Guest Article

(From the March 10, 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.)

Tax Court's Wells Fargo Decision on Post-Retirement Medical Benefits Creates Potential Opportunities

(Thanks to Debbie Walker of the Washington National Tax Practice for submitting this article.)

A recent decision by the Tax Court creates potential refund opportunities for taxpayers that have welfare benefit funds with reserves for post-retirement medical benefits. In Wells Fargo & Co. v. Commissioner, 120 T.C. No. 5 (Feb. 13, 2003), the court addressed the deductibility of post-retirement benefits for employees who are retired when the section 419A(c)(2) reserve is created. As reported in a previous edition of Washington Bulletin, the court held that 100 percent of the present value of an employee's benefit may be allocated to the year in which the reserve is created if the employee is retired when the reserve is created.

The Wells Fargo decision presents opportunities for taxpayers who fully funded section 419A(c)(2) reserves but deducted less than the funded amount.

Background

Wells Fargo had fully funded its section 419A(c)(2) reserve and claimed a deduction for the entire contribution for the year it made the contribution. Other taxpayers similarly deducted 100 percent but settled for much less when challenged by the IRS. Because of the Service's position, many taxpayers deducted only a fraction of the present value of the retirees' benefit.

In Wells Fargo's case, the taxpayer argued that 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 IRS countered that the cost of the retirees' post-retirement benefits had to be spread over the remaining working lives of the active employees because the retirees had no remaining "working lives" as that term is used in section 419A.

The Tax Court agreed with Wells Fargo. The court explained that the "present value of the projected benefit of each covered employee should be allocated . . . 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 . . . 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. . . . 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."

The Opportunity

The Wells Fargo decision offers certain taxpayers the ability to significantly accelerate payments for funding retiree medical benefits. Taxpayers may deduct amounts funded prior to the close of the taxable year. For those taxpayers who have previously funded and not yet deducted such amounts, the case provides an opportunity to apply for a change in accounting method, for which a taxpayer must file Form 3115. Taxpayers applying for a change in method and obtaining approval for such change would be entitled to deduct as a section 481 adjustment in the current year all of the nondeducted funded amounts, even for amounts contributed in closed years.

Caveat

In reality, this opportunity may benefit a small number of taxpayers. The deduction is allowable for taxpayers only to the extent that the section 419A reserve was funded. Since many taxpayers funded the reserve only to the extent they believed the contribution would be deductible, many taxpayers did not fully fund their reserves, as did the taxpayer in Wells Fargo.

In addition, the IRS Chief Counsel group responsible for litigation is currently reviewing the Tax Court's Wells Fargo decision, but there has been no decision made regarding whether the case will be appealed. Thus, it is not certain that the IRS would approve a request for a change in accounting method.

For More Information

If you have any questions or need additional information about this opportunity, please contact your Deloitte advisor.

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.