IRS States Position on Hybrid Plan Arrangement

BY JAMES OZELLO

The IRS released a coordinated issue paper for all industries on the use of pension plan distributions to pay for certain benefits. The paper says the portion of pension plan distributions former employees use to purchase benefits in their employer’s cafeteria plan under a tax-free salary reduction does not reduce the amount of the taxable distribution. An employer cannot utilize this cafeteria plan/qualified retirement plan hybrid arrangement to lower health care expenses or taxable pension distributions for its former employees.

FASB Statement no. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, created an incentive for employers to use alternative methods to provide accident and health benefits to retirees. The purpose was to offset the effect of retiree health obligations on employers’ financial statements and reduce the escalating costs of accident and health coverage to employers.

One method, prompted by the observations in Statement no. 106, permitted retirees to apply a salary reduction agreement to their pension distributions. The employers would then use the distributions to purchase accident and health coverage for the former employees through their cafeteria plan. The employers would then report the retirement distributions on forms 1099R, less the benefit costs, effectively paying the health benefits with pretax dollars.

The IRS rejected the proposed method. It said IRC section 125, which governs cafeteria plans, allows employees to defer, tax-free, part of their salaries to purchase certain benefits. But pension distributions are taxable under section 402; the IRS noted that Congress had neither enacted nor intended any exception to section 402 to allow pension distributions to be tax deferred under section 125.

The IRS also stated that its position is consistent with two pre-ERISA rulings. Revenue ruling 61-164 (1961-2 CB 99) states that the use of trust funds to purchase accident and health coverage would not disqualify a pension plan. However, it goes on to say that such use is a distribution within the meaning of section 402. Also, revenue ruling 69-141 (1969-1 CB 48), states that distributions from a qualified plan to pay an employee-participant’s medical expenses are not accident and health benefits excludable under section 105(b), but are taxable under section 402(a) as previously earned deferred compensation.

Recommendation. Practitioners should review their clients’ pension and cafeteria plans to amend or eliminate any provisions that would conflict with the position the IRS has taken in the issue paper.

Coordinated Issue Paper—All Industries: Cafeteria Plan/Qualified Retirement Plan Hybrid Arrangement, 2/1/00.

—James Ozello, Esq.,
Ozello Tax and Legal Consulting,
Ringwood, NJ.

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