IRS small pension plan audit (and amnesty) program; March 31 deadline nears for program that resolves cases quickly and reduces taxpayer liability.

In connection with the Employee Retirement Income Security Act of 1974 (ERISA), Congress established the concept of "reasonable over a significant range" as a guideline for selecting values for the actuarial assumptions that are essential inputs to determining annual funding for defined benefit pension plans. Congress considered authorizing the establishment of specific assumptions, e.g., specific turnover rates for certain types of firms, but decided that "proper actuarial assumptions may differ substantially between industries, among firms, geographically, and over time." (1) Since then, the IRS has sought to establish objective, enforceable benchmarks for this concept in its Actuarial Guidelines Handbook and technical advance memoranda, and in the courts. (2) Recently, through the Actuarial Examination Program, the Service moved to enforce a floor for two assumptions--investment return and average retirement age--for small plan sponsors. This action has already reduced prior year tax deductions and resulted in tax penalties for thousands of plans. (3) Several completed audits are headed for the Tax Court in winter 1992. (4) Now, in an abrupt an uncommon move, the IRS has offered taxpayers potential protection from penalties through the Actuarial Resolutions Program in exchange for acceptance of the new IRS assumption restrictions.

Practitioners with small business clients should know the implications of the examinations and resolutions programs. Since IRS inquiries are typically directed to the plan administrator or the taxpayer, the tax practitioner may be unaware that an audit of the assumptions is in progress even though there may be a significant tax effect for the client. The taxpayer may underestimate the potential tax consequences of the audit and may miss an opportunity to avert, or at least to narrow, the scope of the audit. (5) If an audit has already been initiated, the tax practitioner may be called on to evaluate options under the new resolutions program.

This article will describe the origin and development of the actuarial audit program; discuss the new resolutions program; and examine the choices available to taxpayers.

Pension Plans and

IRS Regulatory Guidelines

A pension plan is an arrangement in which an employer provides benefits to employees after they retire. One common plan is a defined benefit plan in which the benefits are a function of the level of compensation near retirement and of the number of years of service. The benefits defined in this formula must be funded by the employer over the work lives of the employees covered by the plan. The funds set aside are tax-deductible for the employer, but are not taxed as income to the employee until the benefits are received during retirement. (6)

* Assumptions required for funding

The final cost of a funded pension plan consists of total benefits paid plus operating expense outlay minus investment income. This cost is only observable when the last participant (or his beneficiary) is deceased. An estimate of the various factors that determine net pension plan cost is necessary to calculate the contributions needed to maintain a financially sound plan. Actuaries consult with the plan sponsor to estimate long-term costs and current contributions.

Mortality rates of the participants, work force turnover, investment return, compensation scales, retirement rates and ages, and disability experience are the principal variables considered by actuaries in estimating pension costs. Each will affect the total cost of the plan. Yet each factor is unknown except in retrospect, and must be estimated as a part of the funding formula. The investment return on assets and the retirement age are the two assumptions currently under investigation by the Service. Small plans typically fund over a short period of time and have less plan experience to use as a guide to setting assumptions. They are also perceived as a vehicle to tax shelter income for the primary plan participant. As a result, small plans tend to use more conservative assumptions, which increase annual funding.

* IRS attack on plan assumptions

The IRS's concern over "excessive" current tax deductions is not new. What is new, however, is the focus on small plans and the apparent adoption of a much narrower concept of what constitutes reasonable assumptions. In the early 1980s, there was a widening in the disparity between investment yields and the lower interest rates adopted for funding purposes, and a reduction in the average retirement age assumption from the traditional 65 years. Both of these trends resulted in significant lost revenues to the government and may have precipitated the small plan actuarial audit program. This audit focus has met with considerable opposition from taxpayers and actuaries; resulting debate has led to the IRS compromise initiative in the form of an amnesty program.

The IRS Actuarial Guidelines Handbook, published in 1984, demonstrates the agency's initial formal response to its dual responsibility to ensure minimum funding under Sec. 412 and to limit excessive deductions under Sec. 404. (7) Both investment return and retirement age are used as example of assumptions subject to misestimation. If the actual experience of the plan differs from that which was assumed to occur by the choice of actuarial assumptions, an actuarial gain or loss occurs. The Handbook requires the field agent to analyze the historical experience of the plan. A build-up of actuarial gains is an indication of misspecified actuarial assumptions. However, employee plans specialists are cautioned that the "determination of whether assumptions in the aggregate are reasonable is very subjective." (8) Since the employee plans specialists are not actuaries, the Service continues to seek a more objective approach to the test of reasonableness.

The IRS attempted to reduce subjectivity for its auditors when it tied the evaluation of the reasonableness of the investment return assumption to investment yields in a series of technical advice memoranda issued in 1985. (9) In reviewing some 13 plans, the IRS identified an 8% interest rate and an age 65 retirement as reasonable assumptions. (10) In these cases, the 8% interest rate was within four percentage points of the long-term Treasury bond rates for the period under review. This appears to be the first evidence of a movement away from a methodology of judging assumptions based on plan experience to one based on reference rates. (11) In a 1986 presentation to enrolled actuaries, IRS Chief Actuary Ira Cohen noted that the majority of plans examined by the Service used investment returns that fell within just such a 4% corridor. (12)

An important Seventh Circuit decision in 1989 seemed to solidify the Service's new approach to evaluation of the investment return. At issue in Jerome Mirza & Associates, Ltd. (13) were the investment return assumption and the cost method used in the 1980 tax year. Mirza used a 5% rate. Although the reference rates cited by the government ranged between 11.65% and 15.75%, the government proposed, and the court approved, an 8% rate. This approach seems to confirm Cohen's 4% variation from the reference rate approach discussed with actuaries in 1986. Mirza assumed a 55 retirement age, which was not contested.

* IRS Actuarial Examination Program

In a Nov. 29, 1989 memorandum, (14) the Service addressed the issue of acceptable actuarial assumptions. For the first time it focused on small defined benefit plans and specifically mentioned 8% as a minimum investment return assumption and age 65 as a minimum retirement age assumption. The Service adopted the 8% rate as a minimum acceptable discoun rate without mentioning the 4% corridor concept. This very narrow approach was later softened in a Jan. 19, 1990 memorandum, which stated that National Office actuaries could approve investment returns other than 8% and retirement ages other than 65. (15)

The examination program focuses on plans with one to five participants and annual contributions exceeding $100,000 per participant that use actuarial assumptions for funding purposes of less than 8% for the investment return assumption, and/or a retirement age assumption of less than 65 years and for which annual contributions exceed $100,000 per participant. Originally, 20,000 plans out of a total of 370,000 were slated for audit for years 1986, 1987 and 1988, with tax recovery estimated at $666 million. (16)

Although the IRS has not proposed any regulations, its prescribed acceptable investment return assumption appears to stand at no lower than 8% and the retirement age assumption no lower than 65. The audit program covers only 1986, 1987 and 1988, but there is no indication that the guidelines will not continue is force in subsequent years. The significance of the investment return and retirement age benchmarks is that they do not allow for changes in the environment. Investment yields have dropped froom the highs of the early 1980s and a decrease in the average retirement age has been documented. A rigid formula for compliance would seem out of place in a changing U.S. social and economic environment, despite the ease with which it can be applied. For example, during the years subject to the audit program, average Treasury bond interest rates were 7.8% in 1986, 8.39% in 1987 and 8.96% in 1988. (17) For plan years immediately following 1988, tax law changes (e.g., the current liability calculation) have greatly reduced the plan sponsor's ability to make significant contributions, regardless of the assumption used to calculated plan costs. (18) Several years of limited funding may result in an underfunded plan. If this occurs, the precedent for restrictions on assumptions established by the IRS Actuarial Examination Program may delay the return of the plan to a funded position.

*Counterattack 

Small plan sponsors and the American Society of Pension Actuaries have concentrated their counterattack on the IRS by lobbying Congress, petitioning the Tax Court and soliciting support from voting constituencies through press coverage. They have pressured Congress to question the IRS audit program and introduce legislation to restrict IRS audits to the 1984 Handbook guidelines. Several plans that have received adverse audits have prepared for a confrontation in the Tax Court.

In addition, several articles have been published (19) emphasizing the small plan sponsor arguments: the IRS approach differs for large versus small plans; there has been a retroactive change in guidelines without advance notification of a policy change; and the assumptions selected are unreasonable and arbitrary,, with no reference to the facts and circumstances in individual cases.

IRS Actuarial Resolutions Program

In response to criticism from several fronts, the IRS has not backed down from its original position that tax abuse was the only reason for its action. However, it has adopted a conciliatory approach in its resolutions program. On June 18, 1991, the IRS announced that from July 1, 1991 through Mar. 31, 1992 limited participant defined benefit plans that are being audited will be able to resolve theis cases quickly (in order to stop the accumulation of penalties and interest) through the IRS Actuarial Resolutions Program. It is estimated that taxpayers who take advantage of this program could reduce their tax liability by one-half. The procedural aspects of this program were set out in Ann. 91-92. (20)

* Criteria for participating in the program

After the IRS completes a plan audit, the examining agent will discuss the proposed changes with the taxpayer or the taxpaye's representative. After evaluating the taxpayer's response to the proposed adjustments, the case file will be forwarded to a resolution officer to determine if the taxpayer is eligible to participate in the IRS Actuarial Resolutions Program. Although eligibility requirements are not discussed in Ann. 91-92, the announcement does state that certain taxpayers will not be eligible to participate in the program due to the "extreme nature of the practices at issue, or because there are other qualification or examination issues that can not be resolved as part of the Actuarial Resolutions Program." However, the IRS expects to make settlement proposals in the majority of the cases examined.

* Program options

If the taxpayer is eligible to participate in the Actuarial Resolutions Program, the IRS resolution officer will issue a letter offering the taxpayer three options: (1) protesting the adjustment to the IRS Appeals Division; (2) accepting the proposed adjustment(s) and paying all applicable tax and additions to the tax; or (3) accepting the Actuarial Resolutions Program settlement and paying the tax applicable to proposed adjustments without the Sec. 4972 excise penalty tax or the additions to the tax that could be assessed under other Code sections. The taxpayer will be given 60 days to respond, but may request an extension of up to 30 days if extra time is needed to assess the situation. A closing agreement is included with the letter stating the terms and conditions of the settlement agreement. The taxpayer must execute and return the closing agreement within the 60-day period plus any approved extension period.

If the taxpayer files a protest with the IRS Appeals Division while the settlement offer is outstanding, the case will be processed through the Appeals Division and the settlement offer will be withdrawn. This will result in the Appeals Office considering the case from the agent's proposed adjustments, including the excise and penalty taxes. Cases already at the Appeals Office may be transferred to the Actuarial Resolutions Program if so requested by the taxpayer by Aug. 31, 1991. Cases docketed for trial in the Tax Court will not be offered settlement under the program.

Several cases are awaiting trial in the Tax Court but are not expected to be heard until early 1992. To defer action on a taxpayer's situation until a decision is reached by the Tax Court could prove too costly, especially if the IRS's position prevails. Accrued interest on the proposed tax deficieny and penalties could substantially increase the total amount ultimately paid by the taxpayer.

* Participation

While no guidelines can be developed that apply uniformly to all taxpayers, there are a number of factors that taxpayers should consider before deciding to participate in the Actuarial Resolutions Program.

1. The amount of tax and penalty proposed.

2. The likelihood of the IRS prevailing in court.

3. The impact of accepting the IRS's proposed adjustments on the future viability of the plan.

4. The range of deviation between the IRS assumptions and the actual performance of the plan.

5. The probability of prevailing at the appeals conference.

6. The cost to litigate the taxpayer's position in court.

7. The time required to settle the case.

The only general conclusion that can be reached from an analysis of these factors is that plans with minimal tax consequences should take advantage of the Actuarial Resolutions Program since the costs of litigation may be in excess of the assessed tax deficiency. All other cases should be evaluated on their facts and circumstances.

In considering whether or not to agree to any adjustments proposed by the IRS, taxpayers should also consider any excise and penalty taxes that relate to the proposed income tax increase, plus interest that accrues with the tax liability. Consider the example on page 83.

* Another way?

An alternative to the structure being used in the small pension plan audit program would be for the IRS and those taxpayers that are being audited because of a change in IRS audit policy to jointly develop an amnesty program. This would allow the resolution program to be mutually beneficial and would enhance taxpayer acceptance of the program. The use of a limited amnesty program may have the potential to be applied in other enforcement areas. There are many Code provisions that require taxpayers to make assumption in order to determine the amount deductible. For example, transfer pricing is an area in which taxpayers must make judgments and assumptions to determine the correct transfer price for the firm. It is also an area of continuing controversy between the IRS and taxpayers and may be suitable for a jointly developed amnesty program.

Conclusion

While the actuarial Resolutions Program has some drawbacks, the IRS should consider the use of resolution programs (similar to the alternative approach suggested by the authors) in other areas of enforcement if the one presented here achieves meaningful, positive results.

From the IRS's standpoint, the use of such programs has several positive incentives. First, if taxpayers use the program, the time spent in the enforcement process is shortened and the Service can move to other areas of enforcement. This could ultimately increase the IRS audit coverage rate and enhance the overall U.S. rate of voluntary compliance. Second, the use of resolution programs could save both the taxpayers and the IRS the costs of appeals and litigation. Taxpayers have the additional incentives of the interest saved by a shortened resolution period and the expeditious resolution of their audit.

(1) H. Rep. No. 93-779, 93d Cong. 2d Sess. 27 (1974).

(2) Reish, Ashton and Ashton, Actuarial Audits: A Legal and Tactical Analysis (American Society of Pension Actuaries, 1990), at 2-3.

(3) Thompson. "The IRS Targets Small Pension Plans," 79 Nation's Business 44 (May 1991).

(4) As noted in a letter from Nancy L. Johnson (R-Conn.), Committee on Ways and Means, House of Representatives, Congress of the United States, to John E. Burke, Assistant Commissioner, Employee Plans and Exempt Organizations, Department of the Treasury, dated May 21, 1991.

(5) Reish and Ashton, note 2, at 8.

(6) Secs. 402(a) and 404(a).

(7) IRM 7(10)5(10).

(8) IRM 7(10)5(10), Chapter 400, at 450(1).

(9) See, e.g., IRS Letter Rulings (TAMs) 8552001 (8/13/85) and 8604001 (9/9/85).

(10) Reish and Ashton, note 2, at 59.

(11) Interestingly, this occurred at the same time the Financial Accounting Standards Board was moving towards the use of reference rates in the adoption of discount rates for accounting purposes. See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 87: Employers' Accounting for Pensions (FASB Dec. 1985).

(12) Included in unpublished remarks by Ira Cohen, Chief Actuary of the IRS, during the 1986 Enrolled Actuaries Meeting, Washington, D.C.

(13) Jerome Mirza @ Associates, Ltd., 882 F2d 229 (7th Cir. 1989((64 AFTR2d 89-5233, 89-2 USTC p9492), aff'g 692 F Supp 918 (C.D. Ill. 1988)(62 AFTR2d 88-5485, 88-2 USTC p9505), cert. denied.

(14) Memorandum from Robert I. Brauer, Assistant Commissioner, Employee Plans and Exempt Organizations, IRS to Assistant Regional Commissioners (Examination), dated Nov. 29, 1989.

(15) Memorandum from Robert I. Brauer, Assistant Commissioner, Employee Plans and Exempt Organizations, IRS to Assistant Regional Commissioners (Examination), dated Jan. 19, 1990.

(16) "Small Plan Audit Program Consistent With IRS Policy, Agency Official Says," BNA Daily Tax Report (4/3/90). at G-1.

(17) Thompson, note 3, at 46.

(18) See Sec. 412(b)(5), (c)(7) and (1)(7), amended by the Revenue Act of 1987.

(19) See, e.g., Thompson, note 3; Stout, "IRS Targets Thousands of Small-Business Pension Plans," The Wall Street Journal, 3/27/90, at B2.

(20) Ann. 91-92, IRB 1991-25, 58.

Frieda A. Bayer, Ph.D., CPA Assistant Professor of Accounting College of Business Administration University of North Texas Denton, Tex.

John E. Price, Ph.D., CPA Associate Professor of Accounting College of Business Administration University of North Texas Denton, Tex.