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LEGAL ISSUES

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.

There are, to be sure, certain inside operators who understand precisely what Section 89 is all about -- the people who wrote it. One such operator was attorney Kent A. Mason, working in the Treasury Department's Office of Tax Policy. Mason was 30 at the time he was drafting the nondiscrimination language for Treasury II. When Reagan sent the plan to Congress, Mason shifted his energy to Capitol Hill, to help push it through. After the Tax Reform Act became law, he joined the staff of the Joint Committee on Taxation. It is Joint Tax that estimates revenues accruing from new tax laws. In the case of Section 89, it projected about $150 million a year, to be derived chiefly from taxes on discriminatory benefits.

In authoring Section 89, Mason proceeded under the belief -- disputed strongly by some benefit-research groups -- that corporate fringe benefits are unfairly distributed. Section 89, Mason explains, "is an effort to cut back on what is significant unfairness in the tax code. It's not just a revenue issue; it's a fairness issue, about how the tax burden ought to be distributed."

The process of correcting this unfairness, Mason and others concluded, would also help solve a problem causing great consternation in Congress -- the 37 million Americans without health insurance. Companies with health plans would be forced to broaden them to lower-paid and even part-time workers or face severe tax penalties.

* * *

The premise was simple enough. The details, however, made it a nightmare. They require all sorts of data collection, analysis, and testing. Compliance has to be continuously monitored and reaffirmed annually. The law applies to all companies, big and small alike, to nonprofits, to universities, to government agencies at all levels, including even school boards. Compliance is so onerous and burdensome, so complex and costly, critics argue, that it might bring about the exact opposite of the intended effect: companies could be tempted to drop their health plans altogether rather than try to comply.

Given its two-year fuse and its decidedly unsexy nature, Section 89 was slow to sink into the corporate consciousness. But by late 1988, as accountants and benefit planners started explaining the new rules to their clients, pockets of outrage began to develop around the country. This time Congress had gone too far.

The new law so puzzled the Internal Revenue Service -- the actual enforcer -- that by the New Year's Day start date, regulations were nowhere in sight. Companies trying to comply staggered through a nearly unsolvable maze. When regs finally did appear in March, they filled scores of pages of the Federal Register with small print, in language so dense and turgid that only a masochistic lawyer could love it. All told, the IRS announced, Section 89 would pile on the nation's employers some 9 million hours of paperwork -- congressional analysts believe the IRS estimate should be at least five times higher, or about 22,000 worker-years -- just so they could prove what most of them already knew: that their benefit plans did not discriminate against non-highly compensated employees.

* * *

Months earlier, complaints had begun pouring into the office of Rep. John J. LaFalce, a New York Democrat and chairman of the House Small Business Committee. LaFalce has fought hard for small business causes. Stunned by the ferocious reaction to the new law, he searched for an explanation. "I have talked to members of Congress," he says. "I said, 'Well, who authored Section 89?' It's a mystery. No one will claim responsibility for authoring Section 89."

In fact, few had even heard of it. Even those close to the health-insurance issue professed ignorance. Consider Sen. Dave Durenberger, a Minnesota Republican. He had been chairman of the Health Subcommittee of the Senate Finance Committee when the Tax Reform Act was written. He was unaware of the crushing impact of Section 89, he admitted to one lobbyist, until he ran for reelection in 1988. Then he got an earful from enraged constituents.

Kent Mason insists that one man who knew about it was Rep. Dan Rostenkowski (D-Ill.), the blustery chairman of Ways and Means. "I can't say he memorized every single provision," Mason says, "but he certainly was aware of the general concepts."

It was in the little provisions of the statute, however, that the real damage lay. For instance, if a company that fails the qualification tests for its health plan pays out $100,000 on behalf of an employee with a catastrophic illness, that money could become taxable income for the employee. Plans could even fail the employee-participation rules and become subject to heavy tax liability if too many workers refuse coverage. "Whoever wrote the thing certainly had no understanding of small business, the complexities of benefits, or the health-insurance industry," Alice B. Griffin, president of Griffin Pension Services Inc., in Hamilton, Mass., complains.

The more LaFalce learned, the more atrocious Section 89 looked. "Some individuals have said it's like throwing an atomic bomb at a suspect anthill," he observes, "and missing the anthill." And so early last January, LaFalce began making noises about remedial action. There was, however, one giant obstacle: Rostenkowski. One of the most powerful members of Congress, "Rosty" was known to want no part of tampering with the Tax Reform Act. It had involved too much delicate compromise. Controversy surrounding it had been so extreme that Rostenkowski, Packwood, and other Hill power brokers had cobbled the thing together behind closed doors. It was inviolate as well as fragile. Pulling any thread could unravel the whole thing.

* * *

By the government's original estimate, Section 89 would bring in only $150 million a year -- an amount so puny as to be almost ludicrous by congressional standards. And who knew what compliance would cost? Some estimates, remember, pegged it as high as $5 billion in deductible expense. It might be a net revenue loser. Still, the $150 million was an integral part of the tax-reform whole. If La-Falce messed with Section 89, Rostenkowski reportedly warned, he might reopen the entire issue of tax reform.

There are few committee chairs who would dare challenge Rostenkowski. And certainly the Small Business Committee is small potatoes compared with Ways and Means. But LaFalce was not easily intimidated. He had voted his conscience before against party pressure. So he pressed on, introducing a repeal bill on January 24.

Perhaps LaFalce was emboldened by the fast-rising support. His bill had 45 cosponsors right off the bat, and the effort had plenty of reinforcements elsewhere. The National Federation of Independent Business launched a repeal drive of its own and quickly enlisted 70 other organizations, representing millions of small businesses. They issued Mayday alerts to their forces across the land. Within two weeks, as irate company owners pressured their legislators, the bill had 112 cosponsors. More signed on as LaFalce paraded witnesses before the House Small Business Committee. They told one horror story after another.

Earlyn Church, co-owner of Superior Technical Ceramics Corp., in St. Albans, Vt., has fewer than 100 employees. But Section 89, she testified, had already cost her company $23,250 for legal and accounting fees, software, and analysis. In addition, she'd been forced to hire a personnel manager at $28,000 a year, plus 40% for fringes, to shoulder the ongoing compliance requirement. Another witness cited a company with 50 employees that paid $60,000 to a consultant to see if its plans met the guidelines. The upshot? The company was advised to impute an additional $4,000 worth of income to its higher-paid people.

The repeal bill passed a milestone on March 17, when it garnered its 218th cosponsor, giving it a majority of the House, enough for passage if it reached the floor. But since the bill affected taxes, it would first have to clear Ways and Means, and Rostenkowski was holding firm. Lobbyists began exploring various mechanisms to spring the bill out of committee. There was talk of a discharge petition, a rare maneuver that would amount to a declaration of war against Rostenkowski.

By April 13, with the list of cosponsors approaching 300 and its momentum seemingly unstoppable, Rostenkowski had seen enough. He came forward with a bill that amounted to de facto repeal of Section 89 -- stripping it of all benefits except health care and making compliance easier, understandable, and relatively inexpensive.

But not painless. In fact, it was the various components of Rostenkowski's proposal that drew such intense small-business interest at those Ways and Means hearings in early May. Would it include part-timers? Would it cap employee-paid portions of health insurance at too low a threshold? Would it take into account the fine points of cafeteria plans? The complexities seemed endless as one witness after another stepped up to the microphone.

* * *

Those questions remain unresolved. By and large, Rostenkowski and Senate Finance Committee chairman Lloyd Bentsen will determine the fate of the new Section 89 in conference this summer. The final version will likely become law as part of budget-reconciliation legislation, probably by September. Total repeal, meanwhile, remains a possibility. In any case, Treasury Secretary Nicholas F. Brady has delayed IRS implementation of Section 89 until October.

So small-business advocates are celebrating -- and for good reason. The Rostenkowski retreat is as improbable an outcome as one can imagine. "If you had said last year that Section 89 would be radically changed, you'd have been laughed out of town," lobbyist Allen Neece told about 200 NSBU leaders in April, as they rallied in Washington for their onslaught. "Rostenkowski has been brought up short. And it was your pressure on Congress that made all the difference. The lobbyists were making no headway until the constituents became enraged."

Yet even as the specific problems created by Section 89 are being addressed, questions about how it originated in the first place won't disappear so readily. Consider the number of players involved in the legislative process in Washington. There are some 19,000 congressional staffers; most have, at best, a dim understanding of business realities. "I worry about the increasing complexity and micromanagement of the economy by Congress," says Frank Swain, chief counsel for advocacy at the Small Business Administration. "The mushrooming of staff is a major factor. They'll say they're just carrying out the wishes of their bosses, but they're doing so with much greater specificity and exactitude than 20 years ago. It reached the level of a science with Section 89."

Finally, we return to Kent Mason, the man who touched off the storm. In October 1988 Mason left the government to join a private Washington law firm. Until the Rostenkowski reversal, he was doing a land-office business in -- you guessed it -- helping businesses cope with Section 89.


SECTION 89: NEW AND IMPROVED?

The proposed revision of Section 89 of the tax code is a far cry from the original

THE ORIGINAL SECTION 89
1.
Applies to all benefits except pensions.

2. Covers anyone working more than 17.5 hours per week or six months per year.

3. For a simple plan, there is a simple test. If a plan benefits 80% of lower-paid workers, it does not discriminate. Eligibility is not enough, however; 80% must be actually enrolled. If an employer has one plan for single persons and another for families, those are considered separate plans. Benefit plans that can't pass this test must pass three other tests to be in compliance. Otherwise, highly compensated employees (HCEs) must pay tax on the discriminatory portion of the premium.

The 50% test. For each benefit offered, lower-paid workers must comprise at least 50% of all employees eligible to participate. Companies with more higher-paid than low-paid employees pass the test if all workers are eligible for each benefit. The intent: to shut down executive-only plans.

The 90%-50% test. At least 90% of a company's lower-paid workers must be eligible for benefits at least half as valuable as those available to its most highly compensated employees.

The average-value test. Lower-paid workers' benefits must equal at least 75% of the average value of benefits if they are provided to HCEs.

4. Five general rules apply to all benefits: the plan must be in writing; it must be legally enforceable; employees must be notified of plan benefits; plans must be for the exclusive benefit of workers; and employers must intend to maintain them indefinitely. Otherwise, employees are taxed on the value of actual benefits received.

5. All current employees must be tested together with potential exceptions for separate lines of business.

6. At least the highest-paid officer is automatically considered highly compensated regardless of salary, as are officers who own more than 5% of the company's stock.

7. Compliance must be continuously monitored and reaffirmed annually.

REP. DAN ROSTENKOWSKI'S PROPOSAL

1. Applies to health benefits only.

2. Covers anyone working more than 25 hours per week.


3.
A plan will pass muster if it is not discriminatory "on its face" and if it is available to at least 90% of a company's lower-paid workers at a weekly cost to employees of no more than $10 for single-person coverage or $25 for family coverage, indexed for inflation. Highly compensated employees must count their benefits as taxable income if their company-paid premiums were greater than 133% of premiums paid for most lower-paid workers.

4. The same general rules apply, with different penalties. If the company fails to comply with any of the qualification rules, it must pay a 34% excise tax on company-paid premiums.

5. Union employees may be tested separately.

6. HCEs are defined as they are in the current Section 89, but officers are not automatically considered highly compensated as long as they earn less than $45,000 per year.

7. Compliance may be reaffirmed annually.

Last updated: Jul 1, 1989




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