Company Aircraft, Backdated Stock Options, COBRA Alternative Coverage; Stale SPDs

Focus On Employee Benefits
05.14.08

Payroll Tax & Fringe Benefits: Regulatory Dissonance on Personal Use of Company Aircraft -- IRS vs. SEC vs. FAA

Lee Spence

It is probably too much to ask of federal regulators to coordinate their rules, but the IRS, SEC and FAA rules affecting personal use of company aircraft by executives are frustratingly out of synch. Companies need to be careful that they use the correct valuation method in determining the value of any personal use of a company aircraft by an executive or his or her guest.

IRS Requirements

The IRS rules are not even internally consistent. Under IRS rules and regulations, the amount of compensation to be imputed to an executive for a personal flight on a company aircraft must be based on one of two alternative measures. The first is a fair market value equal based on the cost of a charter on a comparable aircraft for a comparable flight. The second is a value based on the IRS' Standard Industry Fare Level (SIFL) tables, which take into account the distance traveled and the size of the aircraft. A higher multiple of the SIFL value is required for "control" employees such as top executives, but this value is still much lower than charter at today's prices.

The IRS' rules for determining the amount of a company's deduction disallowance for entertainment use of company aircraft by "specified individuals" are based on an approach that looks not to the value of the entertainment flight but rather to an allocation to the entertainment flight of the company's total direct and indirect costs of flying and maintaining the aircraft. This allocation involves the application of either an occupied seat hour or mile allocation method or a modified flight-by-flight allocation method. The resulting cost amount will likely far exceed SIFL value and may be less or more than charter value, depending upon the facts, but is conceptually unrelated to SIFL or charter values. In developing the disallowance rules, the IRS turned a deaf ear to pleas from companies to be permitted to impute compensation to specified individuals for entertainment flights using the same allocated cost methods, thereby eliminating the deduction disallowance that is based on subtracting from the allocated cost of the specified individuals' entertainment flights the amount of compensation imputed to them (and reported as such). As a further example of the disconnect between the income and deduction disallowance rules, the so-called "consistency rules" take away the company's choice of imputing compensation to different specified individuals for entertainment flights based on either charter value or SIFL value -- i.e., the company must use the same method consistently for all entertainment use by all specified individuals in computing the amount of the deduction disallowance.

SEC Requirements

A totally different valuation approach is followed by the SEC. The SEC requires publicly-held companies to disclose the "aggregate incremental cost" associated with personal flights taken on a company-provided aircraft by each of the named executive officers. Although, the SEC has not defined the term "aggregate incremental cost" in the context of disclosure of personal use of company aircraft, it has made it clear that the tax value of the benefit (e.g., the SIFL or charter amount), or the application of some other valuation method that is not based on the incremental cost associated with the particular flight, is not appropriate for SEC disclosure purposes. As a result, companies are left to use their best judgment as to how to interpret "aggregate incremental cost." Many companies have interpreted the phrase to mean the direct operating costs related to a personal flight (e.g., landing fees specific to the flight, meals, personnel expenses, etc.), thereby excluding from the valuation fixed costs incurred by the company (e.g., capital expenditures, certain personnel and maintenance costs, hangar expenses, etc.). Of course, both direct and indirect costs must be included in the IRS deduction disallowance allocations; so there is no congruence between the IRS and SEC approaches to valuation or cost. Ironically, it is uncertain whether any amounts of deduction disallowed to the company by the IRS with respect to entertainment flights by the named executive officers should be included in the aggregate incremental cost associated with such flights for SEC disclosure purposes.

FAA Requirements

Some executives may wish to reimburse the company for personal flights (whether for entertainment or non-entertainment personal reasons, e.g., to attend a funeral) out of a sense of fairness and in order to avoid disclosure to shareholders. But the FAA has generally frustrated this objective by forbidding any such reimbursement as a violation of its rules. Although there are some ways to navigate around this prohibition, this is not easy to do and will not work under all circumstances. Finally, it is abundantly clear that even if reimbursement were permitted, the amount of the executive's reimbursement to the company could not possibly match up with all of the disparate regulatory formulations described above.

 

Exec Comp: IRS Redesignates Backdated Stock Options as a Tier II Issue

Gary Quintiere & Patricia Szoeke

Late last month, the IRS issued a directive announcing that the issue of backdated stock options was being redesignated from Tier I status to Tier II status. Tier II issues are those where the IRS' Large and Mid-Sized Business (LMSB) division believes there is a significant risk of noncompliance.

In July 2007, the IRS had issued publicly a directive (dated June 15, 2007) designating transactions involving backdated stock options as a Tier I issue for its agents. This designation afforded backdated stock options the highest level of specialized enforcement within the LMSB division. As a result of this directive, the IRS increased its audit of transactions involving backdated stock options and/or backdated exercise prices.

After approximately 10 months of such increased focus, the IRS has issued another directive stating that, due to the increased sophistication of its field personnel to identify and examine backdated stock option issues and the progress of IRS examinations on this issue, the issue of backdated stock options would now be redesignated as a Tier II issue, thereby allowing the IRS' Issue Management Team (IMT) to provide assistance and field support to ongoing examinations. As such, no additional backdated stock option Tier I cases will be assigned to the field.

For those Tier I cases already assigned to the field, the directive identifies the following changes as applying:

  • The case agent's monthly reporting requirements will be eliminated after submission of the April 10, 2008 report.
  • A closing report will continue to be required upon completion of the examination.
  • Non-assertion of penalties still requires IMT approval prior to any penalty discussion with the taxpayer.
  • UIL, Project and Tracking Codes will continue to be mandatory and conform to those outlined in the first directive issued in July 2007.

 

Health & Welfare: Continuation Coverage that Integrates Alternative Coverage and COBRA Rights

Susan Relland & Patricia Szoeke

Employers increasingly are using alternative coverage as a means of reducing their exposure to COBRA liability and decreasing administrative expenses associated with providing COBRA coverage. Alternative coverage generally refers to continued coverage that is provided independently from COBRA and that covers a period of time following the occurrence of a qualifying event. Such coverage may take various forms, including continued coverage under the employer-sponsored health plan, retiree coverage, coverage under a severance agreement, or coverage required under applicable state law.

The COBRA regulations provide that an employer may provide alternative coverage in combination with (or in lieu of) COBRA coverage using one of the following three methods:

Employers increasingly are using alternative coverage as a means of reducing their exposure to COBRA liability and decreasing administrative expenses associated with providing COBRA coverage. Alternative coverage generally refers to continued coverage that is provided independently from COBRA and that covers a period of time following the occurrence of a qualifying event. Such coverage may take various forms, including continued coverage under the employer-sponsored health plan, retiree coverage, coverage under a severance agreement, or coverage required under applicable state law.

The COBRA regulations provide that an employer may provide alternative coverage in combination with (or in lieu of) COBRA coverage using one of the following three methods:

Consecutive Coverage Method

Some employers provide their employees with alternative coverage, followed by full COBRA coverage after the expiration of the alternative coverage. For example, an employer may apply the consecutive coverage method by providing terminated employees with six months of coverage under the employer-sponsored medical plan following the date of termination, followed by 18 full months of COBRA coverage after the initial six months have elapsed. The consecutive coverage method results in the individuals' receiving coverage for a period of time longer than that mandated under COBRA, thereby exposing the employer to greater risk of significant claims under its health and welfare plan.

Concurrent Coverage Method

As an alternative to providing consecutive coverage, COBRA permits time covered under an alternative coverage arrangement that is substantially similar to COBRA coverage to count toward fulfillment of the COBRA coverage period. For example, instead of providing for 18 full months of COBRA coverage following expiration of the six months of alternative coverage, an employer may apply the concurrent coverage method by providing that the six months of coverage under the employer-sponsored medical plan following the date of termination will be credited toward the 18 months of COBRA coverage. Under this approach, the employer's financial risk is mitigated, as the total time during which claims are covered under the employer's plan is reduced in comparison to the consecutive coverage method.

Choice Method

An alternative becoming more popular among employers involves providing individuals with a choice of either (i) electing coverage under COBRA or (ii) waiving coverage under COBRA and electing coverage under another arrangement. Usually, the alternate coverage provided under the choice method is the same coverage the individual had prior to incurring a qualified event, but with rates that are less than those under COBRA and covering a period of time shorter than 18 months. For example, an employer may provide that a terminated individual elect (i) COBRA coverage at the higher COBRA premiums for the full 18-month period or (ii) coverage under the employer's health plan at active employee (i.e., subsidized) rates for a period of six months. Under the second option, although the total amount of money the employer must incur in order to continue to provide subsidized active employee rates would increase, the total claims exposure period would be reduced from 18 months to six months.

In deciding which approach to take with regard to integrating alternative coverage into continuation benefits, it is important that employers make sure the coverage they offer squarely fits within the options available under the COBRA regulations. In addition, careful drafting will help ensure individuals do not receive more benefits than the employer had intended.

 

Qualified Plans: Beware of Stale SPDs

Gary Quintiere & Veronica Rouse

The importance of a well-written summary plan description (SPD) cannot be overstated. Substantial damages have been imposed upon many a plan sponsor for failure to keep its SPD consistent with its plan. Accordingly, we recommend that plan sponsors who have not reviewed their SPDs in a while do so. What happened to the plan sponsor in the case summarized below should act as a motivator for engaging in this critical exercise.

A U.S. district court in California ruled last September that when a pension plan specifically omitted service with predecessor companies from the benefits calculation and the plan document conflicted with the SPD, the SPD controlled because it was more favorable to the employees. Vasquez v. Cargill Inc. and Associated Companies Salaried Employees' Pension Plan, 509 F. Supp. 2d 903 (C.D. Cal., Sept. 2007).

In Vasquez, three employees worked at the same oil facility for more than 35 years. For nearly 25 of those years, the employees worked for Hunt-Wesson. In 1990, Cargill Inc. acquired the oil facility from Hunt-Wesson. Shortly before the transaction, the three employees attended a meeting regarding the acquisition. During the meeting, they were told that their years of service with Hunt-Wesson would be taken into account for vesting purposes. Unfortunately, no written documentation was provided to support comments made at the meeting.

The three employees became participants in the Cargill Inc. and Associated Companies Pension Plan for Production Employees (Plan) upon becoming Cargill employees. The Plan document states that prior service from a predecessor company would not be included in the years of service used to calculate Plan benefits. In contrast, the SPD stated that for service prior to January 1, 1964, "no predecessor company employment counts" for purposes of benefit calculation. The SPD included no restriction regarding service with a predecessor company for service years on or after January 1, 1964.

Upon the employees' retirement between 2003 and 2005, they learned that their benefits would not be calculated to include the years of service they earned while employees of Hunt-Wesson. The employees sued under ERISA claiming that they were entitled to benefits calculated on the basis of all of their years of service while working for both Hunt-Wesson
and Cargill.

The court held that while the Plan document clearly stated that years of service with predecessor companies would not count toward benefit calculations, the Plan document conflicted with the SPD. Specifically, the court stated that the SPD explicitly omitted "predecessor company employment" from the benefit calculations for years of service credited prior to January 1, 1964 while the SPD was silent as to the disposition of those same service credits earned on or after January 1, 1964. The court was also swayed by testimony of the employees -- each of whom testified that he was told at the 1990 meeting that his prior years of service with Hunt-Wesson would be incorporated into the benefits calculation. The court faulted Cargill, saying that it was "in a position of superior power, knowledge and experience" and should have given the employees documents or summaries at that meeting, which outlined whether and by what method the prior years of service would be used to calculate benefits in order to protect employees from any verbal misunderstandings.

In light of this case and others like it, we urge plan sponsors to review their SPDs that have not been updated to reflect plan changes, whether by amendment or interpretation. In this regard, plan sponsors should take note that Cargill did not just lose this case on the merits (resulting in its obligation to pay additional pension benefits to the plaintiffs), but it was also required to pay the plaintiffs' attorneys' fees -- which the court set at just over $420,000. Vasquez v. Cargill, Inc., 2008 U.S. Dist. LEXIS 19341 (C.D. Cal, 2008).

For further information, please contact any of the following lawyers:

Lee Spence, lspence@milchev.com, 202-626-5965

Gary Quintiere, gquintiere@milchev.com, 202-626-1491

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