1 These cases have been consolidated for trial, briefing,

and opinion solely with respect to the issue involved herein. 120 T.C. No. 5

UNITED STATES TAX COURT

WELLS FARGO & COMPANY (f.k.a. NORWEST CORPORATION) AND

SUBSIDIARIES, Petitioners v

. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 7620-98, 12136-98, Filed February 13, 2003.

19891-98, 7282-99,

12484-99. 1

For the years 1991-94, Ps made contr ibutions to a

voluntary employee benefit trust (the postretirement

medical trust) for the purpose of providing

postretirement medical benefits to their employees. For

1991, Ps’ actuary computed the present value of future

postretirement medical benefits for active employees to

be $ 14,096,473 and for retired employees to be

$27,759,057. The actuary divided the $14,096,473 for

active employees by the average actuarial present value

o f future service to produce a 1991 funding amo unt of

$2,930,660 for active employees. The actuary determined

that the $27,759,057 for retired employees could be fully

funded in 1991. Ps contributed $30,689,717 to the- 2 -

postretirement medical trust in 1991 and, on Ps’

consolidated return for 1991, claimed a deduction for the

contribution as an addition to a “qualified asset

account” pursuant to sec. 419A(b), I.R.C.

R determined that Ps’ method for computing the 1991

contribution for postretirement benefits for retirees was

improper and resulted in a contribution that exceeded the

account limit for a reserve under sec. 419A(c)(2), I.R.C.

R further determined deficiencies for years 1992-94 as a

result of the determined overfunding in 1991.

Held

, with respect to an employee who is retired

when the reserv e is created, the present value of that

employee’s projected benefit may be allocated to the year

the reserve is created. Accordingly, Ps’ contributions

to the postretirement me dical trust for 1991 did not

cause the qualified asset account to exceed the account

limit under sec. 419A(b), I.R.C., with respe ct to the

reserve for postretirement medical benefits provided in

sec. 419A(c)(2), I.R.C.

Walter A. Pickhardt

, Mark A. Hager , and Andrew T. Gardner

,

for petitioners.

Alan M. Jacobson

, Randall P. Andreozzi

, Christa A. Gruber

,

and James S. Stanis , for respondent.

Contents

FINDINGS OF FACT

....................... 4

A. Background

........................ 5

B. Norwest’s Welfare Benefit Plans

............. 6

C. Financial Accounting Standards Board Statement of

Financial Accounting Standards No. 106

.......... 8

D. Norwest’s Contributions to the Postretirement Medical

Trust

......................... 11

1. Funding the Postretirement Medical Trust for 1991

. 11- 3 -

2. Funding the Postretirement Medical Trust for 1992-

94

........................ 12

3. Mercer’s Actuarial Assumptions for the 1991-94

Contributions to the Postretirement Medical Trust

. 13

4. Contributions to the Postretirement Medical Trust

. 15

E. Respondent’s Determinations

............... 15

OPINION

........................... 15

A. Statutory Framework: Sections 419 and 419A

...... 15

B. Method for Computing the Account Limit With Respect to a

Reserve

........................ 17

1. Actuarial Cost Methods

.............. 18

a. Aggregate Cost Method

............ 20

b. Entry Age Normal Cost Method

......... 20

c. Individual Level Premium Cost Method

..... 21

2. Computations by the Experts

............ 22

a. Mr. Cohen

.................. 22

b. Mr. Scharmer

................. 23

c. Mr. Daskais

................. 25

3. Positions of the Parties

............. 33

4. Statutory Construction

.............. 34

5. The Statute

.................... 35

a. Reserve

................... 36

b. Reserve Funded Over the Working Lives of the

Covered Employees and Actua rially Determined

on a Level Basis

............... 39

(i) Reserve Funded Over the Working Lives of

the Covered Employees

.......... 40

(ii) Reserve Actuarially Determined on a Level

Basis

.................. 46

C. Investment Rates

.................... 51

JACOBS, Judge : Respondent determined deficiencies in Federal

income tax and accuracy-related penalties with regard to

petitioners’ consolidated returns for 1990-94 as follows:- 4 -

2 All section references are to the Internal Revenue Code

as in effect for the years in issue. Addition to Tax

Year Deficiency Sec. 6662(a)

1990 $52,073,344 $5,161,509

1991 216,338,093 23,353,180

1992 417,310,889 1,047,868

1993 86,406,356 5,655,276

1994 62,493,719 5,135,972

Numerous issues have been raised as a consequence of respondent’s

determinations; many of these issues heretofore have been resolved.

The issue to be decided herein concerns the amounts petitioners may

deduct for years 1991-94 for contributions made to a voluntary

employee benefit association (VEBA) trust to provide postretirement

medical benef its to covered employees and their eligible

dependents. To determine the allowable amounts, we first must

decide the proper method to be used in computing the reserve under

section 419A(c)(2). 2 Then we must decide whether petitioners used

reasonable investment rates in their actuarial computations.

FINDINGS OF FACT

Some of the facts have been stipulated and ar e found

accordingly. The stipulations of facts and the attached exhibits

are incorporated herein by this reference.- 5 -

3 Norwest Corp. was formerly known as Northwest

Bancorporation. A. Background

Norwest Corp. 3 (Norwest ) is a multibank holding company

organized in 1929. It owns substantially all of the outstanding

capita l stock of numerous commercial banks in Minnesota, Iowa,

South Dakota, Nebraska, Wisconsin, North Dakota, Montana, Wyoming,

Illinois, In diana, and Arizona. Norwest also owns subsidiaries

engaged in various businesses relate d to banking, principally

mortgage banking, equipment leasing, agricultural finance,

commercial finance, consumer finance, securities dealings and

underwriting, insurance agency services, computer and data

processing services, corporate trust services, and venture capital

investments. For each of the years at issue, Norwest and its

subsidiaries filed consolidated Federal income tax returns.

On November 2, 1998, Wells Fargo & Co. was merged into a

wholly owned subsidiary of Norwest. Simultaneously with the

merger, Norwest changed its name to Wells Fargo & Co. Hereinafter,

reference to Norwest is to Norwest and its subsidiaries before the

merger with Wells Fargo & Co.

When Norwest filed the petitions in docket Nos. 7620-9 8 and

12136-98 (which was before the merger), its principal place of

business was in Minneapolis, Minnesota. At the time Wells Fargo &

Co. filed the petitions in docket Nos. 1 9891-98, 7282-99, and- 6 -

12484-99 ( which was after the merger), its principal place of

business was in San Francisco, California.

B. Norwest’s Welfare Benefit Plans

On January 1, 1930, Norwest establ ished the Norwest Corp.

Medical Plan, also known as the Norwest Corp. Hospital-Medical Plan

(the medical plan). The medical plan is a self-insured welfare

plan providing for the payment (or reimbursement) of all or a

portion of covered medical expenses incurred by Norwest’s eligible

employees (including eligible retired employees) and their eligible

dependents. Since June 1, 1957, the medical plan has provided

postretirement medical benefits (i.e., medical benefits for its

retirees), pursuant to a rider issued by Prudential Insurance Co.

of America, relating to Norwest’s group health insurance policy.

Over the years, Norwest established other plans, in addition

to the medical plan, to provide benefits for Norwest’s eligible

employees (including under some plans retired employees) and their

eligible dependents. The employee benefit plans include a long-- 7 -

4 On Aug. 1 , 1969, Norwest established the Norwest Corp.

Long-Term Salary Continuation Plan (now known as the Norwest Corp.

L ong-Term Disability Plan) (the long-term disability plan). The

long-term disability plan is a combination self-insured/insurance

welfare benefit plan providing monthly disability income benefits

for eligible disabled employees.

5 On Jan. 1, 1980, Norwest established the Norwest Corp.

Dental Plan (the dental plan). The dental plan is a combination

self-insured/insured welfare benefit plan providing for the payment

or reimbursement of all or a portion of covered dental expenses.

6 The Norwest Corp. Severance Pay Plan is a sel f-insured

we lfare plan providing for the payment of severance benefits for

Norwest’s eligible employees.

7 Norwest established the Norwest Corp. HMO Premiums Plan,

an insured welfare benefit plan providing for the payment or

reimbursement of all or a portion of covered medical expenses.

8 Norwest established the Norwest Corp. Choice Plus Plan

(the choice plus medical plan), effective Jan. 1, 1993, which was

funded by the master trust. The choice plus medical plan is a

self-insured welfare plan pr o viding for the payment or

reimbursement of all or a portion of covered medical expenses. term disability plan, 4 a dental plan, 5 a severance plan, 6 an HMO

premium plan, 7 and a choice plus medical plan. 8

On November 11, 1978, Norwest established, effective January

1, 1979, a VEBA trust, under section 501(c)(9), to fund the

employee benef it plans then in existence (i.e., the medical plan

and the long-term disability plan). This trust was originally

called the “Northwest Bancorporation Employee Benefit Trust” and is

hereinafter referred to as the master trust. Over the years, the

master trust was amended to fu nd the dental plan and the HMO- 8 -

9 “Attribution period” is the period of an e m ployee’s

service to which the expected postretirement benefit obligation for

that employee is assigned. Generally, the beginning of the

attribution period is the employee’s date of hire and the end of

the attribution period is the employee’s full eligibility date. An

equal amount of the expected postretirement benefit obligation is

attributed to each year. premium plan. The master trust was amended and restated effective

January 1, 1991; the name of the master trust was changed to the

Norwest Corp. Employee Benefit Trust.

C. Financial Accounting Standards Board Statement of Financial

Accounting Standards No. 106

From 1957 to 1991, Norwest paid medical benefits for retired

employees as claims wer e submitted; i.e., on a “pay-as-you-go”

basis. For financial accounting and tax purposes, Norwest

recognized these costs when the benefits were paid.

In 1990, new financial accounting rules for nonp ension,

postretirement benefits were promulgated in Statement of Financial

Accounting Standards No. 106 (SFAS 106). Pursuant to SFAS 106, for

financial accounting purposes, employers must accrue (during the

employment of an employee) the cost of future health care benefits

to be paid to the employee a f ter retirement. 9 Thus, because SFAS

106 applies to a postretirement benefit plan regardless of the

means or timing of funding, the e mployer cannot postpone

recognition of the cost of the employee’s postretirement benefit by

contributing at the time of retirement a lump sum equal to the- 9 -

10 The transition obligation recognized upon initial

application of SFAS 106 does not include “(a) any previously

unrecognized post-retirement benefit obligation assumed in a

business combination accou nted for as a purchase, (b) a plan

initiation, and (c) any plan amendment that improved benefits, to

the extent that those events occur aft er the issuance of * * *

[SFAS 106].” SFAS 106, par. 261.

11 The Financial Accounting Standards Board concluded that

to permit immediate recognition at any subsequent time would result

in too much variability in financial reporting for a long period of

time. present value of the employee’s benefit (terminal funding). SFAS

106, par. 8.

SFAS 106 permits an employer to immediately recognize, at the

date of initial applica tion of SFAS 106, obligations that the

employer had not accrued for financial purposes in prior years

(transition obligation 10 ). SFAS 106, par. 260. Immediate

recognition is not permitted after the initial application of SFAS

106. 11

Norwest adopted SFAS 106, effective January 1, 1992. As a- 10 -

12 SFAS 106, par. 518, defines an “unrecognized transition

obligation” as the unrecognized amount, as of the date SFAS 106 is

initially applied, of “(a) the accumulated post-retirement benefit

obligation in excess of (b) the fair va lue of plan assets plus

accrued post-retirement benefit cost or less any recognized prepaid

post-retirement benefit cost.” “Accumulated post-retirement

benefit obligation” is defined by SFAS 106, par. 518, as the

actuarial present value of benefits attributed to employee service

rendered to a particular date. Since Norwest historically had

n either paid nor deducted the benefits until incurred, th e

unrecognized transition obligation was equal to the ac cumulated

postretirement benefit obligation.

13 Effectiv e Jan. 1, 1991, Norwest also established a

separate VEBA trust to fund the liabilities for the severance plan.

By an amendment to the master trust, effective Jan. 1, 1993,

Norwest merged the severance plan into the master trust. consequence, Norwest elected to recognize as an immediate expense

its unrecognized transition obligation. 12 The amount of this

obligation was $71.7 million (after tax).

On December 20, 1991, Norwest established the Norwest Corp.

Employee Benefit Trust for Retiree Medical Ben efits (the

postretirement medical trust), effective December 16, 1991. 13 The

postretirement medical trust funded postretirement medical benefits

to be provided to all employees, both active and retired (other

than “key employees”), under Norwest’s medical plan. Simultaneously

with the creation of t he postretirement medical trust, Norwest

amended the master trust, effective December 16, 1991, to eliminate

the master trust’s responsibility to pay postretirement medical

benefits for all but key employees.- 11 -

D. Norwest’s Contributions to the Postretirement Medical Trust

For the years 1991-94, Norwest made contributions to the

postretirement medical trust for the purpo se of providing

postretirement medical benefits.

1. Funding the Postretirement Medical Trust for 1991

During the years at is sue, William M. Mercer, Inc.

(hereinafter referred to as Mercer), a national actuari al firm,

prepared actuarial funding valuations for Norwest’s pension plans

and postretirement medical plans. Sometime in late 1990/early

1991, Norwest ex pressed to Mercer an interest in funding its

retiree medical benefits plan. Norwest understood that employers

were permitted a tax deduction for funding a reserve for

postretirement medical benefits.

On April 14, 1992, Mercer prepared and presented to Norwest a

valuation report entitled “Norwest Corporation Actuarial Funding

V aluation of the Post-retirement Medical Plans as of January 1,

1991" (the 1991 valuation). Mercer computed the present value of

future medical benefits to be $14,096,473 for active employees and

$27,759,057 for re tired employees. In determining these

computations, Mercer used a pretax investment rate assumption of 9

percent and an after-tax investment rate of 5.5 percent. Mercer

divided the $14,096,473 for active employees by the “average

actuarial present value of future service” for the active employees

(4.81) to produce a 1991 funding amount of $2,930,660 for active- 12 -

employees. Mercer determined that, because the retired employees

had no remaining working life, the present value of future benefits

f or retired employees ($27,759,057) could be funded in 1991.

Mercer believed that Norwest’s resulting reserve for active and

retired employees ($30,689,717) would be with in the section

419A(c)(2) account limit.

On the basis of the 1991 valuation report, Norwest contributed

$30,689,717 to the postretirement medical trust in 1991. On the

consolidated return for 1991, Norwest claimed a deduction for the

contribution as an addition to a “qualified asset account” pursuant

to section 419A(b).

2. Funding the Postretirement Medical Trust for 1992-94

At the request of Norwest, Mercer prepared actuarial funding

valuation reports as of January 1 for each year 1992-94, relating

to the funding of the postretirement medical trust (the 1992-94

valuation reports). In the 1992-94 valuation reports, Mercer

computed the end-of-year contributions to be $6,859,600,

$11,308,043, and $12,247,933, respectively. Mercer calculated the

contribution amount to be equal to a fraction. The numerator of

the fraction was the present value of future benefits for active

employees and retirees, reduced by the sum of the value of (a) the

postretirement medical trust assets and (b) the sectio n 401(h)

account assets. The denominator of the fraction was the average

present value of future working lifetimes of the employees. The- 13 -

present value of the future working life of an employee is

comparable to the present value of an annuity (computed with the

actuarial interest rate used by the plan) that pays $1 each year

until the employee is expected to retire.

3. Mercer’s Actuarial Assumptions for the 1991-94

Contributions to the Postretirement Medical Trust

In order to compute the present value of future benefits in

the 1991-94 valuation reports, Mercer made certain actuarial

a ssumptions, including investment rates, the number of employees

who would “retire, die, terminate their services or become

disabled, their ages at termination, and their expected benefits.”

Mercer requested Norwest to provide an estimate of Norwest’s

effective tax rates for years 1991-94. Norwest advised Mercer that

those tax rates would be approximately 39 percent in 1991-92 and 40

percent in 1993-94.

The pretax and after-tax investment rates Mercer used in the

1991-94 valuation reports were as follows:

1991 1992 1993 1994

Pretax investment rate 9.00% 8.00% 6.00% 6.00%

After-tax investment rate 5.50 4.90 3.60 3.60

The following chart illustrates the various factors disclosed

in the 1991-94 valuation reports (minor computational discrepancies

are unexplained):- 14 -

Valuation Date

1/1/91 1/1/92 1/1/93 1/1/94

1. Actuarial present value of

projected benefits

Active employees $13,361,586 $38,521,857 $62,860,146 $83,594,015

Retired employees 26,311,902 36,694,928 47,731,960 48,947,859

Total 39,673,488 75,216,785 110,592,106 132,541,874

2. Actuarial value of assets

VEBA -0- 30,736,554 30,176,217 39,940,676

401(h) -0- 1,125,467 1,172,269 7,598,653

Total -0- 31,862,021 31,348,486 47,539,329

3. Actuarial present value of

future normal costs [1-2] 1 13,361,588 43,354,764 79,243,620 85,002,545

4. Actuarial present value of

future service 4.81 6.63 7.26 7.19

5. Normal cost at beginning of

year [3/4] 2,777,877 6,539,180 10,915,099 11,822,329

6. Maximum contribution 2

a. Paid at beginning of year 29,089,779 6,539,180 10,915,099 11,822,329

b. Interest to yearend 1,599,938 320,420 392,944 425,604

c. Paid at yearend [a + b] 30,689,717 6,859,600 11,308,043 12,247,933

1 In 1991, this is the present value of active benefits only, excluding the 1991 net benefit costs.

2 In 1991, this includes the normal cost for active participants, plus the entire present value for

those retired as of Jan. 1, 1991, excluding the retirees’ 1991 net benefit costs.- 15 -

14 For purposes of secs. 419 and 419A, a welfare benefit

fund includes a VEBA that is exempt from taxation under sec.

501(c)(9). 4. Contributions to the Postretirement Medical Trust

In 1991-94, Norwest made contributions to the postretirement

medical trust of $30,689,717, $2,170,000, $13,791,600, and

$12,247,933, respectively. During 1992-94, Norwest’s retired

employees made contributions to the postretirement medical trust of

$473,832.62, $736,176.25, and $784,906.22, respectively. In 1993,

$175,216 was transferred from the master trust to the

postretirement medical trust.

E. Respondent’s Determinations

Respondent determined that Norwest’s method for computing the

1991 contribution for postretirement benefits for retirees was

improper and resulted in a contribution that exceeded the account

limit for a reserve under section 419A(c)(2). As a result of the

1991 overfunding, respondent determined that the reserve was also

overfunded in 1992-94.

OPINION

A. Statutory Framework: Sections 419 and 419A

Sections 419 and 419A limit deductions for contributions made

by a taxpayer to an employee welfare b enefit fund. 1 4 In general,

section 419(a)(1) d enies a deduction for contributions paid or

accrued by an employer to a welfare benefit fund. However, if the

contributions would otherwise be deductible, then section 419(a)(2)- 16 -

15 A contribution to a welfare benefit fund in excess of

that year’s qualified cost is treated as a contribution by the

employer to the fund during the succeeding taxable year. Sec.

419(d).

16 The fund’s qualified cost for the taxable year is reduced

by the fund’s after-tax income for that year. Sec. 419(c)(2). permits a deduction for the taxable year in which the contribution

is paid, subject to the limitation contained in section 419(b).

Section 41 9(b) limits the deduction for any taxable year to

the welfare benefit fund’s “qualified cost”. 15 The fund’s qualified

cost is equal to the sum of the fund’s “qualified direct cost” for

the year, and, subject to the limitation of section 419A(b), any

addition to a “qualified asset accou nt” for the year. 1 6 Sec.

419(c)(1).

Section 419A(a) defines a qualified asset account as any

account consisting of assets set aside to provide for the payment

of (1) disability benefits, (2) medical benefits, (3) SUB

(supplemental compensation benefit) or severance pay benefits, or

(4) life insurance benefits. Additions to a qualified asset

account are included in the fund’s qualified cost only to the

extent they do not exceed the fund’s “account limit” for the

taxable year. Sec. 419A(b).

For purposes of the present case, the account limit includes:

(1) The amount reasonably and actuarially necessary to fund claims

that are incurred but unpa id as of the close of the taxable year

and related administ rative costs and (2) the amount of an- 17 -

additional reserve funded over the working lives of the covered

employee s and actuarially determined on a level basis (using

assumptions that are reasonable in the aggregate) as necessary for

postretirement medical and life in surance benefits. Sec.

419A(c)(1) and (2).

At issue in this case is the computation of the account limit

for the reserve necessary for postre t irement medical benefits

provided under section 419A(c)(2). Petitioners and respondent

disagree as to the proper method for computing the account limit

for “a reserve funded over the working lives of the covered

em ployees and actuarially determined on a level basis (using

assumptions that are reasonable in the aggregate) as necessary for

post-retirement medical benefits”. Additionally, respondent

asserts that the investment rates petitioners used in computing the

reserve were too low.

B. Method for Computing the Account Lim it With Respect to a

Reserve

For 1991, Mercer computed Norwest’s contribution to the

postretirement medical trust by including (1) the present value of

postretirement medical benefits for the active employees amortized

over the employees’ remaining working lives, and (2) the entire

present value of the postretirement medical benefits for the

retirees funded in 1 year (the Mercer method). Respondent asserts

that Mercer’s methodology in computing Norwest’s 1991 contribution

for medical benefits to retirees was improper and resulted in a- 18 -

17 Respondent does not dispute the method petitioners used

for computing the contribution for the years 1992-94. contribution that exceeded the account limit for a reserve under

section 419A(c)(2). 17 For the reasons set forth below, we disagree

with respondent’s assertion. To the contrary, we approve of the

Mercer method used in computing Norwest’s 1991 contribution to the

postretirement trust.

The parties rely on expert report s and testimony to explain

actuarial methods appropriate for computing a reserve for

postretirement medical benefits described in section 419A(c)(2) and

to compute the account limit using those methods. Petitioners

presented the re ports and testimony of two expert witnesses:

Messrs. Ira Cohen and Gary Scharmer. Respondent presented the

expert report and testimony of Mr. Richard Daskais. The experts

generally agree that actuarial cost methods approved for computing

the funding of defined benefit pension plans may be used for

computing the funding of postretirement medical benefits.

1. Actuarial Cost Methods

In calculating reserves, actuaries first calculate the stream

of benefits to be paid from the trust (the year- by-year benefit

payments to be made to covered employees in future years) and then

calculate t he present value of that stream by discounting the

payment each year at a determined interest or investment rate. The

stream of benefit payments is based on actuarial assumptions. For

postretirement medical benefits, these assumptions include those as- 19 -

to when employees will retire, how long they will live after

retirement, how many will have spouses entitled to benefits, the

annual cost of the benefits for each retired employee or spouse,

and an interest rate for discounting the stream of benefits to

present value.

An actuary uses an actuarial cost method to assign the present

value of promised benefits to individual plan years as an annual

cost. The portion of the total cost of the plan that is assigned

by the actuarial cost method to the current year or to a future

year is called the normal cost.

In general, six actuarial cost methods (or variations thereof)

are used for purposes of computing pension costs. They include (1)

the unit credit method (also known as the accrued benefit cost

method); (2) the entry age normal cost method; (3) the individual

level premium cost method; (4) the aggregate cost method; (5) the

attained age normal cost method; and (6) the frozen initial

liability cost method. The methods discussed by the parties’

experts are the aggregate cost method (resp o ndent’s preferred

method), the entry age normal cost method (petitioners’ preferred

method), and the individual level premium cost method (the method

Mercer used in 1991 and the on e which we find satisfies the

requirements of section 419A(c)(2)).- 20 -

a. Aggregate Cost Method

The aggregate cost method calculates costs for all employees

on an aggregate basis. The aggregate cost method computes normal

costs in relation to the assets of the fund; this method does not

calculate an accrued liability independent of those assets.

In computing the normal cost under the aggregate cost method,

the value of the plan assets is subtracted from the present value

of future benefits for all particip ants. The remaining present

value of future benefits is then divided by the sum of the present

v alue of the future working lives of the active employees. The

present value of the future working life of an employee is

comparable to the present value of an annuity (computed with the

actuarial interest rate used b y the plan) that pays $1 each year

until the employee is expected to retire.

b. Entry Age Normal Cost Method

The entry age normal cost method can be applied on an

indivi dual or aggregate basis; in this case, it is applied on an

individual basis. Under the entry age normal cost method, the

actu arial present value of each employee’s projected benefit is

spread over the entire length of the employee’s service, beginning

at the date the employee began service with the employer and ending

with the anticipated normal retirement date.

The normal cost computed under the entry age norma l cost

method is a dollar amount which, if paid ann ually and allowed to- 21 -

accumulate from the date the employee began service until the

projected retirement date of that employee, will have accumulated

at retirement the amount necessary to fully fund the benefit to the

covered employee. The actuarial accrued liability is the portion

of the actuarial present value that is not provided for by future

normal costs.

c. Individual Level Premium Cost Method

Th e individual level premium cost method is an individual

method, similar to the entry age normal cost method. Under the

individual level premium cost method, the normal cost is separately

determined for each covered emplo yee as a level dollar amount

which, if accumulated from the later of the date the plan is

established or the date that the employee was hired, would

accumulate at retirement the amount neces sary to fully fund the

benefit to the covered employee.

The primary difference between the individual level premium

cost method and the entry age normal cost method is the date when

normal cost is assumed t o commence. If the plan is established

after the employee is hired, under the entry age normal cost

method, normal cost is assumed to have retroactively commenced at

the date of hire. Under the individual level premium cost method,

normal cost begins no earlier than the date the plan is

established.- 22 -

2. Computations by the Experts

The parties’ experts described the way s that actuaries

interpret the account limit for a reser ve provided in section

419A(c)(2) and made computations using variations of the aggregate

and entry age normal cost methods.

a. Mr. Cohen

Mr. Cohen, one of petitioners’ experts, is an expert in

actuarial sc ience and a principal at PricewaterhouseCoopers LLP,

advi s ing clients on various matters involving actuarial, tax,

pension, and postretirement medical issues. He is a fellow of the

Society of Actuaries, an enrolled actuary under ERISA, and a member

of the American Academy of Actuaries. From 1970-86, Mr. Cohen was

employed by the Internal Revenue Service, serving in a variety of

positions, including director of the Employee Plans, Technical and

Actuarial Division.

Mr. Cohen us es the terms “reserve” and “accrued liability”

interchangeably and posits that the reserve for retirees is the

present value of future benefits. In Mr. Cohen’s opinion, the

aggregate cost method is not appropriate for computing the account

limit for a reserve for postretirement benefits because that method

does not directly compute an accrued liability and fails to fully

fund the reserve for an employee upon retirement. In his opinion,

the entry age normal cost method is the appropriate method because

that method allocates the cost over the entire working life of an- 23 -

employee, directly computes an accrued liability, and provides for

full funding upon retirement.

Mr. Cohen opined that (1) the account limit for the reserve is

equal to the reserve (accrued liability) computed under the entry

age normal cost method, (2) for retirees, the reserve (accrued

liability) is the present value of future benefits, and (3) for

active employees, the reserve is the present value of future

benefits minus the present value of future normal costs.

b. Mr. Scharmer

Mr. Scharmer is an expert in actuarial science and is a

principal at Mercer. He is a fellow of the Society of Actuaries,

an enrolled actuary under ERISA, a member of the American Academy

of Actuaries, and a member of the Conference of Actuaries.

Mr. Scharmer opined that the account limit for a reserve under

section 419A(c)(2) wa s equal to the accrued liability using the

entry age normal cost method. For 1991-94, Mr. Scharmer calculated

the account limit for the reserve by applying the entry age normal

cost method and by using the same facts and assumptions that Mercer

relied upon when it prepared the 1991-94 valuation reports. Mr.

Scha rmer computed the accrued liability (dollars in millions) on

the valuation date for each year as follows:- 24 -

1991 1992 1993 1994

A. Investment return 5.5% 4.9% 3.6% 3.6%

B. Present value accrued benefits

(beginning of year)

a. Active $14.7 $38.5 $62.9 $83.6

b. Retired 28.2 36.7 47.7 48.9

c. Total 42.9 75.2 110.6 132.5

C. Accrued liability (beginning of year)

a. Active $12.6 $28.7 44.7 $59.4

b. Retired 28.2 36.7 47.7 48.9

c. Total 40.8 65.4 92.4 108.3

D. Normal cost (beginning of year) 0.3 1.2 2.5 3.3

E. Accrued liability (yearend)

a. Active $12.3 $31.2 $48.7 $64.7

b. Retired 27.8 34.5 45.2 45.8

c. Total 40.1 65.7 93.9 110.5

F. Account limit 40.1 65.7 93.9 110.5

G. Plan assets (VEBA + 401(h)) -0- 29.3 28.0 44.1

H. Deductible limit 40.1 36.4 65.9 66.4

Mr. Scharmer also calculated the account limit for the reserve

by varying the application of the afore mentioned methodology to

reflect the investment rates Mr. Daskais proposed. Under these

computations, he determined that the accrued liability (dollars in

millions) for 1991-94 was as follows:

1991 1992 1993 1994

A. Investment return 6.0% 5.7% 4.9%

B. Accrued liability (beginning of year)

a. Active $10.3 $26.1 $35.0 $51.6

b. Retired 26.0 32.3 40.0 42.4

c. Total 36.3 58.4 75.0 94.0

C. Account limit 36.3 58.4 75.0 94.0

D. Plan assets (VEBA + 401(h)) -0- 29.6 28.6 44.7

E. Deductible limit 36.3 28.8 46.4 49.3- 25 -

18 A third example is a uniform (or level) percent of the

total payroll of active employees each year, so that the total

dollar amount increases or decreases as the total payroll of active

employees increases or decreases. The experts agree that

allocating by percentages is inappropriate for postretirement

medical benefits because postretirement benefits us ually are not

pay related.

c. Mr. Daskais

Mr. Daskais, responden t’s expert, is an expert in actuarial

science. He is a fellow of the Society of Actuaries and was an

enrolled actuary under ERISA from 1976 to 1995.

Mr. Da skais opined that “actuarially determined on a level

basis” means that the systematic year-to-year increments to the

reserve are the same (or “level” in some sense) each year.

Examples of level increments that are appropriate for computing a

reserve for postretirement medical benefits include (1) a uniform

(or level) dollar amou nt each year or (2) a uniform (or level)

dollar amount per active employee each year, so that the total

dollar amount increases or decreases as the numb er of active

employees increases or decreases. 18

Mr. Daskais opined that in actuarial parlance a “reserve

funded over the working lives of covered employees” is a “onesentence description of the aggregate cost method.” It means a

reserve, determined on the basis of an actuarial cost method and

actuarial assumptions, t hat will increase from year to year and

will be exactly sufficient to provide the trust fund’s benefits at

the end of the working lives of the covered employees. Mr. Daskais- 26 -

acknowledged that the reserve funded using the aggregate cost

method will not be fully funded with respect to an individual

employee upon retirement. In Mr. Daskais’s opinion, full funding

upon retirement of an individual employee is not required; in his

opinion the end of the working lives of covered employees occurs

when the employment of all covered employees has terminated.

Mr. Daskais computed the maximum contribution for 1991-94 to

the postreti rement medical trust deductible under section 419 by

applying the aggregate cost method using the same actuarial values

(including the investment rate) Mercer used, as follows:- 27 -

1991 1992 1993 1994

A. Investment return 5.5% 4.9% 3.6% 3.6%

B. Present value accrued benefits

a. Active $13,361,586 $38,521,857 $62,860,146 $83,594,015

b. Retired 26,311,902 36,694,928 47,731,960 48,947,859

c. Total 39,673,488 75,216,785 110,592,106 132,541,874

C. Value of assets (beginning of year)

a. VEBA

--- 30,736,554 30,176,217 39,940,676

b. 401(h)

--- 1,125,467 1,172,269 7,598,653

c. Total

--- 31,862,021 31,348,486 47,539,329

D. Nondeductible contribution from prior

years (O from prior year)

--- 22,034,781 14,394,743 14,426,384

E. Net value of assets 1

--- 9,827,240 16,953,743 33,112,945

F. Present value future normal costs 2 39,673,488 65,389,545 93,638,363 99,428,929

G. Average present value of future service 4.81 6.63 7.26 7.19

H. Normal cost (beginning of year) 3 8,248,126 9,862,676 12,897,846 13,828,780

I. Benefits paid during year N/A 4,078,160 4,859,441 5,301,930

J. Employee contributions during year N/A 473,833 736,176 784,906

K. Interest to yearend 4 453,647 821,352 958,237 1,335,044

L. Account limit (yearend) 5 8,701,773 15,781,474 25,514,292 36,161,092

M. Actual contribution 30,689,717 2,170,000 13,966,816 12,247,933

N. Value of assets (yearend) 30,736,554 30,176,217 39,940,676 47,668,557

O. Nondeductible contribution

carryforward 6 22,034,781 14,394,743 14,426,384 11,507,465

P. Deductible limit 7 8,654,936 9,810,038 13,935,175 15,166,852

1 C.c - D

2 B.c - E

3 F/G

4 A x (C.a - D + H + 1⁄2 of (J - I))

5 C.a - D + H - I + J + K

6 Smaller of (N - L) and (D + M), but not below zero

7 D + M - O- 28 -

In Mr. Daskais’s opinion, the investment rates Mercer used

were unreasonably low. Mr. Daskais recalculated the contribution

l imit by applying the aggregate cost method using the Mercer

assumptions but substituting investment rates that, in his opinion,

were reasonable. Under these computations, he determined that the

maximum contributions for 1991-94 were as follows:- 29 -

1991 1992 1993 1994

A. Investment return 6.6% 6.0% 5.7% 4.9%

B. Present value accrued benefits

a. Active $11,154,103 $30,515,975 $38,396,684 $61,044,923

b. Retired 23,798,600 33,006,450 38,374,995 42,599,819

c. Total 34,952,703 63,522,425 76,771,679 103,644,742

C. Value of assets (beginning of year)

a. VEBA

--- 30,736,554 30,176,217 39,940,676

b. 401(h)

--- 1,125,467 1,172,269 7,598,653

c. Total

--- 31,862,021 31,348,486 47,539,329

D. Nondeductible contribution from prior

years (O from prior year)

--- 22,679,988 16,144,825 19,283,596

E. Net value of assets 1

--- 9,182,033 15,203,661 28,255,733

F. Present value future normal costs 2 34,952,703 54,340,392 61,568,018 75,389,009

G. Average present value of future service 4.62 6.26 6.46 6.68

H. Normal cost (beginning of year) 3 7,557,754 8,682,914 9,523,819 11,286,962

I. Benefits paid during year N/A 4,078,160 4,859,441 5,301,930

J. Employee contributions during year N/A 473,833 736,176 784,906

K. Interest to yearend 4 498,812 896,239 1,225,134 1,454,591

L. Account limit (yearend) 5 8,056,566 14,031,392 20,657,080 28,881,609

M. Actual contribution 30,689,717 2,170,000 13,966,816 12,247,933

N. Value of assets (yearend) 30,736,554 30,176,217 39,940,676 47,668,557

O. Nondeductible contribution

carryforward 6 22,679,988 16,144,825 19,283,596 18,786,948

P. Deductible limit 7 8,009,729 8,705,163 10,828,045 12,744,581

1 C.c - D

2 B.c - E

3 F/G

4 A x (C.a - D + H + 1⁄2 of (J - I))

5 C.a - D + H - I + J + K

6 Smaller of (N - L) and (D + M), but not below zero

7 D + M - O- 30 -

Mr. Daskais opined that, if the funding method used to

calculate the reserve computes an accrued liability, that liability

must be amortized. In Mr. Daskais’s opinion, since there are no

s pecific amortization rules applicable to the fundin g of

postretirement medical benefits in section 419A or in the income

tax regulations, the amortizatio n rules applicable to pensions

should be applied.

Mr. Daskais calculated the contribution limit by applying the

entry age normal cost method a nd by using the same facts and

assumptions Mercer used. He amortized the accrued liability over

the present value of the remaining working lives of the active

employees. Under these computations, he determined that the

maximum contributions (dollars in millions; discrepancies

attributable to rounding) for 1991-94 were as follows:

1991 1992 1993 1994

A. Investment return 5.5% 4.9% 3.6% 3.6%

B. Present value accrued benefits

a. Active $13.4 $38.5 $62.9 $83.6

b. Retired 26.3 36.7 47.7 48.9

c. Total 39.7 75.2 110.6 132.5

C. Accrued liability

a. Active 11.3 28.7 44.7 59.4

b. Retired 26.3 36.7 47.7 48.9

c. Total 37.6 65.4 92.4 108.3

D. Normal cost 0.3 1.2 2.5 3.3

E. Average present value of future service 4.81 6.63 7.26 7.19

F. Amortized accrued liability from prior

years 1

--- 8.6 15.5 25.5

G. Remaining unamortized accrued liability 2 37.6 56.8 76.9 82.8

H. Amortization of accrued liability 3 7.8 8.6 10.6 11.5

I. Account limit (beginning of year) 4 8.1 18.3 28.6 40.3

J. Interest to yearend 0.4 0.9 1.0 1.5

K. Account limit (yearend) 5 8.6 19.2 29.7 41.7- 31 -

L. Benefits paid less employee

contributions

--- 3.6 4.1

---

M. Interest for one-half year

--- 0.1 0.1

---

N. Amortized accrued liability (yearend) 6 8.6 15.5 25.5

--–

O. Nondeductible contribution from prior

years 7

--- 22.1 15.3 16.2

P. Actuarial value of assets

a. VEBA --- 30.7 30.2 39.9

b. 401(h)

--- 1.1 1.2 7.6

c. Total (beginning of year)

--- 31.9 31.3 47.5

d. Net after nondeductible

contributions 8

--- 9.7 16.1 31.3

e. Interest to yearend

--- 0.5 0.6 1.1

f. Total (yearend) 9

--- 10.2 16.7 32.4

Q. Actual contribution 30.7 2.2 14.0 12.2

R. Deductible contribution 10 8.6 9.0 13.0 9.3

S. Nondeductible contribution

carryforward 11 22.1 15.3 16.2 19.2

1 N of prior year

2 C.c - F

3 G/E

4 D + F + H

5 I + J

6 K - L - M

7 S of prior year

8 P.c - O

9 P.d + P.e

10 Smaller of (K - P) and (O + Q)

11 O + Q - R

Mr. Daskais also calculated the contribution limit by applying

his variation of the entry age normal cost method (amortizing the

accrued liability over the remaining lives of the active employees)

as above but substituting investmen t rates that, in his opinion,

were reasonable. Under these computations, he determined that the

maximum contributions (dollars in millions; discrepancies

attributable to rounding) for 1991-94 were as follows:- 32 -

1991 1992 1993 1994

A. Investment return 6.6% 6.0% 5.7% 4.9%

B. Present value accrued benefits

a. Active $11.2 $30.5 $38.4 $61.0

b. Retired 23.8 33.0 38.4 42.6

c. Total 35.0 63.5 76.8 103.6

C. Accrued liability

a. Active 9.4 22.7 27.3 43.4

b. Retired 23.8 33.0 38.4 42.6

c. Total 33.1 55.2 64.1 84.7

D. Normal cost 0.2 1.0 1.5 2.4

E. Average present value of future service 4.62 6.26 6.46 6.68

F. Amortized accrued liability from prior

years 1

--- 7.9 13.7 20.1

G. Remaining unamortized accrued liability 2 33.1 47.3 50.4 64.6

H. Amortization of accrued liability 3 7.2 7.6 7.8 9.7

I. Account limit (beginning of year) 4 7.4 16.4 23.0 32.2

J. Interest to yearend 0.5 1.0 1.3 1.6

K. Account limit (yearend) 5 7.9 17.4 24.3 33.8

L. Benefits paid less employee

contributions

--- 3.6 4.1

---

M. Interest for one-half year

--- 0.1 0.1

---

N. Amortized accrued liability (yearend) 6 7.9 13.7 20.1

---

O. Nondeductible contribution from prior

years 7

--- 22.8 17.2 21.8

P. Actuarial value of assets

a. VEBA --- 30.7 30.2 39.9

b. 401(h)

--- 1.1 1.2 7.6

c. Total (beginning of year)

--- 31.9 31.3 47.5

d. Net after nondeductible

contributions 8

--- 9.1 14.2 25.8

e. Interest to yearend

--- 0.5 0.8 1.3

f. Total (yearend) 9

--- 9.6 15.0 27.0

Q. Actual contribution 30.7 2.2 14.0 12.2

R. Deductible contribution 10 7.9 7.8 9.4 6.7

S. Nondeductible contribution

carryforward 11 22.8 17.2 21.8 27.3

1 N of prior year

2 C.c - F

3 G/E

4 D + F + H

5 I + J

6 K - L - M

7 S of prior year

8 P.c - O

9 P.d + P.e- 33 -

10 Smaller of (K - P) and (O + Q)

11 O + Q - R

3. Positions of the Parties

Petitioners assert that the reserve under section 419A(c)(2)

refers to the employer’s accrued liability to provide the

postretirement benefits. Petitioners maintain that, since the

entry age normal cost method is the only method that directly

computes an accrued liability and allocates the present value of an

employee’s future benefit over the employee’s entire working life,

the account limit for the reserve is equal to the accrued liability

computed under the entry age normal cost method. Petitioners

further maintain that (1) for a retiree the accrued liability is

the present value of the employee’s future benefits, and (2) for an

active employee the accrued liability is the present value of the

employee’s future benefits minus the present value of future normal

costs determined under the entry age normal cost method.

Petitioners contend that their contribution to the reserve for each

year at issue did not cause the reserve to exceed the account limit

and, the refore, the contributions were deductible under section

419.

Respondent argues that petitioners’ position is inconsistent

with (1) the language of sect ion 419A(c)(2), (2) the established

judicial precedent interpreting that section, (3) Congress’s

purpose in enacting that section, (4) the accepted interpretation

given “nearly identical language” in the provisions gov e rning- 34 -

pension plans, (5) the law in effect before the enactment of

section 419, and (6) principles of actuarial practice. Respondent

contends that the cost of the postretirement benefit must be spread

over the remaini ng working lives of the covered employees.

Respondent further contends that, since retirees have no remaining

working lives, the cost must spread over the remaining working

lives of the active employees. Respondent concludes, therefore,

that the aggregate cost method is the proper method for computing

the account limit for the reserve under section 419A(c)(2).

Respondent asserts in the alternative that, if the entry age normal

cost method is a proper method, then the accrued liability must be

amortized over the remaining lives of the active employees.

4. Statutory Construction

“Our first step in interpreting a statute is to determine

whether the language at issue has a plain and unambiguous meaning

with regard to the particula r dispute in the case.” R obinson v.

Shell Oil Co.

, 519 U.S. 337, 3 40 (1997). We look to the

legislative history primarily to learn the purpose of the statute

and to resolve any ambigui ty in the words contained in the text.

Landgraf v. USI Film Prods. , 511 U.S. 244 (1994); Commissioner v.

Soliman

, 506 U.S. 168, 174 (1993); Consumer Prod. Safety Commn. v.

GTE Sylvania, Inc.

, 447 U.S. 102, 108 (1980); United States v. Am.

Trucking Associations, Inc.

, 310 U.S. 534, 543-544 (1940); Allen v.

Commissioner , 118 T.C. 1, 7 (2002); V enture Funding, Ltd. v.- 35 -

Commissioner

, 110 T.C. 236, 241-242 (1998), affd. without published

opinion 198 F.3d 248 (6th Cir. 1999); Trans City Life Ins. Co. v.

Commissioner

, 106 T.C. 274, 299 (1996). Where Congress has

expressed its will in reasonably plain terms, those terms must

ordinarily be regarded as conclusive. N egonsott v. Samuels

, 507

U.S. 99, 104 (1993).

The plainness or ambiguity of statutory language is determined

by reference to the language itself, the specific context in which

that language is used, and the broader context of the statute as a

whole. E state of Cowa rt v. Nicklos Drilling Co. , 505 U.S. 469

(1992); M cCarthy v. Bronson

, 50 0 U.S. 136, 139 (1991). In

analyzing the plain meaning of section 419A(c)(2), we examine the

section as a whole, with all of its subsections in mind. See

Hellmich v. Hellman , 276 U.S. 233, 237 (1928); H uffman v.

Commissioner , 978 F.2d 1139, 1145 (9th Cir. 1992), affg. in part,

revg. and remanding in part T.C. Memo. 1991-144.

5. The Statute

We begin with the specific language of section 419 A(c)(2),

which provides:

The account limit for any taxable year may include a

reserve funded over the working lives of the co vered

employees and actuarially determined on a le vel basis

(using assumptions that are reasonable in the aggregate)

as necessary for–-

(A) post-retirement medical benefits to be

provided to covered employees (determined on the

basis of current medical costs), or- 36 -

(B) post-retirement life insurance benefits to

be provided to covered employees.

We first addressed the requirements of section 419A(c)(2) in

Gen. Signal Corp. v. Commissioner

, 103 T.C. 216, 239 (1994), affd.

142 F.3d 546 (2d Cir. 199 8). In that case, we held that section

4 19A(c)(2) requires an accumulation of assets equal to the

deduction taken, and that those assets must be used to pay welfare

benefit expenses of ret ired employees. See also S quare D Co. v.

Commissioner , 109 T.C. 200 (1997); P arker-Hannifin Corp. v.

Commissioner

, T.C. Memo. 1996-337, affd. in part, revd. in part and

remanded 139 F.3d 1090 (6th Cir. 1998). In G en. Signal Corp.

,

Square D Co.

, and Parker-Hannifin Corp.

, we found that no reserves

had been created, obviating the need to c onsider whether the

contributions were excessive from an actuarial standpoint. In the

case at hand, respondent agrees that a reserve was created; i.e.,

assets in the amount of the deduction taken were accumulated to be

used to pay medical expenses of retired employees.

a. Reserve

Petitioners assert that the term “reserve” in section

419A(c)(2) refe rs to the employer’s accrued liability to provide

the postretirement benefits. Petitioners conclude, therefore, that

the method used in computing the reserve must compute the accrued

liability.

Respondent asserts that section 419A(c)(2) does not define the

account limit but rather describes contributions to a reserve- 37 -

(equal to the normal cost computed under the aggregate cost method)

which may be included as a component of the account limit, together

with the amounts set aside for incurred but unpaid claims.

Respondent concludes, therefore, that section 419A(c)(2) does not

require the computation of the accrued liability.

A comparison of the language in section 419A(c)(1) with that

in section 419A(c)(2) belies respondent’s position. Section

419A(c)(1) provides that the account limit “for any taxable year is

the amount reasonably and actuarially necessary to fund ” (emphasis

supplied) incurred but unpaid claims and administrative costs with

respect to such claims. By contrast, section 419A(c)(2) provides

that the account limit “for any taxable year may include a

reserve”.

Congress could have used iden tical language in both

provisions; the fact that Congress chose not to do so must be given

heed. Cf. Keene Corp. v. United States , 508 U.S. 200, 208 (1993)

(“Where Congress includes particular language in one section of a

statute but omits it in another * * *, it is generally presumed

that Congress acts intentionally and purposely in the disparate

inclusion or exclusion.” (Internal quotation ma rks and citation

omitted.)); United States v. $359,500 in U.S. Currency , 828 F.2d

930, 933 (2d Cir. 1987) (“‘contrasting language in similar statutes

may show that the legislature intended different standards of

compliance’” (quoting 2A Singer, Sutherland Statutory Construction,- 38 -

sec. 57.06, at 654 (Sands 4th ed. 1984))). Thus, it is the

reserve, not merely a contribution equal to the normal cost for the

year, that must be computed in determining the account limit.

Respondent asserts that courts have held in prior cases, such

as Gen. Signal Corp. v. Commissioner

, supra

, Square D Co. v.

Commissioner

, supra

, and Parker-Hannifin Corp. v. Commissioner

,

supra , that “reserve” as used in section 419A(c)(2) does not mean

a measure of liability. At issue in those cases, however, was

whether section 419A(c)(2) required the actual funding of a

reserve. The taxpayers in those cases argued that term “reserve”

was an actuarial term of art meaning “a quantity of liability” that

did not require actual funding. We held that a mere quantity of

liability does not constitute a “reserve funded over the working

lives of the covered employees”; i.e., we held that section

419A(c)(2) requires the actual funding of the reserve.

When Congress uses a term of art that has an established

meaning, a strong presumption arises that Congress intends to

incorporate that meaning. M orissette v. United States , 342 U.S.

246, 263 (1952). Congress’s choice of the word “reserve” (rather

than “account” or “fund”, for example) connotes a measure of

liability. W. Natl. Mut. Ins. Co. v. Commissioner , 102 T.C. 338,

373 (1994) (“reserves * * * are estimates of liabilities: ‘“best

estimates” of future settlement costs’” (quoting Salzmann,

Estimated Liabilities For Loss es & Loss Adjustment Expenses 155- 39 -

(1984))), affd. 65 F.3d 90 (8th Cir. 1995); see also Ins. Co. of N.

Am. v. McCoach , 224 F. 657, 659 (3d Cir. 1915) (defining “reserve

funds” as “funds as must be reserved to meet liabilities”); Black’s

Law Dictionary 1309 (7th ed. 1999) (defining “reserve” to mean

“Something retained or stored for future use; esp., a fund of money

set aside by a bank or an insuran ce company to cover future

liabilities.”).

Section 419A(c)(2) includes in the account limit a reserve

funded for the payment of postretirement medical (or life

insurance) benefits. The payment of those benefits is a liability

of the employer, and “reserve” as used in section 419A(c)(2)

connotes a measure of that liability; it refers to the accumulation

of assets in an amount necessary to satisf y the employer’s

liability to pay the covered employees’ postretirement medical (or

life insurance) benefits when those benefits become due.

b. Reserve Funded Over the Working Lives of the

Covered Employees and Actuarially Determined on a

Level Basis

Section 419A(c)(2) limits the reserve that may be included in

the accoun t limit to “a reserve funded over the lives of the

covered employees and actuarially determined on a level basis”.

Respondent asserts t hat Norwest’s contribution in 1991 was

excessive because it created a reserve that was not “funded over

the working lives of the covered employees and actuarially

determined on a level basis”. Respondent maintains that the- 40 -

language of section 419A(c)(2) is, in essence, a one-clause

definition of th e aggregate cost method. Respondent posits that

section 41 9A requires that (1) a reserve for postretirement

benefits must be “funded”; i.e., contributions must be made for the

purpose of providing postretirement medical benefits, and (2) the

funding must be done on a “level” basis over the working lives of

the employees. Respondent contends that the funding cannot begin

before the reserve is created and, therefore, the funding must be

determined on a level basis over the remaining working lives of the

covered employee s. Respondent concludes that, since retired

employees have no remaining working lives, the funding must be

determined on a level basis over the remaining working lives of the

active employees. Disagreeing with respondent, petitioners assert

that the term “funded” means “calculated”, not “contributed”, and

that the reserve (accrued liability) is calculated over the working

lives of the covered employe es. Thus, petitioners conclude that

the reserve included in the account limit is an actuarially

determined accrued liability (i.e., a “reserve”) that is calculated

(i.e., “funded”) over the working lives of the covered employees.

(i) Reserve Funded Over the Work ing Lives of the

Covered Employees

We do not agree with petitioners that funded means calculated.

We have previously he ld that the “funded” reserve in section

419A(c)(2) refers to an accumulation of assets and the funding of

benefits. N atl. Presto Indus., Inc. v. Commissioner

, 104 T.C. 559,- 41 -

574 (1995). A “reserve funded over the working lives of the

covered employees” “clearly evokes the gra dual accumulation of

funds measured with an eye toward complete funding at the time of

retirement”. G en. Signal Corp. v. Commissioner

, 142 F.3d at 549

(citing Parker-Hannifin Corp. v. Commissioner

, 139 F.3d 1090, 1094

(6th Cir. 1998)). We agree with respondent that the funding of the

reserve cannot begin until the reserve is created. However, we do

not agree with respondent that the reserve must be funded over the

aggregate remaining working lives of the active employees.

Respondent asserts that once the reserve is created it may be

funded ove r the aggregate working lives of the covered employees

and that the end of the working lives of the cov ered employees

occurs when the last covered employee is no longer employed by the

employer, because the employment of all covered employees has

terminated. Respondent acknowledges that, under that reading, the

reserve will not be fully funded upon retirement with respect to

any individual employee (except the last employee). The position

taken by respondent in this case is contrary to the position

successfully urged by the Commissioner in Gen. Signal Corp. In

Gen. Signal Corp. v. Commissioner , 142 F.3d at 549, the Court of

Appeals for the Second Circuit agreed with the Commissioner’s

interpretation that the phrase “funded over the workin g lives”

means that “the amount that is supposed to be added to the reserve

each year would, assuming the reserve remain ed intact, result in- 42 -

19 The deduction for a contribution to a pension trust is

limited to the amount provided in sec. 404(a)(1) (A)(ii) when it

exceeds the minimum funding amount provided in sec. 412(a) and the

(continued...) full funding for retirement benefits at the end of each employee’s

term of service.” (Emphasis supplied.)

Respondent acknowledges that sections 419 and 419A do not

impose an obligation on an employer to create a reserve to pay for

postretirement medical benefits; i.e., employers may pay and deduct

the medical claims as they become due on a pay-as-you-go basis.

Respondent further acknowledges that if an employer establishes a

reserve under section 419A(c)(2), sections 419 and 419A do not

impose a minimum annual contribution req uirement or require an

employer to make contributions that are precisely level.

Respondent contends, however, that “funded” in section 419A(c)(2)

is synonymous with “amortized” and that if an employer does not

make a contribution in a given year, then the “contribution that

was not made would be funded over the remaining working lives of

employ ees in subsequent years”. Respondent asserts that the

language “funded over the working lives of the covered employees”

is essentially identical to the language of section

404(a)(1)(A)(ii), and, t herefore, any accrued liability must be

amortized over the remaining lives of the active employees. We

disagree.

The language of section 404(a)(1)(A)(ii) is clearly different

from the language of 419A(c) (2). When applicable, 1 9 section- 43 -

19 (...continued)

amount provided in sec. 404(a)(1)(A)(iii). 404(a)(1)(A)(ii) limits the deduction for a contribution to a

pension plan to “the amount necessary to provide with respect to

all of the employees under the trust the remaining unfunded cost of

their past and current service credits distributed as a level

amount * * * over the remaining future servic e of each such

employee”. The phrases “over the remaining future service of each

such employee” (the section 404(a) (1)(A)(ii) language) and “over

the working lives of the covered employees” (the section 419A(c)(2)

language) are not identical. We give heed to the fact that

Congress could have used identical language in both the pension and

VEBA provisions but chose not to do so.

Moreover, Congress in section 419A(e)(1) specifically made the

pension nondiscrimination rules of section 505(b) applicable to the

section 419A(c)(2) reserve. This is an indication that Congress

did not intend to automatically apply pension provisions to section

419A. Additionally, in section 419(c)(3), Congress provided for

the amortization of the adjusted basis of a child care facility

over 60 months. This is a further indication that Congress did not

intend to require amortization of the postretirement benefit of a

retired employee.

When Congress has intended to require costs to be spread over

the remaining working lives of active employees, it has done so

clearly. For example, the funding period for purposes of- 44 -

20 Sec. 192(b) limits contributions to a black lung benefit

trust as follows:

SEC. 192(b). Limitation.--The maximum amount of the

deduction allowed by subsection (a) for any taxpayer for

any taxable year shall not exceed the greater of--

(1) the amo unt necessary to fund (with level

funding) the remaining unfunded liability of the

t axpayer for black lung claims filed (or expecte d

to be filed) by (or with respect to) past or

present employees of the taxpayer, or

(2) the aggregate amount necessary to increase

each trust describe d in section 501(c)(21) to the

amount required to pay all amounts payable out of

such trust for the taxable year. contributions to a black lung benefit trust 20 is the greater of “(i)

the aver age remaining working life of miners who are present

employees of the taxpayer, or (ii) 10 taxable years.” Sec.

192(c)(1)(B). We conclude, therefore, that the amortization rules

applicable to pensions do not apply to the computation of the

section 419A(c)(2) reserve.

In Gen. Signal Corp. v. Commissioner

, 103 T.C. at 240, in

light of the taxpayer’s assertions that the phrase “reserve funded”

does not have a commonly understood meaning, we assume d arguendo

that the phrase was ambiguous and considered the legislative

history. We shall do likewise in this case.

In consulting the legislative history of section 419A, we are

mindful that the relevant portion of the committee report states:

Prefunding of life insurance, death benefits, or

medical benefits for retirees .--The qualified asset

account limits allow amounts reasonably necessary to

accumulate reserves under a welfare benefit plan so that- 45 -

the medical benefit or life insurance (including death

benefit) payable to a retired employee during retirement

is fully funded upon retir ement. These amounts may be

accumulated no more rapid ly than on a level basis over

the working life of the employee, with the employer of

each employee. * * * The conferees intend that the

Treasury Department prescribe rules requiring that the

funding of retiree be nefits be based on reasonable and

consistently applied actuarial cost methods, which take

into account expe rience gains and losses, changes in

assumptions, and o ther similar items, and be no more

rapid than on a l evel basis over the remaining working

lifetimes of the current participants. * * * [H. Conf.

Rept. 98-861, at 1157 (1984), 1984-3 C.B. (V ol. 2) 1,

411.]

T he legislative history makes clear that the funding of the

reserve can be completed no more rapidly than over the working life

of the employee. Therefore, we conclude that fully funding the

reserve at or after retirement is permissible because, in that

case, the assets are accumulated less rapidly than over the working

life of the employee.

To conclude this aspect of our deliberation, we hold that for

purposes of section 419A(c)(2), the phrase “reserve funded over the

working lives of the covered employees” means that assets necessary

to satisfy the employer’s liability may be accumulated no more

rapidly than over the working lives of the covered employees, such

that the reserve with respect to an employee can be fully funded no

earlier than upon retirement of the employee.- 46 -

(ii) Reserve Actuarially Determined on a Level

Basis

We now turn our attention to the requirement that the reserve

under section 4 19A(c)(2) be “actuarially determined on a level

basis” and the calculation of the reserve. We have held that the

term “reserve” in section 419A(c)(2) refers to assets in an amount

necessary to satisfy the employer’s liability to pay the covered

employees’ postretirement medical benefits when the benefits become

due.

Petitioners assert that “level”, as an actuaria l concept,

refers to normal cost and that, to an actuary, “level” means that

the normal costs are level. Normal cost is that portion of the

present value of the benefit that is assigned to the current or a

future year. In other words, the value of the benefit assigned to

the current year is the same as the amount assign ed to each

subsequent year until the employee’s retirement date. Petitioners

further assert that the actuarial concept of level is unrelated to

the employer’s actual contributions to a plan and that actu arial

methods determine amounts that can be contributed but do not

mandate funding.

Petitioners acknowledge that both the aggregate and entry age

normal cost methods produce level n ormal costs. Petitioners

assert, however, that the aggregate cost method is not appropriate

because it does not directly calculate the accrued liability

independently of the assets.- 47 -

Respondent asserts that a direct c alculation of the accrued

liability independent of the assets is not necessary. Respondent

contends that the actuary must compute on a level basis a reserve

funded over the working lives of the covered employees. Further,

respondent posits that since the funding does not begin before the

reserve is created, the reserve must be computed by allocating the

cost in a level amount over the remaining lives of the employees.

Respondent c ontends that (1) the actuarial methodology used must

determine contributions at a “rate” that would be level if

actuarial assumptions were exactly realized, (2) the funds may only

accumulate gradually, and (3) in order to accomplish the gradual

funding, the actuarial method must provide for the r atable

a ccumulation of funds over the r emaining working lives of the

covered employees. Respondent asserts that the following excerpt

from the legislative history supports his position: “The conferees

intend * * * that the funding of retiree benefits * * * be no more

rapid than on a level basis over the remaining working lifetimes of

the current participants”. H. Conf. Rept. 98-861, supra at 1157,

1984-3 C.B. (Vol. 2) at 411. Respondent contends that once an

employer elects to fund a reserve for postretirement benefits under

section 419A(c)(2), it must then select an act uarial cost method

that satisfies this stat utory requirement. Respondent concludes

that the aggregate cost method properly allocates the costs in a

level amount over the remaining lives of the covered employees. In- 48 -

21 We note that use of the aggregate cost method is not

permitted in computing the full-funding li mit for pensions under

sec. 412. Sec. 412(c)(7) defines the term “full-funding limitation”

for purposes of sec. 412(c)(6) as the excess of the accrued

liability (including normal cost) under the plan, over the value of

the plan’s assets. The accrued liability is determined under the

entry age normal cost method if the accrued liability cannot be

directly calculated under the funding method used for the plan. the alternative, respondent argues that, if the method used

calculates an accrued liability independently of the fund assets,

the unfunded accrued liability must be amortized over the remaining

lives of the active employees.

We believe that use of the aggregate cost method to compute

the reserve is not appropriate because that method will not permit

full funding of the reserve with respect to a retired employee at

retirement o f that employee. Further, we agree with petitioners

that the accrued liability should be computed independently of the

plan assets. Indeed, there are circumstances under which the

reserve could become overfunded and yet additional amounts could be

added to the reserve using the aggregate cost method. 21 We have no

doubt that, in such an event, the Commissioner would require the

use of another method that directly calculates an accrued liability

independently of the plan assets. Additionally, we have held that

section 419A(c)(2) does not require the amortization of the accrued

liability.

Section 419A(c)(2) requires that the reserve funded over the

lives of the covered employees be “actuarially determined on a

level basis”. Thus, assets necessary to satisfy the employer’s- 49 -

liability may be accumulated no more rapidly than on a level basis

over the working lives of the covered employees, such that the

reserve with respect to an employee can be fully funded no earlier

than upon retirement of the employee. We conclude that the maximum

amount of the liability that may be satisfied by the reserve is the

a mount at the time with respect to which the reserve is computed

that, together with future normal co sts and interest, will be

sufficient upon retirement of each employee to pay future medical

claims of the e mployee when they become due. See, e.g., U nited

States v. Atlas Life Ins. Co. , 381 U.S. 233, 236 n.3 (1965);

Travelers Ins. Co. v. United States

, 303 F.3d 1373, 1380-1381 (Fed.

Cir. 2002); Natl. States Ins. Co. v. Commissioner , 758 F.2d 1277,

1278 (8th Cir. 1985) (a reserve is computed by calculating the

excess of the present value of future benefits payable over the

present value of future net premiums receivable), affg. 81 T.C. 325

(1983). That amount must be actuarially determined on a level

basis.

The actuarial present value of the projected benefit of each

covered employee should be allocated on a level basis to each year

commencing with the year in which the allocation is first

recognized and ending with the year the employee is expected to

retire. The funding of “a reserve funded over the working lives of

the covered employees” cannot begin until the reserve is created.

Thus, the allocation is first recognized on the later of the date- 50 -

when the reserve is created and the date the empl oyee becomes a

covered employee. Essentially, this is the individual level

premium cost method with the date of the creation of the reserve

substituted for the date the plan is instituted. When the year in

which the allocation is first recognized is after the employee has

retired, the re are no future years to which the benefits may be

allocated. Since there are no future years to which the benefits

may be allocated, there are no future normal costs, and the entire

present value of the projected benefit is properly allocated to the

first year. This is the method that Mercer used in computing

Norwest’s contribution for 1991, the year the reserve was created.

The individual level premium cost method comports wi th our

holding that the amount of the liability that may be satisfied by

the reserve is the amount at the time with respect to which the

reserve is computed t hat, together with future normal costs and

interest, will be sufficient upon retirement of an employee to pay

future medical claims of the employee when they become due. See,

e.g., United States v. Atlas Life Ins. Co.

, supra ; Travelers Ins.

Co. v. United States

, supra ; Best Life Assur. Co. v. Commissioner

,

281 F.3d 828, 830 (9th Cir. 2002), affg. T.C. Memo. 2000-134; Natl.

States Ins. Co. v. Commissioner

, supra ; Sears, Roebuck & Co. v.

Commissioner

, 96 T.C. 61, 110 (1991), revd. on other grounds 972

F.2d 858 (7th Cir. 1992).- 51 -

22 Unless otherwise indicated, all rates are rounded to the

nearest tenth of 1 percent. C. Investment Rates

The pretax and after-tax investment rates 22 Mercer used in the

1991-94 valuation reports were as follows:

1991 1992 1993 1994

Pretax rate 9.0% 8.0% 6.0% 6.0%

After-tax rate 5.5 4.9 3.6 3.6

The after-tax investment rate was determined by applying a tax rate

of 39 percent for 1991-92 and 40 percent for 1993-94.

In the notices of deficiency, respondent did not dispute the

actuarial assumptions, including the pretax and after-tax

investment rates, Mercer used in the 1991-94 valuation reports. In

an amended answer, however, respondent asserted that the pretax

investment rates used in the 1993 and 1994 calculations and the

after-tax investment rate used in the computation f or all years

1991-94 were too low.

Respondent assert s that the pretax and after-tax rates Mr.

Daskais proposed are reasonab le and demonstrate that the rates

petitioners used are unreasonab le. The pretax and after-tax

investment rates Mr. Daskais proposed are as follows:

1991 1992 1993 1994

Pretax rate 9.0% 8.0% 8.0% 7.0%

After-tax rate 6.6 6.0 5.7 4.9

M r. Daskais determined the after-tax investment rates by

applying a tax rate of 29 percent for 1991-92 and 31.9 percent for- 52 -

23 The combined tax rate for 1991-92 is computed as follows:

Starting point 100.0%

Minn. State tax at 9.8% (100 x 9.8%) - 9.8

90.2

Federal tax at 29% (90.2 x 29%) -26.2

64.0

Combined tax rate (100% - 64%) 36

24 The combined tax rate for 1993-94 is computed as follows:

Starting point 100.0 %

Minn. State tax at 9.8% (100 x 9.8%) - 9.8

90.2

Federal tax at 31.9% (90.2 x 31.9%) -28.8

61.4

Combined tax rate (100% - 61.4%) 38.6 1992-94. In our opinion, Mr. Daskais’s after-tax rates are too

high because they do not take into account the Minnesota State tax

on unrelated business income. Minnesota taxes the unrelated income

of an exempt organization at the corporate rate of 9.8 percent.

Minn. Stat. Ann. secs. 290.05, subd. 3, and 290.06, subd. 1 (West

1999 & Supp. 2003). Since State taxes paid are deducted for

purposes of Federal tax, the combined tax rate would be 36 percent 23

for 1991-92 and 38.6 percent 24 for 1993-94. Applying the combined

tax rates to the pretax investment rates Mr. Daskais considers

reasonable results in the following after-tax investment rates

(rounded to nearest tenth of a percent):

1991 1992 1993 1994

Pretax rate 9.0% 8.0% 8.0% 7.0%

After-tax rate 5.8 5.1 4.9 4.3- 53 -

The difference of 0.3 percent between the 5.8-percent aftertax rate computed for 1991 and the 5.5-percent after-ta x rate

petitioners used in 1991 is relatively minimal and does not

establish that the 5.5-percent rate was unreasonable.

Moreover, the Internal Revenue Service publishes a permissible

range of interest rates used to calculate the current liability for

purposes of the full-funding limitation for pensions under section

412(c)(7). See Notice 88-73 , 1988-2 C.B. 383. Although we are

mindful that Notice 88-73, supra

, provides that no inference should

be drawn from the notice as to any issue not specifically addressed

therein, in the absence of regulations or other guidance to the

contrary, in our o pinion rates that fall within the permissible

range of rates for purposes of the full-funding limitations on

pensions are reasonable for purposes of computing the reserve under

section 419A(c)(2).

The published range for a January 1991 valuation date is 7.77-

9.49 percent. Notice 91-5, 1991-1 C.B. 315. The income of a

pension trust is not taxable, and the interest rates provided for

purp oses of the full-funding limitation represent pretax rates.

Application of a 36-percent combined tax rate to 7.8 percent (the

lowest investment rate (rounded) in the permissible range for

purposes of section 412(c)(7)) gives an after-tax investment rate

of 5.0 percent, which we believe supports the reasonableness of the

5.5-percent after-tax rate petitioners used for 1991.- 54 -

In computing Norwest’s contribution for 1991, Mercer applied

a reasonable inv estment rate and used the appropriate individual

level premium cost method. We conclude, therefore, that Norwest’s

contribution to fund the reserve under section 419A(c)(2) for 1991

did not exceed the account limit.

Further, for years 1992-94, even using the higher after-tax

investment rates Mr. Daskais proposed of 6.0 percent for 1992, 5.7

percent for 1993, and 4.9 percent for 1994, it is clear that

Norw est’s contributions to fund the reserve do not exceed the

account limit when the reserve is computed by applying the

individual level premium cost method.

We conclude that Norwest’s contributions to the postretirement

benefit trust to fund a reserve for postretirement medical benefits

for 1991 -94 did not exceed the account limit for a reserve under

section 419A(c)(2). We hold, therefore, that in computing

petitioners’ consolidated income tax for 1991-94, petitioners are

entitled to deductions for postretirement medical benefit

contributions of $30,689,717 in 1991 , $2,170,000 in 1992,

$13,791,600 in 1993, and $12,247,933 in 1994.

To reflect the foregoing, and because othe r issues in these

cases remain for resolution,

An appropriate order will

be issued

.