Month: July 2003

ERISAblog: 2d Circuit Case on Deficient SPDs Testing trackback

Mark Hamblett for the New York Law Journal via Law.com has this article on the very recent Second Circuit ERISA case of Burke v. Kodak Retirement Income Plan: “Deficient Benefit Plan Not Enough to Overcome Denial of Benefits.” More on this case later . . . (By the way the title to the article should likely read “Deficient Benefit Plan Description Not Enough to Overcome Denial of Benefits.”)

PlanSponsor.com has this article on what’s in the Portman-Cardin substitute bill which was approved by the House Ways and Means Committee on Friday: “Pension Bill (Still) Contains Some Welcome Relief, Controversy: The late introduction of a substitute amendment for pension reform touched off a firestorm in the House Friday – but what was in the bill?”

TheStreet.com has this op-ed by Jonas Max Ferris: “The Downside of Restricted Stock.”

Imagine the following scenario:

Husband (H) and Wife (W) are the sole shareholders of a group of related S-corporations which we will call “MC.” (The tax consequences of an S-corporation flow through to the shareholders, so the shareholders recognize the corporation’s income and expenses on their individual tax returns.) From 1989 to 1997, an individual which we will call “X” was the Chief Operating Officer of MC and was responsible for all of the company’s legal, financial, administrative, and other business affairs. In 1995, MC entered into an employment agreement with X that gave him a 10 percent ownership interest in the company. Under that contract, full ownership of the stock representing the 10 percent ownership share would vest gradually over time according to a schedule that would lead to partial forfeiture of his ownership rights in the event of early termination of his employment. X paid MC $2 million as consideration for the stock.

In 1995, X made a timely election under Internal Revenue Code (“Code”) section 83(b) to include the bargain element of the MC stock in his income for that tax year. However, because X represented that the $2 million that he paid for the stock reflected its fair market value-that is, that the bargain element of the transfer was zero-he did not report any income from the transfer. (Later it was discovered that X was allegedly incorrect in assigning a zero value to the bargain element, because the $2 million payment represented only a small fraction of the stock’s true value, which was allegedly $28.8 million at the time of the transfer.)

Under Treasury Department regulations, X was required to file a copy of the section 83(b) election with his employer notifying the employer of his election. (Treas. Reg. § 1.83-2(c), (d)) Because X was the chief operating officer of MC, the person he notified was himself.

Subsequently, in June 1998, MC and X terminated their employer-employee relationship. As part of the separation agreement, MC repurchased from X the portion of the stock that had vested. The purchase price was $13.2 million, based on an estimated company value of $165 million. At that point, H and W discovered that X had made a section 83(b) election in 1995. As a result, MC calculated the 1995 value of the property that had been transferred to X and issued corrected W-2 forms reflecting that value. The modification increased X’s wage income by more than $20 million. MC also paid the employer’s share of the employment taxes for that compensation. The IRS has since audited X’s tax return and issued an audit report proposing to increase his gross income by $26,759,800 based on a stock value of $28,759,800. However, the agency and X have not yet reached a final determination as to the amount, if any, by which his gross income will be increased for purposes of calculating his 1995 tax liability.

Should H and W be entitled to deduct for 1998 the full amount that should have been included in X’s income for the year as a matter of law, or only the amount that actually was included in income by X for that year?

In a very well-written opinion and ruling for H and W, the United States Court of Appeals for the Federal Circuit in the case of Robinson v. U.S. (via Findlaw.com) held that that H and W were entitled to a deduction based on the amount that was legally required to be included in X’s gross income, without regard to the amount that was actually included on his return or that X and the IRS ultimately agree should be included on that return for purposes of calculating his tax liability. The opinion apparently conflicts with a Tax Court decision and also a Sixth Circuit unpublished ruling. In holding for H and W, the court stated:

We recognize that our decision conflicts with language in the decision of the Tax Court (although that court was divided 9-8 on the issue), see Venture Funding, Ltd. v. Comm’r, 110 T.C. 236 (1998), which was affirmed by the Sixth Circuit in an unpublished ruling, 198 F.3d 248 (6th Cir. 1999), but we are persuaded by the arguments made by [H and W] and by the dissenting judges of the Tax Court.

Also, the opinion goes against the IRS position as expressed in their Treasury Regulation § 1.83-6(a). In holding against the IRS, the court stated:

The government contends that . . [H and W]’s interpretation of section 83 creates a “whipsaw” problem for the Internal Revenue Service. The government explains that if the employer and the employee disagree about the value of the bargain element of a section 83 transfer, the disputes could give rise to separately litigated cases, which could lead to decisions adverse to the government in both cases, resulting in the allowance of a deduction for the employer greater than the income recognized by the employee. While that outcome is possible, we think the similar “whipsaw” policy argument made by [H and W] is even more compelling. The IRS can at least participate in the cases involving both the employer and the employee and thus can take steps to protect itself against an inconsistent result. The employer, however, has no standing to participate in a dispute between the employee and the IRS regarding the amount claimed by the employee as gross income from the section 83 transfer. Moreover, because any reduction in the amount claimed by the employee results in a reduction in the amount that can be deducted by the employer, the IRS would have little economic incentive to insist on the employee reporting the full value of the transferred property. In that setting, the employer would be helpless to avoid a settlement between the IRS and the employee that significantly understated that value, and thus resulted in an artificially low deduction for the employer. Accordingly, we do not find the policy argument regarding possible “whipsaws” sufficient to persuade us to read the statute as the government urges. Instead, we conclude that the “whipsaw” argument cuts in favor of the employer’s interpretation, not the government’s.

For those who wish to learn more about Code Section 83 generally, you can continue reading:

Because the stock given to X was part of his salary, and because it was conveyed with restrictions on X’s ownership rights, the tax treatment of the transfer of the stock is governed by section 83(a) of the Code. Section 83(a) provides that the transfer of property in connection with performance of services yields taxable income to the service provider in the amount of the excess of “the fair market value of such property” over “the amount (if any) paid for such property.” That amount is known as the “bargain element” of the property transfer. Section 83(a) provides that the amount of the bargain element “shall be included in the gross income” of the service provider. Id.

Section 83(a) addresses, inter alia, transfers that include restrictions on vesting or on retransfer of the property. In the case of property that is conveyed subject to such restrictions, the bargain element is ordinarily treated as income to the employee in the year that the employee’s rights in the property are no longer “subject to a substantial risk of forfeiture.” (Code Section 83(a) and Treas. Reg. §§ 1.83-1(a), 1.83-3(a) & (b).) It is then taxed as ordinary income. Section 83(b) of the Code, however, gives the employee the opportunity within 30 days of the transfer to elect to recognize the income in the year of receipt, notwithstanding the existence of restrictions on ownership. (Section 83(b)). By making that election, the employee is subject to immediate tax liability for the amount of the compensation. However, electing that option enables the employee to treat as a capital gain any appreciation in the value of the property between the time of the transfer and the time that the restrictions lapse. See Venture Funding, Ltd. v. Comm’r, 110 T.C. 236, 239-40 (1998), aff’d, 198 F.3d 248 (6th Cir. 1999) (unpublished table decision).

Section 83(h) addresses the tax consequences to the employer of a property transfer made under section 83. With respect to value, section 83(h) states that the employer shall receive “a deduction” under section 162 of the Code in “an amount equal to the amount included under subsection (a), (b), or (d)(2) in the gross income of the person who performed the services.” Code § 83(h). With respect to timing, section 83(h) states that the deduction “shall be allowed for the taxable year of such person . . . in which such amount is included in the gross income of the person who performed such services.” Id.

“Lawyers Get Big Raises At Top Corporations“: Kara Scannell for the Wall Street Journal today reports on how general counsels received the biggest pay raises in decades in 2002. (Subscription required.) The article quotes Robin Sparkman, editor-in-chief of Corporate Counsel magazine, which conducted the survey that runs in the August issue, as saying that this is a “good gauge industrywide of how companies are taking their general counsel much more seriously.” The article reports Sarbanes-Oxley compliance as being one of the main reasons for the rise in pay.

Milliman USA provides a discussion of the proposed section 401(k) and 401(m) regulations issued last week: “Client Action Bulletin: Proposed 401(k) Regulations Restrict Bottom-Up QNECs.”

Here are some helpful links in accessing the Portman-Cardin legislation which passed the House Ways and Means Committee Friday:

• Description of the Chairman’s Amendment In the Nature of a Substitute to HR 1776, the “Pension Preservation and Savings Expansion Act of 2003” issued by the Joint Committee on Taxation
• Joint Committee of Taxation’s Estimated Revenue Effects of the Chairman’s Amendment In the Nature of a Substitute to HR 1776, the “Pension Preservation and Savings Expansion Act of 2003
• Chairman Bill Thomas’s Summary of the Proposed Legislation

(Thanks to Benefitslink.com for the links.)

Today’s Federal Register contains temporary and proposed regulations concerning requirements for employee stock ownership plans (ESOPs) holding stock of S corporations. The regulations provide guidance on identifying disqualified persons and determining whether a plan year is a nonallocation year under Internal Revenue Code section 409(p) and on the definition of synthetic equity under Internal Revenue Code section 409(p)(5).

Several news sources are carrying this Associated Press article today (this one via ABCNews.com): “Don’t Fret Over Pension Notice: Don’t Immediately Fret Over Notice From Employer of Underfunded Pension.”

Stephen Taub for CFO.com provides this report: “Ways and Means of Relieving Underfunded Pensions: Committee’s recommendation to full House of Representatives may ”free up cash for other corporate uses.” The article reports that shortly after the announcement that the Portman-Cardin bill had passed the Ways and Means Committee, Standard and Poor released a statement that its estimate of pension underfunding for the S&P 500 is under review. You can read the press release here. The press release provides:

“If the House approves the proposed three-year use of the high-grade corporate bond rate, which is currently yielding 128 basis points higher than the 30-year Treasury, the amount of pension underfunding among U.S. companies would significantly decrease, resulting in lower corporate contributions to their pension funds. . . This change would free up cash for other corporate uses.”

Business Week Online provides this op-ed by Steve Hamm: “Commentary: Expense Options–but Give Startups a Break.” The article discusses how FASB is open to creating special rules for Pre-IPO nonpublic companies.

Albert Crenshaw for the Washington Post discusses “bottom-up leveling” in 401(k) plans in this article: “How a 401(k) Loophole for the Rich Can Mean a Windfall for the Poor.”

Susan Tempor for the Detroit Free Press writes: “Tax law changes add 401(k) quirks.”