IRS attacks vacation pay deduction acceleration.

In Letter Ruling (TAM) 9443006, the IRS National Office ruled against a widely used method of accelerating deductions of vacation pay accrued at the end of a tax year but not received by employees until they take their vacations during the following year. This position will presumably be followed by IRS agents in the field, which will probably lead to many audit challenges to similar arrangements. The argument underlying this ruling is extremely weak, however. It is based on an out-of-context reading of the applicable Code provision's legislative history that is unlikely to persuade many courts and will need to be bolstered if the IRS is to prevail in litigation. Nevertheless, it would be prudent to recommend that clients disclose accelerated vacation pay deductions under Sec. 6662 to avoid any potential issue as to whether substantial authority exists for claiming the deduction.

Description of the acceleration

technique

The subject of the TAM was an accrual-basis employer. Under its vacation policy, employees accrued vacation days during a particular year and then could take paid vacation during the following year. This vacation pay was fully vested and was paid in cash to employees who separated from service before using all of their entitlement.

Fully vested vacation pay accrued as of the end of a tax year meets the threshold criterion for tax accrual, since the employer's liability satisfies the all-events test: The fact of liability is certain, and the amount can be reasonably estimated. The accrual also satisfies the economic performance requirement of Sec. 461(h), because the services that give rise to the vacation entitlement have already been performed (Sec. 461(h)(2)(A)(i)).

Nevertheless, vacation pay that employees receive later than 2 1/2 months after the end of the tax year is not deductible in the year of accrual; it is treated as deferred compensation and, under Sec. 404(a)(5), may not be deducted until the year of payment (Temp. Regs. Sec. 1.404(b)-1T, Q&A-2(b)(1) and (c)). This timing provision overrides the normal deduction rules under the taxpayer's method of accounting, because deferred compensation may be deducted only in accordance with the requirements of Sec. 404 (Sec. 404(a)).

To avoid this result, the tax-payer in the TAM, within 2 1/2 months after the end of its tax year, obtained an irrevocable letter of credit to secure payment of accrued vacation compensation. Its employees were the sole beneficiaries of the letter of credit, and their rights were not subject to the claims of the taxpayer's creditors in bankruptcy. The taxpayer's position was that its employees were in constructive receipt of vacation pay under the economic benefit doctrine when the letter of credit was obtained. Since that event occurred within 2 1/2 months after the end of the tax year, the vacation pay was not deferred compensation and therefore could be deducted in the year of accrual in accordance with the normal principles applicable to accrual-basis taxpayers.

IRS analysis

The National Office agreed that securing vacation pay promises with a letter of credit resulted in immediate inclusion of the pay in employees' gross income. This conclusion was based on a conventional, uncontroversial Sec. 83 analysis:

Here, Taxpayer's promise to pay vacation benefits was secured by an irrevocable standby letter of credit, and payments made or to be made thereunder were not subject to the claims of its general creditors. Accordingly, we have concluded that Taxpayer's secured promise to pay vacation benefits constituted "property" for purposes of section 83 of the Code.

Because Taxpayer's employees were named beneficiaries under the letter of credit, they were, both in form and in substance, transferred beneficial interests in the secured promise to pay their vacation benefits. Accordingly, we have concluded that, by securing its promise to pay vacation benefits, Taxpayer made "transfers of property" to its employees for purposes of section 83 of the Code.

Because Taxpayer's employees were not required to perform substantial future services in order to retain their beneficial interests in its secured promise to pay their vacation benefits, those interests were "substantially vested" in the employees upon transfer. Accordingly, we have concluded that, under the rules of section 83 of the Code, the fair market value of those interests was includible in the employees' gross income for 1992 as of the date that those interests were transferred. (Footnote omitted.)

Having reached this conclusion, the TAM cited Temp. Regs. Sec. 1.404(b)-1T as to the circumstances under which a plan was considered to be a plan of deferred compensation. These regulations include the following statement:

A plan, or method or arrangement, shall not be considered as deferring the receipt of compensation or benefits for more than a brief period of time after the end of the employer's taxable year to the extent that compensation or benefits are received by the employee on or before the end of the applicable 2 1/2 month period. Thus, for example, salary under an employment contract or a bonus under a year-end bonus declaration is not considered paid under a plan, or method or arrangement, deferring the receipt of compensation to the extent that such salary or bonus is received by the employee on or before the end of the applicable 2 1/2 month period. (Emphasis added.)

In the face of this regulatory language, the TAM concluded that the plan in question did defer the receipt of compensation and that no deduction was allowable until the employer's tax year in which cash payments were made to employees on account of vacation. The argument was based entirely on the legislative history of the last sentence of Sec. 404(a)(5), which was added to the Code in 1987 in connection with the repeal of Sec. 463.

Sec. 463 had allowed accrual basis taxpayers to deduct estimated vacation pay for the first 8 1/2 months of the tax year following the year of the deduction, without regard to whether employees' rights were vested. As a result of its repeal, vacation pay was subjected to the same rules as other compensation paid after year-end, with one exception set forth in the addition to Sec. 404(a)(5): When vacation pay was treated as deferred compensation, the payor was allowed a deduction in its tax year in which the payment was made. For other forms of deferred compensation, the deduction is allowable only in the tax year with or within which the recipient's tax year ends (Regs. Sec. 1.404(a)-12(b)(1)). For example, if an employer operating on a June 30 tax year pays deferred compensation (other than vacation pay) on Jan. 1, 1994, it may not claim a deduction until its year ending June 30, 1995, because that is the tax year within which the employees' tax year (the calendar year) ends.

The TAM quoted from the following portion of the legislative history of the amendment to Sec. 404(a)(5), underlining the second sentence for emphasis:

The conference agreement provides that vacation pay earned during any taxable year, but not paid to employees on or before the date that is 2 1/2 months after the end of the taxable year, is deductible for the taxable year of the employer in which it is paid to employees. This provision is an exception to the general rule for deferred compensation and deferred benefits pursuant to which an employer is allowed a deduction for the taxable year of the employer in which ends the taxable year of the employee in which the compensation or benefit is includible in gross income.

The TAM interpreted this paragraph as contrasting the time of payment with the time of receipt, summarizing its meaning as:

Thus, as indicated by the referenced legislative history, even if the fair market value of deferred vacation pay becomes includible in the gross incomes of employees (for example, by reason of certain types of security arrangements under the rules of section 83, such vacation pay is not deductible by their employer, under the rules of section 404(a)(5) until it is paid to the employees.

Comments on the analysis

This analysis has several weaknesses. First, it assumes that paid is used in the legislative history not as the correlative to received but with the special meaning paid in cash, so that "receipt" can occur before "payment." It is not obvious that the conferees meant to make any such distinction. On the surface, the report merely states that the deduction of deferred vacation pay, unlike the deduction of other forms of deferred compensation, is not postponed until the tax year within which the recipients' tax year ends. Thus, the timing rule for vacation pay deductions is slightly more liberal than the rule for other deferred compensation.

The difference in phraseology between the first and second sentences of Sec. 404(a)(5) is easily explained by the need to express this timing difference clearly. The first sentence states that the deduction for contributions to a deferred compensation plan is allowable in the tax year in which an amount attributable to the contribution is includible in the employees' gross income. Long-standing regulations have interpreted this to mean that the employer cannot take the deduction until the employees' year of inclusion has ended, and the Conference Report recites that as the general rule for deducting deferred compensation. A different rule was intended for deferred vacation pay, but it would be difficult to use the phrase "includible in the gross income of employees" in that rule without either writing an extremely awk-ward sentence or rewriting the existing text of Sec. 404(a)(5). The simple solution was to leave the first sentence untouched and to use is paid in the second sentence to mean "the event occurs that gives rise to the inclusion of the deferred vacation pay in the gross income of employees."

Second, neither the amendment to Sec. 404(a)(5) nor its legislative history purports to define when vacation pay is treated as deferred compensation. Sec. 404(a)(5) has no application to nondeferred pay of any kind, and there is no hint that Congress intended to alter the existing rules for distinguishing between deferred and nondeferred compensation. Under those rules, compensation is not deferred if it is includible in income within 2 1/2 months after the end of the employer's tax year. Even if the alleged distinction between that time and time of payment exists, payment has no significance for the question of whether vacation pay is in fact deferred compensation subject to Sec. 404(a)(5).

At root, the TAM's reasoning is circular, asserting that no deduction is allowable under the rules of Sec. 404(a)(5) but begging the question of whether those rules apply. It therefore will probably be unpersuasive in court.

Conclusion

According to the practitioner who received the TAM, the issues presented were handled by high-level IRS personnel; well-reasoned or not, the conclusions reached appear to represent a firm National Office position.

IRS auditors will undoubtedly use it as a basis for challenging similar arrangements maintained by other companies. Under these circumstances, it may be prudent for taxpayers to make Sec. 6662 disclosure of accelerated vacation pay deductions in order to avoid any potential issue as to whether substantial authority exists for claiming the deduction.

This recommendation does not imply that the arguments advanced in the TAM are at all convincing or are likely to prevail in litigation. The TAM relies on a patent distortion of legislative history, and the Service will probably make different, as yet unarticulated, arguments in any lawsuits that may arise.