An overview of recent developments in employee benefits.

• Author: Elinsky, Peter I.
• Position: Executive compensation, health and welfare plans and fringe benefits. - Part 2

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. this two-part (Employee Benefits & Pensions)

EXECUTIVE SUMMARY

* The IRS addressed AMT treatment and deduction issues stemming from the exercise of NQSOs.

* Sec. 4980B final regulations provide guidance on COBRA coverage-continuation requirements.

* The IRS updated the model grantor trust for nonqualified deferred-compensation arrangements for the new Sec. 1032 regulations.

Executive Compensation

Withdrawn Parachute Ruling Request

An IRS legal memorandum to the Chief of the Examination Division described the facts and law involved in a withdrawn letter ruling request under Sec. 280G. (30) The taxpayer had requested three rulings:

1. The waiver of market-based restrictions on the exercise of stock options held by the taxpayer's executives would not constitute a parachute payment due to accelerated vesting.

2. The calculation of the contingent portion of the taxpayer's stock options vested on account of the merger is performed under Prop. Regs. Sec. 1.280G-1, Q&A-24(c), taking into account only the service restriction on the options.

3. Q&A-24(c) applies to any lump-sum payments received by the taxpayer's executives on account of a change of ownership or control that served as a substitute for amounts they would have received had they continued to work for the taxpayer.

   The taxpayer withdrew the ruling request on being informed that the IRS was prepared to issue an adverse ruling on all three requests.

   Law: Sec. 280G prevents an employer from deducting "excess parachute payments." Sec. 4999 imposes a 20% excise tax on the recipient of an excess parachute payment. "Parachute payments" are payments in the nature of compensation to (or for the benefit of) a disqualified individual (e.g., an officer, shareholder or highly compensated employee (HCE)) if the (1) payment is on account of a change on ownership or control of a corporation and (2) present value of the contingent payments equals or exceeds three times the individual's average taxable compensation for the last five years (the "base amount").

   A payment to a disqualified individual is rebuttably presumed to be contingent on a change of control if made under an agreement (or amendment) entered into within one year before a change of ownership or control. Only the excess portion of a parachute payment is subject to adverse tax treatment.

   Prop. Regs. Sec. 1.280G-1, Q&A-24(c), reduces a parachute payment by the value of any payments the disqualified person was "reasonably certain" to have received absent the change in control.

   The memorandum stated that Q&A-24(c) was included in the proposed regulations to reduce the contingent portion of a nonvested payment partially earned by the taxpayer with services, but unpaid. The legal memorandum also stated that this does not occur with amounts under an employment agreement (which are paid as earned).

   Proposed ruling: The IRS informed the taxpayer that it had been prepared to rule that:

   * The market-based exercisability restrictions on stock options issued to executives caused the options to be "unvested." The waiver of the restrictions resulted in parachute payments on accelerated vesting of the options, due to a change of control.

   * The payments due to the accelerated vesting of the options cannot be reduced under Q&A-24(c).

   * Q&A-24(c) does not apply to any lump-sum payments made on a change of control that are severance payments.

   The memorandum concluded: "We bring this matter to your attention so that you may take whatever action, if any, you deem appropriate." Generally, taxpayers who undertake the expense of applying for a letter ruling are seeking guidance and assurance and place the IRS on notice as to the nature of their transaction. It is difficult to see why a taxpayer would withdraw a letter ruling request on notice of a proposed adverse opinion, then complete the transaction. This is what the memorandum seems to be telling the IRS district office. The IRS appears to be issuing a warning to the public about completing a similar transaction. Possibly, more formal guidance could not be published for internal reasons.

   Parachute Payment Valuation

   In Letter Ruling 200110025, (31) an executive was constructively terminated after a change in control and received a payment equal to his salary and bonus for the remainder of his employment agreement. The IRS held that this payment would not be valued under Prop. Regs. Sec. 1.280G-1, Q&A-24(c), which provides that a reduced amount is included in the parachute payment amount. The IRS also held that a reasonable payment established by clear and convincing evidence under a noncompete agreement is not a parachute payment.

   Executive was the president of Target Company (Target), wholly owned by Corporation A. Executive had an employment agreement (Agreement) with Target that provided a minimum annual salary and bonus; the Agreement was to run through a specified date. The Agreement provided that for the term of the Agreement and for 12 months following the end of Executive's employment with Target, Executive could not compete directly or indirectly with Target.

   Parent Company made an offer to acquire Corporation A. After the acquisition, Executive's job duties were to change and he would be required to move to a new location. Executive invoked a provision of his Agreement to treat the changes in employment as a termination. Under the Agreement, Executive received an amount equal to his current salary and bonus multiplied by the Agreement's remaining term. A ruling was requested as to whether the parachute payment made to Executive on the change in Target control could be reduced by Prop. Regs. Sec. 1.280G-1, Q&As-11 and -24(c).

   Law and analysis: Sec. 280G provides that a deduction is not allowed for an excess parachute payment. Q&A-11 provides that certain types of payments are deemed compensation for the performance of services and can be included as parachute payments. Under Q&A-11, the performance of services includes refraining from performing services (e.g., under a covenant-not-to-compete or a similar arrangement). If a taxpayer establishes by clear and convincing evidence that an amount attributable to a noncompete covenant is reasonable, the payment will not qualify as a parachute payment under Sec. 280G(b)(2)(A). The IRS held that a reasonable amount attributable to refraining from performing services under the noncompete covenant would not be a parachute payment under Sec. 280G(b)(2)(A).

   Q&A-22(c) provides that a payment that would have been made had no change in control occurred is treated as contingent on a change in control if the change accelerated the time at which payment was made. However, the payment might be significantly reduced under Q&A-24(c) if it was substantially certain at the time of the change that the payment would have been made without regard to it had the disqualified individual continued to perform services for the corporation for a specified period.

   Q&A-24(c) reduces the contingent portion of a nonvested payment partially earned by the taxpayer with services, but unpaid. The IRS stated that Q&A-42(b) correctly governs payments made under an employment agreement; it provides that amounts paid as damages for a breach of contract may be reasonable compensation for personal services to be rendered on or after the date of the change in control, if certain requirements are met. Further, Q&A-44 provides that severance payments are not treated as reasonable compensation for personal service actually rendered before (or to be rendered after) the change in control.

   In the ruling, the IRS held that the amounts paid under the Agreement substituted for the compensation Executive would have earned had he continued to perform services for the remainder of the contract term and did not qualify for the Q&A-24(c) reduction.

   This ruling evidences no change in the Service's position. The IRS has long held that the performance of services under Sec. 280G includes refraining from performing services. Also, a reasonable value (established by clear and convincing evidence) attributed to a noncompete covenant is not a parachute payment. The important issue is the ruling on Q&A-24(c). In the past, taxpayers have aggressively argued that payments similar to those in this ruling made under an employment agreement could be valued using Q&A-24(c). Letter Ruling 200110025 evidences the IRS's position on this issue.

   Rabbi Trust Guidance

   In Notice 2000-56, (32) the IRS updated the model grantor trust for nonqualified deferred-compensation arrangements for the new Sec. 1032 regulations. (33)

   Many employers establish nonqualifled deferred-compensation plans ("top hat" plans) for their top executives. While these plans are unfunded, unsecured liabilities of the employer, it is not unusual for an employer to set aside money in a grantor trust (a "rabbi trust") to help pay for the benefits as employees retire. The rabbi trust assets remain the employer's property for tax purposes and are available to the company's creditors in case of insolvency. In certain cases, a subsidiary establishes a rabbi trust for its own executives and includes parent stock as one of the trust assets.

   Regs. Sec. 1.83-6 provides that if a shareholder transfers company stock to company employees, the stock is treated as a capital contribution to the company; any payment back to the shareholder may be a dividend. However, new Regs. Sec. 1.1032-3 addresses the corporate treatment of transfers of parent stock to a subsidiary. Under the "cash purchase" model in Regs. Sec. 1.1032-3 (b) and (c), if parent shares are received by the subsidiary...