Why is this Topic Important to Wealth Managers? Discusses particulars of Section 419 plans. Presents a situation where deduction may be limited due to non-current liabilities.
Company is an accrual basis fiscal year taxpayer. Company pays severance benefits in its discretion on an ad hoc basis, and vacation benefits pursuant to its established policy.
Historically, Company has paid both severance and vacation pay from its general assets. Due to a decline in the Market over the past few years, Company has paid significant severance and expects to continue to pay additional severance over the next few years. Effective Jan 1, 2009 Company established Trust to pay this anticipated severance and vacation pay. Trust intends to submit an application for recognition of exempt status in 2010. On 1/1/2009 Company contributed over $1,000,000 to the Trust and deducted that amount on its tax return for 2009. Company indicates that beginning in 2010, Company will make payments for vacation and severance and will seek reimbursement from the Trust.
Company computed the amount deducted based on the limitation set forth in the Code.
Company has not provided any information documenting any severance claims incurred in 2009 that it expects to pay in 2010. Company indicates that because the Trust was established “to pay severance that they anticipate they will have to pay over the next few years …”, and because the amount deducted is within the limit set forth in the Code that the deduction is proper.
Assuming the addition to the reserve is within the limit for severance benefits as a “safe harbor”, Company is not required to have actuarial certification of the amount. This amount does not provide an alternative for determining the account limit, but rather the 75% limit is an upper limit on the amount that an employer may treat as an addition to a reserve for severance pay benefits without actuarial certification.
Thus, to deduct the amount contributed under section 419 in 2009, Company must demonstrate that the amount contributed and deducted in 2009 for severance benefits is not greater than the sum of qualified direct costs plus permitted additions to the qualified asset account, minus after-tax income of the fund. Accordingly, the amounts either had to be used for benefits paid in 2009 (qualified direct costs), or be within the general limit for severance pay benefits of an amount reasonably and actuarially necessary to pay the claims incurred but unpaid as of the end of 2009.
Whether an amount is reasonably and actuarially necessary to pay the claims incurred but unpaid as of the end of 2009 is a determination that should be made based upon the particular facts and circumstances.
Among factors to take into consideration is whether there is an established obligation to make severance payments for a fixed amount of time, or whether continuation of any severance payments is in the Company’s discretion. In this example, Company “pays severance benefits in its discretion and on an ad hoc basis”.
Accordingly, Company’s employees do not have an automatic right to severance benefits if they are terminated. To establish that the severance benefits were “incurred” by the end of 2009, at minimum, Company would need to demonstrate that as of the end of 2009, some of its employees had been terminated, and also demonstrate that it reasonably expected to pay severance benefits to those employees beyond 2009. In any event, the amount of the deduction in 2009 should not exceed amounts paid in severance benefits in 2009 plus the amount that Company can demonstrate it reasonably expected, as of the end of 2009, to pay beyond 2009 in severance benefits for those terminated employees.
This “reserve for incurred but unpaid claims” as of the end of 2009 would not take into account benefits expected to be paid to employees who as of the end of 2009 were still employed by Company. The reserve should not take into account any benefits for employees that were expected to be severed in 2010 and beyond, because any severance claims for such employees were not “incurred” by the end of 2009.
Lastly, the reserve must be intended to pay severance benefits, and use for vacation or other benefits particularly within a short period of time, would tend to negate Company’s demonstration of intent, which is generally a consideration with regards to formation of a trust.
Next week’s blogticles will discuss important planning consideration for wealth managers.
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