a plan may be used is sometimes brought to its attention. In one such case, a physician performing services for a taxexempt organization was able to defer 90 percent of his compensation for those services. In another, broader case, an arrangement was made between a tax-exempt organization and 100 physicians, each of whom also maintained a qualified retirement plan. The total deferral under the arrangement was $1,533,832 for 1974 and $1,464,530 for 1975 average of approximately $15,000 per person each year. -- an Although the proposed regulations apply to salary reduction arrangements and similar arrangements maintained by all types of employers, they will impact on some employees of State and local governments. In this light, some of the history behind the proposed regulations would be helpful. The first private ruling on a governmental plan of this type was issued about six years ago after approval at relatively low levels in the Service. The case was then sent to the Service's Chief Counsel for consideration with a view to publication of a public revenue ruling. In the meantime, having issued one favorable ruling, the Service continued to issue favorable rulings pending completion of consideration by the Chief Counsel's office. After lengthy deliberation, the Chief Counsel's office concluded that the original ruling was incorrect. This caused the issue to be referred to officials at the policy level in the Service and the Treasury Department. It also resulted in the Service's announcement on September 7, 1977, that it had suspended the issuance of rulings dealing with the income tax treatment of certain nonqualified deferred compensation plans established by employers (including State and local governments) pending completion of its review. The proposed regulations represent the conclusions reached as a result of this review. The Service and the Treasury Department concluded that the private rulings already issued reflected an incorrect interpretation of the law as it now exists. A taxpayer on a cash basis of accounting is normally taxed only when he or she receives cash or its equivalent. However, "under the . doctrine of constructive receipt, a taxpayer may not deliberately turn his back on income and thereby select the year for which he will report it."* Thus, income earned on a savings account is taxable whether or not a taxpayer ⭑ Rev. Rul. 60-31, 1960-1 Cum. Bull. 174, 178. withdraws it or has it entered on a passbook. In the context of deferred compensation arrangements, the Service stated in Revenue Ruling 60-31 that it could not administer the law "by speculating whether the payor would have been willing to agree to an earlier payment". However, with arrangements of the type affected by the proposed regulation, no such speculation is required. If an employee is in complete control of the disposition of part of his or her compensation and the employer is willing to pay or withhold that amount at the direction of the employee, the fact that the employee elects deferral should not, in the absence of statutory authorization, result in exclusion of the amount from gross income. In similar instances, no exclusion would result if the employee directed the employer to withhold an amount from compensation and pay the amount into a savings account or as a premium on an annuity contract owned by the employee. We realized the potential impact of the proposed regulations, and we did not undertake their publication lightly. We did so only because we were firmly convinced that they are the proper interpretation of the law as it exists in the Code today. This does not mean, however, that we cannot be convinced otherwise, for that is the purpose of the administrative procedure of publishing proposed regulations subject to public comment and a public hearing if one is requested. The proposed regulations contain a grandfather provision for arrangements in existence on February 3, 1978. The regulations will not apply to the amount of any payment which the taxpayer has chosen to defer under such a plan or arrangement if the amount would have been payable, but for the taxpayer's exercise of the option to defer receipt, before a date 30 days following publication of final regulations. The effect of this transition rule is that amounts withheld before finalization of the regulations will not be subject to tax, but grandfathered plans will be subject to the new rules from that time forward. In the meantime, existing plans should be able to continue operation while consideration is being given to the proposed rules within the Service and the Treasury Department. This also allows time, of course, for consideration by the Congress. The period for public comment is still open, so we have not made a full analysis of the responses to the proposed regulations. Therefore, we cannot predict what our final position will be. However, as of now we have not been persuaded that the position taken in the proposed regulations is incorrect under existing law. We cannot, of course, close our eyes to the possibility of a legislative solution, whatever the outcome of our deliberations under present law. We believe the possibility of legislation raises two fundamental issues of tax policy: first, the necessity of restricting favorable tax treatment of compensation to benefits provided in a nondiscriminatory manner; and second, the extent to which the favorable treatment should remain if participation in the nondiscriminatory arrangement is at the choice of the employee. The latter question has been troubling the Treasury and Congress for several years, and it is the subject of section 2006 of ERISA, now under consideration in H. R. 9251 (the so-called "extender" bill). But first, I want to discuss the question of nondiscrimination. Deferral of tax on the payment of compensation disrupts the progressive nature of our income tax system. This disruption should occur only for the sake of implementing an important social policy. In the case of retirement plans, the goal is assurance that employees at all levels of compensation will be provided with protection after retirement. It is particularly difficult for employees at low income levels to provide this protection for themselves. This has led to the proposal in the Administration's tax reform program for improvements in the rules which allow qualified retirement plans to integrate with the Social Security system. Tax incentives for retirement plans are offered to encourage employers to provide for rank-and-file employees as well as highly compensated employees. In the case of a taxable employer which maintains a qualified plan, this incentive is an immediate deduction for contributions, while employees may defer the taxation of those contributions and income earned on them. In the absence of a qualified plan, the price of deferral for employees is a similar delay in the timing of the employer deduction. However, the ability to accelerate a deduction in comparison to inclusion of income by the employees is not relevant to a tax-exempt entity. As noted above, such an employer can essentially provide its employees with the tax-deferral benefits of a qualified plan through an unfunded nonqualified arrangement. ERISA, however, prohibits unfunded plans for rank-and-file employees, except in the case of government and church plans. Surely, in relieving these entities of the requirements of funding, Congress did not intend to provide them with a unique opportunity to achieve tax deferral for their employees without regard to the restrictions or limitations of qualified plans (or even Individual Retirement Accounts or Section 403(b) annuities). The practical result is that a dollar of after-tax compensation under a nonqualified plan can be provided more cheaply by a State or local government than by other employers. This leads us to the conclusion that if favorable tax treatment is to be granted, salary reduction arrangements maintained by governmental employers should be subject to many of the same requirements as qualified plans. This would mean, for instance, that the arrangement should be nondiscriminatory with respect to both the potential group of employees who may participate and the group of employees who actually do participate. Moreover, since the employee is deferring his or her own contributions to the plan, there should not be any possibility of forfeiture. The arrangement should be a funded plan, with the plan (rather than the employer) bearing the obligation to pay benefits to the employee. In order to prevent excessive deferrals, such arrangements should be subject to the overall limitations on contributions and benefits applied to qualified retirement plans, and perhaps a specific limitation should be imposed on a salary reduction arrangement itself. As is true in the case of a qualified pension plan, distributions during employment should be prohibited. If the arrangement does not meet these requirements, the amount of the salary reduction would be taxable to the employee as earned. Such a legislative approach has the practical effect of allowing deductible employee contributions to a plan. On the other hand, employees who participate in qualified plans may not deduct their own contributions to a plan, even if those contributions are a prerequisite either to the accrual of benefits derived from the employer or to employment itself. This inequality in treatment, which would be the result of a combination of a legislative change for nonqualified salary reduction arrangements and a continuation of present law for employee contributions, raises a much broader question of the possibility of deductions and exclusions for employee contributions by way of salary reduction or otherwise to all types of tax-favored deferred compensation arrangements and fringe benefit plans. This is the broad question to which I suggest that we the Congress and the Treasury together begin to give serious consideration. A solution to the problem of salary reduction arrangements for governmental employees may well be a logical result of that consideration. - - Overall Considerations of Salary Reduction and Deductions for Employee Contributions This issue can arise in numerous forms. Initially, if an amount is designated as an employee contribution, it is taxable to the employee and a deduction is disallowed even if, as is the case with the Civil Service Retirement System, the employee is required to make the contribution as a condition of employment.* In a salary reduction arrangement such as the type covered by the recently proposed regulations, it is generally clear that amounts involved are taken from an employee's compensation and, hence, are effectively the same as employee contributions. However, the tax treatment may be in dispute. Employers have established socalled "cafeteria" plans under which a participating employee may elect an immediate distribution of cash or the application of part or all of the money to fringe benefits, such as medical or life insurance which would be nontaxable if they had been provided directly by the employer. Other employers maintain so-called "cash and deferred" profit-sharing plans under which employees can choose immediate payment in cash or contribution to a qualified plan. Existing revenue rulings allow a substantial degree of discrimination in these plans without loss of qualification. Cafeteria plans and cash and deferred profit sharing plans are the subject of a special provision of ERISA (section 2006) which provided differing treatment depending upon whether the plans were in existence on June 27, 1974. This provision expired on January 1, 1978, but a two-year extension is now under consideration. In its recent Tax Reform proposals, the Administration supported continued nontaxability of benefits provided by cafeteria plans, provided the tax-favored benefits are actually provided in a nondiscriminatory manner. In the case of cash and deferred profit-sharing plans, the Treasury in its comments on H.R. 8136 has recommended that tax deferral be precluded except for a limited grandfather rule. Different rules have * Under section 414 (h) (2) of the Internal Revenue Code, contributions to a qualified plan which are otherwise designated as employee contributions but which are "picked up" by a governmental employer are treated as employer contributions. Therefore, the picked-up amount is excluded from income until it is distributed or made available. Rev. Rul. 77-462, 1977-50 I.R.B. 20. See |