OPEB, COLI and Post-Retiree Needs

Next month's installment will discuss safe harbors.

Lawrence L. Bell is Counsel Special Projects for Lynchval Systems Worldwide. He teaches business and estate planning to actuaries, attorneys, accountants, financial planners, and insurance professionals. He is a qualified expert, and testifies on taxes and benefits. Bell works with entrepreneurial, profit, nonprofit, and government organizations in strategic planning on a regional, national, and international basis. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.

Part One of a Two-Part Article

The recently passed COLI Best Practices ' 101(j), Deferred Compensation ' 409A and the Medicare Act of 2003 require advisers to review all qualified and nonqualified benefit programs. These legislative changes and the courts' review of COLI [See Bell, Lawrence L. "Deferred Compensation Nonqualified Employee Benefits ' The COLI Wars," Journal of Compensation and Benefits, July/Aug. 2002; Lawrence L. Bell, "Deferred Compensation Nonqualified Employee Benefits (Part I)," Journal of Retirement Planning, May-June 2003.] provide attorneys with a different approach to help solve their benefits planning problems. While pensions have been codified, limited, and scrutinized since 1974 with ERISA, non-pension post-retiree benefits (OPEB-GASB 45, FAS 106, and IAS 19) have been less regulated ' until now. Judicial action, legislation, and administrative agency action have caused a paradigm shift in benefits planning.

OPEB Limitations

Previous to the Enron, Tyco, and WorldCom/MCI situations, there were two bills containing nonqualified, deferred-compensation provisions from the Senate Finance Committee and House Ways and Means Committee (S. 1971 and H.R. 5095). These bills did not become law. However, there is further activity for change to the present laws and rules governing deferred compensation arrangements as lawmakers have continued to focus on perceived abuses in the executive compensation area.

Since January 2003, various legislation was proposed. S-1054, S-9 and H.R.-2 are general pension reform bills that contain deferred compensation provisions. Some bills propose repealing Section 132 of the Revenue Act of 1978. That section prohibits the Internal Revenue Service from changing the deferred compensation principles of law in place on Feb. 1, 1978. This prohibition was enacted to stop the Internal Revenue Service from finalizing proposed regulations (Proposed Regulation Section 1.61-16) that would have severely impacted the ability of employers to provide salary reduction deferred compensation to employees.

The law changes as codified in Internal Revenue Code ' 409A effectively eliminated the use of offshore rabbi trusts. Under ' 409A, assets used to fund a nonqualified, deferred-compensation plan located outside the United States will be currently taxed to the executive.

The third attack on executive compensation is the definition of “funded deferred compensation.” A plan is not considered to be a qualified, funded, deferred compensation plan unless it satisfies three requirements:

• The employee's rights to the deferred compensation are no greater than the rights of a general contractor;
• All amounts set aside directly or indirectly, and all income attributable to those amounts, remain solely the property of the employer, without being restricted to the provision of benefits under the plan, until made available to the participant; and
• The amounts set aside must be available to satisfy the claims of the employer's general creditors at all times, not merely after bankruptcy or insolvency.

The deferred compensation rules further provide that the compensation can only be payable upon separation from service, death, disability, or at a specified time. Acceleration of the deferred compensation is not permitted by reason of any event.

Court Cases: Why the Need for Change?

In Winn-Dixie ( Winn-Dixie Stores, Inc. v. C.I.R. , 254 F. 3d 1313 [11
Cir. 2001] 87 AFTR 2d 2002-2626), the taxpayer entered into a COLI program. In this COLI arrangement, the employer purchased life insurance policies insuring the lives of its employees, then as part of the plan, borrowed against the policies. The interest and fees with respect to the arrangement outweighed the cash surrender value and benefits paid on the policies, with the result that the program yielded a pre-tax loss. However, if the interest was properly deductible for tax purposes, a post-tax benefit. The Internal Revenue Service (“IRS”) sought to set aside the interest deduction because there was no reason for the deduction other than the tax benefit. By arguing that the arrangement was a sham, the Tax Court upheld the IRS's argument. The Eleventh Circuit Court also agreed with the Tax Court. The court, citing a Supreme Court decision, Knetsch v. United States, [364 U.S. 361 (1960) 6 AFTR 2d 5851, 60-2 USTC P 9785], indicated the sham doctrine applies even if the interest deduction is not prohibited by IRC ' 264. Winn-Dixie's broad-based COLI program did not meet any business need, and had no function other than generating interest deductions, nor could it have been conceived of as an employee benefit since Winn-Dixie was the beneficiary of the policies. The Appeals Court concluded that the COLI program lacked sufficient economic substance to be respected for tax purposes.

American Electric Power ( American Electric Power Inc. v. United States , 136 F.Supp. 2d 762 (S.D. Ohio 2001)) and In re C.M. Holdings, Inc. (C.M. Holdings, Inc., 254 B.R. 578 (D. Del. 2000)) followed the same approach. The court applied an “economic substance,” “business purpose,” and “step transaction analysis” usually applied to corporate tax shelters. The Tax Court considered the applicability of the sham transaction doctrine, looking beyond the form of a transaction and to determine whether its substance is of such a nature that expenses or losses incurred in connection with it are deductible under an applicable section of the IRC. If a transaction's form complies with the Code's requirements for deductibility, but the transaction lacks the factual or economic substance that form represents, then expenses or losses incurred in connection with the transaction are not deductible.

The court examined the economic substance of the COLI transaction by analyzing the “marketing material” ' the agent's work product and the common characteristics of modern corporate tax shelter transactions. The court's reviews are in line with the Joint Committee on Taxation's 1999 and 2003 reviews of economic substance, tax shelters, and listed transactions. Any corporate transaction, which exhibits one of these characteristics, that is, “tax shelter indicators,” should be considered to have a significant purpose of avoiding or evading federal income tax for purposes of an understatement penalty.

The key to understanding these cases, the proposed legislation, and their application to prohibiting the COLI cases lies in the economics of the transaction. If there is economic significance and viability to the transaction, then there is reality and the transaction should withstand attack. If there is not, then it is unlikely that the courts will apply the test unless the client is legally bound to use the money or assets for the intended purpose.

Under a COLI arrangement, if the economics are reasonable for the client, that is, a prudent man invests his monies in an insurance program where there is a reasonable return on the investment or benefit provided to further business, the Plan should be deemed to have economic substance. If the IRS finds that the economics are, in fact, unreasonable, then it might successfully argue that there was some type of quid pro quo for the client and that the steps of the transaction should be collapsed on the basis of the “end result” test.

A 2001 Appeals Court case, United Parcel Services of America, Inc. v. Commissioner, (254 F.3d 1014 [11th Cir 2001]), 87 AFTR 2d 2001-2565, (“UPS“) gave further directions in charting a good route to a safe harbor for COLI and employee benefits, giving the sham transaction both real economic effects and a business purpose, while overcoming the step transaction doctrine. The court found that UPS had a business purpose, under the standard that a “business purpose” does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a “business purpose” when a going concern such as UPS figures in a bona fide profit-seeking business. In light of the UPS case, the business purpose standard could be met where a going concern alters its manner of handling a needed bona fide function, even if the change is made primarily for tax purposes. Providing death benefits as an employee welfare benefit in tandem with COLI would fall under this rubric. Recent proposed legislation supports this approach.

The business purpose does not require the transaction to be free of tax considerations. The transaction under challenge by the IRS and the COLI attack simply alters the form of an existing, bona fide business, and this, therefore, fails for not finding an adequate business purpose to neutralize any tax-avoiding motive.

The government's litany of cases and regulatory victory-winning streak was “snapped” with Dow Chemical Company and Subsidiaries v. U.S.A. , 250 F.Supp. 2d 748 (E.D. Mich 2003), 91 A.F.T. R.2d 2003-1489. The taxpayer succeeded in complying with the two-pronged test that brought down the other COLI cases.

The court found that Dow had a real expectation of economic benefit beyond the availability of tax deductions. In the earlier cases, the courts found a lack of economic substance. Dow, however, had a real business purpose to defray the future cost of unfunded employee retirement medical benefits. Dow made an exhaustive study of available plans and chose one that avoided most of the egregious features found in the other COLI cases. Dow obtained expert advice on the satisfaction of the mechanical tests under IRC ' 7702 and on the qualification of the plans as insurance under state law. This case is at odds with the American Electric Power (“AEP“) decision. The Dow case has been appealed to the Sixth Circuit Court of Appeals; the same circuit will hear both cases. In American Electric Power Co., Inc. v. U.S. 326 F.3d 737, (6th Cir. 2003), the Supreme Court has denied certiorari. See 124 S.Ct. 1043 (2004).

The government's position on COLI has evolved from an attack on leveraged COLI to COLI previous to the IRC ' 264(e) (1), pre-1986 law changes. The Joint Committee on Taxation testimony on Nov. 10, 1999 (JCX-82-1999) set forth the position that there needed to be a substantive law change because there was no definition of a “tax shelter.” These issues were continued in IRS Notice 2000-15 and amendments to regulations 6110, 6111, and 6112.

Under the COLI Best Practices proposal in 2006, benefits paid under a COLI contract would not be taxable if:

• The deceased individual was an employee within 12 months of his or her death;
• The benefits were payable to the employee's family, beneficiary, trust or estate, or were used to purchase an equity interest in the employer, such as a buy-sell agreement; or
• The employee was a “key person,” defined as a “highly compensated employee” under ' 414(q) of the Internal Revenue Code, or a “highly compensated individual” under ' 105(h) (5) with a salary in the top 35% for the employer, or is a director of the company.

The law imposed notice, consent, and reporting requirements. The employee must receive written notice of the insurance coverage, including that the coverage may continue after the insured terminates his or her employment with the employer; and that the employer will be the beneficiary of any proceeds. The employee must consent in writing. In terms of reporting requirements, the employer would be required to submit the following information to the IRS in respect to COLI:

• The number of its employees at the end of the year;
• The number of employees insured under the COLI program at the end of the year;
• The total amount of insurance in force at the end of the year; and
• The name, address, and taxpayer identification number of the employer, and a description of the kind of business in which it is engaged.

These changes are effective for policies issued after 2006. In June 2009 the IRS issued further guidance in Notice 2009-48, providing a safe harbor planning approach that can coordinate with IRC ' 409A to provide a platform to fund for post retiree health care as well, and deferred compensation in an economically efficient fashion.

Next month's installment will discuss safe harbors.

Lawrence L. Bell is Counsel Special Projects for Lynchval Systems Worldwide. He teaches business and estate planning to actuaries, attorneys, accountants, financial planners, and insurance professionals. He is a qualified expert, and testifies on taxes and benefits. Bell works with entrepreneurial, profit, nonprofit, and government organizations in strategic planning on a regional, national, and international basis. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.