SE individual.

Exclusion: The IRS also concluded that the cost of health coverage or medical expense reimbursements will be excludible from the employee-spouse's income if he is a bona fide employee under common-law rules.

If the spouse is not a bona fide employee, the cost of coverage under an insured plan is not excludible under Sec. 106; medical expense reimbursements received by the spouse are not excludible under Sec. 105(b). If the cost of the coverage is included in the spouse's income, all amounts received by the spouse and family for personal injury and sickness would be excludible under Sec. 104(a)(3).

The IRS listed several additional factors to consider in determining whether the spouse is a bona fide employee:

* Does the plan document provide that the spouse is eligible to participate (e.g., has the spouse satisfied any applicable waiting period requirements)? If not, medical expense reimbursements may not be excludible, because they would not have been received under a health plan. Also, if such requirements are not consistently applied to all employees, a self-insured plan could be considered discriminatory under Sec. 105(h).

* What is the extent and nature of the spouse's involvement in the business? Part-time work does not negate employee status, but nominal or insignificant services with no economic substance may be challenged.

* Is the spouse an SE individual engaged in the trade or business as a joint owner, co-owner or partner? A significant investment of the spouse's separate funds may indicate that the spouse is an SE individual, too.

* Marital property or community property laws may be relevant (but not necessarily conclusive) in determining whether the spouse is self-employed in the business.

* A spouse of a greater-than-2% S corporation shareholder is treated as a greater-than-2% shareholder for certain employee fringe benefit purposes (including health benefits), under Secs. 318 and 1372. Thus, both the spouse and the greater-than-2% shareholder would be treated as partners in a partnership for health benefit purposes.

Executive Compensation

Surrender of Stock Options Not Constructive Receipt

In Letter Ruling 9901006,(24) the IRS held that a rabbi trust participant's opportunity to surrender incentive stock options (ISOs) and nonqualified stock options (NQSOs), and the actual surrender of such options, do not result in taxable income to participating employees and their beneficiaries under either (1) Sec. 61 and the constructive receipt doctrine or (2) Sec. 451 and the economic benefit doctrine.

Facts: A parent company has no employees; its subsidiaries have employees to whom the parent had granted both ISOs and NQSOs from 1995-1997. The exercise price was determined at the .grant date. The options had no readily ascertainable fair market value (FMV); the options vested in three to five years, with additional vesting rights at death or on dismissal due to a change in control.

An outsider bought a portion of the parent's stock at a price in excess of its appraised FMV. To allow the employees holding stock options to share in the stock's enhanced value, the parent allowed participants to surrender their options for a "deferral amount" equal to the difference between the per-share price paid by the outsider and an employee's exercise price, multiplied by the number of options the employee held. The deferred amounts were credited to hypothetical accounts established for each surrendering employee. Subaccounts were established for the proceeds from each separate grant of options over the years. None of the participating employees was a controlling shareholder.

The subsidiary employing the participants established a rabbi trust under Rev. Proc. 92-64(25) to meet its obligations under the stock option surrender plan. The trust assets remain subject to the claims of the subsidiary's general creditors if the subsidiary becomes insolvent.

Rulings: In addition to ruling that the surrender did not result in taxable income to the participants under either Sec. 61 or 451, the IRS also ruled that grantor trust rules would apply to the trust, such that the subsidiary would be treated as the owner of the trust and taxed on all its income. Neither the creation of the trust nor the contribution of assets to it would be deemed a transfer of property under Sec. 83. The subsidiary will take a deduction for amounts paid under the plan when participants include those amounts in income.

The IRS expressed no opinion on whether the surrender right for the ISOs would be treated as a modification under Sec. 424(h)(3) that would cause the grant to be treated as a new grant.

FICA Withholding on Nonqualified Deferred Compensation Plans

The IRS released final regulations on when and how employers must withhold FICA on nonqualified deferred compensation.(26) Sec. 3121(v) provides that employers maintaining nonqualified deferred compensation plans must withhold FICA on deferred amounts as of the later of when the contribution is (1) earned or (2) no longer subject to a substantial risk of forfeiture. The regulations are effective as of 2000.

Accelerated Payment Not Subject to Sec. 162(m) Limit

Letter Ruling 9920011(27) addressed whether accelerated payments to employees under option contracts existing on Feb. 17, 1993, were applicable employee remuneration (AER) for Sec. 162(m) purposes. The IRS held that a company's accelerated (but discounted) payments were not a material modification of the contracts; thus, the payments were not AER under Sec. 162(m). Because the payments were not AER, the Sec. 162(m) $1 million deduction limit did not apply to the accelerated payments.

Facts: Before Feb. 17, 1993, a company entered into NQSO agreements with three employees, then amended the agreements before that date. Under the agreements, when the options were exercised, the employees were given interest-free recourse loans for the income tax owed on exercise, which did not have to be paid back until the stocks were sold. Although the loans were interest-flee, interest was imputed to the employees as income under Sec. 7872. The option agreements provided that, for each year the loans were outstanding, the company would pay the income tax attributable to the employees' imputed interest and gross-up the employees for the payment.

Under the option agreements, when the stocks were ultimately sold, the company was required to pay the employees a tax indemnification payment equal to the sum of (1) the excess of (a) the tax (at ordinary income rates) that the employee had paid on exercising the option, plus the tax (at capital gains rates) he would pay on the sale of the optioned stock, over (b) the amount of tax (at capital gains rates) the employee would have paid on the sale of the optioned stock had he instead purchased the stock for the amount paid to purchase the option; and (2) the grossed-up tax the employee would have to pay as a result of recognizing the income described in (1).

The tax indemnification payment was made to put the employees in the position they would have been in had they exercised the options when granted. Because the company wanted to end its obligation to make such payments, it proposed accelerating payment of all amounts owed under the option agreements. The accelerated payments would equal the tax indemnification payment; all imputed interest payments would end. The elimination of the imputed interest payments would create a discount for all payments, varying for each employee from 6%-7.3%. The discount was similar to the applicable Federal rate in effect at the time of the proposal. The company claimed that the accelerated payments were a reasonable discount of the amount owed (the combined tax indemnification payment plus the imputed interest payments).

Applicable law: The issue was whether the proposed accelerated payments were a material modification of the option agreements that would trigger the Sec. 162(m) $1 million deduction limit. Sec. 162(m) (1) limits the deduction a publicly held corporation is allowed for AER for covered employees to $1 million. Sec. 162(m) (3) defines "covered employees" as the chief executive officer (CEO) or the four highest-paid officers other than the CEO. AER is defined by Sec. 162(m)(4) as the aggregate amount allowable as a deduction per year for remuneration of services performed by the employee; this amount is determined without regard to Sec. 162(m).

However, an exception to the definition of AER exists for contracts existing before Feb. 17, 1993. Sec. 162 (m)(4)(D) provides that AER does not include remuneration paid under a written binding contract in effect on Feb. 17, 1993, if the contract was not materially modified after that date. If the contract was materially modified, it is treated as a new contract effective on the modification date, under Regs. Sec. 1.162-27(h)(1). A modification is material if it provides for increased or additional compensation. A modification that accelerates payment is a material modification unless the amount is discounted to take into account the time value of money.

IRS decision: The imputed interest payments and the tax indemnification payments would not be subject to Sec. 162(m) deduction disallowance, because the company's proposal to accelerate the option agreements was not a material modification. Thus, the proposed accelerated payments would not be AER under Sec. 162(m) and the company could deduct them in full.

Who is the CEO?

In Letter Ruling 9921032,(28) the IRS was confronted with a situation not contemplated in the Sec. 162(m) regulations--a publicly held corporation with co-CEOs. The IRS ruled that the co-CEO who is more highly compensated is the CEO, and a covered employee under Sec. 162(m)(3)(A).The other co-CEO is a covered employee under Sec. 162 (m)(3)(B) if he is among the four most highly compensated officers other than the CEO.

The ruling involved the merger of two corporations; the merged entity appointed two individuals to serve as co-CEOs. Sec. 162(m) generally provides that, in the case of a public corporation, no deduction is allowed for AER for any covered employee to the extent it exceeds $1 million. A "covered employee" is defined by Sec. 162(m)(3) as any employee of the taxpayer if (1) as of the close of the tax year, the employee is the CEO of the corporation (or acting in that capacity) (Sec. 162(m)(3)(A)); or (2) the employee's total compensation for the tax year must be reported to shareholders under the Securities Exchange Act of 1934, by reason of the employee's being one of the four highest paid officers for the tax year (other than the CEO) (Sec. 162(m)(3)(B)).

The IRS noted that "CEO" is stated in the singular in both Sec. 162 (m)(3)(A) and Regs. Sec. 1.162-27(c)(2)(i)(A); the Sec. 162(m) legislative history does not indicate that Congress ever contemplated that a company might have more than one CEO. The more highly compensated co-CEO will be a covered employee under Sec. 162(m)(3)(A) ; the less highly compensated co-CEO will be a covered employee under Sec. 162 (m) (3) (B) if he is among the four highest compensated officers other than the CEO. According to Regs. Sec. 1.162-27(c)(2)(ii), which co-CEO is more highly compensated is determined under the method set out in the Instructions to Item 402(a)(3) of Securities and Exchange Commission Regulation S-K, Determination of Most Highly Compensated Executive Officers.

Sixth Circuit Addresses "Reasonable Compensation" In Alpha Medical Inc.,(29) the Sixth Circuit reversed a Tax Court decision concerning reasonable compensation for the president, sole director and shareholder of a medical management company.

Facts: Alpha Medical began operations in Tennessee in 1986 with two employees and one client. By 1990, the year at issue, it had 60 employees, 43 clients and operated in several states, providing a wide array of management services to home healthcare agencies and hospitals with home healthcare departments.

William Rogers was Alpha's president, sole director and sole shareholder. Rogers made an initial capital contribution of $1,000 to incorporate Alpha, worked 12 or more hours per day and was available at all times by telephone or pager. He made all decisions that affected Alpha's mid- and long-range plans and handled all client and employee problems.

In 1986 (the year Alpha began operations), Rogers received a job offer from a firm in California. Although that job would have paid him more than $1 million annually, Rogers rejected the offer because he did not want to leave Tennessee. In 1990, Alpha paid Rogers $4,439,180 and deducted it on its tax return.

Law: Sec. 162(a)(1) permits a corporation to deduct as a business expense "a reasonable allowance for salaries or other compensation for personal services actually rendered" Regs. Sec. 1.162-7(a) and (b) explain that the test of deductibility is whether compensation is (1) reasonable, (2) in an amount that would ordinarily be paid for like services by like enterprises under like circumstances and (3) payment purely for services.

In large public corporations, the deductibility of compensation is seldom questioned, because employees are generally dealt with at arm's length.

However, in small, closely held corporations, the issue arises more frequently, because the corporations' shareholders are often key employees. Thus, it is in the interest of all parties to characterize amounts distributed to shareholder-employees as deductible compensation rather than nondeductible dividends.

IRS and Tax Court: The IRS determined that Rogers' $4.439 million 1990 compensation was unreasonable and that the excess over $400,000 was nondeductible. The Tax Court ruled that $2.3 million of compensation was reasonable, but did not explain how it reached that figure. (The Sixth Circuit noted that $2.3 million appeared to be halfway between $400,000 and $4,439,180.) The Tax Court also upheld the accuracy-related penalty assessed against Alpha for substantially understating its 1990 income.

Sixth Circuit: The Sixth Circuit examined the following nine factors in considering the reasonableness of compensation:(30)

1. The employee's qualifications.

2. The nature, extent and scope of the employee's work.

3. The business's size and complexities.

4. Comparison of salaries paid with gross and net income.

5. Prevailing general economic conditions.

6. Comparison of salaries with distributions to stockholders.

7. Prevailing rates of compensation for comparable positions in comparable concerns.

8. The compensation paid to the employee in previous years.

9. The salary policy of the taxpayer as to all employees.

Employee's qualifications: The Sixth Circuit agreed with the Tax Court that Rogers' qualifications supported the position that his 1990 compensation was reasonable, because Alpha's success was mainly attributable to his hard work, talent and considerable experience. Rogers held a pharmacy doctorate and had previously founded several successful businesses.

Nature, extent and scope of employee's work: Because Rogers held most of the management positions and handled responsibilities for a wide range of Alpha's activities, the Sixth Circuit agreed with the Tax Court that Rogers was an indispensable condition to the company's remarkable growth. Therefore, the nature, extent and scope of Rogers' work supported the position that his 1990 compensation was reasonable.

Size and complexities of business: Managing a home healthcare business requires special technical expertise as well as compliance with a complicated array of Federal and state laws and regulations. In light of these challenges and the fact that a significant amount of Alpha's growth occurred between 1989 and 1990, the Sixth Circuit and Tax Court agreed that the business's size and complexities supported the reasonableness of Rogers' 1990 compensation.

Comparison of salaries paid with gross and net income: In 1990, Rogers' compensation was 64.6% of Alpha's net taxable income and 44.9% of its gross receipts. The Sixth Circuit agreed with the Tax Court that this comparison (and the fact that Rogers, as Alpha's president and sole shareholder, alone made all salary and dividend distribution decisions, yet received only $1,500 in dividends during 1990) supported the IRS's position that his 1990 compensation was unreasonable.

Prevailing general economic conditions: The Sixth Circuit agreed with the Tax Court's assessment that Alpha did not prove that the home healthcare industry suffered from adverse economic conditions or that the industry was significantly more competitive in 1990 than in 1989. Accordingly, the courts agreed that prevailing general economic conditions supported the IRS's position that Rogers' 1990 compensation was unreasonable.

Comparison of salaries and distributions: According to the Sixth Circuit, if a company's earnings on equity remain at a level that would satisfy an independent investor, it is a strong indication that management is providing compensable services and profits are not being distributed disguised as salary. Because the total return on Rogers' equity for 1990 was 98.65%, the Sixth Circuit agreed with the Tax Court that this comparison supported the reasonableness of Rogers' 1990 compensation.

Comparable positions: Alpha failed to provide comparables; accordingly, the Sixth Circuit agreed with the Tax Court that this factor favored neither party.

Compensation paid in previous years: Extra compensation paid to an employee to make up for insufficient compensation in prior years is generally not considered unreasonable compensation. Alpha had paid Rogers the following compensation in prior years:

Year                   Amount

1986                  $ 66,943
1987                  $ 75,914
1988                  $431,702
1989                  $928,883

Because Rogers was paid less than $1 million in each of these years (following his 1986 $1 million salary offer), the Sixth Circuit agreed with the Tax Court that Rogers was underpaid in previous years. The courts agreed that Rogers' previous undercompensation supported the reasonableness of his 1990 compensation.

Taxpayer's salary policy: In comparison to all 60 Alpha employees, Rogers received 73% of the total compensation paid in 1990 and nearly 86% of the compensation paid to key employees that year. The Tax Court concluded that this disparity in compensation levels, the fact that Rogers alone determined employee compensation and the rise in Rogers' salary from $928,883 in 1989 to $4.439 million in 1990, supported the IRS's position that Rogers' salary was unreasonable.

The Sixth Circuit disagreed; although noting that the rise in Rogers' salary was "eye-opening," it reiterated Rogers' qualifications, expertise, the scope of work he performed and Alpha's equity growth. The court observed that, in the healthcare industry (as well as many other industries), corporations have been allowed without contest to deduct executive compensation packages more than 10 times the level received by Rogers. Oddly, the court did not make this observation in discussing the "comparables" factor; moreover, the court cited no authority for this statement.

The Sixth Circuit reversed the Tax Court's decision, finding that Rogers' 1990 compensation was reasonable. Although the Sixth Circuit agreed with the Tax Court on nearly every issue, it ruled the Tax Court's decision clearly erroneous. The Sixth Circuit's reversal is surprising, because the court failed to adequately explain why it disagreed with the Tax Court on the sole issue on which the courts reached different conclusions. Moreover, the case involved almost exclusively an analysis of the facts and circumstances; appellate courts generally defer to the trier of fact's judgment.

Change of Ownership

In Letter Ruling 9914032,(31) the IRS held that a surviving corporation underwent a change of ownership under Sec. 280G. The acquired corporation did not undergo a change in ownership or control, because its shareholders received more than 50% of the surviving corporation's stock. Further, payments made to executives of the acquired corporation were not subject to the Sec. 4999 20% excise tax on excess parachute payments.

Facts: Corporations X and Y merged; X was the survivor. Y's outstanding stock was exchanged for X stock; Y stock options were exchanged for X stock options. As a result, although X was the surviving entity, Y's shareholders acquired more than 50% of X's outstanding stock.

Y had employment agreements with its CEO, president and executive vice presidents that provided for cash payments and other benefits in the event of actual or constructive discharge. Under the merger agreement, X assumed the employment agreements and agreed to treat the executives as constructively discharged. The issues were whether there had been a change in control of either X or Y under Sec. 280G and whether the payments to Y's executives were subject to Sec. 4999.

Applicable law: Sec. 280G(a) states that no deduction is allowed for any excess parachute payment; Sec. 4999 imposes a 20% excise tax on the recipient of an excess parachute payment, which is defined by Sec. 280G(b)(1) as the excess of any parachute payment over the portion of the base amount allocated thereto.

According to Sec. 280G(b)(2)(A), for a payment to constitute a parachute payment, it must be contingent on a change in the (1) corporation's ownership or effective control or (2) ownership of a substantial portion of the corporation's assets.

A "change in ownership" occurs, under Prop. Regs. Sec. 1.280G-1, Q&A-27, when a person (or group of persons) acquires ownership of stock that, together with other stock held by the person or group, brings its ownership to more than 50% of the stock's total FMV or voting power.

A "change in effective control" occurs, under Prop. Regs. Sec. 1.280G-1, Q&A-28, when (1) a person (or group of persons) acquires 20% or more of the corporation's total voting power or (2) a majority 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 board members before the date of the appointment or election.

A "change in the ownership of a substantial portion of the corporation's assets" occurs, under Prop. Regs. Sec. 1.280G-1, Q&A-29, on the date any person (or group of persons) acquires from the corporation assets with a total FMV of more than one-third the total FMV of all the corporation's assets immediately before the acquisition.

IRS decision: Under the merger agreement, X transferred to Y's shareholders X stock in exchange for Y's assets. Because Y's shareholders received over 50% of X's voting power from this transaction, X had undergone an ownership change.

As part of the merger, Y transferred its assets to X. While it appears that Y had undergone an ownership change as to a substantial portion of assets, the stock received by Y's shareholders represented a greater-than-50% interest in X immediately after the merger. Thus, the ownership of the assets was not considered to have changed; Y did not undergo an ownership change and the payments to Y's executives were not subject to Sec. 4999.

While it may seem unusual that the acquired company did not undergo a change in control under Sec. 280G, the IRS has maintained this position previously.(32)

Merger Did Not Trigger Excise Tax

In Letter Ruling 9915021,(33) the IRS held that a target had not undergone an effective change in control under Sec. 280G, because the acquiring corporation did not act in a concerted way to control the target's management or policies. Also, the target had acquired sufficient voting power and stock value in the merger such that there was no ownership change.

Facts: Corporations X and Y entered into a merger agreement. Parent was created as a holding company for X and Y and their subsidiaries. Parent also formed two wholly owned subsidiaries, Sub X and Sub Y. Sub X merged into X; the latter was the survivor. Sub Y merged into Y; the latter was the survivor. X and Y became Parent's wholly owned subsidiaries. The X and Y shareholders exchanged their stock for Parent stock. Under the merger agreement, half of Parent's board of directors was selected by X and half by Y.

X had employment agreements with its officers; after the merger, Parent made the payments. A ruling was requested as to whether X had undergone a change in control under Sec. 280G such that the payments were subject to Sec. 4999.

Applicable law: Sec. 280G(a) disallows a deduction for any excess parachute payment; Sec. 4999 imposes a 20% excise tax on the recipient of an excess parachute payment (i.e., the excess of any parachute payment over the portion of the base amount allocated thereto).

Examining Prop. Regs. Sec. 1.280G-1, Q&As-27,-28 and -29, the IRS ruled that, although X had surrendered potential control when it issued its stock to Parent, X's shareholders acquired sufficient Parent stock value and voting power in the merger such that X did not undergo an ownership change.

Y's stock was transferred to Parent for Parent stock, giving Y's shareholders a greater-than-20% voting interest in Parent and an indirect interest in X. While Prop. Regs. Sec. 1.280G-1, Q&A-28, presumes that X experienced an effective change in control, Y's shareholders never acted in a concerted way to control X'S management and policies. Further, Parent's board was approved by both X and Y; neither corporation appointed a majority of directors. The IRS ruled that X had not undergone an effective change in control, provided that after the merger, Y did not act in a concerted way to control X's management and policies.

The IRS also concluded that neither the approval nor the implementation of the merger would result in a change in ownership or effective control of X under Sec. 280G; Sec. 4999 would not apply to the payments received by X's officers.

Temporary or final regulations on the issues addressed in this ruling have not yet been adopted. Thus, Letter Ruling 9915021 could be modified or revoked by the adoption of regulations inconsistent with its conclusions. However, if the criteria in Rev. Proc. 98-1,(34) section 12.05, are met, the ruling will not be revoked or modified retroactively (except in rare or unusual circumstances).

Contingent Options Do Not Determine Change in Control

In FSA 9915007,(35) the IRS concluded that an option to acquire stock with serious conditions precedent resulting in a substantial risk of forfeiture did not convey constructive ownership of the stock; thus, the purchaser did not have an option for Sec. 280G purposes.

The purchaser of a company and its shareholders entered into stock option and merger agreements, each of which were subject to contingencies. Advice was sought as to whether the purchaser had constructive ownership of the optioned stock on the date the agreements were entered into. The determination of this issue affected whether there had been a change in control under Sec. 280G.

Prop. Regs. Sec. 1.280G-1, Q&As-27,-28 and -29, offer guidance in determining whether there has been a change of control under Sec. 280G. All three reference Sec. 318(a) to determine stock ownership. Under Sec. 318(a)(4), a person with an option to acquire stock is deemed to own the optioned stock. However, this rule does not apply if there are contingencies outside the optionee's control that remove the election from his unilateral decision.(36)

In the FSA, there were several ways the option agreement could be terminated. The IRS ruled that these conditions precedent created a substantial risk of forfeiture and removed from the optionee the unilateral election to exercise the options. Thus, Sec. 318 did not attribute the stock to the optionee, nor would the options be applicable in determining a change of control under Sec. 280G.

Three-Year Performance Unit Was Not Deferred Compensation

In Letter Ruling (TAM) 9923045,(37) the IRS concluded that payments made 2 1/2 years after the close of the tax year in which units under an employer's performance unit plan vested did not constitute deferred compensation--even though the units had been granted three years earlier. Thus, the employer's deduction was not subject to Sec. 404(a)(5).

A company was an accrual-basis taxpayer with a fiscal year ending August 31. It maintained an executive compensation program under which certain executives received payments equal to the value of vested performance units issued under the plan. Units were awarded to eligible executives at the discretion of a board of directors committee; the number of units awarded was influenced by factors such as individual merit, organizational level and years of service. The value of each unit was based on a formula described in the plan, and determined at the close of the three-year period beginning with the fiscal year in which the unit was awarded.

The value of each unit vested in an executive at the close of business on the last day of the third year of this three-year period, and was paid in cash within 2 1/2 months after the close of the third year. If an executive terminated employment before the end of the three-year vesting period for any reason other than death, disability or retirement, the units were forfeited. In the event of death, disability or retirement, the committee had the discretion to allow for the vesting and payment of unvested units.

Believing the all-events and economic performance tests under Sec. 461 were met as of the close of the tax year when the units became vested, the company accrued the expense for that year, even though payment was not made until 2 1/2 months into its next tax year. The IRS agent, believing that the payments constituted deferred compensation, because they were not made within 2 1/2 months after the close of the tax year in which the units were granted, took the position that, under Sec. 404(a)(5), the company had to delay its deduction until the tax year following the year in which the units vested.

All-events and economic performance tests: An accrual-method taxpayer generally is allowed a deduction in the tax year in which all the events have occurred that determine the fact of a liability and the amount thereof can be determined with reasonable accuracy (the all-events test). In determining whether an amount has been incurred with respect to any item during the tax year, the all-events test is not treated as having been met any earlier than when economic performance occurs, according to Sec. 461(h). For a liability that arises as a result of another person's providing services to the taxpayer, economic performance generally occurs when such services are provided.

Deferred compensation: Sec. 404 governs the timing of an employer's deductions for payments under a deferred compensation plan. Sec. 404(a)(5) states in part that in the case of compensation paid or accrued under a nonqualified deferred compensation plan, the employer is entitled to a deduction in the tax year in which the amount is includible in the employee's income.

Temp. Regs. Sec. 1.404(b)-1T, Q&A-2(a), addresses when a plan is considered to defer the receipt of compensation for Sec. 404(a) purposes. It provides that a plan defers the receipt of compensation to the extent that, under the plan, an employee receives compensation "more than a brief period of time" after the end of the employer's tax year in which the services creating the right to the compensation are performed. Temp. Regs. Sec. 1.404(b)-1T, Q&A-2(b), provides that a plan is presumed to defer the receipt of compensation for more than a brief period of time to the extent an employee receives the compensation after the fifteenth day of the third calendar month following the end of the employer's tax year in which the related services were rendered.

Vesting: An examination of the legislative history revealed that the payment of bonuses or other amounts within 2 1/2 months after the close of the tax year in which significant services required for payment have been performed is not considered a deferred compensation or deferred benefit plan.

Although the executives' rights to the units arose in part from services performed in the year the units were granted, "significant services" were required through the end of the third year; otherwise, the payments were subject to forfeiture. The IRS concluded that, because the units did not vest until the end of the third year, and their value was paid within 2 1/2 months after the end of the fiscal year in which they vested, the payments did not constitute deferred compensation and the employer's deduction was not governed by Sec. 404(a)(5).

The IRS also concluded that the fact an employee could receive payment before the end of the three-year period (i.e., in the case of death, disability or retirement) did not change its analysis. In such case, (1) related services would be performed from the date of the award through the date of death, disability or retirement, (2) units would not be vested until the end of that period and (3) payment would be made within 2 1/2 months after the end of the fiscal year in which death, disability or retirement occurred. Thus, any payments so made would not constitute deferred compensation under Sec. 404(a)(5).

The IRS did not specifically rule on when the company could take a deduction--just that the timing was not governed by Sec. 404(a)(5). The IRS stated that it was neither expressing nor implying an opinion on the application of any other Code section to the transaction.

Fringe Benefits

Deducting Employee Meals

According to the Ninth Circuit in Boyd Gaming Corp.,(38) casino employees prohibited from leaving their employer's premises receive meals for the convenience of their employer. Thus, Sec. 119 applies and the employees will not be taxed on the value of those meals. Under Sec. 274(n)(2)(B), the meals are fully deductible by the employer. While the decision applies only to taxpayers in the Ninth Circuit, the case is likely to generate employers' interest in the appropriate tax treatment of employer-provided meals.

Background: Secs. 119, 132(e) and 274(n) interact to determine the tax treatment of employer-provided meals to both the employer and the employee. Under Sec. 119, employer-provided meals are not taxable to employees if they are provided for the employer's convenience and served on its premises. Section 5002(a) of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98) added Sec. 119(b)(4), providing that if more than half of the employees receiving meals are receiving them for the employer's convenience, all employees receiving meals are so treated. (Prior law required that "substantially all" employees receiving meals receive them for the employer's convenience.) Under IRSRRA '98 Section 5002(b), this change applies to tax years beginning before, on or after July 22, 1998.

Under Sec. 132(e)(2), meals offered from an employer's eating facilities located near or on the employer's premises are treated as nontaxable de minimis fringe benefits if those facilities generate revenue equal to or exceeding their operating costs. An employee permitted to exclude the value of a meal under Sec. 119 is treated as having paid full value for it for Sec. 132(e) purposes. Hence, any meal service "for the convenience of the employer" will be. treated as a "break even" meal for purposes of calculating the facility's revenue under Sec. 132(e).

Under Sec. 274(n)(1), 50% of the cost of employer-provided meals are deductible (80% for the years at issue in Boyd); however, Sec. 274(n)(2)(B) exempts from the 50% deduction limit meals excludible from an employee's income under Sec. 132(e).

Domino theory: These sections interact like tax-saving dominos. If a meal is for the employer's convenience, it is nontaxable to the employee. If at least 50% of employees receiving such meals are not taxed because of the convenience factor, none of the employees receiving such meals are taxed. Under Sec. 132(e)(2), an employee receiving meals exempt from tax under Sec. 119 is treated as having paid for them for Sec. 132(e) purposes. These meals, deemed to be fully paid for, may enable the entire food service facility to be treated as covering the costs of operation. If the facility's costs of operation are covered, all meals served by the facility would be treated as de minimis under Sec. 132(e), so that no employee receiving meals would be taxed. All meals would be deductible under Sec. 274(n)(2) (B).

Tax Court's view: Boyd required its casino employees to remain on the premises for security and logistics reasons throughout the work shift. As a result, its employees received free meals at on-site cafeterias. Boyd argued that it was exempt from the 80% cap on deductions applied during the years at issue because the meals were a de minimis fringe benefit under Secs. 274(n)(2) and 132(e); they were furnished to more than half the employees for the employer's convenience. The Tax Court held that Boyd did not furnish meals to "substantially all" its employees for the employer's convenience; thus, Boyd was limited to deducting 80% of the meal expenses.

Ninth Circuit: The Ninth Circuit's analysis began with an examination of the meaning of "convenience of the employer," which the court ruled should be measured according to a business-necessity theory. Under that theory, the exclusion from gross income applies only when an employee must accept the meals to perform his duties properly. According to the Ninth Circuit, the Tax Court erred in second-guessing Boyd's business judgment. The Tax Court cannot substitute a business judgment contrary to the unimpeached and uncontradicted evidence presented by the taxpayer.

Boyd had adopted a "stay-on-premises" requirement; as a result, it furnishes meals to its employees because they cannot leave the casino properties during their shifts. Common sense dictates that once the policy was embraced, the "captive" employees had no choice but to eat on the premises. In effect, the furnished meals were indispensable to the proper discharge of the employees' duties.

Contrary to the Tax Court's conclusion, no nexus other than the "stay-on-premises" policy was required. The IRS'S argument that the meals had to be linked to an employee's specific duties would render the test virtually impossible to satisfy; only restaurant critics and dieticians could meet such a test.

The appeals court also found the IRS's position to be inconsistent with Regs. Sec. 1.119-1(a)(2)(ii)(c) and (f)(7), which envision that meals furnished to employees who are similarly confined to business premises during meal times, but for different reasons (i.e., remote location, insufficient eating facilities in the vicinity), are provided for the employer's convenience. For regulation purposes, the Ninth Circuit found no logical distinction between workers isolated by geography and those isolated by employer policy.

Nevertheless, it would not have sufficed for Boyd simply to have said it had a policy to be entitled to a deduction. In the court's view, Boyd supported its closed-campus policy with adequate evidence of legitimate business reasons. While reasonable minds might differ regarding whether a "stay-on-premises" policy is necessary for security and logistics, the casinos actually operated under this policy. Given the credible and uncontradicted evidence regarding the reasons underlying the "stay-on-premises" policy, it is inappropriate to second-guess these reasons or to substitute a different business judgment for Boyd's.

The court concluded that, as a result of the "stay-on-premises" requirement, more than half of Boyd's employees received the free meals for the employer's convenience; thus, Boyd was entitled to invoke Sec. 119(b)(4). As a result, for the tax years at issue, Boyd could deduct 100% of its employee cafeteria expenses.

(18) TD 8812 and REG-209485-86 (2/2/99); for a discussion, see Patterson, Tax Clinic, "Final and Prop. COBRA Kegs.," 30 The Tax Adviser 380 (June 1999).

(19) IRS Letter Ruling 9915059 (1/20/99).

(20) Parker-Hannifin Corp., 139 F3d 1090 (6th Cir. 1998).

(21) Retroactive Adoption of an Accident and Health Plan, Coordinated Issue Paper, Industry Specialization Program (3/29/99).

(22) Health Insurance Deductibility for Self-Employed Individuals, Coordinated Issue Paper, Industry Specialization Program (3/29/99).

(23) Rev. Rul. 71-588, 1971-2 CB 91.

(24) IRS Letter Ruling 9901006 (9/28/98).

(25) Rev. Proc. 92-64, 1992-2 CB 11.

(26) TD 8814 (1/28/99); for a discussion, see Field, Tax Clinic, "Final FICA Withholding Regs. on Nonqualified Deferred Compensation," 30 The Tax Adviser 382 (June 1999).

(27) IRS Letter Ruling 9920011 (2/10/99).

(28) IRS Letter Ruling 9921032 (2/25/99).

(29) Alpha Medical Inc., 172 F2d 942 (6th Cir. 1999)(83 AFTR2d 99-1922, 99-1 USTC [paragraph]50,461), rev'g TC Memo 1997-464.

(30) Mayson Mfg. Co., 178 F2d 115 (6th Cir. 1949)(38 AFTR 1028, 49-2 USTC [paragraph]9467).

(31) IRS Letter Ruling 9914032 (1/13/99).

(32) See, e.g., IRS Letter Rulings 9536014 (6/8/95) and (TAM) 9719003 (12/24/96).

(33) IRS Letter Ruling 9915021 (1/7/99).

(34) Rev. Proc. 98-1, IRB 1998-1, 7.

(35) IRS Letter Ruling (FSA) 9915007 (12/21/98).

(36) Rev. Rul. 68-601, 1968-2 CB 124.

(37) IRS Letter Ruling (TAM) 9923045 (10/9/98).

(38) Boyd Gaming Corp., 177 F3d 1096 (9th Cir. 1999)(83 AFTR2d 99-2354, 99-1 USTC [paragraph]50,530), rev'g TC Memo 1997-445.

Peter I. Elinsky, Esq. Partner KPMG LLP Washington, DC

Terrance E Richardson, Esq. Manager KPMG LLP Arlington, VA

Eugene Holmes, Esq. Tax Specialist KPMG LLP Arlington, VA

Authors' note: The authors acknowledge the significant assistance of Gary Cvach, Karen Field, Martha Patterson, Denis Yurkovic, Tracey Schlabach, Terri Stecher, Donna M. Prestia and Pamela Hobbs, of KPMG LLP's Washington National Tax Compensation and Benefits Practice, in compiling information for this article.