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Executive compensation, fringe benefits and employee business expense reimbursements.

Executive Compensation, Fringe Benefits and Employee Business Expense Reimbursements

This two-part article will provide an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and welfare benefit plans. Part I, below, will focus on executive compensation and welfare benefit plans, including the special rules that apply to tax-exempt organizations and employee business expense reimbursement arrangements. The past year has seen a number of particularly favorable judicial decisions for taxpayers, regarding nonqualified deferred compensation and the receipt of property for services. On the other hand, employers are experiencing increased enforcement of income tax withholding requirements, particularly for expense allowance arrangements. For the first time since the passage of the Employee Retirement Income Security Act of 1974 (ERISA), the Department of Labor (DOL) is monitoring compliance with reporting requirements for benefit plans and many employers are receiving penalty notices.

Part II, to be published in December, will focus on recent qualified plan developments, specifically recently released final regulations under Secs. 401(a)(4), 401(k), 401(m) and 410(b). These regulations will guide plan sponsors in determining whether their qualified retirement plans are nondiscriminatory. Proposed regulations under Sec. 414(r) describe how the employer can apply discrimination testing rules on a separate line of business basis. In addition, the IRS has started two programs to restore the qualified status to plans that inadvertently become disqualified. Finally, the DOL is releasing new rules on plan investments and the courts have addressed prohibited transactions between qualified plans and the employer.

Nonqualified Deferred Compensation

* Constructive receipt In this uncertain economy with its many business failures, employees who participate in nonqualified deferred compensation plans may want to withdraw their balances from those plans. This is because participants in nonqualified plans are unsecured creditors of the employer, which means they might not realize their expected benefit if the employer were to become insolvent. The question is whether giving these employees the option to withdraw these funds will trigger current tax under the constructive receipt doctrine. It is also important to be careful that amounts are not withdrawn in violation of regulatory or legal considerations.

Generally, individuals recognize income in the year of receipt. Under the constructive receipt doctrine, income is taxable to the individual in the year it is set apart or otherwise made available to him to draw on at any time or with the giving of notice of intention to draw on the income. However, an individual will not be in constructive receipt of income if receipt is subject to substantial limitations or restrictions.(1) Neither the Code nor the regulations define the term "substantial limitations or restrictions."

Whether a penalty is substantial depends on the facts and circumstances. It seems reasonable that a discount of some amount on a lump-sum payment would result in a substantial limitation or restriction. How large this discount must be will depend on many factors, including the investment alternatives available to the individual and the financial security of the payor. If the payor's financial security is questionable, the discount will have to be greater than if the payor is financially secure and the likelihood of payment is great. Similarly, if the employee has investment alternatives with significantly greater return potential than that earned by the deferred compensation held by the employer, a relatively large discount might not be a substantial restriction or limitation. While the particular facts and circumstances will control, the IRS has issued some guidelines as to what is a substantial penalty.

An employee is not required to recognize income on a stock appreciation right (SAR) until the year he exercises the right.(2) The employee's right to benefit from further appreciation in the stock without risking capital is a valuable right--and the forfeiture of a valuable right by its exercise is a substantial limitation that precludes constructive receipt.

Similarly, a taxpayer with the immediate right to cash out certain amounts from a Sec. 403(b) annuity contract was not in constructive receipt of the amounts.(3) The IRS based its reasoning on Rev. Rul. 68-482, in which, due to reincurred loading charges, an employee could not normally buy a new annuity contract of comparable or greater value.(4) These reincurred loading charges were enough to prevent constructive receipt. In the letter ruling, the employee had to pay a $10 minimum withdrawal charge plus an amount equal to 6% of the portion of the amount withdrawn that exceeded 20% of the value of the account. The IRS concluded that the employee was not in constructive receipt of the contract.

This year, in a significant taxpayer victory (Martin(5)), the Tax Court held that employees, whose election as to the form of their benefits was extremely close in time to their eligibility for those benefits, were not in constructive receipt of the amounts. The question before the Tax Court was whether the employees were in constructive receipt of the amounts either at the time a lump-sum option first became available or at the time the participants elected to receive installments.

The court considered five factors in applying the criteria of the regulations and legal precedent to the facts in this case.

1. Whether the plan was funded; 2. whether the participant's right under, and interest in, the plan was secured; 3. whether the election could be made only before the amounts became due and/or ascertainable; 4. whether the participant's right to receive income was subject to substantial limitations or restrictions; and 5. whether interest was payable on installment payments and

when interest, if any, accrued.

According to the court, these factors are neither exclusive nor necessarily individually determinative. The plan was unfunded, and the participants had only an unsecured right under the plan to receive benefits. The election to receive installment payments could be made only before the amounts became due and fully ascertainable. Further, once a payment method was elected, a change in the form of payment would not be effective until the year after the requested change. Because participants had to make their elections before the surrender date, they did not acquire an unconditional right to receive payment before the surrender date. Although the participants had the right to receive a lump-sum distribution before electing to receive installment payments, the lump-sum was not due. Because the value of the benefit fluctuated on a monthly basis, it was not ascertainable on the election day. The participants would have had to forfeit certain rights and future benefits in exchange for current or installment benefits, such as the right to benefit from future equity growth without risking actual capital. The court held this to be a substantial limitation or restriction on the right to receive income. Finally, the fact that interest accrued only after the first installment payment supported the taxpayers' argument for no constructive receipt.

Based on the application of the five factors to the facts in Martin, the court concluded that the choice to receive lump-sum or installment benefits was not sufficiently unfettered to cause constructive receipt of the lump-sum amount. While the determination of constructive receipt is a factual determination, the five factors the Tax Court used in reaching its decision can help in determining whether constructive receipt applies when participants in a deferred compensation plan can choose a payout option.

The facts in Martin were considered in IRS Letter Ruling (TAM) 8632003(6) five years before the Tax Court's decision. The IRS distinguished the facts in the letter ruling from situations in which an election to defer income after it was earned was allowed. When the employee was required to perform additional services for the employer in order to achieve the deferral of earned fees, and the employer wanted to delay payment of the fees, and when further deferral of income was the result of a bilateral negotiation between the employee and the employer, constructive receipt did not apply.(7)

* Employment taxes The rules governing the application of social security (FICA) taxes to payments made under non-qualified deferred compensation arrangements are complex. IRS Letter Ruling 9107014(8) outlines the rules when an employee receives amounts for services performed both before 1984 and after 1983.

In general, wages subject to FICA include all remuneration for employment, unless specifically excepted.(9) Any amount deferred under a nonqualified deferred compensation agreement is taken into account for FICA purposes as of the later of

--when the services are performed; or --when there is no substantial risk of forfeiture of the right to such amounts.(10)

Once a deferred compensation amount becomes subject to FICA, it (and the income attributed to it) will not be treated as FICA wages again when actually paid.(11) This rule is effective for remuneration paid after 1983, except for that paid under an arrangement in existence on Mar. 24, 1983. For these arrangements, the rule applies only for services performed after 1983. Amounts for services performed before 1984 are subject to the rules in effect before the enactment of Sec. 3121(v).(12)

Before Sec. 3121(v) was enacted by the Social Security Amendments of 1983, Sec. 3121 contained several exceptions for retirement payments. The following were not subject to tax.

* Payments made to, or on behalf of, an employee under an employer plan that provides for employees generally or for a class or classes of employees on account of retirement.(13) * Any payment made to an employee on account of retirement.(14) * Any payment or series of payments by an employer to an employee under an employer-established plan that provides for employees generally, or for a class or classes of employees, on termination of the employee's employment relationship because of retirement after attaining an age specified in the plan or in a pension plan of the employer.(15)

A payment or series of payments made because of retirement is excluded from wages even if made under an incentive compensation plan that also provides for other types of payments. But any payments that would have been made had the employment relationship not terminated is not excluded from wages under this rule.(16)

Payments made to employees are wages subject to FICA for the pre-1984 service if they do not meet any of the Sec. 3121(a) exceptions. Whether payments are made on account of retirement is a facts and circumstances determination. Facts that may be considered include the type of work the employee continues to perform, the amount of hours worked after "retirement," whether the continuation of work is part of a prearranged plan between the employer and the employee, and the age of the employee at retirement. For payments attributable to post-1983 service, payments should be taken into account for FICA purposes as of the later of when the services were rendered or when there was no longer a substantial risk of forfeiture.

* Employer's deduction Turning to the employer's deduction for non-qualified deferred compensation, the Tax Court has held that interest accruing on deferred compensation amounts is deductible by the employer only under the rules of Sec. 404 as additional deferred compensation, and not under Sec. 163 as interest. In Albertson's Inc.,(17) the accrual-basis taxpayer established nonqualified deferred compensation arrangements (DCAs) for eight executives and one board member. The DCAs were unfunded and represented Albertson's unsecured contractual obligation to pay its executives deferred compensation--plus an amount designated as interest for the deferral period--on termination, retirement or (for the director only) attainment of age 72. Each participant had a separate bookkeeping account, showing his deferred compensation and the interest on it.

In 1982, the IRS granted Albertson's permission to change its accounting method for the interest portion of the DCAs. Up to that time, Albertson's had not deducted interest until it was actually paid to the recipient and included in the recipient's gross income. The IRS granted Albertson's request to deduct the interest component in the year accrued, rather than in the year paid. Albertson's deducted such interest on its fiscal year 1983 tax return--and subsequently received a deficiency notice retroactively revoking the IRS's permission.

The Tax Court determined that the "interest component" of the DCAs was not really interest, but additional deferred compensation for personal services. For interest to exist, there must be a contract for the use of borrowed money, or a forbearance of money. For interest to accrue in deferred compensation arrangements, the employer would have had to borrow the account balances from the employees for whose benefit they were established.

Here, the employees had no current right to the account balances under the DCAs until termination or retirement. (If they had, the doctrine of constructive receipt would have mandated current recognition of income of both the deferred amounts and the accruing interest.) The court found that the amounts recorded in the bookkeeping accounts as interest did not represent payments made by Albertson's for the use of money borrowed from its employees, nor did they constitute liabilities owed to the DCA participants for the forbearance of money whose payment had become due. Rather, the court concluded that Albertson's was the owner of the money, and could not "borrow" from itself to produce the interest that was accruing. The fat that the time value of money affects the amount of compensation paid to an employee in the future does not transform deferred compensation into interest.

As compensation, deductibility is governed by Sec. 404, relating to employee benefit plans. For nonqualified plans, the employer is allowed a deduction when the amount is includible in the participants' income.(18) While this conclusion seems well-settled, five Tax Court judges disagreed with the majority opinion, finding the excess amounts to be interest and, as such, deductible under Sec. 163. IRS rulings in this area have consistently held that amounts deferred (and amounts in excess of actual deferrals) are not deductible by the employer until actually paid.(19)

* Application to tax-exempt organizations Providing nonqualified deferred compensation to employees is even more difficult for tax-exempt employers. In general, such amounts must meet rigid rules, including a relatively low maximum deferral limit.(20) Planning for such employees involves designing arrangements that avoid these rules.

One such arrangement uses a deferred fee arrangement, as well as a deferred compensation arrangement. The arrangement involves three key players: (1) a tax-exempt entity (e.g., a hospital), (2) a taxable personal service corporation (PSC) that preferably has an existing service relationship with the tax-exempt entity (e.g., a medical PSC that has an existing service relationship with the hospital) and (3) at least one employee or independent contractor of the PSC (e.g., a doctor). Both the PSC and the participant(s) must be cash-basis taxpayers.

The DCA is a typical nonqualified DCA usually entered into by a taxable corporation with its employees or independent contractors. The arrangement allows participants to defer all or a portion of their annual compensation from the PSC before the compensation is earned. The PSC may supplement a participant's deferrals with matching contributions. A participant can make quarterly "deemed" elections on how amounts credited to the participant's bookkeeping account will be invested. To avoid many of the ERISA rules, participation is limited to individuals who are members of a "select group of management or highly compensated employees" and independent contractors.

Although deferrals are described as fully vested at all times, the employer's obligation to pay any amounts under the DCA constitutes an unsecured promise. Thus, participants run the risk that, in the event of the PSC's insolvency or bankruptcy, there will not be enough funds to satisfy their interests under the arrangement.

The deferred fee arrangement is a DCA between the PSC and the tax-exempt entity. It generally parallels the DCA. The PSC agrees to defer a portion of the fees it will earn providing services to the tax-exempt entity. The PSC can make quarterly "deemed" elections on how amounts credited to its bookkeeping account will be invested.

The tax-exempt entity deposits an amount equal to the deferred fees into a grantor trust. The tax-exempt entity's investment directions to the trustee reflect the deemed investment directions the tax-exempt entity receives from the PSC, which, in turn, can reflect the deemed investment directions the PSC receives from the participants. The trust is intended as a source from which the tax-exempt entity can pay its obligations under the deferred fee arrangement, but the trust's assets are at all times subject to the claims of the tax-exempt entity's general creditors--in other words, it follows the model of a rabbi trust.

The arrangement is purported to be a plan that will allow pretax contributions of up to 100% of salary, tax-deferred employer matching contributions, and tax-deferred accumulation of interest earned on plan assets--without the usual trappings of qualified plans (nondiscrimination rules, minimum distribution rules, early distribution penalties, excess distribution penalties, etc.), and without violating the Sec. 457 limits on nonqualified plans of tax-exempt employers.

The tax deferral for the participants stems from the facts that they are cash-basis taxpayers, they make their deferral elections before the compensation is earned, and their interests under the arrangement are subject to the claims of the PSC's general creditors. By limiting participation to a select group of management or highly compensated employees and independent contractors, the arrangement avoids having to meet the ERISA's "funding" requirement, which would have a negative impact on the arrangement's viability as a tax-deferral vehicle.

The PSC itself can defer the tax on its deferred fees because it, too, is a cash-basis taxpayer that has elected to defer income before the period of service. Because the arrangement involves two corporations, the Sec. 457 rules do not apply. Because the tax-exempt entity is treated as the trust owner, it is treated as earning the income generated by the trust and earnings are tax deferred.

The biggest risk this plan faces is that the IRS may collapse it into a two-party arrangement between the tax-exempt entity and the participants, to which Sec. 457 would apply. Since the unlimited deferrals permitted under the arrangement would exceed the Sec. 457 limits, the participants would be subject to tax in the year of the deferral. The tax-exempt entity would be responsible for applicable income and employment tax withholding. Assessments may include interest and penalties, and would be especially onerous if funds held in the trust that secures the DCA could not be liquidated. Other risks include the possible application of Sec. 269 (acquisitions made to evade or avoid income tax) or Sec. 269A (personal service corporations formed or availed of to avoid or evade income tax).

Property Transfers

* Revocation of Sec. 83(b) election In a landmark ruling this year, the IRS ruled that a Sec. 83(b) election could be rescinded. This is the first time the IRS has allowed a Sec. 83(b) election to be revoked or rescinded after the expiration of the 30-day period for making a Sec. 83(b) election.

In Letter Ruling 9104039,(21) the employer's board of directors voted to transfer restricted stock to certain employees and to gross up the employees through a bonus for the taxes payable if the employees made Sec. 83(b) elections. The employees executed agreements with the employer and made Sec. 83(b) elections, and the stock was transferred to them. Later the employer determined that the plan would have a significant negative impact on its financial statements. As a result, the employer, with the full agreement of the employees, decided to rescind the stock transfer. The IRS ruled that it would treat the Sec. 83(b) elections as null and void because the entire transaction had been rescinded.

The IRS previously ruled that no gain is recognized on the sale of land by a taxpayer who accepts reconveyance of the land and returns the buyer's funds in the tax year of sale.(22) According to the letter ruling, the legal concept of rescission refers to the abrogation, cancellation or voiding of a contract, which has the effect of releasing the contracting parties from further obligations. Thus, the parties are restored to the positions they would have occupied had no contract been made. The ruling also employed the concept of annual accounting, which requires looking at a transaction on an annual basis, using the facts as they exist at the end of the year. Under that concept, if the rescission occurs in the same year as the sale, it places the parties at the end of the tax year in the same position as they were in before the sale.

With the stock transfer to employees, the employer planned to rescind the transaction within the same calendar year in which it was made. Thus, as of the end of the year, the employees were restored to the same position they would have occupied had no contract been made. The IRS concluded that the effect of the rescission was to void the transfer on which the Sec. 83(b) election was based and, thus, the Sec. 83(b) election was null and void and should be disregarded.

This is an important ruling when income tax planning involves the transfer of stock for services. The IRS will always be reluctant to allow a revocation of a Sec. 83(b) election after the 30-day election period. Thus, if a situation arises in which a stock transfer and a Sec. 83(b) election are clearly detrimental to both a company and the employees, a rescission of the entire transaction may be appropriate. Remember, however, that such a rescission must be made within the same tax year as the original stock transfer.

* Receipt of a partnership interest for services The Eighth Circuit has reversed the Tax Court's decision in Campbell,(23) holding that a "speculative" interest in future partnership profits received as compensation for past services was without fair market value (FMV) at the time received and should not be included in income when received. This case represents a significant development, but unfortunately does not appear to be the definitive answer regarding the taxability of a partnership profits interest.

William Campbell was an employee of Summa T. Group, which was primarily involved in real estate syndication. Campbell was responsible for locating suitable properties, negotiating the acquisition of and obtaining the financing for those properties, organizing the partnerships that would acquire the properties, assisting in the preparation of offering materials in connection with the partnership syndication and promoting partnership interest sales to investors. Under his employment arrangement, Campbell was to receive 15% of the proceeds from each limited partnership syndication. In addition, for his services, Campbell was to receive a "special limited partnership interest" in the partnerships he helped from and finance. The special limited partnership interests were not transferable and had distribution rights subordinate to both the limited partnership interests that were sold and the general partnership interest.

The Tax Court held that Campbell received the partnership profits interests as compensation for prior services rendered. Accordingly, Sec. 721 was inapplicable. The court applied Sec. 83 to determine when the income should be recognized. Additionally, the court calculated the FMV of the partnership interests Campbell received. Fair market value was determined based on the present value of tax benefits and future cash payments, reduced due to the speculative nature of the partnership interest. The court relied heavily on the fact that the limited partners who purchased their interests were willing to pay a substantial amount for those interests at the time Campbell received his special limited partnership interest.

The court of appeals (agreeing with the Tax Court) held that the contribution of services to the partnership was not property, Sec. 721 was not applicable and Sec. 83 applied. However, the Eighth Circuit indicated that the Tax Court placed too much reliance on the fact that Class A limited partners were willing to pay substantial amounts for their limited partnership interests at the time Campbell received his special limited partnership interest. The Class A limited partnership interests had priority rights to distributions and return of capital, as well as some participation rights. Because of these differences in the nature of the investments, the value of the Class A limited partnership interests was not relevant. In determining that the profits interests Campbell received had only speculative value (if any), the Eighth Circuit placed much weight on the fact that the special limited partnership interests were not transferable and were not likely to provide immediate returns. Accordingly, the court held that the partnership profits interests received were without FMV at the time received and should not be included in income.

* Property received by insiders New regulations under Section 16(b) of the Securities Exchange Act of 1934 affect the timing of taxable income for corporate officers and directors who exercise options for stock on or after May 1, 1991. Insiders who exercise company-granted options that have been held for at least six months will recognize taxable income currently and be able to take their profits immediately in cash (i.e., exercise and sell the shares) without holding the stock for six months after exercise.(24) If the option has been held for less than six months, there will be a holding period for the shares purchased equal to the remaining portion of the six-month period.

Strategies for mitigating the effect of the six-month holding period for insiders who exercise options will significantly diminish. Companies that have found the accounting charges incident to stock appreciation rights to be burdensome will welcome this change because SARs for insiders will no longer be necessary. Companies may, therefore, want to work out an arrangement with executives to cancel existing tandem SARs. However, management should be aware that past accrued compensation expense related to the SARs cannot be reversed, thereby increasing reported earnings.(25)

While the potential loss of profits incident to these restrictions is considered a substantial risk of forfeiture for income tax purposes, the change in the restrictions eliminates a taxpayer's ability to defer income.(26) These rules would affect alternative minimum taxable income when incentive stock options are exercised.(27)

* Reload feature in cashless exercise One of the major hurdles for executives in exercising nonqualified stock options is accumulating cash to pay both the exercise price and the withholding on the related compensation. A "cashless exercise" allows an employee to exchange shares of employer stock he already owns for the exercise price and withholding in lieu of making a cash payment.(28) When the employee uses previously owned stock, his ownership opportunity does not grow as quickly as it would under a cash exercise. The addition of a "reload" feature gives the employee the opportunity to maintain his stock ownership capacity, while encouraging exercise of the options sooner than might otherwise occur. A reload is the grant of a new option when another option is exercised with previously acquired shares. Example: Employee E has an option to buy 2,000 shares of employer stock at $5 a share, when the FMV of the stock is $20 a share. Under a cashless exercise, E could pay for the stock by tendering 500 shares of previously acquired stock (500 shares x $20 FMV = $10,000, the exercise price). Because he does not have to pay the $10,000 in cash, E is more apt to exercise the option under this cashless exercise approach. If the employer's plan also included a reload feature, E would be granted a new option to buy 500 additional shares at $20 a share when he used 500 shares to exercise his option. The reload feature encourages E to exercise his options even if he expects the value of the stock to continue rising, since he continues to realize the appreciation potential on the stock he used to exercise his option through the new option.

The additional acquisition of shares also helps protect E from a downturn in the value of the stock. If the value of the stock dropped after exercise to $15 a share, E would own 2,000 shares at $15, for a total value of $30,000. Had E never exercised the option, he would own only 500 shares at $15, for a total value of $7,500. In the meantime, he has also paid tax on additional compensation of $30,000 due to the exercise, but at current tax rates.(29)

* Transfer tax effects of property transfers While it has long been settled that a stock transfer by a shareholder to corporate employees is a contribution of capital to the corporation, followed by a distribution from the corporation to the employees for income tax purposes, the IRS now says that if the contribution to the corporation is not pro rata among the shareholders, the contributing shareholder has made a gift to the corporation's other shareholders. This could have a substantial impact on nonsole shareholders who are accustomed to transfering their stock to employees, or even on shareholders of publicly owned companies who compensate executives in nonwholly owned subsidiaries with stock of the publicly held parent.

In Letter Ruling 9114023,(30) a shareholder (not the sole shareholder) transferred a certain number of shares to key employees as a nonforfeitable, compensatory award. The IRS ruled that the stock transfer to the employees was treated as a gratuitous transfer for the benefit of the employer, with the other shareholders of the employer as the donees.(31) The IRS's rationale is that a transfer to a corporate employee by a shareholder, in connection with the employee's services to the corporation, is a transfer of additional capital to the corporation that indirectly accrues, as a gift, to the proportionate interest of each noncontributing shareholder. The gift is essentially satisfaction of the corporation's liability, compensation for services.

The IRS previously ruled that a pro rata transfer of shares from a corporation's two shareholders to key employees did not result in a gift because the transfer was in the ordinary course of business.(32) A transfer of property made in the ordinary course of business (a transaction that is bona fide, at arm's length and free of donative intent) is considered made for adequate and full consideration ("ordinary course of business standard").(33) If a transfer is made for adequate and full consideration, it is not considered a gift.

Unfortunately, these authorities involved a pro rata transfer from the shareholders of a corporation that resulted in a reciprocal gift (i.e., each shareholder received as much as he relinquished) and no taxable gift. The transfer in the letter ruling involved a contribution by only one of the shareholders. As a result, the transferor shareholder was not receiving an offsetting benefit from the other shareholders (i.e., there was no reciprocal gift). The IRS further ruled that, because the shareholders of a corporation did not have an unrestricted right to the immediate possession of an increase in the corporate capital, the indirect gift to the shareholders was regarded as the gift of a future interest that would not qualify for the $10,000 annual exclusion.

Fringe Benefits

* Partners and S corporation shareholder health benefits This past year, the IRS clarified that partners and more-than-2% S corporation shareholder-employees must include in income the value of health insurance premiums paid on their behalf by the partnership or S corporation.(34) While this is probably correct, the social security implications for S corporation shareholders are not so clear.

Amounts paid to employees for accident and health benefits are excludible from FICA wages.(35) While Sec. 1372 states that a more-than-2% shareholder-employee will be treated as a partner for income tax purposes, that section does not apply for employment tax purposes. Thus, social security wages for a more-than-2% shareholder-employee should not include the value of employer-provided health benefits. However, the deduction for health insurance for self-employed persons is not available for self-employment tax purposes.(36)

Ann. 85-113(37) stated that the withholding for noncash fringe benefits can be made once during the year rather than during each pay period when the benefit is received. The payment of health insurance would most likely be a noncash fringe benefit subject to these rules. If payment is made for a group policy, the argument that this is a noncash benefit is stronger than if reimbursement is made by the employer for the partner's or shareholder-employee's purchase of an individual policy. In the latter case, withholding could occur when the cash reimbursement is made.

Many S corporations, partnerships and, in some cases, sole proprietorships self-insure their medical plans--and often, the shareholder-employees, partners and sole proprietors of these entities participate in the self-insured plan. These individuals are receiving a benefit, the value of which may be the medical reimbursements received under the plan, rather than just the value of the "insurance coverage" (i.e., a premium amount). For example, if a more-than-2% S corporation shareholder-employee was reimbursed for medical bills totaling $50,000, the IRS could argue that, in the case of a self-insured plan, the income inclusion is the amount of the reimbursement--$50,000--rather than merely the value of the "insurance premium" that provided the coverage for the expenses. However, if the benefit is provided through an insurance contract or a fund that has the effect of insurance, the more-than-2% S corporation shareholder-employee, partner or sole proprietor who pays to purchase the insurance or to participate in the fund could argue that the receipt of medical benefits is excluded under Sec. 104(a)(3).

Sec. 106 excludes from an employee's gross income employer-provided coverage under an accident or health plan. Sec. 105 excludes from gross income certain amounts an employee receives through accident and health insurance for personal injuries or sickness. Both of these provisions apply only to employees, not to self-employed individuals. For this purpose, self-employed individuals include S corporation shareholder-employees who own more than 2% of the S corporation's stock, partners and sole proprietors.(38)

In some cases, spouses can be hired as employees and given health coverage for the family, which would include coverage for the self-employed individual. However, for purposes of Sec. 1372, a spouse is considered to own the stock owned by the other spouse; as a result, this would not be a useful planning technique for most S corporations. Of course, any employees can be paid no more than reasonable compensation (including both taxable and nontaxable benefits) for the services provided.

Because Secs. 105 and 106 are not available for shareholder-employees, partners or sole proprietors, the only way for these individuals to avoid income inclusion on the receipt of health benefits is under Sec. 104(a)(3). That section excludes from gross income certain amounts received through accident or health insurance for personal injuries or sickness.

The Sec. 104(a)(3) exclusion applies to amounts received from an accident or health insurance policy for personal injuries or sickness.(39) It also applies to amounts an employee receives for personal injuries or sickness from a fund maintained exclusively by employee contributions. A more-than-2% S corporation shareholder-employee or a partner who contributes to a fund that has the effect of insurance may be able to use this exclusion because these individuals are making after-tax contributions that are comparable to employee contributions. Unfortunately, the regulations do not specifically allow such self-employed individuals to rely on these rules.(40) These taxpayers should be made aware of the tax risk associated with a noninsured plan.

* Cafeteria plans The importance of maintaining a valid Sec. 125 cafeteria plan was highlighted in Letter Ruling 9104050,(41) in which the IRS said that a plan offering a combination of tax-exempt and tax-deferred benefits resulted in taxable income for participants selecting tax-exempt benefits. In this arrangement, employees can elect (on an annual basis before the benefits are received) to waive health coverage in favor of an increased contribution to a pension plan. A waiver would be effective only if the employee provided the employer with proof of other health coverage.

The IRS ruled that employees who elected health coverage rather than increased contributions to the pension plan would be taxed on contributions to the health care fund in the tax year in which the contributions were made. The IRS reasoned that contributions to a qualified pension plan were merely tax-deferred benefits, not tax-exempt benefits. Thus, the election to receive current health coverage rather than additional pension contributions was an "assignment of income" from a future tax period to the current tax period--essentially, a substitute for what the employee would otherwise have received as ordinary income at a future date.

Historically, the IRS and the courts have used assignment of income to prevent a taxpayer from assigning taxable income to another taxpayer. In Letter Ruling 9104050, the IRS expanded this principle to restrict the assignment of income from one accounting period to another accounting period of the same taxpayer. If this plan had been structured as a Sec. 125 cafeteria plan, with a Sec. 401(k) plan, the result could have been avoided.

* Fringe benefit reporting As the DOL's increased enforcement effort continues, many employees sponsoring benefit plans find the reporting and audit requirements confusing. Although a Form 5500 needs to be filed for each plan, no formal advice defines a plan. An employer can treat all the benefit options under a cafeteria plan as being offered through a single integrated plan or can apply the rules separately to each component.

All cafeteria plans must file a Form 5500, while the various components may be exempt.(42) While a cafeteria plan is not subject to ERISA reporting, the individual plans must comply. Plans with fewer than 100 participants that are unfunded, fully insured, or a combination of the two, do not have to file.(43) An employer may treat a cafeteria plan as several ERISA plans (with reporting requirements for each plan) or design the arrangement as a single ERISA plan (to minimize the ERISA reporting and disclosure requirements).

Whether a plan must be audited depends on whether it is subject to the ERISA and whether it is funded. The ERISA provides an exception from the audit requirement for plans with fewer than 100 participants as of the beginning of the plan year.(44) Also, plans that pay benefits solely from the general assets of the employer, through insurance contracts, or through a combination of the two, are exempt from the audit requirement.(45)

The DOL interprets the phrase "solely from the general assets of the employer" very narrowly. If a plan uses participant contributions to purchase insurance and forwards such contributions within a reasonable time (no more than three months), an audit will not be required. If, however, a self-insured plan has participant contributions, benefits are not paid from the employer's general assets, since participant contributions (either before or after tax) are not the employer's general assets. Therefore, according to the DOL, an audit would be required. Separate checking accounts and administrative-services-only arrangements may also violate the solely-from-employer-general-assets test.(46) Note: Governmental plans are not subject to the ERISA reporting requirements. Governmental cafeteria plans, however, must file a Form 5500.(47)

Expense Allowance Arrangements

In December 1990, the IRS issued final regulations on the business expense reimbursement rules under Sec. 62(c) and provided payors with a reminder of their withholding obligations. If the business connection, substantiation and return-of-excess reimbursement requirements are satisfied, an expense reimbursement or allowance arrangement will be treated as an "accountable" plan.(48) Amounts paid or reimbursed to employees under an accountable plan are excluded from the employee's gross income, are not reported as wages or other income on the employee's Form W-2, and are exempt from withholding and the payment of employment taxes.(49) If an arrangement fails any of the three requirements, it will be treated as a "nonaccountable" plan.(50) Amounts paid under a nonaccountable plan are included in the employee's gross income, are reported on the W-2 and are subject to withholding and employment taxes.(51)

An employer may have more than one expense reimbursement arrangement with an employee. If a single arrangement would be partly accountable and partly nonaccountable when viewed as two separate arrangements, it can be treated as two arrangements--one that is a fully accountable plan and another that is a nonaccountable plan. Thus, if the employer reimburses for business-related travel expenses that are partly excludible and partly nonexcludible, only the nonexcludible expenses must be included in the employee's gross income, subject to withholding and employment taxes.

Can a portion of an employee's salary be recharacterized as being paid under a reimbursement arrangement? The final regulations explain that if a payor arranges to pay an amount to an employee regardless of whether the employee incurs, or is reasonably expected to incur, deductible business expenses or other bona fide expenses related to the employer's business that are not deductible, the arrangement does not meet the business connection requirement. Thus, all amounts paid under such an arrangement would be treated as paid under a nonaccountable plan, subject to withholding and payment of employment taxes when the amounts are paid.(52)

To be excludible from income under an accountable plan, business expenses must be substantiated within a reasonable period of time, and amounts paid in excess of substantiated expenses must be returned to the employer within a reasonable period of time.(53) If the reasonable-period-of-time requirements are not met, the amount treated as paid under a nonaccountable plan is subject to withholding and employment taxes no later than the first payroll period following the end of the reasonable period.(54)

An employee is relieved of substantiating the amount of certain expenses deemed substantiated under an arrangement providing a per diem or other fixed allowance approved by the IRS.(55) If, under an accountable plan, the employer pays a mileage allowance or per diem allowance in lieu of actual expenses and does not require the employee to return the portion of the allowance that exceeds the amount deemed substantiated, the excess portion is treated as paid under a nonaccountable plan.(56) If an employer reimburses substantiated mileage at a rate in excess of the federal rate (27.5 cents per mile for 1991), only the amount in excess of the federal rate is considered income subject to withholding and employment tax.

Since there is no requirement to return the excess amounts to the employer, the reasonable-period-of-time provisions do not apply. As a result, the employer must withhold and pay employment taxes on the excess reimbursement in the payroll period in which the employer reimburses the employee for the substantiated expenses. If the employer advances amounts to the employee, the withholding on excess amounts occurs in the payroll period in which the expenses are substantiated.

The reporting rules for employee business expense reimbursement arrangements are effective for payments received on or after Jan. 1, 1989. The withholding rules are effective for payments received on or after July 1, 1990. However, the IRS announced that it will not impose penalties for failure to report payments, or for failure to pay or make timely deposits of employment taxes, for payments made under reimbursement or other expense allowance arrangements before July 1, 1991, if the employer has made a substantial and good-faith effort to comply with the regulations.(57)

With increased payroll tax audits, the IRS will be scrutinizing employee business expense and allowance arrangements. The risk is significant. Assessment can result not only in income inclusion for individuals, but also, in the case of shareholder-employees, loss of a deduction for the employer.

(1)Regs. Sec. 1.451-2(a). (2)Rev. Rul. 80-300, 1980-2 CB 165. (3)IRS Letter Ruling 8508005 (9/7/84). (4)Rev. Rul. 68-482, 1968-2 CB 186. (5)George C. Martin, 96 TC No. 39 (1991). (6)IRS Letter Ruling (TAM) 8632003 (4/18/86). (7)Howard Veit, 8 TC 809 (1947); Howard Veit, 8 TCM 919 (1949). (8)IRS Letter Ruling 9107014 (11/16/90). (9)Sec. 3121(a). (10)Sec. 3121(v)(2)(A). (11)Sec. 3121(v)(2)(B). (12)PL 98-21, Section 324(d). (13)Sec. 3121(a)(2)(A), prior to amendment. (14)Sec. 3121(a)(3), prior to amendment. (15)Sec. 3121(a)(13)(A)(iii), prior to amendment. (16)Regs. Sec. 31.3121(a)(13)-1. (17)Albertson's, Inc., 95 TC 415 (1990). (18)Sec. 404(a)(5); Regs. Sec. 1.404(a)-12. (19)See, e.g., Rev. Rul. 60-31, 1960-1 CB 174. (20)Sec. 457. (21)IRS Letter Ruling 9104039 (10/31/90). (22)Rev. Rul. 80-58, 1980-1 CB 181. See also Stella E. Penn, 115 F2d 167 (4th Cir. 1940)(25 AFTR 940, 40-2 USTC [P] 9707). (23)William G. Campbell, 8th Cir., 1991 (68 AFTR2d 91-5425, 91-2 USTC [P] 50,420), aff'g and rev'g TC Memo 1990-162. (24)SEC Regs. Section 240.16(b)-3. (25)FASB Interpretation 28, [P] 5. (26)Sec. 83(c)(3). (27)Sec. 56(b)(3). (28)See IRS Letter Ruling 9030015 (4/25/90). (29)Example based on Rev. Rul. 80-244, 1980-2 CB 234. (30)IRS Letter Ruling 9114023 (1/7/91). (31)Regs. Sec. 25.2511-1(h)(1). See also Stephen F. Heringer, 235 F2d 149 (9th Cir. 1956)(49 AFTR2d 1703, 56-2 USTC [P] 11,622). (32)Rev. Rul. 80-196, 1980-2 CB 32. (33)Regs. Sec. 25.2512-8. (34)Rev. Rul. 91-26, IRB 1991-15, 23. (35)Sec. 3121(a)(2). (36)Sec. 162(1)(4). (37)Ann. 85-113, IRB 1985-31, 31. (38)Sec. 105(g); Rev. Rul. 91-26, note 34; Secs. 401(c)(1) and 1372. (39)Regs. Sec. 1.104-1(d). (40)Regs. Secs. 1.105-5(b) and 1.72-15(g). (41)IRS Letter Ruling 9104050 (11/1/90). (42)Sec. 6039D; Notice 90-24, 1990-1 CB 335. (43)DOL Regs. Section 2520.104-20. (44)DOL Regs. Section 2520.104-46. (45)DOL Regs. Section 2520.104-44. (46)DOL Advisory Opinions 81-32A (3/23/81) and 84-10A (2/22/89). (47)Sec. 6039D. (48)Regs. Sec. 1.62-2(c)(2). (49)Regs. Sec. 1.62-2(c)(4). (50)Regs. Sec. 1.62-2(c)(3). (51)Regs. Sec. 1.62-2(c)(5). (52)Regs. Sec. 1.62-2(d)(3). (53)Regs. Sec. 1.62-2(e) and (f). (54)Regs. Sec. 1.62-2(h)(2)(i)(A). (55)Rev. Procs. 90-59, 1990-2 CB 644, and 90-60, 1990-2 CB 651. (56)Regs. Sec. 1.62-2(h)(2)(i)(B). (57)Notice 90-74, 1990-2 CB 356.

Deborah Walker, MBA, CPA Partner KPMG Peat Marwick Washington, D.C.
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Title Annotation:Current Developments in Employee Benefits, part 1
Author:Walker, Deborah
Publication:The Tax Adviser
Date:Nov 1, 1991
Next Article:Related-party transfers of inventory; write-downs should precede transfers to minimize related-party loss limitations.

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