Whodunit

The Senate Finance Committee addresses some of the problems created by Section 89 of the tax code.

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It may be the most ill-conceived piece of legislation to come out of Washington in a decade. Will whoever is responsible for Section 89 please stand up?

Unable to sell direct taxation of benefits to Congress, Treasury came up with the next best thing: a test to see if a company's benefit plans are "discriminatory." Simple? Not according to the people who have to administer it. "Whodunit" describes the improbable but successful small-business campaign to modify Section 89. -- J.F.

It looked like a scene from the Iran-Contra hearings. The unruly throng of witnesses and lobbyists stretched down the corridor of the Longworth House Office Building and disappeared around a corner. Uniformed Capitol Hill police scrambled to maintain control. When the doors finally opened to the cavernous hearing room of the Ways and Means Committee that morning in early May, the crowd surged in as though to a heavyweight title fight.

Inside, TV crews were turning on the klieg lights. Print journalists sprawled across two large tables and besieged staffers for copies of testimony. Members of the committee settled into place behind their panel. Among the standing-room-only audience were leading activists of the small-business community, who had flown into Washington from all over the country. The hearings stretched over two days, only to be replayed a week later before the Senate Finance Committee.

The cause of the tempest is an arcane tax law known as Section 89. Under the law, company benefits have to meet certain standards regarding availability and coverage to retain their tax-favored status (see The Law, "Who Benefits?," January 1989, [Article link]). The statute applies to health plans, life insurance, group legal services, tuition assistance, child care, cafeteria plans, even parking spaces. As originally concocted, Section 89 marks the deepest federal intrusion yet into the complicated realm of employee benefits. What's more, compliance is maddeningly complex, so much so that some critics have estimated its cost will be as high as $5 billion. Business owners nationwide are asking how such an obviously flawed piece of legislation became law in the first place.

Section 89 emerged from the warfare that accompanied the creation of the giant Tax Reform Act of 1986. Ironically, it sprang from the administration of President Ronald Reagan, who opposed everything Section 89 represents.

In November 1984, right after Reagan's reelection, the Treasury Department filed its report to the President on fundamental tax reform. The so-called Treasury I plan called for the taxing of employee benefits. They were eroding the tax base, the department argued, forcing higher rates on cash income. Treasury I proposed to bring in $50 billion over five years by capping the exemption on employer-provided health insurance at $70 a month for single coverage and repealing tax breaks on life insurance, tuition assistance, and other benefits.

That idea didn't sit well with Oregon Republican Bob Packwood, then chairman of the Senate Finance Committee, the Senate's primary tax-writing authority. Packwood liked the idea of tax-free benefits, even though they cost some $30 billion to $40 billion annually in forgone revenue. The exemption was an appropriate way, he thought, to take care of workers.

Regrouping, the Treasury Department came back in 1985 with Treasury II, Reagan's official tax-reform proposal. Direct taxation of benefits was essentially gone. But in its place was the concept of nondiscrimination. The underlying idea, Treasury II made clear, was to allow tax exclusion only for plans that "fulfill important social policy objectives." In short, companies could be penalized for providing gold-plated plans for executives while offering rank-and-file workers substantially less.

While there was some grumbling about yet more federal red tape, the business community -- relieved to have fought off any direct taxes on benefits -- moved on to the bigger battles being waged. "The elimination of the graduated corporate income tax -- that's what hit you in the face when you looked at the bill," Ohio attorney and construction-company owner James H. Lagos, a past president of National Small Business United (NSBU), remembers. "We had a lot of things to worry about."

And so unbeknownst to Lagos, to the business community at large, and to virtually every member of Congress as well, hidden deep inside the final 925-page Tax Reform Act -- like a computer virus programmed to take effect January 1, 1989 -- was the obscure Section 89, so named for its position in the U.S. Internal Revenue Code. It is incredible, considering the massive new compliance burden it would place on business, that Section 89 slipped through without a single dedicated hearing.

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