Monthly Archives: April 2013
Monday, April 29, 2013

On Tuesday, the PPACA triumvirate of DOL, Treasury/IRS and HHS issued a new set of FAQs (number 14, for those still counting) covering changes to the Summary of Benefits and Coverage.  The only changes (as emphasized in multiple places in the FAQs) are to add two disclosures:

– Whether the plan provides “minimum essential coverage” (or MEC)

– Whether the plan meets, or does not meet, the “minimum value” requirements.

MEC, simply put, is an employer-sponsored plan that complies with health care reform (whether or not its grandfathered).  Minimum value (which is also relevant for play or pay purposes) generally means that the plan’s share of the total allowed costs of benefits provided under the plan or coverage is not less than 60 percent of such costs.

The agencies released templates in both Word and PDF showing how this is done (as well as blank revised SBCs in Word and PDF).

The good news is that the agencies did not add additional coverage examples or otherwise modify the SBC format, even though they had previously said that they would.

The agencies also extended much of the transition relief provided in prior guidance (see Q5).  However, there is some question as to whether the transition relief afforded under Q10 of Number IX Set of FAQs, was extended.  That FAQ provides, in relevant part, that for the first year only, a group health plan utilizing two or more insured products under a single health plan (as where the plan separately insures medical and prescription drugs) may issue separate partial SBCs for the different insured pieces of the plan.  Additional clarification from the agencies would be helpful; however, we think the better interpretation is that this relief from the prior FAQ is extended.

The minimal SBC changes are welcome news for plan sponsors in dealing with this additional disclosure obligation.  Plan sponsors should be sure to update their SBC templates for the new disclosures mentioned in the FAQs.

Friday, April 19, 2013

Update: The post below has been updated.  After discussing this post with an alert reader, we have concluded that the correct reading of the regulations is reflected in Q8-10 below.  The good news is: we don’t think there is a hole in the play or pay regulations!  However, this reading of the rules results in John Boy (in our example) not getting coverage for more than two full years!  Please see below.

In a prior post we discussed the general rules for hours counting and what it means to be full time under the play or pay/shared responsibility rules under ACA (a.k.a. health care reform).  In this post, we address the special rules for new hires/new employees and how those rules overlap with the rules for ongoing employees.  As before, we retain our Q&A format.

Q1: Who is considered a new employee?

Someone who has not been employed for at least one standard measurement period (SMP) is a new employee.  (See our prior post for more detail on SMPs).

Q2: Do I have to count hours for all my new employees?

You don’t have to count hours for anyone if you just offer coverage to all your employees.  However, assuming you don’t want to do that, then to the extent you choose to count hours, you can only count hours for new employees who are either (1) seasonal employees or (2) variable hour employees.

Q3: Who is a seasonal employee?

Right now, we don’t know.  The definition is “reserved.”  The IRS has said any reasonable, good faith interpretation may be used.  However, it is not reasonable to treat an employee of an educational organization (e.g. teachers/professors) as “seasonal” even though they may not work a full 12-month year.  (Note that “seasonal employee” is different than “seasonal worker,” which is the term that applies for determining if an employer is subject to the play or pay/shared responsibility tax.)

Q4: Who is a variable hour employee?


Not this kind of imp.

A variable hour employee is someone who, as of his/her start date, you cannot tell whether that employee is reasonably expected to work an average of at least 30 hours per week during the initial measurement period (IMP).  This is a “facts and circumstances” determination, which basically means you have to take all relevant information into account and the IRS is unlikely to provide much, if any, guidance on what facts and circumstances are relevant.  However, the IRS has said that, beginning in 2015, you cannot take into account the likelihood that the employee may terminate employment before the end of the IMP, so at least you know that.

Q5: How long can an IMP be?

It can be between 3 and 12 months, as selected by the employer.

Q6: When does an IMP start?

It can start any time between date of hire and the first of the month following date of hire.  You could even pick two days in a month.  For example, you could say that the IMP for all employees hired on the first through 15th will be the 15th and the IMP for all employees hired after that will begin on the last day of the month.

Q7: What if I determine that my new seasonal or variable hour employee worked more than 30 hours/week or 130 hours/month during the IMP?

Then you have to treat her as full time (i.e. offer coverage for her and her non-spouse dependents) during the following stability period.  The stability period has to be at least six months long and cannot be shorter than your IMP.  However, there are special rules for when the person moves from being a “new” employee to an “ongoing” employee” discussed below.

Q8: And if I determine that he didn’t?

Then you can treat him as not full-time/not have to offer him coverage during the stability period.  In this case, the stability period is subject to a few rules:

(1)  it cannot be more than 1 month longer than the IMP

(2)  it cannot exceed the remainder of the SMP (plus any administrative period) in which the IMP ends.

So for example, say you have an SMP of October 15 to October 14 and an administrative period that runs through December 31.  Say you’ve also chosen an 12-month IMP and a 12-month stability period following the IMP.  John Boy is hired on October 31, 2013 and he’s a variable hour employee.  You measure JB’s hours from October 31, 2013 to October 30, 2014 and determine that he was not full-time.   Under rule (2) immediately above, John Boy’s stability period cannot exceed the remainder of the SMP (plus any administrative period) in which the IMP ends.  Shall we read this to mean that the period in which the IMP ends includes the associated administrative period, or that it does not?   October 30, 2014 falls in the administrative period following the 2013-2014 SMP, but it also falls within the 2014-2015 SMP that begins on October 15, 2014.  While the regulations are a bit unclear, we think the better reading is that the period in which the IMP ends does not include the associated administrative period, and therefore, that John Boy’s initial stability period does not end December 31, 2014, but can last the full 12 months.

Q9: Do I get any kind of administrative period for new employees?

Yes, it can also be up to 90 days, but there are a couple of catches.  First, you do not have to start your IMP on a date of hire (as noted above).  But if you pick a later date (like first of the month following date of hire), any days between date of hire and that later date count against the 90-day period.

Perhaps more important, however, is that the combination of your IMP and the administrative period for new employees cannot extend beyond the last day of the first calendar month beginning on or after the first anniversary of date of hire.  So in the example above with John Boy, the combined IMP and administrative period could not extend beyond November 30, 2014.  This creates an incentive to hire employees early in the month but after the first of the month to provide as much time as possible for the administrative period.  This is particularly true for employers who choose a date other than date of hire to start the IMP.

Q10: You mentioned some rules about new hires transitioning to ongoing employees.  Can you talk about that some more?

Basically, once an employee has been employed for one full SMP, he or she is an ongoing employee.  This means there could be significant overlap between the SMP and IMP and their respective stability periods.  There are essentially 4 scenarios:

(1)  Employee determined to be full-time during IMP and SMP – This is an easy one.  The employee must be offered coverage for the stability period following the IMP and the stability period following the SMP.  Going back to the John Boy example, assuming you took the maximum administrative period (through November 30), he would have to be offered coverage for the month of December 2014 and all of 2015.

(2)  Employee determined to be full-time during the IMP, but not during the SMP – This employee has to be offered coverage for the entire stability period following the IMP.  In the John Boy example, he would be offered coverage through November 30, 2015.

(3) Employee not full-time during IMP, but is full time during SMP – The employee does not have to be offered coverage until the stability period following the SMP.  In the John Boy example, the initial stability period would go through November 30, 2015.  At that point, JB has been through an SMP (October 15, 2014 – October 14, 2015), but his coverage (if elected) does not need to begin until January 1, 2016.  Note that under our facts, John Boy is not offered coverage for more than two years from his date of hire (October 31, 2013)!

(4)  Employee not full-time during either measurement period – This result is the one you think it is – no coverage during either period.

Q11: Can I have different IMPs and IMP stability periods, like I do for SMPs, for different categories of employees?

Yes, and they’re the same categories as we detailed in the prior post.

Q12: What if I determined that John Boy was full-time during the IMP and during the stability period he tells me he wants to go back to the prairie and only work part-time (because of the long commute)?

The same rules as we described in the prior post apply: he still must be considered full-time and eligible for coverage during the stability period.

Q13: Does the same rule apply if he is not full-time, but then I promote him to a full-time position during the IMP?

Here it’s a bit different.  Under these rules, you have to treat John Boy as a full-time as of the earlier of:

(1)  the first day of the fourth month following his promotion; or

(2)  The first day of the first month after the end of the IMP and any administrative period.

However, other health reform rules currently require you to offer coverage within 90 days of when someone becomes full-time, which will likely be less than the first day of the fourth month following the promotion.  Failure to comply with the 90-day rule could result in other penalties being assessed on the employer. It’s not yet clear how these rules interact, so the safest bet is to make the offer no later than 90 days following the promotion or the period described in (2), at least until the IRS clears up this confusion.

Q14: What if John Boy quits and then I rehire him?  How do I count hours?  What about leaves of absence?  I still have so many questions left unanswered!

This is already getting kind of long, so we’ll address those in a future post.

Related Links

Proposed Regulations under Code Section 4980H on Employer Shared Responsibility/Play or Pay Penalties

Technical Corrections to Proposed Regulations

IRS Q&A on Employer Shared Responsibility Penalties

Other Health Care Reform Posts

Disclaimer/IRS Circular 230 Notice


Tuesday, April 16, 2013

Yesterday, the Supreme Court granted a plan participant’s petition for a writ of certiorari in Heimeshoff v. Hartford Life & Acc. Ins. Co., No. 12-729, 2013 WL 1500233 (Apr. 15, 2013). The Court limited its review to a single question raised by the petitioner: “When should a statute of limitations accrue for judicial review of an ERISA disability adverse benefit determination?” The Supreme Court declined review of two other questions raised by the petition regarding the adequacy of notice provided to the participant: (1) “What notice regarding time limits for judicial review of an adverse benefit determination should an ERISA plan or its fiduciary give the claimant with a disability claim?”; and (2) “When an ERISA plan or its fiduciary fails to give proper notice of the time limits for filing a judicial action to review denial of disability benefits, what is the remedy?”

The Second Circuit in Heimeshoff had affirmed the district court’s judgment, holding that Connecticut law permitted the plan to shorten the applicable state limitations period (to a period not less than one year) and that the plan’s three-year limitations period could begin to run before the participant’s claim accrued, as prescribed by plan terms. Heimeshoff v. Hartford Life & Acc. Ins. Co., 496 Fed. Appx. 129, 130 (2d Cir. 2012). In this case, the plan provided that the limitations period ran from the time that proof of loss was due under the plan. Id.

In January, Bryan Cave issued a client alert detailing the Second Circuit opinion in Heimeshoff.


Monday, April 15, 2013

Health insurance exchanges will offer government-regulated and standardized healthcare plans from which individuals may purchase health insurance eligible for federal subsidies.  These exchanges must be ready to begin enrollment by October 1, 2013.

Every state, plus the District of Columbia, must have an exchange.  States may choose to operate the exchange itself, operate it in partnership with the federal government or allow the federal Department of Health and Human Services (HHS) to operate the exchange.

Currently, it appears that 25 will have federal-run exchanges, 18 will have state-run exchanges, and 8 will have jointly-run (state/HHS) exchanges.  The following identifies the respective state choices.


State-run exchange
Calif. Hawaii Md. N.M. Texas
Colo. Idaho Mass. N.Y. Vt.
Conn. Ky. Minn. Ore. Wash.
D.C. Nev. R.I.


Federal exchange
Ala. Ind. Mo. N.D. S.D.
Alaska Kan. Mont. Okla. Tenn.
Ariz. La. Neb. Ohio Va.
Fla. Maine N.J. Pa. Wis.
Ga. Miss. N.C. S.C. Wyo.


Planned partnership exchange
Ark. Ill. Mich. Utah
Del. Iowa N.H. W.Va.


Friday, April 12, 2013

The administration views certain savings for retirement to be a tax loophole.  The just released budget, in its Overview, states:  “[The budget] ends a loophole that lets wealthy individuals circumvent contribution limits and accumulate millions in tax-preferred retirement accounts.”  [There is no acknowledgement that these dollars are subject to ordinary income tax when withdrawn nor is there an explanation of how these wealthy folks get around contribution limits which apply regardless of income.]  In the section of the budget that is titled Providing Middle Class Tax Cuts and Rebalancing the Tax Code through Tax Reform, there is a description of the President’s attack on retirement savings that states:

Prohibit Individuals from Accumulating Over $3 Million in Tax-Preferred Retirement Accounts. Individual Retirement 87767941Accounts and other tax-preferred savings vehicles are intended to help middle class families save for retirement. But under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The Budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013. This proposal would raise $9 billion over 10 years.

In a budget that claims to simplify the tax code, this provision, if it becomes law, is fraught with complexity and will result in reams of new regulations.  Some of the issues that would require regulation might include:

  1. In measuring an “individual’s total balance across tax-preferred accounts” are defined benefits ignored?  Nope, not according to the “Greenbook.”  (As opposed to one of these “green books“.)
  2. Since annuities are interest-rate sensitive, account balances falling under the “about $3 million” threshold would increase as interest rates rise – assuming they ever do.  How would those adjustments apply and when?
  3. What are the variables that determine an annuity of $205,000 per year?  The “Greenbook” states it’s a joint and 100% survivor annuity commencing at age 62.
  4. Does the limit apply at any time or only when someone reaches some undisclosed retirement age?  The “Greenbook” states that the determination will be made annually and by taking each account balance and converting it into an actuarial equivalent annuity (presumably for all participants).  No administrative cost there!
  5. And what happens if you go over the limit?   The “Greenbook” suggests that there will be a cessation of contributions and accruals, but earnings can continue.  However, that point underscores just how ineffective this cap is likely to be at limiting retirement savings (which is a poor goal to begin with).  In many cases, large retirement account accumulations (particularly in IRAs) are not the result of excessive contributions, but of investment of assets.  Generally speaking, at the point at which someone’s account reaches $3 million dollars, the investment return has the potential to be significantly more valuable in growing the account than additional contributions.
  6. Of course, if the limitation increased, contributions and accruals could start again.  Certainly every employer looks forward to addressing these additional administrative headaches.  And, it would seem that every American participating in both a 401(a) plan and an IRA will have to employ her own actuary.
  7. Do Roth earnings count toward the limit or is it just traditional pre-tax dollars and their earnings that count?
  8. Will the limit be indexed on some basis?

Surely there are many more issues that will need attention before this type of limitation might be implemented.  The cost of implementation by government and the private sector may even challenge the $9 billion in proposed federal savings!

An unintended consequence of such a limit may be that business owners whose own accounts could reach the limit, or who don’t want the added administrative cost, either terminate their company plans or eliminate employer contributions to those that continue in operation.  That would be detrimental to the middle class that the administration believes it is protecting.  If the idea is to put a limit on the tax-favored savings of the so-called “wealthy” [actually many may just be smart savers and investors], it is fraught with the potential to backfire and harm the middle class.  On the other hand, this may all be smoke and mirrors.  EBRI followed up the release of the budget by demonstrating that about 1% of all account holders would be affected in today’s interest environment.  However, EBRI points out that the threshold would decrease dramatically, cover many more accounts and have the most significant impact on the younger generations as time goes by.  But if so few are impacted, why would any employer want the additional headache?  And will the DOL let the plan pay for this – probably not – after all, it only affects the wealthy, right?

Best of all, this is intended to go into effect for taxable years beginning January 1, 2014 – if it becomes law.

Related Links
Thursday, April 11, 2013
 The Eighth Circuit’s recent decision in Dakota, Minn. & E. R.R. Corp. v. Schieffer (Schieffer II), No. 12-1807, 2013 WL 1235235 (8th Cir. Mar. 28, 2013), offers new insight into the circumstances under which severance benefits provided under an executive’s employment contract are governed by ERISA.  The opinion clarifies that ERISA does not govern contractual obligations in an executive employment contract that are not provided under an ERISA plan and, even where amount of payments are made by reference to the terms of an ERISA plan, the arrangement does not “relate to” an ERISA plan.
Schieffer concerned a dispute over severance benefits after the employer (“DM&E”) terminated its CEO in anticipation of a merger.  Under the employment agreement, DM&E had agreed to continue providing Schieffer benefits for three years following his severance payment.  These benefits, as described in the employment agreement, included “‘all employee health, welfare and retirement benefits plans and programs made available generally to senior executives,’ and, if Schieffer became ineligible to participate, ‘whether by law or the terms thereof,’” DM&E “would make ‘a cash payment equal to’ what it would have contributed if he participated” in the plan.  Id. at *3.
Schieffer filed a demand for arbitration, seeking among other things double-damages under a state wage statute that would be preempted if ERISA applied. DM&E responded by filing a declaratory judgment action in federal court to enjoin the arbitration.  The arbitration demand had alleged that DM&E had breached obligations under the employment agreement by (1) terminating health insurance coverage prematurely; (2) failing to pay life and disability insurance coverage for the full contractual period; (3) miscalculating retirement benefits; and (4) failing to pay “vacation accruals and banked vacation cash compensation payable to terminated employees under the employment benefit programs.”  Id. at *2.  Because neither the Declaratory Judgment Act nor the Federal Arbitration Act (which Schieffer might have used to compel arbitration) is jurisdictional, the federal court could not hear the case unless the dispute arose under ERISA.  Thus, DM&E contended that the demand sought benefits covered by the company’s ERISA plan.  Note that neither the Eighth Circuit nor this blog entry addresses the potential tax issues associated with this type of arrangement (e.g., under Code Section 409A and/or 105(h)).  Be on the lookout for a blog entry highlighting the tax consequences associated with the continuation of executive health and welfare benefits post-separation from service.
In Schieffer I, the Eighth Circuit court held that an individual employment agreement providing severance benefits to a single executive is not an ERISA welfare benefit plan within the meaning of the statute and, therefore, that Schieffer’s benefits were not provided under an ERISA plan.  Dakota, Minn. & E. R.R. v. Schieffer (Schieffer I), 648 F.3d 935, 938 (8th Cir. 2011).  The analysis, however, did not end there because, as the Eighth Circuit noted, ERISA preemption extends to all state laws that “relate to” an employee benefit plan.  See 29 U.S.C. § 1144(a).  Schieffer’s employment agreement provided that DM&E would “continue to provide [him] the Employee Benefits described in section 3(c) of this Agreement for a period of not less than three years from the date on which the Severance Payment is paid in full . . . .”  Schieffer II, 2013 WL 1235235, at *3.  The cross-referenced section 3(c) provided that Schieffer and his dependents would participate in “all employee health, welfare, and retirement benefit plans and programs made available generally to senior executives” and, if he became ineligible to participate, then DM&E would make “a cash payment equal to” what it would have contributed if he participated.  According to the Eighth Circuit, if Schieffer’s arbitration demands were demands for payment under an ERISA benefit plan, then to that extent all state law remedies are preempted and the district court would have subject matter jurisdiction.  Id. at *2.  On the other hand, if Schieffer’s demands were pursuant to “a free-standing single-employee contract that simply pegged DM&E’s payment obligations to amounts that would have been due under ERISA plans, there [was] no preemption” of state law remedies asserted in the demand for arbitration.”  Id. (quoting Schieffer I, 648 F.3d at 938)) (emphasis added).  The Eighth Circuit remanded to the district court for a determination of this issue.
On remand, the district court determined that the provisions merely “pegged” the former CEO’s benefits to amounts due under the actual ERISA plan without providing coverage under the plan itself.  Id. at *1.  This decision set the stage for DM&E’s appeal and Schieffer II.  In Schieffer II, the Eighth Circuit identified two circumstances under which the employment agreement might create benefits due under an ERISA plan.  First, the agreement could be an “amendment” to an ERISA plan.  Id. at *3.  Second, the agreement might be a “promise that ERISA plan benefits will be paid if a future contingency occur[red].”  Id. (quoting Johnson v. U.S. Bancorp., 387 F.3d 939, 942 (8th Cir. 2004)).
The Eighth Circuit found that neither of these exceptions applied.  To begin, there was no evidence that the agreement amended an ERISA plan, and in fact, the agreement concerned post-termination payments that could only occur when Schieffer was no longer a participant in the company’s plans.  Next, this was a “free-standing agreement” and not a promise to pay benefits upon a future contingency.  Although the benefits were measured by the ERISA plans, two considerations prevented the necessary link to the ERISA plans themselves.  First, DM&E had not indicated that the funds came from anywhere other than its general assets (i.e., they had not alleged that the benefits were funded by an ERISA plan).  Id.  Second, DM&E had not alleged that the payment would affect the administration of its ERISA plans or “threaten ERISA’s goal of uniformity in the administration of plan benefits.”  Id.  Accordingly, the Eighth Circuit concluded that Schieffer’s arbitration demand did not seek benefits “due under” an ERISA plan, and the federal court lacked subject matter jurisdiction over the dispute.  Id.  As a corollary, ERISA could not preempt Schieffer’s state law claims, including his request for double damages.
Following the Eighth Circuit’s decision in Schieffer II, consider the following:

1. Cash payments calculated by reference to benefits provided under an ERISA plan do not “relate to” an ERISA plan for purposes of determining ERISA preemption issues.

2. Attempts to bring executive severance payments and benefits within the scope of ERISA raise a variety of tax and benefits issues that require careful consideration.

Wednesday, April 10, 2013

As noted in our blog entry on October 16, 2012, under the Sixth Circuit’s discussion in U.S. v. Quality Stores, severance payments made because of an employee’s involuntary separation resulting from a reduction-in-force or discontinuance of a plant or operation are not subject to FICA taxes.  This holding is contrary to a prior decision of the Federal Circuit Court of Appeals and published IRS guidance.  The government has until May 3 to appeal the case to the Supreme Court.  Until a final decision in this case has been rendered, taxpayers that have made severance payments in 2009 should file a protective claim for a FICA tax refund no later than April 15, 2013.  This protective claim will preserve the taxpayer’s right to a refund should the IRS not appeal the decision or should the decision be upheld on appeal.


Wednesday, April 10, 2013

Last month the SEC issued a no-action letter to a financial services firm that sheds light on the scope of the prohibition under Section 402 of the Sarbanes-Oxley Act of 2002 which makes it unlawful for an issuer to “extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or any executive officer . . . of that issuer.” 

Historically, the SEC appears to have been reluctant to issue formal guidance respecting the parameters of the loan prohibition under Section 402.  Common arrangements left in limbo by this lack of regulatory guidance extend to personal use of company credit cards, personal use of company cars, travel-related advances, and broker-assisted option exercises. 

The SEC’s no-action letter was issued to RingsEnd Partners, a financial services firm.  The letter addresses a program established to facilitate the payment of taxes associated with the grant of restricted stock awards.  Under this program, recipients of restricted stock awards make a qualifying election to be taxed on those shares at the time of grant (a so-called 83(b) election) and then transfer those shares to a trust administered by an independent trustee who is directed to borrow funds from an independent bank through non-recourse loans sufficient in amount to pay the tax liability incurred as a result of the stock awards.  Through this mechanism, recipients of these awards can retain ownership of all shares granted to them rather than sacrificing a number of those shares necessary to pay applicable tax obligations.  To facilitate utilization of the program, however, an employer is involved in a variety of administrative actions necessary to maintain the program, including delivering the share awards to the trust, providing information to the lending institution and delivering prospectuses and registration statements covering the shares to the trustee.  All administrative costs associated with administering the trust are borne by those recipients electing to participate in the trust. 

The SEC concluded that employers whose employees where involved in this program would not by their administrative activities be deemed to be in violation of the prohibitions of Section 402.  The conclusions reached by the SEC in this case would appear to be very instructive in reaching conclusions about the permissibility of other more common practices that would appear to involve arrangements that are no more administratively intensive, such as broker-assisted option exercises.

Wednesday, April 3, 2013

Section 162(a) of the Internal Revenue Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the year in carrying on a trade or business, including “reasonable compensation for personal services actually rendered.”

The reasonableness of compensation is a question of fact.  A taxpayer is entitled to a deduction for salaries or other compensation if the payments were reasonable in amount and are in fact payments purely for services.

Sometimes it is difficult to determine whether amounts are “reasonable,” especially when payments are made to a shareholder-employee or the shareholder’s relatives.

A ruling by the U.S. Tax Court on March 25, 2013, provides a helpful analysis of 10 factors considered by the Court in deciding that amounts deducted as compensation paid to a sole shareholder-employee, his officer-wife, employee-brother and employee-daughter were not reasonable.  (K & K Veterinary Supply, Inc. v. Commissioner, T.C. No. 9442-11, T.C. Memo 2013-84, 3/25/2013).

Compensation Reasonableness Factors

The following is a brief summary of the 10 factors discussed by the Court:

  1. Employee Qualifications.  An employee’s superior qualifications for his or her position with the business may justify high compensation.
  2. Nature, Extent and Scope of Employee’s Work.  An employee’s position, duties performed, hours worked, and general importance to the company’s success may justify high compensation.
  3. Size and Complexity of the Business.  The size and complexity of a taxpayer’s business may warrant high compensation.  This assessment may include consideration of a company’s sales, net income, gross receipts, or capital value, as well as the number of clients, and the number of employees of the company; growth in these areas; and compliance with government regulations.
  4. General Economic Conditions.  General economic conditions may affect a company’s performance.  This factor may be relevant, for example, in connection with adverse economic conditions where the taxpayer may show that an employee’s skill was important to the growth of the company during lean years.
  5. Comparison of Salaries Paid With Gross and Net Income.  Compensation as a percentage of a taxpayer’s gross or net income may be important in deciding whether compensation is reasonable.
  6. Prevailing Rates of Compensation.  The Court considered prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry as “a most significant” factor.  Both the taxpayer and the Commissioner relied on expert reports and testimony to support this factor.
  7. Salary Policy of the Taxpayer as to All Employees.  The amount of compensation paid to all employees may be a factor that supports a high level of compensation.  Whether the company pays top dollar to all of its employees, including both shareholders and non-shareholder employees may be relevant in assessing the pay of shareholder-employees.  Evidence of a reasonable, longstanding, consistently applied all-employee compensation plan may support that the compensation paid was reasonable.
  8. Compensation Paid in Previous Years. The amount of compensation paid in previous years may support a high amount of compensation for a tax year.  This factor will likely only be relevant where the company is deducting compensation in one year for services rendered in prior years.
  9. Comparison of Salaries With Distributions and Retained Earnings.  The reasonableness of compensation may take into account the absence of dividend payments by a profitable corporation.  Because a corporation is not required to pay a dividend, the company’s return on equity may be a better measure of this factor.
  10. Debt Guaranty.  The Court also considered whether an employee personally guaranteed the taxpayer employer’s debt.

The Court considered these various factors and noted that some factors favored the taxpayer, other factors favored the Commissioner, and other factors were either neutral or did not apply.

Expert Reports and Testimony

After giving “due weight” to each of the factors, the Court found the report of the Commissioner’s expert on prevailing rates of compensation, supported by individual company information and financial data, as “persuasive.”  In contrast, the report of taxpayer’s expert provided “guidance of dubious value” because it failed to identify comparable companies by industry or size and the expert did not provide any financial analysis or relevant financial data.

Unreasonable Rent and No Equitable Recoupment

In addition to finding that amounts paid as compensation to the officers (shareholder-employee and his officer-wife) and certain employees (the shareholder’s brother and daughter) were not reasonable, the Court ruled on two related issues.  The Court disallowed a deduction for certain amounts paid by K & K Veterinary Supply, Inc. as rental expenses to a related entity (an entity owned 100% by the shareholder-employee and his officer-wife).  The taxpayer then unsuccessfully argued that the disallowed portions of the compensation and rent were dividends taxable at a lower rate – using the doctrine of equitable recoupment.


Monday, April 1, 2013

Last week, the Internal Revenue Service (“IRS”) issued Rev. Proc. 2013-22 describing the procedures for submitting an application for an opinion or advisory letter on a prototype or volume submitter 403(b) plan. This news is relevant for employers sponsoring 403(b) plans. Why? Read on.

The IRS issued regulations in 2007 requiring sponsors of 403(b) plans to have a written plan document in place by January 1, 2009, that complied both in form and operation with the requirements of the regulations. In Rev. Proc. 2007-71, the IRS provided model language that school districts (and other employers, with some modifications) could utilize to draft the required written document. In 2009, the IRS requested comments on a draft revenue procedure that was intended to provide an opinion letter program for 403(b) prototype plans. Despite suggestions by the IRS that it was just a matter of months, no program for either the issuance of opinion and advisory letters for prototype 403(b) plans or a favorable determination letter for individually designed 403(b) plans was forthcoming.

Now, under Rev. Proc. 2013-22, sponsors of both pre-approved and individually designed 403(b) plans can amend their plans (including any investment arrangements and any other documents incorporated by reference into the plan) retroactively to the first day of the plan’s remedial amendment period (i.e., the later of January 1, 2010 or the plan’s effective date) to satisfy the requirements under Code Section 403(b) and the 2007 regulations and to correct any defects in the form of its written plan.   This requirement is automatically satisfied (except to the extent any documents incorporated by reference into the plan must be amended) if sponsors retroactively adopt a pre-approved plan by the last day of the plan’s remedial amendment period.

Now comes the tricky part. The IRS has yet to announce the date that will be the last day of this first remedial amendment period for 403(b) plans. According to the revenue procedure, the date will be published in conjunction with the IRS’s issuance of opinion and advisory letters and is expected to provide in excess of one year during which sponsors can adopt a pre-approved 403(b) plan.  Sponsors who wish to maintain individually designed plans have more waiting to do.  IRS plans to establish an individual determination letter program for 403(b) plans appear to be on hold.

For parties interested in marketing a prototype or volume submitter 403 plan, the IRS will start accepting those applications beginning June 28, 2013.

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