Current developments in employee benefits.

• Author: Walker, Deborah
• Position: Part 3

This three-part article provides an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and employee benefits, including changes not only under the Code, but also various other Federal laws, most notably the Employee Retirement Income Security Act of 1974 (ERISA) and the Age Discrimination in Employment Act (ADEA). Part I, published in November, focused on executive compensation and employee benefits. Part II, published in December, focused on current developments affecting qualified retirement plans, including recently enacted rules facilitating retirement plan rollovers and imposing a 20% withholding tax on certain qualified plan distributions; changes to the qualified plan nondiscrimination rules and transition rules for casing compliance with such rules, and additional IRS guidance on employee stock ownership plans (ESOPs). Part III, below, also focuses on developments affecting qualified plans, specifically judicial consideration of the prohibited transaction and minimum funding rules, IRS liberalization of the distribution rules for plans whose assets are held in receivership, IRS guidance on early retirement windows, and the Supreme Court's determination that certain retirement assets are protected from an individual's bankruptcy creditors. Many of these developments indicate a growing awareness that retirement savings should be conserved for retirement and employers should be aided in offering such benefits to employees.

Excise Tax Developments

* Sale of property to ESOP

In a decision with an unusually harsh result, the Tax Court in Zabolony(104) upheld the IRS's imposition of first- and second-tier prohibited transaction penalties totaling almost $8.5 million against a married couple in connection with their sale of land to an ESOP in which they were the sole participants. This result seems especially harsh--draconian, in the words of one dissenting judge(105)--because the land proved to be an exceptionally good investment for the ESOP. Anton and Bernel Zabolotny owned and farmed 1,205 acres of land in western North Dakota. During the 1970s, the Zabolotnys discovered oil on their land, and in 1977, they entered various lease arrangements with a major oil company with respect to the mineral rights to the land, while continuing their farming operation. On May 20, 1981, Anton and Bernel incorporated the farming operation, with each taking 50% of the corporation's stock. Anton served as a director and president of the corporation, Bernel served as a director and secretary-treasurer.

That same day, the corporation adopted a qualified ESOP, with the Zabolotnys as the sole initial participants. Anton was named trustee. Immediately thereafter, the ESOP bought three tracts of the Zabolotnys' farmland, together with the mineral rights in those tracts. As payment for the land, the ESOP established for the Zabolotnys a $478,615 joint and survivor annuity, which had a present value of $6,481,915. (This amount was stipulated to represent adequate consideration.) The ESOP later entered a five-year lease of the land's surface rights to the corporation; the ESOP retained the mineral rights.

As an investment asset, the land paid off handsomely for the ESOP. In five years' time, the ESOP's gross royalty income from the mineral rights totaled over $9 million, and its net asset value grew to approximately $5.3 million--all this despite cumulative employer contributions totaling only $12,900.

In November 1986, the IRS issued deficiency notices to Anton and Bernel imposing a first-tier prohibited transaction excise tax of $39.4,095.75 15% of $6,481,9151 a year for each of six tax years (for a total first-tier penalty of $1,944,574.50), and a second-tier penalty of $6,481,915, for a grand total of $8,426,489. According to the IRS, the sale of the land to the ESOP was a prohibited transaction that was not excused by any applicable exemption; the Tax Court agreed.

For purposes of the prohibited transaction excise tax, a prohibited transaction includes any sale of property between a plan and a disqualified person, unless an exemption applies. Clearly, both of the Zabolotnys were disqualified persons: Anton as trustee of the ESOP,(106) a 50% shareholder of the employer corporation,(107) and an officer of the employer corporation; and Bernel as a 50% shareholder, an officer and a member of the family of a fiduciary.(108)

The Zabolotnys first argued that the sale was exempt from the prohibited transaction rules under Sec. 4975(d)(13). Under that section, a transaction is exempt from the excise tax if it is exempt from ERISA's prohibited transaction rules by reason of ERISA Section 408(b) or (e). ERISA Section 408(e) provides an exemption for sales of "qualifying employer real property." Property sold to a plan is "employer real property" if it is leased to an employer of employees covered under the plan, and is qualifying employer real property if it consists of parcels of real property that are adaptable, without undue expense, for more than one use, and if a substantial number of those parcels are dispersed geographically(109) The court held that because all the land the Zabolotnys sold to the ESOP was in the same geographical environment, the property did not satisfy the geographic dispersion requirement.

The Zabolotnys then claimed that even if the plan's purchase of the land was a prohibited transaction, the excise tax should not apply because the prohibited transaction was "corrected" simultaneously with the sale.

The prohibited transaction excise tax is a twotier tax: The first tier is a tax of 5% of the amount involved in the prohibited transaction, and is imposed for each year of the "taxable period"--i.e., the period that begins on the date the prohibited transaction occurs and ends on the date the IRS either mails a deficiency notice for the tax or assesses the tax, or the date the disqualified person corrects the transaction, whichever occurs first. The second tier is a tax equal to 100% of the amount involved, and is imposed if the disqualified person does not correct the transaction within the taxable period. Correcting a prohibited transaction means undoing it to the extent possible, but in any case putting the plan in a financial position no worse than it would have been in had the disqualifying person been acting in accordance with the highest fiduciary standards.(110) The Zabolotnys argued that because the plan made a substantial profit on the transaction, they had acted in accordance with the highest fiduciary standards in making the sale. Thus, the prohibited transaction had been corrected at the same time as the sale, and no excise tax should be imposed.

A majority of the Tax Court rejected the Zabolotnys' argument. According to the majority opinion, the Code and the regulations contemplate some affirmative act to effect a correction-- a transaction will not be considered corrected merely because it turns out to be a good deal. On that basis, the court found that the Zabolotnys still had not corrected the prohibited transaction, and that the $8.5 million of first- and second-tier penalties had been properly determined. While recognizing this as a harsh result, the court stated that the legislative history and the language in the Code suggest that violations of the prohibited transaction rules are to be treated harshly.

In a dissenting opinion, Judge Ruwe noted that the purpose of the two-tier excise tax is to protect the interests of the beneficiaries from being jeopardized by transactions between the plan and a disqualified person. Here, the very people whom the tax was intended to protect--the beneficiaries-were being hit with a crushing tax burden for engaging in a transaction that not only protected, but substantially enhanced, the interests of the beneficiaries. Judge Ruwe would have found that the initial prohibited transaction was subject to the first-tier 5% excise tax, and that the prohibited transaction had been corrected before the end of the first tax year, thus stopping further excise taxes from accruing. By the end of the first year, the financial interest of the beneficiaries was protected beyond any requirements in Sec. 4975(f)(5). Moreover, under the facts and circumstances of the case--including the substantial benefit to the beneficiaries and the fact that the high cost of undoing the transaction would fall on the very people the law was designed to protect--it would have been irrational to require that the transaction be undone.

As the majority opinion notes, the Zabolotnys could have avoided this litigation altogether if they had obtained a special prohibited transaction exemption under Sec. 4975(c)(2).

* Underfunding excise tax In Ahlberg,(111) a U.S. district court held that imposition of the Sec. 4971 underfunding excise tax was unwarranted when the underfunding was a result of a book entry misallocation of funds between a pension plan and a profit-sharing plan, and neither the plans nor the sole participant was harmed. The court also held that even though the participant waited 2 1/2 years to record a mortgage he had given as security for a plan loan, imposition of the Sec. 4975 prohibited transaction excise tax was inappropriate since the plan suffered no harm.

In January 1980, Metropolitan Neurosurgery, P.A., established a pension plan and a profit sharing plan. Daniel Ahlberg, Metropolitan's sole shareholder and employee, was the sole participant and the administrator of both plans. For 1980, 1981 and 1984, the corporation made the maximum allowable contribution to the plans, paying the funds into a commingled money market account for the plans' benefit. Although the total contribution for each of those years was correct, book entry errors resulted in an incorrect allocation between the pension plan and the profit-sharing plan. This misallocation, which resulted in an underfunding of the pension plan...