Current developments in employee benefits.
* Deduction limits
On Dec. 15, 1993, the IRS released proposed regulations implementing the Sec. 162(m) limit on deductions for certain executive compensation in excess of $1 million annually.(38) The preamble indicates that, to the extent that an issue is not covered by the proposed regulations, taxpayers should follow a reasonable, good-faith interpretation of the statutory provisions. The proposed regulations were later modified by Notice 94-2(39) and Notice 94-68.(40)
The Sec. 162(m) limit on deductions paid to "covered employees" applies to the chief executive officer (CEO) and the four highest paid executives (other than the CEO) of publicly traded companies for compensation that is not "performance-based." Both for purposes of determining what is a publicly held company and who is a "covered employee," the status on the last day of the tax year controls. A company that "goes private" during a year will not be subject to Sec. 162(m).
A "publicly held corporation" includes all corporations in the affiliated group of the publicly held corporation (as defined in Sec. 1504, without regard to Sec. 1504(b)) whether or not they file a consolidated return. Therefore, a group consisting of several affiliated corporations may still have as few as five covered employees among the entirety of the group.
A performance goal will not be considered to be "preestablished," and hence, exempt from the $1 million cap, unless it has been established by the compensation committee in writing before the employee performs the services, and while the outcome of the goal is substantially uncertain. Further, both the performance goal and the amount of compensation under it must be objective. The committee may retain the discretion to lower the compensation under the plan if the goal is reached, but not to increase compensation under the performance goal. The standard for "objectivity" requires that a third party with knowledge of the relevant facts should be able to determine whether (and to what extent) the goal was satisfied, and the amount of the compensation that would be payable to the employee.
According to Notice 94-68, the final regulations will provide that a performance goal based on a period of service will be "preestablished" if it is established in writing by the compensation committee no later than 90 days after the commencement of that period of service and if the outcome is substantially uncertain at that time. This will allow compensation committees to use year-end financial information in setting performance goals, while satisfying the requirement that goals be set while the outcome is substantially uncertain. The final regulations will also provide that in no event will a performance goal be considered preestablished if it is established after 25% of the period of service has elapsed.
Stock options and appreciation rights will be considered "performance-based" compensation if the grant is made by the compensation committee, the plan includes a per-employee limitation on the number of shares for which options or rights may be granted during a specified period, and the exercise price or base price is no less than the fair market value of the stock on the date of the grant or award. An unconditional grant of discounted stock, appreciation rights and restricted stock will not be considered performance-based compensation. The fact that discounts are granted on some stock options or rights will not cause other compensation attributable to qualified grants or awards to become includible in the $1 million cap. If, however, the grant of a discount option or restricted stock is contingent on the attainment of a performance goal, the compensation attributable to those shares could meet the requirements for performance-based compensation.
If options or other rights are repriced after their initial issuance, the repricing will be treated as the issuance of a new option and a cancelation of the original grant. Both the original grant and the stock repriced will count against the employee's individual limit on the number of shares contained in the original performance-based compensation plan.
The compensation committee must consist solely of outside directors. The proposed regulations describe an outside director as an individual who is not a current employee, is not a former employee receiving compensation for prior services (other than from a tax-qualified retirement benefit plan), has not been an officer of the company, and does not receive remuneration from the company directly or indirectly other than as a director. Remuneration includes other than de minimis payments for goods and services, including payments to entities in which the director has at least a 5% ownership interest or is employed. Under a transition rule, a "disinterested director" within the meaning of Securities and Exchange Commission (SEC) Rule 16b-3 is treated as an outside director until the first shareholders' meeting at which directors are to be elected occurring after July 1, 1994.
Shareholder disclosure must include a description of the broad class of employees covered by the performance goal arrangement, a general description of the goals, and the formula for computing the compensation or the maximum dollar amount that will be paid if the goal is attained. Specific targets need not be disclosed, and general SEC disclosure standards that protect confidential and commercial business information can be followed. For example, the "third party" disclosure requirement establishing the objectivity of the performance goal is not the shareholder disclosure standard. Redisclosure and reapproval are required only when material terms are changed, or at least once every five years.
Sec. 162(m) does not apply to copensation paid under written binding contracts in existence on Feb. 17, 1993. State law determines whether the contract is binding. Any material modification will be treated as a new, non-grandfathered contract. For plans that meet the grandfather rule as of Feb. 17, 1993, an individual who was an employee as of that date or had a contract to participate eventually in the plan as of that date is not subject to the deduction limit, even though the employee was not actually eligible to participate in the plan on that date.
* Proxy disclosure
On Nov. 29, 1993, the SEC announced several changes to the executive compensation disclosure rules, intended to make compensation disclosure clearer and more useful to shareholders.(41)
Prior to the changes, the rules covered only executive officers employed at fiscal year-end. The amendments broaden the group of persons covered by the rules to include CEOs and no more than two other top-paid executive officers who left the company during the latest completed fiscal year. The salary and bonus reportable are those paid, earned or accrued. Amounts are not to be annualized for the period after departure.
Previously, disclosure of year-end restricted stock holdings for named executive officers was required only when an award of restricted stock appeared in the Summary Compensation Table. The amended rule requires disclosure of all year-end restricted stock holdings.
Registrants using a Black-Scholes or binomial pricing model to value options were previously permitted to limit their disclosure to a simple declaration of the use of such model. Under the amended rules, registrants must disclose specific assumptions and adjustments underlying the option valuations.
The amended rules also change the point at which the market capitalization of a peer group index or market capitalization index is calculated, from the end of the period for which a return is indicated, to the beginning of the period.
The SEC has specified that the compensation committee report should address the registrant's policy with respect to qualifying compensation paid to its executive officers for deductibility under Sec. 162(m). At a minimum, this would include a statement that the compensation committee has structured compensation paid to the CEO and other named officers to be deductible to the extent possible. Further explanation may be necessary, depending on the circumstances.
In General Signal Corp.,(42) the Tax Court ruled that VEBA sponsors may not automatically rely on the safe harbor in Sec. 419A(c)(5)(B), or on reserve numbers reported by insurance administrators before plan year-end, to establish the account limit for a qualified asset account in calculating the appropriate employer deduction for VEBA funding contributions under Sec. 419A. The Tax Court also upheld the IRS's denial of deductions for additions to the account limit to fund postretirement medical and life insurance benefits under Sec. 419A(c)(2) when contributed assets were used to pay for active employees' benefits.
At the urging of a consultant to take advantage of perceived tax savings, the taxpayer established a VEBA for several benefits, including health care benefits for active employees, and postretirement medical and death benefits. On the basis of actuarial calculations, the taxpayer contributed more than $35 million to fund the postretirement medical and death benefits for 1986 and in excess of $40 million for 1987.
During 1988, the taxpayer decided that, based on tax rates and the cost of capital, prefunding the VEBA was no longer cost-effective. It began funding on a pay-as-you-go basis and essentially used the amounts contributed for the postretirement "qualified asset account" to pay all claims received by the VEBA, including those of active employees.
The Tax Court rejected the taxpayer's use of the 35% safe harbor method in computing its deductible VEBA contribution. It followed the IRS's views on the so-called safe-harbor provisions, using virtually the same analysis used by the IRS in Letter Ruling (TAM) 9334002.(43) It concluded that the safe harbor limits in Sec. 419A(c)(5)(B) do not allow a taxpayer to automatically claim 35% of its prior-year's qualified direct costs as the amount of incurred but unpaid medical claims. Rather, the statute merely allows a taxpayer to claim amounts at or below this threshold without obtaining an actuarial certification.
The court then referred to the legislative history(44) of Sec. 419A(c)(5)(B), which provided that an actuarial certification by a qualified actuary (determined under Treasury regulations) justifying the taxpayer's reserve computations is not necessary if the amount in the qualified asset account is below a prescribed safe harbor, equal to the sum of separate safe harbor amounts computed with respect to each benefit. If the safe harbors are met, the taxpayer must show that the reserves, as allowed under the general standards provided by the bill (e.g., claims incurred but unpaid), are reasonable. The court found that the taxpayer had not demonstrated that 35% of its qualified direct costs was a reasonable estimate of its incurred but unpaid medical claims.
Also rejected was the taxpayer's argument that "the amount reasonably and actuarially necessary" to fund incurred but unpaid medical claims could be based on the reserve numbers reported by the insurance administrators. The taxpayer conceded that most of these estimated amounts were calculated during the middle, not the end, of the VEBA plan year. However, because there were no significant changes in the benefits provided through the VEBA, the number or class of employees or retirees covered under the VEBA, or the administrators processing the claims, the taxpayer argued that the numbers provided by the insurance administrators should be viewed as the amounts reasonable and actuarially necessary to fund medical claims incurred but unpaid at each year-end.
The court rejected this estimating approach for calculating the qualified asset account for incurred but unpaid claims, holding that the taxpayer's arguments that (1) there were few changes in the benefits or demographics of the plans and (2) estimates of incurred but unpaid claims varied only 3% from the 1986 and 1987 estimates, were inconclusive. Presumably, the guidance provided by the IRS in Letter Ruling (TAM) 9334002, permitting the use of estimates based on VEBA year-end figures, could be used.
The court also disagreed with the taxpayer's argument that Sec. 419A(c)(2) does not require establishment of a funded reserve to include an amount in the account limit. The court noted that whether Sec. 419A(c)(2) requires the accumulation of assets in the nature of a funded reserve was an issue of first impression. In the court's view, the statute was clear that such a fund was required, and could be funded with general, rather than specific, assets. The court did not impose a requirement that a separate account be established with respect to the reserve.
The court provided no guidance as to how that reserve should be calculated, however. Because the taxpayer failed to establish any funded reserve, the court did not have to address the required rate of funding under Sec. 419A(c)(2).
Any plan sponsor taking a deduction for additions to a qualified asset account under Sec. 419A for claims incurred but unpaid, or taking a deduction for reserves funding postretirement medical or life insurance benefits, may be affected. If a deduction is taken for claims incurred but unpaid, the plan sponsor will need either an actuarial certification of those claims or some other evidence that the amount deducted was "reasonably" necessary to fund the expense. If a deduction is taken for funding reserves for postretirement benefits, there should be some evidence that a fund actually exists within the VEBA and that the funds so contributed are not depleted to pay other benefits.
Summary Plan Description
Recently, in Aiken v. Policy Management Systems Corp.,(45) the Fourth Circuit reiterated its view that representations in a Summary Plan Description (SPD) control over inconsistent provisions in an official plan document. Plan sponsors are concerned about Aiken because it reflects the views of at least five other circuits, and the court maintained its position even though the plan (as with most plans) indicated that the plan document would control.
Ronald Aiken was accused of sexual harassment and was offered the choice of resigning or being fired. He opted for resignation "under protest." Aiken claimed that he resigned in part because he believed he would be immediately eligible for retirement benefits. Aiken based his claim for benefits on the SPD, which on its face indicated that Aiken was entitled to a lump-sum distribution of his vested benefits. The employer, Policy Management Systems, denied Aiken's claim, because the terms of the plan document differed from the SPD and did not provide for such a distribution.
On cross-motions for summary judgment, the district court had concluded that the plan terms controlled over those of the SPD and dismissed Aiken's claim. It alternatively found that even if the SPD controlled, Aiken was not entitled to recover, because he had failed to demonstrate reliance on the SPD or prejudice resulting therefrom. The Fourth Circuit overruled the district court on both issues.
The specific provision in the SPD on which Aiken based his claim stated that if a participant terminated employment after completing 20 years of service but before attaining age 60, the participant was entitled to a distribution of his vested interest in the plan. At the time of resignation, Aiken was not yet 60 years of age and had served with the employer for more than 20 years.
Reviewing the lower court's decision, the Fourth Circuit stated that representations in an SPD control over inconsistent provisions in an official plan document. In so ruling, the court cited its decision in Pierce v. Security Trust Life Ins. Co.,(46) in which it recognized that the SPD is the statutorily established means of informing participants of the terms of the plan and its benefits, and is the employee's primary source of information regarding employment benefits. The court concluded that if there was a conflict between the complexities of the plan's language and the simple language of the SPD, the latter would control.
The Fourth Circuit dismissed the lower court's ruling that even if the SPD did control, Aiken had to show that he had relied on the SPD and suffered prejudice as a result of such reliance. The Fourth Circuit responded that the district court must try the case, and, if it determined that Aiken relied on the SPD or was prejudiced by it, it had to rule for Aiken. The court did not discuss how the plan was to make distributions in violation of the plan document. Presumably, the plan would have to be amended to comply with the SPD.
In Albertson's, Inc.,(47) the Ninth Circuit overruled the Tax Court and held that an employer could claim current deductions for interest-like obligations that had accrued under deferred compensation agreements (DCAs).
The taxpayer had several DCAs in which the recipients had agreed to receive payment, plus an additional amount calculated on a predetermined formula, at a later time. In 1982, it requested IRS permission to currently deduct the additional amounts (not the deferred compensation), instead of waiting until the end of the deferral period. In 1983, the IRS granted the request. The taxpayer claimed deductions for the additional amounts that had already accrued, even though it had not yet paid the DCA participants. In 1987, the IRS changed its mind and sought a deficiency for the amounts involved. The taxpayer petitioned the Tax Court, claiming that the additional amounts constituted "interest" and thus, could be deducted as they accrued. A sharply divided Tax Court ruled that the amounts could not be currently deducted.
The taxpayer appealed to the Ninth Circuit. The IRS argued first that the additional amounts that accrued on the deferred compensation were not interest, but were additional deferred compensation. Alternatively, the IRS argued that even if the amounts were interest, Sec. 404 applied to delay the deduction until the employees paid tax on those amounts.
The Ninth Circuit addressed the first issue by stating that the additional amounts were "interest" under the Code. While the regulations under Sec. 163 do not define interest, the court cited the Supreme Court's holding that interest is the measure of the value of the use of money over time.(48) Because the additional amounts specified in the DCAs were a direct reflection of what the taxpayer would have paid on the open market to borrow such amounts, they were interest. The court also rejected the IRS's argument that the additional amounts were not interest, but rather, additional deferred compensation.
The court then addressed whether interest could be deducted as accrued under Sec. 404. Because that section specifically limits deductions under Secs. 162 and 212, but does not refer to Sec. 163 interest deductions, the court ruled that Sec. 404's (1983) restrictions against taking deductions prior to the end of the deferral period did not apply to interest expenses.
In a holding that arguably affects taxpayers under the current version of Sec. 404, the court rejected the IRS's argument that a 1986 "clarifying" amendment(49) to Sec. 404, which eliminated the references to Secs. 162 and 212 to make clear the broad scope of the statute, evidenced congressional intent to include interest under that section. In the court's view, although Congress intended to clarify Sec. 404 to include all forms of compensation for services rendered, there was insufficient indication that Congress intended to include anything other than compensation. Further, for DCA purposes, "compensation" and "interest" are two very different concepts. Accordingly, the court rejected the IRS's argument that the 1986 amendment evidenced an intent by Congress to include interest expenses under the timing restrictions of Sec. 404.
The Albertson's decision unleashed a storm of protest from a variety of sources. Senator Pryor (D-Ark.) introduced legislation(50) that would have the effect of retroactively overturning the case. His bill would add new Sec. 404(m), to treat as compensation in determining the tax year for which a deduction will be allowed, amounts that are "(A) interest or a similar amount based on the time value of money, and (B) an integral part of the method used to calculate the total amount of deferred compensation to be paid." The amendment would apply retroactively, so as to prohibit any plan sponsor from using the Albertson's decision for any year.
As expected, the IRS protested the Albertson's holding vigorously. It sought and obtained a rehearing before the Ninth Circuit on June 29, 1994. A Justice Department brief filed on the IRS's behalf alleged that allowing employers to claim a current deduction for an amount designated as interest on deferred compensation would cost the government about $7 billion over five years and would act as a disincentive for employers to set up qualified plans.
Following the COBRA proposed regulations, the First Circuit determined in Gaskell v. The Harvard Cooperative Society(51) that the triggering event for counting the COBRA continuation of coverage period is the date of the event that could ultimately lead to the loss of employer-provider coverage, not the date employer-provided coverage is actually lost. Two items of interest evolve from this case. First, although the First Circuit relied in part on the proposed COBRA regulations in reaching its decision, the court specifically stated that the proposed regulations are not authoritative. Second, the view that the event potentially causing loss of coverage, rather than the actual lack of coverage, will trigger the COBRA time period may complicate COBRA coverage in situations in which Family and Medical Leave Act (FMLA) leave has been taken, and the employee then decides not to return to work.
In Gaskell, David Gaskell went on full disability leave on Jan. 14, 1987, at which time he was eligible for full salary and benefits, including medical coverage for himself and his wife. In February 1988, David terminated his employment with the employer retroactive to Jan. 14, 1988. The employer's plan, Blue Cross, sent the Gaskells a notice stating that they were entitled to COBRA coverage for 18 months, beginning on July 1, 1988. The Gaskells accepted the coverage until David became eligible for Medicare. Under a complicated and immaterial set of facts, Mrs. Gaskell wanted continued coverage from Blue Cross, but Blue Cross argued that its responsibility ended on June 30, 1989, when the employer dropped it as insurer. The employer and the new plan administrator also refused to give Mrs. Gaskell coverage. The lower court ruled that the employer and the new plan administrator had to provide coverage to Mrs. Gaskell between July 1, 1989 and July 1, 1991.
The First Circuit looked first to the COBRA statutory language, which provides that the term "qualifying event" means, with respect to any covered employee, any termination or reduction in hours which, but for continuation coverage, would result in the loss of coverage of a qualified beneficiary. The court stated that the statutory language offered no explicit guidance in determining the relevant "qualifying event" when the employee's termination or reduction in hours does not coincide with the "loss of coverage" under the employer's plan. The district court elected to view the "qualifying event" as the point at which David Gaskell experienced a loss of coverage because of the reduction in hours.
The First Circuit noted that other courts have held that the 18-month coverage period should be counted from the event itself, i.e., the employee's reduction in hours or termination. Either interpretation is plausible. The First Circuit consulted the legislative history to determine which reading would be more plausible, and held that, under COBRA's legislative history, Congress intended an employee's 18-month period of continuation coverage to commence with the event leading, under the terms of the plan, to loss of coverage, rather than on the loss of coverage itself.
In examining the legislative history, the First Circuit referred to the IRS's proposed COBRA regulations. Although the proposed regulations specifically state that the continuation period should run from the occurrence of the triggering event, not the date coverage would otherwise be lost absent COBRA, the court did not hold that the regulations were determinative, but only that they added weight to the legislative history.
Absent other Federal laws (e.g., the FMLA and COBRA), a clear statement in employee handbooks and SPDs of when health care benefits will be terminated could reduce the length of COBRA coverage in many cases, especially for terminations that arise after FMLA leave has been exhausted.
Deductible Business Expenses
* Travel away from home
In Rev. Rul. 93-86,(52) the IRS opined on the application of the one-year limit on "temporary" travel that was enacted as part of the Energy Policy Act of 1992 (EPA). The ruling indicates that the standard for determining whether an assignment is temporary is the employee's "realistic expectation" regarding the duration of the assignment, both at the commencement of the assignment and on a change in circumstances. It appears that the IRS has liberalized its position on assignments of more than one year.
Generally, Sec. 162(a)(2) allows a deduction for travel expenses (transportation, meals, lodging, etc.) that are (1) ordinary and necessary, (2) incurred in pursuit of a trade or business and (3) incurred while "away from home." Travel expenses are normally considered to be away from home if they are incurred in connection with a temporary assignment away from home; however, travel expenses incurred in connection with an indefinite or permanent assignment are generally nondeductible.
Before the enactment of the EPA, the IRS's position on away-from-home expenses was illustrated in Rev. Rul. 83-82.(53) This ruling provided that, if the taxpayer anticipated the away-from-home employment to last for less than one year, the determination of whether the employment was temporary depended on the facts and circumstances. If the employment was anticipated to, and did in fact, last from one to two years, it was rebuttably presumed to be indefinite. If the employment was anticipated to or actually did last for more than two years, it was determined to be indefinite, regardless of the facts and circumstances.
The EPA added a provision to Sec. 162(a) such that a taxpayer is not treated as being temporarily away from home during any period of employment that exceeds one year, effective for costs paid or incurred after 1991. While this provision was not meant to completely override Rev. Rul. 83-82, the intended effect on away-from-home travel expenses was unclear.
Rev. Rul. 93-86 provides that Sec. 162(a)(2), as amended, eliminates the rebuttable presumption category under Rev. Rul. 83-82 for employment lasting between one and two years, and shortens the two-year limit under that ruling to one year. It further states that Rev. Rul. 83-82 is obsoleted for costs paid or incurred after 1992, because all of the factual situations in that ruling involve employment in a single location for more than one year.
In addition, it appears that the IRS has eliminated the requirement that the taxpayer must realistically expect to return to the claimed tax home after the job terminates. This expectation was one of three objective factors that rebutted the "indefinite employment" presumption, but was not generally required to deduct away-from-home travel expenses. Consequently, by eliminating the "rebuttable presumption" category of Rev. Rul. 83-82, the "expectation of returning home" requirement would also be eliminated. This language implies that there can be travel expenses incurred while away from home in a second location that are related to a "second period of employment." This language would be unnecessary if the second period of employment were required to be the taxpayer's claimed tax home, because expenses incurred at a taxpayer's tax home are nondeductible, as they are personal in nature. However, it is unclear whether a third period of employment away from home would cause a change in tax home.
Given that the IRS has once again chosen to focus on an employee's "realistic expectations" surrounding a period of employment, and not simply on the length of the assignment, it is extremely important for employers to document the anticipated and actual length of an assignment. Once it has been determined that an assignment that was expected to last for one year or less will in fact last for more than one year, the employer should document this change. For example, the employer might send the individual a separate assignment letter documenting the extension. If possible, assignments should be scheduled with a projected period of employment for as close to one year as possible, but not over one year. A possible, although aggressive, position exists that all travel expenses associated with an assignment that actually exceeds one year, but totals less than two years, are deductible.
* Accountable plans
It has generally been thought that an employer and employee can negotiate both a salary and an expense reimbursement agreement that would qualify as an accountable plan under Regs. Sec. 1.62-2(c)(2)(i). This often occurs during the negotiation of a total compensation package, in which the employee negotiates a salary figure and agrees to a maximum expense reimbursement amount to be paid under an accountable plan. In Letter Ruling 9325023,(54) however, the IRS expresses concern that such negotiations constitute an assignment of income.
In the ruling, Company X, which sells various insurance products through independent agents, employs "district managers" to supervise the agents in their districts. District managers are paid a percentage of the commissions paid to the agents they supervise, and earn additional compensation based on the sales performance of their districts. Each district manager pays the normal business expenses incurred in the performance of his duties, including office and equipment rent, business meals and entertainment, travel expenses, agents' contests and other miscellaneous expenses out of the gross compensation received from X. X wanted to convert the current arrangement, which is not an "accountable plan" under Sec. 62(c), into an arrangement under which district managers would forgo an elected percentage of commissions, and the company would pay the managers' actual business expenses up to the amount of the forgone commissions. The company requested four separate rulings on the proposed arrangement. The IRS noted that the requests reduced to whether the proposed arrangement was an "accountable plan"--i.e., whether the arrangement was a reimbursement or other expense allowance arrangement, as defined in Sec. 62(a)(2)(A).
It is well established that a gratuitous assignment of income does not shift the burden of taxation; the donor is taxable when the income is received by the donee. The IRS concluded that if a district manager of X elects to forgo future compensation under the reimbursement arrangement in consideration of X's agreement to reimburse his business expenses up to an equivalent amount, the district manager is making an anticipatory assignment of future income to X for consideration. Thus, when X reimburses a district manager, the district manager is treated as currently receiving the forgone compensation for which the reimbursement is a substitute, and the reimbursements will be includible in the district manager's income in the year paid, just as if the district manager had received the forgone compensation. Further, the reimbursements are subject to employment taxes because they are not paid under an accountable plan.
Sec. 62 generally defines "adjusted gross income" as gross income minus certain "above-the-line" deductions. Sec. 62(a)(2)(A) allows an employee an above-the-line deduction for expenses paid by the employee, in connection with his performance of services as an employee, under a reimbursement or other expense allowance arrangement with his employer. Sec. 62(c) provides that an arrangement will not be treated as a reimbursement or other expense allowance arrangement under Sec. 62(a)(2)(A) if it (1) does not require the employee to substantiate the expenses covered by the arrangement to the person providing the reimbursement, or (2) provides the employee with the right to retain any amount in excess of the substantiated expenses covered under the arrangement.
Under Regs. Sec. 1.62-2(c)(1), a reimbursement or other expense allowance arrangement satisfies Sec. 62(c) if it meets the three requirements of (1) business connection, (2) substantiation and (3) returning amounts in excess of expenses, set forth in Regs. Sec. 1.62-2(d), (e) and (f). Regs. Sec. 1.62-2(c)(2)(i) treats all amounts paid under the arrangement as paid under an "accountable plan," and Regs. Sec. 1.62-2(c)(4) excludes all amounts paid under an accountable plan from the employee's gross income. Such amounts do not have to be reported on the employee's Form W-2, and are exempt from the withholding and payment of employment taxes.(55)
On the other hand, under Regs. Sec. 1.62-2(c)(3)(i), if an arrangement does not meet one of the three requirements, all amounts paid under the arrangement are treated as paid under a "nonaccountable plan" and are included in the employee's gross income for the tax year, must be reported to the employee on Form W-2 and are subject to withholding and payment of employment taxes.(56) As an example, under Regs. Sec. 1.62-2(d)(3)(i), the business connection requirement is not met if the employer pays an amount to an employee as reimbursement, regardless of whether the employee incurs (or is reasonably expected to incur) business expenses.
The IRS concluded that an employer cannot recharacterize a portion of an employee's salary as being paid under a reimbursement or other expense allowance arrangement. According to the IRS, to have an accountable plan, Sec. 62(c) and the regulations thereunder contemplate that the reimbursement or other expense allowance arrangement provided by an employer should be amounts paid to an employee in addition to salary. The IRS also cited the preamble to the final regulations,(57) which provides that no part of an employee's salary may be recharacterized as being paid under a reimbursement arrangement or other expense allowance arrangement.
Since the taxpayer's proposed arrangement in Letter Ruling 9325023 was not consistent with the example (i.e., amounts would only be paid for actual expenses incurred), the violation of the accountable plan rules outlined in the ruling was not on point. Based on this discussion, it is apparent that assignment of income is the IRS's concern. Arrangements can be structured this way, but future income cannot be assigned to these accounts--even amounts not yet earned. An employment contract for a specific "not to exceed" sum for otherwise reimbursable expenses from an accountable plan and a separate salary appears to be the wiser course.
* Employee meal allowances
The IRS recently released an Industry Specialization Program (ISP) coordinated issue paper(58) (used for internal guidance) on the tax and withholding treatment of employee meal allowances and reimbursements. This paper concluded that when such allowances are company policy, they are taxable and subject to withholding for Federal income, FICA and FUTA taxes for employees who receive the benefit more than "occasionally."
In the case under consideration in the paper, an employer policy of providing overtime meals in the form of allowances or reimbursements is incorporated into a collective bargaining agreement. Overtime is a routine part of the employer's business. Two key issues arise regarding the meal allowances: are they includible in the employees' income under Sec. 61? If so, are they subject to FICA, FUTA and income tax withholding under Secs. 3121(a), 3306(b) and 3401(a)?
The paper starts with the premise that meals and meal allowances are fringe benefits included in gross income under Sec. 61 unless they can be excluded under some other Code section. In determining whether any benefit is excludible under Sec. 132(a)(4) as a de minimis fringe, the frequency with which the benefits are provided, as well as the value of the benefits, are taken into account. (While the paper does not address the issue, there appears to be no other exception under Sec. 132 or any other Code section that would exclude the benefits.) The paper then cites the three requirements under Regs. Sec. 1.132-6(d)(2)(i), which specifically addresses the excludibility of meals and meal money as a de minimis fringe: the meals and meal money must be provided (1) only occasionally, (2) because overtime requires an extension of the employee's ordinary work day and (3) to enable the employee to work overtime.
According to the paper, "frequency" is the first factor to consider in determining whether fringe benefits are de minimis. Whether a benefit is provided occasionally is to be determined on a caseby-case basis. The paper seems to establish the following general rule: assuming all three conditions in the regulations are met, if an employee's receipt of meal money is at the employer's discretion, the meal money may be occasional and therefore excludible. If the payment is due to an unwritten or written employer policy based on a pre-identified set of facts, "further analysis may be warranted" to determine whether the meals are occasional.
The paper also notes that the regulations require the payments to be analyzed on an individual employee basis. Therefore, even if an employer has a policy of providing meal allowances, the frequency with which the benefit is provided is determined on an individual employee basis. Obviously, there will be cases in which some employees will pay tax on the meals because they receive them more than "occasionally," and in which other employees' meal money will not be taxable because they rarely work overtime.
After determining frequency, the value of the benefit must be determined. The paper states that whether a benefit is de minimis is determined by reference to the value of the benefits attributed to the individual employee, and not whether the total amount of benefits provided by the employer to its employees is de minimis when compared to the employer's payroll, gross receipts or total assets.
In addressing the Federal income tax withholding and FICA and FUTA tax issues, the paper acknowledges that the Code sections addressing such withholding exempt from the definition of "wages" any benefit if, at the time it is provided, it is reasonable the employee could exclude it under Sec. 132. However, the paper notes that such exemptions are not triggered merely by an employer's assertion that they apply; rather, an employer seeking to rely on those exemptions must, at a minimum, have ascertained the law and applied it to the particular facts. Furthermore, if the employer in the paper had ascertained the applicable law, it would have determined that the general rule is that wages include cash meal allowances and reimbursements unless the requirements in the regulations are met. Therefore, it was generally not reasonable for the employer to believe that meal allowances were excludible from wages for employment tax purposes if those allowances did not meet the requirements for exclusion.
Employers who provide meal money, meal allowances or meals for overtime to employees will now have to track how frequently an employee receives them. If the employee receives such benefits more than "occasionally" (an undefined term), the benefits will be taxable and the employer should withhold Federal income, FICA and FUTA taxes on their value.
* Club dues
The IRS has proposed regulations(59) to comply with the Revenue Reconciliation Act of 1993's (RRA's) ban on deducting dues for business lunch, airline or hotel clubs. The rules would permit deductions for membership dues for professional organizations (e.g., bar and medical associations), civic or public service associations (e.g., Kiwanis, Lions, Rotary, Civitan, etc.) and certain organizations similar to professional organizations (e.g., business leagues, trade associations, chambers of commerce, boards of trade and real estate boards). The regulations are proposed to be effective for amounts paid or incurred after 1993.
The proposed rules would amend Regs. Sec. 1.274-2 to disallow a deduction for amounts paid or incurred for membership in any club organized for business, pleasure, recreation or ther social purpose. Although the proposed rules generally would allow exceptions from dues disallowance for civic and public service organizations, professional organizations and certain organizations similar to professional organizations, the exceptions are not available if the organization's principal purpose is to conduct entertainment activities for members or their guests or to provide them with access to entertainment facilities.
RRA Section 13210(a) added Sec. 274(a)(3), which disallows a deduction for amounts paid or incurred for membership in any club organized for business, pleasure, recreation or other social purpose. Prior to the enactment of Sec. 274(a)(3), membership dues or fees paid to three types of organizations were excepted from the dues disallowance provisions, because they were not considered to be social, athletic or sporting clubs within the meaning of Sec. 274(a)(2)(A): (1) professional organizations, (2) civic or public service organizations and (3) business luncheon clubs described in Regs. Sec. 1.274-2(e)(3)(ii).(60)
The legislative history indicates that the enactment of Sec. 274(a)(3) eliminated the third exception to dues disallowance listed above, and that airline and hotel clubs are now subject to dues disallowance.(61) However, the legislative history does not indicate whether Sec. 274(a)(3) has any effect on the first and second exceptions listed above. Accordingly, the proposed regulations provide that the dues disallowance provisions of Sec. 274(a)(3) apply to business luncheon group clubs and airline and hotel clubs, but generally not to professional organizations or civic or public service organizations. The proposed regulations further provide that certain organizations similar to professional organizations are also generally excepted from dues disallowance.
On Oct. 22, 1994, President Clinton signed into law the Social Security Domestic Employment Reform Act,(62) under which the threshold of wages for domestic service employees subject to Social Security tax has been raised from $50 per quarter to $1,000 per year. After 1995, this figure will be indexed to the nearest $100. The $1,000 threshold applies retroactively, beginning after 1993. Refunds are available to those individuals who paid Social Security taxes on wages below the $1,000 threshold for 1994. Effective in 1995, household workers under age 18 are exempted from FICA and FUTA coverage, unless their principal occupation is household employment.
Senator Moynihan (D-N.Y.) sponsored the Senate legislation out of his commitment to resolve issues concerning the employment taxes of domestic employees. These issues arose when some of President Clinton's nominees were thwarted from Senate confirmation for failure to pay these taxes.
Household employers will continue to file Form 942, Employer's Quarterly Tax Return for Household Employees, for 1994. For 1995, however, reporting will occur annually on the employer's Form 1040. Beginning in 1998, household employers will be required to meet their tax obligations by increasing their quarterly estimated tax payments or tax withholding on their own wages. During 1995 through 1997, employers will be permitted to pay domestic employment taxes in a lump sum when they file their own tax returns without incurring a late payment penalty. The Treasury is authorized to enter into agreements with states to collect state unemployment taxes in the same manner.
In a Mar. 21, 1994 letter to counsel for CSX Insurance Company (CSX), the rail and transportation company, the Department of Labor (DOL) refused to grant a prohibited transaction exemption for CSX to reinsure life insurance provided to CSX employees through CSX plans. According to the letter, CSX had argued that the substantial tax savings to the CSX corporate group from using such reinsurance would be passed through to the plans in the form of lower premiums to employees. The DOL rejected this argument, stating that it did not find the limited information provided on cost savings to be persuasive in light of the potential abuse in transactions involving a plan and an employer.
The DOL's decision was based in part on the fact that CSX derived approximately 90% of its premiums from sales of insurance and reinsurance with the CSX corporate group. The DOL cited an earlier letter, Prohibited Transaction Class Exemption 79-41,(63) for the proposition that significant independent business (usually, at least 50% of premiums) is required before the DOL will provide relief from the prohibited transaction rules of Employee Retirement Income Security Act of 1974 Section 406. Clearly, CSX did not meet this test.
While CSX's attempt to pass through the significant tax savings from reinsurance to employees may have been laudable, apparently, the DOL remains unconvinced. From DOL comments, it seems there was no commitment or pledge that the savings would, in fact, be passed on to employees.
(39)Notice 94-2, IRB 1994-2, 25.
(40)Notice 94-68, IRB 1994-26, 12.
(41)58 Fed. Reg. 63010 (11/29/93).
(42)General Signal Corp., 103 TC No. 14 (1994).
(43)IRS Letter Ruling (TAM) 9334002 (5/4/93).
(44)General Explanation of the Revenue Provisions of the Tax Reform Act of 1984, Staff of the Joint Committee on Taxation, at 786.
(45)Aiken v. Policy Management Systems Corp., 13 F3d 138 (4th Cir. 1993).
(46)Pierce v. Security Trust Life Ins. Co., 979 F2d 23 (4th Cir. 1992).
(47)Albertson's, Inc., 12 F3d 1529 (9th Cir. 1993)(74 AFTR2d 94-558, 94-1 USTC [paragraph]50,016), rev'g 95 TC 415 (1990), aff'g TC Memo 1988-582.
(48)Esther C. Dickman, 465 US 330 (1984)(53 AFTR2d 84-1608, 84-1 USTC [paragraph]9240), reh'g denied.
(49)S. Rep. No. 99-313, 99th Cong., 2d Sess. 1013 (1986).
(50)S 1877, 103d Cong., 2d Sess. (1994).
(51)Gaskell v. The Harvard Cooperative Society, 3 F3d 495 (1st Cir. 1993), vac'g and rem'g 762 F Supp 1539 (1991).
(52)Rev. Rul. 93-86, 1993-2 CB 71.
(53)Rev. Rul. 83-82, 1983-1 CB 45.
(54)IRS Letter Ruling 9325023 (3/24/93).
(55)Regs. Secs. 31.3121(a)-3, 31.3306(b)-2, 31.3401(a)-4 and 1.6041-3(i).
(56)Regs. Secs. 1.62-2(c)(5), 31.3121(a)-3(b)(2), 31.3306(b)-2(b)(2) and 31.3401(a)-4(b)(2).
(57)55 Fed. Reg. 51688, 51689 (12/17/90).
(58)ISP on Meal Allowances (4/15/94).
(60)See Q&A-56 and -57 of Rev. Rul. 63-144, 1963-2 CB 129; H. Rep. No. 87-1447, 87th Cong., 2d Sess. 22 (1962); S. Rep. No. 87-1881, 87th Cong., 2d Sess. 33 (1962); and H. Rep. No. 96-1278, 96th Cong., 2d Sess. 32 (1980).
(61)H. Rep. No. 103-213, 103d Cong., 1st Sess. 583 (1993).
(62)HR 4278, 103d Cong., 2d Sess. (1994).
(63)Prohibited Transaction Class Exemption 79-41 (8/7/79).
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|Title Annotation:||part 2|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 1994|
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