Author: jfortenberry@fortenberrylaw.com

Thanks to Joe Kristan at Roth CPA.com for the following discussion regarding the IRS’s modernization of its tax compliance and enforcement sytems:

The IRS yesterday shut out its prime systems modernization contractor from new projects worth approximately $40 million. The contractor, Computer Science Corporation, recently disclosed that it will miss an April deadline for a critical part of the $15 billion project.

The project has been plagued with overruns and delays from the start.

. . .The contractor accepted responsibility in testimony before the Ways and Means Committee yesterday. The IRS also has some responsibility; at one point, according to the contractor, the IRS had 1100 change orders in ongoing projects. The sheer difficulty of upgrading a 1960’s tape-based system to a 21st century database has also delayed the project.

“Frustrated IRS to Seek New Technology Contractors“: the Associated Press via the Washington Post has the story. (Another report here from Washington Technology.)

Jottings by an Employment Lawyer provides the following discussion of the case of Cruthis v. Metropolitan Life (7th Cir. 2/2/04) [pdf]:

MetLife was no doubt shocked when it removed a claim for disability benefits under an employee benefit plan to federal court on the basis of a federal question and had it remanded to state court. The district court relied on language in the STATEMENT OF ERISA RIGHTS which provides in part, “If you have a claim for benefits which is denied or ignored, in whole or in part, you may file suit in a state or federal court.” Interpreting this as a contractual forum selection clause, the court held that MetLife was bound by an agreement that the case could be heard in state court. Since MetLife had copied a model form provided by the DOL for compliance with ERISA, it was less than pleased. Fortunately, the 7th Circuit had jurisdiction to hear the appeal of the remand since it was based on a choice of forum clause rather than a lack of jurisdiction.

On appeal, the 7th Circuit held that the statement was not a contractual agreement, but just a statement of rights, and sent the case back to the district court for a ruling on the merits, stating as follows:

We conclude that MetLife’s statement clearly was made to comply with ERISA’s disclosure requirements. Significantly, MetLife copied the model statement quoted above verbatim. Moreover, there is no evidence that the statement was intended to be part of the contract between the parties. The clause began with the capitalized title “STATEMENT OF ERISA RIGHTS” and the first sentence states that “[t]he following statement is required by federal law and regulation.” The statement further specified that “[u]nder ERISA there are steps you can take to enforce the above rights.” Thus, the plain language of the statement indicates that it is a disclosure of applicable law rather than a substantive contract provision.

Michael Fox notes the time, expense and attorneys fees caused by the erroneous opinion. While there is very little about the facts of the case in the opinion, it is interesting to note that this is one of those many “denial of disability benefits” cases which is making its way through the courts as discussed in this Workforce Management article.

Also, regarding the ERISA rights statement, remember this case? Prescott v. Little Six, Inc., 2003 U.S. Dist. LEXIS 17484 (D. Minn. 2003)? According to the court in Prescott, an Indian tribal government entity waived its tribal sovereign immunity from lawsuits in federal court based upon language in the model statement of ERISA rights. In deciding that the tribal entity had waived its immunity, the court relied in part on several plans’ SPDs, each of which contained language from the model statement. The court keyed in on this language that a plan participant “may file suit in a federal court” if a benefit claim was denied, in holding that the tribal entity had waived its sovereign immunity.

The IRS is putting a halt to abusive 412(i) plans as announced in this press release: “Treasury and IRS shut down abusive Life Insurance Policies in Retirement Plans.” According to the press release, Assistant Secretary for Tax Policy Pam Olson says that “[t]here are many legitimate section 412(i) plans, but some push the envelope, claiming tax results for employees and employers that do not reflect the underlying economics of the arrangements.”

The guidance issued is as follows:

1. New proposed regulations state that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full fair market value. (The regulations make changes to Treas. regulations 1.79-1, 1.83-3, and 1.402(a)-1.)

According to the press release, some firms have promoted an arrangement whereby the employer establishes a section 412(i) plan under which the contributions made to the plan, which are deducted by the employer, are used to purchase a specially designed life insurance contract, made available only to highly compensated employees. The insurance contract is designed so that the cash surrender value is temporarily depressed, so that it is significantly below the premiums paid. The contract is then distributed or sold to the employee for the amount of the current cash surrender value during the period the cash surrender value is depressed. However, the contract is structured so that the cash surrender value increases significantly after it is transferred to the employee.

According to the IRS, use of this “springing cash value life insurance” gives employers tax deductions for amounts far in excess of what the employee recognizes in income. The regulations are designed to prevent taxpayers from artificially understating the value of these contracts.

2. Revenue Procedure 2004-16 issued today along with the proposed regulations provides a temporary safe harbor for determining fair market value.

3. Revenue Ruling 2004-20 states that an employer cannot buy excessive life insurance (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee’s beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment) in order to claim large tax deductions. These arrangements generally will be listed transactions for tax-shelter reporting purposes.

4. Revenue Ruling 2004-21 states that a qualified plan funded with life insurance contracts which discriminate in favor of highly paid employees will not meet the requirements of section 401(a)(4) of the Internal Revenue Code and the benefits, rights, and features provisions of Treas. regulation section 1.401(a)(4)-1(b)(3) and section 1.401(a)(4)-4(a).

Judge Patrick Murphy has issued a Memorandum and Order in the case of Cooper v. IBM Personal Pension Plan and IBM Corporation. The Memorandum and Order grants plaintiffs’ motion to strike defendants’ attempt to assert “an affirmative defense out of time, or, in the alternative, to compel discovery and for extension of time.” IBM was arguing against the retroactive relief requested by plaintiffs based upon an argument that IBM was “blind-sided by what is characterized as a drastic change in the law.” IBM argued that the Court’s declaration that IBM’s 1995 PCF and 1999 cash balance plan violated the age discrimination prohibitions of ERISA section 204(b)91)(H) was a “startling new development in pension law” so that the “Court should exercise its discretion and grant only prospective relief.”

The Court says the following, in granting plaintiffs’ motion to strike:

. . . IBM is by no means in the sympathetic position of the employer in Manhart. Defined benefit plans are highly regulated and strictly scrutinized relative to defined contribution plans. The prohibition against age discrimination existed long before the appearance of cash balance plans. Indeed, the voluminous record in this case unequivocally shows that cash balance plans were a “response” to the long standing restrictive proscriptions that are the woof [warp?] and weave of a defined benefit plan. If this Court is correct, then the class is entitled to retroactive relief. There has not been a change in the law. All that has changed is IBM’s clever, but ineffectual, response to law that it finds too restrictive for its business model. . .

“It’s getting less murky how companies should book the effects of a new Medicare bill in their financial statements”: the Wall Street Journal reports on FASB‘s meeting on Wednesday at which it was decided that “companies should book the amount of federal subsidy they expect to receive under the Medicare Act as a reduction of future benefit costs — instead of as a stream of income from continuing operations.” The article is entitled: “FASB Confirms Standard on Medicare Accounting.” (Subscription required.)

Accounting Web also reports: “FASB Confirms Existing Rules on Medicare Accounting.”

Dennis Kennedy discusses Howard Bashman’s move to a solo practice here and notes his own prediction of this solo practice trend for big firm lawyers in his article: “2004 Legal Technology Trends: Do We Stand on the Threshold of the Next Legal Killer App?“

Mike O’Sullivan at Corp Law Blog has an enjoyable discussion of an employment contract provision gone awry (brought to our attention by Professor Bainbridge in a contract intrepretation quiz).

The Mid-Atlantic Pension Liaison Group met yesterday in Philadelphia. In attendance were practitioners from the Mid-Atlantic region as well as Vicki Surguy (Area II Determinations Manager from Cincinnati), Cathy Jones (the Employee Plans (“EP”) Mid-Atlantic Area Manager), George Brim (Area Coordinator), Michael Sanders (Supervisor and Internal Revenue Agent), as well as other agents and officials.

I. EP Determinations Update: Vicki Surguy provided the following updates:

(1) She confirmed that Paul Schultz will be leaving the IRS in March.

(2) As many of you know, Dick Wickersham left the IRS last year. His replacement will be Marty Pippins.

(3) Another draft of the White Paper on the Future of the Employee Plans Determinations Program is expected soon. (You can access the first White Paper here and the second White Paper here.) Ms. Surguy indicated that the approach being favored now is referred to as the “Bifurcated Approach” and would involve staggered “remedial amendment periods” for individually designed plans, based on the employer identification numbers (“EINs”) of the plan sponsor, as well as staggered submission of specimen plans (Volume Submitter and Master/Prototype). (If you want to see my rough notes as to what the schedule might look like, I have posted it in the “Continue Reading” section below.) The bottom line in this is that the “Status Quo” approach (i.e. keeping things as they are) is no longer favored by the IRS (as was reported at the last meeting) due to the staffing issues for IRS that ensue from having Determination Letter (“DL”) applications come in all at once.

(4) The Master & Prototype and Volume Submitter programs will likely be combined into one program. The combined program will probably include ESOPs and cross-tested plans, and be administered out of Cincinnati, Ohio. There will be a Revenue Procedure coming out soon on this.

(5) The IRS is working to close some of the “old” determination letter application cases that were submitted in 2002 and 2003 and are still open.

(6) The IRS is still working on quality assurance in the issuance of determination letters. As you may recall, at a previous meeting in October, Gary Runge, Quality Assurance Staff Manager, told the group that 24% of all DLs issued have errors in them, e.g. dates that are wrong, etc. If errors are discovered after a case is closed, the specialist fixing the error will have to retrieve the file from the Federal Records Center in Dayton, Ohio, in order to get the DL fixed. Ms. Surguy also informed us that EP records are retained for 10 years at the Federal Records Center, and then destroyed after that, but that Exempt Organization records are never destroyed.

(7) Ms. Surguy also gave a briefing on the status of the Tax Exempt Determination System (TEDS), the IRS’s new system which will allow for the electronic submission of DL applications and payment of user fees. It will also give plan sponsors the ability to track the status of their applications and even to access and change certain information in the system. As Ms. Surguy described the current “hard copy” system–of how the files are constantly being placed in boxes, shipped to other locations, unloaded, and then reboxed, reshipped to other locations, and unloaded again, and how agents reviewing these documents often work from their homes–it seems almost a “miracle” that our plans ever receive the DL’s that are applied for, due to the opportunity for error along the way. TEDS will apparently be phased in over the next few years, and will eliminate much of the paper handling burdens associated with the current system.

II. Local Determinations and Examinations Update: Cathy Jones and Michael Sanders gave the following update:

(1) The Employee Plans Team Audit Program (“EPTA”) seems to be getting into full swing with six different groups being sent out from the six different areas of EP Examination. In the Mid-Atlantic Area, the EPTA agents will be located in Philadelphia, Washington, D.C., Baltimore, Trenton, Pittsburgh, and Charlotte. The Group Manager, Elsie Garcia, is located in Trenton, New Jersey. EPTA agents will be examining large employers, including 403(b) plans, multi-employer plans, and many other types of plans as well. Audits will be targeting the following 5 market segments: (1) DB/health care, (2) DB/construction, (3) Profit-Sharing/manufacturing, (4) 401(k)/Finance and Insurance, and (5)Profit Sharing and Money Purchase/Other Services.

(2) The IRS is also implementing what are called “Focus Audits” which are audits limited to only 4 issues (in addition to “form” compliance). Michael Sanders will be heading the initiative in the Mid-Atlantic Area. There will be 4 groups of agents, working out of Texas (Dallas and Austin), Tennessee (Nashville, Knoxville, and Oklahoma City), Connecticut, and Philadelphia (Philadelphia, Scranton, Cherry Hill, and Trenton.) These agents will also work from the 5 market segments listed above. The program is a pilot and will start with 1,000 returns, with 200 coming out of each targeted market segment.

If agents begin a Focus Audit, and find that the plan is noncompliant in the identified areas, the audit may be expanded into additional issues or a Full Scope audit. Audits will be limited at first to the year under examination, but could extend to all years that the plan was noncompliant, according to Mr. Sanders.

Focus Audits will involve “Internal Control Interviews” and the IRS has prepared “Internal Control Checklists” for use in the audits. According to Cathy Jones, plans that are targeted should be prepared to discuss their “internal controls” with agents upon review.

As an example of what they will be targeting, in the DB/health care arena, agents will focus on Internal Revenue Code section 404 (deduction) and 412 (minimum funding) issues, as well as lump sum issues.

(3) All examinations–whether Full Scope or Focus Audits–will involve a review of plan documents to determine if they are up-to-date and compliant.

(4) The IRS will continue to do examinations based on referrals it receives from the Department of Labor as well as the general public.

(5) Cathy Jones stated that they are starting a new pilot program which will involve the examination of section 412(i) plans. The IRS will audit 10 to 50 of these plans, starting with the “springing cash value” plans first, and then focusing on returns with Schedule A’s.

(6) The IRS is also developing an Employee Plans Examination Process Guide which will detail the different stages of an Employee Plans Audit. The Guide will be available to the public at some time in the future.

(7) There was an article in the Winter 2004 edition of the IRS’s Employee Plan News entitled “Conducting Audits at a Taxpayer’s Place of Business” in which Preston Butcher, Director, EP Examinations, states:

Our efforts are focused on conducting effective and efficient high quality audits. In this regard, we have discussed with our agents the need for audits to generally be conducted at the taxpayer’s place of business, unless facts and circumstances dictate otherwise.

Apparently, the IRS will be providing a revision to this policy in an upcoming newsletter. The policy will not be as rigid as expected. According to officials at the meeting, there will be exceptions made on a case by case basis. The Service expects that 90% of the examinations will be conducted at the plan sponsor’s venue.

(8) Cathy Jones indicated that they will begin auditing SIMPLE Plans, starting in the 3rd quarter of this year. She noted that they just completed a program of auditing SEP Plans and found a great deal of noncompliance. The IRS is looking into an outreach program to educate the public regarding SEP compliance.

UPDATE: I would like to post notes from other Pension Liaison Group Meetings in other regions of the country for readers. If you are a member of another group and would like to provide this information, please email me by clicking here.

Here are my “rough” notes regarding the proposed DL Program (“Bifurcated Approach”) discussed above:

• Year 1: Defined Contribution (DC) Specimen Documents would be submitted to the IRS, as well as all individually designed plans (both DC and Defined Benefit (DB) plans) where the EINs of the plan sponsor end in 1 or 6.
• Year 2: Individually designed plans with plan sponsor EINs ending in 2 or 7 would come in for a DL.
• Year 3: Individually designed plans with plan sponsor EINs ending in 3 or 8 would come in for a DL, and DC Specimen Document letters would be issued by EP.
• Year 4: DB specimen documents would come in for a DL, as well as individually designed plans with plan sponsor EINs ending in 4 or 9 would come in as well.
• Year 5: Individually designed plans with plan sponsor EINs ending in 5 or 0 would come in for a DL.
• Year 6: DB specimen document letters would be issued, and the individually designed plan cycle would begin again (i.e. EINs ending in 1 or 6.)