March 27, 2003

Tax Planning Opportunity for Unfunded, Post-retirement Benefit Obligations

Holland & Knight Newsletter
Robert J. Friedman

A decision by the U.S. Tax Court in February creates a tax opportunity for employers that have obligations for post-retirement employee benefits. 

In Wells Fargo & Co. v. Commissioner, the employer sponsored a medical plan that provided post-retirement benefits to its employees.  The employer established an employee benefit trust in 1979 for the purpose of funding the benefits under its medical plan and made contributions to the trust to pay or reimburse post-retirement medical benefits.  Until 1991, the employer made such contributions on a current or “pay as you go” basis.

In 1990, new financial accounting rules for nonpension, post-retirement benefits were promulgated in Statement of Financial Accounting Standards No. 106 (SFAS 106). Essentially, SFAS 106 required employers to accrue during the employment of an employee the cost of future health care benefits to be paid after the employee retires.  Therefore, as a result of SFAS 106, for financial accounting purposes, the employer was going to recognize a current expense for post-retirement medical benefits even though the actual funding may not occur until years later.

Because of the impact of SFAS 106, commencing with its 1991 tax year, the employer decided to fund its obligation for retiree medical benefits for active and already retired employees.  Under current federal tax law, in general, an employer may make a deductible contribution to an employee benefit trust for a reserve, which is to be funded over the working lives of the covered employees and actuarially determined on a level basis (using assumptions that are reasonable in the aggregate) as necessary for post-retirement medical benefits.  Based on the position that the already retired employees did not have any remaining working lives, the employer made contributions to the trust for the already retired employees equal to the entire present value of such employees’ projected benefits for the year the reserve was created.

The employer deducted the full amount of the contributions allocable to the reserve with respect to the benefits for the already retired employees in the year it made the contributions.  The IRS disallowed the deductions, claiming that the reserve had to be funded over the working lives of all covered employees, i.e. the active employees and the retired employees, and deducted accordingly.  The Tax Court, however, agreed with the employer that the contributions to the reserve for benefits for the already retired employees could be based on the position that they did not have any remaining working lives.  Accordingly, the court held that such contributions were deductible.

The ability to deduct the entire contribution to a benefits reserve for the benefits payable to retired employees in the year the contribution was made may lead to substantial tax savings. The Wells Fargo decision may present a tax planning opportunity for employers that have unfunded, post-retirement benefit obligations for already retired employees and the capacity to make contributions which can be allocated to the reserve created to pay such benefits. 

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