IRS Ruling Offers Taxpayers New Flexibility in Benefit Allocations

One of the most seminal quotes in tax law came from Judge Learned Hand almost a century ago in Gregory v. Helvering: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Judge Hand ultimately held for the Commissioner in this case of substance over form. The quote continues to resonate today in the realm of tax law. A recent IRS Letter Ruling may provide another opportunity for taxpayers to arrange their affairs and reduce their income tax burden. 

IRS Approves Flexible Benefit Allocation Plan  

On August 23, 2024, the IRS released Private Letter Ruling 202434006, allowing plan participants to allocate what would otherwise be an employer contribution to the company’s 401(k) plan to various nontaxable benefits. Since the infancy of the Code, the IRS has disliked taxpayers arbitrarily selecting tax-free reimbursements over the receipt of taxable benefits. Employers often want to offer employees a base or higher compensation package if the employee elects to receive a part of the compensation as a nontaxable benefit, such as disability insurance.  

Overcoming the Constructive Receipt Doctrine  

The IRS has defeated this approach to compensation under the "doctrine of constructive receipt." This doctrine holds that because the taxpayer can receive taxable cash benefits instead of tax-free reimbursements, the taxpayer has constructively received a cash benefit regardless of whether he gets the full benefit in the form of a cashout benefit. 

The statutory basis of the constructive receipt doctrine is provided in IRC §451(a). The regulations thereunder provide that income, although not reduced to a taxpayer's possession, is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.  

The IRS Ruling’s Significance  

In the Letter Ruling, the IRS stated that the proposed retirement plan amendment allowing participant selections of benefits made under an annual irrevocable allocation election did not permit the employee to elect between receiving cash or contributing the amount to a deferred compensation plan. That is, the arrangement did not violate the constructive receipt doctrine. 

The facts of the Letter Ruling state that the taxpayer offered a 401(k) profit-sharing plan, a retiree health reimbursement arrangement (HRA), an educational assistance plan (EAP), and employee health savings accounts (HSA). The 401(k)-plan consisted of a nonelective safe harbor contribution and a discretionary profit-sharing contribution. The taxpayer proposed to reduce its regular discretionary profit-sharing contribution and then make an additional contribution, providing the eligible employees with a choice to make an annual irrevocable election to allocate the discretionary profit-sharing contribution between the 401(k) plan, the retiree HRA, the EAP, or the HSA. All taxpayer plans were operated within their statutory limits and were otherwise compliant. 

Tailored Tax Planning for Individual Needs

The flexibility permitted by this arrangement would allow taxpayers to indeed allocate employer money to the benefits most needed in their lives and select the taxable benefit of the 401(k) plan, or the nontaxable benefits provided by the HRA, EAP, or HSA, arranging their affairs and reducing their tax burden. 

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