Current developments.

• Author: Elinsky, Peter I.
• Position: Part 1

EXECUTIVE SUMMARY

* The Ninth and Tenth Circuits decided whether a corporation could deduct defined benefit plan contributions made after the end of the tax year but before the extended due date of that year's return.

* The IRS amended the Internal Revenue Manual to include a host of Sec. 403(b) plan examination guidelines.

* Final regulations allow S corporation ESOPs and other stock bonus plans to substitute cash distributions for stock distributions without violating the Sec. 411(d)(6) anti-cutback rules.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I focuses on general developments in retirement plan qualification requirements and employee stock ownership plans.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, below, focuses on general developments in retirement plan qualification requirements and employee stock ownership plans (ESOPs).

Qualified Plan Cases

Lucky Stores, Inc.

In May 1999, the U.S. Supreme Court declined to review a Ninth Circuit decision(1) denying Lucky Stores, Inc. a deduction for contributions to multiemployer defined benefit plans made after the tax year for which the deduction was taken.

Lucky Stores contributed monthly to several collectively bargained defined benefit plans. Before 1986, it deducted a total of 12 monthly contributions attributable to employee service during a particular tax year from its taxable income for that year. Although the twelfth payment was made after the end of the tax year, it was attributed to the previous year as a payment "on account of" that year under Sec. 404(a)(6). However, for its tax year ended Feb. 2, 1986, the taxpayer obtained an extension and fried in October 1986. On that return, it attributed to its tax year ended Feb. 2, 1986, all monthly contributions made during the extension period, claiming such payments were "on account of" the prior tax year. These deductions totaled $36,661,529, which the IRS disallowed; the Tax Court agreed with the Service.

Appeals court's analysis: Under Sec. 404(a)(1)(A), accrual- or cash-basis employers may deduct contributions to qualified pension plans in the tax year the contribution is actually paid. Additionally, Sec. 404(a)(6) deems a taxpayer to have made a payment on the last day of the preceding tax year if it is made (1) on account of such tax year and (2) not later than the extended due date of that year's return. The Ninth Circuit stated that the plain meaning of Sec. 404(a)(6) supported the Tax Court's decision, noting the seven or eight months of additional payments stemmed from 1987 employee service, not 1986.

The taxpayer relied on Rev. Rul. 76-28,(2) which permits deductions if the payment is treated by the plan in the same manner as it would have been if received on the last day of the preceding tax year. The taxpayer's defined benefit plans calculated a pension under a formula based on years worked and the highest salary maintained over a particular period; thus, the employer's contribution had no direct relation to the workers' benefits--the contributions were simply placed in one common pool to fund the entire plan. Because the plan treated all contributions similarly (no matter when received), the post-1986 contributions met Rev. Rul. 76-28's requirements and were deductible.

The appeals court dismissed this argument, noting that under the terms of the collective bargaining agreement, the taxpayer was required to make monthly payments to the plans, based on the hours or weeks of employee service in the immediately preceding month. Plan administrators treated each remittance as the fulfillment of the taxpayer's required contribution for a discrete month. Thus, the extra contributions were treated by the plans as meeting the taxpayer's 1987 obligations, which differed from the treatment than if they had been received in 1986. Thus, the taxpayer did not meet Rev. Rul. 76-28 or Sec. 404(a)(6). Further, the court ruled that plan administrators could not properly calculate meaningful contribution amounts if employers were allowed to count work performed after the plan year.

American Stores Co.

Similarly, in American Stores Co.,(3) the Tenth Circuit affirmed a Tax Court decision holding that an employer could not deduct more than 12 months' contributions to a qualified multiemployer defined benefit plan.

The accrual-basis taxpayer and its subsidiaries contributed to 39 qualified multiemployer defined benefit plans. Generally, at the end of each month, the various plan administrators sent bills to participating employers, who would calculate their required contributions by multiplying the units of service (e.g., hours or weeks) worked by covered employees by fixed dollar rates set by the applicable collective bargaining agreements. Contributions based on work performed within a particular month were due at the end of the following month.

For tax years before 1988, the taxpayer and its subsidiaries used one of two methods to calculate pension deductions. Some would deduct contributions actually paid during the tax year; others would deduct contributions corresponding to work done during the tax year, including one payment made after the close of the tax year, corresponding to work done in the last month. For the tax year ended Jan. 30, 1988, however, the taxpayer deducted the typical 12 payments, plus seven or eight additional payments made (and based on services performed) after the close of the tax year, but before the extended due date of that year's return. The IRS disallowed the deduction for the additional months' contributions; the Tax Court held for the Service.

Deduction rules: Sec. 413 contains special rules for collectively bargained plans. Under Sec. 413(b)(7), Sec. 404(a) deduction limits are determined on a plan-wide basis, as if all plan participants were employed by a single employer. At the beginning of the plan year, working from the terms of collective bargaining agreements and past contribution levels, the plan determines the "anticipated employer contributions" it will receive for that year. If such contributions for the plan year are within the plan-wide deduction limit, each participating employer may (without further determination and regardless of subsequent events) deduct all contributions-it makes for the portion of its tax year included within the plan year. Of course, employers will make only those contributions required by the plan, because their employees receive a predetermined level of benefits independent of the amounts contributed by a specific employer.

"On account of" previous tax year: On appeal, the taxpayer argued that deductibility of contributions under a multiemployer defined benefit plan is not tied to the concept of monthly obligations paid or accrued through the end of the year under the terms of a collective bargaining agreement. Rather, its payments during the Sec. 404(a)(6) "grace period" were "on account of" its 1988 tax year and, thus, deductible for that year. The taxpayer also contended that it met Rev. Rul. 76-28.

Rejecting these arguments, the Tenth Circuit stated that, because Sec. 413(b)(7) requires a multiemployer plan to calculate a plan-wide deduction limit in advance based on anticipated employer contributions, those contributions are effectively restricted by that limit only if the plan and the contributing employers use a common method for attributing payments to specific plan years and tax years. Thus, an employer's grace-period payment to a multiemployer plan is on account of its previous tax year only if a deduction for that year is consistent with the way the plan calculates anticipated employer contributions for Secs. 404(a) and 413(b)(7) purposes. Here, each of the plans was required to calculate anticipated employer contributions for the plan year by considering only contributions attributable to services performed during that year, consistent with the method used to determine each employer's contribution obligation. Thus, the taxpayer could deduct "on account of" its previous tax year only those grace-period contributions attributable to services performed during that year.

The court also concluded that Rev. Rul. 76-28 requires that, for an employer to deduct a payment on account of a previous tax year, the plan must have treated the payment as if made on the last day of the tax year. In the case of a multiemployer plan, the plan itself must have treated the payment as being made on the last day of the preceding tax year for purposes of calculating the plan-wide deduction limit under Sec. 413(b)(7). This requirement was not met, because the plan did not treat the disputed grace-period payments as being made on the last day of the taxpayer's 1988 tax year in calculating the plan-wide deduction limit under Sec. 413(b) (7).

Improper Termination

In Gant,(4) the Tax Court held that two retirement plans were improperly terminated; when the plans failed to meet employee participation requirements, the company president, a highly compensated employee (HCE), was required to include all his vested accrued benefits in gross income. While the Sec. 401(a)(26) participation requirements no longer apply to defined contribution plans, they still apply to defined benefit plans.

The taxpayer was the president and sole shareholder of a corporation with a defined benefit plan (pension plan) and a money-purchase plan. Both plans were intended to be Sec. 401(a) qualified plans. The taxpayer was each plan's trustee and fiduciary. In October 1987, the board of directors decided to terminate the plans; the taxpayer sent a letter to the plans' third-party administrator requesting that the plans be terminated. Neither the corporation nor the taxpayer...