Disability Funding of Pension Contributions

Although pension plans are thought of primarily as a source of cash income for the elderly, they typically serve other functions as well. For example, they usually contain early retirement features and often provide pensions to workers who lose their jobs because of disability. The high proportion of pension plans with disability retirement features is dramatized in data from the Bureau of Labor Statistics' annual survey of the incidence and characteristics of employee benefit plans in medium and large establishments. Of the 1,002 private pension plans found in the 1980 survey, 86% had disability retirement. None of these programs had provisions to make up employee contributions and employer matches where the employee becomes disabled during their employment years. See, “Employee Benefits in Industry, 1980,” Bulletin 2107 (Bureau of Labor Statistics, 1981).

There is a 12.9% probability of an employee dying during his or her working years. There is a 25% chance of an employee becoming disabled. If you were going to place a wager in Las Vegas, wouldn't you think more people would be behind the 1:4 likelihood than the 1:7.7?

There has been a product developed ' and a patent issued ' that addresses this need. A guaranteed issue disability policy is now available to overcome continued funding requirements if an employee participant in a 401(a) or 403(b) plan becomes disabled and no longer an employee of the employer/plan sponsor. Under most plans, upon such an occurrence the employee participant is no longer deemed an active participant in the plan. Before suggesting your client, as plan sponsor, should provide this benefit you should ask the following questions.

Is the program considered a “listed transaction” under the Treasury Regulations, a “potentially abusive tax shelter” under Internal Revenue Code (IRC) '6112(b) and Treas. Reg. '301.6112-1(b), a “reportable transaction” under Treas. Reg. '1.6011-4(b) and IRC '101(j) and Notice 2009-48 compliant, or violates the Economic Substance Doctrine codified in new IRC '7701(o)?

NO. Based on a review of the IRC and Treasury Regulation provisions (the Tax Shelter Provisions), the program does not fall within the definition of a “listed transaction,” a “tax shelter,” a “potentially abusive tax shelter,” or a “reportable transaction” as defined therein. Furthermore, the program is not considered to be “substantially similar to” a “listed transaction,” a “tax shelter,” a “potentially abusive tax shelter,” or a “reportable transaction” as defined in the applicable sections of the IRC and Treasury Regulations. (For more on the Economic Substance Doctrine, see, “Codification of Economic Substance Doctrine and Related Penalties,” IRS.gov.)

Does the design of the program meet the standards of “disability benefits” under IRC ”104, 105 or Treas. Reg. ”1.162-10,31.3121(a) and (b), and if so, are participants solely taxed on the cost of the premium as the economic benefit rather than the benefits provided by the program?

YES. The program complies with the ”104(a)(3), 105 rules and as defined under Treas. Reg. '31.3121, and the participants are taxed only on the premium costs for the program. IRC ”104 and105 and accompanying regulations and Revenue Rulings set forth criteria that disability insurance plans must meet in order to be considered compliant. The program follows Revenue Ruling 2004-55'and as such the holding applies:

Under the amended plan, long-term disability benefits received by an employee who has irrevocably elected, prior to the beginning of the plan year, to have the coverage paid by the employer on an after-tax basis for the plan year in which the employee becomes disabled, are attributable solely to after-tax employee contributions and are excludable from the employee's gross income under '104(a)(3).

Does the program comply with the propose Tax Reform Act of 2014?

YES. Chairman of the Ways and Means Committee, David Camp, provides a safe harbor for RIAP Plans structured as the program. Other planning tools, such as deferred compensations under '409A and '457 will require risks of forfeiture, and funding is limited as to time and amount. The program also will not be required to limit the amount of the contribution. For a detailed look at the Tax Reform Act of 2014, see , “Tax Reform Act of 2014: Discussion Draft; Section-by-Section Summary.” Additionally the provisions comply with amended Treas. Reg. '1.1402(a)-1 for tax years post 2014. (TD 9665, May 12, 2014).

When is the latest you can make a contribution to the program and have it qualify for a deduction?

The program has funding and timing opportunities similar to qualified plans without the added expenses and discrimination testing of '401(a)-type plans. If an existing group term plan is in existence and it is amended, the contribution can be made up to 8.5 months after year end. See, IRC '461(h)(3). If there is no form of Group Term Disability Plan sponsored by the employer at the time of implementation, the contribution must be made within 3.5 months of the employer's year end. See, IRC ”104, 105, 162, 461.

Does the program create the possibility of a Prohibited Transaction under IRC '4975(e)?

NO. The program is not a Prohibited Transaction. IRC '4975 imposes a tax on prohibited transactions between “plans” and disqualified persons. For this purpose, the IRC defines “plan” as 403(a) plans or 401(a) trusts which are exempt from tax under '501(a), individual retirement accounts, Archer medical savings accounts, health savings accounts, and a trust, plan, account or annuity which has been determined to be one of the preceding by the Secretary of the Treasury.

The program provides only a disability benefit to covered individuals. The program is not a 403(a) plan, a 401(a) trust or one of the types of savings accounts described in IRC '4975(e). The program is not a Prohibited Transaction. See, IRC '4975.

Is the program required to comply under IRC '419(e) as a welfare benefit fund?

YES. The program is not required to comply with IRC ”419 or 419A, which place limitations on the deductibility of amounts contributed by employers to a “welfare benefit fund” (including, in some cases, reserve requirements). The program complies with all rules and regulations, and the entire premium is deductible for income tax purposes.

Does the program constitute a “pension plan” as described in Revenue Ruling 81-162?

NO. Revenue Ruling 81-162 was issued to clarify whether a plan providing benefits through the purchase of ordinary disability insurance contracts, which may be converted to annuity payments upon retirement, constitutes a pension plan. The tax regulations provide that a pension plan is a plan established and maintained primarily to provide for payments to employees over a period of years, usually for disability. A pension plan may also provide for the payment of incidental death benefits through insurance or otherwise. See, IRC '401(a); Treas. Reg. '1.401-1(b) (1) (I).

Revenue Ruling 81-162 clarified whether a plan created for the purchase of ordinary disability insurance contracts and not primarily for the payment of benefits to employees over a period of years with only an “incidental” disability insurance benefit was a pension plan. The disability insurance benefits were the primary purpose of the plan, not merely an “incidental benefit” under IRC '401(a). The fact that the insurance contracts could later be converted to a disability annuity did not make the plan a pension plan.

The program was developed for the primary purpose of providing funding of the employer and employee contributions to a qualifying plan as though the plan participant was not disabled through disability insurance. As long as it does not provide disability insurance benefits that are merely “incidental” to a retirement benefit over a period of years, it is not considered a pension plan. See, Romach v. Nestle, USA Inc., 211 F.3d 190 (2nd Cir. 2000), Anderson v. Suburban Teamsters, 588 F.3d 641 (9th Cir. 2009).

Is the program a “nonqualified deferred compensation plan” as described in IRC '409A?

NO. The program is not deferred compensation. IRC '409A defines a nonqualified deferred compensation plan as any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. The IRS provided the definition of “benefit plan” on Dec. 21, 2004 with the issuance of Notice 2005-1. The program complies with the definition as set forth in Treas. Reg. '1.31.3121(v)(2)-1(b)(4)(IV)(C).

The program was developed for the primary purpose of providing disability benefits through disability insurance to equalize what the participant would otherwise have received had they been able to continue employment and contribute to the qualified plan. The new rules targets certain nonqualified deferred compensation plans and specifically excludes programs under Treas. Reg. '1.31.3121. The program qualifies under this provision so it is not governed by IRC '409A.

Are employer contributions to the program, currently deductible by the employer, subject only to limitations on reasonable compensation?

YES. The contributions are currently deductible. IRC '162(a)(1) allows a deduction for ordinary and necessary business expenses, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Specifically, amounts paid for sickness, accident, welfare, medical and similar benefits are deductible under '162(a)(1). See, Treas Reg. '1.162-10(a) (no deduction would be allowed, however, if under any circumstances, the amounts may be used to provide benefits under certain deferred compensation plans). The test is whether the amounts are reasonable and are, in fact, payment for services. See, Treas. Reg. '1.162-7(a).

Where the actuarially determined contributions are equal to the cost of the current disability benefit protection provided under the program, there are no factors that should question whether compensation would be reasonable.

Does the program meet the requirements of a “group insurance arrangement” within the meaning of Labor Reg. '2520.104-21?

YES. The program qualifies as a group insurance arrangement. Labor Reg. '2520.104-21 exempts certain welfare benefit plans from reporting and disclosure requirements under ERISA. Specifically, the administrator of group insurance arrangements which cover fewer than 100 participants at the beginning of the plan year and which meet certain requirements do not have to file a terminal report regarding the plan. See, Labor Reg. '2520.104-21(a).

Is the program considered a Multiple Employer Welfare Arrangement (MEWA) under ERISA?

NO. The program has no MEWA compliance issues. Under ERISA '3(40)(A), a MEWA is an employee welfare benefit plan or other arrangement established or maintained to offer or provide any benefit of the type provided by ERISA welfare benefit plans ' which includes death benefits under ERISA '3(1) ' to employees or beneficiaries of two or more employers, including one or more self-employed individuals. The definition specifically excludes arrangements established or maintained pursuant to a collective bargaining agreement or by rural electric cooperatives or rural cooperating telephone associations. Also, for purposes of determining whether an arrangement covers multiple employers, or only one, a group of trades or businesses will be deemed to be a single employer if they are under “common control” as defined in IRC '414(c) and Treas. Reg. '1.44(1). The program will qualify as a Single Plan. See, DOL Advisory Opinions 83-22A and 2003-17A, EBIA's ERISA Compliance Manual, Sec. XIX.D.)

Is the program in compliance with the COLI Best Practices and the 2006 Tax Law changes?

To the extent the provisions of the COLI Best Practices apply, they are being followed. The participant having the right to name a beneficiary during employment is a safe harbor for compliance purposes. This approach can also be wrapped around an existing COLI program to provide compliance on a tax-deductible basis. For more, see the Pension Protection Act of 2006. The structure also follows the requirements of Notice 2009-48'from a compliance standpoint.

Conclusion

With these questions answered, the economic reasonableness of the costs in proportion to the benefit is a tool that should seriously be considered to safeguard all plan participants.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A and Benefit Planning.

Although pension plans are thought of primarily as a source of cash income for the elderly, they typically serve other functions as well. For example, they usually contain early retirement features and often provide pensions to workers who lose their jobs because of disability. The high proportion of pension plans with disability retirement features is dramatized in data from the Bureau of Labor Statistics' annual survey of the incidence and characteristics of employee benefit plans in medium and large establishments. Of the 1,002 private pension plans found in the 1980 survey, 86% had disability retirement. None of these programs had provisions to make up employee contributions and employer matches where the employee becomes disabled during their employment years. See, “Employee Benefits in Industry, 1980,” Bulletin 2107 (Bureau of Labor Statistics, 1981).

There is a 12.9% probability of an employee dying during his or her working years. There is a 25% chance of an employee becoming disabled. If you were going to place a wager in Las Vegas, wouldn't you think more people would be behind the 1:4 likelihood than the 1:7.7?

There has been a product developed ' and a patent issued ' that addresses this need. A guaranteed issue disability policy is now available to overcome continued funding requirements if an employee participant in a 401(a) or 403(b) plan becomes disabled and no longer an employee of the employer/plan sponsor. Under most plans, upon such an occurrence the employee participant is no longer deemed an active participant in the plan. Before suggesting your client, as plan sponsor, should provide this benefit you should ask the following questions.

Is the program considered a “listed transaction” under the Treasury Regulations, a “potentially abusive tax shelter” under Internal Revenue Code (IRC) '6112(b) and Treas. Reg. '301.6112-1(b), a “reportable transaction” under Treas. Reg. '1.6011-4(b) and IRC '101(j) and Notice 2009-48 compliant, or violates the Economic Substance Doctrine codified in new IRC '7701(o)?

NO. Based on a review of the IRC and Treasury Regulation provisions (the Tax Shelter Provisions), the program does not fall within the definition of a “listed transaction,” a “tax shelter,” a “potentially abusive tax shelter,” or a “reportable transaction” as defined therein. Furthermore, the program is not considered to be “substantially similar to” a “listed transaction,” a “tax shelter,” a “potentially abusive tax shelter,” or a “reportable transaction” as defined in the applicable sections of the IRC and Treasury Regulations. (For more on the Economic Substance Doctrine, see, “Codification of Economic Substance Doctrine and Related Penalties,” IRS.gov.)

Does the design of the program meet the standards of “disability benefits” under IRC ”104, 105 or Treas. Reg. ”1.162-10,31.3121(a) and (b), and if so, are participants solely taxed on the cost of the premium as the economic benefit rather than the benefits provided by the program?

YES. The program complies with the ”104(a)(3), 105 rules and as defined under Treas. Reg. '31.3121, and the participants are taxed only on the premium costs for the program. IRC ”104 and105 and accompanying regulations and Revenue Rulings set forth criteria that disability insurance plans must meet in order to be considered compliant. The program follows Revenue Ruling 2004-55'and as such the holding applies:

Under the amended plan, long-term disability benefits received by an employee who has irrevocably elected, prior to the beginning of the plan year, to have the coverage paid by the employer on an after-tax basis for the plan year in which the employee becomes disabled, are attributable solely to after-tax employee contributions and are excludable from the employee's gross income under '104(a)(3).

Does the program comply with the propose Tax Reform Act of 2014?

YES. Chairman of the Ways and Means Committee, David Camp, provides a safe harbor for RIAP Plans structured as the program. Other planning tools, such as deferred compensations under '409A and '457 will require risks of forfeiture, and funding is limited as to time and amount. The program also will not be required to limit the amount of the contribution. For a detailed look at the Tax Reform Act of 2014, see , “Tax Reform Act of 2014: Discussion Draft; Section-by-Section Summary.” Additionally the provisions comply with amended Treas. Reg. '1.1402(a)-1 for tax years post 2014. (TD 9665, May 12, 2014).

When is the latest you can make a contribution to the program and have it qualify for a deduction?

The program has funding and timing opportunities similar to qualified plans without the added expenses and discrimination testing of '401(a)-type plans. If an existing group term plan is in existence and it is amended, the contribution can be made up to 8.5 months after year end. See, IRC '461(h)(3). If there is no form of Group Term Disability Plan sponsored by the employer at the time of implementation, the contribution must be made within 3.5 months of the employer's year end. See, IRC ”104, 105, 162, 461.

Does the program create the possibility of a Prohibited Transaction under IRC '4975(e)?

NO. The program is not a Prohibited Transaction. IRC '4975 imposes a tax on prohibited transactions between “plans” and disqualified persons. For this purpose, the IRC defines “plan” as 403(a) plans or 401(a) trusts which are exempt from tax under '501(a), individual retirement accounts, Archer medical savings accounts, health savings accounts, and a trust, plan, account or annuity which has been determined to be one of the preceding by the Secretary of the Treasury.

The program provides only a disability benefit to covered individuals. The program is not a 403(a) plan, a 401(a) trust or one of the types of savings accounts described in IRC '4975(e). The program is not a Prohibited Transaction. See, IRC '4975.

Is the program required to comply under IRC '419(e) as a welfare benefit fund?

YES. The program is not required to comply with IRC ”419 or 419A, which place limitations on the deductibility of amounts contributed by employers to a “welfare benefit fund” (including, in some cases, reserve requirements). The program complies with all rules and regulations, and the entire premium is deductible for income tax purposes.

Does the program constitute a “pension plan” as described in Revenue Ruling 81-162?

NO. Revenue Ruling 81-162 was issued to clarify whether a plan providing benefits through the purchase of ordinary disability insurance contracts, which may be converted to annuity payments upon retirement, constitutes a pension plan. The tax regulations provide that a pension plan is a plan established and maintained primarily to provide for payments to employees over a period of years, usually for disability. A pension plan may also provide for the payment of incidental death benefits through insurance or otherwise. See, IRC '401(a); Treas. Reg. '1.401-1(b) (1) (I).

Revenue Ruling 81-162 clarified whether a plan created for the purchase of ordinary disability insurance contracts and not primarily for the payment of benefits to employees over a period of years with only an “incidental” disability insurance benefit was a pension plan. The disability insurance benefits were the primary purpose of the plan, not merely an “incidental benefit” under IRC '401(a). The fact that the insurance contracts could later be converted to a disability annuity did not make the plan a pension plan.

The program was developed for the primary purpose of providing funding of the employer and employee contributions to a qualifying plan as though the plan participant was not disabled through disability insurance. As long as it does not provide disability insurance benefits that are merely “incidental” to a retirement benefit over a period of years, it is not considered a pension plan. See, Romach v. Nestle, USA Inc., 211 F.3d 190 (2nd Cir. 2000), Anderson v. Suburban Teamsters, 588 F.3d 641 (9th Cir. 2009).

Is the program a “nonqualified deferred compensation plan” as described in IRC '409A?

NO. The program is not deferred compensation. IRC '409A defines a nonqualified deferred compensation plan as any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. The IRS provided the definition of “benefit plan” on Dec. 21, 2004 with the issuance of Notice 2005-1. The program complies with the definition as set forth in Treas. Reg. '1.31.3121(v)(2)-1(b)(4)(IV)(C).

The program was developed for the primary purpose of providing disability benefits through disability insurance to equalize what the participant would otherwise have received had they been able to continue employment and contribute to the qualified plan. The new rules targets certain nonqualified deferred compensation plans and specifically excludes programs under Treas. Reg. '1.31.3121. The program qualifies under this provision so it is not governed by IRC '409A.

Are employer contributions to the program, currently deductible by the employer, subject only to limitations on reasonable compensation?

YES. The contributions are currently deductible. IRC '162(a)(1) allows a deduction for ordinary and necessary business expenses, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Specifically, amounts paid for sickness, accident, welfare, medical and similar benefits are deductible under '162(a)(1). See, Treas Reg. '1.162-10(a) (no deduction would be allowed, however, if under any circumstances, the amounts may be used to provide benefits under certain deferred compensation plans). The test is whether the amounts are reasonable and are, in fact, payment for services. See, Treas. Reg. '1.162-7(a).

Where the actuarially determined contributions are equal to the cost of the current disability benefit protection provided under the program, there are no factors that should question whether compensation would be reasonable.

Does the program meet the requirements of a “group insurance arrangement” within the meaning of Labor Reg. '2520.104-21?

YES. The program qualifies as a group insurance arrangement. Labor Reg. '2520.104-21 exempts certain welfare benefit plans from reporting and disclosure requirements under ERISA. Specifically, the administrator of group insurance arrangements which cover fewer than 100 participants at the beginning of the plan year and which meet certain requirements do not have to file a terminal report regarding the plan. See, Labor Reg. '2520.104-21(a).

Is the program considered a Multiple Employer Welfare Arrangement (MEWA) under ERISA?

NO. The program has no MEWA compliance issues. Under ERISA '3(40)(A), a MEWA is an employee welfare benefit plan or other arrangement established or maintained to offer or provide any benefit of the type provided by ERISA welfare benefit plans ' which includes death benefits under ERISA '3(1) ' to employees or beneficiaries of two or more employers, including one or more self-employed individuals. The definition specifically excludes arrangements established or maintained pursuant to a collective bargaining agreement or by rural electric cooperatives or rural cooperating telephone associations. Also, for purposes of determining whether an arrangement covers multiple employers, or only one, a group of trades or businesses will be deemed to be a single employer if they are under “common control” as defined in IRC '414(c) and Treas. Reg. '1.44(1). The program will qualify as a Single Plan. See, DOL Advisory Opinions 83-22A and 2003-17A, EBIA's ERISA Compliance Manual, Sec. XIX.D.)

Is the program in compliance with the COLI Best Practices and the 2006 Tax Law changes?

To the extent the provisions of the COLI Best Practices apply, they are being followed. The participant having the right to name a beneficiary during employment is a safe harbor for compliance purposes. This approach can also be wrapped around an existing COLI program to provide compliance on a tax-deductible basis. For more, see the Pension Protection Act of 2006. The structure also follows the requirements of Notice 2009-48'from a compliance standpoint.

Conclusion

With these questions answered, the economic reasonableness of the costs in proportion to the benefit is a tool that should seriously be considered to safeguard all plan participants.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A and Benefit Planning.