Future salary election differs from cash-for-health-benefits ruling

Plain-English summary

Public school employees received a brief, one-time irrevocable choice between retaining future retiree health benefits and avoiding a reduction in future compensation. An earlier IRS memorandum treated that choice like the election in Revenue Ruling 75-539 between a current cash payment for unused sick leave and using the payment for health premiums. Chief Counsel advised that the situations were not analogous because the school employees chose between future salary not yet earned and a future benefit, not between current cash and health coverage. The IRS should not rely on the earlier memorandum's analysis, and Chief Counsel said the facts required further study under several benefit, constructive-receipt, cafeteria-plan, payroll-tax, and deferred-compensation rules.

Ruling snapshot

• Question: Did Revenue Ruling 75-539 control a one-time election between future compensation and future retiree health benefits?
• Outcome: Advice that the ruling was distinguishable and should not support denial of the refund claims.
• Key authorities: IRC §§ 105, 106, 125, 401(k), 451, 3121(a); Rev. Rul. 75-539.

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201640015
           Release Date: 9/30/2016
           CC:TEGE:EB
           POSTN-119190-16

 UILC:     106.01-00

  date:    June 28, 2016

     to:   David Conrad
           Area Counsel, Mountain States Area
           (Tax Exempt & Government Entities Division Counsel)

  from:    Stephen B. Tackney
           Deputy Associate Chief Counsel (Employee Benefits)
           (Tax Exempt & Government Entities)


subject:   ------------------------------------------------------------------------------------------------------------------
           -----------------------------------------------------------------------


           This is in response to the request for reconsideration of a memorandum dated August 4,
           2015, prepared by you for Amy Myers, FSLG Mid-Atlantic Area Group Manager, and
           reviewed by this office in 2015. The memorandum relies upon Rev. Rul. 75-539, 1975-
           2 C.B. 45, and advises FSLG to deny refund claims filed by the school district relating to
           contributions made by public school employees under --------------------------------------------
           ------. As explained below, after further consideration of this matter, we question the
           reliance on Rev. Rul. 75-539 as the basis for the position taken in the memorandum,
           and have concluded that the IRS should not rely upon the memorandum’s analysis
           related to the application of the revenue ruling to the particular facts at issue.




           Rev. Rul. 75-539 considers whether amounts paid for health insurance are excludible
           from gross income of retired employees under § 106. The ruling describes two labor
           contracts. Contract A provides that, upon retirement, an employee will receive a cash
           payment for one-half of the employee’s unused sick leave credits in excess of 50 days
           or, at the option of the employee, that payment may be applied as the employee’s
           payment of premiums for continued participation in the employer’s health plan until the
           funds are exhausted. Contract B provides that the value of three-fourths of a retiring
POSTN-119190-16                               2

employee’s unused sick leave credits will be placed by the employer in an escrow
account to pay the premiums of continued participation by the retired employee in the
employer’s health plan until the funds are exhausted. Contract B further provides that
the retired employee, the retired employee’s spouse, or dependents may not receive
any of this escrow amount in cash. Furthermore, any part of the escrow amount which,
for any cause, is not expended for premiums reverts to the employer.

With respect to Contract A, Rev. Rul. 75-539 finds that a retiree’s option to relinquish
the right to the cash payment so that it may be used to pay premiums for continued
participation in the employer’s health plan, does not alter the conclusion that the amount
is constructively received by the retiree under § 451, and thus is includible in the
retiree’s gross income. Rev. Rul. 75-539 further provides that the amount of the
premium payments is considered an employee contribution out of salary and not a
contribution by the employer within the scope of § 106. Accordingly, under Contract A,
Rev. Rul. 75-539 holds that the value of unused sick leave credits, whether paid in cash
to the retired employee or used under the plan to continue health coverage for the
employee, is includible in the retired employee’s gross income.

With respect to Contract B, Rev. Rul. 75-539 notes that the value of unused sick leave
credits is placed in escrow by the employer solely for the payment of health insurance
premiums and may not be received in cash by the employee, the employee’s spouse, or
dependents. Accordingly, Rev. Rul. 75-539 holds that the amounts are not
constructively received by the retiree under § 451, but rather are contributions by the
employer to the employer’s health plan, and thus are excludible from the retired
employee’s gross income under § 106.

Under ---------, public school employees who earned service credit in the -----------------
ending -------------------------, or were on an approved leave of absence on that date, were
provided a brief, one-time irrevocable election window to opt out of the future right to
receive retiree health benefits under the state system. The election window opened in
late ------ and closed in early ------. Under ---------, employees who elected to opt out of
the future right to receive retiree health benefits under the state system would not be
subject to a ---------------------------------in their future compensation. Those who did not
opt out would have a ------------------applied to their compensation and would retain the
future right to receive retiree health benefits under the state system.

The August 2015 memorandum concludes that the election under --------- is analogous
to the choice offered to employees under Contract A in Rev. Rul. 75-539. The
conclusion that the two elections are analogous is not correct. Under the facts
described in Rev. Rul. 75-539, Contract A provided the employee a choice between a
current cash payment and the application of the payment to premiums for continued
coverage under the employer’s health plan. In contrast, the election provided in
accordance with --------- is distinguishable because it provides employees a choice
between future salary not yet earned (not a current cash payment) and a future right to
receive retiree health benefits. Accordingly, the facts described in Rev. Rul. 75-539 are
POSTN-119190-16                              3

distinguishable, and the IRS should not rely upon the application of its conclusions to
the facts at issue in the August 2015 memorandum.

After further consideration of this matter, we have concluded that there is not explicit or
analogous guidance addressing the federal tax consequences under these particular
facts. In addition, analysis of these particular facts raises issues not only concerning
the application of §§ 105 and 106, but also the application of the constructive receipt
doctrine, the definition of a cafeteria plan, the application of § 125, the application of
§ 3121(a), and, by analogy, the definition of a cash or deferred arrangement (CODA)
under § 401(k) and the potential relevance of the concept of a one-time irrevocable
election contained in § 1.401(k)-1(a)(3)(v).

We will continue to analyze these and similar facts to determine the federal tax
consequences, including whether published guidance may be appropriate to address
the series of issues raised.