Law Firm Comments on Proposed Regs on Treatment of Medical, Accident Insurance Payments From Qualified Plans

On behalf of the Pension Advisory Group, The Wagner Law Group is submitting this comment on proposed 26 CFR § 1.402(a)-1(e) Medical, accident, etc. benefits paid from a qualified pension annuity, profit sharing, or stock bonus plan.¹ I will represent our client at the December 6 hearing on the proposed regulation. Before the November 15 deadline, I will submit an outline of the topics to be discussed at the hearing.

The proposed regulation reverses the position espoused in several private letter rulings² providing favorable tax treatment for the purchase of long-term disability (LTD) insurance under 401(k) plans. Under those rulings, a participant would not be currently taxed on the cost of the LTD coverage, nor would the participant be taxed when LTD payments are allocated to the participant's account if the participant becomes disabled. Instead, the LTD payments would be taxable when they are ultimately distributed from the participant's account. The LTD payments in question were designed to continue periodic deposits to the participant's account at essentially the same contribution level in effect before the participant's disability. In describing this LTD insurance, our client has explained that it is analogous to the "waiver of premium" rider for life insurance that continues the coverage in force upon the disability of the insured.

The key concept underlying the private letter rulings was that the purchase of LTD coverage is a plan investment instead of a plan distribution. Without explanation, the proposed regulation³ takes the opposite position but then invites comments on whether there should be an "exception for a provision that has the effect of a waiver of premium in the case of disability."

We urge the IRS to incorporate in the final regulation an "exception for a provision that has the effect of a waiver of premium in the case of disability." Failure to do so would:

• be inconsistent with the public policy that has been evolving since at least 1982 to enable disabled employees to accumulate adequate retirement savings;

• ignores the significant difference in the tax treatment of health benefits under Internal Revenue Code ("IRC") § 105(b) and LTD benefits under IRC § 105(a); and

• discriminates against plan participants whose employer chooses to insure rather than self-insure against the risk of disability.

TEFRA amended⁷ IRC § 415 to allow an employer to elect to continue⁸ making annual additions under defined contribution plans on behalf of an employee who is permanently and totally disabled under essentially two conditions. First, the disabled participants must be fully and immediately vested in benefits derived from the contributions made while they are disabled. Second, no disability contributions could be made on behalf of participants who were highly compensated employees⁹ before they became disabled.

SBJPA. The Small Business Job Protection Act of 1996¹⁰ amended¹¹ IRC § 415 to allow annual additions on behalf of highly compensated employees if the defined contribution plan provides for the continuation of contributions on behalf of all participants who are disabled. In explaining this change, both the House Ways and Means Committee¹² and the Senate Finance Committee¹³ agreed on the public policy that:

As required, the final regulations reflect the IRC § 415 provision allowing annual additions for disabled participants.¹⁶ However, final regulations also add an exception to the post-severance timing rule¹⁷ for compensation paid to a permanently and totally disabled participant if the participant is not a highly compensated employee or if the plan provides for the continuation of contributions on behalf of all participants who are permanently and totally disabled for a fixed or determinable period.¹⁸ Under this exception, if an employer continues to compensate a disabled participant after severance of employment, annual additions can be based on this compensation.

Thus, under the final IRC § 415 regulations, an employer can continue to make annual additions for disabled plan participants in two ways:

• make annual additions to the accounts of the disabled plan participants based on their "deemed compensation," or

• continue to compensate the disabled plan participants and make annual additions based on their actual compensation.

IRC § 105(c) Dual-Purpose Plan. In the 1979, the Ninth Circuit²⁰ held that a lump sum payment from a so-called "dual-purpose" profit-sharing plan was tax-free under IRC § 105(c).²¹ The IRS then engaged in protracted litigation over the next decade to curb the use of dual-purpose profit sharing plans. With the publication of its litigation position in 1988, the IRS appears to have achieved its objective.²² Occasionally, however, a tax practitioner will fondly remember old-fashioned IRC § 104(c) dual-purpose profit sharing plans.²³

IRC § 105(b) Dual Purpose Plan. Since the Deficit Reduction Act (DEFRA)²⁴ added welfare benefit fund rules to the Internal Revenue Code in 1984, employers have been searching for a tax-efficient way to fund retiree health benefits. The search intensified in 1990 when the Financial Accounting Standard Board ("FASB") changed the accounting rules for employers with retiree health plans.²⁵ Because of the change, employers are required to recognize a liability on their balance sheet to the extent they do not fund the retiree health expenses accruing on their income statements.

To solve the funding problem for retiree health plans, tax practitioners recycled the dual-purpose profit sharing plan -- but this time asserting the tax benefits of IRC § 105(b) instead of IRC § 105(c).²⁶ Surprisingly, the IRS did not officially attack the new version of the dual-purpose profit sharing plan until Rev. Rul. 2005-55,²⁷ although IRS officials would informally express their disapproval at trade group meetings.

In Rev. Rul. 2005-55, IRS noted that the IRC § 105(b) dual-purpose profit sharing plans employed a separate sub-account that a participant could use only for medical premiums or expenses. Any remainder in the account at death is forfeited to comply with the IRC § 105(b) rules for tax-free health coverage. The IRS then ruled that this forfeiture provision violates the IRC § 411 vesting rules that apply to profit sharing plans.

Recognizing that some IRC § 105(b) dual-purpose profit sharing plans had received favorable determination letters, the IRS said that plans would not be retroactively disqualified if they were operating with a favorable determination letter so long as they remove the forfeiture provision as of the first day of the first plan year beginning after August 15, 2005. In addition, the IRS said it would not disallow tax-free treatment under IRC § 105(b) for distributions from the medical expense sub-account prior to the effective date of the plan amendment.

Different Tax Treatment for Health and LTD Benefits. In light of the above history, it seems clear that the proposed regulation is designed to drive a stake through the heart of dual-purpose profit sharing plans. The proposed regulation treats the payment of health insurance premiums by a qualified retirement plan as taxable distributions to plan participant.²⁸ This certainly would prevent tax-deferred compensation accumulating in a qualified retirement plan from being converted into tax-free heath coverage.

However, we are not aware of any rationale to support treating 401(k) plans (or other defined contribution plans) purchasing LTD insurance the same as the dual-purpose profit sharing plans that were attempting to convert tax-deferred compensation into tax-free heath coverage. Indeed, we would be surprised to learn of any such attempt given that LTD benefit payments are taxed differently than health benefit payments. Unlike health benefit payments governed by IRC § 105(b). LTD benefit payments are taxable under IRC § 105(a) if LTD premiums are paid by the employer or by employees with pre-tax salary reductions.²⁹ Thus, there has been no incentive for plan designers to convert taxable 401(k) distributions into disability benefit payments because they are also taxable.

Because both 401(k) plan distributions and LTD benefit payments are taxable, no harm was caused to IRS revenue collection efforts by the private letter rulings treating the purchase of LTD coverage as an investment by the plan. In addition, the investment treatment simplified the administration of the 401(k) plan because the LTD benefit payments are not treated as employer or employee contributions, or annual additions for IRC § 415 purposes. Thus, like the earlier IRC § 415 legislative and regulatory changes, the private letter rulings have furthered the public policy³⁰ to "facilitate the provision of benefits for disabled employees."

The proposed regulation does not articulate that the adverse tax consequences would apply to plan participants whose employers self-insure against the disability risk. For example, the proposed regulation does not suggest that plan participants would be taxed on the imputed value of the LTD coverage and then treated as if they made an after-tax contribution to the plan based on that imputed value. However, if the employer insures against the disability risk by purchasing LTD insurance, then the proposed regulation treats the payment of LTD insurance premiums as taxable distributions to plan participants.

What tax policy is served by the disparate treatment of plan participants depending upon whether the employer self-insures or insures against the disability risk? The disparity strongly suggests that the proposed regulation is fundamentally flawed in its treatment of the purchase of LTD insurance by a 401(k) plan or other defined contribution plan.

A final regulation that takes the position espoused in the private letter rulings -- the purchase of LTD coverage is a plan investment, not a plan distribution -- would encourage other insurers and employers who would otherwise be reluctant to rely on private letter rulings to consider providing or offering 401(k) plan participants insurance against the disability risk that threatens their retirement savings.

The proposed regulation is apparently aimed at dual-purpose profit sharing plans that attempt to convert tax-deferred compensation into tax-free health benefit payments under IRC § 105(b) or tax-free dismemberment or disfigurement benefit payments under IRC § 105(c). However, LTD benefit payments are taxed under either § 105(a) if funded with pre-tax contributions or § 104(a)(3) if funded with after-tax contributions. Neither IRC § 105(b) nor § 105(c) can be used to convert tax-deferred compensation into tax-free LTD benefit payments. Thus, the proposed regulation is overbroad in treating LTD benefits in the same manner as health benefits.

Importantly, one of proposed regulation's remedies for dual-purpose health plans -- treating health benefits payable to a qualified retirement plan as after-tax contributions by plan participants -- is totally unworkable from an administrative point of view. Thus, qualified retirement plans are highly likely not to accept health insurance benefit payments. This is not an alternative for 401(k) plans (or defined contribution plans) providing or offering LTD insurance to enable disabled participants to accumulate adequate retirement savings within the plan. Thus, the proposed regulation would effectively kill funding a disabled participant's future contributions under a 401(k) plan with LTD insurance. The disparity in the treatment of plan participants depending upon whether the employer self-insures or insures against the disability risk also strongly suggests that the proposed regulation is fundamentally flawed.

Finally, if the final regulation does not adopt the position espoused in the private letter rulings, then the final regulation should reserve the treatment of the purchase of LTD coverage pending another, more thoughtful proposal on the issue. This would enable more members of the employee benefit community to provide comments to the IRS on a proposal that would either enhance or undercut the ability of disabled plan participants in 401(k) plans or other defined contribution plans to accumulate adequate retirement savings.

Thank you for your attention to and consideration of this comment.

² Private Letter Ruling ("PLR") 9852026 (9/9/98), PLR 200031060 (8/26/00), and PLR 200235043 (6/6/02).

³ Preamble to proposed 26 CFR § 1.402(a)-1(e)(1) at 72 Federal Register 46423 (8/20/07).

⁴ Public Law 97-248 (9/3/82).

⁵ An "annual addition" under IRC § 415(c)(2) includes employer contributions, certain employee contributions, and forfeitures.

⁶ At that time, annual additions were limited to 25% of compensation under IRC § 415(c)(1)(B). The § 415 compensation limit was subsequently increased to 100% of compensation by Section 632(a)(1) of the Economic Tax Relief and Reconciliation Recovery Act of 2001 [P.L. 107-16 (6/7/01)].

⁷ Section 253(a) of TEFRA amending IRC § 415(c)(3)(C).

⁸ Although the IRC § 415 compensation limit still applies to disabled participants, IRC § 415(c)(3)(C) says the disabled participants are deemed to have compensation equal to their annualized compensation before becoming disabled. This change applies to years beginning after December 31, 1981. See IRS Notice 83-10, 1983-1 C.B. 536.

⁹ The term "a highly compensated employee (within the meaning of section 414(q))" was substituted for "an officer, owner or highly compensated" in IRC § 415(c)(3)(C) for years beginning after December 31, 1988 by Section 1114(b)(12) of the Tax Reform Act of 1986 [P.L. 99-514 (10/22/86)].

¹⁰ P.L. 104-188(8/20/96).

¹¹ Section 1446(a) of SBJPA added this change, effective for years beginning after December 31, 1996.

¹² House Ways and Means Report 104-586 on H.R. 3448 at page 116 (5/20/96).

¹³ Senate Finance Committee Report 104-281 on HR 3448 at page 84 (6/18/96).

¹⁴ 72 Federal Register 16877-16931 (April 5, 2007).

¹⁵ This letter does not describe marginally related technical changes to IRC § 415(c)(3)(C) made by Section 122(c)(5) of Social Security Act Amendments of 1983 [P.L.98-21 (4/20/83)], Section 713(k) of the Deficit Reduction Act of 1984 [P.L. 98-369 (7/18/84)], and by Sections 1847(b)(4) and 1875(c)(11) of the Tax Reform Act of 1986 [P.L. 99-514 (10/22/86)].

¹⁶ 26 CFR § 1.415(c)-2(g)(4) Permanent and total disability of defined contribution plan participant at 72 Federal Register 16917 (April 5, 2007).

¹⁷ The post-severance timing rule generally prohibits a defined contribution from using compensation paid to an employee after severance of employment to determine annual additions. Technically, 26 CFR § 415(e)(1)(ii) says "compensation within the meaning of section 415(c)(3) must be paid or treated as paid to the employee (in accordance with the rules of paragraph (e)(1)(i) of this section) prior to the employee's severance from employment with the employer maintaining the plan."

¹⁸ 26 CFR 1.415(c)-2(e)(4) Salary continuation payments for military service and disabled participants at 72 Federal Register 16917 (April 5, 2007)

¹⁹ The treatment of the LTD benefit payments as after-tax contributions by the plan participants would increase the complexity of administering the plan. The LTD benefits payments "must satisfy the qualification requirements applicable to employee contributions." See proposed 26 CFR § 1.402(a)-1(e)(1)(ii) at 72 Federal Register 46425 (8/20/07). In addition, the LTD benefit payments would threaten the qualification of plan (e.g., for violating the IRC § 415 limit on annual additions or for failing the applicable nondiscrimination tests).

²⁰Wood v. United States, 590 F.2d 321 (9th Cir. 1979).

²¹ IRC § 105(c) excludes from gross income payments from a health plan for the permanent disfigurement or permanent loss of the use of a body member or function if the payments are computed with reference to the nature of the injury without regard to the period the employee is absent from work.

²² Litigation Guideline Memoranda TL-60 (11/8/88)

²³ See Paul D. Callister, "Dual-purpose retirement/Section 105(c) disability plans," Journal of Compensation and Benefits, Sep/Oct 98, pp. 35-4, comparing the tax benefits against the inherent risks of dual-purpose profit sharing plans.

²⁴ Public Law 98-369 (7/18/84). Sections 511-513 of DEFRA added the welfare benefit fund rules in IRC §§ 419, 419A, 505, 512, and 4976. IRC §§ 419 and 419A limit an employer's tax deduction on contributions set aside to fund retiree health benefits over the working lives of plan participants. In particular, the tax deduction calculation must be based on the current medical costs and cannot take into account future medical inflation in projecting health benefits that will be paid during retirement. IRC §§ §§ 501(b) and 512(a)(3) impose an unrelated business income tax on all investment income set aside to fund retiree health benefits. IRC § 4976 imposes an excise tax to enforce the welfare benefit funding rules.

²⁵ FASB Statement No. 106, Accounting for Postretirement Benefits Other Than Pensions (December 1990). See summary posted at http://www.fasb.org/st/summary/stsum106.shtml.

²⁶ Anonymous, "Fidelity Uses Sec. 401(k) Plan as Solution to Retiree Health Funding," Employee Benefit Plan Review, page 66 (Nov 1992); and Pamela D. Perdue, "Using a Profit Sharing Plan to Provide Post-Retirement Medical Benefits," Pension and Benefits Week, (6/7/99).

²⁷ Revenue Ruling 2005-55, Internal Revenue Bulletin 2005-33 (8/15/05).

²⁸ As explained above, if the health insurance benefit payments are paid to the qualified retirement plan, they are treated as after-tax contributions by the participant to the plan. Because of administrative complexity associated with receiving health benefit payments, it is highly likely that qualified retirement plans will not accept health insurance benefit payments. This is not an alternative for 401(k) plans (or defined contribution plans) providing or offering LTD insurance to enable disabled participants to accumulate adequate retirement savings within the plan.

²⁹ Revenue Ruling 2004-55, Internal Revenue Bulletin 2004-26 (6/28/04). LTD benefits are tax free under IRC § 104(a)(3) if the disabled employee irrevocably elected, prior to the beginning of the plan year in which the disability occurred, to have the coverage paid for by the employer on an after-tax basis (e.g., the employee is taxed on the value of the employer's contribution).

³⁰ See David M. Katz, "Keeping 401(k) Contributions Alive," 11/2/00) posted at http://www.cfo.eom/article.cfm/2987846/c2984379/. "[A] recent IRS ruling [PLR 200031060] enabling a 401(k) plan to buy long-term disability insurance may put the spotlight on a problem Silicon Valley and dot-com companies didn't know they had: The need to keep funds flowing into defined-contribution plans while an employee is out of work."

³¹ AALU (Association for Advanced Life Underwriting) Bulletin No: 02-110 (September 12, 2002).