WASHINGTON - The Internal Revenue Service is reconsidering its ruling that cleared the way for The Travelers Group, New York, to contribute stock options to its $2.3 billion 401(k)/profit-sharing plan.
The IRS had said a company could deduct the value of options it contributes to its profit-sharing/401(k) plan.
Stuart M. Lewis, Travelers' attorney in the matter, said the IRS since has written to Travelers, expressing concerns over the ability of the company to claim a tax deduction for the market value of stock options contributed to the retirement plan. Mr. Lewis is managing partner at the Washington law firm of Silverstein and Mullens.
In addition, the Department of Labor has delayed approving Travelers' application for a prohibited transaction exemption, confirmed Ivan Strasfeld, director of the Labor Department's office of exemption determinations.
Earlier, Mr. Strasfeld had said he expected the approval to be "fairly routine," and to be completed by the end of March (Pensions & Investments, March 17).
Mr. Lewis said Travelers wouldn't decide how to proceed with the IRS until it receives formal notification revoking the private letter ruling made public March 21.
"The ball is in their court. We will hold negotiations with them once they decide," Mr. Lewis said.
Said Travelers spokesman Gordon Andrew: "Everything is still pending. We are still awaiting resolution of this matter from both agencies."
IRS spokesman Steve Pyrek declined to comment.
Legal experts say IRS officials now worry the agency could lose tax revenue.
They said IRS officials are concerned if other big companies follow Travelers' lead, they would issue more options to qualified, tax-exempt plans than to traditional, taxable stock option plans.
While tax rules applying to retirement plans are different from rules for executive stock options, the private letter ruling contradicts the IRS' traditional view that companies cannot take deductions for stock options when issued because they do not have a "readily ascertainable value," said A. Richard "Brick" Susko, partner at Cleary, Gottleib, Steen & Hamilton, New York.
Rather, companies can only deduct, as an expense, the cost of stock options when they are exercised by employees.
What's more, companies would enjoy a cash flow advantage by claiming tax deductions for stock options upfront, at the time they contribute them to retirement plans, without feeling the financial pinch until employees cash them in years later.
And, some tax experts suggested the additional five-year vesting for stock options for participants who already have worked at Travelers for at least five years might violate the IRS' rules granting favorable tax status to retirement plans. The IRS, however, hasn't raised that issue.
"There is certainly a potential implication for tax revenue when you open the floodgates for a new method of funding qualified benefits plan. The government wants to have an idea of the revenue impact of this ruling because when the options are exercised (within a qualified plan) there will be no taxable event," said one lawyer.
"If they open it up to everyone and more companies start using options in their defined contribution plans rather than traditional stock option programs, it could have serious tax implications as a tax shelter; they probably now want to review the tax considerations in more detail," he said.
Another attorney said it is not unusual for the IRS to reconsider a private letter ruling. He said a reversal would not be unprecedented.
At the Labor Department, Mr. Strasfeld said: "We have received and are evaluating some additional information from Travelers. .*.*. The exemption has not been issued. It is too early to say what we will do; there are strong feelings both ways."
He said the DOL has three options: "grant the exemption, withdraw it or deny it."
Backing away from earlier statements that the Travelers application was fairly routine, Mr. Strasfeld said: "It is not routine at all and people are starting to raise all sorts of issues. .*.*. It seemed routine at the time, and it is still under review."
He said he did not know when or if the application would be approved.
Sources now say Labor Department officials are divided over the issue of using options in 401(k) plans. Some fear the practice would increase allocations to company stock.
Elected and appointed government officials clearly are worried about the amount of defined contribution assets in company stock, estimated to be at least 27%. They fear plan participant losses should a company go bankrupt or the stock drop in value.
Legislation introduced last year and again this year would limit the allocation to company stock to 10% of total assets.
Mr. Lewis dismissed the notion the Travelers plan would put employees' retirement savings at risk. He said employees exercising the stock options would be free to sell the company stock and invest their money elsewhere.
He also said the plan was designed specifically to ensure lower-paid employees would be able to profit from a stock price gain. The options were being given to employees earning less than $40,000 a year, regardless of whether they contribute to the 401(k) plan. Mid- and senior-level employees would have received the stock options as an employer match to their own contributions to the retirement plan, up to 10% of their pay up to $40,000. The company's top executives, considered "insiders" under securities rules, would not have been eligible for options under the plan.
Travelers officials had cleared the plans with Sen. Barbara Boxer, D-Calif., who introduced legislation limiting 401(k) plans from holding more than 10% of assets in employer stock. Her legislation does not cover employer matches and would not affect the Travelers' plan, Mr. Lewis said.
Another labor attorney in Washington said he was "amazed" the IRS issued its initial private letter ruling because "there is such a tradition of the agency not allowing non-traded option securities to be included" in tax-exempt trust accounts.
"I have been told that at the IRS, there was a feeling this case didn't get sufficient high-level treatment and now they want to take another look at it," he said. "And, now I think the DOL is also having second thoughts. These government agencies apparently didn't realize the full implications of what they were dealing with. If they do decide to review this case, we could be back to square one and this could become the biggest non-event of the year," he said.