SECTION 2. BACKGROUND

.01 Section 404(a)(5) and the regulations thereunder provide that deferred vacation pay is deductible in the taxable year in which it is paid to the employee and that other deferred benefits are deductible in the taxable year in which or with which ends the employee’s taxable year in which the benefits are includible in gross income. (Special rules, not relevant to these cases, apply to compensation provided through a qualified plan or deferred benefits provided through a welfare benefit fund.)

.02 Section 1.404(b)–1T, Q&A-2 provides that compensation and benefits are considered deferred to the extent they are received by the employees more than 2 ¹ ⁄2 months after the end of the employer’s taxable year in which the related services are performed.

.03 Certain taxpayers have deducted for a taxable year the unpaid portion of accrued vacation pay and other benefits that the taxpayers secured during the first 2 ¹ ⁄2 months of the following taxable year by purchasing a letter of credit, bond, or

other similar financial instrument. Taxpayers argue that the securitization constitutes a transfer of property pursuant to § 83 and that this in turn constitutes receipt by the employees within the 2 ¹ ⁄2month period, thereby precluding the application of § 404. Accordingly, taxpayers argue that the timing of the deduction for the unpaid benefits secured by the letter of credit or other financial instrument is accelerated to the taxable year the benefits accrue, pursuant to the timing rules of § 83.

.04 In Schmidt Baking Co. v. Commis- sioner, 107 T.C. 271 (1996), the Tax Court addressed the application of the timing rules of §§ 83 and 404 to the securitization of vacation and severance pay benefits with an irrevocable standby letter of credit. The Tax Court held that the taxpayer was entitled to deduct the benefits under § 83 in the taxable year the benefits accrued. The Court concluded that a § 83 transfer of property constitutes receipt within the meaning § 404 and the regulations thereunder. Based upon the stipulation that the securitization of the benefits with the irrevocable letter of credit constituted a transfer of property under § 83, the Tax Court concluded that the benefits were received by the employees within the 2 ¹ ⁄2-month period, so that the employer’s deduction for the benefits was not subject to § 404. The Service has neither appealed nor acquiesced in that decision.

.05 Congress specifically overturned the decision in Schmidt Baking with the enactment of section 404(a)(11), which was added to the Code by § 7001 of the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA), Pub. L. No. 105–206, 112 Stat. 685, 827 (July 22, 1998). Section 404(a)(11) provides that, for purposes of determining under § 404 whether compensation of an employee is deferred compensation and when deferred compensation is paid, no amount is treated as received by the employee, or paid, until it is actually received by the employee. Section 404(a)(11) is effective for taxable years ending after July 22, 1998. .06 The RRA provides that a taxpayer changing its method of accounting to comply with § 404(a)(11) for its first tax

.07 The House and Senate committee reports on § 404(a)(11) state that “no inference is intended that the result in Schmidt Baking is present law beyond its immediate facts or that the use of similar arrangements is permitted under present law.” H. Rep. No 364, 105th Cong. 1st Sess. 87, 89 (1997); S. Rep. No. 175, 105th Cong. 2nd Sess.118, 120 (1998). .08 The Conference committee report on § 404(a)(11) suggests that the Service consider “on a case-by-case basis

[whether the] continued challenge of these arrangements for prior years represents the best use of litigation resources.” H. Rep.No. 599, 105th Cong. 2nd Sess. 342, 345 (1998). .09 In Notice 99–16, 1999–13 I.R.B. 10, the Service provided procedures for taxpayers to change their method of accounting for their first taxable year ending after July 22, 1998, to comply with § 404(a)(11). The Service withheld audit protection in connection with the change, thereby preserving the right to challenge these arrangements for prior taxable years.

.10 The Service has continued to examine cases involving these securitization arrangements and has concluded that, in general, they lack sufficient nontax business purpose and economic substance to be respected for tax purposes. Although the Service agreed to stipulate in Schmidt that, for purposes of that litigation, a “transfer of property” occurred under the rules of § 83, a review of the facts of other cases has led the Service to conclude that such a stipulation would not correctly reflect the facts of those cases. The Service reached that conclusion because, although the employees whose benefits were secured were thereby given certain legal rights, those rights were of such minimal significance that there was no sufficiently meaningful change in the parties’ relationships to support the conclusion that

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the arrangements rose to the level of transfers of property under § 83. Accordingly, in the majority of cases, the Service has proposed to disallow the accelerated deductions attributable to the arrangements. Compare Revenue Ruling 99–14, 1999–13 I.R.B. 3. .11 Disallowance of the accelerated deductions on the basis of those doctrines will be pursued, wherever appropriate. This analysis requires the Service to evaluate the facts and circumstances of each case with respect to business purpose and economic substance. Additional field work may be required by examiners to more fully develop the issue, particularly with regard to the taxpayer’s nontax business purpose for entering into the arrangement. This may include, but would not be limited to, contact with third parties (such as the pertinent financial institutions, employees, former employees, corporate officers, escrow agents etc.); the use of depositions, summonses, etc., to obtain all relevant testimony and documentation pertaining to the implementation of the arrangement (including, but not limited to, any promotional materials, legal opinions regarding the tax consequences of the arrangement, etc.); and any other techniques deemed appropriate in order to fully establish the purpose for entering into the arrangement and to clarify the factors that may establish sufficient economic substance to the transactions.

.12 Absent an exception, FICA taxes must be deposited within specified times after wages are actually or constructively paid. No exception applies to these securitization arrangements. Therefore, if the Service examines a case and determines that the arrangement should be respected for tax purposes, the Service will assert the 10-percent failure-to-deposit penalty under § 6656 for taxpayers who have failed to timely deposit the employer’s share of the FICA taxes.