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Current developments in employee benefits.

As the provision of executive compensation and employee welfare benefits becomes more important to employees, the need to monitor the tax treatment of such amounts also increases. Now more than ever practitioners face increased IRS scrutiny of plans. It is important to understand not only the tax rules regarding these plans, but also financial accounting, securities rules and labor law.

The past 12 months have brought significant changes in the taxation of compensation and employee benefits. Not only have there been significant developments in the taxation of certain forms of executive compensation, most notably deferred compensation secured in a secular trust, but new positions can be taken in the taxation of employee fringe benefits.

This three-part article will discuss the recent changes in compensation and employee benefits. Part I, below, will discuss executive compensation and employee benefits, Part II, to be published in December, and Part III, in January, will focus on changes affecting qualified retirement plans.

Nonqualified Deferred Compensation

* Secular trusts

Secular trusts are a means of funding and securing nonqualified deferred compensation agreements. While the employee for whom the benefit is being provided is currently taxed on the vested amounts set aside in the trust for his benefit, the current low tax rates and added certainty of future payments make this type of arrangement acceptable in the current economic environment. Since the Tax Reform Act of 1986, many practitioners have questioned how Sec. 402(b)(1)and (2) apply to secular trusts and whether secular trusts are grantor trusts. Recent letter rulings provide some answers.

In IRS Letter Ruling 9206009,(1) X Corporation established a plan to provide nonqualified deferred compensation for nonemployee members of its board of directors. To secure its obligations under the plan, X proposed to contribute funds to a trust for any plan participant whose benefits were vested. A participant would have the right to receive his trust account balance at a future date in accordance with payment terms under the plan. The participant would not have a vested right to the income allocable to the participant's account balance until the participant's benefit was payable. Income earned by the trust would be allocated to the participants' accounts once benefit payments began. Before benefit payments began, the trust income would be distributed to X. Each year, the participants would receive a payment from the trust to cover their Federal income tax liability.

Sec. 402(b)(1) provides that employer contributions to a nonqualified employees' trust are included in the employees' gross income in accordance with Sec. 83. To apply Sec. 83 to a trust, the value of the employee's interest in the trust is substituted for the Sec. 83 taxable value--the property's fair market value (FMV).

Old Sec. 402(b)(2)(A)(now Sec. 402(b)(4)(A))provides that if one of the reasons a trust is not a qualified trust is the plan's failure to meet the requirements of Sec. 401(a)(26)or Sec. 410(b), highly compensated employees (defined under Sec. 414(q))must include in gross income their vested accrued benefit in the trust in lieu of the amount determined under Sec. 402(b)(i)(now (b)(1) or (2)).

For purposes of the Sec. 402 rules, "employee" includes a self-employed individual(2) The employer of such an individual is the person treated as his employer under Sec. 401(c)(4), which includes an individual who owns the entire interest in an unincorporated trade or business. Because a corporate director is a self-employed individual, he is treated as his own employer.

The IRS ruled that the plan met the requirements of Secs. 401(a)(26) and 410(b) with respect to each participant because each employer (i.e., each participant) had only one employee. Therefore, Sec. 402(b)(1), instead of Sec. 402(b)(2)(now (b)(4)), applied to the trust. Thus, each participant would be taxed on the portion of the contribution to the trust equal to the present value of the contribution payable in accordance with the terms of the plan, but not greater than the present value of the accrued benefit under the plan.

The facts in IRS Letter Ruling 9207010(3) are similar to Letter Ruling 9206009, except that the plan participants were employees rather than independent contractors. Because the plan covered only a select group of officers, it failed both Sec. 401(a)(26) and Sec. 410(b). The taxation of contributions for the highly compensated employees would be dictated by Sec. 402(b)(2)(now (4)), while taxation of the nonhighly compensated employees would be similar to that described in Letter Ruling 9206009. A highly compensated employee must include in income an amount equal to his vested accrued benefit (other than his investment in the contract) as of the close of the tax year of the trust that ends with or within his tax year. Under these rules, accumulated earnings, whether or not realized for tax purposes, are taxed to the highly compensated employee. For years in which the company retains the right to allocate trust income among participants, the taxable amount will be the lesser of the present value of the participant's trust account balance payable at the time provided under the plan, or the present value of the participant's benefit under the plan. For years in which the company can allocate income only to the participant's account, the participant's vested accrued benefit will be the lesser of his account balance or the present value of his benefits under the plan. IRS Letter Rulings 9212019(4) and 9212024(5) detailed similar tax consequences for participants accruing benefits in an employee's trust.

Contributions paid by an employer to a nonqualified deferred compensation plan are deductible in the employer's tax year in which ends the employee's tax year in which an amount attributable to such contribution is included in the employee's gross income.(6) For example, if an employer contributes $1,000 to an employee's account for the employer's 1977 calendar tax year, but the amount is not included in the employee's gross income until 1980 (at which time the includible amount is $1,150), the employer's deduction is $1,000 in 1980. When a funded plan has more than one employee participant, the employer is not allowed a deduction unless separate accounts are maintained for each employee to which employer contributions are allocated, along with any income earned thereon. Such accounts must be sufficiently separate and independent to qualify as separate shares under Sec. 663(c). The deduction timing rules under Sec. 404 also apply to plans covering independent contractors.(7)

In Letter Ruling 9206009, the IRS ruled that the trust established by X did not satisfy the separate share rule until the participants had the right to the trust income. Thus, X could not deduct currently or in the future contributions allocated to such trust accounts. This interpretation of the separate share rule can result in a significant detriment to some existing arrangements. X would receive a deduction for contributions allocated to trust accounts when X no longer retained the power to reallocate trust income.

A similar result regarding deductibility was reached in Letter Ruling 9207010. Under the terms of the plan in this ruling, the employer retained the power to allocate the trust income on shares of participants not yet in pay status among any of the other participants not in pay status. As soon as benefits became payable under the plan, the income allocable to a participant's share could not be allocated to any other participant. Again, no deduction was allowed to the employer for contributions to accounts of participants not in pay status because the separate share rule had not been met.

This result can be corrected, if consistent with plan design, by providing that the income allocable to each participant's share is allocable solely to his account, removing any right of payment of trust income to the employer or right to allocate income among participants' accounts. Letter Rulings 9212019 and 9212024 provide that language to this effect in a plan will meet the separate share rule, and that a deduction will be allowed under Sec. 404(a)(5) in the tax year in which amounts attributable to those contributions are includible in the participant's gross income, to the extent the ordinary, necessary and reasonable test of Sec. 169. is met. Alternatively, a separate trust for each plan participant could be used, providing that all income is allocated to trust beneficiaries in accordance with their account balances.

The IRS next addressed the grantor trust issue. Sec. 677(a)(1) provides that the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be distributed to the grantor. Sec. 677(a)(2) provides that the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be held or accumulated for future distribution to the grantor.

The IRS, however, ruled that the rules that apply to employee trusts under Secs. 402(b) and 404(a)(5) preclude such a trust from being a grantor trust. Thus, X is not treated as the owner of any portion of the trust and the income is taxed to the trust under Sec. 641. When the trust is taxed as other than a grantor trust, the income is effectively taxed twice--once at the trust level and once when amounts are distributed from the trust or, under Sec. 402(b)(2), when the highly compensated employee has an increased accrued benefit. To avoid this result, the employer could design the trust as a grantor trust of the employee. In this case, many employees would prefer to receive cash currently.

* Rabbi trusts

While secular trusts may not be as tax beneficial as they formerly were considered to be, the IRS has made the use of rabbi trusts (another means of securing nonqualified deferred compensation) easier for the taxpayer. The Service has released two revenue procedures, both effective July 28, 1992, providing guidance on requesting rulings on unfunded deferred compensation plans and rabbi trusts.

Rev. Proc. 92-64(8) provided a model rabbi trust that includes various options for trust design. If the model trust is used, an employee will not be deemed to be in constructive receipt of income or incur an economic benefit solely on account of the trust; however, the nonqualified deferred compensation plan must also be operated to effectively defer compensation in order to avoid constructive receipt principles.

The IRS will continue to rule on unfunded deferred compensation plans that do not use a trust or that use the model trust, and, when the model trust is used, on the issue of whether the trust is a grantor trust. But rulings will not be issued on unfunded deferred compensation plans using a trust other than the model trust except in rare and unusual circumstances.

Taxpayers seeking a ruling must include the plan and the trust, along with a representation that the trust conforms to the model language and is valid under state law. The trust may include additional language, not inconsistent with the provisions of the model trust, if such language is included, the language should be underlined. The trustee must be an independent third party with trustee powers under state law.

Appropriately, the IRS makes no representations regarding the application of the Employee Retirement Income Security Act of 1974 (ERISA) to the rabbi trust arrangement.

Rev. Proc. 92-65(9) provided guidance in requesting a ruling on the application of the constructive receipt doctrine to unfunded deferred compensation arrangements in general. It amplified Rev. Proc. 71-19(10) on unfunded deferred compensation, and provided that the IRS will rule on constructive receipt in deferred compensation arrangements if the requirements of Rev. Proc. 71-19 and the following guidelines are met.

* For years in which the plan is first implemented or in which the participant is first eligible, the participant may make an election to defer compensation within 30 days after the adoption of the plan or eligibility, respectively.

* The plan must define the time and the method for paying the deferred compensation for each event entitling a participant to payment (termination, disability, etc.).

* The plan may provide for payment in the event of "unforeseeable emergencies," defined as events beyond the participant's control.

* The plan must provide that the participants are general, unsecured creditors; any trust for the plan must conform to the requirements in Rev. Proc. 92-64 for rabbi trusts; and the plan must state that the parties intend the arrangements to be unfunded for tax and ERISA purposes.

* The plan must state that the participant's rights are not subject to alienation or assignment by creditors of the participant or his beneficiary.

To the extent not otherwise specified in Rev. Proc. 92-65, the general procedures of Rev. Proc. 92-1(11) apply to ruling requests for unfunded deferred compensation arrangements.

* Payments under an annuity policy Often when a taxpayer is reviewing various methods of securing deferred compensation, the use of an annuity is considered. Unfortunately, this can result in the recognition of current compensation for the individual. The IRS has ruled that a taxpayer's right to receive payments under an annuity policy as payment for professional services is a nonforfeitable right to property transferred in connection with the performance of services. As such, the FMV of the policy is includible in the taxpayer's gross income for the tax year in which the policy is purchased.

The taxpayer in IRS Letter Ruling (TAM) 9134006(12) was an attorney who represented a client in a personal injury suit. As part of the settlement process, the taxpayer's client executed a release and indemnity agreement, under which the liability insurer was to pay a specified portion of settlement proceeds to the taxpayer as payment for his legal services.

The liability insurer subsequently assigned its obligation to a second insurance company. Under an assignment and assumption agreement, the second insurance company purchased an annuity policy from a guarantor to provide for a medium of payment to the taxpayer and to ensure that payment would be made.

The taxpayer was designated as the sole annuitant and payee, with his estate as beneficiary. Payments due under the annuity policy could not be accelerated, deferred, increased or encumbered. The taxpayer's rights against the insurance company were those of a general creditor, and the taxpayer could not forfeit the payments to be made for any reason.

The IRS cited Regs. Sec. 1.83-1(a)(1), which states that property is not taxable under Sec. 83(a) until it has become substantially vested. Property is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture.(13) Whether or not property is subject to a substantial risk of forfeiture depends on the facts and circumstances. A substantial risk of forfeiture exists when the rights in property are conditioned, directly or indirectly, on the future performance of services by an individual or on the occurrence of a condition related to the purpose of the transfer.(14)

The IRS concluded that the taxpayer's right to the payments from the annuity was not conditioned on future services, and that his interest was not subject to a substantial risk of forfeiture. The IRS next determined that the taxpayer's right to receive payments constituted "property" as defined in Regs. See. 1.83-3(e). The IRS then ruled that the FMV of the taxpayer's right to receive payments under the annuity policy was taxable under Sec. 83 in the year the policy was purchased.

Providing Welfare Benefits To Employees

* Deductible limits for VEBAs ironically, voluntary employees' beneficiary associations (VEBAs) now provide one of the best opportunities available for accelerating income tax deductions for an employer. Originally enacted to limit tax deductions, Sec. 419A defines specified deduction limits applicable to contributions to a welfare benefit fund. Understanding and taking advantage of these deduction limits has reduced taxes for many employers, while securing the payment of benefits for employees.

In a recent technical advice memorandum, Letter Ruling 9215002,(15) the IRS opened the floodgates for VEBA deductions for union employees. The Service said that when medical and other welfare benefits are provided under a collective bargaining agreement and are funded by a separate welfare benefit fund, contributions to the separate fund are not subject to the Sec. 419A account limits. Additionally, the unrelated business income tax (UBIT) provisions operate to exempt the income generated by assets accumulated under such an arrangement. There is an explanation why this "too good to be true" opportunity exists.

Contributions to a welfare fund(16)--to the extent otherwise deductible as ordinary and necessary expenses-are deductible within the limits prescribed by Sec. 419. Generally, the annual limit on deductions is the "pay-as-you-go" cost (qualified direct cost(17)) plus an amount to accumulate as a reserve(18) Except for certain permitted additions for specified postretirement welfare benefits, the account limit(19) restricts the asset build-up to year-end fund liability (claims and expenses incurred but unpaid).

There is an exception, however, to the restrictions on account limits for certain collectively bargained plans(20) When applicable, the union plan exception eliminates all restrictions on the account limit. In such cases, deductibility depends only on the overall "ordinary and necessary expense" requirements. In the letter ruling, the IRS concluded that the collective bargaining exception applies to a separate fund (a VEBA in this case) established to provide welfare benefits required by bona fide union contracts. A critical fact was that the collective bargaining agreements (and the summary plan description (SPD)) specifically did not require establishing a welfare benefit fund to provide the benefits. The employer took the sole initiative to establish and hand the VEBA.

The letter ruling did not address either the reasonable and necessary constraint or the UBIT. As to the latter, however, IRS Letter Ruling 9207038(21) concluded that when the union exception applies, there is no account limit and, therefore, Sec. 512(a)(3)(E)(i) provides that there is no limit on the assets "set aside" (asset reserves) and the income derived therefrom (exempt function income) does not constitute unrelated business taxable income.

The IRS recently issued Letter Ruling 9213029,(22) which bears on the ordinary and necessary issue. The ruling applied the Sec. 419A(f)(5) exception to a fund used to provide postretirement medical benefits and concluded that contributions would be deductible until accumulated plan assets equal the present value of future benefits. The letter ruling cited, but went beyond, earlier published guidance: Rev. Ruls. 69-382,(23) 69-478(24) and 73-599(25) limited contributions to the amount necessary to allocate costs over covered employees' working lifetimes. The letter ruling, which concluded that the union exception applied (and, therefore, the limits of Sec. 419 did not apply), stated that "if the amount of the contribution satisfies the requirements of section 419 ... , the deduction of such amount is generally not limited by section 162 .... "Whether the IRS would draw the same conclusion for nondeferred welfare benefits--such as health insurance for current employees--is questionable. Presumably, the ordinary and necessary test would be applied for annual insurance coverage in a way that is related to the value of current finsread of nature) benefits.

Read literally, Letter Rulings 9215002 and 9213029 seem to say that a company that bargains for health and welfare benefits with its union can establish a separate VEBA to fund those benefits and deduct the net present value of such contributions. Economically, the employer is obligated to make the payments and, once made to an irrevocable trust, the employer no longer controls payment. The far-reaching nature of the rulings is surprising. While the statutory and regulatory guidance can be read more restrictively, taxpayers should take advantage of this interpretation to accelerate income tax deductions for handing VEBAs.

* VEBAs paying payroll-type benefits

In a much more restrictive ruling, Letter Ruling (TAM) 9126004,(26) the IRS interpreted the deductible limit for a VEBA that was established to fund payroll-type employee benefits to be severely restricted, although the trust was a valid Sec. 501(c)(9) organization. Because the employer had a preexisting obligation for the benefits offered through the VEBA, the IRS ruled that the trust functioned only to relieve the employer of payroll obligations. Therefore, accelerated contributions to fund the employer's obligation that exceeded actual distributions during the year were not deductible, except to the extent amounts were funded for benefits dependent on an employee's years of service.

The ruling set out facts that are common to many employers. In discussing this with the IRS National Office, the author has learned that the ruling was adverse primarily because the trust was not considered to be an employees' trust, as there was no evidence that the funding of the trust had been communicated to employees. The technical basis for the conclusion is strained at best. A court may disagree.

While the ruling was decided under law in force before the enactment of Secs. 419 and 419A, the IRS position would be identical under current law. As more and more clients turn to welfare benefit funds for accelerating benefit deductions, they should be made aware of the importance of communicating the funding to their employees. In the case of a union plan, it may be necessary that this communication be made through the union.

The corporation in the ruling established a trust before the close of its 1984 fiscal year from which certain employee benefits (holiday pay, personal days, sick pay and short-term disability) were to be paid. Each of these benefits had previously been paid directly by the corporation. The trust maintained separate records, and established an agency arrangement with the corporation under which the corporation paid the described benefits as part of its regular payroll, and the trust reimbursed the corporation for benefits it paid as the trust's agent. Under the trust instrument, no trust assets could revert to the corporation. Employees' rights to the benefits were established through a collective bargaining agreement, but the agreement did not require that the benefits be provided through a trust.

The trust received a ruling that it was tax exempt as a Sec. 501(c)(9) VEBA.

The first issue was whether the benefits provided by the trust were permissible benefits for a Sec. 501(c)(9) VEBA. The IRS ruled that the sick pay and disability wage replacement benefits were permissible benefits under Regs. Sec. 1.501(c)(9)-3(c), as were the personal days and vacation benefits under Regs. Sec. 1.501(c)(9)-3(e).

The second issue was whether the corporation's contributions to the trust were deductible under Regs. Sec. 1.162-10, or, if not, under the transition rules of Temp. Regs. Sec. 1.419-1T. Regs. Sec. 1.162-10(a) allows a deduction for amounts paid or accrued within the tax year for dismissal wages, unemployment benefits, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare or similar benefit plan if these amounts are ordinary and necessary business expenses. Before the enactment of Sec. 419, irrevocable payments made to a valid employees' trust could be deducted under Regs. Sec. 1.169.-10 under certain circumstances even if they exceeded current distributions from the trust.(27)

Other cases limited the ability to claim a deduction when there was a possibility of the trust assets reverting to the sponsoring corporation or when the employer had practical control over the trust' assets(28) In Anesthesia Service Medical Group,(29) a trust that accumulated funds to pay malpractice claims against employees was held to be a trust for the benefit of the employer, not the employees.(30) Since the fund was available to satisfy the employer's future liabilities for the tortious acts of its employees, the fund was deemed to provide an indirect benefit to the employer. According to the court, this indirect benefit could disqualify the trust as an employee benefits trust under Regs. Sec. 1.162-10, in the same way as would the direct benefit of an asset reversion.

Many practitioners disagree with this reading of Regs. Sec. 1.162-10. Under the regulation, amounts are deductible if they are ordinary, necessary and reasonable, and without regard to whether the funding is through a trust. The IRS's very narrow reading of this rule reflects a desire to disallow the deduction when regulatory, statutory and judicial authority for such a disallowance does not exist.

In the letter ruling, the IRS ruled that the VEBA was formed to benefit the corporation and not the employees; it functioned entirely to relieve the corporation from obligations it had made with the union. The integration of the trust with the corporation's payroll system further demonstrated the trust's employer orientation. Therefore, no deduction under Regs. Sec. 1.162-10 was allowed.

The corporation tried to argue that, if Regs. Sec. 1.162-10 did not allow a deduction, the safe harbors under Temp. Regs. Sec. 1.419-1T, Q&A-10(c) would apply to allow the deduction. The IRS applied the reasoning of several revenue rulings dealing with postretirement benefits(31) in reaching the conclusion that the holiday and sick benefits were attributable to the current year of service and therefore not deductible under the rulings. The corporation was allowed a deduction for payments for short-term disability benefits, since these benefits are fairly attributable to the employee's entire working life and not just the year at issue. The deduction for personal days depends on whether the personal days are based on the employee's length of service, or are only associated with the current year.

Under current law, Sees. 419 and 419A would allow deductions to the employer for all of the direct costs of permissible benefits in the VEBA or taxable welfare benefit fund. Additional deductions are allowed for certain additions to the qualified asset account if the amount is reasonable and actuarially necessary to fund administrative costs or claims incurred but unpaid as of the close of the tax year.(32)

No actuarial certification is needed for certain benefits as provided in the Sec. 419A(c)(5) safe harbors, including short-term disability benefits and medical benefits for current employees. The safe-harbor account limit for short-term disability benefits is 17.5% of the qualified direct costs (other than insurance premiums) for the preceding year.

So, if current law were applied to the facts in Letter Ruling 9126004 and the trust was deemed to be an employee's trust, a deduction would be allowed for only the qualified direct costs of all of the benefits, plus an amount not in excess of 17.5% of the prior tax year's short-term disability costs not paid through insurance.

* DOL enforcement policy for cafeteria plans The reporting requirements for employee benefit plans are among the most confusing issues facing employers. This confusion has been compounded by the duplicative reporting requirements of ERISA Title I and the Internal Revenue Code, and the lack of enforcement of these rules in the past. In an effort to combat criticism for lax enforcement, the Department of Labor (DOL)has announced that enforcement of the reporting requirements will be significantly increased in the near future. However, enforcement is not possible until the rules are better understood. Because the reporting requirements are not understood and in some cases seem inappropriate, the DOL has issued ERISA Technical Release 92-1,(33) essentially stating that until the earlier of Dec. 31, 1993, or the adoption of final regulations providing relief from the trust, reporting and disclosure requirements of ERISA Title I, participant contributions to cafeteria plans or certain other welfare plans need not be held in a trust and will not create an audit requirement or a further filing requirement. Or as the DOL phrases it, "the Department will not assert a violation in any enforcement procedure or assess a civil penalty..." solely because of a failure to meet certain trust and reporting requirements resulting from the existence of participant contributions.

This technical release expands on ERISA Technical Release No. 88-1.(34) Technical Release No. 92-1 specifically states that in the case of a cafeteria plan, the DOL will not assert a violation in any enforcement procedure solely for failure to hold participant contributions in trust; nor will it assert a violation or assess a civil penalty because of a failure to meet the reporting or audit requirements if that failure results from not coming within the exemptions in DOL Regs. Sections 2520.104-20 and 2520.104-44 solely because participant contributions are used to pay plan benefits or expenses of providing such benefits. In the case of welfare plans, if participant contributions are applied only to premium payments consistent with DOL Regs. Section 2520.104-20(b)(2)(ii) or (iii) and DOL Regs. Section 2520.104-44(b)(1)(ii) or (iii), the DOL will not assert a violation in any enforcement proceeding or assess a civil penalty solely because of failure to hold the employee contributions in a trust.

DOL Regs. Section 2520.104-20 exempts plans with fewer than 100 participants from the requirement of filing an annual Form 5500, Annual Return/Report of Employee Benefit Plan (With 100 or more participants), and DOL Regs. Section 2520.104-44 exempts plans with 100 or more participants from submitting an audit with their Form 5500, if the plans fall into one of the following classifications.

1. Benefits are paid solely from the general assets of the employer.

2. Benefits are provided exclusively through insurance contracts or health maintenance organizations (HMOs), the premiums of which are paid from the employer's general assets or a combination of such employer assets and employee contributions forwarded to the insurance company or HMO within three months of receipt by the employer, and refunds, if any, are delivered back to the employee within three months.

3. Benefits are provided partly through employer assets and partly through contracts as described in (2).

These exemptions do not apply if the benefits are paid from a trust.

In short, the DOL is saying that if a plan fits under a reporting exemption set out in the regulations, it will not lose the exemption simply because the plan accepts employee contributions, if those contributions are forwarded to an insurance company or an HMO at least every three months and paid out in refunds, if any, within three months.

This release leaves unclear the treatment of welfare plans in which employee after-tax contributions are accepted and sent to a third-party administrator in an administrative-services-only (ASO) situation, and self-funded plans in which the benefit payments always exceed the after-tax employee contributions. The DOL has said that self-insured plans and ASOs do not fit within the exemptions, unless they are considered a part of a cafeteria plan. Whether the DOL will stick with this view is unknown.

Of course, a welfare plan must still fit within the exemptions in the regulations. And the DOL specifically warns that this policy in no way relieves plan sponsors or fiduciaries from the need to use participant contributions only for benefits and reasonable expenses. Their use for any other purpose may result in civil and criminal sanctions.

* DOL grace period

The DOL has extended through Dec. 31, 1992 its grace period for accepting late or unfiled Forms 5500 due for 1988 and subsequent plan years. The DOL cited the need to extend the grace period (originally scheduled to terminate Sept. 30, 1992) in order to encourage filing, especially because guidance on coverage of "top hat" plans for selected executives was not clarified until late July. The decision was also in response to plan sponsors who are having difficulty completing the audits that must accompany certain Form 5500 filings, and to plan sponsors affected by Hurricane Andrew or Hurricane Iniki.

The grace period arose as part of the DOL's stricter enforcement program for filing Forms 5500, announced in March 1992. Although the DOL has statutory authority to assess a penalty of $1,000 a day for late or unfiled Forms 5500,(35) the DOL has been casual in enforcing late penalties. In the March announcement,(36) however, the DOL said it would begin assessing a $50 a day penalty for late Forms 5500. For those who failed completely to file the Form 5500, a $300 a day penalty, up to $30,000 a year, would be assessed.

However, the DOL announced that before it began to impose this penalty policy, it would permit plan sponsors to correct past filing failures by filing a completed Form 5500 and all necessary accompanying information and submitting a $1,000 check for each Form 5500 due since 1988 through the end of the original grace period. In a later clarification, the DOL also stated that the grace period would apply to late Forms 5500 that had been filed before the beginning of the grace period and that the grace period would also apply to top hat plan filings for a reporting exemption under the regulations. In short, for a plan that had not filed Forms 5500 since 1988, the reporting failure could be corrected by preparing the Forms 5500 for 1988, 1989 and 1990, filing the forms with the IRS and the DOL, and submitting a check for $3,000 to the DOL. If the 1991 plan year Form 5500 was not filed on time, a $50 a day penalty, up to $1,000, would be due for it as well. Top-hat plans need to file only the alternative reporting statement and submit a check for $1,000, irrespective of the number of plans an employer has or the year a plan was created.

* DOL guidance on plan assets

The DOL has issued an advisory opinion on insurance contracts and plan assets. DOL Opinion Letter 99,-09,A(37) stated that, under the facts in the opinion, an employer-owned stop-loss insurance policy will not be considered a "plan asset."

The request described a situation in which the employer establishes a medical benefit plan for its employees, with benefit payments made from the employer's general assets. The employer buys a stop-loss insurance policy that will pay benefits under the plan when benefit claims exceed a predetermined amount. The employer retains all rights of ownership of the policy; payments made under the policy are made directly to the employer; neither the plan nor any participant or beneficiary under the plan will have any preferential claim against the policy; the employer will not represent to the participants or beneficiaries that payments under the plan are made or secured by the policy, plan benefits are not limited or governed by the amount of insurance proceeds received by the employer, and the plan does not and will not require employee contributions.

The ERISA does not require that welfare benefit plans be funded. Benefits under unfunded plans are paid from the employer's general assets. The advisory opinion states that, in situations outside the scope of DOL Regs. Section 2510.3-101 (generally dealing with what constitutes a plan asset with respect to a plan's investment in another entity), plan assets are to be identified "on the basis of ordinary notions of property rights under non-ERISA law." In making this identification, consideration must be given to any contract or other legal instrument involving the plan, including plan documents, and to any actions or representations of the involved parties. A footnote to the advisory opinion notes that such consideration must take into account whether the purchase of the insurance is required by the plan or other relevant documents, such as a collective bargaining agreement.

The DOL concluded that, under the facts presented, the policy is not an asset of the plan. Such a policy would not provide benefits under the plan and would not have to be reported on Schedule A of Form 5500, or be submitted with the annual report in accordance with ERISA Section 103(a)(2)(A) and (e).

* Plan document controls

Reporting and disclosure are not the only concerns that an employer has in maintaining and administering a welfare benefit plan. It is important to be sure that the plan document accurately reflects the intended plan benefits. In Confer v. Custom Engineering Co.,(38) the Third Circuit has affirmed the authority of the actual plan document language to control the provisions of health plans. The lesson for employers is to read their documents before adopting them. A companion decision confirms that corporate officers and plan supervisors are not fiduciaries merely by virtue of their status as such.(39)

On Apr. 1, 1985, the president of Custom Engineering announced in a speech to all employees that effective Apr. 1, 1985 the health plan would no longer cover injuries incurred in motorcycle accidents. The same information was posted as a bulletin board notice. Custom Engineering received the plan document Apr. 10, 1985, and executed it sometime in May. The plan document did not contain an exclusion for injuries incurred in motorcycle accidents. On June 1, 1985, an employee, Ricky Confer, was injured in a motorcycle accident. When Custom Engineering subsequently discovered that the plan document did not exclude motorcycle accidents from coverage, Custom Engineering's president adopted an amendment to exclude such accidents, backdating it to Apr. 10, 1985. The plan then refused to pay Confer's medical claims.

Confer sued, alleging that the plan covered his injuries, that the corporation and the officers of Custom Engineering had violated their fiduciary duties, and that Custom Engineering had shown extreme bad faith in backdating the amendment and was therefore liable for attorneys' fees. The district court agreed on all counts, except on the fiduciary status of the corporate officers.

The Third Circuit found that only a formal written amendment could change the plan document's coverage. The court also found that such a change could be prospective only. The lower court's ruling that Confer's injuries were covered by the plan was affirmed.

In a separate decision, the Third Circuit affirmed the lower court's findings that the corporate officers were not fiduciaries of the plan merely by virtue of their being corporate officers.

In Custom Engineering's case, the named fiduciary was the corporation. The court found that when a corporation is the named fiduciary, the officers who actually carry out the acts for the corporation will not be fiduciaries unless the officers have individual discretionary roles-for example, as a plan administrator. The officers in this case did not have such discretionary roles. The court explained that the officers' decisions to exclude motorcycle accident coverage and to backdate the plan amendment were made as "business decisions," not as decisions in administering the plan.

The court also affirmed the lower court's finding that the plan supervisor, a third-party administrator, was not a fiduciary, as it had no discretion to pay or not pay the claims in light of the amended document.

Once again the Third Circuit has reaffirmed the importance of plan documents. Particularly in the area of health plans, employers tend to be lax about keeping documents up-to-date and requiring that documents accurately and clearly reflect the plan. The Confer case should remind them how critical such "details" are.

* COBRA coverage

In a similar case, National Companies Health Benefit Plan v. St. Joseph's Hospital of Atlanta,(40) the Eleventh Circuit held an employer liable for Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA)coverage to a terminated employee, even though the employee was not eligible for COBRA coverage under the terms of the plan, because the employee relied to his detriment on the employer's representations that coverage was available. The court awarded medical expenses, attorneys' fees for the employee and another employer involved in the suit, and prejudgment interest.

While Robert Hersh was employed by National Distributing Company (NDC), he and his family were covered under NDC's self-insured health plan (the Plan). On terminating his employment with NDC, Hersh informed his manager of his desire to continue medical coverage. The manager consulted with the benefits claims clerk--who was aware that Hersh was also covered under his wife's employer's medical plan--and subsequently informed Hersh he was eligible for continuation coverage. Hersh signed the continuation coverage agreement on his last day of work and paid the first monthly premium.

The continuation coverage agreement provided for up to 36 months of coverage, which could be terminated for "becoming covered under another group health plan because of either employment or remarriage." Hersh continued to pay the premiums, which NDC accepted and deposited. Hersh submitted minor claims, which were less than his deductible amount.

When Hersh's wife gave birth prematurely to twins, NDC informed Hersh that he was not eligible for COBRA coverage and that NDC was revoking his coverage retroactive to his date of resignation. NDC based the revocation on the fact that Hersh and his dependents were covered under another group health insurance plan. Hersh and his wife's employer (whose coverage of the Hershes was secondary to the NDC plan except for Mrs. Hersh, for whom it was the primary insurer) sued for payment of claims, attorneys' fees and prejudgment interest. The district court for the Northern District of Georgia granted summary judgment for Hersh and the secondary plan on all counts.

The Eleventh Circuit first examined Hersh's rights under ERISA, and held that Hersh was ineligible for COBRA coverage because of his coverage under his wife's plan. The court held that it is immaterial when the employee acquires another group health coverage; the only relevant question is when, after the election date, does that coverage take effect. In this case, that coverage took effect immediately. The court cited Oakley v. City of Longmont(41) and Brock v. Primedica, In (2;. (42).

However, the Eleventh Circuit held that under the doctrine of "equitable estoppel" NDC could not deny Hersh coverage once it had made an offer of coverage and Hersh had relied on that offer in declining to obtain additional outside coverage.

The doctrine of equitable estoppel consists of five elements.

1. The party to be estopped misrepresented material facts.

2. The party to be estopped was aware of the true facts.

3. The party to be estopped intended that the misrepresentation be acted on or had reason to believe the party asserting the estoppel would rely on it.

4. The party asserting the estoppel did not know, nor should have known, the true facts.

5. The party asserting the estoppel reasonably and detrimentally relied on the misrepresentation.

Here, all the elements necessary to estop NDC from revoking the continuation coverage under its health plan were present. Because the NDC plan was the primary insurer of Hersh and his children, and the medical bills under the continuation coverage resulted from the birth and care of the premature twins, the court awarded Hersh all medical expenses of the children, along with 18% interest that had been charged by the hospital on the unpaid claims. The court also awarded attorneys' fees to both Hersh and his wife's employer, who joined in the suit, because NDC acted in bad faith by attempting to avoid its obligation after Hersh relied to his detriment on NDC's representations. The total award was in excess of $900,000.

The Eleventh Circuit agreed with the Fifth Circuit in Brock that the existence of any comparable group coverage at the time of the employee's election for COBRA coverage renders the employee ineligible for coverage. However, if the employer offers coverage and the employee accepts and complies with the terms of the coverage agreement, the Eleventh Circuit holds the employer responsible for continuation coverage under the plan. The Brock court found no detrimental reliance on the employer's representations, and did not hold the employer responsible for continued coverage. The Tenth Circuit in Oakley held that preexisting coverage under another group health plan does not render an employee ineligible for COBRA continuation coverage.

Excluding Fringe Benefits From Income

* Disability policies distributed from a VEBA

In Letter Ruling 9143071,(43) the IRS said that disability insurance policies distributed to employees from a terminated VEBA were not includible in the employees' gross income. The ruling also provided that because the insurance policies were purchased with employee assets and the premiums were not deducted under Sec. 213, participants will not include in gross income disability payments received under the insurance policies.

In the ruling, company S was acquired by company P and all S employees were transferred to P in contemplation of S's dissolution. Before being acquired, S maintained an employee disability plan funded solely by employee contributions. The plan's assets were held in a VEBA. After S was acquired, the VEBA was terminated. As part of the termination process, participants currently receiving disability benefits from the plan would receive insurance policies that would replace those benefits. The insurance policies would contain provisions similar to those of the disability plan, such as the amount of payments and when payments will cease. The policies would be noncancelable, nonsurrenderable and nonassignable.

Sec. 104(a)(3) provides that amounts received under a disability insurance plan are not includible in gross income, provided the individual pays all the insurance premiums and does not deduct the premiums as medical expenses under Sec. 213. Because the disability plan contained only employee assets and none of the payments made were deducted by the employees, benefits received from the insurance policies are not includible in the employees' gross income. Further, because the VEBA assets were used to buy insurance policies to satisfy the current obligation of the disability plan, and the benefits participants will receive under the insurance policies are essentially the same, no income will be recognized on receipt of the insurance policies.

* Two percent S corporation shareholders Amounts for payment of accident and health insurance provided to 2% shareholder/employees in S corporations will not be subject to Social Security and Medicare taxes if the requirements of Sec. 3121(a)(2)(B) are met, according to IRS Ann. 92-16.(44) Under Sec. 3121(a)(2)(B) amounts paid for such benefits are exempt from Social Security and Medicare tax if those benefits are paid under a plan or system for employees and their dependents generally, or for a class or classes of employees and their dependents. If the Sec. 3121(a)(2)(B) standard is met, no Social Security or Medicare taxes are due on amounts for such benefits, even though those amounts must be reported as wages for income tax withholding purposes. If that standard is not met, amounts paid for such accident and health insurance premiums are subject to Social Security and Medicare taxes. Whether such benefits are included for those tax purposes is thus a fact question in each case.

This announcement clarifies Rev. Rul. 91-26,(45) which stated that amounts paid by an S corporation for accident and health insurance covering a 2% shareholder/employee must be reported as wages for income tax purposes on his Form W-2. The ruling carefully did not address the issue of whether a 2% shareholder/employee for partner) would be subject to Social Security tax on the value of insurance coverage or the amount of health benefits paid by the employer under a selfinsured medical plan.

* Health benefits for "domestic partners"

IRS Letter Ruling 99,31062,(46) which addressed the applicability of the health insurance exclusion for a nondependent of the employee, revealed more about the IRS's interpretation of whether benefit payments or coverage is excludible by the employee who participates in a self-insured plan of the employer. The IRS ruled that for an employee to exclude from income the cost of employer-provided health coverage for a "domestic partner," the domestic partner generally must meet all the requirements for qualifying as the employee's dependent, regardless of the existence of a local law that affirmatively recognizes unmarried cohabitation.

In the ruling, City enacted a statute governing the rights and responsibilities of domestic partners. The statute defined "domestic partners" as two adults who live together and who have agreed to be jointly responsible for basic living expenses incurred during the partnership. In addition, the partners must make a declaration that neither is married and that they are not related to each other in a way that would bar marriage under state law. For City employees, one of the benefits of domestic partnership status is that they are entitled to enroll their domestic partners for coverage under City's health plan. The health plan requires mandatory employee contributions through payroll deductions, some or all of which are later reimbursed to the employee on a periodic basis.

Sec. 106 provides an exclusion from gross income for employer-provided coverage under a health plan for personal injuries or sickness incurred by an employee, the employee's spouse or the employee's dependents.(47) Under Sec. 105, benefits received under employer-provided health coverage are generally taxable to the employee,(48) unless they are paid to reimburse the employee for expenses incurred for the medical care of the employee, the employee's spouse or the employee's dependents.(49) And under Sec. 104(a)(3), gross income generally does not include amounts received through health insurance for personal injuries or sickness. The Sec. 104(a)(3) exclusion does not apply to amounts received by an employee, to the extent those amounts either are attributable to employer contributions that were not taxable to the employee, or are paid by the employer.

An individual's marital status for Federal tax purposes depends on his marital status under applicable state law. Unless the state recognizes common-law marriages, a domestic partner cannot qualify as an employee's spouse for purposes of the Sec. 105 or 106 exclusion. Thus, the key question in most cases is whether the domestic partner qualifies as the employee's dependent. The IRS stated that a domestic partner cannot qualify as a dependent of an employee unless the partner meets both of the following requirements.

* The partner receives more than half of his support for the year from the employee.

* The partner either is related to the employee in one of the familial relationships specified in Sec. 152(a)(1) through (8), or meets the requirements

of Sec. 152(a)(9)--i.e., the partner is a member of the employee's household and has, as his principal place of abode, the home of the employee. An individual is not considered a member of a taxpayer's household if the relationship between the individual and the taxpayer is in violation of local law.(50)

According to the IRS, whether a domestic partner satisfies the definition of "dependent" under Sec. 152(a)(9) depends on all the facts and circumstances of each case. The existence of a local law that affirmatively recognizes unmarried cohabitation may address the legality of the relationship, but it has no bearing on the support requirement; the employee must still provide over half of his domestic partner's support for the year for the partner to qualify as the employee's dependent.

The IRS concluded that if an employee's domestic partner does not qualify as a dependent of the employee, the Sec. 106 exclusion does not apply to the health coverage attributable to the partner. Thus, the employee must include in income the excess of the FMV of the group health coverage provided to the domestic partner over the amount the employee paid for that coverage. Further, any reimbursements to an employee of amounts paid by the employee that are attributable to coverage of a domestic partner are included in the employee's income. However, to the extent amounts for health insurance coverage are includible in income under Sec. 61 or 105(a) benefits received for personal injuries or sickness attributable to that coverage are excludible from the income of both the employee and the domestic partner under Sec. 1041a)[31.

* Outplacement services

The IRS has issued its long-awaited ruling on the tax treatment of employer-provided outplacement services. According to Rev. Rul. 92-69(51) an employee generally can exclude the value of employer-provided outplacement services as a working condition fringe if (1) the employer derives a substantial business benefit from providing the services apart from the benefit it would derive from the mere payment of additional compensation and (21 the employee would have been entitled to deduct the cost of the services under Sec. 162 had the employee paid for the services himself. However, the exclusion is not available if the employee is given the choice of receiving cash instead of outplacement services.

The ruling presented three fact patterns. In Situation 1, the employer informed 300 of its employees that they would be terminated as part of a work force reduction. To promote a positive corporate image, maintain employee morale and avoid wrongful termination suits, the employer hired an outplacement firm to help the terminated employees develop skills to obtain new employment. Of the 300 terminated employees, 222 accepted the employer's offer of outplacement services.

In Situation 2, the employer has a general policy of providing outplacement services to employees it has decided to terminate and who need help in finding new employment. The employer believes this policy fosters a positive work atmosphere and helps attract quality employees. In one particular year, the employer decided to terminate 22 employees and determined that only five needed outplacement services.

The facts in Situation 3 are the same as in Situation 1, except that the employer also maintains a severance pay plan, and the employees who were offered outplacement services could elect either their full severance pay or the outplacement services and reduced severance pay.

In all three situations, the employees being terminated were seeking new employment within the same trade or business of being a clerical employee, manager, executive, etc.

For an employer-provided service to qualify as a working condition fringe under Sec. 132(d), a hypothetical payment for the service by the employee must be allowable as a deduction with respect to the employee's specific trade or business of being an employee of the employer--not merely with respect to the employee's general trade or business of performing services as an employee.(52) According to the IRS, this requirement is generally satisfied if(1)the employer derives a substantial business benefit from providing the services apart from the benefit it would derive from the mere payment of additional compensation and (2) the employee would have been entitled to deduct the cost of the services under Sec. 162 had the employee paid for the services himself.

Citing Rev. Ruls. 75-120(53) and 78-93(54) and Primuth,(55) the IRS ruled that an employee's hypothetical payment for outplacement services in seeking new employment in the same trade or business would generally be considered a Sec. 162 expense. Thus, if the employer also derives a substantial business benefit distinct from the mere payment of additional compensation--such as promoting a positive corporate image, maintaining employee morale and avoiding wrongful termination suits--the services may generally be treated as a working condition fringe. Thus, the IRS ruled that the outplacement services provided in Situations 1 and 2 are excludible from the employees' gross income as a working condition fringe benefit. Further, they are not subject to FICA, FUTA or income tax withholding.(56)

In Situation 3, the IRS ruled that an employee who is offered outplacement services construetively receives income equal to the difference between the unreduced severance payment and the reduced severance payment. However, the employee can deduct the value of the outplacement services received (up to the amount of income constructively received) as a miscellaneous itemized deduction, subject to the 2% floor. The amount considered constructively received is considered wages for FICA, FUTA and income tax withholding purposes.

* Transportation and transit passes

The IRS has issued final regulations under Sees. 61 and 132 concerning the tax treatment of certain transportation provided by an employer due to unsafe conditions, and adopting the proposed regulations' increase in the exclusion for employer-provided transit passes. The final regulations are effective July 1, 1991.(51) Unsafe conditions: The value of employer-provided transportation used for commuting purposes is generally not excludible from an employee's income because commuting is a See. 262 personal expense of the employee; nor is it excludible as a working condition fringe benefit under Sec. 132(a)(3), since it would not be deductible by the employee if the employee paid the expense himself.

To provide relief for employees for whom the employer provides transportation to or from work for safety reasons (e.g., cab fare for an employee who works overtime and would have to walk or take public transportation into or through an unsafe neighborhood at night), the IRS has established a new valuation rule under Sec. 61. New Regs. Sec. 1.61-21(k) provides that the value of employer-provided transportation includible in a "qualified employee's" compensation is $1.50 for each one-way commute paid for by the employer due to unsafe conditions.

To qualify for the special valuation rule, the employer must establish a written policy under which the transportation is not available for personal purposes other than commuting due to unsafe conditions by an employee who would walk or use public transportation to commute to or from work. Unsafe conditions exist if a reasonable person would consider it unsafe to walk or to use public transportation at the time of day the employee must commute. The determination is made on a trip-by-trip basis.

A qualified employee is generally one who is paid on an hourly basis, is not exempt from the minimum wage and maximum hour provisions of the Fair Labor Standards Act, and does not receive compensation from the employer in excess of the Sec. 414(q)(1)(C) amount ($62,345 for 1992). If an employee is not a qualified employee within the meaning of the regulation, no portion of the value of the commuting use of employer-provided transportation is excluded under the special valuation rule. However, a portion may be excludible as a de minimis fringe benefit under Regs. Sec. 1.132-6(d)(2)(iii).

The final regulations did not make any substantive changes to the proposed regulations, but they have clarified certain areas.

* Employer-provided transportation includes cash reimbursement arrangements for transportation paid directly by employees to third-party providers (taxis or car services).

* Employer-provided transportation does not include employee-owned or leased vehicles.

* The meaning of "a qualified employee paid on an hourly basis" may include an employee whose compensation is stated on an annual basis.

* Compensation under these regulations is compensation as defined in Sec. 414(q)(7).

Public transit passes: Employer-provided passes for employees to use public transportation had previously been excluded from income under Sec. 132(a)(4) as a de minimis fringe benefit provided that the value of the monthly pass did not exceed $15. The final regulations amend Regs. Sec. 1.132-6(d)(1) to increase the $15 monthly amount to $21, to reflect cost-of-living increases. Many commentators requested that the transit pass de minimis exclusion be further increased to promote the use of public transportation. Their requests, however, were denied. Note that if the value of the ,monthly pass exceeds the $15 or $21 amount, the entire value--not just the excess over $15 or $21--is includible in the employee's gross income. As we go to press, Congress has passed--and the President is expected to sign--legislation that would exclude from income up to $60 a month in "qualified transportation fringe benefits" consisting of transit passes and transportation in certain commuter highways. This legislation, which would also cap the exclusion for employer-provided parking at $155 a month, would be effective for benefits provided after 1999. The dollar figures would be indexed for inflation.

* Employer-provided lunches

In Letter Ruling (TAM) 9143003,(58) the IRS revoked an earlier, unspecified ruling that free, employer-provided lunches were nontaxable to the employees. The new ruling provides that the lunches are taxable to the employees because the company did not establish a valid noncompensatory business reason for providing free lunches.

Company is a nationwide business that operates from a single location. It limits its employee lunch periods to 30 minutes and provides free lunches to employees on its business premises. Company has stated that its peak business hours are between 11:00 a.m. and 1:00 p.m. and that it requires most of its employees to be at their desks to answer telephone calls and to keep Company operations running smoothly. It claims that outside eating facilities are insufficient. Company submitted a study by an outside consulting firm supporting its claim that there were insufficient eating facilities. Company requires all employees to remain on the premises for the entire workday because in many cases employees will be called while at lunch to attend to Company business. In certain eases, employees are called away from lunch as many as three times a week.

Sec. 119(a)provides that meals furnished to employees for the convenience of the employer are excludible from the employee's income if the meals are furnished on the employer's premises. In determining whether meals are furnished for the convenience of the employer, each ease must be analyzed based on its particular facts and circumstances. Circumstances that justify the conclusion that meals are being provided for the employer's convenience include --the need to have employees available for emergency calls during meal periods;

* --the fact that the employer's business requires that the employees be restricted to a shorter meal period, such as 30 minutes, and that the employee cannot be expected to eat elsewhere in such a short period; --insufficient eating facilities in the vicinity of the employer's premises; and --the existence of a genuine noncompensatory business reason for providing meals to

each of substantially all of the employees.(59)

In revoking its earlier ruling, the Service stated that Company had not established a valid business reason for the shortened lunch period and did not prove that there are insufficient eating facilities in the area. It also stated that Company did not have a genuine noncompensatory business reason for furnishing meals because it did not meet the "each of substantially all of the employees" standard: The facts indicated that less than 65% of Company's work force required the shortened lunch period; Company could have met its lunchtime business demands by having fewer, more extended lunch periods.

The IRS and Company could not agree on the relevant facts in determining whether adequate eating facilities were available. However, the IRS did note that the published precedents applying the inadequate eating facilities exclusion usually involved remote work sites or night employees.

The IRS then reviewed the volume of work taking place during lunch hours and compared it to the volume of work during other hours. It found no significant difference--that is, the IRS found that, contrary to Company's claim, the volume of work did not peak during the lunch period. Therefore, on the basis of all the facts and circumstances, the IRS concluded that the meals Company provided to its employees were not provided for the convenience of the employer, and should be included in their income.

* Employer-provided lodging

The IRS has stated that it will not follow the Eighth Circuit's opinion in Erdelt,(60) which held that lodging provided to a school superintendent was excludible from income under Sec. 119.(61) The IRS said that conflicts with the Erdelt opinion will be sought in other circuits and will be litigated in the Eighth Circuit in cases that are factually distinguishable.

Virgil Erdelt was hired as a superintendent for a school district in a small community. His duties included making the school facilities open to the public at large, dealing with school emergencies on a round-the-clock basis and providing some amount of security for the school. He was not explicitly required, when originally hired, to live in the district-provided house, which was about a block away from the school, with other houses in between. The district court held that Erdelt met all the requirements of Sec. 119--specifically, that he lived in the "teacherage" for the convenience of the school district, that the house was located on the business premises of the employer and that his occupancy of the house was a condition of employment. Thus, the fair rental value of the teacherage was excludible from his gross income. The Eighth Circuit treated the issue as factual and affirmed.

The district court found that the convenience of-the-employer test is met as long as there is a direct nexus between the housing furnished to the employee and the business interests of the employer served thereby. For such purposes, the house could be located miles from the school complex. The "convenience" factor lies in the ability of the district to hire a person with Erdelt's qualities, and by locating him in close proximity to the school, making him available for daily interaction with the community, the school staff and the physical plant.

The court held that the house was "located on the business premises" of the employer since the employer owns the premises and the occupancy of the premises has a necessary and reasonable connection with the performance of Erdelt's official duties.

Finally, the court held that an objective examination of the facts and circumstances led to the conclusion that Erdelt was required to accept the housing as a condition of employment if he were going to fulfill his duties efficiently and as required by the nature of the position. The unique requirements of a school superintendent in a small school district appear to have weighed on the court's decision. Having met all three tests, the court held that the value of the housing was excludible under Sec. 119.

The IRS disagreed with the court's decision on all three tests. The IRS interprets the condition-of-employment test as meaning the employee is required to accept the lodging in order to properly perform his duties, e.g., when the lodging is furnished because the requirements of the job make it necessary for the employee to be available for duty at all times. The IRS cited Willcheil(62) for its interpretation that school presidents who are on call for infrequent emergency situations do not satisfy the test of being available for duty at all times.

The IRS pointed out that the convenience-of-the-employer test is basically the same as the condition-of-employment test, thus, the failure to meet the condition-of-employment test subsumes the failure to meet the convenience-of-the-employer test.

The IRS also disagreed with the "business premises" definition developed by the district court. The mere fact that the employer owns the property and establishes a necessary and reasonable connection with the performance of duties does not meet the established standard for business premises. Citing Goldsboro Christian Schools, INC.,(63) the IRS noted that the business premises of a school are ordinarily the physical facilities in which the teaching occurs.

Because the appeals court treated the issue as turning on its facts, the IRS did not recommend certiorari, but has put practitioners on notice that it will litigate similar cases.

Retiree Medical Benefits

As employers struggle to address the formerly unrecorded liability for retiree medical benefits, many are deciding that limiting the benefit promise made to employees is the most cost-effective way of limiting the liability that must be recorded under FASB 106. The ability to limit benefits was enhanced by a Federal district court in California, which ruled that a company's offer to grant continued retiree medical benefits to those individuals eligible to retire, if those individuals did in fact retire within 14 months, while reducing retiree medical benefits for all remaining employees, did not violate either the Age Discrimination in Employment Act (ADEA) or ERISA.(64)

Bay View Federal Savings & Loan Association amended its retiree medical plan to provide that--medical benefits would continue for existing retirees;--any active employee who was eligible to retire and who did retire within 14 months of the announced changes would receive retiree medical coverage under the old program; and--other employees could retire with medical benefits at their own cost.

Within a month after the window closed, Bay View again changed the plan in response to employee complaints, so that any employees eligible to retire or near retirement age at the present time could retire at any time in the future, and the company would pay as much for retiree medical benefits for them as the company was paying immediately before their retirement.

Three of the employees who elected to retire during the 14-month window period sued Bay View, alleging ADEA and ERISA violations, including constructive dismissal. According to these retirees, they would not have retired had it not been for the plan changes. The court addressed the ADEA allegations first, stating that the changes affected all employees regardless of age, although retirement-eligible employees had their choice between the changes affecting all employees and a "better deal" covering retiree medical insurance. Thus, the court found no "facially discriminatory" action on the part of the employer and no persuasive evidence of discriminatory intent.

Moving to the ERISA allegations, the court rejected the retirees' arguments that the retiree medical benefits had vested and could not be changed. The court explained that as a matter of law, ERISA did not vest welfare benefits. Nor in this case was there evidence of "contractual" vesting created by plan documents or statements. The retirees also alleged that Bay View had violated fiduciary duties under ERISA Section 404 by making the plan changes. The court found that Section 404 did not apply because Bay View had acted in its role as an employer with the right to amend the plan.

Finally, the employees argued that Bay View had violated ERISA Section 510, prohibiting retaliation against employees exercising ERISA rights, by forcing them to choose between retiring with higher medical benefits or continuing to work and, in effect, losing those higher medical benefits. The court rejected this argument, noting that the retirees had not been constructively discharged because benefits were changed for all employees. More important, the court stated that retirement was always a condition precedent for receiving retirement benefits, a rather obvious conclusion.

While the retirees had a number of innovative arguments, they did not have any winning arguments. The case serves as another helpful example of permissible "window"-type retirement provisions under the ADEA.

(1) IRS Letter Ruling 9206009 (11/11/91).

(2) Sec. 402(i).

(3) IRS Letter Ruling 9207010 (11/12/91).

(4) IRS Letter Ruling 9212019 (12/20/91).

(5) IRS Letter Ruling 9212024 (12/20/91).

(6) Sec. 404(a)(5); Regs. Sec. 1.404(a)-12(b)(1).

(7) Sec. 404(d).

(8) Rev. Proc. 92-64, IRB 1992-33, 11.

(9) Rev. Proc. 92-65, IRB 1992-33, 16.

(10) Rev. Pro. 71-19, 1971-1 CB 698.

(11) Rev. Proc. 92-1, IRB 1992-1, 9.

(12) IRS Letter Ruling (TAM) 9134006 (5/7/91) (same text as IRS Letter Ruling (TAM)9134004 (5/7/91)).

(13) Regs. Sec. 1.83-3(b).

(14) Regs. Sec. 1.83-3(c).

(15) IRS Letter Ruling (TAM) 9215002 (11/15/91).

(16) As defined in Sec. 419(e).

(17) Sec. 419(c)(3).

(18) Sec. 419(c)(1)(B).

(19) Sec. 419(c)(1)

(20) Sec. 419A(f)(5).

(21) IRS Letter Ruling 9207038 (11/21/91).

(22) IRS Letter Ruling 9213029 (12/31/91).

(23) Rev. Rul. 69-382, 1969-2 CB 28.

(24) Rev. Rul. 69-478, 1969-2 CB 29.

(25) Rev. Rul. 73-599, 1973-2 CB 40.

(26) IRS Letter Ruling (TAM) 9126004 (3/15/91).

(27) See Weil Clothing Co., 13 TC 873 (1949), and Greensboro Pathology Associates, P.A., 698 F2d 1196 (Fed. Cir. 1982)(51 AFTR2d 83-564, 83-1 USTC [paragraph] 9112).

(28) See Citrus Orthopedic Medical Group, Inc., 72 TC 461 (1979).

(29) Anesthesia Service Medical Group, 85 TC 1031 (1985), all'd, 825 F2d 241 (9th Cir. 1987)(60 AFTR2d 87-5499, 87-2 USTC [paragraph] 9480).

(30) But see IRS Letter Ruling 9136005 (5/31/91), in which a deferral of income achieved a tax result that was not available to the employer here.

(31) See the revenue rulings cited in notes 23, 24 and 25.

(32) 2Sec. 419A(c)(1).

(33) ERISA Technical Release 92-1 (6/2/92).

(34) ERISA Technical Release 88-1 (3/29/88).

(35) ERISA Section 502(c)(2).

(36) DOL News Release No. 92-158.

(37) DOL Opinion Letter 92-02A (1/17/92).

(38) Ricky Confer, et al. v. Custom Engineering Co., 952 F2d 41 (3d Cir. 1991), aff'g DC.

(39) Ricky Confer, et al. v. Custom Engineering Co., 952 F2d 34 (3d Cir. 1991), aff'g DC.

(40) National Companies Health Benefit Plan, et al. v. St. Joseph's Hospital of Atlanta, Inc., et al., 13 E.B.C. 2041 (11th Cir. 1991), aff'g N.D. Ga.

(41) James Oakley v. City of Longmont, et al., 890 F2d 1128 (10th Cir. 1989).

(42) Karin P. Brock and Keith Brock v. Primedica, Inc., et al., 904 F2d 295 (5th Cir. 1990).

(43) IRS Letter Ruling 9143071 (7/31/91).

(44) Ann. 92-16 , IRB 1992-5, 53.

(45) Rev. Rul. 91-26, 1991-1 CB 184.

(46) IRS Letter Ruling 9231062 (5/7/92).

(47) Sec, 106; Regs. Sec. 1.106-1.

(48) Sec. 105(a).

(49) Sec. 105(b).

(50) Sec. 159(b)(5).

(51) Rev. Rul. 92-69, IRB 1992-36, 5.

(52) Regs. Sec. 1.132-5(a)(2)(i).

(53) Rev. Rul. 75-120, 1975-1 CB 55.

(54) Rev. Rul. 78-93, 1978-1 CB 38.

(55) David J. Primuth, 54 TC 374 (1970).

(56) Secs. 3121(a)(20), 3306(b)(16) and 3401(a)(19).

(57) TD 8389 (1/15/92).

(58) IRS Letter Ruling (TAM) 9143003 (7/11/91).

(59) Regs. Sec. 1.119-1(a)(2).

(60) Virgil L. Erdelt, 909 F2d 510 (8th Cir. 1.990), aff'g in an unpublished opinion, 715 F Supp 278 (DC N.D. 1989)(63 AFTR2d 89-1247, 89-1 USTC [paragraph] 9226).

(61) AOD 1992-001 (12/19/91).

(62) Richard D. Winchell, 564 F Supp 131 (DC Neb. 1983)152 AFTR2d 83-5222, 83-1 USTC [paragraph] 9344), all'd, 725 F2d 689 (8th Cir. 1983).

(65) Goldsboro Christian Schools, Inc,, 436 F Supp 1314 (E.D, N.C. 1977)(41 AFTR2d 78-750, 78-1 USTC [paragraph] 9191), aff'd in an unpublished opinion, 644 F2d 879 (4th Cit. 1981).

(64) Allen O, Tusting, et al. v. Bay View Federal Savings & Loan Ass'n, 789 F Supp 1034 (N.D. Cal. 1992).
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Title Annotation:part 1
Author:Walker, Deborah
Publication:The Tax Adviser
Date:Nov 1, 1992
Words:12346
Previous Article:Significant recent developments in estate planning.
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