Current developments.

• Author: Elinsky, Peter I.
• Position: Part 2 - Employee benefits

EXECUTIVE SUMMARY

* The Ninth Circuit reversed the Tax Court in Boyd Gaming; the employer can deduct 100% of meals furnished to employees.

*IRS coordinated issue papers examined tax-free reimbursements under self-insured medical plans and the deduction of family medical coverage provided to an employee spouse.

* In Alpha Medical, the Sixth Circuit decided the age-old question of reasonableness of compensation.

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 II focuses on general developments in executive compensation, health and welfare plans and fringe benefits.

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

Welfare Benefits

COBRA Regs.

Twelve years after the first Consolidated Omnibus Reconciliation Act of 1985 (COBRA) healthcare continuation proposed regulations were released under Sec. 4980B, the IRS issued final regulations and more proposed regulations.(18) The IRS has "caught up" the regulations to Congress's frequent changes in the COBRA statute. The final regulations are effective for COBRA qualifying events occurring in plan years beginning after 1999.

VEBAs

The IRS ruled in Letter Ruling 9915059(19) that a voluntary employee benefits association (VEBA) must include in unrelated business taxable income (UBTI) investment income it earned on amounts set aside to pay insurance premiums for employees with "banked" hours.

Banked hours: In the ruling, a VEBA paid premiums to insurance carriers that provide medical benefits to employees who participate in the employer's medical plan. Employees must work a specified minimum number of hours to be eligible for benefits; employees who work more than the minimum number of hours can "bank" them to cover periods when they do not work the minimum. The VEBA proposed to set aside, in a separate bank account, investment income to pay future insurance premiums and trust expenses resulting from the use of banked hours. It requested a ruling that this investment income would not be included in its taxable income, on the basis that its obligation to pay future premiums for banked hours constitutes "claims incurred but unpaid."

Account limit: Tax is imposed on a VEBA's UBTI for each tax year, under Sec. 511 (a) (1). A VEBA's UBTI equals its gross income (excluding exempt-function income (EFI)), minus the deductions attributable thereto. A VEBA's EFI is its gross income from employee contributions to provide the VEBA benefits, plus employer contributions and passive investment income (other than UBTI) set aside for exempt purposes. Sec. 512(a) (3) (E) provides that the set-aside cannot exceed the account limit determined under Sec. 419A. Generally under Sec. 419A(c)(1), the account limit is the amount reasonably and actuarially necessary to fund incurred but unpaid claims, plus related administrative costs.

Zero account limit: Citing the legislative history of Sec. 419A and the Sixth Circuit's decision in Parker-Hannifin Corp.,(20) the IRS found that claims are incurred only when an event (such as a medical expense) actually occurs; a contractual obligation to pay benefits does not meet that requirement. Thus, according to the IRS, a fully insured plan has a zero account limit. Because a set-aside cannot exceed the account limit, no part of the VEBA's proposed set-aside could be treated as EFI; rather, all of the investment income earned on amounts set aside to pay insurance premiums on behalf of employees with banked hours was includible in the VEBA's UBTI.

Tax-Free Reimbursements Under Self-Insured Medical Plans

The IRS has taken the position in a coordinated issue paper(21) that employees cannot exclude from income employer reimbursements under a self-insured medical plan for medical expenses incurred before the employer adopted the plan. Such retroactive adoption of medical plans often arises when a self-employed (SE) individual hires his spouse as an employee and seeks to cover the family's medical expenses.

Sec. 105(b) excludes from gross income amounts an employee receives through accident or health insurance as reimbursement for expenses incurred for medical care for himself, his spouse or dependents. Sec. 105(e) provides that, for purposes of the exclusion, amounts received under an accident or health plan for employees will be treated as received through accident or health insurance. Thus, the Sec. 105(b) exclusion is available for self-insured medical plans.

The IRS stated that, for there to be a "plan" under Sec. 105(e), the employer must be committed to certain rules and regulations governing payment; these rules must be made known to employees as a definite policy and be determinable before the employee's medical expenses are incurred. Accordingly, the IRS position is that payments of medical expenses incurred before plan adoption are not paid or received under an accident or health plan; thus, they are includible in an employee's income under Sec. 61, not excludible under Sec. 105(b). On the other hand, as long as the expenses are ordinary and necessary business expenses, they are deductible under Sec. 162(a).

The industry's argument in favor of the exclusion is based on Kegs. Sec. 1.105-5(a), which provides that an accident or health plan may be either uninsured or insured, and that the employee's rights under the plan may or may not be enforceable. However, if the employee's rights are not enforceable, an amount is deemed to have been received under a plan only if, on the date the employee became sick or injured, he was covered by a plan providing for the payment of amounts to employees in the event of personal injuries or sickness, and notice or knowledge of such plan was reasonably available.

According to the IRS, this language has been misread by tax advisers to mean that, if an employee's right to payment is enforceable, there is no requirement that the (1) plan be in effect when the medical expenses are incurred or (2) employee have notice of the plan. The IRS's position is that Sec. 105 does not address the retroactivity issue and that Regs. Sec. 1.105-5(a) is open to other interpretations.

Family Coverage Provided to Employee Spouse

The IRS has concluded in a coordinated issue paper(22) that an SE individual can deduct the cost of accident and health coverage provided to his spouse as an employee, if the spouse is a bona fide employee in the business. In appropriate circumstances, this position would allow SE individuals to escape the Sec. 162(1) limits on the deductibility of medical insurance premiums.

This issue arises when an SE individual hires his spouse as an employee, then provides the spouse family coverage through a self-insured (or an insured) medical plan. The SE individual is covered by the plan as a member of the employee-spouse's family. This arrangement allows the SE individual to deduct the cost of providing medical coverage to himself and his family as a Sec. 162(a) business expense (i.e., as part of a reasonable allowance for compensation); the employee-spouse excludes from income both the cost of the coverage and the benefits paid under the plan.

Deduction: The IRS's position, based on Rev. Rul. 71-588,(23) is that the cost of the coverage (including medical expense reimbursements) is deductible by the SE individual under Sec. 162 if the employee-spouse (1) is a bona fide employee under common-law rules or (2) otherwise provides services to the business for which the coverage constitutes reasonable compensation.

If the employee-spouse does not meet that standard, the coverage is a personal expense under Sec. 262(a) and nondeductible under Sec. 162(a). The cost of health insurance purchased by the SE individual would be deductible up to the applicable percentage limit under Sec. 162(1); any excess would be deductible only to the extent allowed under Sec. 213 (i.e., in excess of 7.5% of adjusted gross income). Amounts paid by an SE individual for reimbursement under a self-insured plan for himself, his spouse and dependents would be deductible only to the extent allowed under Sec. 213.

The IRS noted that if a health insurance policy is purchased in the SE individual's name, the Sec. 162(1) limits would apply, even though coverage is provided for the employee-spouse and dependents in addition to the SE individual.

Exclusion: The IRS also concluded that the cost of health coverage or medical expense reimbursements will be excludible from the employee-spouse's income if he is a bona fide employee under common-law rules.

If the spouse is not a bona fide employee, the cost of coverage under an insured plan is not excludible under Sec. 106; medical expense reimbursements received by the spouse are not excludible under Sec. 105(b). If the cost of the coverage is included in the spouse's income, all amounts received by the spouse and family for personal injury and sickness would be excludible under Sec. 104(a)(3).

The IRS listed several additional factors to consider in determining whether the spouse is a bona fide employee:

* Does the plan document provide that the spouse is eligible to participate (e.g., has the spouse satisfied any applicable waiting period requirements)? If not, medical expense reimbursements may not be excludible, because they would not have been received under a health plan. Also, if such requirements are not consistently applied to all employees, a self-insured plan could be considered discriminatory under Sec. 105(h).

* What is the extent and nature of the...