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Guest Article
(From the February 24, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)
Employer Can Fund and Deduct Present Value of Retiree Medical Benefits for Current Retirees, Tax Court Rules
A recent Tax Court decision indicates employers may be able to take a significant tax deduction by pre-funding the present value of their retiree medical liabilities for current retirees. Wells Fargo & Company v. Commissioner of Internal Revenue, 120 T.C. No. 5 (February 13, 2003).
Effect on Employers
The Tax Court's decision may create significant new opportunities for employers to fund retiree medical benefits on a tax-favored basis. However, the IRS has not yet acquiesced to the Tax Court's decision, so there is still a chance that a higher court will overturn it.
A brief summary of the Court's decision follows. If you have any questions, or would like a copy of the decision, please contact your Deloitte advisor. (The decision also can be downloaded from the Tax Court's Web site, at www.ustaxcourt.gov.)
Case Summary
In Wells Fargo, the employer established a trust in 1991 to fund its retiree medical benefits. The employer's actuary calculated the present value of its retiree medical benefits for active employees ($14,096,473) and retirees ($27,759,057). Based on these calculations, the actuary determined the employer could contribute the following amounts to the trust in 1991:
- $2,930,660 to fund retiree medical benefits for active employees; and
- $27,759,057 to fund retiree medical benefits for current retirees.
The employer contributed the full amount ($30,689,717) to the trust in 1991 and claimed a deduction for the contribution based on IRC sections 419 and 419A. In general, IRC section 419 allows employers to deduct contributions to a welfare benefit fund, subject to certain limits. Among other things, these limits allow for a retiree medical benefits reserve "funded over the working lives of the covered employees and actuarially determined on a level basis (using assumptions that are reasonable in the aggregate)." IRC section 419A(c)(2).
The issue in Wells Fargo is whether the employer could contribute and deduct the present value of retiree medical benefits for current retirees ($27,759,057) in 1991 consistent with the IRC section 419A(c)(2) limit. For its part, the employer argued the current retirees had exhausted their working lives, and thus the entire present value of the projected benefit could be contributed and deducted in the fund's first year. The Tax Court stated the IRS's position as follows:
Respondent (IRS) argues that petitioners' position is inconsistent with (1) the language of section 419A(c)(2), (2) the established judicial precedent interpreting that section, (3) Congress's purpose in enacting that section, (4) the accepted interpretation given "nearly identical language" in the provisions governing pension plans, (5) the law in effect before the enactment of section 419, and (6) principles of actuarial practice. Respondent contends that the cost of the postretirement benefit must be spread over the remaining working lives of the covered employees. Respondent concludes, therefore, that the aggregate cost method is the proper method for computing the account limit for the reserve under section 419A(c)(2). Respondent asserts in the alternative that, if the entry age normal cost method is the proper method, then the accrued liability must be amortized over the remaining lives of the active employees. |
After reviewing arguments by the IRS and the employer, as well as the various actuarial experts retained by both parties, the Tax Court concluded the deduction was proper. In the Tax Court's own words:
The actuarial present value of the projected benefit of each covered employee should be allocated on a level basis to each year commencing with the year in which the allocation is first recognized and ending with the year the employee is expected to retire. The funding of "a reserve funded over the working lives of the covered employees" cannot begin until the reserve is created. Thus, the allocation is first recognized on the later of the date when the reserve is created and the date the employee becomes a covered employee. Essentially, this is the individual level premium cost method with the date of the creation of the reserve substituted for the date the plan is instituted. When the year in which the allocation is first recognized is after the employee has retired, there are no future years to which the benefits may be allocated. Since there are no future years to which the benefits may be allocated, there are no future normal costs, and the entire present value of the projected benefit is properly allocated to the first year. This is the method that Mercer used in computing [Petitioner's] contribution for 1991, the year the reserve was created. |
| The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte. |
BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above. |