Wells Fargo & Company (f.k.a. Norwest Corporation) and Subsidiaries v. Commissioner , 120 T.C. No. 5 ( 2003 )

120 T.C. No. 5UNITED STATES TAX COURT
WELLS FARGO & COMPANY (f.k.a. NORWEST CORPORATION) AND
SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 7620-98, 12136-98, Filed February 13, 2003.
19891-98, 7282-99,
12484-99.1
For the years 1991-94, Ps made contributions to a
voluntary employee benefit trust (the postretirement
medical trust) for the purpose of providing
postretirement medical benefits to their employees. For
1991, Ps’ actuary computed the present value of future
postretirement medical benefits for active employees to
be $14,096,473 and for retired employees to be
$27,759,057. The actuary divided the $14,096,473 for
active employees by the average actuarial present value
of future service to produce a 1991 funding amount of
$2,930,660 for active employees. The actuary determined
that the $27,759,057 for retired employees could be fully
funded in 1991. Ps contributed $30,689,717 to the
1
These cases have been consolidated for trial, briefing,
and opinion solely with respect to the issue involved herein.
- 2 -
postretirement medical trust in 1991 and, on Ps’
consolidated return for 1991, claimed a deduction for the
contribution as an addition to a “qualified asset
account” pursuant to sec. 419A(b), I.R.C.
R determined that Ps’ method for computing the 1991
contribution for postretirement benefits for retirees was
improper and resulted in a contribution that exceeded the
account limit for a reserve under sec. 419A(c)(2), I.R.C.
R further determined deficiencies for years 1992-94 as a
result of the determined overfunding in 1991.
Held, with respect to an employee who is retired
when the reserve is created, the present value of that
employee’s projected benefit may be allocated to the year
the reserve is created. Accordingly, Ps’ contributions
to the postretirement medical trust for 1991 did not
cause the qualified asset account to exceed the account
limit under sec. 419A(b), I.R.C., with respect to the
reserve for postretirement medical benefits provided in
sec. 419A(c)(2), I.R.C.
Walter A. Pickhardt, Mark A. Hager, and Andrew T. Gardner,
for petitioners.
Alan M. Jacobson, Randall P. Andreozzi, Christa A. Gruber,
and James S. Stanis, for respondent.
Contents
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . . 4
A. Background . . . . . . . . . . . . . . . . . . . . . . . . 5
B. Norwest’s Welfare Benefit Plans . . . . . . . . . . . . . 6
C. Financial Accounting Standards Board Statement of
Financial Accounting Standards No. 106 . . . . . . . . . . 8
D. Norwest’s Contributions to the Postretirement Medical
Trust . . . . . . . . . . . . . . . . . . . . . . . . . 11
1. Funding the Postretirement Medical Trust for 1991 . 11
- 3 -
2. Funding the Postretirement Medical Trust for 1992-
94 . . . . . . . . . . . . . . . . . . . . . . . . 12
3. Mercer’s Actuarial Assumptions for the 1991-94
Contributions to the Postretirement Medical Trust . 13
4. Contributions to the Postretirement Medical Trust . 15
E. Respondent’s Determinations . . . . . . . . . . . . . . . 15
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
A. Statutory Framework: Sections 419 and 419A . . . . . . 15
B. Method for Computing the Account Limit With Respect to a
Reserve . . . . . . . . . . . . . . . . . . . . . . . . 17
1. Actuarial Cost Methods . . . . . . . . . . . . . . 18
a. Aggregate Cost Method . . . . . . . . . . . . 20
b. Entry Age Normal Cost Method . . . . . . . . . 20
c. Individual Level Premium Cost Method . . . . . 21
2. Computations by the Experts . . . . . . . . . . . . 22
a. Mr. Cohen . . . . . . . . . . . . . . . . . . 22
b. Mr. Scharmer . . . . . . . . . . . . . . . . . 23
c. Mr. Daskais . . . . . . . . . . . . . . . . . 25
3. Positions of the Parties . . . . . . . . . . . . . 33
4. Statutory Construction . . . . . . . . . . . . . . 34
5. The Statute . . . . . . . . . . . . . . . . . . . . 35
a. Reserve . . . . . . . . . . . . . . . . . . . 36
b. Reserve Funded Over the Working Lives of the
Covered Employees and Actuarially Determined
on a Level Basis . . . . . . . . . . . . . . . 39
(i) Reserve Funded Over the Working Lives of
the Covered Employees . . . . . . . . . . 40
(ii) Reserve Actuarially Determined on a Level
Basis . . . . . . . . . . . . . . . . . . 46
C. Investment Rates . . . . . . . . . . . . . . . . . . . . 51
JACOBS, Judge: Respondent determined deficiencies in Federal
income tax and accuracy-related penalties with regard to
petitioners’ consolidated returns for 1990-94 as follows:
- 4 -
Addition to Tax
Year Deficiency Sec. 6662(a)
1990 $52,073,344 $5,161,509
1991 216,338,093 23,353,180
1992 417,310,889 1,047,868
1993 86,406,356 5,655,276
1994 62,493,719 5,135,972
Numerous issues have been raised as a consequence of respondent’s
determinations; many of these issues heretofore have been resolved.
The issue to be decided herein concerns the amounts petitioners may
deduct for years 1991-94 for contributions made to a voluntary
employee benefit association (VEBA) trust to provide postretirement
medical benefits to covered employees and their eligible
dependents. To determine the allowable amounts, we first must
decide the proper method to be used in computing the reserve under
section 419A(c)(2).2 Then we must decide whether petitioners used
reasonable investment rates in their actuarial computations.
FINDINGS OF FACT
Some of the facts have been stipulated and are found
accordingly. The stipulations of facts and the attached exhibits
are incorporated herein by this reference.
2
All section references are to the Internal Revenue Code
as in effect for the years in issue.
- 5 -
A. Background
Norwest Corp.3 (Norwest) is a multibank holding company
organized in 1929. It owns substantially all of the outstanding
capital stock of numerous commercial banks in Minnesota, Iowa,
South Dakota, Nebraska, Wisconsin, North Dakota, Montana, Wyoming,
Illinois, Indiana, and Arizona. Norwest also owns subsidiaries
engaged in various businesses related to banking, principally
mortgage banking, equipment leasing, agricultural finance,
commercial finance, consumer finance, securities dealings and
underwriting, insurance agency services, computer and data
processing services, corporate trust services, and venture capital
investments. For each of the years at issue, Norwest and its
subsidiaries filed consolidated Federal income tax returns.
On November 2, 1998, Wells Fargo & Co. was merged into a
wholly owned subsidiary of Norwest. Simultaneously with the
merger, Norwest changed its name to Wells Fargo & Co. Hereinafter,
reference to Norwest is to Norwest and its subsidiaries before the
merger with Wells Fargo & Co.
When Norwest filed the petitions in docket Nos. 7620-98 and
12136-98 (which was before the merger), its principal place of
business was in Minneapolis, Minnesota. At the time Wells Fargo &
Co. filed the petitions in docket Nos. 19891-98, 7282-99, and
3
Norwest Corp. was formerly known as Northwest
Bancorporation.
- 6 -
12484-99 (which was after the merger), its principal place of
business was in San Francisco, California.
B. Norwest’s Welfare Benefit Plans
On January 1, 1930, Norwest established the Norwest Corp.
Medical Plan, also known as the Norwest Corp. Hospital-Medical Plan
(the medical plan). The medical plan is a self-insured welfare
plan providing for the payment (or reimbursement) of all or a
portion of covered medical expenses incurred by Norwest’s eligible
employees (including eligible retired employees) and their eligible
dependents. Since June 1, 1957, the medical plan has provided
postretirement medical benefits (i.e., medical benefits for its
retirees), pursuant to a rider issued by Prudential Insurance Co.
of America, relating to Norwest’s group health insurance policy.
Over the years, Norwest established other plans, in addition
to the medical plan, to provide benefits for Norwest’s eligible
employees (including under some plans retired employees) and their
eligible dependents. The employee benefit plans include a long-
- 7 -
term disability plan,4 a dental plan,5 a severance plan,6 an HMO
premium plan,7 and a choice plus medical plan.8
On November 11, 1978, Norwest established, effective January
1, 1979, a VEBA trust, under section 501(c)(9), to fund the
employee benefit plans then in existence (i.e., the medical plan
and the long-term disability plan). This trust was originally
called the “Northwest Bancorporation Employee Benefit Trust” and is
hereinafter referred to as the master trust. Over the years, the
master trust was amended to fund the dental plan and the HMO
4
On Aug. 1, 1969, Norwest established the Norwest Corp.
Long-Term Salary Continuation Plan (now known as the Norwest Corp.
Long-Term Disability Plan) (the long-term disability plan). The
long-term disability plan is a combination self-insured/insurance
welfare benefit plan providing monthly disability income benefits
for eligible disabled employees.
5
On Jan. 1, 1980, Norwest established the Norwest Corp.
Dental Plan (the dental plan). The dental plan is a combination
self-insured/insured welfare benefit plan providing for the payment
or reimbursement of all or a portion of covered dental expenses.
6
The Norwest Corp. Severance Pay Plan is a self-insured
welfare plan providing for the payment of severance benefits for
Norwest’s eligible employees.
7
Norwest established the Norwest Corp. HMO Premiums Plan,
an insured welfare benefit plan providing for the payment or
reimbursement of all or a portion of covered medical expenses.
8
Norwest established the Norwest Corp. Choice Plus Plan
(the choice plus medical plan), effective Jan. 1, 1993, which was
funded by the master trust. The choice plus medical plan is a
self-insured welfare plan providing for the payment or
reimbursement of all or a portion of covered medical expenses.
- 8 -
premium plan. The master trust was amended and restated effective
January 1, 1991; the name of the master trust was changed to the
Norwest Corp. Employee Benefit Trust.
C. Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 106
From 1957 to 1991, Norwest paid medical benefits for retired
employees as claims were submitted; i.e., on a “pay-as-you-go”
basis. For financial accounting and tax purposes, Norwest
recognized these costs when the benefits were paid.
In 1990, new financial accounting rules for nonpension,
postretirement benefits were promulgated in Statement of Financial
Accounting Standards No. 106 (SFAS 106). Pursuant to SFAS 106, for
financial accounting purposes, employers must accrue (during the
employment of an employee) the cost of future health care benefits
to be paid to the employee after retirement.9 Thus, because SFAS
106 applies to a postretirement benefit plan regardless of the
means or timing of funding, the employer cannot postpone
recognition of the cost of the employee’s postretirement benefit by
contributing at the time of retirement a lump sum equal to the
9
“Attribution period” is the period of an employee’s
service to which the expected postretirement benefit obligation for
that employee is assigned. Generally, the beginning of the
attribution period is the employee’s date of hire and the end of
the attribution period is the employee’s full eligibility date. An
equal amount of the expected postretirement benefit obligation is
attributed to each year.
- 9 -
present value of the employee’s benefit (terminal funding). SFAS
106, par. 8.
SFAS 106 permits an employer to immediately recognize, at the
date of initial application of SFAS 106, obligations that the
employer had not accrued for financial purposes in prior years
(transition obligation10). SFAS 106, par. 260. Immediate
recognition is not permitted after the initial application of SFAS
106.11
Norwest adopted SFAS 106, effective January 1, 1992. As a
10
The transition obligation recognized upon initial
application of SFAS 106 does not include “(a) any previously
unrecognized post-retirement benefit obligation assumed in a
business combination accounted for as a purchase, (b) a plan
initiation, and (c) any plan amendment that improved benefits, to
the extent that those events occur after the issuance of * * *
[SFAS 106].” SFAS 106, par. 261.
11
The Financial Accounting Standards Board concluded that
to permit immediate recognition at any subsequent time would result
in too much variability in financial reporting for a long period of
time.
- 10 -
consequence, Norwest elected to recognize as an immediate expense
its unrecognized transition obligation.12 The amount of this
obligation was $71.7 million (after tax).
On December 20, 1991, Norwest established the Norwest Corp.
Employee Benefit Trust for Retiree Medical Benefits (the
postretirement medical trust), effective December 16, 1991.13 The
postretirement medical trust funded postretirement medical benefits
to be provided to all employees, both active and retired (other
than “key employees”), under Norwest’s medical plan. Simultaneously
with the creation of the postretirement medical trust, Norwest
amended the master trust, effective December 16, 1991, to eliminate
the master trust’s responsibility to pay postretirement medical
benefits for all but key employees.
12
SFAS 106, par. 518, defines an “unrecognized transition
obligation” as the unrecognized amount, as of the date SFAS 106 is
initially applied, of “(a) the accumulated post-retirement benefit
obligation in excess of (b) the fair value of plan assets plus
accrued post-retirement benefit cost or less any recognized prepaid
post-retirement benefit cost.” “Accumulated post-retirement
benefit obligation” is defined by SFAS 106, par. 518, as the
actuarial present value of benefits attributed to employee service
rendered to a particular date. Since Norwest historically had
neither paid nor deducted the benefits until incurred, the
unrecognized transition obligation was equal to the accumulated
postretirement benefit obligation.
13
Effective Jan. 1, 1991, Norwest also established a
separate VEBA trust to fund the liabilities for the severance plan.
By an amendment to the master trust, effective Jan. 1, 1993,
Norwest merged the severance plan into the master trust.
- 11 -
D. Norwest’s Contributions to the Postretirement Medical Trust
For the years 1991-94, Norwest made contributions to the
postretirement medical trust for the purpose of providing
postretirement medical benefits.
1. Funding the Postretirement Medical Trust for 1991
During the years at issue, William M. Mercer, Inc.
(hereinafter referred to as Mercer), a national actuarial firm,
prepared actuarial funding valuations for Norwest’s pension plans
and postretirement medical plans. Sometime in late 1990/early
1991, Norwest expressed to Mercer an interest in funding its
retiree medical benefits plan. Norwest understood that employers
were permitted a tax deduction for funding a reserve for
postretirement medical benefits.
On April 14, 1992, Mercer prepared and presented to Norwest a
valuation report entitled “Norwest Corporation Actuarial Funding
Valuation of the Post-retirement Medical Plans as of January 1,
1991" (the 1991 valuation). Mercer computed the present value of
future medical benefits to be $14,096,473 for active employees and
$27,759,057 for retired employees. In determining these
computations, Mercer used a pretax investment rate assumption of 9
percent and an after-tax investment rate of 5.5 percent. Mercer
divided the $14,096,473 for active employees by the “average
actuarial present value of future service” for the active employees
(4.81) to produce a 1991 funding amount of $2,930,660 for active
- 12 -
employees. Mercer determined that, because the retired employees
had no remaining working life, the present value of future benefits
for retired employees ($27,759,057) could be funded in 1991.
Mercer believed that Norwest’s resulting reserve for active and
retired employees ($30,689,717) would be within the section
419A(c)(2) account limit.
On the basis of the 1991 valuation report, Norwest contributed
$30,689,717 to the postretirement medical trust in 1991. On the
consolidated return for 1991, Norwest claimed a deduction for the
contribution as an addition to a “qualified asset account” pursuant
to section 419A(b).
2. Funding the Postretirement Medical Trust for 1992-94
At the request of Norwest, Mercer prepared actuarial funding
valuation reports as of January 1 for each year 1992-94, relating
to the funding of the postretirement medical trust (the 1992-94
valuation reports). In the 1992-94 valuation reports, Mercer
computed the end-of-year contributions to be $6,859,600,
$11,308,043, and $12,247,933, respectively. Mercer calculated the
contribution amount to be equal to a fraction. The numerator of
the fraction was the present value of future benefits for active
employees and retirees, reduced by the sum of the value of (a) the
postretirement medical trust assets and (b) the section 401(h)
account assets. The denominator of the fraction was the average
present value of future working lifetimes of the employees. The
- 13 -
present value of the future working life of an employee is
comparable to the present value of an annuity (computed with the
actuarial interest rate used by the plan) that pays $1 each year
until the employee is expected to retire.
3. Mercer’s Actuarial Assumptions for the 1991-94
Contributions to the Postretirement Medical Trust
In order to compute the present value of future benefits in
the 1991-94 valuation reports, Mercer made certain actuarial
assumptions, including investment rates, the number of employees
who would “retire, die, terminate their services or become
disabled, their ages at termination, and their expected benefits.”
Mercer requested Norwest to provide an estimate of Norwest’s
effective tax rates for years 1991-94. Norwest advised Mercer that
those tax rates would be approximately 39 percent in 1991-92 and 40
percent in 1993-94.
The pretax and after-tax investment rates Mercer used in the
1991-94 valuation reports were as follows:
1991 1992 1993 1994
Pretax investment rate 9.00% 8.00% 6.00% 6.00%
After-tax investment rate 5.50 4.90 3.60 3.60
The following chart illustrates the various factors disclosed
in the 1991-94 valuation reports (minor computational discrepancies
are unexplained):
- 14 -
Valuation Date
1/1/91 1/1/92 1/1/93 1/1/94
1. Actuarial present value of
projected benefits
Active employees $13,361,586 $38,521,857 $62,860,146 $83,594,015
Retired employees 26,311,902 36,694,928 47,731,960 48,947,859
Total 39,673,488 75,216,785 110,592,106 132,541,874
2. Actuarial value of assets
VEBA -0- 30,736,554 30,176,217 39,940,676
401(h) -0- 1,125,467 1,172,269 7,598,653
Total -0- 31,862,021 31,348,486 47,539,329
3. Actuarial present value of
future normal costs [1-2]1 13,361,588 43,354,764 79,243,620 85,002,545
4. Actuarial present value of
future service 4.81 6.63 7.26 7.19
5. Normal cost at beginning of
year [3/4] 2,777,877 6,539,180 10,915,099 11,822,329
6. Maximum contribution2
a. Paid at beginning of year 29,089,779 6,539,180 10,915,099 11,822,329
b. Interest to yearend 1,599,938 320,420 392,944 425,604
c. Paid at yearend [a + b] 30,689,717 6,859,600 11,308,043 12,247,933
1
In 1991, this is the present value of active benefits only, excluding the 1991 net benefit costs.
2
In 1991, this includes the normal cost for active participants, plus the entire present value for
those retired as of Jan. 1, 1991, excluding the retirees’ 1991 net benefit costs.
- 15 -
4. Contributions to the Postretirement Medical Trust
In 1991-94, Norwest made contributions to the postretirement
medical trust of $30,689,717, $2,170,000, $13,791,600, and
$12,247,933, respectively. During 1992-94, Norwest’s retired
employees made contributions to the postretirement medical trust of
$473,832.62, $736,176.25, and $784,906.22, respectively. In 1993,
$175,216 was transferred from the master trust to the
postretirement medical trust.
E. Respondent’s Determinations
Respondent determined that Norwest’s method for computing the
1991 contribution for postretirement benefits for retirees was
improper and resulted in a contribution that exceeded the account
limit for a reserve under section 419A(c)(2). As a result of the
1991 overfunding, respondent determined that the reserve was also
overfunded in 1992-94.
OPINION
A. Statutory Framework: Sections 419 and 419A
Sections 419 and 419A limit deductions for contributions made
by a taxpayer to an employee welfare benefit fund.14 In general,
section 419(a)(1) denies a deduction for contributions paid or
accrued by an employer to a welfare benefit fund. However, if the
contributions would otherwise be deductible, then section 419(a)(2)
14
For purposes of secs. 419 and 419A, a welfare benefit
fund includes a VEBA that is exempt from taxation under sec.
501(c)(9).
- 16 -
permits a deduction for the taxable year in which the contribution
is paid, subject to the limitation contained in section 419(b).
Section 419(b) limits the deduction for any taxable year to
the welfare benefit fund’s “qualified cost”.15 The fund’s qualified
cost is equal to the sum of the fund’s “qualified direct cost” for
the year, and, subject to the limitation of section 419A(b), any
addition to a “qualified asset account” for the year.16 Sec.
419(c)(1).
Section 419A(a) defines a qualified asset account as any
account consisting of assets set aside to provide for the payment
of (1) disability benefits, (2) medical benefits, (3) SUB
(supplemental compensation benefit) or severance pay benefits, or
(4) life insurance benefits. Additions to a qualified asset
account are included in the fund’s qualified cost only to the
extent they do not exceed the fund’s “account limit” for the
taxable year. Sec. 419A(b).
For purposes of the present case, the account limit includes:
(1) The amount reasonably and actuarially necessary to fund claims
that are incurred but unpaid as of the close of the taxable year
and related administrative costs and (2) the amount of an
15
A contribution to a welfare benefit fund in excess of
that year’s qualified cost is treated as a contribution by the
employer to the fund during the succeeding taxable year. Sec.
419(d).
16
The fund’s qualified cost for the taxable year is reduced
by the fund’s after-tax income for that year. Sec. 419(c)(2).
- 17 -
additional reserve 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
postretirement medical and life insurance benefits. Sec.
419A(c)(1) and (2).
At issue in this case is the computation of the account limit
for the reserve necessary for postretirement medical benefits
provided under section 419A(c)(2). Petitioners and respondent
disagree as to the proper method for computing the account limit
for “a reserve 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”. Additionally, respondent
asserts that the investment rates petitioners used in computing the
reserve were too low.
B. Method for Computing the Account Limit With Respect to a
Reserve
For 1991, Mercer computed Norwest’s contribution to the
postretirement medical trust by including (1) the present value of
postretirement medical benefits for the active employees amortized
over the employees’ remaining working lives, and (2) the entire
present value of the postretirement medical benefits for the
retirees funded in 1 year (the Mercer method). Respondent asserts
that Mercer’s methodology in computing Norwest’s 1991 contribution
for medical benefits to retirees was improper and resulted in a
- 18 -
contribution that exceeded the account limit for a reserve under
section 419A(c)(2).17 For the reasons set forth below, we disagree
with respondent’s assertion. To the contrary, we approve of the
Mercer method used in computing Norwest’s 1991 contribution to the
postretirement trust.
The parties rely on expert reports and testimony to explain
actuarial methods appropriate for computing a reserve for
postretirement medical benefits described in section 419A(c)(2) and
to compute the account limit using those methods. Petitioners
presented the reports and testimony of two expert witnesses:
Messrs. Ira Cohen and Gary Scharmer. Respondent presented the
expert report and testimony of Mr. Richard Daskais. The experts
generally agree that actuarial cost methods approved for computing
the funding of defined benefit pension plans may be used for
computing the funding of postretirement medical benefits.
1. Actuarial Cost Methods
In calculating reserves, actuaries first calculate the stream
of benefits to be paid from the trust (the year-by-year benefit
payments to be made to covered employees in future years) and then
calculate the present value of that stream by discounting the
payment each year at a determined interest or investment rate. The
stream of benefit payments is based on actuarial assumptions. For
postretirement medical benefits, these assumptions include those as
17
Respondent does not dispute the method petitioners used
for computing the contribution for the years 1992-94.
- 19 -
to when employees will retire, how long they will live after
retirement, how many will have spouses entitled to benefits, the
annual cost of the benefits for each retired employee or spouse,
and an interest rate for discounting the stream of benefits to
present value.
An actuary uses an actuarial cost method to assign the present
value of promised benefits to individual plan years as an annual
cost. The portion of the total cost of the plan that is assigned
by the actuarial cost method to the current year or to a future
year is called the normal cost.
In general, six actuarial cost methods (or variations thereof)
are used for purposes of computing pension costs. They include (1)
the unit credit method (also known as the accrued benefit cost
method); (2) the entry age normal cost method; (3) the individual
level premium cost method; (4) the aggregate cost method; (5) the
attained age normal cost method; and (6) the frozen initial
liability cost method. The methods discussed by the parties’
experts are the aggregate cost method (respondent’s preferred
method), the entry age normal cost method (petitioners’ preferred
method), and the individual level premium cost method (the method
Mercer used in 1991 and the one which we find satisfies the
requirements of section 419A(c)(2)).
- 20 -
a. Aggregate Cost Method
The aggregate cost method calculates costs for all employees
on an aggregate basis. The aggregate cost method computes normal
costs in relation to the assets of the fund; this method does not
calculate an accrued liability independent of those assets.
In computing the normal cost under the aggregate cost method,
the value of the plan assets is subtracted from the present value
of future benefits for all participants. The remaining present
value of future benefits is then divided by the sum of the present
value of the future working lives of the active employees. The
present value of the future working life of an employee is
comparable to the present value of an annuity (computed with the
actuarial interest rate used by the plan) that pays $1 each year
until the employee is expected to retire.
b. Entry Age Normal Cost Method
The entry age normal cost method can be applied on an
individual or aggregate basis; in this case, it is applied on an
individual basis. Under the entry age normal cost method, the
actuarial present value of each employee’s projected benefit is
spread over the entire length of the employee’s service, beginning
at the date the employee began service with the employer and ending
with the anticipated normal retirement date.
The normal cost computed under the entry age normal cost
method is a dollar amount which, if paid annually and allowed to
- 21 -
accumulate from the date the employee began service until the
projected retirement date of that employee, will have accumulated
at retirement the amount necessary to fully fund the benefit to the
covered employee. The actuarial accrued liability is the portion
of the actuarial present value that is not provided for by future
normal costs.
c. Individual Level Premium Cost Method
The individual level premium cost method is an individual
method, similar to the entry age normal cost method. Under the
individual level premium cost method, the normal cost is separately
determined for each covered employee as a level dollar amount
which, if accumulated from the later of the date the plan is
established or the date that the employee was hired, would
accumulate at retirement the amount necessary to fully fund the
benefit to the covered employee.
The primary difference between the individual level premium
cost method and the entry age normal cost method is the date when
normal cost is assumed to commence. If the plan is established
after the employee is hired, under the entry age normal cost
method, normal cost is assumed to have retroactively commenced at
the date of hire. Under the individual level premium cost method,
normal cost begins no earlier than the date the plan is
established.
- 22 -
2. Computations by the Experts
The parties’ experts described the ways that actuaries
interpret the account limit for a reserve provided in section
419A(c)(2) and made computations using variations of the aggregate
and entry age normal cost methods.
a. Mr. Cohen
Mr. Cohen, one of petitioners’ experts, is an expert in
actuarial science and a principal at PricewaterhouseCoopers LLP,
advising clients on various matters involving actuarial, tax,
pension, and postretirement medical issues. He is a fellow of the
Society of Actuaries, an enrolled actuary under ERISA, and a member
of the American Academy of Actuaries. From 1970-86, Mr. Cohen was
employed by the Internal Revenue Service, serving in a variety of
positions, including director of the Employee Plans, Technical and
Actuarial Division.
Mr. Cohen uses the terms “reserve” and “accrued liability”
interchangeably and posits that the reserve for retirees is the
present value of future benefits. In Mr. Cohen’s opinion, the
aggregate cost method is not appropriate for computing the account
limit for a reserve for postretirement benefits because that method
does not directly compute an accrued liability and fails to fully
fund the reserve for an employee upon retirement. In his opinion,
the entry age normal cost method is the appropriate method because
that method allocates the cost over the entire working life of an
- 23 -
employee, directly computes an accrued liability, and provides for
full funding upon retirement.
Mr. Cohen opined that (1) the account limit for the reserve is
equal to the reserve (accrued liability) computed under the entry
age normal cost method, (2) for retirees, the reserve (accrued
liability) is the present value of future benefits, and (3) for
active employees, the reserve is the present value of future
benefits minus the present value of future normal costs.
b. Mr. Scharmer
Mr. Scharmer is an expert in actuarial science and is a
principal at Mercer. He is a fellow of the Society of Actuaries,
an enrolled actuary under ERISA, a member of the American Academy
of Actuaries, and a member of the Conference of Actuaries.
Mr. Scharmer opined that the account limit for a reserve under
section 419A(c)(2) was equal to the accrued liability using the
entry age normal cost method. For 1991-94, Mr. Scharmer calculated
the account limit for the reserve by applying the entry age normal
cost method and by using the same facts and assumptions that Mercer
relied upon when it prepared the 1991-94 valuation reports. Mr.
Scharmer computed the accrued liability (dollars in millions) on
the valuation date for each year as follows:
- 24 -
1991 1992 1993 1994
A. Investment return 5.5% 4.9% 3.6% 3.6%
B. Present value accrued benefits
(beginning of year)
a. Active $14.7 $38.5 $62.9 $83.6
b. Retired 28.2 36.7 47.7 48.9
c. Total 42.9 75.2 110.6 132.5
C. Accrued liability (beginning of year)
a. Active $12.6 $28.7 44.7 $59.4
b. Retired 28.2 36.7 47.7 48.9
c. Total 40.8 65.4 92.4 108.3
D. Normal cost (beginning of year) 0.3 1.2 2.5 3.3
E. Accrued liability (yearend)
a. Active $12.3 $31.2 $48.7 $64.7
b. Retired 27.8 34.5 45.2 45.8
c. Total 40.1 65.7 93.9 110.5
F. Account limit 40.1 65.7 93.9 110.5
G. Plan assets (VEBA + 401(h)) -0- 29.3 28.0 44.1
H. Deductible limit 40.1 36.4 65.9 66.4
Mr. Scharmer also calculated the account limit for the reserve
by varying the application of the aforementioned methodology to
reflect the investment rates Mr. Daskais proposed. Under these
computations, he determined that the accrued liability (dollars in
millions) for 1991-94 was as follows:
1991 1992 1993 1994
A. Investment return 6.0% 5.7% 4.9%
B. Accrued liability (beginning of year)
a. Active $10.3 $26.1 $35.0 $51.6
b. Retired 26.0 32.3 40.0 42.4
c. Total 36.3 58.4 75.0 94.0
C. Account limit 36.3 58.4 75.0 94.0
D. Plan assets (VEBA + 401(h)) -0- 29.6 28.6 44.7
E. Deductible limit 36.3 28.8 46.4 49.3
- 25 -
c. Mr. Daskais
Mr. Daskais, respondent’s expert, is an expert in actuarial
science. He is a fellow of the Society of Actuaries and was an
enrolled actuary under ERISA from 1976 to 1995.
Mr. Daskais opined that “actuarially determined on a level
basis” means that the systematic year-to-year increments to the
reserve are the same (or “level” in some sense) each year.
Examples of level increments that are appropriate for computing a
reserve for postretirement medical benefits include (1) a uniform
(or level) dollar amount each year or (2) a uniform (or level)
dollar amount per active employee each year, so that the total
dollar amount increases or decreases as the number of active
employees increases or decreases.18
Mr. Daskais opined that in actuarial parlance a “reserve
funded over the working lives of covered employees” is a “one-
sentence description of the aggregate cost method.” It means a
reserve, determined on the basis of an actuarial cost method and
actuarial assumptions, that will increase from year to year and
will be exactly sufficient to provide the trust fund’s benefits at
the end of the working lives of the covered employees. Mr. Daskais
18
A third example is a uniform (or level) percent of the
total payroll of active employees each year, so that the total
dollar amount increases or decreases as the total payroll of active
employees increases or decreases. The experts agree that
allocating by percentages is inappropriate for postretirement
medical benefits because postretirement benefits usually are not
pay related.
- 26 -
acknowledged that the reserve funded using the aggregate cost
method will not be fully funded with respect to an individual
employee upon retirement. In Mr. Daskais’s opinion, full funding
upon retirement of an individual employee is not required; in his
opinion the end of the working lives of covered employees occurs
when the employment of all covered employees has terminated.
Mr. Daskais computed the maximum contribution for 1991-94 to
the postretirement medical trust deductible under section 419 by
applying the aggregate cost method using the same actuarial values
(including the investment rate) Mercer used, as follows:
- 27 -
1991 1992 1993 1994
A. Investment return 5.5% 4.9% 3.6% 3.6%
B. Present value accrued benefits
a. Active $13,361,586 $38,521,857 $62,860,146 $83,594,015
b. Retired 26,311,902 36,694,928 47,731,960 48,947,859
c. Total 39,673,488 75,216,785 110,592,106 132,541,874
C. Value of assets (beginning of year)
a. VEBA --- 30,736,554 30,176,217 39,940,676
b. 401(h) --- 1,125,467 1,172,269 7,598,653
c. Total --- 31,862,021 31,348,486 47,539,329
D. Nondeductible contribution from prior
years (O from prior year) --- 22,034,781 14,394,743 14,426,384
E. Net value of assets1 --- 9,827,240 16,953,743 33,112,945
F. Present value future normal costs2 39,673,488 65,389,545 93,638,363 99,428,929
G. Average present value of future service 4.81 6.63 7.26 7.19
H. Normal cost (beginning of year)3 8,248,126 9,862,676 12,897,846 13,828,780
I. Benefits paid during year N/A 4,078,160 4,859,441 5,301,930
J. Employee contributions during year N/A 473,833 736,176 784,906
K. Interest to yearend4 453,647 821,352 958,237 1,335,044
L. Account limit (yearend)5 8,701,773 15,781,474 25,514,292 36,161,092
M. Actual contribution 30,689,717 2,170,000 13,966,816 12,247,933
N. Value of assets (yearend) 30,736,554 30,176,217 39,940,676 47,668,557
O. Nondeductible contribution
carryforward6 22,034,781 14,394,743 14,426,384 11,507,465
P. Deductible limit7 8,654,936 9,810,038 13,935,175 15,166,852
1
C.c - D
2
B.c - E
3
F/G
4
A x (C.a - D + H + ½ of (J - I))
5
C.a - D + H - I + J + K
6
Smaller of (N - L) and (D + M), but not below zero
7
D + M - O
- 28 -
In Mr. Daskais’s opinion, the investment rates Mercer used
were unreasonably low. Mr. Daskais recalculated the contribution
limit by applying the aggregate cost method using the Mercer
assumptions but substituting investment rates that, in his opinion,
were reasonable. Under these computations, he determined that the
maximum contributions for 1991-94 were as follows:
- 29 -
1991 1992 1993 1994
A. Investment return 6.6% 6.0% 5.7% 4.9%
B. Present value accrued benefits
a. Active $11,154,103 $30,515,975 $38,396,684 $61,044,923
b. Retired 23,798,600 33,006,450 38,374,995 42,599,819
c. Total 34,952,703 63,522,425 76,771,679 103,644,742
C. Value of assets (beginning of year)
a. VEBA --- 30,736,554 30,176,217 39,940,676
b. 401(h) --- 1,125,467 1,172,269 7,598,653
c. Total --- 31,862,021 31,348,486 47,539,329
D. Nondeductible contribution from prior
years (O from prior year) --- 22,679,988 16,144,825 19,283,596
E. Net value of assets1 --- 9,182,033 15,203,661 28,255,733
F. Present value future normal costs2 34,952,703 54,340,392 61,568,018 75,389,009
G. Average present value of future service 4.62 6.26 6.46 6.68
H. Normal cost (beginning of year)3 7,557,754 8,682,914 9,523,819 11,286,962
I. Benefits paid during year N/A 4,078,160 4,859,441 5,301,930
J. Employee contributions during year N/A 473,833 736,176 784,906
K. Interest to yearend4 498,812 896,239 1,225,134 1,454,591
L. Account limit (yearend)5 8,056,566 14,031,392 20,657,080 28,881,609
M. Actual contribution 30,689,717 2,170,000 13,966,816 12,247,933
N. Value of assets (yearend) 30,736,554 30,176,217 39,940,676 47,668,557
O. Nondeductible contribution
carryforward6 22,679,988 16,144,825 19,283,596 18,786,948
P. Deductible limit7 8,009,729 8,705,163 10,828,045 12,744,581
1
C.c - D
2
B.c - E
3
F/G
4
A x (C.a - D + H + ½ of (J - I))
5
C.a - D + H - I + J + K
6
Smaller of (N - L) and (D + M), but not below zero
7
D + M - O
- 30 -
Mr. Daskais opined that, if the funding method used to
calculate the reserve computes an accrued liability, that liability
must be amortized. In Mr. Daskais’s opinion, since there are no
specific amortization rules applicable to the funding of
postretirement medical benefits in section 419A or in the income
tax regulations, the amortization rules applicable to pensions
should be applied.
Mr. Daskais calculated the contribution limit by applying the
entry age normal cost method and by using the same facts and
assumptions Mercer used. He amortized the accrued liability over
the present value of the remaining working lives of the active
employees. Under these computations, he determined that the
maximum contributions (dollars in millions; discrepancies
attributable to rounding) for 1991-94 were as follows:
1991 1992 1993 1994
A. Investment return 5.5% 4.9% 3.6% 3.6%
B. Present value accrued benefits
a. Active $13.4 $38.5 $62.9 $83.6
b. Retired 26.3 36.7 47.7 48.9
c. Total 39.7 75.2 110.6 132.5
C. Accrued liability
a. Active 11.3 28.7 44.7 59.4
b. Retired 26.3 36.7 47.7 48.9
c. Total 37.6 65.4 92.4 108.3
D. Normal cost 0.3 1.2 2.5 3.3
E. Average present value of future service 4.81 6.63 7.26 7.19
F. Amortized accrued liability from prior
years1 --- 8.6 15.5 25.5
G. Remaining unamortized accrued liability2 37.6 56.8 76.9 82.8
H. Amortization of accrued liability3 7.8 8.6 10.6 11.5
I. Account limit (beginning of year)4 8.1 18.3 28.6 40.3
J. Interest to yearend 0.4 0.9 1.0 1.5
K. Account limit (yearend)5 8.6 19.2 29.7 41.7
- 31 -
L. Benefits paid less employee
contributions --- 3.6 4.1 ---
M. Interest for one-half year --- 0.1 0.1 ---
N. Amortized accrued liability (yearend)6 8.6 15.5 25.5 --–
O. Nondeductible contribution from prior
years7 --- 22.1 15.3 16.2
P. Actuarial value of assets
a. VEBA --- 30.7 30.2 39.9
b. 401(h) --- 1.1 1.2 7.6
c. Total (beginning of year) --- 31.9 31.3 47.5
d. Net after nondeductible
contributions8 --- 9.7 16.1 31.3
e. Interest to yearend --- 0.5 0.6 1.1
f. Total (yearend)9 --- 10.2 16.7 32.4
Q. Actual contribution 30.7 2.2 14.0 12.2
R. Deductible contribution10 8.6 9.0 13.0 9.3
S. Nondeductible contribution
carryforward11 22.1 15.3 16.2 19.2
1
N of prior year
2
C.c - F
3
G/E
4
D + F + H
5
I + J
6
K - L - M
7
S of prior year
8
P.c - O
9
P.d + P.e
10
Smaller of (K - P) and (O + Q)
11
O + Q - R
Mr. Daskais also calculated the contribution limit by applying
his variation of the entry age normal cost method (amortizing the
accrued liability over the remaining lives of the active employees)
as above but substituting investment rates that, in his opinion,
were reasonable. Under these computations, he determined that the
maximum contributions (dollars in millions; discrepancies
attributable to rounding) for 1991-94 were as follows:
- 32 -
1991 1992 1993 1994
A. Investment return 6.6% 6.0% 5.7% 4.9%
B. Present value accrued benefits
a. Active $11.2 $30.5 $38.4 $61.0
b. Retired 23.8 33.0 38.4 42.6
c. Total 35.0 63.5 76.8 103.6
C. Accrued liability
a. Active 9.4 22.7 27.3 43.4
b. Retired 23.8 33.0 38.4 42.6
c. Total 33.1 55.2 64.1 84.7
D. Normal cost 0.2 1.0 1.5 2.4
E. Average present value of future service 4.62 6.26 6.46 6.68
F. Amortized accrued liability from prior
years1 --- 7.9 13.7 20.1
G. Remaining unamortized accrued liability2 33.1 47.3 50.4 64.6
H. Amortization of accrued liability3 7.2 7.6 7.8 9.7
I. Account limit (beginning of year)4 7.4 16.4 23.0 32.2
J. Interest to yearend 0.5 1.0 1.3 1.6
K. Account limit (yearend)5 7.9 17.4 24.3 33.8
L. Benefits paid less employee
contributions --- 3.6 4.1 ---
M. Interest for one-half year --- 0.1 0.1 ---
N. Amortized accrued liability (yearend)6 7.9 13.7 20.1 ---
O. Nondeductible contribution from prior
years7 --- 22.8 17.2 21.8
P. Actuarial value of assets
a. VEBA --- 30.7 30.2 39.9
b. 401(h) --- 1.1 1.2 7.6
c. Total (beginning of year) --- 31.9 31.3 47.5
d. Net after nondeductible
contributions8 --- 9.1 14.2 25.8
e. Interest to yearend --- 0.5 0.8 1.3
f. Total (yearend)9 --- 9.6 15.0 27.0
Q. Actual contribution 30.7 2.2 14.0 12.2
R. Deductible contribution10 7.9 7.8 9.4 6.7
S. Nondeductible contribution
carryforward11 22.8 17.2 21.8 27.3
1
N of prior year
2
C.c - F
3
G/E
4
D + F + H
5
I + J
6
K - L - M
7
S of prior year
8
P.c - O
9
P.d + P.e
- 33 -
10
Smaller of (K - P) and (O + Q)
11
O + Q - R
3. Positions of the Parties
Petitioners assert that the reserve under section 419A(c)(2)
refers to the employer’s accrued liability to provide the
postretirement benefits. Petitioners maintain that, since the
entry age normal cost method is the only method that directly
computes an accrued liability and allocates the present value of an
employee’s future benefit over the employee’s entire working life,
the account limit for the reserve is equal to the accrued liability
computed under the entry age normal cost method. Petitioners
further maintain that (1) for a retiree the accrued liability is
the present value of the employee’s future benefits, and (2) for an
active employee the accrued liability is the present value of the
employee’s future benefits minus the present value of future normal
costs determined under the entry age normal cost method.
Petitioners contend that their contribution to the reserve for each
year at issue did not cause the reserve to exceed the account limit
and, therefore, the contributions were deductible under section
419.
Respondent argues that petitioners’ position is inconsistent
with (1) the language of section 419A(c)(2), (2) the established
judicial precedent interpreting that section, (3) Congress’s
purpose in enacting that section, (4) the accepted interpretation
given “nearly identical language” in the provisions governing
- 34 -
pension plans, (5) the law in effect before the enactment of
section 419, and (6) principles of actuarial practice. Respondent
contends that the cost of the postretirement benefit must be spread
over the remaining working lives of the covered employees.
Respondent further contends that, since retirees have no remaining
working lives, the cost must spread over the remaining working
lives of the active employees. Respondent concludes, therefore,
that the aggregate cost method is the proper method for computing
the account limit for the reserve under section 419A(c)(2).
Respondent asserts in the alternative that, if the entry age normal
cost method is a proper method, then the accrued liability must be
amortized over the remaining lives of the active employees.
4. Statutory Construction
“Our first step in interpreting a statute is to determine
whether the language at issue has a plain and unambiguous meaning
with regard to the particular dispute in the case.” Robinson v.
Shell Oil Co., 519 U.S. 337, 340 (1997). We look to the
legislative history primarily to learn the purpose of the statute
and to resolve any ambiguity in the words contained in the text.
Landgraf v. USI Film Prods., 511 U.S. 244 (1994); Commissioner v.
Soliman, 506 U.S. 168, 174 (1993); Consumer Prod. Safety Commn. v.
GTE Sylvania, Inc., 447 U.S. 102, 108 (1980); United States v. Am.
Trucking Associations, Inc., 310 U.S. 534, 543-544 (1940); Allen v.
Commissioner, 118 T.C. 1, 7 (2002); Venture Funding, Ltd. v.
- 35 -
Commissioner, 110 T.C. 236, 241-242 (1998), affd. without published
opinion 198 F.3d 248 (6th Cir. 1999); Trans City Life Ins. Co. v.
Commissioner, 106 T.C. 274, 299 (1996). Where Congress has
expressed its will in reasonably plain terms, those terms must
ordinarily be regarded as conclusive. Negonsott v. Samuels, 507
U.S. 99, 104 (1993).
The plainness or ambiguity of statutory language is determined
by reference to the language itself, the specific context in which
that language is used, and the broader context of the statute as a
whole. Estate of Cowart v. Nicklos Drilling Co., 505 U.S. 469(1992); McCarthy v. Bronson, 500 U.S. 136, 139 (1991). In
analyzing the plain meaning of section 419A(c)(2), we examine the
section as a whole, with all of its subsections in mind. See
Hellmich v. Hellman, 276 U.S. 233, 237 (1928); Huffman v.
Commissioner, 978 F.2d 1139, 1145 (9th Cir. 1992), affg. in part,
revg. and remanding in part T.C. Memo. 1991-144.
5. The Statute
We begin with the specific language of section 419A(c)(2),
which provides:
The account limit for any taxable year may include a
reserve 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–-
(A) post-retirement medical benefits to be
provided to covered employees (determined on the
basis of current medical costs), or
- 36 -
(B) post-retirement life insurance benefits to
be provided to covered employees.
We first addressed the requirements of section 419A(c)(2) in
Gen. Signal Corp. v. Commissioner, 103 T.C. 216, 239 (1994), affd.
142 F.3d 546 (2d Cir. 1998). In that case, we held that section
419A(c)(2) requires an accumulation of assets equal to the
deduction taken, and that those assets must be used to pay welfare
benefit expenses of retired employees. See also Square D Co. v.
Commissioner, 109 T.C. 200 (1997); Parker-Hannifin Corp. v.
Commissioner, T.C. Memo. 1996-337, affd. in part, revd. in part and
remanded 139 F.3d 1090 (6th Cir. 1998). In Gen. Signal Corp.,
Square D Co., and Parker-Hannifin Corp., we found that no reserves
had been created, obviating the need to consider whether the
contributions were excessive from an actuarial standpoint. In the
case at hand, respondent agrees that a reserve was created; i.e.,
assets in the amount of the deduction taken were accumulated to be
used to pay medical expenses of retired employees.
a. Reserve
Petitioners assert that the term “reserve” in section
419A(c)(2) refers to the employer’s accrued liability to provide
the postretirement benefits. Petitioners conclude, therefore, that
the method used in computing the reserve must compute the accrued
liability.
Respondent asserts that section 419A(c)(2) does not define the
account limit but rather describes contributions to a reserve
- 37 -
(equal to the normal cost computed under the aggregate cost method)
which may be included as a component of the account limit, together
with the amounts set aside for incurred but unpaid claims.
Respondent concludes, therefore, that section 419A(c)(2) does not
require the computation of the accrued liability.
A comparison of the language in section 419A(c)(1) with that
in section 419A(c)(2) belies respondent’s position. Section
419A(c)(1) provides that the account limit “for any taxable year is
the amount reasonably and actuarially necessary to fund” (emphasis
supplied) incurred but unpaid claims and administrative costs with
respect to such claims. By contrast, section 419A(c)(2) provides
that the account limit “for any taxable year may include a
reserve”.
Congress could have used identical language in both
provisions; the fact that Congress chose not to do so must be given
heed. Cf. Keene Corp. v. United States, 508 U.S. 200, 208 (1993)
(“Where Congress includes particular language in one section of a
statute but omits it in another * * *, it is generally presumed
that Congress acts intentionally and purposely in the disparate
inclusion or exclusion.” (Internal quotation marks and citation
omitted.)); United States v. $359,500 in U.S. Currency, 828 F.2d
930, 933 (2d Cir. 1987) (“‘contrasting language in similar statutes
may show that the legislature intended different standards of
compliance’” (quoting 2A Singer, Sutherland Statutory Construction,
- 38 -
sec. 57.06, at 654 (Sands 4th ed. 1984))). Thus, it is the
reserve, not merely a contribution equal to the normal cost for the
year, that must be computed in determining the account limit.
Respondent asserts that courts have held in prior cases, such
as Gen. Signal Corp. v. Commissioner, supra, Square D Co. v.
Commissioner, supra, and Parker-Hannifin Corp. v. Commissioner,
supra, that “reserve” as used in section 419A(c)(2) does not mean
a measure of liability. At issue in those cases, however, was
whether section 419A(c)(2) required the actual funding of a
reserve. The taxpayers in those cases argued that term “reserve”
was an actuarial term of art meaning “a quantity of liability” that
did not require actual funding. We held that a mere quantity of
liability does not constitute a “reserve funded over the working
lives of the covered employees”; i.e., we held that section
419A(c)(2) requires the actual funding of the reserve.
When Congress uses a term of art that has an established
meaning, a strong presumption arises that Congress intends to
incorporate that meaning. Morissette v. United States, 342 U.S.
246, 263 (1952). Congress’s choice of the word “reserve” (rather
than “account” or “fund”, for example) connotes a measure of
liability. W. Natl. Mut. Ins. Co. v. Commissioner, 102 T.C. 338,
373 (1994) (“reserves * * * are estimates of liabilities: ‘“best
estimates” of future settlement costs’” (quoting Salzmann,
Estimated Liabilities For Losses & Loss Adjustment Expenses 155
- 39 -
(1984))), affd. 65 F.3d 90 (8th Cir. 1995); see also Ins. Co. of N.
Am. v. McCoach, 224 F. 657, 659 (3d Cir. 1915) (defining “reserve
funds” as “funds as must be reserved to meet liabilities”); Black’s
Law Dictionary 1309 (7th ed. 1999) (defining “reserve” to mean
“Something retained or stored for future use; esp., a fund of money
set aside by a bank or an insurance company to cover future
liabilities.”).
Section 419A(c)(2) includes in the account limit a reserve
funded for the payment of postretirement medical (or life
insurance) benefits. The payment of those benefits is a liability
of the employer, and “reserve” as used in section 419A(c)(2)
connotes a measure of that liability; it refers to the accumulation
of assets in an amount necessary to satisfy the employer’s
liability to pay the covered employees’ postretirement medical (or
life insurance) benefits when those benefits become due.
b. Reserve Funded Over the Working Lives of the
Covered Employees and Actuarially Determined on a
Level Basis
Section 419A(c)(2) limits the reserve that may be included in
the account limit to “a reserve funded over the lives of the
covered employees and actuarially determined on a level basis”.
Respondent asserts that Norwest’s contribution in 1991 was
excessive because it created a reserve that was not “funded over
the working lives of the covered employees and actuarially
determined on a level basis”. Respondent maintains that the
- 40 -
language of section 419A(c)(2) is, in essence, a one-clause
definition of the aggregate cost method. Respondent posits that
section 419A requires that (1) a reserve for postretirement
benefits must be “funded”; i.e., contributions must be made for the
purpose of providing postretirement medical benefits, and (2) the
funding must be done on a “level” basis over the working lives of
the employees. Respondent contends that the funding cannot begin
before the reserve is created and, therefore, the funding must be
determined on a level basis over the remaining working lives of the
covered employees. Respondent concludes that, since retired
employees have no remaining working lives, the funding must be
determined on a level basis over the remaining working lives of the
active employees. Disagreeing with respondent, petitioners assert
that the term “funded” means “calculated”, not “contributed”, and
that the reserve (accrued liability) is calculated over the working
lives of the covered employees. Thus, petitioners conclude that
the reserve included in the account limit is an actuarially
determined accrued liability (i.e., a “reserve”) that is calculated
(i.e., “funded”) over the working lives of the covered employees.
(i) Reserve Funded Over the Working Lives of the
Covered Employees
We do not agree with petitioners that funded means calculated.
We have previously held that the “funded” reserve in section
419A(c)(2) refers to an accumulation of assets and the funding of
benefits. Natl. Presto Indus., Inc. v. Commissioner, 104 T.C. 559,
- 41 -
574 (1995). A “reserve funded over the working lives of the
covered employees” “clearly evokes the gradual accumulation of
funds measured with an eye toward complete funding at the time of
retirement”. Gen. Signal Corp. v. Commissioner, 142 F.3d at 549
(citing Parker-Hannifin Corp. v. Commissioner, 139 F.3d 1090, 1094
(6th Cir. 1998)). We agree with respondent that the funding of the
reserve cannot begin until the reserve is created. However, we do
not agree with respondent that the reserve must be funded over the
aggregate remaining working lives of the active employees.
Respondent asserts that once the reserve is created it may be
funded over the aggregate working lives of the covered employees
and that the end of the working lives of the covered employees
occurs when the last covered employee is no longer employed by the
employer, because the employment of all covered employees has
terminated. Respondent acknowledges that, under that reading, the
reserve will not be fully funded upon retirement with respect to
any individual employee (except the last employee). The position
taken by respondent in this case is contrary to the position
successfully urged by the Commissioner in Gen. Signal Corp. In
Gen. Signal Corp. v. Commissioner, 142 F.3d at 549, the Court of
Appeals for the Second Circuit agreed with the Commissioner’s
interpretation that the phrase “funded over the working lives”
means that “the amount that is supposed to be added to the reserve
each year would, assuming the reserve remained intact, result in
- 42 -
full funding for retirement benefits at the end of each employee’s
term of service.” (Emphasis supplied.)
Respondent acknowledges that sections 419 and 419A do not
impose an obligation on an employer to create a reserve to pay for
postretirement medical benefits; i.e., employers may pay and deduct
the medical claims as they become due on a pay-as-you-go basis.
Respondent further acknowledges that if an employer establishes a
reserve under section 419A(c)(2), sections 419 and 419A do not
impose a minimum annual contribution requirement or require an
employer to make contributions that are precisely level.
Respondent contends, however, that “funded” in section 419A(c)(2)
is synonymous with “amortized” and that if an employer does not
make a contribution in a given year, then the “contribution that
was not made would be funded over the remaining working lives of
employees in subsequent years”. Respondent asserts that the
language “funded over the working lives of the covered employees”
is essentially identical to the language of section
404(a)(1)(A)(ii), and, therefore, any accrued liability must be
amortized over the remaining lives of the active employees. We
disagree.
The language of section 404(a)(1)(A)(ii) is clearly different
from the language of 419A(c)(2). When applicable,19 section
19
The deduction for a contribution to a pension trust is
limited to the amount provided in sec. 404(a)(1)(A)(ii) when it
exceeds the minimum funding amount provided in sec. 412(a) and the
(continued...)
- 43 -
404(a)(1)(A)(ii) limits the deduction for a contribution to a
pension plan to “the amount necessary to provide with respect to
all of the employees under the trust the remaining unfunded cost of
their past and current service credits distributed as a level
amount * * * over the remaining future service of each such
employee”. The phrases “over the remaining future service of each
such employee” (the section 404(a)(1)(A)(ii) language) and “over
the working lives of the covered employees” (the section 419A(c)(2)
language) are not identical. We give heed to the fact that
Congress could have used identical language in both the pension and
VEBA provisions but chose not to do so.
Moreover, Congress in section 419A(e)(1) specifically made the
pension nondiscrimination rules of section 505(b) applicable to the
section 419A(c)(2) reserve. This is an indication that Congress
did not intend to automatically apply pension provisions to section
419A. Additionally, in section 419(c)(3), Congress provided for
the amortization of the adjusted basis of a child care facility
over 60 months. This is a further indication that Congress did not
intend to require amortization of the postretirement benefit of a
retired employee.
When Congress has intended to require costs to be spread over
the remaining working lives of active employees, it has done so
clearly. For example, the funding period for purposes of
19
(...continued)
amount provided in sec. 404(a)(1)(A)(iii).
- 44 -
contributions to a black lung benefit trust20 is the greater of “(i)
the average remaining working life of miners who are present
employees of the taxpayer, or (ii) 10 taxable years.” Sec.
192(c)(1)(B). We conclude, therefore, that the amortization rules
applicable to pensions do not apply to the computation of the
section 419A(c)(2) reserve.
In Gen. Signal Corp. v. Commissioner, 103 T.C. at 240, in
light of the taxpayer’s assertions that the phrase “reserve funded”
does not have a commonly understood meaning, we assumed arguendo
that the phrase was ambiguous and considered the legislative
history. We shall do likewise in this case.
In consulting the legislative history of section 419A, we are
mindful that the relevant portion of the committee report states:
Prefunding of life insurance, death benefits, or
medical benefits for retirees.--The qualified asset
account limits allow amounts reasonably necessary to
accumulate reserves under a welfare benefit plan so that
20
Sec. 192(b) limits contributions to a black lung benefit
trust as follows:
SEC. 192(b). Limitation.--The maximum amount of the
deduction allowed by subsection (a) for any taxpayer for
any taxable year shall not exceed the greater of--
(1) the amount necessary to fund (with level
funding) the remaining unfunded liability of the
taxpayer for black lung claims filed (or expected
to be filed) by (or with respect to) past or
present employees of the taxpayer, or
(2) the aggregate amount necessary to increase
each trust described in section 501(c)(21) to the
amount required to pay all amounts payable out of
such trust for the taxable year.
- 45 -
the medical benefit or life insurance (including death
benefit) payable to a retired employee during retirement
is fully funded upon retirement. These amounts may be
accumulated no more rapidly than on a level basis over
the working life of the employee, with the employer of
each employee. * * * The conferees intend that the
Treasury Department prescribe rules requiring that the
funding of retiree benefits be based on reasonable and
consistently applied actuarial cost methods, which take
into account experience gains and losses, changes in
assumptions, and other similar items, and be no more
rapid than on a level basis over the remaining working
lifetimes of the current participants. * * * [H. Conf.
Rept. 98-861, at 1157 (1984), 1984-3 C.B. (Vol. 2) 1,
411.]
The legislative history makes clear that the funding of the
reserve can be completed no more rapidly than over the working life
of the employee. Therefore, we conclude that fully funding the
reserve at or after retirement is permissible because, in that
case, the assets are accumulated less rapidly than over the working
life of the employee.
To conclude this aspect of our deliberation, we hold that for
purposes of section 419A(c)(2), the phrase “reserve funded over the
working lives of the covered employees” means that assets necessary
to satisfy the employer’s liability may be accumulated no more
rapidly than over the working lives of the covered employees, such
that the reserve with respect to an employee can be fully funded no
earlier than upon retirement of the employee.
- 46 -
(ii) Reserve Actuarially Determined on a Level
Basis
We now turn our attention to the requirement that the reserve
under section 419A(c)(2) be “actuarially determined on a level
basis” and the calculation of the reserve. We have held that the
term “reserve” in section 419A(c)(2) refers to assets in an amount
necessary to satisfy the employer’s liability to pay the covered
employees’ postretirement medical benefits when the benefits become
due.
Petitioners assert that “level”, as an actuarial concept,
refers to normal cost and that, to an actuary, “level” means that
the normal costs are level. Normal cost is that portion of the
present value of the benefit that is assigned to the current or a
future year. In other words, the value of the benefit assigned to
the current year is the same as the amount assigned to each
subsequent year until the employee’s retirement date. Petitioners
further assert that the actuarial concept of level is unrelated to
the employer’s actual contributions to a plan and that actuarial
methods determine amounts that can be contributed but do not
mandate funding.
Petitioners acknowledge that both the aggregate and entry age
normal cost methods produce level normal costs. Petitioners
assert, however, that the aggregate cost method is not appropriate
because it does not directly calculate the accrued liability
independently of the assets.
- 47 -
Respondent asserts that a direct calculation of the accrued
liability independent of the assets is not necessary. Respondent
contends that the actuary must compute on a level basis a reserve
funded over the working lives of the covered employees. Further,
respondent posits that since the funding does not begin before the
reserve is created, the reserve must be computed by allocating the
cost in a level amount over the remaining lives of the employees.
Respondent contends that (1) the actuarial methodology used must
determine contributions at a “rate” that would be level if
actuarial assumptions were exactly realized, (2) the funds may only
accumulate gradually, and (3) in order to accomplish the gradual
funding, the actuarial method must provide for the ratable
accumulation of funds over the remaining working lives of the
covered employees. Respondent asserts that the following excerpt
from the legislative history supports his position: “The conferees
intend * * * that the funding of retiree benefits * * * be no more
rapid than on a level basis over the remaining working lifetimes of
the current participants”. H. Conf. Rept. 98-861, supra at 1157,
1984-3 C.B. (Vol. 2) at 411. Respondent contends that once an
employer elects to fund a reserve for postretirement benefits under
section 419A(c)(2), it must then select an actuarial cost method
that satisfies this statutory requirement. Respondent concludes
that the aggregate cost method properly allocates the costs in a
level amount over the remaining lives of the covered employees. In
- 48 -
the alternative, respondent argues that, if the method used
calculates an accrued liability independently of the fund assets,
the unfunded accrued liability must be amortized over the remaining
lives of the active employees.
We believe that use of the aggregate cost method to compute
the reserve is not appropriate because that method will not permit
full funding of the reserve with respect to a retired employee at
retirement of that employee. Further, we agree with petitioners
that the accrued liability should be computed independently of the
plan assets. Indeed, there are circumstances under which the
reserve could become overfunded and yet additional amounts could be
added to the reserve using the aggregate cost method.21 We have no
doubt that, in such an event, the Commissioner would require the
use of another method that directly calculates an accrued liability
independently of the plan assets. Additionally, we have held that
section 419A(c)(2) does not require the amortization of the accrued
liability.
Section 419A(c)(2) requires that the reserve funded over the
lives of the covered employees be “actuarially determined on a
level basis”. Thus, assets necessary to satisfy the employer’s
21
We note that use of the aggregate cost method is not
permitted in computing the full-funding limit for pensions under
sec. 412. Sec. 412(c)(7) defines the term “full-funding limitation”
for purposes of sec. 412(c)(6) as the excess of the accrued
liability (including normal cost) under the plan, over the value of
the plan’s assets. The accrued liability is determined under the
entry age normal cost method if the accrued liability cannot be
directly calculated under the funding method used for the plan.
- 49 -
liability may be accumulated no more rapidly than on a level basis
over the working lives of the covered employees, such that the
reserve with respect to an employee can be fully funded no earlier
than upon retirement of the employee. We conclude that the maximum
amount of the liability that may be satisfied by the reserve is the
amount at the time with respect to which the reserve is computed
that, together with future normal costs and interest, will be
sufficient upon retirement of each employee to pay future medical
claims of the employee when they become due. See, e.g., United
States v. Atlas Life Ins. Co., 381 U.S. 233, 236 n.3 (1965);
Travelers Ins. Co. v. United States, 303 F.3d 1373, 1380-1381 (Fed.
Cir. 2002); Natl. States Ins. Co. v. Commissioner, 758 F.2d 1277,
1278 (8th Cir. 1985) (a reserve is computed by calculating the
excess of the present value of future benefits payable over the
present value of future net premiums receivable), affg. 81 T.C. 325(1983). That amount must be actuarially determined on a level
basis.
The actuarial present value of the projected benefit of each
covered employee should be allocated on a level basis to each year
commencing with the year in which the allocation is first
recognized and ending with the year the employee is expected to
retire. The funding of “a reserve funded over the working lives of
the covered employees” cannot begin until the reserve is created.
Thus, the allocation is first recognized on the later of the date
- 50 -
when the reserve is created and the date the employee becomes a
covered employee. Essentially, this is the individual level
premium cost method with the date of the creation of the reserve
substituted for the date the plan is instituted. When the year in
which the allocation is first recognized is after the employee has
retired, there are no future years to which the benefits may be
allocated. Since there are no future years to which the benefits
may be allocated, there are no future normal costs, and the entire
present value of the projected benefit is properly allocated to the
first year. This is the method that Mercer used in computing
Norwest’s contribution for 1991, the year the reserve was created.
The individual level premium cost method comports with our
holding that the amount of the liability that may be satisfied by
the reserve is the amount at the time with respect to which the
reserve is computed that, together with future normal costs and
interest, will be sufficient upon retirement of an employee to pay
future medical claims of the employee when they become due. See,
e.g., United States v. Atlas Life Ins. Co., supra; Travelers Ins.
Co. v. United States, supra; Best Life Assur. Co. v. Commissioner,
281 F.3d 828, 830 (9th Cir. 2002), affg. T.C. Memo. 2000-134; Natl.
States Ins. Co. v. Commissioner, supra; Sears, Roebuck & Co. v.
Commissioner, 96 T.C. 61, 110 (1991), revd. on other grounds 972
F.2d 858 (7th Cir. 1992).
- 51 -
C. Investment Rates
The pretax and after-tax investment rates22 Mercer used in the
1991-94 valuation reports were as follows:
1991 1992 1993 1994
Pretax rate 9.0% 8.0% 6.0% 6.0%
After-tax rate 5.5 4.9 3.6 3.6
The after-tax investment rate was determined by applying a tax rate
of 39 percent for 1991-92 and 40 percent for 1993-94.
In the notices of deficiency, respondent did not dispute the
actuarial assumptions, including the pretax and after-tax
investment rates, Mercer used in the 1991-94 valuation reports. In
an amended answer, however, respondent asserted that the pretax
investment rates used in the 1993 and 1994 calculations and the
after-tax investment rate used in the computation for all years
1991-94 were too low.
Respondent asserts that the pretax and after-tax rates Mr.
Daskais proposed are reasonable and demonstrate that the rates
petitioners used are unreasonable. The pretax and after-tax
investment rates Mr. Daskais proposed are as follows:
1991 1992 1993 1994
Pretax rate 9.0% 8.0% 8.0% 7.0%
After-tax rate 6.6 6.0 5.7 4.9
Mr. Daskais determined the after-tax investment rates by
applying a tax rate of 29 percent for 1991-92 and 31.9 percent for
22
Unless otherwise indicated, all rates are rounded to the
nearest tenth of 1 percent.
- 52 -
1992-94. In our opinion, Mr. Daskais’s after-tax rates are too
high because they do not take into account the Minnesota State tax
on unrelated business income. Minnesota taxes the unrelated income
of an exempt organization at the corporate rate of 9.8 percent.
Minn. Stat. Ann. secs. 290.05, subd. 3, and 290.06, subd. 1 (West
1999 & Supp. 2003). Since State taxes paid are deducted for
purposes of Federal tax, the combined tax rate would be 36 percent23
for 1991-92 and 38.6 percent24 for 1993-94. Applying the combined
tax rates to the pretax investment rates Mr. Daskais considers
reasonable results in the following after-tax investment rates
(rounded to nearest tenth of a percent):
1991 1992 1993 1994
Pretax rate 9.0% 8.0% 8.0% 7.0%
After-tax rate 5.8 5.1 4.9 4.3
23
The combined tax rate for 1991-92 is computed as follows:
Starting point 100.0%
Minn. State tax at 9.8% (100 x 9.8%) - 9.8
90.2
Federal tax at 29% (90.2 x 29%) -26.2
64.0
Combined tax rate (100% - 64%) 36
24
The combined tax rate for 1993-94 is computed as follows:
Starting point 100.0 %
Minn. State tax at 9.8% (100 x 9.8%) - 9.8
90.2
Federal tax at 31.9% (90.2 x 31.9%) -28.8
61.4
Combined tax rate (100% - 61.4%) 38.6
- 53 -
The difference of 0.3 percent between the 5.8-percent after-
tax rate computed for 1991 and the 5.5-percent after-tax rate
petitioners used in 1991 is relatively minimal and does not
establish that the 5.5-percent rate was unreasonable.
Moreover, the Internal Revenue Service publishes a permissible
range of interest rates used to calculate the current liability for
purposes of the full-funding limitation for pensions under section
412(c)(7). See Notice 88-73, 1988-2 C.B. 383. Although we are
mindful that Notice 88-73, supra, provides that no inference should
be drawn from the notice as to any issue not specifically addressed
therein, in the absence of regulations or other guidance to the
contrary, in our opinion rates that fall within the permissible
range of rates for purposes of the full-funding limitations on
pensions are reasonable for purposes of computing the reserve under
section 419A(c)(2).
The published range for a January 1991 valuation date is 7.77-
9.49 percent. Notice 91-5, 1991-1 C.B. 315. The income of a
pension trust is not taxable, and the interest rates provided for
purposes of the full-funding limitation represent pretax rates.
Application of a 36-percent combined tax rate to 7.8 percent (the
lowest investment rate (rounded) in the permissible range for
purposes of section 412(c)(7)) gives an after-tax investment rate
of 5.0 percent, which we believe supports the reasonableness of the
5.5-percent after-tax rate petitioners used for 1991.
- 54 -
In computing Norwest’s contribution for 1991, Mercer applied
a reasonable investment rate and used the appropriate individual
level premium cost method. We conclude, therefore, that Norwest’s
contribution to fund the reserve under section 419A(c)(2) for 1991
did not exceed the account limit.
Further, for years 1992-94, even using the higher after-tax
investment rates Mr. Daskais proposed of 6.0 percent for 1992, 5.7
percent for 1993, and 4.9 percent for 1994, it is clear that
Norwest’s contributions to fund the reserve do not exceed the
account limit when the reserve is computed by applying the
individual level premium cost method.
We conclude that Norwest’s contributions to the postretirement
benefit trust to fund a reserve for postretirement medical benefits
for 1991-94 did not exceed the account limit for a reserve under
section 419A(c)(2). We hold, therefore, that in computing
petitioners’ consolidated income tax for 1991-94, petitioners are
entitled to deductions for postretirement medical benefit
contributions of $30,689,717 in 1991, $2,170,000 in 1992,
$13,791,600 in 1993, and $12,247,933 in 1994.
To reflect the foregoing, and because other issues in these
cases remain for resolution,
An appropriate order will
be issued.