CRS RELEASES REPORT ON TAX STATUS OF GROUP LEGAL SERVICES PLANS.

                          Louis Alan Talley

The tax exclusion for group legal services plans is scheduled to expire on June 30,1992. The congressional rationale for exempting this fringe benefit from taxation was the hope that legal services would become available to large numbers of individuals who individually would probably not have access to such help.

The advantages of this provision are the obvious ones which relate to legal services being provided to a large number of individuals who individually would probably not have access to such help. An additional policy argument was made in Fundamentals of Employee Benefit Programs (3rd edition) published by the Employee Benefit Research Institute that "legal services plans offer the potential for reduced rates and broader protection against unexpected, costly lawsuits. They offer a form of preventive service that can cut legal costs. Under these plans, legal costs can be predicted, and they are based on group rates. A prepayment feature permits legal services costs to be spread over a period of time."

There are three principal arguments made against the provision of tax-free fringe benefits. Those arguments are that the benefits are not always economically efficient, are generally inconsistent with horizontal and vertical equity principles, and contribute to high marginal tax rates on income that remains taxable. When fringe benefits are not subject to tax, they tend to be used to a greater degree than would be the case in a market environment and hence, this can result in an inefficient allocation of resources. Since all employers will not provide such benefits, the provision will violate horizontal equity principles, in that all taxpayers with similar incomes will not be treated equally. The argument is also made that upper income taxpayers will receive a greater subsidy than lower income taxpayers because of their higher tax rate, and that the tax subsidy is inverse to need. Finally, since such nontaxable benefits tend to reduce the tax base, critics argue they contribute to high marginal tax rates on income that is taxable. In addition, to the extent that employers provide these benefits as a substitute for increases in salaries or wages, it impacts upon the Social Security Trust Fund, since such fringe benefits are not taxed for Social Security purposes.

Prior to the passage of the Revenue Reconciliation Act of 1990, the Joint Committee on Taxation had estimated the cost of extending this provision permanently. It had estimated that such an extension would lose revenue of $546 million during the 1991-95 FY period. Further, the Tax Extension Act of 1991 extended this provision for a six month period. It was estimated that $55 million will be lost in Federal revenues for FY 1992 because of the half-year extension of the provision.

                          TABLE OF CONTENTS

This report concerns the current tax status of group legal services plans. The rationale for provision of this fringe benefit and a brief chronology of the legislation containing the provision are provided. Additionally, policy arguments both pro and con which concern the continued exclusion from taxable income of the value of group legal services provided by employers as a fringe benefit are given. A revenue estimate of projected Federal revenue losses from making the provision permanent is provided along with a selected bibliography.

LEGISLATIVE CHRONOLOGY IN BRIEF

This provision entered the law with the passage of the Tax Reform Act of 1976, Public Law 94-455. ¹ Prior to enactment there were questions as to the proper tax treatment of group legal service plans as provided by employers. It was generally recognized that employers were eligible for a deduction for such amounts contributed to plans as ordinary and necessary business expenses. However, the plan structure caused the employee either to include the pro rata share contributed by the employer in his wages or the value of legal services or reimbursement of legal service expenses received under the plan (or both).

RATIONALE

The Congress stated that the reason for provision of this benefit was that . . .

The Congress believed that it was appropriate to provide a tax incentive to promote prepaid legal services plans. Within the last 3 years, the American Bar Association and many State bar associations have endorsed the creation of this type of arrangement as a means of making legal services more generally available. Several unions have already established prepaid group legal services plans which are supported entirely or in part by employer contributions.

The Congress believed that excluding such employer contributions from the employees' income would promote interest in such plans and increase the access to legal services for many taxpayers by encouraging employers to offer and employees to seek such plans as a fringe benefit.

The Congress decided a tax incentive, which would increase the availability of legal services, would be especially helpful to middle-income taxpayers who at present may be the most under- represented economic group in terms of legal services. Lower- income persons have access to publicly-supported legal aid services, while taxpayers with higher incomes can generally afford their own legal expenses.

The Congress believed that providing favorable tax treatment for group prepaid legal services plans (which has some similarity to the tax treatment provided for accident and health plans) would grant taxpayers some relief from the high cost of legal fees and would promote the adoption and implementation of such plans by many employers and employees.

In order to ensure that the tax law encourages only those plans which may be considered nondiscriminatory employee fringe benefits, the Congress decided that it was necessary to adopt rules which would prohibit discrimination and minimize the possibility of abuse of the tax incentive by those taxpayers who might create such plans to channel otherwise taxable compensation through a plan providing a tax-free fringe benefit. ²

CONTINUATION OF THE PROVISION

This original provision was effective until January 1, 1982. A three year extension, until December 31,1984, was provided in the Economic Recovery Tax Act of 1981 (P.L. 97-34). The Technical Corrections Act of 1982 (P.L. 97-448) clarified the exemption status of Internal Revenue Code 501(c)(20) organizations, and extended the fringe benefit portion until January 1, 1985. An additional one year extension was provided in Internal Revenue Code Amendments: Group Legal Services Plans; Fringe Benefits; Imputed interest (P.L. 98- 612).

The Tax Reform Act of 1986 (P.L. 99-514) provided a two-year extension retroactively from December 31, 1985, to December 31, 1987, for exclusion of group legal services as a qualified fringe benefit. Additionally, it provided a similar extension for organizations which provide as their exclusive function the indemnification against legal costs to group legal service plans (hereafter referred to as indemnification organizations) to retain their tax-exempt status.

Under a provision of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647) the exclusion was extended through December 31, 1988. As under prior law, a similar extension for indemnification organizations permits them to retain their tax-exempt status. However, a provision of this law also provided that the value of the insurance against legal costs was limited to $70 annually for the employee, his spouse, or dependents.

Both the exclusion and tax-exempt status for such organizations were retroactively extended as part of the Revenue Reconciliation Act of 1989 (P.L. 101-239) so as to expire for tax years beginning after September 30, 1990. Again, under the Revenue Reconciliation Act of 1990 (P.L. 101-508) both the exclusion and the tax-exemption of indemnification organizations were extended until December 31,1991.

Finally, with passage of the Tax Extension Act of 1991 (P.L. 102-227) the exclusion and tax exempt status of indemnification organizations were extended for a six month period. These provisions are now scheduled to expire on June 30,1992.

President Bush's budget proposal would allow the exclusion for group legal services to expire. The Congress sent to the President the Tax Fairness and Economic Growth Act of 1992 which he vetoed. The exclusion of group legal service benefits and tax-exemption of indemnification organizations had been added to the bill under a Senate amendment. The conference report provided for extension through June 30, 1993. ³

ARGUMENTS FOR AND AGAINST CONTINUATION OF THIS PROVISION

ARGUMENTS FOR

Supporters maintain the provision encourages legal services being provided to a large number of individuals who individually would probably not have access to such help. Proponents of extension argue that "unlike lower-income workers, middle-income workers are not generally eligible for legal aid or for the services of public defenders. Unlike higher-income workers, middle-income workers tend to postpone hiring attorneys until their needs become acute. Thus, wills go unwritten, legal documents go unchecked, and many people take the risk of inadequately representing themselves in court. Legal services plans provide affordable legal representation and consultation, especially to middle-income workers." ⁴

It is also argued that "legal services plans offer the potential for reduced rates and broader protection against unexpected, costly lawsuits. They offer a form of preventive service that can cut legal costs. Under these plans, legal costs can be predicted, and they are based on group rates. A prepayment feature permits legal services costs to be spread over a period of time." ⁵ Proponents argue that in general, group legal services plans provide risk pool efficiencies in that they avoid the problem of adverse selection. ⁶

ARGUMENTS AGAINST

Critics point out that when fringe benefits are not subject to tax they tend to be used to a greater degree than would be the case in a market environment and hence, this results in an inefficient allocation of resources. The Treasury Department report to the President in November 1984 entitled Tax Reform for Fairness, Simplicity, and Economic Growth, called for repeal of the exclusion on the basis that "the exclusion from income of employer-provided group legal services encourages overconsumption of legal services by permitting employees to purchase them with pre-tax dollars." ⁷

They argue that since all employers will not provide such benefits, the provision will violate horizontal equity principles, in that all taxpayers with similar incomes will not be treated equally. Such plans are most often offered by large employers. Thus, the most likely beneficiaries are the employees of large business firms. Typically, small employers do not offer group legal service plans.

The argument is also made that upper income taxpayers will receive a greater subsidy than lower income taxpayers because of their higher tax rate, and that the tax subsidy is inverse to need. For example, an individual in the 15 percent tax bracket would pay $15 less for each $100 excluded from income while someone in the 31 percent bracket would receive a tax benefit of $31 for each $100 of exclusion. Since such nontaxable benefits tend to reduce the tax base, they contribute to high marginal tax rates on income that is taxable.

Opponents of further extension of this fringe benefit will likely point out that the legislation loses Federal revenue during a time of budget deficits. If employers did not sponsor group legal services benefits, many taxpayers would have purchased legal services with after-tax dollars, and, thus, Federal revenues are lost. If employers provide these benefits as a substitute for increases in salaries or wages, it also impacts upon the Social Security Trust Fund, since such fringe benefits are not taxed for Social Security purposes, either.

Tax expenditures such as this one are often not acted upon in the normal budgetary process, they are able to grow in size and are not subject to periodic review. Even though the group legal services exclusion has from its beginning contained a "sunset" provision (expiration date), it has been routinely renewed without much review of its effectiveness or efficiency.

REVENUE ESTIMATE

The Joint Committee on Taxation had estimated the cost of extending this provision permanently. It had estimated that such an extension would cost $80 million in FY 1991, $108 million in FY 1992, $113 million in FY 1993, $120 million in FY 1994, and $125 million in FY 1995 for a total revenue loss of $546 million during the 1991-95 FY period. ⁸ It was estimated that the most recent extension, a part of the Tax Extension Act of 1991, will result in loss Federal receipts of $55 million. This $55 million loss is for the six month period from January 1 through June 30, 1992. ⁹

² U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1976 (H.R. 10612, 94th Congress, Public Law 94-455). Washington, U.S. Govt. Print. Off., 1976. p. 668-669.

³ U.S. Congress. Conference Committees, 1992. Tax Fairness and Economic Growth Act of 1992; Conference Report to Accompany H.R. 4210. Washington, U.S. Govt. Print. Off., 1992. p. 408. (102d Congress, 2d session. House. Report no. 102-461)

⁴ Employee Benefit Research Institute. Fundamentals of Employee Benefit Programs. Washington, 1987. p. 255.

⁵ Ibid., p.256.

⁶ Adverse selection occurs when individuals join plans with fore-knowledge of the need for benefits. Increased benefit use thereby increases plan costs. In group legal services plans the employer typically covers all employees. There is a greater likelihood of adverse selection under employer sponsored "cafeteria" fringe benefit plans. Under cafeteria benefit plans employees select from a basket of fringe benefits according to individual needs.

⁷ U.S. Dept. of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, The Dept., 1984. p. 33.

⁸ U.S. Congress. Joint Committee on Taxation. Estimated Revenue Effects of Extending Expiring Provisions Permanently; Provisions with Negative Revenue Effects. Com. Doc. JCX-2-90. Washington, U.S. Govt. Print. Off., 1990. 1 p.

⁹ U.S. Congress. House. Committee on Ways and Means. Tax Extension Act of 1991; report to accompany H.R. 3909 including cost estimate of the Congressional Budget Office. Washington, G.P.O. 1991. p. 18. (Report, House, 102nd Congress, 1st session, no. 102-377)

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