| Home Online Publications Online Issues TTA Home Table of Contents Employee Benefits & Pensions: Current Developments (Part II) | |
Current Developments (Part II) This two-part article provides an overview of current developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part II, below, focuses on general developments in executive compensation and health and welfare issues.
Gary Q. Cvach
Authors’ note: The authors acknowledge the significant contributions of Karen Field, Robert Masnik, Tracey Schlabach, Pamela Hobbs and Robert Delgado, of KPMG LLP’s Washington National Tax Compensation and Benefits Practice, in compiling information for this article.
Executive Summary
Part I, in the last issue, focused on general developments in retirement plan qualification requirements and employee stock ownership plans. Part II, below, addresses executive compensation and health and welfare benefit issues.
Executive Compensation Optional Reporting of Stock Options Ann. 2001-9219 has extended relief from mandatory separate reporting of compensation from employer nonqualified stock options (NQSOs) through 2002. According to the IRS, the use of Code V in Box 12 on 2002 Form W-2 is optional, but mandatory for 2003. The IRS is considering alternative cost-effective methods for collecting this information.
New Form 1099-B Reporting Exceptions Rev. Proc. 2002-5020 provided an exception to reporting transactions involving an employee, former employee or other service provider who has obtained a stock option in connection with the performance of services, on Form 1099-B, "Proceeds From Broker and Barter Exchange Transactions." Under this exception, if the stock option exercise and the stock sale through a broker occur on the same day, the broker will not be required to report the sale on Form 1099-B, as long as the transaction meets certain requirements. After exercise of the NQSOs, service providers (including employees and former employees) will often direct an immediate sale of some or all of the acquired stock for cash. In such a "cashless exercise," service providers can pay the exercise price and any employment taxes without having to use their own funds. These immediate exercise and sale transactions are typically handled by third-party administrators (such as brokerage firms and banks) through an agreement with the employer sponsoring the NQSO plan. The service providers covered by the plan instruct the brokerage firm or bank as to how and when NQSO should be exercised. For income tax purposes, the optioned stock’s sale price is the stock’s fair market value (FMV) at excercise. Thus, service providers do not realize additional income on the sale of the optioned stock, because their tax basis in the NQSO stock equals the sales price. Qualifying for exception. The exception will apply to a sale of stock acquired by a service provider via the exercise of an option if:
The exception will not apply if the stock option had a readily ascertainable FMV at the grant date, or the service recipient uses an amount other than the shares’ sale price to calculate the compensation income generated to the service provider by the option exercise.
Additional Sec. 280G Guidance Proposed Sec. 280G regulations21 on golden parachute payments have been amended; Rev. Proc. 2002-4522 provides additional guidance on stock option valuation for Secs. 280G and 4999 purposes. The most important change to the Sec. 280G proposed regulations is the change to their effective date. Under Prop. Regs. Sec. 1.280G-1, Q&A-48, taxpayers can rely on the rules for the treatment of any parachute payment. Thus, a taxpayer can rely on the proposed regulations for any parachute payment, not just a payment made after the Feb. 20, 2002 release date of the regulations. This gives taxpayers greater flexibility in determining whether to use the 1989 or the 2002 proposed regulations. Another correction includes the addition of Sec. 132(m) qualified retirement planning services to the list of nondiscriminatory employee plans or programs defined in Regs. Sec. 1.280G-1, Q&A-26(c). Valuing stock options. Rev. Proc. 2002-45 provides guidance on the proper valuation of stock options for both publicly and nonpublicly traded stock. A stock option for nonpublicly traded stock will be properly valued for Secs. 280G and 4999 purposes if the value is determined using any valuation method consistent with generally accepted accounting principles (GAAP) and considers the factors provided in new and old Prop. Regs. Sec. 1.280G-1, Q&A-13. The safe-harbor valuation method provided in Rev. Proc. 2002-13,23 Section 4, is deemed consistent with GAAP and takes into account the relevant factors. A stock option for publicly traded stock can be valued using:
For Secs. 280G and 4999 purposes, a stock option is not considered properly valued if it is valued solely by reference to the spread between the option’s exercise price and the stock’s value at the time of the change in control or without regard to the factors provided in new and old Prop. Regs. Sec. 1.280G-1, Q&A-13. Rev. Proc. 2002-45 provides a new valuation table for use with the Rev. Proc. 2002-13 safe harbor, superseding the table in Rev. Proc. 2002-13.
Shareholder Approval Requirements The IRS ruled25 that a bankruptcy judge’s and creditors’ committee approval of payments to disqualified individuals met the shareholder approval requirements for Sec. 280G purposes. According to the IRS, the judge and committee represented the shareholders’ interests and the shareholders were not otherwise able to approve the payments. Because shareholder approval was received, the payments were not Sec. 280G "parachute payments." Exemptions: Sec. 280G(b)(5)(A)(ii) exempts from the definition of parachute payments, payments made by a corporation without readily tradable stock if the payments receive shareholder approval. According to Sec. 280G(b)(5)(B), shareholder approval requirements are met for any payments if (1) the payment is approved by a vote of the persons who owned (immediately before the change in control) more than 75% of the voting power of all the corporation’s outstanding stock, and (2) all material facts concerning all payments that would be parachute payments are adequately disclosed to shareholders. In the ruling, the company’s stock was not currently sold on an established securities market before the change in control. The IRS ruled that the shareholder approval requirements had been met when the bankruptcy court’s order approved the payments to executives, because the payments had already been approved by the creditors’ committee and the bankruptcy judge, who represented the shareholders’ interests for Sec. 280G purposes. Further, the shareholders were not otherwise eligible to approve the payments to the executives. Thus, the plan payments were not parachute payments.
Corporate Officer Compensation The IRS ruled26 that a corporate officer who resigns before the last day of the tax year with no intention of returning is not a covered employee under the Sec. 162(m) deduction limit. In addition, the officers of an acquired corporation are not covered employees if they are not required to be listed on the Summary Compensation Tables under SEC executive compensation disclosure rules. Sec. 162(m) limits the salary deduction available to an employer for the pay of a covered employee to $1 million. Under Sec. 162(m)(3), a covered em-ployee is the Chief Executive Officer as of the close of the tax year and the four highest-paid executives whose compensation is required to be reported under the SEC rules.27 Regs. Sec. 1.162-27(c)(2) provides that the four highest-paid executive officers must also be employed as of the last day of the tax year. The IRS ruled that, because the acquired corporation’s officers were not required to be listed for SEC purposes, their compensation was not subject to the Sec. 162(m) limit.
Sec. 83 and Reverse Vesting The IRS ruled28 on the application of Sec. 83 when shareholder-employees agree to exchange their fully vested shares for nonvested shares (reverse-vested shares). The ruling focuses on the interaction between Sec. 83 and the Sec. 280G golden parachute rules and provides guidance on how the IRS views reverse-vesting provisions. The issue was whether reverse-vested shares that vest on a change in control are subject to the Sec. 280G golden parachute rules, and thus must be counted as compensation payments in determining whether the total compensation package exceeds the golden parachute threshold. The IRS ruled that because the shareholder already owned the shares, the subsequent imposition of forfeiture provisions must have been accomplished in the absence of a Sec. 83 "transfer"; thus, the reverse-vesting had no effect for Sec. 83 purposes. The IRS further ruled that the accelerated vesting on a change in control was not compensation; thus, the value of the accelerated vesting should not be counted in the parachute calculation.
Employer May Make Sec. 83(b) Election for Employees In a Service Center Advice (SCA),29 the IRS held that an employer with power of attorney can make a Sec. 83(b) election for its employees, even though it is not signed by the employee (as required by Regs. Sec. 1.83-2(e)). Under Sec. 83(a), the FMV (in excess of the cost) of property transferred in connection with the performance of services is includible in a recipient’s gross income. The inclusion occurs in the first year the recipient can freely transfer the property or there is no substantial risk of forfeiture. Sec. 83(b)(1) permits the recipient to shift the year of inclusion to the year the property is transferred to the employee. The election must be made no later than 30 days after the transfer date. Regs. Sec. 1.83-2(c) states that a Sec. 83(b) election is made by filing a copy of a written statement with the IRS within 30 days of the transfer and sending another copy to the IRS with the service provider’s tax return for the year of the property transfer. Regs. Sec. 1.83-2(e) states that the statement is to be signed by the person making the election. However, a power of attorney signed by the employee and authorizing the employer to make a Sec. 83(b) election, along with the statement signed by the employer, met the Regs. Sec. 1.83-2(e) requirements.
Determining Reasonable Compensation In Haffner’s Service Stations, Inc.,30 the Tax Court combined the multifactor and independent investor tests in analyzing whether bonuses paid to shareholder-employees are reasonable. Compensation reasonableness is determined by comparing the compensation paid to an employee to the value of the services performed by the employee. Courts usually list factors to be considered in determining reasonable compensation. They are: 1. The employee’s qualifications. 2. The nature, extent and scope of the employee’s work. 3. The size and complexity of the employer’s business. 4. A comparison of salaries paid with the employer’s gross and net incomes. 5. The prevailing general economic conditions. 6. A comparison of the salaries to distributions to shareholders and retained net earnings. 7. The salary policy the employer has for all employees. 8. The amount of compensation paid to the particular employee in earlier years. 9. Whether the employer offers a pension or profit-sharing plan to employees. The Tax Court noted that the Seventh Circuit has recently expressed its dissatisfaction with the multifactor test and chose to base its analysis of reasonable compensation on whether a reasonable investor would have approved the compensation amount.31 However, it chose to follow another Tax Court case, Wagner Construction, Inc.32 (which was not appealable to a circuit that applied the multifactor test) and apply the multifactor test from the viewpoint of an independent investor. The Tax Court analyzed the nine factors through the independent investor lens and decided all except numbers five and nine negatively. The court made no findings on factors five and nine. Its analysis was based on the actual work done during the years at issue.
Health and Welfare Automatic Enrollment in Cafeteria Plan Rev. Rul. 2002-2733 approved the automatic enrollment of employees in group health insurance under a cafeteria plan. The ruling discusses the effect of the automatic enrollment procedure on the qualified plan definition of "compensation" under Sec. 415(c)(3)(D)(ii). The ruling also discusses the ramifications of required enrollment in the plan’s single-person-only health coverage when an employee is unable to certify coverage under another health plan. Under Sec. 415(c)(3)(D)(ii), an employee’s compensation for purposes of calculating contributions or benefits under a qualified plan includes any amount contributed by the employer at the employee’s election that is excluded from the employee’s income by Sec. 125. Rev. Rul. 2002-27 addresses two hypothetical situations. First, an employer has a written cafeteria plan that offers group health insurance indemnity coverage. The plan provides that an employee is automatically enrolled on a pre-tax salary reduction basis unless the employee elects cash. The second situation is the same as the first, except that the employee has no choice but to accept the employer’s health insurance, unless the employee can certify that other health coverage is applicable. The employer does not otherwise request or collect information on the other health coverage from employees as part of the enrollment process. An employee could elect between self-only and family coverage, even if he or she is forced into the health coverage. In both situations, an employee is given a notice fully describing the plans and his or her rights. Rev. Rul. 2002-27 notes that after receiving notice, an employee can choose between cash and health insurance, so that the plan’s automatic enrollment process in the first situation is subject to the Sec. 125 requirements. The amounts subject to Sec. 125 are excludible from the employee’s gross income and includible in the qualified plan definition of compensation. The result is the same in the second situation to the extent that the employee can elect cash. If the employee cannot (as is the case for employees who have no other health coverage and are enrolled in the employer’s health plan), Sec. 125 does not apply to the self-only coverage. Sec. 125 only applies to the election between self-only and family coverage. The lack of choice between health coverage and cash does not effect whether the plan satisfies the requirements for exclusion of accident and health coverage from gross income under Sec. 106(a). In the second situation, the ruling holds that when the employee cannot elect cash, the amounts are not described in Sec. 125, but the employer may treat the amounts as "deemed Sec. 125 compensation" includible in compensation for qualified plan purposes. The amount can be treated as deemed Sec. 125 compensation only if the employer does not collect information on the employee’s other health coverage. Deemed Sec. 125 compensation is defined as an excludible amount not available to the employee in cash in lieu of group health coverage under a Sec. 125 arrangement, because the employee is unable to certify that he or she has other health coverage. The new definition of compensation for qualified plans may be used for plan and limit years beginning after 1997. Under Rev. Rul. 2002-27, for plan years beginning after 1997 and before 2002, the IRS will not disqualify a plan because it treated deemed Sec. 125 compensation as compensation for contribution or benefits’ purposes, if the plan is amended before the end of the 2002 plan year and the amendment is effective for all years the plan used the "deemed Sec. 125 compensation" definition. A plan that has not been using deemed Sec. 125 compensation for years beginning before 2002, cannot be amended retroactively. The plan can be amended to include deemed 125 compensation prospectively as long as the amendment is made by the end of the plan year in which it is effective.
Merger of SUB and VEBA Trusts The IRS approved34 the merger of a Sec. 501(c)(17) supplemental unemployment compensation benefit (SUB) trust with a voluntary employee beneficiary association (VEBA) trust. A company had an existing SUB trust established under Sec. 501(c)(17) that was overfunded. The company recently established a Sec. 501(c)(9) VEBA trust to pay healthcare premiums as provided by the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) as part of an early retirement package. The company expected to expand the benefits after the COBRA period expired. The company sought to merge the SUB trust into the healthcare VEBA trust, after satisfying the expiring trust’s administrative costs. The IRS held that the merger and the transfer of assets from one trust to another for employees will not be a reversion under Sec. 4976; further, the VEBA trust will retain its tax-exempt status. This ruling extends a line of cases allowing mergers of VEBA trusts that provided different benefits to different groups of employees. The extension is significant, because it focuses on the merger of a VEBA trust with a related non-VEBA trust. The employer "benefits" from the merger in that the surplus funds in the first trust (for the severance plan benefits) will be used to help pay for different benefits in the second plan. The employer cannot use the assets for other corporate purposes, just the provision of welfare benefits. Thus, it makes sense that the IRS permitted this transfer and might permit other like transfers.
Reimbursements of Amounts to Pay Health Insurance Premiums Under Rev. Rul. 2002-3,35 employer reimbursements of salary reduction amounts used to pay health insurance premiums are includible in employees’ gross income. An employer provides health coverage to employees through a group health plan qualifying as Sec. 106 employer-provided accident or health coverage. The salary reduction (whether unilateral or elected) is excludible from gross income under Sec. 106 as employer-provided accident or health coverage. In addition to paying the premiums, the employer also reimbursed the employees for their salary reductions. The employer and employees treat these payments as reimbursements for employee-paid medical care excludible from income under Secs. 105(b) and 106(a), income tax withholding under Sec. 3401, and FICA and FUTA taxes under Secs. 3121(a) and 3306(b). Under Sec. 105(b), employees may usually exclude amounts that an employer pays to reimburse employees for their medical expenses. However, Rev. Rul. 61-14636 allows employees to exclude employer reimbursements for health insurance premiums only if those premiums are actually paid by the employee. Although the employees’ salaries are reduced, their health insurance premiums are actually paid by the employer. Accordingly, the IRS ruled that employees in these arrangements must recognize income when employers reimburse them for health insurance premiums. |
