**DESCRIPTION OF REVENUE PROVISION IN CHAIRMAN'S AMENDMENT IN THE NATURE OF A SUBSTITUTE TO H.R. 1432, THE "AFRICAN GROWTH AND OPPORTUNITY ACT"
Scheduled for Markup

by the

HOUSE COMMITTEE ON WAYS AND MEANS

on

February 25, 1998

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

February 23, 1998

JCX-12-98

**CONTENTS**

**INTRODUCTION**

**EMPLOYER DEDUCTION FOR SEVERANCE PAY**

**INTRODUCTION**

	This document,(1) prepared by the staff of the Joint Committee on Taxation, provides adescription of a revenue proposal in the Chairman's Amendment in the Nature of a Substitute toH.R. 1432, the "African Growth and Opportunity Act," to be considered by the House Committeeon Ways and Means on February 25, 1998.

	The revenue proposal relates to the employer deduction for severance pay.

**EMPLOYER DEDUCTION FOR SEVERANCE PAY**

**Present Law**
	For deduction purposes, any method or arrangement that has the effect of a plan deferringthe receipt of compensation or other benefits for employees is treated as a deferred compensationplan (sec. 404(b)).  In general, contributions under a deferred compensation plan (other thancertain pension, profit-sharing and similar plans) are deductible in the taxable year in which anamount attributable to the contribution is includible in income of the employee.  However,vacation pay which is treated as deferred compensation is deductible for the taxable year of theemployer in which the vacation pay is paid to the employee (sec. 404(a)(5)).  

	Temporary Treasury regulations provide that a plan, method, or arrangement defers thereceipt of compensation or benefits to the extent it is one under which an employee receivescompensation or benefits more than a brief period of time after the end of the employer's taxableyear in which the services creating the right to such compensation or benefits are performed.  Aplan, method or arrangement is presumed to defer the receipt of compensation for more than abrief period of time after the end of an employer's taxable year to the extent that compensation isreceived after the 15th day of the 3rd calendar month after the end of the employer's taxable yearin which the related services are rendered (the "2-1/2 month" period).  A plan, method orarrangement is not considered to defer the receipt of compensation or benefits for more than abrief period of time after the end of the employer's taxable year to the extent that compensationor benefits are received by the employee on or before the end of the applicable 2-1/2 monthperiod.  (Temp. Treas. Reg. sec. 1.404(b)-1T A-2).

	The Tax Court recently addressed the issue of when vacation pay and severance pay areconsidered deferred compensation in Schmidt Baking Co., Inc., 107 T.C. 271 (1996).  In SchmidtBaking, the taxpayer was an accrual basis taxpayer with a fiscal year that ended December 28,1991.  The taxpayer funded its accrued vacation and severance pay liabilities for 1991 bypurchasing an irrevocable letter of credit on March 13, 1992.  The parties stipulated that the letterof credit represented a transfer of substantially vested interest in property to employees forpurposes of section 83, and that the fair market value of such interest was includible in theemployees' gross incomes for 1992 as a result of the transfer.(2)  The Tax Court held that thepurchase of the letter of credit, and the resulting income inclusion, constituted payment of thevacation and severance pay within the 2-1/2 month period.  Thus, the vacation and severance paywere treated as received by the employees within the 2-1/2 month period and were not treated asdeferred compensation.  The vacation pay and severance pay were deductible by the taxpayer forits 1991 fiscal year pursuant to its normal accrual method of accounting.

**Description of Proposal
	The proposal would provide that, for purposes of determining whether severance pay,(3) isdeferred compensation****(under Code sec. 404), the severance pay would not be considered to bepaid or received until actually received by the employee.  In addition, severance pay would not beconsidered paid to an employee until actually received by the employee.  The proposal is intendedto overrule the result in Schmidt Baking.  Thus, with respect to the determination of whetherseverance pay is deferred compensation, the fact that the value of the severance pay is includiblein the income of employees within the applicable 2-1/2 month period would not be not relevant. Rather, the severance pay must have been actually received by employees within the 2-1/2 monthperiod in order for the severance pay not to be treated as deferred compensation.

	It is intended that similar arrangements, in addition to the letter of credit approach used inSchmidt Baking, would not constitute actual receipt by the employee, even if there is an incomeinclusion.  Thus, for example, actual receipt would not include the furnishing of a note or letter orother evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by anyother instrument or by any third party.  As a further example, actual receipt would not include apromise of the taxpayer to provide service or property in the future (whether or not the promise isevidenced by a contract or other written agreement).  In addition, actual receipt would not includean amount transferred as a loan, refundable deposit, or contingent payment.  Amounts set aside ina trust for employees generally would not be considered to be actually received by the employee.

	The proposal would not change the rule under which deferred compensation (other thanvacation pay and deferred compensation under qualified plans) is deductible in the year includiblein the gross income of employees participating in the plan if separate accounts are maintained foreach employee. 

	There is concern that the type of arrangement used in Schmidt Baking may be tried tocircumvent other provisions of the Code where payment is required in order for a deduction tooccur. Thus, it is intended that the Secretary will prevent the use of similar arrangements.  Noinference is intended that the result in Schmidt Baking is present law beyond its immediate facts orthat the use of similar arrangements is permitted under present law.  

	The proposal would not affect the determination of whether an item is includible inincome.  Thus, for example, using the mechanism in Schmidt Baking for severance pay would stillresult in income inclusion to the employees, but the employer would not be entitled to a deductionfor the vacation pay until actually paid to and received by the employees.

**Effective Date**

	The proposal would be effective for taxable years ending after October 8, 1997.  Anychange in method of accounting required by the provision would be treated as initiated by thetaxpayer with the consent of the Secretary of the Treasury.  Any adjustment required by section481 as a result of the change would be taken into account in the year of the change.

1.   This document may be cited as follows: Joint Committee on Taxation *Description ofRevenue Provision in Chairman's Amendment in the Nature of a Substitute to H.R. 1432, the"African Growth and Opportunity Act"* (JCX-12-98), February 23, 1998.
2.   While the rules of section 83 may govern the income inclusion, section 404 governs thededuction if the amount involved is deferred compensation.
3.    A provision that overrules Schmidt Baking with respect to vacation pay and otherdeferred compensation (including severance pay) is included in H.R. 2646,  the "EducationSavings Act for Public and Private Schools," as passed by the House on October 23, 1997.  (SeeH. Rept. 105-332, October 21, 1997.)****