Unused vacation may fund a 401(k) plan or retiree health account

Plain-English summary

An employer proposed allowing collectively bargained employees to make an advance, irrevocable election to direct the value of forfeitable unused vacation to a 401(k) plan, a retiree health reimbursement arrangement, or both. Employees could not take those amounts as cash or another taxable benefit. The IRS ruled that the amendment would not create an additional cash or deferred arrangement, so the vacation contributions would be employer contributions rather than elective deferrals subject to IRC § 402(g). It also ruled that qualifying medical reimbursements from the employer-funded retiree HRA would be excluded from the gross income of retired employees, their spouses, and their dependents under IRC §§ 105(b) and 106.

Ruling snapshot

• Question: May employees direct forfeitable unused vacation to a 401(k) plan or retiree HRA without creating another cash or deferred arrangement, and are the HRA reimbursements tax-free?
• Outcome: Approved
• Key authorities: IRC §§ 105(b), 106, 213(d), 401(k), 402(g), 415(c); Treas. Reg. §§ 1.105-2, 1.106-1, 1.401(k)-1(a)(3), 1.401(k)-6; Rev. Rul. 2002-41; Rev. Rul. 2009-31; Notice 2002-45

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201601012
Release Date: 12/31/2015
Index Number: 401.29-00, 105.00-00,
106.00-00

Third Party Communication: None
Date of Communication: Not Applicable

Person To Contact:

, ID No.

Telephone Number:

Refer Reply To:
CC:TEGE:EB:QP3

PLR-T-101793-15

Date:
September 30, 2015

Taxpayer =

HRA Plan =

401(k) Plan =

Dear

This letter is in response to your ruling request dated March 15, 2013, as supplemented
by correspondence dated November 25, 2013, May 28, 2015 and September 2, 2015
for a private letter ruling concerning the HRA Plan and the 401(k) Plan.

The following facts and representations have been submitted under penalties of perjury
in support of your request:

Pursuant to a collective bargaining agreement, Taxpayer proposes to amend two plans.
The first is a medical expense reimbursement plan for retirees, known as the HRA Plan,
funded through a trust (“Trust”) that the Taxpayer represents is a VEBA as described in
section 501(c)(9) of the Internal Revenue Code (the “Code”). Each participant has a
retiree HRA that is funded by mandatory contributions from each employee's salary.
Each retiree HRA is only usable by the employee on or after his or her retirement to
provide reimbursement of qualified medical expenses under section 213(d).

PLR-T-101793-15 2

The second plan is a defined contribution retirement plan called the 401(k) Plan. The
401(k) plan is a collectively-bargained plan, intended to be a tax qualified defined
contribution plan.

Pursuant to the collective bargaining agreement, each employee accrues a certain
amount of paid time off each year. The total amount of paid time off allowed to an
employee for any year is determined pursuant to a formula, and such total amount
includes a certain number of days of paid vacation for each “Vacation Year.” A Vacation
Year runs from May 1 of each year through April 30 of the following year. Under the
collective bargaining agreement, any unused vacation time at the end of a Vacation
Year may not be carried over; any unused vacation time up to 21 days is forfeited, and
the excess of any unused vacation time over 21 days is paid out as regular wages. For
purposes of this ruling, the term “annual Unused Vacation” refers only to the unused
vacation up to 21 days that may not be carried over and is not paid out as regular
wages.

Pursuant to a collective bargaining agreement, Taxpayer is proposing to amend the
HRA Plan and 401(k) Plan to allow each employee covered under such collective
bargaining agreement to make an annual irrevocable election before the start of the
calendar year in which the leave is earned (that is, before the start of the calendar year
in which the Vacation Year begins), to have the dollar equivalent (determined under a
formula set forth in the collective bargaining agreement) of the annual Unused Vacation
up to 21 days contributed by Taxpayer into the 401(k) Plan, the employee's retiree
HRA, or a combination of both. An employee may not make this election with respect to
any unused vacation in excess of 21 days. Such amounts are paid to the employee as
regular wages.

In the event that any amount attributable to any employee’s annual Unused Vacation
cannot be contributed to the 401(k) Plan due to the annual limitations under sections
401(a)(17) and 415(c), the Taxpayer will contribute the dollar equivalent of the excess
amount to the employee’s retiree HRA at the same time that the Taxpayer would have
made such contribution to the 401(k) Plan. In the event that an employee fails to make
an employee election by the end of the calendar year preceding the Vacation Year, the
dollar equivalent of the entirety of such annual Unused Vacation will be contributed as
an employer contribution to the 401(k) Plan, and any excess amounts above the annual
limitations will be contributed to the retiree HRA.

Based on the above facts and representations, you request the following rulings:

(1) The proposed amendment to the 401(k) Plan will not cause the plan to offer an
additional cash or deferred arrangement pursuant to section 401(k), such that the
Taxpayer’s contributions of accrued vacation amounts are considered employee
pre-tax contributions subject to the annual limitation under section 402(g); and

PLR-T-101793-15 3

(2) The proposed amendment to the Trust and payments made from the Trust to the
HRA Plan that are used to reimburse qualified medical expenses (as defined in
section 213(d)) of retired employees, their spouses, and their dependents are
excludable from the gross income of retired employees, their spouses and
dependents under sections 105(b) and 106.

With respect to the first ruling request, section 401(a) provides that a trust created or
organized in the United States and forming part of a stock bonus, pension, or profit-
sharing plan of an employer for the exclusive benefit of its employees or their
beneficiaries constitutes a qualified trust under that section if a series of conditions are
met.

Section 401(a)(4) provides as one of those conditions that the contributions or benefits
provided under the plan do not discriminate in favor of highly compensated employees
(within the meaning of section 414(q)). A plan maintained pursuant to a collective
bargaining agreement is deemed to satisfy the nondiscrimination requirements.

Section 401(a)(17) provides that a trust will not constitute a qualified trust unless, under
the plan of which the trust is a part, each employee is subject to the annual section
401(a)(17) compensation limit.

Section 401(k)(2)(A) provides, in pertinent part, that a qualified cash or deferred
arrangement is any arrangement which is part of a profit sharing plan or stock bonus
plan, a pre-ERISA money purchase plan, or a rural cooperative plan, which meets the
requirements of section 401(a), and under which a covered employee may elect to have
the employer make payments as contributions to a trust under the plan on behalf of the
employee, or to the employee directly in cash.

Section 402(g)(1) provides, in part, that the elective deferrals of any individual for any
taxable year shall be included in such individual’s gross income to the extent the
amount of such deferrals for the taxable year exceeds the applicable dollar amount.

Section 402(g)(3)(A) provides that the term “elective deferrals” includes, in part, with
respect to any taxable year, any employer contribution under a qualified cash or
deferred arrangement (as defined in section 401(k)) to the extent not includible under
section 402(e)(3)).

Section 415(a)(1)(B) provides that a trust which is part of a pension, profit-sharing, or
stock bonus plan shall not constitute a qualified trust under section 401(a) if, in the case
of a defined contribution plan, contributions and other additions under the plan with
respect to any participant for any taxable year exceed the limitation of section 415(c).

Section 415(c)(1) provides that contributions and other additions with respect to a
participant exceed the limitation of section 415(c) if, when expressed as an annual

PLR-T-101793-15 4

addition to the participant’s account, the annual addition is greater than the lesser of the
applicable annual dollar limitation or 100 percent of the participant's compensation.

Section 1.401(k)-1(a)(3)(i) of the Income Tax Regulations (the “Regulations”) provides
that a cash or deferred election is any election by an employee to have the employer
either: (A) provide an amount to the employee in the form of cash or some other taxable
benefit that is not currently available, or (B) contribute an amount to a trust, or provide
an accrual or other benefit, under a plan deferring the receipt of compensation.

Section 1.401(k)-6 defines non-elective contributions as employer contributions (other
than matching contributions) with respect to which the employee may not elect to have
the contributions paid to the employee in cash or other benefits instead of being
contributed to the plan.

Section 1.401(k)-6 defines elective contributions as contributions made pursuant to a
cash or deferred election under a cash or deferred arrangement.

Section 1.415(c)-1(b)(1)(i) generally defines the term “annual addition” as the sum,
credited to a participant’s account for any limitation year, of (A) employer contributions,
(B) employee contributions, and (C) forfeitures.

Revenue Ruling 2009-31, 2009-39 I.R.B. 395, provides that annual employer non-
elective contributions of the dollar equivalent of unused paid time off to a qualified profit-
sharing plan that vary for each employee will not cause the plan to fail to meet the
qualification requirements of section 401(a), provided that the contributions satisfy the
applicable requirements of sections 401(a)(4) and 415(c) and, where applicable, other
requirements of the Code.

Under the 401(k) Plan, amounts attributable to unused accrued vacation contributions
up to a stated limit may only be distributed, and therefore made available to employees,
in the future. While employees are permitted to make an annual irrevocable election as
to which plan the contributions are to be made to, they are not permitted to elect to have
the contributions paid in cash or other taxable benefit. Accordingly, the proposed
amendment to the 401(k) Plan will not cause the plan to offer an additional cash or
deferred arrangement pursuant to section 401(k), such that the Taxpayer's contributions
of annual Unused Vacation are considered employee pre-tax contributions subject to
the annual limitation under section 402(g).

With respect to the second ruling request, section 61(a)(1) and §1.61-21(a)(3) provide
that, except as otherwise provided in Subtitle A, gross income includes compensation
for services, including fees, commissions, fringe benefits, and similar items.

Section 106 provides that gross income of an employee does not include employer
provided coverage under an accident or health plan. Section 1.106-1 provides that the
gross income of an employee does not include contributions which the employee’s

PLR-T-101793-15 5

employer makes to an accident or health plan for compensation (through insurance or
otherwise) to the employee for personal injuries or sickness incurred by the employee or
the employee’s spouse or dependents (as defined in section 152). The employer may
contribute to an accident or health plan either by paying the premium on a policy of
accident or health insurance covering one or more of the employees, or by contributing
to a separate trust or fund which provides accident or health benefits directly or through
insurance to one or more of the employees. However, if the insurance policy, trust or
fund provides other benefits in addition to accident or health, section 106 applies only to
the portion of the contributions allocable to accident or health benefits.

Section 105(b) states that except in the case of amounts attributable to (and not in
excess of) deductions allowed under section 213 (relating to medical expenses) for any
prior taxable year, gross income does not include amounts attributable to employer-
provided coverage (1) if such amounts are paid, directly or indirectly, to the taxpayer to
reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as
defined in section 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as
defined in section 152, determined without regard to subsections (b)(1), (b)(2), and
(d)(1)(B)) and any child (as defined in section 152(f)(1)) who has not attained age 27 as
of the end of the taxable year. Section 1.105-2 provides that only amounts that are paid
specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the
prescribed medical care are excludable from gross income. Thus, section 105(b) does
not apply to amounts that the taxpayer would be entitled to receive irrespective of
whether or not the taxpayer incurs expenses for medical care.

In Rev. Rul. 2002-41, 2002-2 C.B. 75, an employer sponsors a health reimbursement
arrangement (HRA) that is paid for solely by the employer and not through salary
reduction contributions. The HRA reimburses substantiated medical care expenses (as
defined in section 213(d)) of participating employees and their spouses and dependents
(as defined in section 152) up to a maximum annual reimbursement amount. Unused
amounts from one coverage period are carried forward to subsequent coverage periods.
Participating employees have no right to receive cash or any other benefit in lieu of
medical expense reimbursements. In Situation 2 of Rev. Rul. 2002-41, the maximum
reimbursement amount under the HRA that is not applied to reimburse medical care
expenses before an employee retires or otherwise terminates employment continues to
be available after retirement or termination for any medical care expense under section
213(d) incurred by the former employee or the former employee’s spouse and
dependents. The ruling concludes that coverage and reimbursements made under the
HRA are excludable from the gross income of participating employees under sections
106 and 105.

Notice 2002-45, 2002-2 C.B. 93, provides that an HRA is an arrangement that: (1) is
paid for solely by the employer and not pursuant to salary reduction; (2) reimburses the
employee for medical care expenses (as defined in section 213(d)) incurred by the
employee and the employee’s spouse and dependents (as defined in section 152); and
(3) provides that any unused portion of the maximum dollar amount available during the

PLR-T-101793-15 6

coverage period is carried forward to subsequent periods. Notice 2002-45 also
provides that benefits under an HRA must be limited to reimbursements of section
213(d) expenses and that all such expense reimbursements must be substantiated to
be excludable under section 105. Notice 2002-45 further provides that medical care
expense reimbursements under an HRA are excludable under section 105(b) if the
reimbursements are provided to the following individuals: current and former
employees (including retired employees), their spouses and dependents (as defined in
section 152 as modified by the last sentence of section 152(b)), and the spouses and
dependents of deceased employees.

Under the collectively bargained HRA Plan, if the employee timely elects to have annual
Unused Vacation contributed to his or her retiree HRA, such amounts are paid solely by
Taxpayer and not pursuant to salary reduction elections or otherwise. The amounts will
be used to provide benefits that reimburse eligible post-retirement medical expenses
and will not be used to provide for the payment of death benefits, bonuses, or
separation pay nor may amounts be used to provide other taxable or nontaxable
benefits. Thus, the collectively bargained HRA Plan meets the requirements of Rev.
Rul. 2002-41 and Notice 2002-45 and the amounts are excludable from the gross
income of retired employees, their spouses and dependents under sections 105(b) and
106.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is based upon the assumption that the 401(k) Plan satisfies the qualification
requirements set forth in section 401(a).

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that
it may not be used or cited as precedent.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party.

While this office has not verified any of the material submitted in support of the request
for rulings, it is subject to verification on examination.

PLR-T-101793-15 7

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

Sincerely,

Ingrid Grinde

Senior Tax Law Specialist
Qualified Plans Branch 3

Tax Exempt & Government Entities

CC: