In a breakthrough private letter ruling, the Internal Revenue Service has approved a complex arrangement involving a charity and a taxable organization that allows the taxable organization to fund a tax-exempt trust, which is generally beyond the reach of creditors, in order to provide deferred compensation benefits for its employees. This ruling comes closer to giving non-qualified deferred compensation a number of the tax benefits of a qualified plan than has any previous ruling.

The private letter ruling in question, PLR 9810005, involves an unusual set of facts, but one that can be nearly replicated at least in some situations. Those facts require the dual operation of a tax-exempt organization, such as a charity, and a taxable organization. In addition, there is a contractual arrangement between the two organizations by which the tax-exempt organization pays service fees to the taxable organization. This is presumably not an unusual arrangement for medical organizations.

AALU counsel understands that PLR 9810005 was issued to Kaiser Permanente, the largest health maintenance organization in the United States. It operates through two entities, Kaiser, which is a tax-exempt 501(c)(3) organization, and Permanente, which is a taxable corporation. Permanente hires the doctors that provide the medical services to Kaiser. This relationship has been in existence for many years. For purposes of the ruling, the IRS assumed that the two organizations were independent entities that negotiated on an arm's length basis. (For purposes of this discussion, it will be assumed that this ruling was, in fact, issued to Kaiser and Permanente.)

Under the contractual arrangement, Kaiser is required to reimburse Permanente's operating expenses on an annual basis. Permanente established an unfunded, non-qualified retirement plan (the "supplemental plan") that provides benefits for employees whose benefits in their qualified plan are capped due to limitations under section 401(a)(17) ($160,000 compensation limit); section 415 limit on contributions and benefits (generally $30,000 for defined contribution plans and $130,000 for defined benefit plans); and another provision that has now been repealed. In order to qualify for the benefits, the employees of Permanente must satisfy certain age and service requirements; otherwise their benefits under the plan would be forfeited. The benefits provided under this non-qualified plan are part of the operating costs of Permanente that are to be paid annually (or more frequently) by Kaiser.

As part of the ruling, Kaiser proposed to establish an irrevocable, funded trust into which it would contribute the amounts appropriate to satisfy its obligation under this supplemental plan. Payments would be made from the trust to Permanente as Permanente becomes obligated to make the payments to the employees. The trust assets would not be reachable by the creditors of either Kaiser or Permanente, but once payments were made from the trust to Permanente, its creditors could then reach these assets.

The trust would be funded by making contributions equal to the present value of the benefits that Kaiser would be expected to pay under the supplemental plan. The funding would be calculated in a way that would be likely to create significant over-funding of the plan because it would ignore certain factors such as employee turnover and mortality. The trust amounts would be held in individual memorandum accounts that would be identified by reference to the individual employees covered by Permanente's plan. Contributions would not be made on behalf of employees who were within two years of satisfying the age and service requirements for benefit payment. The trust would pay amounts to Permanente generally on a quarterly basis and excess amounts would revert back to Kaiser periodically. The amounts in the trust would also revert to Kaiser if Permanente voluntarily terminated its relationship with Kaiser or if Kaiser terminated its relationship with Permanente for cause. If Kaiser terminated its relationship with Permanente without cause, the trust assets would be distributed to Permanente. The ruling states that for financial accounting purposes, Kaiser would expense all contributions to the trust, and Permanente would show the trust assets on its balance sheet as an offset against liabilities under the supplemental plan).

Based on these facts, the Internal Revenue Service reached two particularly significant conclusions. First, they concluded the trust would be treated as a grantor trust under the Internal Revenue Code, with the result that the trust income would not be taxed since the grantor of the trust, Kaiser, is a tax-exempt organization. This effectively provides a tax-exemption for the trust investments.

Second, the Service analyzed the taxation of the trust to Permanente under section 83, apparently on the theory that the contract was a "service" contract, and section 83 governs the taxation of payments in connection with the performance of services. Section 83 can apply to corporations as well as individuals. Based on the section 83 analysis, the Revenue Service concluded that Permanente was not taxable until the amounts in the trust were no longer subject to a substantial risk of forfeiture, and that would not occur until such time as the payments to Permanente's employees were no longer subject to the age and service requirements. The Internal Revenue Service held that these conditions represented a substantial risk of forfeiture under section 83 because the property transfers were conditioned on the occurrence of a condition related to the purpose of the transfer. Normally, substantial risk of forfeiture is only found if the condition requires the performance of future services. However, the IRS regulations provide an alternate definition of substantial risk of forfeiture, which was utilized here. Presumably that definition was necessary because the services that Permanente would provide would be provided in any event, but perhaps with different doctors.

The IRS also held that once the assets in the trust are no longer subject to a substantial risk of forfeiture, they would be taxed to Permanente and Permanente would be treated as the owner of that portion of the trust. At that point, Permanente would be treated as the grantor of that portion of the trust (a "deemed trust"). Therefore, to the extent a deemed trust resulted from this arrangement, those amounts would be included in Permanente's income, subject to an offsetting deduction for compensation payments made to the covered employees who would then, of course, have taxable income. The IRS expressly noted that the transfer of assets to the trust, the allocation of those assets, the allocation of earnings on the assets and the distribution of the assets to Permanente would not create any income to the participants or beneficiaries of the supplemental plan.

The ruling is also significant for what it did not say. The IRS did not rule on either section 402(b) or section 457(f). Section 402(b) taxes funded non-qualified trusts and section 457(f) taxes deferred compensation plans of tax-exempt employers. AALU counsel understands that this ruling has been under consideration at the IRS for several years, and presumably this no-ruling aspect of the ruling was part of a negotiated compromise in order to obtain the favorable rulings that resulted.

However, substantial arguments are available that adverse taxation under section 402(b) and section 457(f) would not result, notwithstanding the IRS' apparent reluctance to rule on those issues. Section 402(b) generally taxes employees' trusts and, if the independence of the two organizations is recognized, a substantial argument could be made that the trust involved is not an "employees' trust" because it is not for the benefit of Kaiser employees. Further, section 402(b)(4) provides special rules for taxing highly compensated employees in a funded non-qualified trust and does not use the term "employees' trust." However, again, because presumably there would be no highly compensated employees of Kaiser who were receiving benefits under the trust, it is questionable whether section 402(b)(4) would be applicable either.

Likewise, section 457(f) arguably would be not applicable because section 457(f) is directed at non-qualified deferred compensation arrangements for employees of a tax-exempt employer. The arrangement in question is for employees of another employer, and that employer is a taxable entity.

Finally, as an historical note, it should be recognized that Kaiser Permanente tried to accomplish a similar result twenty-five years ago in a case that went to the Supreme Court, U.S. v. Basye, 410 U.S. 441 (1973). However, Basye was decided when Permanente was a limited partnership of doctors and the Supreme Court's decision relied heavily on the partnership taxation rules in reaching its result. The Supreme Court largely ignored the form of the transaction and held that partners of the Permanente limited partnership were taxable on the trust created by Kaiser, applying the anticipatory assignment of income doctrine and the partnership taxation rules. It appears that Kaiser and Permanente have now circumvented the Basye decision.

While the ruling is somewhat circumscribed in usefulness by its factual setting, it nevertheless constitutes a breakthrough in the world of non-qualified deferred compensation. Benefits under this arrangement would be funded largely, if not entirely, on a tax-exempt basis and the benefits would remain exempt from the claims of creditors, at least until the amounts were paid to Permanente for payment to the employees. If Permanente were in financial difficulties at that time, creditors could reach the amounts as they pass through Permanente; but, in such a case, it is probable that the contractual arrangements between Permanente and Kaiser would have been terminated anyway.

A number of medical providers have parallel tax-exempt and taxable organizations providing services and those arrangements may be able to replicate this ruling in providing non-qualified deferred compensation for their employees. A number of trade associations and other tax-exempt employers may also be able to replicate non-qualified arrangements based on this model.