S
P O N S O R M E M O
G
R E A T E R M E T R O P O L I
T A N M U L T I P L E
E M P L O Y E R
W
E L F A R E B E N E F I T
P L A N
DATE:
July 19, 2001
FROM: Byron R. Prusky
SUBJECT:
PLR 200127047 – IRS rules that a trust is not a welfare benefit fund
The Ruling:
The IRS recently ruled that a welfare benefit plan was actually a
deferred compensation plan. The
ruling was released on September 3, 2000, and it was published in Tax Notes
Today on July 9, 2001.
The plan provided its participants tax-free post retirement benefits.
IRS ruled that the participating employers could not take current
deductions for contributions to the plan. Instead,
the employers had to defer the deductions until such time as the participants
included those amounts in gross income.
The ruling is important in that any welfare benefit plan, whether a VEBA
or a taxable plan, must measure itself against the facts in the ruling, in order
to distinguish itself from an abusive plan such as this one.
It is for this reason that we must objectively look at the ruling to be
in a position to evaluate the IRS viewpoint.
But more important than the IRS view is the state of the law, both the
statutory provisions under IRC §419A(f)(6) and §162, as well as the case law
developed in the courts in the recent past.
Facts:
The trust provided death benefits as well as severance benefits. Those benefits were provided to such employees who were specified in the
adoption agreement signed by the participating employers of the trust. The death benefits were provided to all of the participants, while
severance benefits were provided only to certain employees whose employers made
a separate election to provide severance benefits.
There were no facts indicating any pattern as to which employees received
severance benefits, whether owners, highly-compensated employees or rank and
file.
Under the trust, if a participant was terminated from employment, he had
the option to purchase the life insurance policy that was providing the death
benefit. Each employee was fully
vested in the severance benefit provided for him after 10 years of employment. Owners who had significant voting power of all classes of stock forfeited
their right to receive death benefits upon the attainment of the later of age 70½
or ten years of participation. There
were also benefits provided on account of employer withdrawal from the plan, as
well as on termination of the plan itself.
Each participating employer was appointed as the plan administrator, as
to its own portion of the trust. As
plan administrator, the participating employer was given all discretionary and
other authority to control and manage the operation and administration of the
trust. However, the trust required
each plan administrator to delegate certain duties and responsibilities to a
third party contract administrator. These
duties included (i) directing the trustee as to the crediting and distribution
of funds, (ii) making claims decisions, and (iii) maintaining accounting
records.
The assets of the trust were invested in several broad investment
categories:
1.
Individual life insurance contracts;
2.
Tax-exempt securities; and
3.
Cash
Each participating employer had a separate account, entitled “allocable
share”, which was generally equal to the amounts held under the individual
life insurance contracts covering that employer’s employees, plus the value of
any additional assets held in that employer’s share of the tax-exempt
securities and cash.
There were four special purpose accounts, which were funded from amounts
withheld at the discretion of the contract administrator.
These special accounts were entitled:
1.
Tax Reserve Account – used to pay various tax liabilities of the
trust;
2.
Professional Fee Reserve Account – used to retain professionals
on behalf of the trust.
3.
Reserve Account – used to pay benefits to participants, only to
the extent that such benefits have not been funded by the employer of that
participant; and
4.
Surplus Account – also used to pay benefits to participants, not
funded by the employer, and funded by the “experience gains” of those
employers who have achieved full funding of their benefit obligations.
Ruling
Requests:
The taxpayer requested three rulings from the IRS, as follows:
1.
The trust provided welfare benefits, and was not a plan of deferred
compensation;
2.
The trust was a single plan, rather than a collection of individual
plans; and
3.
The trust maintained no experience-rating arrangements.
The taxpayer asked the IRS to conclude, on the basis of the above 3
favorable findings sought, that the trust satisfied the requirements of §419A(f)(6),
and further that all contributions made to the trust by the participating
employers would be currently deductible as ordinary and necessary business
expenses.
Ruling
by IRS:
The IRS concluded that because of the virtual certainty that the benefits
will be provided in one form or another, the plan is a deferred compensation
plan and not a welfare benefit fund.
The plan was held to be not a single plan, because it maintains a
separate accounting of each employer’s “allocable share” of assets in
separate accounts. There was
therefore no mechanism whereby assets, liabilities or claims are pooled or
shared.
Further, the plan maintains an arrangement for experience rating for
individual employees.
Finally, one of the participating employers contributed more than 10% of
the total contributions, and therefore the requirements of §419A(f)(6) were not
met.
Discussion:
The IRS cited the requirements of §419A(f)(6), the exception to the
severe funding restrictions and limitations of §419 and §419A.
These requirements are a 10-or-more-employer plan, in which no employer
normally contributes more than 10% of the total contributions, and which does
not have experience-rating arrangements for individual employers. IRS ruled that this plan did not meet those requirements, other than
having more than 10 employers.
The death benefits were found to constitute deferred compensation,
because of the virtual certainty that the benefits would be provided to
participants in one form or another. This
is because the benefits would be paid not only upon death, but also if an
employer withdrew from the trust or if the trust itself terminated.
The employers who elected to provide death benefits only made
contributions to the trust which were substantially in excess of that needed for
current insurance protection. Further,
these excess amounts were available to participants as termination
distributions.
The owners of a participating employer could cause that employer to
withdraw from the trust at will, in which case termination distributions would
be made to its employees. Therefore,
there was no realistic risk that the excess contributions would be forfeited.
The severance benefits were also deemed to constitute deferred
compensation. This is because the
severance benefits were not insurance against a contingent event which may or
may not happen, but rather were an expected source of income. The marketing materials distributed by the trust’s sponsors were
particularly damaging, since they gave specific examples of how the severance
benefits would still be payable, no matter what the circumstances.
As to the issue of a single plan, IRS found that the adoption agreement
signed by each employer was similar to adoption agreements used under master
plans, and there was no system under which the trust’s assets were pooled,
shared or distributed among the various participating employers.
Based upon this finding, the IRS found that the trust was merely a
collection of separate plans with a common administrator, rather than being a
single plan.
The experience rating prohibition was not met by the trust. Since the trust adjusted benefits to reflect the amounts credited to each
employer’s account, then the IRS determined that an experience-rating
arrangement existed.
Since one of the participating employers contributed more than 10% of the
total contributions contributed by all employers, the trust failed to satisfy
the principal statutory requirement of §419A(f)(6).
Analysis:
The facts in this case were enough to convince IRS that the plan here was
so abusive as to run afoul of its warning in IRS Notice 95-34, as well as
the existing case law in the Tax Court cases of Booth (1997) and Neonatology
Associates, P.A. (2000).
The overall finding of the trust being a plan of deferred compensation
was based upon the “virtual certainty that the benefits will be provided in
one form or another.” There was
no risk that the benefits would be lost by an employee terminating, because of
the vesting provisions. Therefore,
IRS held that the plan was similar to the Wellons case, where the 7th
Circuit found that a severance pay benefit plan was actually deferred
compensation, because it was payable upon termination for any reason except
dishonesty or fraud or leave of absence or part-time status.
Obviously, where there is no risk of forfeiture by terminating
employment, a finding of deferred compensation is in order.
However, where a plan provides that there is no vesting of benefits, and
that a terminated employee will not be entitled to anything upon leaving, the
same finding of deferred compensation status could not be made.
In the ruling, it was stated in the trust’s marketing materials that
one of the benefits provided by the trust is a “post retirement income stream
from your paid up life insurance policy – tax-free.”
This statement came from the brochure entitled “Increase
Benefits/Reduce Taxes.” These
marketing materials proved to be a significant part of the downfall of this
trust, because the statements in them flaunted the issue of deferred
compensation, allowing the IRS to easily seize upon this clear statement of
intent on the part of the trust, and therefore imputed to the employers.
In order to avoid the flawed result of this ruling, it is important that
the marketing materials clearly indicate that this is neither a plan of deferred
compensation nor a retirement plan. It
is also advisable for a disclosure form to be signed by each participating
employer, in which the employer recognizes that the plan is not deferred
compensation nor a retirement plan, and specifically acknowledges this intent. Additionally, it is probably a good idea for each
participating employer to have an existing retirement plan in place, or if none
is in place at the time of adoption of the welfare benefit plan, to adopt a
profit-sharing plan. This feature
would negate a finding that the welfare benefit plan is in fact a substitute for
a retirement plan.
As far as the IRS’s conclusion that the participating employers
generally possess the ability to cause the employer to withdraw from the trust
at will, the Tax Court has previously put that issue to rest in two cases, Moser
and Schneider. (See July 1,
2001 Tax Opinion letter, pages 21-23).
The issue of severance benefits being an expected source of income is one
that was properly handled in the ruling. We
have specifically avoided any severance benefits in our plan, and we have
previously explained the many reasons why severance benefits do not belong in a
properly-designed welfare benefit plan. Some of those reasons are cited in the ruling.
There are many others, and therefore we believe that any plan that has
severance benefits is initially suspect, and does not stand any reasonable
chance of success with the IRS.
The issue of the trust being an aggregation of individual plans, rather
than a single plan, is one that was handled poorly by the trust sponsor in this
ruling request. The teachings of
the Booth case were totally ignored, which is surprising in that the
ruling request was dated December 30, 1997, some six months after the
unfavorable June, 1997 ruling by the Tax Court in Booth. It is obvious that the plan here had no substantive method whereby assets
or liabilities are pooled, shared or distributed among the plans of the various
individual employers. It is because
of this feature that the IRS ruled that the trust is an aggregation of separate
plans with a common administrator, and not a single plan.
The treatment of the Reserve Accounts and Surplus Account showed a
singular lack of knowledge or caring on the part of the trust sponsor, since the
separate accounting was carried through to these special accounts, and the
amount of assets in all of those accounts was relatively insignificant. IRS held that these funds were not material enough nor separate enough to
have made any difference.
A properly designed trust should not in any way limit the assets of the
trust to any particular employer, or to the employees of any specific employer.
Rather, the plan and trust should provide that all assets are available
to pay the claims of all creditors and beneficiaries. This is so, notwithstanding the source of the funds coming
from an employee’s employer or from other employers or from all employers in
the trust.
The experience-rating issue was decided by IRS on the basis of the trust
failing to observe the teachings of the Booth case in the Tax Court.
Limiting the severance benefits as described in the ruling proved to be
fatal, since those provisions called into question the integrity of the whole of
the plan assets being available to the employees of all participating employers. The experience gains attributable to an employer remain within that
employer's allocable share of the trust's assets.
With respect to death benefits, the trust was also poorly designed. Death benefits were made from insurance policies, and any deficiency was
made up by payments from the side fund assets allocable to the employees group,
and placed a lien on the policy equal to the payments made from the side fund.
IRS found it easy to classify this as an arrangement which met the
definition of experience-rating.
Investment earnings were allocated to the employer's allocable share of
trust assets. Therefore, the termination distributions functioned as
experience refunds, which were viewed by IRS as an arrangement for
experience-rating.
Finally, the facts of the ruling indicated that one employer contributed
more than 10% of the total contributions into the plan.
This fact nailed down the obvious violation of §419A(f)(6).
Conclusion:
This is a ruling that should not have happened. The facts were so egregious that the taxpayer had no chance to secure a
favorable ruling on any of the issues brought before the IRS. The drafters of the plan paid no attention to the l997 landmark Booth
case, the first case to be decided in the welfare benefit area under §419A(f)(6)
since its passage in DEFRA in 1984.
For the reasons set forth in the Analysis above, if the suggestions made
are carried out, then responsible sponsors of welfare benefit plans should be
able to design their plans to properly navigate the landmines of this ruling. Thus, they can observe the spirit of the law, by having a
trust where all assets are available to all employees of all employers.
Plans should be of the death-benefit-only type, and severance benefits
should not be part of a plan. Reserve
accounts should not be maintained. Allocable
share accounts should not be utilized. There
should be no side funds. Employers
should be required as a condition of participation to sign disclosure forms in
which they acknowledge that the plan is not a retirement plan and not a plan of
deferred compensation. There should
be a significant risk of forfeiture of benefits upon termination of employment. Finally, the plan should not discriminate in favor of the
highly-compensated owner group, even if nondiscriminatory treatment is not
called for under the law. All
issues of experience-rating should be resolved in favor of eliminating those
issues which could possibly call into question any intent to experience rate the
plan.
If a welfare benefit plan and trust is designed to eliminate the
egregious behavior demonstrated by the taxpayer this ruling request, then it
would seem to permit a non-abusive plan to pass the tests set forth in this
ruling request.
Sincerely yours,
PRUSKY LAW ASSOCIATES, P.C.
By:________________________
Byron R. Prusky
BRP:b
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