Harry A. Wellons, Jr., M.d., S.c., Petitioner-appellant, v. Commissioner of Internal Revenue, Respondent-appellee, 31 F.3d 569 (7th Cir. 1994)

Cardiovascular surgeon Dr. Harry A. Wellons, Jr. set up a severance pay plan for his employees in 1983. Dr. Wellons contributed $194,000 to the trust for the plan in 1984 and again in 1985, and deducted these amounts from his income taxes as a business expense under 29 U.S.C. § 162. The IRS disallowed the deductions on the grounds that the payments were made to a deferred compensation plan within the meaning of 26 U.S.C. § 404(a) and were not deductible. The Tax Court agreed. We affirm.I.

On July 1, 1984, Dr. Wellons adopted the Harry A. Wellons, Jr., M.D., S.C. Employee Benefit Plan and Trust Agreement (the plan).¹  All employees were eligible to enroll. The plan provides a severance benefit to plan members upon termination of their employment after five years with Dr. Wellons. The amount of the benefit payable under the plan is dependent on several factors including the number of years a member has served with Dr. Wellons and the member's rate of compensation. A plan member who terminates employment with Wellons is entitled to a benefit equaling twenty-one weeks of average weekly compensation for each year of service. The maximum benefit that a member can receive is two times her annual salary for the year immediately preceding termination. Payments of benefits must be made within twenty-four months of the employee's severance. A member may forfeit her benefits if she is terminated because of dishonesty or fraud, or if she leaves to take a leave of absence or to convert to part-time employment. When the plan first became effective, only Dr. Wellons and his wife, Florence L. Wellons, were members, but two others joined in 1985.

The plan was funded through a trust which required Dr. Wellons to contribute an amount sufficient to provide for the expected benefits. No employees terminated their employment with Dr. Wellons during the relevant period; so no benefits were paid. In both 1984 and 1985, Dr. Wellons contributed $194,000 to the plan. Dr. Wellons claimed both contributions as deductions on his corporation's income tax returns as ordinary and necessary business expenses for the fiscal years ending June 30, 1984, and June 30, 1985.

The Commissioner refused to allow the deductions, claiming that the plan in question was not deductible under 26 U.S.C. § 162,²  but rather was a deferred compensation plan as defined in 26 U.S.C. § 404(a),³  under which payments are deductible only in the years when benefits are actually paid. The Tax Court determined that the Wellons plan was a deferred compensation plan and that, pursuant to 26 U.S.C. § 404(a) (5),⁴  deductions could not be made until the benefits were actually paid.

If the Wellons plan is a deferred compensation plan, then payments are not deductible, 26 U.S.C. § 404(a) (5); if it is something other than a deferred compensation plan, such as a welfare benefit plan, the payments are deductible as an ordinary business expense. 26 U.S.C. § 162. "The general characterization of a transaction for tax purposes is a question of law subject to review. The particular facts from which the characterization is to be made are not so subject." Frank Lyon Co. v. United States, 435 U.S. 561, 581 n. 16, 98 S. Ct. 1291, 1302, 55 L. Ed. 2d 550 (1978); see also Nickerson v. Commissioner, 700 F.2d 402, 405 (7th Cir. 1983). Thus we review the Tax Court's characterization of the plan de novo.

As a general rule, Sec. 162 allows an income tax deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 26 U.S.C. § 162. Section 404(a) carves out an exception to Sec. 162 for contributions to a "stock bonus, pension, profit-sharing, or annuity plan ... or a plan deferring the receipt of such compensation." 26 U.S.C. § 404(a). Contributions to a deferred compensation plan are deductible only "in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan." 26 U.S.C. § 404(a) (5).

The Code itself does not define "a plan deferring the receipt of compensation."⁵  The Treasury Regulations promulgated under Secs. 162 and 404 offer some clues. Under 26 C.F.R. Sec. 1.162-10(a) (1993), "amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare, or similar benefit plan" are deductible under Sec. 162. Dr. Wellons argues that since his plan provides both dismissal wages and welfare benefits, it is deductible under Sec. 162. But the regulations also provide that contributions to dismissal or welfare benefit plans are not deductible under Sec. 162 "if, under any circumstances, they may be used to provide benefits under a ... deferred compensation plan of the type referred to in Sec. 404(a)." 26 C.F.R. Sec. 1.162-10(a). Since, for reasons explained more fully below, the Wellons plan at least in some circumstances, appears to be a deferred compensation plan, we must analyze this case under Sec. 404(a) and related regulations.

The regulations under Sec. 404 likewise distinguish between welfare benefit plans and deferred compensation plans that share some of the characteristics of welfare benefit plans. Section 404(a) does not apply to contributions to a plan that is "solely a dismissal wage or unemployment benefit plan, or a sickness, accident, hospitalization, medical expense, recreation, welfare, or similar benefit plan, or a combination thereof." 26 C.F.R. Sec. 1.404(a)-1(a) (2) (emphasis supplied). The regulations give an example: " [I]f under a plan an employer contributes 5 percent of each employee's compensation per month to a fund out of which employees who are laid off will be paid benefits for temporary periods, but employees who are not laid off have no rights to the funds, such a plan is an unemployment benefit plan." Sec. 1.404(a)-1(a)2. Wellons argues, that if his plan is a welfare benefit plan, the game is over and he wins: the contributions are not subject to the limitations of Sec. 404(a) (5). But on its face, the regulation exempts only those plans that are nothing more than welfare or other enumerated plans. Wellons' plan operates somewhat differently, in that payments are made to all employees after a certain period of time, regardless of the reason for termination. Moreover, the regulations go on to provide that, when a plan has features of both a welfare benefit and a deferred compensation plan, the entire plan is evaluated under Sec. 404(a). 26 C.F.R. Sec. 1.404(a)-1(a) (3).

The central question in applying these regulations, then, is whether Dr. Wellons' plan has any features of a deferred compensation plan, or whether it is solely a welfare benefit plan. On its face, Wellons' plan seems more akin to a pension plan than to a plan providing benefits corresponding to those listed alongside "welfare" benefits in 26 C.F.R. Sec. 1.404(a)-1(a) (2). The instant plan is most akin to an arrangement providing either dismissal wages or unemployment benefits, but even these categories are obviously intended to apply narrowly in limited circumstances, and these plans operate more as insurance in case of a contingent event than as a guarantee of income upon a certain event. Wellons plan, by contrast, covers all employees who leave his employment for whatever reason. Similar to a pension plan, the benefits vest after five years of employment and are commensurate with salary and length of service. The Tax Court has previously found these to be the hallmarks of plans subject to Sec. 404. New York Seven-Up Bottling Co. v. Commissioner, 50 T.C. 391, 1968 WL 1531 (1968); Grant-Jacoby, Inc. v. Commissioner, 73 T.C. 700, 715, 1980 WL 4499 (1980) (held that an educational benefit plan for children of employees was governed by Sec. 404 rather than Sec. 162); New York Post Corp. v. Commissioner, 40 T.C. 882, 1963 WL 1423 (1963) (contributions made under severance pay provision of union contract deductible under Sec. 404). The severance pay plan at issue in New York Bottling Co. provided any terminated employee who had served more than five years with one week of pay for each year of service. The Tax Court held that this plan fell within the scope of Sec. 404(a), and the employer could not deduct unpaid liability. The Tax Court could have been describing the Wellons plan when it remarked "the plan in New York Seven-Up was similar to a pension plan in that the right to receive benefits vested after a certain term of employment, the extent of benefits was related to years of service, and the receipt of benefits by the employee would not begin until after termination of his employment." Latrobe Steel Co. v. Commissioner, 62 T.C. 456, 467, 1974 WL 2696 (1974).

In Latrobe Steel, the Tax Court narrowed the application of Sec. 404(a) to deferred compensation plans which are similar to pension, profit-sharing, stock bonus, or annuity plans. Congress effectively reversed Latrobe Steel by amendment in 1978. Prior to the amendment, the deduction rules of Sec. 404(a) applied to pensions or "similar" deferred compensation plans. 26 U.S.C. § 404(b) (1978).⁶  The amended code applies Sec. 404(a) to pensions or "other" deferred compensation plans. 26 U.S.C. § 404(b). The House Report makes clear that the amendment intended to maintain the broad coverage of Sec. 404: "the bill clarifies current law by providing that a method of compensation or employer contributions having the effect of a plan deferring the receipt of compensation does not have to be similar to a stock bonus, pension, profit-sharing, or annuity plan to be subject to the deferred deduction timing rules." H.R.Rep. No. 95-1445, 95th Cong., 2d Sess., at 61, reprinted in 6 U.S.C.C.A.N. at 7098 (1978).⁷  There may often be some overlapping features in welfare benefit plans and deferred compensation plans. But the regulations very clearly direct us in those circumstances to apply Sec. 404(a), including Sec. 404(a) (5)'s limitations on deductions. The Wellons plan is more akin to a deferred compensation plan than the sort of "welfare benefits" arrangement contemplated by the regulations. We therefore agree with the Tax Court that contributions to the plan are governed by Sec. 404(a), and that the Commissioner properly disallowed the deduction under Sec. 404(a) (5). The decisions of the Tax Court are therefore AFFIRMED.