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IRS Addresses Taxability of Contributions of Unused Leave to Retiree Health Benefit Plans

Two recent private letter rulings issued by the Internal Revenue Service address the taxability of contributions of accrued sick and vacation leave to a health reimbursement account (“HRA”), to be used to pay for medical expenses after retirement.  In the first PLR, the IRS ruled that employees’ elective contributions to a post-retirement medical expense plan would be taxable.  In the other, the IRS confirmed that mandatory contributions to an HRA (made by an employer, of retiring employees’ unused vacation and sick leave) would not be taxable.

In PLR 200704005, the IRS addressed a plan that an employer proposed to adopt to allow its employees to make elective contributions of accrued leave to pay for medical care expenses after retirement.  The plan would have allowed employees to make a one-time, irrevocable election to contribute a portion of their regular pay or accrued leave, or both.  Such an election could not be  revoked once made, and the employee could not receive cash refunds of his or her contributions.

Contributions from accrued leave would be made upon termination of employment.  Any amounts remaining after an employee’s death could be used by the employee’s surviving spouse, dependents, or other beneficiaries.  The IRS concluded that contributions made to such a plan, pursuant to employees’ elections, would not be excludable from gross income under Section 106 of the Tax Code.

On the flip side, in PLR 200708006, the employer likewise proposed to establish a trust for the benefit of eligible retiring employees, their spouses and dependents.  In contrast, however, contributions to the trust were mandatory – in that coverage under the plan would be automatic for eligible employees, and they would not be permitted to elect in or out of coverage.  The contributions would include discretionary employer contributions for all participating employees, contributions of all or a portion of employees’ accumulated and unused vacation and sick leave upon retirement, and contributions of all or a portion of employees’ annual excess vacation and sick leave that would otherwise be forfeited or paid out at year-end.  The employees would not be permitted to decide the amount or percentage of either the  discretionary employer contributions or the vacation or sick leave to be contributed to the trust.

Unlike the plan proposed in the first PLR, the plan at issue provided that retired employees or their spouses or dependents could not elect to receive unused amounts in cash or other benefits.  Following a participant’s death, unused amounts could be carried over for the benefit of his or her surviving spouse and dependents, but after their deaths, any unused amounts would be forfeited.  Under this scenario, the IRS concluded that, so long as the value of unused accrued leave could not be received in cash, the contribution of such leave to the trust would be treated as an employer contribution.  Thus, such contributions would be excludable from the gross income of retired employees (and their spouses and dependents) under Section 106 of the Tax Code.

Both PLRs focused on the IRS’s past guidance on HRAs, emphasizing that contributions must be made solely by an employer and not through salary reductions, and that they must not benefit non-spouse, non-dependent beneficiaries.  The plan proposed in the first ruling was determined to fail both criteria.  Notwithstanding the one-time irrevocable nature of the employee’s election, the elective feature was deemed to make the contribution an employee, rather than employer, contribution. 

Because the plan did not qualify as an HRA, it was subject to the Code Section 125 cafeteria plan rules, under which unused contributions at the end of a coverage  period may generally not be carried forward to subsequent coverage periods. The proposed arrangement clearly violated this requirement.

The second ruling, on the other hand, confirms that the IRS will view mandatory, automatic contributions of unused leave as employer contributions, provided that no employee elections are allowed.

Many employers are seeking cost-effective ways to help their employees save money for post-retirement medical expenses.  Unused accrued leave can be a significant source of funding for such plans.  Based on these two PLRs, an employer’s plan design will be critical in determining whether a plan receives favorable tax treatment.  While plan designs in which an employer contributes the value of unused vacation and sick leave of retiring employees on an automatic and mandatory basis will be tax-free to employees, offering employees an election between cash and nontaxable benefits (e.g., retiree medical expense reimbursements) outside of a cafeteria plan, even if irrevocable, will result in taxable income to the employees.