CCA 1040018: Section 419 limits severance reserves to incurred claims and reasonable actuarial needs

Plain-English summary

Chief Counsel Advice considered whether an employer could deduct contributions to a welfare benefit trust for anticipated severance and vacation payments under IRC §§ 419 and 419A. The advice explains that the section 419A(c)(5) limit is an upper limit, not automatic permission to deduct a reserve, and that the employer must show the reserve reflects qualified direct costs or amounts reasonably and actuarially necessary for claims incurred but unpaid. Because the employer paid severance on a discretionary, ad hoc basis, claims for employees still employed or expected to be terminated in later years were not incurred by the end of the year at issue. The advice also states that using the reserve for vacation or other benefits could undermine the required intent that it fund severance benefits.

Ruling snapshot

• Question: Could an employer deduct contributions to a trust for anticipated severance and vacation payments under the section 419A(c)(5) limit?
• Outcome: Advice given
• Key authorities: IRC §§ 419 and 419A; Conference Committee Report on the Deficit Reduction Act of 1984, H. Conf. Rept. 98-861

Full text (IRS public release)

ID: CCA_2010060415114941 Number: 201040018
Release Date: 10/8/2010
Office: ----------------------------
UILC: 419.12-01, 419.00-00, 419.12-00,
419.11-00

From: ------------------
Sent: Friday, June 04, 2010 3:11:51 PM
To: -------------------------
Cc:
Subject: Continuous Audit Program (CAP) case

Regarding your CAP case question on section 419:

Taxpayer = -------------------------------------------------
Year 1 = -------------------------------------------
Year 2 = -------------------------------------------
X = ---------------
Market = ------------------------
Date 1= --------------------------
Date 2= -------------------------
Consultants = ----------------------

Taxpayer is an accrual basis fiscal year taxpayer. Taxpayer pays severance benefits in
its discretion on an ad hoc basis, and vacation benefits pursuant to its established
policy. Historically, Taxpayer has paid both severance and vacation pay from its
general assets. Due to a decline in the Market over the past few years, Taxpayer has
paid significant severance and expects to continue to pay additional severance over the
next few years. Effective Date 1, Taxpayer established Trust to pay this anticipated
severance and vacation pay. Trust intends to submit an application for recognition of
exempt status in Year 2. On Date 1, Taxpayer contributed over $ X to the Trust and
deducted that amount on its tax return for Year 1. Taxpayer indicates that beginning
Date 2, Taxpayer will make payments for vacation and severance and will seek
reimbursement from the Trust.

Taxpayer computed the amount deducted based on the limitation set forth in section
419A(c)(5). Taxpayer has not provided any information documenting any severance
claims incurred in Year 1 that it expects to pay in Year 2. Taxpayer 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 section 419A(c)(5)(B)(iii), that the deduction is proper. A memorandum
provided to Taxpayer by Consultants further indicates it can use amounts in the Trust
for other benefits, including vacation pay.
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Law and Legislative History

Under 419(a), Contributions paid or accrued by an employer to a welfare benefit fund, if
otherwise deductible, are deductible under section 419 in the year in which paid. The
Trust is a welfare benefit fund. Under section 419(b), the deduction is limited to the
Trust’s qualified cost for the taxable year. Under section 419(c)(1), “qualified cost”
means, with respect to any taxable year, the sum of (A) qualified direct cost for such
taxable year and, (B) subject to 419A(b), any addition to a qualified asset account for
the taxable year. Under section 419(c)(2), the qualified cost is reduced by the fund’s
after tax income for the taxable year.

Under section 419(c)(3)(A), qualified direct cost means, with respect to any taxable
year, the aggregate amount (including administrative expenses) which would have been
allowable as a deduction to the employer with respect to the benefits provided during
the a taxable year, if (i) such benefits were provided directly by the employer, and (ii)
the employer used the cash receipts and disbursements method of accounting.

Section 419A(a) defines the term “qualified asset account” to mean any account set
aside to provide for payment of disability benefits, medical benefits, SUB or severance
pay benefits, or life insurance benefits.

Section 419A(b) states that no addition to any qualified asset account may be taken into
account under section 419(c)(1)(B) to the extent such addition results in the amount in
such account exceeding the account limit.

Section 419A(c)(1) provides that, except as otherwise provided in section 419A(c), the
account limit for any qualified asset account for any taxable year is the amount
reasonably and actuarially necessary to fund –(A) claims incurred but unpaid (as of the
close of such taxable year) for benefits referred to in subsection (a), and (B)
administrative costs with respect to such claims.

Section 419A(c)(5)(A) provides that unless there is an actuarial certification of the
account limit for any taxable year, the account limit shall not exceed the sum of the safe
harbor limits for the taxable year. Section 419A(c)(5)(B) sets forth “Safe Harbor Limits”
for the various types of reservable benefits. Section 419A(c)(5)(B)(iii) provides that in
the case of SUB or severance pay benefits, the safe harbor limit for any taxable year is
the amount determined under paragraph 419A(c)(3). Section 419A(c)(3)(A) provides
that the account limit for any taxable year with respect to SUB or severance pay
benefits is 75 percent of the average annual qualified direct costs for SUB or severance
pay benefits for any 2 of the immediately preceding 7 taxable years (as selected by the
fund).

The legislative history of section 419 specifically states, “Even if the safe harbors are
satisfied, the taxpayer is to show that the reserves, as allowed under the general
standards provided by the bill (e.g., claims incurred but unpaid) are reasonable.”
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Conference Committee Report on the Deficit Reduction Act of 1984 (House Report 98-
861) (the Conference Report) at 1158.

With respect to what is meant by “claims incurred”, the Conference Report explains,
“Claims are incurred only when an event entitling the employee to benefits, such as a
medical expense, a separation, a disability, or a death actually occurs. The allowable
reserve includes amounts for claims estimated to have been incurred but which have
not yet been reported, as well as those claims which have been reported but have not
yet been paid.” Id at 1156.
.
My Analysis and Conclusions

(1) Assuming the addition to the reserve is within the limit for severance benefits set
forth in 419A(c)(5), Taxpayer is not required to have actuarial certification of the
amount. However, section 419A(c)(5)(B)(iii) is not a “safe harbor” in the conventional
sense. This section 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. See,
e.g., General Signal, 103 T.C. 216 at 232 (1994), aff’d 142 F.3d 546 (2nd Cir. 1998) in
which the Tax Court stated: “[s]ection 419A(c)(5)(B) does not allow a taxpayer to
automatically claim 35 percent of its prior year’s qualified direct costs as the amount of
incurred but unpaid medical claims. Rather, the statute merely allows a taxpayer to
claim amounts at or below this threshold without obtaining an actuarial certification.”
Sec. 419A(c)(5)(A)). The General Signal court cited H. Conf. Rept. 98-861, quoted
above.

Thus, to deduct the amount contributed under section 419 in Year 1, Taxpayer must
demonstrate that the amount contributed and deducted in Year 1 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 Year 1 (qualified direct costs), or be within the
general limit for severance pay benefits under 419A(c)(1) of an amount reasonably and
actuarially necessary to pay the claims incurred but unpaid as of the end of Year 1 (and
therefore be a permitted addition to a qualified asset account under section
419A(c)(1)).

Whether an amount is reasonably and actuarially necessary to pay the claims incurred
but unpaid as of the end of Year 1 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 Taxpayer’s
discretion. According to the memo provided by Consultants, Taxpayer “pays severance
benefits in its discretion and on an ad hoc basis”. Accordingly, Taxpayer’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 Year 1, at minimum,
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Taxpayer would need to demonstrate that as of the end of Year 1, some of its
employees had been terminated, and also demonstrate that it reasonably expected to
pay severance benefits to those employees beyond Year 1. In any event, the amount of
the deduction in Year 1 should not exceed amounts paid in severance benefits in Year 1
plus the amount that Taxpayer can demonstrate it reasonably expected, as of the end of
Year 1, to pay beyond Year 1 in severance benefits for those terminated employees.

(2) The reserve for incurred but unpaid claims as of the end of Year 1 would not take
into account benefits expected to be paid to employees who as of the end of Year 1
were still employed by Taxpayer. The reserve should not take into account any benefits
for employees that were expected to be severed in Year 2 and beyond, because any
severance claims for such employees were not “incurred” by the end of Year 1.

(3) The reserve must be intended to pay severance benefits, and use for vacation or
other benefits (if the Trust is amended), particularly within a short period of time, would
tend to negate Taxpayer’s demonstration of intent. Cf, General Signal v. Comm’r, 142
F.3d 546 (2nd Cir. 1998), affirming 103 T.C. 216 at 232 (1994). (General Signal
addressed whether the taxpayer established a reserve for postretirement medical
benefits under section 419A(c)(2), and the Second Circuit said that depended upon the
taxpayer’s intent at the time the reserve was established. The Second Circuit
explained, “Later depletions of a fund may serve as evidence of what a taxpayer’s
intent may have been…While our reading of the statute does not imply a commitment to
establish funding through the working lives of covered employees, if subsequent events
rendered maintenance of the reserve impossible, evidence of the reason for
discontinuing or spending down the reserve could be presented in response to any
accusation that a taxpayer never intended to be established in the first place.”)