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Current developments in employee 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 focuses on current developments related to welfare benefits and compensation and addresses certain regulatory developments contained in the Small Business Job Protection Act Of 1996.

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, below, focuses on current developments related to welfare benefits and compensation (excluding changes made by the Taxpayer Relief Act of 1997). While this article does not discuss specific provisions of the Small Business job Protection Act of 1996 (SBJPA), it does address certain regulatory developments contained in the SBJPA. Part II, to be published in December, will cover qualified and nonqualified retirement plans.

Intermediate Sanctions

The IRS recently issued temporary regulations(1) under Sec. 6071 on reporting the excess benefits tax (i, e., intermediate sanctions) that now applies to disqualified persons significantly benefiting from transactions with Sec 501(c)(3) and (4) exempt organizations. In most cases, the tax will apply to employee who receive excess compensation from the organization.


The Taxpayer Bill of Rights 2 (TBOR2), enacted in 1996, added a series of excise taxes ("intermediate sanctions") under Sec. 4958; they allow the IRS to penalize a "disqualified person" rather than evoke the organization's exempt status. The excise taxes apply when such a person (defined by Sec. 4958(f)(1) as an individual who is in a position to exercise substantial authority over an organization's affairs, regardless of his official title, and certain related persons) enters into an "excess benefit transaction" with a Sec. 501(c)(3) or (4) exempt organization. In this type of transaction, the disqualified person engages in a non-fair market value (FMV) transaction with the organization or receives unreasonable compensation or payment based on the organization's income in a transaction that violates the private inurement rules.

The tax is similar to the Sec. 4975 prohibited transactions tax; the disqualified person must report the benefit on a special form and pay the excise tax. An organization manager who knowingly participates in an excess benefit transaction is also subject to the tax.

Excise Tax Rates

Under Sec. 4958(a)(1), a disqualified person must pay a 25% excise tax of the excess of the value of the consideration over the benefit received. If the excess benefit transaction is not corrected within the tax period, the tax is 200% of the excess benefit, under Sec. 4958(b). "Correction" is defined by Sec. 4958(f)(6) as undoing the excess benefit to the extent possible and taking any additional measures necessary to restore the organization to the financial position it would have had if the disqualified person had dealt with it under the highest fiduciary standards.

An organization manager who knowingly participates in 7an excess benefit transaction is subject to a 10% tax on the excess benefit amount (not to exceed $10,000 for any given transaction), under Sec. 4958(a)(2).

Rebuttable Presumption

The TBOR2 House Committee Report(2) incorporates a rebuttable presumption of reasonableness for a compensation arrangement approved by an independent board or committee that (1) was composed entirely of individuals unrelated to A not subject to the control of the disqualified person, (2) relied on independent, comparable data in approving the transaction and (3) adequately documented its determination. If these steps are met, penalty excise taxes could be imposed only if the IRS develops sufficient contrary evidence to rebut the probative value of the evidence put forth by the parties to the transaction.


Temp. Regs. Sec. 53.6071-1T provides that the Sec. 4958 tax is reported on Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code; it must be filed by the disqualified person or organization manager by the fifteenth day of the fifth month following the close of the person's tax year. Thus, a person who received an excess benefit in 1997 must file Form 4720 by May 15, 1998.

COBRA Continuation Coverage

Does the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) required that COBRA continuation coverage (CCC) be offered to a qualified beneficiary covered by a spouse's health insurance at the time of a qualifying event? Recent decisions indicate that the courts are in favor of denying CCC in such cases unless a significant gap exists between said coverage and coverage under the spouse's health plan. Geissal v. Moore Medical Corp.(3) provides that CCC need not be offered to an otherwise qualified beneficiary if that individual is covered by a spouse's insurance plan at the time of the qualifying event, and no significant gap exists between CCC and coverage under the spouse's plan.

Courts' Current Stance

Employee Retirement Income Security Act of 1974 Section 1162(2)(D)(i)(4) provides that CCC can be terminated when a beneficiary is first covered by another health plan. The Fifth, Seventh and Eleventh Circuits have taken the position that the employer does not have to offer CCC if there are no substantial gaps in coverage under the spouse's plan.(5) The Tenth Circuit has ruled that the employer must offer COBRA coverage, regardless of the quality of the preexisting coverage.(6)

Given the split in authorities and the uniform requirement that CCC be available if gaps exist between it and the spouse's coverage, the prudent business decision would be to offer a qualified beneficiary CCC, regardless of coverage existing prior to the qualifying event. However, more authorities support denial of such coverage when no substantial gaps in coverage exist. The IRS is considering this issue and may eventually provide guidance in its final COBRA regulations.

Family High-Deductible Health Plans

The IRS has confirmed that a family health insurance policy with a $3,000 deductible that begins paying benefits after a family member incurs $1,500 of expenses is not a high deductible policy that will enable the taxpayer to establish a medical savings account (MSA) under Sec. 220. However, Rev. Rul. 97-207 offers relief under Sec. 7805(b), by not disqualifying plans with such policies acquired and effective before Nov. 1, 1997.

Rev. Rul. 97-20 defines a high-deductible plan under Sec. 220(c)(2)(A) that would permit a taxpayer to establish an MSA. High-deductible family plans require an annual deductible of at least $3,000, not exceeding $4,500, with a maximum out-of-pocket cost of $5,500; for individual coverage, an annual deductible of at least $1,500, not exceeding $2,250, with a maximum annual out-of-pocket cost of

Sec. 220 permits eligible individuals (self-employed persons and those who work for employers having no more than 50 employees) with health coverage under high-deductible health insurance policies to set up tax-deductible MSAs. Each year, under Sec. 220(b), the taxpayer may contribute up to 65% of the deductible for individual coverage; 75% of the deductible for family coverage. MSA amounts plus any earnings thereon are nontaxable if used to pay deductible medical expenses, regardless of the 7.5% threshold. Amounts in MSAs need not be used in the year in which they are contributed, but can accumulate year after year.

Long-Term Care Coverage

The IRS has issued interim guidance on qualified long-term care services and qualified long-term care insurance contracts under Secs. 213, 7702B and 4980C. Notice 97-318 includes guidance and safe harbors on the definition of 11 chronically ill individual"; an interim safe harbor allowing insurance companies to interpret certain key provisions in post-1996 qualified long-term care insurance contracts using pre-1997 standards; and guidance on grandfathered pre-1997 contracts. The guidance is effective pending the publication of proposed regulations or other rules.


The Health Insurance Portability and Accountability Act of 1996 amended the Code to provide that qualified long-term care insurance contracts will be treated as accident and health insurance contracts, and amounts received under such contracts will be treated as received for personal injuries and sickness and as reimbursement for medical expenses. Thus, amounts received under such contracts generally will be excludible from income, subject to caps on per them payments. Also, an employer's plan providing coverage under a qualified long-term care insurance contract will be treated as an accident and health plan with respect to that coverage. Amounts paid for long-term care and a limited amount of premiums paid for a qualified long-term care insurance contract may be treated as Sec. 213 medical expenses.

A qualified long-term care contract is one that provides insurance protection only for "qualified long-term care services" (defined by Sec. 7702B (c)(1) as necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance or personal care services required by a "chronically ill individual" and provided under a plan of care prescribed by a licensed health care practitioner). A "chronically ill individual" is defined by Sec. 770213(c)(2)(A) as one a licensed health care practitioner certifies as:

--being unable to perform, without "substantial assistance" from another individual, at least two out of six enumerated (in Sec. 7702B(c)(2)(B)) activities of daily living (ADLs) (eating, toileting, transferring, bathing, dressing and continence) for at least 90 days due to a loss of functional capacity (the ADL Trigger);

--having a level of disability similar to the level described in the ADL Trigger as determined under regulations (the Similar Level Trigger); or

--requiring "substantial supervision" to protect the individual from threats to health and safety due to "severe cognitive impairment" (the Cognitive Impairment Trigger).

Chronically III Individual

ADL Trigger: Notice 97-31 provides that for purposes of the ADL Trigger, taxpayers may rely on the following safe harbor definitions:

[] "Substantial assistance" means hands-on assistance and standby assistance.

[] "Hands-on assistance" means the physical assistance of another person, without which the individual would be unable to perform the ADL.

[] "Standby assistance" means the presence of another person within arm's reach that is necessary to prevent, by physical intervention, injury to the individual while the individual is performing the ADL (such as being ready to catch the individual if he falls while getting out of the bathtub).

The notice clarifies that the 90-day period under the ADL Trigger is not a waiting period before which benefits may be paid or before which services may constitute qualified long-term care services.

Cognitive Impairment Trigger: Taxpayers may rely on the following safe-harbor definitions under the Cognitive Impairment Trigger:

[] "Severe cognitive impairment" means a loss or deterioration in intellectual capacity that is (1) comparable to (and includes) Alzheimer's disease and similar irreversible dementia, and (2) measured by clinical evidence and standardized tests that reliably measure impairment in the individual's (a) short- or long-term memory, (b) orientation as to people, places or time and (c) deductive abstract reasoning.

[] "Substantial supervision" means continual supervision (including cuing by verbal prompting, gestures or other demonstrations) by another person that is necessary to protect the individual from threats to his health or safety.

Under this trigger, unlike the ADL Trigger, a qualified long-term care insurance contract need not take any ADL into account in determining if the individual is chronically ill.


In Letter Ruling 9720034,(9) the IRS ruled that assets from a voluntary employee beneficiary association (VEBA) created to cover active employees and post-1988 retirees may be used to pay benefits for pre- 1989 retirees.

The employer had established the VEBA with an Active Employee Account and a Retiree Account, but found that retiree claims were relatively insignificant and were likely to remain so. The employer wanted to avoid administrative and termination expenses by depleting the trust assets via using the Retiree Account to pay benefits to all retirees, not just post-1988 retirees. The IRS ruled that use of the Retiree Account (1) bid not constitute prohibited inurement (within the meaning of Sec. 501(c)(9) and Regs. Sec. 1.501(c)(9)-4(d)); (2) did not constitute a reversion of plan assets to the employer that would trigger the Sec. 4976 100% excise tax imposed on disqualified welfare fund benefits; and (3) would not result in income to the employer under Sec. 61 (a).

The proposed payment of pre-1989 retirees' medical claims from the Retiree Account would not constitute prohibited inurement under Regs. Sec. 1.501(c)(9)4(d), because such payments would be used to provide benefits contemplated by Sec. 501(c)(9) and would be paid to permissible beneficiaries. Because the post-retirement medical reserve was established to cover the employer's retirees, the use of such reserves for an additional class of its retirees was consistent with the purpose for which the reserve was established. Consequently, the transaction would not result in the inclusion of amounts so paid in the employer's gross income. Because no funds would revert to or for the employer's benefit, the transaction would not trigger the Sec. 4976 excise tax.

Assumed Vacation Pay Liability Deductible

Letter Ruling (TAM) 9716001(10) held that a transferee in a Sec. 351 exchange could deduct payments for a vacation pay liability assumed in the exchange. The IRS also concluded that the transferee need not include in income any reimbursement the transferor paid for the transferee's assumption of the liability; nor did it need to reduce its deduction by that amount.

Accrual-basis corporation P operated several retail stores, and had operated at a loss for a number of years before tax year X. During X (and less than 2 1/2 months after the close of the preceding tax year), P transferred substantially all the assets and liabilities of a number of its stores to newly formed corporation S in a Sec. 351 transfer. S was an accrual-basis corporation with the same tax year as P (a 52-53 week year ending on the Saturday closest to December 3 1). The purchase agreement stated that, in exchange for the assets transferred by P, P would receive (1) S stock; (2) debt payable from S; (3) cash; and (4) S's assumption of certain liabilities relating to the stores.

P maintained a plan under which employees earned vacation pay each year and were entitled to take such pay the year after the year earned. Some P employees were transferred to S in the exchange. Had P paid those employees in advance for the vacation pay they had accrued before their transfer to S, they would have lost their ability to actually use their vacation days. Thus, to preserve employee morale, S and P decided at closing to transfer the vacation pay liability to S as part of the exchange, by reducing the cash S transferred to P at closing. After the exchange and during tax year X, S completely satisfied the vacation pay liability it had assumed by making vacation payments to the transferred employees.

Agent's Assertions

The IRS agent asserted that S could not deduct the vacation payments on its tax year X return, because they were not ordinary and necessary business expenses of S; S did not receive the employee services that gave rise to the vacation payments, and did receive compensation from P for such payments. Alternatively, the agent claimed that if S were allowed a deduction, it should be required to either include the reimbursement in income or reduce its deduction by that amount.

Deduction Allowed

The IRS first noted that because the vacation payments were made to the transferred employees more than 2 1/2 months after the close of the year in which they were earned, the payments were deferred compensation; thus, under Sec. 404(a) and (a) (5), S could deduct the payments only if (1) they would otherwise be deductible as Sec. 162 ordinary and necessary business expenses and (2) the deduction was taken in the tax year the amounts were actually paid. Because S sought to deduct the vacation payments in the tax year paid, the only issue was whether they were ordinary and necessary business expenses.

The IRS cited Rev. 80-19811 and 95-74,(12) in which it had allowed the transferee in a tax-free Sec. 351 property-for-stock transfer to deduct a transferred liability. In allowing the deduction, both rulings emphasized these factors:

[] The The transferor transferred substantially all the assets and liabilities associated with the transferred business in exchange for the transferee's stock.

[] The transferred liability would have been deductible if paid by the transferor.

[] A business purpose existed for the Sec. 351 transaction.

Further, the congressional intent behind Sec. 351(a)--facilitating necessary business adjustments--would be frustrated if S were prohibited from deducting the expenses of an ongoing business. Thus, the IRS concluded that S could deduct the vacation payments in tax year X.

The IRS stated that there was no authority for the agent's assertion that S had to include the amount reimbursed by P in income or reduce its deduction by that amount. According to the Service, the amount P transferred as reimbursement for S's assumption of the vacation pay liability occurred as part of the exchange, and constituted part of the total property S received in exchange for its stock. Thus, S was not required to include the reimbursement in income, or reduce its deduction for the vacation pay.

Deducting Vacation Rights on Company Plane

The IRS has issued a controversial TAM, Letter Ruling 9715001,(13) on how much an employer can deduct for flying an executive and his spouse to their vacation destination in a company-owned plane. The IRS concluded that the employer's deduction is limited to the amount the employer treated as compensation to the executive, as calculated under the Regs. Sec. 1.61-21(g) special valuation rules (an amount far below the employer's cost to provide the flights).

Vacation Flights

Corporation Z owns an aircraft that it uses 90% for business and to fly A and his spouse, Y, from corporate headquarters to vacation sites each year. On each vacation flight, A and Y are the only passengers on the aircraft; the return flight, without passengers, flies back to headquarters. Several weeks later, Z sends an empty aircraft to the vacation site to pick UP A and Y and fly them back to headquarters.

The total cost allocable to these flights is about $340x a year, which Z fully deducts each year. Z has determined that, under Regs. Sec. 1. 1.61-21 (g), the value of the flights to A is about $26x a year. Z has treated the $26x as compensation to A, and included that amount in A's W-2 wages.

Disallowance Rule

Sec. 274(a)(1)(B) generally provides that no deduction is allowed for a facility used in connection with an activity of a type generally considered to constitute entertainment, amusement or recreation. According to the IRS, the use of Z's plane to transport A and Y to and from vacation sites is such a use. Thus, Sec. 274(a) precludes Z's deduction of any portion of the costs allocable to the vacation flights, except to the extent provided under Sec. 274(e).

Sec. 274(e) provides several exceptions to the Sec. 274(a) deduction disallowance rule. Sec. 274(e)(2) states that the disallowance rule does not apply to expenses for entertainment services and facilities to the extent the employer treats these expenses as compensation and wages to the employee who received them.

Dollar-for-Dollar Exception

Z argued that under Sec. 274(e)(2), it could deduct the entire $340x of expenses allocable to the vacation flights, because it had treated the entire $26x value of the vacation flights as compensation to A.

The IRS rejected this interpretation of the link between the special valuation rule in Regs. Sec. 1.61-21 (g) and the Sec. 274(e)(2) exception. The IRS pointed out that Sec. 274(e)(2) states that the deduction disallowance rule does not apply "to the extent" the entertainment facilities are treated as compensation. According to the IRS, the better interpretation of the "to the extent" language is that Sec. 274(e)(2) provides an exception to the Sec. 274(a) deduction disallowance on a dollar-for-dollar basis. Thus, the IRS concluded that Sec. 274(a) precluded Z from deducting its annual $340x of expenses for the vacation flights, except to the extent of the $26x a year that Z treated as compensation and wages to A.

The IRS stated that this result is not affected by Z's claim that Temp. kegs. Sec. 1.162-25T provides specific authority for deducting $340x. That rule provides that if an employer includes the value of a noncash fringe benefit in the employee's income, the employer may not deduct the amount as compensation for services, but rather, may deduct only the costs incurred in providing the benefit to the employee. The IRS's response was that any item allowable as a deduction under Sec. 162 may still be disallowed under Sec. 274.

Deducting Costs of Relocating Employees

The Tax Court held in Amdahl Corp.(14) that expenses paid to a relocation services firm to manage the sale of employees' homes were deductible as ordinary and necessary business expenses. The court rejected the IRSs argument that the homes had become capital assets, finding that the employer had successfully structured the arrangement to avoid taking either legal or beneficial ownership of the properties. By structuring its relocation arrangement this way, the employer converted otherwise capital losses into ordinary deductions.

Amdahl Corp. manufactures and services mainframe computers. To provide maintenance services to its customers, the company transfers employees to locations in which it has installed mainframes and as it expands into new markets.

To induce employees to relocate, Amdahl provides assistance in selling their homes by contracting with unrelated relocation service companies (RSCs); under the arrangement, the RSC offers to buy the employee's home at FMV and resell it to a third parry. An employee who accepts the RSC's offer signs a sales contract with the RSC as the buyer. The employee does not transfer legal title to the RSC or to the taxpayer; rather, the contract requires the employee to transfer title within one year to a third party designated by the RSC. If a third party has not purchased the home within that time, title passes to the RSC. The contract requires the employee to vacate the home within 60 days of accepting the RSC's offer. The employee's responsibility for the home's maintenance costs ceases on moving day, but the employee remains legally responsible for mortgage payments and taxes. On moving day, the RSC pays the employee his equity in the home, based on its appraised value.

The RSC sends the net sales proceeds from the third-party sale to the taxpayer and credits or charges the gain or loss to the taxpayer's account; the taxpayer pays any gain over appraised value to the employee and reimburses the RSc for the equity payment and for all costs incurred in assisting the employee with the sale, plus a fee for services. The RSC bears no risk of loss on the sale.

The IRS's position was that (1) the transactions between the RSCs and the relocating employees constituted sales and (2) the RSCs acted as the taxpayer's agent, making the taxpayer the beneficial (but not the legal) owner of the homes. Because the homes were capital assets to the taxpayer, it could not deduct the payments to the RSCs against ordinary income. This follows the IRS's position in Rev. Rul. 82-204,(15) that an employer's purchase of a relocating employee's home is a capital asset under Sec. 1221 when resold by the employer.

Court Sides With Taxpayer

The Tax Court concluded that the taxpayer did not acquire either legal or beneficial ownership of the homes. First, the RSCs were not the taxpayer's agents; if anything, they were the employee's agents, because the RSCs had authority to transfer ownership to third parties. Second, the parties did not treat the transactions between the RSCs and the employees as sales, and did not intend to transfer ownership through the sales contracts. Further, the sales contracts did not purport to convey ownership to either the taxpayer or the RSCs. The RSC's obligation to purchase the homes was conditional; the sales contracts were executory. In addition, the employees did not have a present, enforceable right to compel the RSCs to buy their homes. The parties treated the transactions as resulting in possible future sales to the RSCs and not as completed, present sales. Moreover, the RSCs were not required to pay the employees the full purchase price of their homes, just their equity. Neither the taxpayer nor the RSCs assumed personal liability for the mortgages on the homes. The taxpayer did not have the opportunity to benefit from any appreciation in the homes' value. Finally, the taxpayer's actions were inconsistent with those of an owner. It was not interested in long-term appreciation, but rather, in quick sales, and viewed the cost of relocation assistance as an expense of conducting its business.

According to the Tax Court, the real benefit the taxpayer received was the transfer of employees to locations in which they were needed. The sales contracts allowed the taxpayer to provide relocating employees the equity in their homes before they were sold. Thus, the purported "sales" were nothing more than a way for the taxpayer to subsidize the costs of transfers. Although the taxpayer assumed certain risks of loss in connection with the employees' homes (responsibility for maintenance costs after a move and the risk that a home would not be sold at its appraised value), those risks were insignificant in comparison with its primary motives and were insufficient to conclude that the taxpayer became the homes' owner for tax purposes. Thus, the payments to the RSCs were deductible compensation expenses under Sec. 162(a).

Merger Involved No Change of Ownership or Control

The IRS ruled in Letter Ruling (TAM) 971900316 that, for excess parachute payment purposes, a corporation did not undergo a change of ownership or control when it merged into a first-tier subsidiary of another corporation despite the fact that the corporation's executives received payments under self-described "change-of-control" agreements with the corporation.


The boards of directors and the shareholders of X Corporation and Y Corporation approved a merger of X into Y- 1, a first-tier subsidiary of Y In the merger, the X shareholders received new shares of Y stock and cash. Immediately following the merger, the former X shareholders owned a greater-than-50% interest in Y. The combined entity was renamed X Corporation (New X).

New X's board of directors has 14 members, 11 of whom had been on Y's board before the merger. Three of X's board members, including its chairman, were elected to the New X board. New X employs officers from both X and Y Several X executives received substantial payments under employment contracts they had with X; the contracts became operative on a "change of control" (as defined thereunder).

Parachute Payment Rules

Sec. 280G provides that no deduction is allowed for any "excess parachute payment." In addition, Sec. 4999 imposes on the recipient a 20% tax on the excess parachute payment, and Sec. 275 (a) (6) denies the recipient a deduction for the excise tax paid. A parachute payment generally is any payment in the nature of compensation to (or for the benefit of) a disqualified individual if:

--the payment is contingent on a change in the corporation's ownership or effective control or in the ownership of a substantial portion of its assets; and

--the aggregate present value of the payments in the nature of compensation to (or for the benefit of) the individual, which are contingent on such change, equals or exceeds three times the individual's "base amount."

The IRS pointed out that, generally, the terms of an executive's employment agreement, and the significance given to an event in the agreement, are irrelevant in determining whether, for Sec. 280G purposes, a corporation has undergone a change of ownership or control.

Defining "Ownership Change"

According to Prop. Regs. Sec. 1.280G-1, Q&A-27, a change in ownership or control of a corporation occurs on the date it is acquired by a person or persons acting as a group that owns more than 50% of the total FMV or total voting power of the stock; Sec. 318(a) rules apply.

From X's perspective, the Y shareholders did not acquire stock that, together with stock held by the Y shareholders, possessed more than 50% of the total FMV or voting power of X stock. Thus, X did not undergo a change in ownership or control. (Y, however, did experience an ownership change under Q&A-27.)

Defining "Change in Control"

According to Prop. Regs. Sec. 1.280G-1, Q&A-28, a change in the "effective control" of a corporation is presumed to occur on the date either (1) a person, or persons acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person, or persons) at least 20% of the corporation's total voting power; or (2) a majority of members 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 members of the board prior to the appointment or election.

From X's perspective, the Y shareholders did not obtain more than 20% of X stock in the merger, and a majority of X's board members was not replaced by directors whose appointment was not endorsed by a majority of X's board before the appointment date. Thus, the transaction did not give rise to a presumption that a change in effective control of X occurred; rather, it gave rise to a rebuttable presumption that such a change did not occur. The National Office left to the district director the question of whether this presumption A rebutted; the burden of proof rests on the director.

No Substantial Change in Asset Ownership

Under Prop. Regs. Sec. 1.280G-1, Q&A-29, a change in the ownership of a substantial portion of a corporation's assets occurs on the date a person, or persons acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation with a total FMV of more than one-third of the total FMV of all the corporation's assets immediately before such acquisition.

From X's perspective, all of its assets were transferred to Y (Y and Y-1 are treated as a single corporation for Sec. 280G(d)(5) purposes) in exchange for the issuance of Y stock to X's shareholders. Thus, Q&A-29 applies to X in determining whether it has undergone an ownership change of a substantial portion of its assets. Because the Y stock that the X shareholders received represented a greater-than-50% interest in Y immediately after the merger, the ownership of X assets did not change.

Deducting Post-Acquisition Severance Pay

The IRS concluded in Letter Ruling (TAM) 9721002(17) that a target in a Sec. 338 deemed asset acquisition could deduct (rather than capitalize) severance payments made immediately after the acquisition, under agreements in place prior to the acquisition. The IRS found that the payments did not result from pre-acquisition liabilities, and did not constitute a cost of acquiring the target.

Deemed Asset Acquisition

Buyer agreed to purchase from Seller all of wholly owned Old Target's stock. Buyer elected under Sec. 338 to treat the transaction as a deemed asset acquisition (i.e., to treat Old Target (1) as having sold all its assets at the close of the acquisition date at FMV in a single transaction, and (2) as having become a new corporation (New Target) that bought Old Target's assets the day after the acquisition date).

Buyer issued termination notices two days after the purchase to 40 New Target senior executives, and began eliminating the jobs of 850 other New Target salaried employees. The senior executives were entitled to severance payments under individual "termination protection" agreements they had entered into with Old Target; the salaried employees were entitled to severance payments under Old Target's general personnel policies. In addition, certain employees were entitled to plant closing costs under the Worker Adjustment and Retraining Notification Act. Buyer deducted these amounts as ordinary and necessary business expenses on its consolidated return.

New Target's Liabilities

A buyer that purchases business assets and assumes a seller's liabilities in connection with the acquisition generally must capitalize payments made on the liabilities. Thus, the IRS first examined whether the New Target severance payments resulted from Old Target liabilities assumed by New Target.

The IRS cited two lines of cases dealing with this issue. In the line requiring the buyer to capitalize the payments, the events most crucial to the creation of the obligation occurred before the acquisition.(18) In the line allowing the buyer to take a deduction, the events most crucial to the creation of the obligation occurred after the acquisition.(19) In the TAM, the liability for severance payments could arise only if the employees were terminated involuntarily--and none of them had been terminated by the acquisition date. Because no liability arose before the acquisition, the severance payments did not result from Old Target's liabilities; rather, they arose as New Target's liabilities.

Ordinary and Necessary?

The IRS then addressed whether New Target could deduct the payments as ordinary and necessary expenses, or had to capitalize them as a cost of acquiring Old Target. The IRS noted that the courts have consistently held that costs incurred incident to a corporate reorganization, recapitalization or acquisition should be capitalized; however, a deductible expense is not converted into a capital expenditure solely because it is incurred in an acquisition. Rather, the nature of a payment must be determined under the "origin of the claim" doctrine.

In Great Lakes Pipe Line Co.,(20) the target had entered into employment contracts with certain key executives, stating that the executives would continue to be paid after a sale of the business even if the buyer did not require their services. The contracts were executed the same day as the sale of the business. After the sale, the buyer terminated several executives covered under the contracts; the target reimbursed the buyer for the amount paid to the executives under the contracts. The district court ruled that, under the origin of the claim doctrine, the amount the target paid arose directly from the sale of assets, and was thus a capital expenditure.

The IRS found that the situation in TAM 9721002 was distinguishable from Great Lakes, for the following reasons:

[] In Great Lakes, the sole purpose of the employment contracts was to prevent a turnover of top management that might jeopardize the sale. In the TAM, Buyer wanted to terminate employees in an effort to consolidate operations.

[] In Great Lakes, the employment contracts were executed on the same day as the closing and were contingent thereon. In the TAM, the termination protection agreements and personnel policy were in place before a sale was ever contemplated, and were not entirely contingent on consummation of the sale.

[] The sales contract in Great Lakes required the buyer to assume any obligation to an executive who became eligible for payments under an employment contract. In the TAM, Old Target's severance arrangements were not mentioned in the purchase agreement.

The IRS concluded that, although the severance payments in the TAM were coincidental with Buyer's acquisition of Old Target, the acquisition was not the basis for the payments; rather, the severance payments had their origin in Buyer's termination of Old Target employees. Thus, the payments were currently deductible by Buyer as ordinary and necessary business expenses. The IRS also concluded that New Target could not include the severance payments in the basis of the Old Target assets deemed acquired by New Target.


The TAM illustrates the importance of timing and of the form and purpose of severance plans. For employers considering adopting severance plans or that have a severance plan and are considering a sale, the issues discussed by the IRS should be particularly relevant.

(1) TD 8705 (12/31/96).

(2) H. Rep. No. 104-506, 104th Cong., 2d Sess. 56 (1996).

(3) Geissal v. Moore Medical Corp., 114 F3d 1458 (8th Cir. 1997).

(4) 29 USC Section 1162(2)(D)(i).

(5) Brock v. Primedica, Inc., 904 F2d 295 (5th Cir. 1990); Lutheran Hosp., Inc. v. Business Men's Assurance Co. Of America, 51 F3d 1308 (7th Cir. 1995); Nat'l Cos. Health Benefit Plan v. St. Joseph's Hospital, Inc., 929 F2d 1558 (11th Cir. 1991). See Walker, Miller and Richardson, "Pensions: Current Developments in Employee Benefits (Part 11)," 27 The Tax Adviser 744, 750 (Dec. 1996).

(6) Oakley v. Longmont, 890 F2d 1128 (10th Cir. 1989), cert. denied; see Walker, Miller and Richardson, id.

(7) Rev. Rul. 97-20, IRB 1997-21, 4; MSAs are discussed in Notice 96-53, IRB 1996-51, 5.

(8) Notice 97-31, IRB 1997-21, 5.

(9) IRS Letter Ruling 9720034 (2/19/97).

(10) IRS Letter Ruling (TAM) 9716001 (6/17/96).

(11) Rev. Rul. 80-198, 1980-2 CB 113.

(12) Rev. Rul. 95-74, 1995-2 CB 36.

(13) IRS Letter Ruling (TAM) 9715001 (10/31/96).

(14) Amdahl Corp., 108 TC No. 24 (1997).

(15) Rev. Rul. 82-204, 1982-2 CB 192.

(16) IRS Letter Ruling (TAM) 9719003 (12/24/96).

(17) IRS Letter Ruling (TAM) 9721002 (1/24/97).

(18) See, e.g., Pacific Transport Co., Inc., 483 F2d 209 (9th Cir. 1973)(32 AFTR2d 73-5663, 73-2 USTC [para.]9615); Portland Gasoline Co., 181 F2d 538 (5th Cir. 1950) (39 AFTR 408, 50-1 USTC [para.]9263); David R. Webb Co., Inc., 708 F2d 1254 (7th Cir. 1983) (52 AFTR2d 83-5104, 83-1 USTC [para.]9384).

(19) See Minneapolis & St. Louis Railway Co., 260 F2d 663 (8th Cir. 1958)(2 AFTR2d 6083,58-2 USTC [para.]9903); Albany Car Wheel Co., Inc., 40TC 831 (1963), aff'd, 333 F2d 653 (2d Cir. 1964) (14 AFTR2d 5024, 64-2 USTC [para.] 9578); M. Buten & Sons, Inc., TC Memo 1972-44.

(20) Great Lakes Pipe Line Co., 352 F Supp 1159 (W.D. Mo. 1973)(31 AFTR2d 73-550, 73-1 USTC [para.]9158), aff'd in an unpub'd order, 7th Cir. 1974.


* If the requirements are met, a rebuttable presumption of reasonableness of compensation arises by which intermediate sanctions may be avoided.

* Yet another circuit has decided that CCC need not be offered to an otherwise qualified beneficiary if that individual is covered by a spouse's insurance at the time of the qualifying event, and no significant gap exists between CCC and coverage under the spouse's plan.

* The IRS ruled that assets from a VEBA to cover active employees and post-1988 retirees could be used to pay benefits for pre-1989 retirees.
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Title Annotation:part 1
Author:Richardson, Terrance
Publication:The Tax Adviser
Date:Nov 1, 1997
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