Current developments, part I.

• Author: Walker, Deborah
• Position: Part 1 - Employee benefits and pensions

This two-part article provides an overview of current developments in employee benefits, including welfare benefit plans, executive compensation and retirement plan requirements. Part I focuses on developments in welfare benefit plans and executive compensation.

During the past 12 months, numerous cases, rulings and regulations on executive compensation, welfare benefits and qualified plan requirements were issued. This two-part article covers the most significant of these. Part I, below, covers developments and associated planning opportunities in executive compensation and the funding or payment of welfare benefits (e.g., health reimbursement accounts and retiree health, life and disability insurance). Part II, in the December 2003 issue, will examine significant developments in qualified retirement plan requirements.

Welfare Benefit Funds

UBTI

Unfavorable decision: In a decision that did not surprise many practitioners, a district court (1) rejected a Sec. 501(c)(9) trust's contention that unrelated business taxable income (UBTI) should be taxed at corporate, rather than trust, rates. Sec. 511(b)(1) provides for taxation at trust rates for trusts described in Sec. 511(b)(2); a trust falls within that provision only if it would be subject to subchapter J but for its tax exemption. A nonexempt employee trust is subject to that subchapter; only its beneficiaries are exempt under Regs. Sec. 1.641 (a)-0(b). Thus, the court conclude that subchapter J would apply to a voluntary employees' beneficiary association (VEBA), and so it would be subject to the trust rates.

Taxpayers with welfare benefits subject to unrelated business income tax (UBIT) should consider a taxable welfare benefit fund, so that any deemed UBTI would be included in the employer's income and would be taxed at the lower corporate tax rates. (Taxpayers in a loss position would avoid taxation.)

Favorable decisions: Taxpayers subject to UBIT received a favorable ruling in Letter Ruling (TAM) 200317036 (2) when the IRS allowed an employer to aggregate two welfare benefit trusts when calculating UBTI. The employer maintained two separate trusts, one taxable and the other exempt under Sec. 501(c)(9), to fund retiree life insurance benefits. According to Sec. 419A(h)(1)(B), an employer can treat two or more trusts as a single fund to the extent not inconsistent with the purposes of Sec. 419, 419A or 512, but there is no published guidance as to when aggregation is consistent with the principles underlying those sections,The ruling points to a statement in the Sec. 419A(g) legislative history (3) (relating only to deemed UBTI), approving an employer's aggregation of taxable trusts, and states there is no reason not to allow the practice when one trust is taxable and the other is not.

The problem addressed in TAM 200317036 arises frequently in various forms. The ruling offers support for aggregation in similar circumtances (e.g., when two trusts provide medical benefits and it would be advantageous to combine their incurred, but not received (IBNR), reserves in computing UBTI or deemed UBTI). The IRS's position is less clear if either reserves or benefits are of different types. For example, can a life insurance trust's post-retirement reserves be combined with a medical trust's IBNR reserve? The ruling's logic suggests that the answer ought to be "yes." Both types of benefit could be provided through a single trust, and the reserves would be combined; separating the trusts, but keeping their reserves aggregated, "does not allow excess accumulation of income." Nonetheless, employers with those facts would be well advised to seek a private letter ruling.

In Sherwin-Williams Co. Employee Health Plan Trust, (4) the Sixth Circuit offered taxpayers another way to avoid UBIT, by applying a new method of calculating UBTI. In general, Temp. Regs. Sec. 1.512(a)-5T, Q&A-3(b) and Sec. 512(a)(3)(E)(i) provide that a VEBA's income is exempt-function income (and, thus, not UBTI) only "to the extent that the total amount set aside in the VEBA...as of the close of the taxable year...does not exceed the qualified asset account limit for such taxable year of the organization:" However, the court held, "the limit is on the amount of income that is still set aside at the end of the year, not to [sic] amounts that were set aside but were spent over the year's course." Thus, it held that the trust had no UBTI, because it spent all of its income during the year on administrative expenses. (5)

If other courts follow this decision, it will be a boon to companies that would like to fund post-retirement medical benefits. Trust assets inevitably are greater than the UBTI account limit,because that limit (unlike the similar limit for deduction purposes) cannot include a reserve for such benefits. As a result, if a trust funds only retiree medical benefits, all of the trust's income is ordinarily UBTI. Reliance on Sherwin-Williams, if warranted, makes it easy to eliminate UBTI. Taxpayers considering relying on that case may want to create a trust in the Sixth Circuit to make it less vulnerable to IRS attack. It is not clear how the IRS will react to the Sixth Circuit's decision. (6)

Funding Reserves for Health Benefits

Welfare benefit funds received another boost when the Tax Court snapped the IRS'S Sec. 419 victory string in Wells Fargo & Co. (7) and approved immediate funding of a reserve for health benefits of current retirees. Sec.419 limits the deduction of contributions to fund welfare benefit plans. Sec. 419A(c)(2) authorizes "a reserve funded over the working lives of the covered employees and actuarially determined on a level basis...as necessary for (A) post-retirement medical benefits to be provided to covered employees..."; contributions up to this limit are immediately deductible (and often allowable as costs in rate-making or under cost-plus contracts). At the same time, plan assets reduce the liability that an employer has to disclose on its financial statements under Financial Accounting Standards Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. The key question (on which the IRS and many plan sponsors have long been at odds), is: "Over what period may the reserve be funded?" The answer is particularly controversial when a large proportion of employees covered have already retired and have no future working lives.

The IRS's longstanding position is that the Sec. 419A(c)(2) language quoted above is actuarial shorthand for a funding method (the aggregate method) that spreads all of the benefit costs over the working lives of participants employed at the time of the calculation; the zero working lives of retirees are ignored. However, most plan sponsors prefer a method that will let them make contributions and claim deductions more rapidly.

In Wells Fargo, the court held that Sec. 419A(c)(2)'s plain language permits sponsors to fund benefits promised to current retirees immediately with de-ductible contributions. The court considered three possible funding methods that can plausibly be said to fit within the statute and chose the level-premium method. This method, use by the plan's actuary for calculating original funding, is a recognized pension funding method no longer widely used. It amortizes the liability attributable to each employee over his or her own anticipated future working life. For those no longer working, the amortization period is zero, so that sponsors can fully fund benefits in the year in which they create a trust. (8)

Salary Reduction Plans

Two IRS rulings addressed salary reduction plans. In Rev. Rul. 2003-62, (9) the IRS ruled that a plan participant cannot avoid tax on qualified retirement plan distributions by electing coverage under a Sec. 125 premium conversion plan or a flexible spending account.The ruling holds that those elections are ineffective for tax purposes, because Sec. 402 sets forth the exclusive rules for including qualified plan distributions in income...