IRS precluded from requiring retroactive changes in actuarial assumptions.

IN THIS DEPARTMENT

Accounting Methods and Periods Payment of accrued compensation; p. 657.

Business Expenses

Tax-related payments; p. 654.

Depreciation

Property placed in service in short tax years; p. 655.

Estate Planning 

Inheritance planning; p. 649.

Gifts Cancellation of installment obligations; p. 650.

Gross Income

Effect of nonrecourse debt on insolvency determination; p. 651.

Liquidation of Corporation

Liquidating trustee's personal liability; p. 652.

Partners and Partnerships

Sec. 752 election under final regulations; p. 660. Workout arrangements; p. 642.

Pensions ESOP valuations; p. 658. Retroactive changes in actuarial assumptions; p. 640. State and local plans; p. 662.

Procedure and Administration Offers in compromise; p. 661.

S Corporations AMT calculations; p. 666. Trust installment obligations; p. 644.

State Taxes Nexus; p. 659.

Unless otherwise indicated, contributors' firms are associated with DFK International.

"Like Christmas in July" was the sentiment among many taxpayers and practitioners who eagerly awaited the decisions handed down in Vinson & Elkms, 99 TC No. 2, and Wachtell, Lipton, Rosan & Katz, TC Memo 1992-392, on July 14, 1992. These cases involved the reasonableness of actuarial assumptions made by the enrolled actuaries of the taxpayers' defined benefit plans. In both cases, the taxpayers prevailed. Unfortunately, the timing of these decisions, the planned expiration of the offers at the Actuarial Resolution Program and the IRS's absolute refusal to discuss the issues may leave taxpayers with no acceptable option. Certainly, advisers should consider the availability of the award of legal fees under Sec. 7430.

Background

The Service has devoted substantial resources since its success in Jerome Mirza and Associates, Ltd., 882 F2d 229 (7th Cir. 1989), aff'g 692 F Supp 918 (DC III. 1988), in identifying the sponsors of primarily small defined benefit plans that are perceived as abusive, and challenging the deductions claimed by these sponsors. The IRS contention has been that actuarial assumptions used in projecting maximum employer contributions have been unreasonable. The Service believes that these assumptions have been set to maximire current contributions and related deductions, and that these assumptions do not reflect economic reality. 1t has been the IRS position that a retroactive change in assumptions--which would translate into tax deficiencies, interest and excise taxes under Sec. 4972, and penalties under Sec. 6651 {a)(1) and {a)( 2)--is appropriate.

In an effort to settle these cases, the Service has developed an Actuarial Resolutions Program. Under the terms of this program, excise taxes and penalties (which can be substantial)would be waived. Faced with Mirza as the only litigated situation, an aggressive IRS and the prospect of huge litigation expenses, taxpayers making the decision to accept or reject the Service's offer have often concluded that the IRS settlement offer is the more attractive choice.

Vinson and Wachtell

The facts in these two cases are very similar. Vinson and Wachtell were law partnerships. Many partners of each firm established individual defined benefit plans effective in 1984. Enrolled actuaries calculated the maximum contributions to each of these one man defined benefit plans using a set of assumptions the actuaries had established. The Service challenged the 1986 [and 1987 in Vinson] deductions related to these contributions on the theory that the assumptions used were not reasonable, i.e., the same arguments successfully made in Mirza. While in Mirza the challenge was limited to the preretirement interest rate assumption, in Vinson and/or Wachtell the IRS challenged pre- and postretirement interest rates, retirement age, expense loads and the use of a particular mortality table.

In both cases the Tax Court found that assumptions made by the enrolled actuaries were reasonable in the aggregate, that the assumptions represented the actuaries' best estimates of anticipated experience under the plans and finally, that since the assumptions used were not substantially unreasonable, the Service could not require a retroactive change of assumptions.

Underlying the reasoning of the court are two principles that appear to pervade the analysis of each of the assumptions the IRS challenged. First is the concept that there is a need for conservatism in the actuarial assumption selection process. The court appears to believe that this need for conservatism is particularly acute in a new plan situation in which there is no plan history on which to evaluate the reasonableness of assumptions. A second major premise accepted by the court is that Congress knowingly elected to defer to the professional judgment of enrolled actuaries when it empowered them with the authority to establish actuarial assumptions. Absent a finding that the assumptions were substantially unreasonable, they should not be modified.

With respect to the interest rate assumptions, the court found the following factors relevant.

* The period over which the plans would operate and invest.

* The existence (or lack thereof) of a professional money manager.

* The past history and experience (or lack thereof)of the plan with respect to earnings and investment strategies.

* The rates used by other actuaries at that time for other small plans.

The evidence presented in both Vinson and Wachtell was such that the court concluded that a 5% interest rate assumption (both preretirement and postretirement) was reasonable. (The Service had taken the position that 8% was appropriate. In those situations, the plans were to operate for extended periods 130 to 50 years) and, accordingly, placing significant weight on current rates was inappropriate. No professional money managers were employed and reduced returns could be expected. The plans were newly created and, therefore, no track record of successful investing could be demonstrated. And finally, "most actuaries used interest rate assumptions of between 5 percent and 6 percent for small plans during the years at issue."

The court found an actuarially assumed retirement age of 62 to be reasonable in Vinson and, similarly, a retirement age of 55 coupled with 15 years of service in Wachtell. Underlying the court's analysis was a belief that an actuary must use assumptions that insure that the promised benefits will be available when the participant is scheduled to retire. In an effort to predict the retirement ages of the Vinson and Wachatell attorneys, the court listened to evidence concerning retirement trends in general and among attorneys in particular. It also analyzed the evidence on factors either demonstrating or likely to influence the retirement decisions of the Vinson and Wachtell attorneys, including terms of partnership agreements, benefit elections and the culture within the firms. A factor that appeared to be persuasive was the changing nature of the legal profession. Traditionally, senior partners had experienced a decreased workload. However, changes in the legal profession have caused high pressure for, and total commitment from, all partners regardless of age. The court clearly accepted the argument that this would lead to earlier retirement in the future.

The court further concluded that an assumption of 5% for annual expenses [legal, actuarial, accounting, etc.)in Vinson, and 7.5% in Wachtell, was not unreasonable. However, the language of the court suggests that 7.5% appears to have pushed the limit of reasonableness.

Finally, the court concluded that using two different mortality tables, one for predicting the cost of a preretirement death benefit, and one for predicting the duration of retirement payments, was not unreasonable.

Mirza reexamined

Mirza involved the defined benefit plan of a two-attorney law firm. The relevant issue was the reasonableness of a 5% preretirement interest rate assumption. The Service took the position that 8% was appropriate and, accordingly, assessed a deficiency.

The district court concluded that the IRS assessment was appropriate. It cited the extremely high returns obtained on short term certificates of deposit acquired by the plan during 1980, which ranged from 11.65% to 15.75%. It also referred to Treasury Bond rates available at the end of 1980, which were approximately 19.%. Also clearly influential was the investment strategy demonstrated through the plan's initial investments--a propensity for investments that were "very conservative with a high income yield."

While Mirza continues to be troubling, particularly to those taxpayers and practitioners in the Seventh Circuit {which affirmed the district court's decisions, it may be possible to draw a factual distinction between Mirza and Vinson/Wachtell. The Mirza plan provided for front-loading of benefits-73% of benefits accrued in the first year of participation and the remaining 27% accrued over the next three years. Additionally, the court concluded that this plan would probably cease benefit accruals at Mirza's retirement, which was assumed by the court to be 12 years in the future. Given those facts, the court concluded that the then current rates were a significant predictor of overall return. The court went so far as to say that "the plan could have invested in 10-year Treasury Bonds and been guaranteed a return of over 12% for more than 4/5th of the pre-retirement investment period." This conclusion appears to have disregarded the demonstrated propensity for short-term investments, as well as the possibility of new plan participants. Absent the extreme front-loading provided for under the terms of the Mirza plan, this decision is less troubling.

Aftermath

As a consequence of the newness of the Vinson and Wachtell decisions, the IRS has not yet formally responded. It will undoubtedly be considering a rehearing in the Tax Court and/or an appeal to the Fifth and Second Circuits, respectively.

Until the Service exhausts its remedies, practitioners do not anticipate a change in the Actuarial Resolutions Program. Some have suggested, however, that in light of Vinson and Wachtell, it may be appropriate for taxpayers to consider the availability of an award of fees. Sec. 7430 provides for such an award to a "prevailing party" in either an administrative or a civil proceeding, if the taxpayer establishes that the IRS.'s position was "not substantially justified." Additionally, in Nancy l. Johnson Bayer, TC Memo 1991-282, the Tax Court held the IRS liable for the taxpayers' legal costs incurred in light of the Service's nonresponsiveness to the issues. If the IRS remains nonresponsive to these issues, taxpayers may be eligible for recovery of fees. Concerns over such an award may cause the Service to modify its position. From Brady Langford, J.D., CPA, Chicago, Ill.