WASHINGTON-The Travelers Group's much-ballyhooed plan to set up an innovative stock option program linked to its 401(k) plan is on hold-at least temporarily-after second thoughts by the Internal Revenue Service.

The proposed program had received widespread attention from other employers, consultants said (BI, March 31).

But in an announcement released last week, the IRS, which had earlier issued a favorable private letter ruling, now says it is "re-examining the plan qualification and other tax issues" under the tax code raised by the proposed program.

An IRS spokesman had no additional comment.

In addition, the Department of Labor, which also had been expected to give its blessing, now says it will need much more time to evaluate the Travelers proposal. A department official noted there are strong feelings for and against the plan within the department.

A Travelers spokesman would say only the company is awaiting word from the IRS and Labor Department.

Benefit consultants, who say it is rare for the IRS to revoke an approval, speculate the agency has been surprised by the intense interest the program has generated and as a result only belatedly realized the negative impact its tax aspects could have on government revenues. They also speculate that the issue was mistakenly handled by low-level, technical employees instead of at the agency's policy-making level.

Some observers, though, are optimistic that at least some version of the program will survive.

"Given the publicity that has been surrounding the issue, it's hard for

the IRS just to revoke it completely and not come up with something," said Dick Joss, resource actuary with Watson Wyatt Worldwide in Bethesda, Md.

It depends on the government's attitude, said Fred Rumack, director of taxes and legal services at Buck Consultants Inc. in New York. If it decides to do so, "it can kill it," he said.

On the other hand, if "people take great pains to make it clear why it should be workable, they may agree to do it with some modification," said Mr. Rumack.

"If it does survive, I think it'll probably be a joint effort by the IRS and DOL to sort of sculpt out certain requirements to protect both the employee as well as the Treasury," said Joel Rich, senior vp at The Segal Co. in New York.

Under the proposed program, Travelers would contribute stock options to its 401(k) plan for all eligible participants. As proposed, Travelers would contribute stock options equal to 10% of an employee's compensation, up to $40,000 of compensation. The options would give employees the right to buy Travelers common stock at the closing price on the day before the option is granted.

Travelers would be able to obtain an immediate tax deduction for the fair market value of the options.

Employees would not be taxed when they received the options or when they exercised the options and received the shares. Even if employees sold the shares and the proceeds stayed in their 401(k) plan accounts, they would not incur any tax liability.

Observers believe one major sticking point for the IRS here could be employers' ability to obtain an immediate tax deduction for the fair market value of the options, even if the stock options are never actually exercised. This also would not take into account what the options ultimately become worth, say observers, who note there are limits as to how much employers can contribute on behalf of employees.

The more usual approach would be to wait until the option is exercised to determine its tax consequences, said Russell Hall, a principal at Towers Perrin in Valhalla, N.Y. If the IRS is having second thoughts about this aspect of the program, "I don't think there is any way they could rehabilitate this."

This issue could be a "deal killer," agreed John Keegan, senior research attorney with Aon Consulting in Newburyport, Mass.

Another possible problem the IRS could have is that the program would only allow employees to exercise options at the rate of 20% a year.

Consultants say this is comparable to the no-longer-allowed "rolling class year vesting" under which employees only gradually become vested in funds contributed by employers. Under the current standard, employees who put in the appropriate service period immediately become fully vested.

This is a technical issue, though, that could probably be resolved, say consultants.

"That can be tweaked and massaged," said Mr. Keegan.

Meanwhile, the IRS' reconsideration has left many in the benefits arena miffed and frustrated. Many consulting firms put considerable effort into studying the program, said Watson Wyatt's Mr. Joss. "Hopefully in the future they would get it right the first time, whatever right is," he said.

There are precedents, though, for the IRS dramatically reversing itself on employee benefit rulings. In 1985, for example, it gave its blessing to an arrangement that would have allowed employers to transfer assets-tax-free- from overfunded defined benefit plans to defined contribution plans, such as 401(k) plans, without terminating the defined benefit plans. The transferred assets would have been used to match employee contributions to the 401(k) plan.

But the IRS, in the wake of widespread publicity about its earlier approval of the arrangement-contained in a general information letter to Buck Consultants-revoked its position on asset transfers just weeks later.