Pension Plan Terminations: Effectiveness of Excise Tax in Recovering Tax Benefits in Asset Reversions

Published by the Government Accountability Office on 1990-07-13.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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GAO          Wmhington.   D.C. 20!348

             Human Rewurces Division

             July 12. 1990

             The IIonorabIe .J.J. Pickle
             Chairman, Subcommittee on Oversight
             CommittcV on Ways and Means
             IIWSC of Representatives

             War Mr. Chairman:

             On ,\pril 12. 1989, you asked us to evaluate the 1S-percent excise tax
             levied on employers who recover excess pension assets by terminating
             cr.~funded pension plans-called aset reversions. Iiexwgnizing that
             normal corporate income taxation may not offset tax-subsidized gains
             (fas benefits) generated through reversions. the Congress imposed a
              1O-percent excise tax on reversions in 1986 and increased it to
             15 percent in 1988. However, you expressed concern about the ade
             quacy of the current excise tax in recovering the tax benefit portion of
             reversions that arises from preferentia’ :IX treatment.

             II’e agreed to estimate the excise tax rates that would offset the amount
             of the tax preference for a sample of reversiorrs. In Kovemher 1989,we
             issued an interim report on our preliminary estimates for a sample of
              18 terminations for reversion that occurred in 1988.1In this study. we
             examine the effectiveness of the excise tax rate in recovering tax bene-
             fits for 55 selected asset reversions. This review expands on the results
             we previously reported and reports similar findings.

             To encourage savings for retirement, tax policy favors defined benefit
Background   and other pension plans. A defined benefit plan promises to pay a cer-
             tain benefit. based on a specified formula, to each participant at retire-
             ment. Consequently, such plans prefund to assure that adequate
             resources are available when participants retire.’

             Although employer contributions to taxqualified plans are tax deduct-
             ible, the essence of the tax preference stems from permitting investment
             earnings from pension trusts to accumulate tax free. The favorable
             treatment granted to the accumulated earnings in qualified pension

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                        Many iwsumpti(bm are used in funding wnsion plans. includingcsti-
                        malrs of         of rWllrn on plan ass4Wand. in most cases,assumptions

                        ilblllt        incrwses. Often. plan sponwr3 use conservative assumg

                        tions iIb)ut investment earnings in c%timating the contributions neces-
                        sary to meet the plan’s prr$wcd liability. Corwrvative assumptions
                        about earnings increase the amount required to prefund the liahility.
                        \Vh~n st(H:k and bond markets rally. plans that have been generously
                        fundt>d according to consen’afivc rates of return can experience a dra-
                        math* growth in assets, A spom+)r might then tcrminatrr the plan and set
                        ;tside money to cover a liability limited to the benefit each participant
                        had carncd to date. instead of the long-term liability for which it
                        prefunded. The excess amount or “surplus” realized can be

                        One rtquirtXmt~nt for a pension plan to qualify under the Internal Rev-
                        enue Code is that sponsors intend to maintain the plan permanently.
                        Ifowevur. federal law permits sponsors to terminate their pension plans,
                        pay each participant only the benefits rhat have accrued up to the ter-
                        mination date. and keep all residual assets. Some employers voluntarily
                        terminate their overfunded defined benefit pension plans and use the
                        csccss fends for nonpension purposes. Since 1980, it is estimated that
                        rcvcrsions by employers in this way have amounted to over $20 billion..i
                        Among our 55 sample cases,the current 15percent excise tax was not
     Results in Brief   high enough to offset the tax benefit portion of pension asset reversions.
                        Otrr analysis assumed that the cr,mpanies in our sample paid historic
                        maximum statutory tax rates. We estimated that the excise tax rate
                        required to recapture tax benefits exceeded 15 percent in all 55 cases.
                        The precise escise tax rate needed to offset tax benefits varied widely.
                        -4ccording to our analysis, the excise tax rates necessary to fully offset
                        pension tax benefits ranged from Ii to 59 percent (see app. I).

                        These offsetting excise tax rates were very sensitive to variatkms in the
                        w-?y different types of income were tased. Plans that primarily obtained

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                                    their investment inrrnne from sources normally subject to the maximum
                                    hr;ttrnory tas rate. such as interest from curporatc bonds. had the
                                    highest offsetting tax rates. Conversely, plans that mainly derived their
                                    income from sources normally subject to the lower rapital gains tax rate,
                                    sut-h ;ts stock prirc appreciation, had the lowest offsetting tax rates.

                                    \\I* iris) crmducted two sensitivity analyses on the offsetting excise tax
                                    tatrs ;Ls!!uming the current statutory tax prdsions and historic
                                    ~nriust~-wide average tax rates. The sensitivity analyses yielded similar

                                    Ikt~d tm agreements with your representatives. this report provides
Objective, Scope, and               information on the excise tax rates needed to offset tax benefits
Methodology                         embedded in a sample of asset reversions. In conducting our analysis,
                                    we reviewed 55 cases from the universe of 202 pension plans with
                                    reversions for S1 million or more that terminated or announced their
                                    inccnt to terminate in 1988.~Using simulated investment portfolios, we
                                    ~al~\rlated an offsetting excise tax rate for each case. For the purpose of
                                    this study. the offsetting excise tax is the rate that equated the rever-
                                    sion’s after-tax vahie with the balance that would have existed had the
                                    sut-plus assets been invested the same way and taxed.

                                     +veral recent legislative proposals, in pursuit of policy objectives such
                                    as protecting workers’ retirement income, have sought to prohibit or
                                    restrict asset reversions, or to use the reversion excise tax to deter
                                    revcr+nns more effectively. In this review, however, we consider only
                                    f he excise tax rate’s effectiveness at recovering pension-related tax

                                    The excise tax rate required to offset or recapture pension tax benefits
                                    depends on an employer’s income tax liabilities. which in turn are based
                                    on marginal tax rates.” However, we did not know the actual tax rates
                                    paid by plan sponsors. Therefore, our estimates used the maximum stat-
                                    utory tax rate that prevailed from 1975 to 1986, when the plans in our
                                    sample accumulated their excess pension assets.
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                                  1. ..I fiscd US rate ~)f:1-I percent. TI!is prospective analysis usesthe cur-
                                  rt-nt maximum statutclq taCEte in conjunction wit!* ine prt5ent tas

                                  retlvct f!itb excisetaws
                                  trcatmcnt {In capital gains and dividcncls. These estimates may better
                                                             necessary for plans that develop cxccss zz*bts
                                  undw currrnt statutory tax stipulations.

                                  2. Ilistoriv average tax rates. This approach uses estimated industry-
                                  ~vide avcrap tax rates for each year of the period we amdyzed. Average
                                  I AS rates ;lrc lower th;in !he statutory rates because they take into
                                  ;lccount the use of tax credits and deferrals. These rates may better
                                  rvflcct the tax position of firms and also give us a lower bound on our
                                  cst imates.

                                  Our review was done in accordance with generally accepted government
                                  ;ulditing standards. As requested by your office, we did not obtain
                                  ivritrsn comments on this report. but WCdid discuss our methodolog,v
                                  \vit h officials from the Pension Benefit Guaranty Corporation ( PHCC
                                                                                                      j and
                                  the Departments of Labor and Treasury. A morr detailed discussion of
                                  our methodology is provided in appendix II.

                                  According to our analysis, the IS-percent excise tax failed to fully
     Current Excise Tax           recapture tax benefits from any ass43reversions in our sample (see
     Rate Not High Enough         fig. I 1.Offsetting excise taxes are estimated using circumstances that
     to Offset Tax Eknefits       arc particular to each plan and employer. We estimated that the escise
                                  tits rate sufficient to offset tax benefits ranged from 17 to 59 perct-nt.
                                  ~rnrmp our 5.5cases. the escise tax rate needed to recover pension tas
                                  bcbncfits I 1) averaged about 37 percent, (2) had a median rate of 39 per-
                                  cent. and (3) equaled or exceeded

                              . 20 percent    in   53 cases (96 percent).
                              - :jO percent   in   41 cases (75 percent).
                              l $5 percent    in   34 cases (62 percent), and
                              l 45 pcrccnt    in   15 cases (5 percent).

                                  PIBe   4                               GAO’ HRIbWlzd   Taxing        of Pen&on   Plan Trrmlrudoiu

Figure 1: Offrettlng  Exclrc Tax Rates
AssocuNtd     With Histonc Slatutory Tax

Plan Asset Allocation                      the incomr. As ;I result.   the excise tax rates newssay to 4tffwt tas bvntr-
Influenced Offsetting                      fits wew very sensitive     to the types of investment  instnlmcnts that
Excise Tax Rates                           wre held in the pension trust. Plans that obtain much of their income
                                           from WII~WSthat receive the least favorabk treatmcm tmder rhc tas
                                           wdr rcwd to have the highest offsetting tax rates. FIR-csampk. t hc
                                           r(~v~~sion~its~‘swith the two highest offserring cwiw tax rat<%I 55 and
                                           39 pvr~~w rcspwti\-cly) on average reccivvd abwt 8(t pw+wnt of f hr,lt
                                           invvstmrbnt inccbmcfrom interest-bearing vchiclvs. such :LSccqwratc
                                           bonds. t Ililt ;1rc’wbjcct to full tasation (ivith no cwhlslon~).
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            *’-. Ttw amrnlnt of timt. escess asets were tas-sheltered in the pension
            trust. Plans that heldyxcess ;issets the longest and thercbv continued
            gtncratmp tas bvnrfits t hc longest accumulated more tax benefits
            t hrrmgh rc*vcrsions. Thercforc. plans that retained esc’eszs
                                                                        assets longe%
            ~t~nerallg needed rciat+ly higher excise tas ratw to offset tax benefits.

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            ‘l‘ht~ asset rcvcrsirm phenomc~nctnh;rs gcncratcd considerable discussion
Cmclusion   ;trntu1g t~Gcyrnakcrs and pnsion esperts. Tax policy favors defined
            benefit and other pension plans to encourage employers to provide
            ret n-emtInt income security for workers. The special tax treatment asso-
            ciated with pension plans cause’ssignificant federal revenue losses.
            \V hen re\crsions rrccur. there may be no commensurate gain in income
            5ccurit)’ for workers.

            So fixed-rate esclse tax will prcQs44y recapture tas benefits from all
            reversions. X single-rate tax IS not responsive to the underlying vari-
            abltbs that gi\.r rise to tas benefits. Two of these factors-asset   alloca-
            tion and rates of return-fluctuate      often. Thus, no single tax rate will
            recapture Al tas benefits and only tas benefits from every reversion.

            A schedule of rates is likely to recover tax benefits more accurately than
            a fised tas. A schedule ur “rough justice” table of excise taxes would                             .
            take into account the factors that affect offsetting excise taxes. This
            tvould require employers to select a rate that best approsimates their
            particular circumstances.

            Page g                           GAO   HBD9@126   Tuing   ot Pm&w~   Plam Tcmkution*       .
Page 7

FtKXIntwnal Revenue &nice
    Pmsion knefit Guaranty C0rporation
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                                 Page 9
pp!‘~~\   !

>ffsetting Excise Tti Rates
‘or 55 Reversion Cases

                                  -Oftt~t$g        s_xch*rLals     [percent)   assuminq
               Excess                     Hlrtonc                 Historic                  Current
               assets                 statutory                   avemge                  statutory
               (thousands)            ial    fates               tar iates
                                                                                          tax rates

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                                                                                          (cant wed)
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                                                      Otfuning     excise      tair rate lcmcent)   arwm
                asrettr                                  8mutofy
                                                          rates rvemgo5tamt
                                                          Historic                       Histolic


                 4400                        19
                                            ---.. ~-~
                                             ~-_. _ -. -_~---
                                                                                                                 tar -f8t

                 5cKJo       . _~  45
                                   41        26
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                  976                                                                          31

                 12560~            42        26

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                                             23-                  37                           22
                     _ _._~~
                 22Tioo   ~.--_---.__-
                                   50     ~~-_-
                 26iti             31
                                   ~-.       10
                                                                                               22     _.--

                 4052929 577
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                $:19.645            35
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                                    26 ,_~-- 21

                 ‘Less than 1 oercenl

                               b~~%ive, Scope, and Methodology

                                                     The Chairman of the Stbctrmmittcu on Oversight. f Iouse Committc! oti
                                                     \Vays and Means. exprcsscd concern about whether the current excise
                                                     tas rate is sufficient to recapture the portion of asset rcvcrsions that
                                                     results from tas benefits. Xt the CkG-rnan’s request, we csamined
                                                     recent reversions to assess the effectiveness of the IS-percent excise tag
                                                     in recapturing the financial gains that resulted from the tax-free
                                                     accumulatmn of pension fund earnings.

                                                     We examined empirical financial performance data from the universe of
                                                     pension plan reversions for %1 million dollars or more in which the plan!
            fi                                       terminated clr announced their intention to terminate in 1988. From this

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                                                     universe of 202 plans. we randomly .sclected 14s reversion cases. We
                                                     rxcluded 3.5plans with fewer than 100 particiPants, because their Form
                                                     5.500 t eports did not require the level of detail needed for our study.: WC
.                                                    diminated the other plans because the Form 5500 information was not
       d                                             available. Sufficient data were available on .iFj plans to conduct this
1 . r;                                               analysis. Our rcsufts are not representative of the universe of plans wit1
_                                                    ahstatreversions because the study is bawd on a limited sample. Conse-
                                                     qutbntly, we did not perform tests of statistical significance.

                                                     N’e designed a simulation modet to calculate the offsetting excise tax for
                                                     individual rcvcrsion cases. For the purposes of this study, the offsetting
                                                     cscise tax rate is the rate that would have left employers no better off
                                                     financially than if the surplus assets k,ad earned the pension fund’s
                                                     pretas rate of return in a nonpe-.;ion fund. Our model generated an
                                                     alternative investment scenario that differed from the actual experienct
                 .                                   t)f the Pension trust only in the imposition of tax liabilities it would haw
                                                     incurred had it paid taxes each year. For each reversion case, we calcu-
                                                     lated the balance that would have existed were the same flow of excess
     . 1’                                            funds trcatcd as identical taxable corporate investments.

                                                      In a manner comparable to an rndividual retirement account, the tax
                               Income Tax            treatment of pension trusts permits employers who terminate for rever-
                               Advantages Examined   .smns to augment their after-tax rate of return. The effect of the ta?c
                                                     advantage for pension trusts on the rate of return can be separated into
                 .                                   two distinct components, a compeunding effect and a tax race effed.

                             I The compounding cffcct ih the additirm to the after-tax rate of return
                            thatxists because the investment return camed on pension contribu-
                            tions is pcnnittpd to accumulate without being ended by taxes. Con-
                            ~~rscly, the invc:,tmcnt return carncd on regular cnrporatc rcswves is
                            tascd clachyear. Thrrcforc, the taxvd pcn-tion can not c%xWibutc to the
                            rrt urn trn future mvestmrnt earnings.

                            2. The tax rate effect is realized when a sponsor’s tax rate at the time of
                            ti\tr rcvcrsicjn is IIIWW th:an its tax rate at the time the deductions for
                            contribution% were taken. The tax advantage from having deferred
                            inconw 1:~sliabilities is inversely relitted tu marg:inal tax rates. There-
                            f(Jrc.  dwlwws     in tTl;lrgl~~il~tas rates cau.seincreases in the tax advan-
                            tages on tax-deferred inerlme. The decrease in marginal income tax rates
                            from Iii tn :3-Ipercent could have added about 22 percent to the after-
                            tau return of each reversion case.

                            To compute thi> offscttmg cscise tax, our mode1cx)mpared the net value
        Excise Tax Rate     of asset reversion with a cr,rrcsponding value generated from the simu-
        Calculated          lated invt%tmc*nts.Our assessment rcquircd (1) appraising the initial
                            funding surplus. (21 calculatmg annual grnwth rates, and (3) simulating
                            tax effects.

        Overfunding on a    To apprarse the initial funding  surplus,  we computed the plan termina-
                            tion funding position. This is the difference between pension assets and
        Termination Basis   benefit liabilities-the cost to purchase annulties or provide lump sum
                            payments to workers and retirees covered by the pension plan. A pen-
                            sion plan is overfunded on a termination basis when plan assets exceed
                            t hesr benefit ii&Air irs.

                            Because the interest rates that pension plan administrators use to esti-
                            mate benefit liabilities can vary widely from p!an to plan, we adjusted
                            benefits reported on the Form 5,500 using rnterest rates used by the Pen-
                            sion Benefit Guaranty Corporation. Becau.sePEW’Srates are bwd on
                            annuity purchas.? prices, they provide a conservative estimate of plans’
                            funding status.’ These adjusted estimates of benefit liabilities then xvere
,                           compared with the plan asset data reported on the Form SSOOto deter-
                            mine the plans’ funding positions.
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                           I~CXUWthe tax trratment of incnmc varied depending upon its origin,
                           \c’(’diffcrtWatcd between varioris sour(*csrlf plan income. Our analysis
                           awlmcd that the sources of incume-such ifi dividends and interest
                           pil)‘mentS   -were symmetrical berw~n the pension trust and the simu-
                           lilted portfolio. For example, if interest constituted 20 percent of income
                           from Iw’nsion trust investments during a plan year. WCassumed that 20
                           p~r~~~ntc,f the in\.c-tment return yaincd from the simulation also was
                           attributable To interest for that year.

                           Several pomts regarding the simlllatcd investment portfolios and rates
                           4 return need clarification:

                           I. Our rxcisc tax rate calculations arc basedon t hc actual rates of
                           rrturn rclalizcd by the sample of pension plans. Some pension analysts
                           consider the high returns that prevailed during that time wriod-19’75
                           tc) 198)3-an aberration. Had we substituted lower rates of return to
                           ~encratc our calculations. the offsetting excise tax rates would have
                           bwn lower.

                           2. The portfolio management practices of a pension trust typically differ
                           from the investment practices of taxable investment funds. The factors
                           involved in prbrtfolio management decismns include the investor’s ability
                           to bear risk. current income needs, and tas cnnsequences. For example,
                           pension trusts arc primarily growth-oriented and stress long-term price
                           appreciation and capital preservation. In addition, due to the trusts’ tax-
‘.                         rscmpt status. investment managers tilt the asset mix towards the least
                           tax-advanta$cd assets. such as corporate bonds.

                           in contrast, corporate investment trusts are primarily income oriented
                           and stress current dividend and interest return. According&, because
                           earnings on corporate reserves are exposed to taxation, investors weight
                           the portfolio with the most tax-advantaged assets. such as real estate,
                           preferred stock, and municipal bonds.

                           Our analysis may have overstated the tax liabilities that employers
                           would have incurred from an alternate investment of excess pe.nsion
                           assets, because we assumed that they would not have altered their port-
                           folio strategy.

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             Sensitivity Analysis
I-. s        Future Reversions Under                ~Ilttiou~h this rt*port ~WS nut spcculatf~ on future corporate tax rates,
                                                    r;lthcr than incrl&ng tax ratm, current revenuccnhanccment efforts
             the Current Tas Code                   1’~~s on &sing Itw~ph~~lcs.   eliminating deductions. and limiting credits.
                                                    Some ptMon plans that have bccomc overfunded since 1988 may termi-
     -                                              natc for rL%V~iOnSWhile the ~rp0rate tax rate is zt its current IWet. To
                                                    give sornc pwsptrctivc on zx5s.e tax rites that would be necessary to
                                                    offset futur? rcvcrsions occurring under today’s tax environment, we
 .                                                  Winiared tIffsetting tas rates by using the ~~lrrrrtt maximum statutory
                                                    tas rate of 34 ptwent    and the prmenc tax treatment on corporate
         ,                                          income from dividends and capital gains.

                                                    I’nder the current statutory tax rare, rarely did the 15percerlt excise
                                                    tax rate offset tax benefits-it did so in only 9 cases {see fig. II. 1). For
                                                    AI 5.5GLNX the offsctting excise tax rates averaged about 3 1 percent.
                                                    The escisc tax rate ncydcd to recover tax *benefitsequaled or exceeded

                                            . 20 percent in 50 cases(90 percent),
                                            l       30 prcent in 33 cases(Ml percent). and
                                            l       :35 percent in 2’r cases(40 percent).

..           Historic Average Tax                   Hecognizing that income tax payments vary by the availability of tax
             Rates                                  c-r-editsand deferrals. we calculated the offsetting excise tax rates using
                                                    industry-average tax rate. These rates may better reflect the actual
                                                    year-to-year historic tax position of firms in our sample. I We used esti-
                                                    mates of average corporate tax rates realized by fu-rns in industries sim-
                                                    ilar to those in our sample to approximate the annual tax position of
                                                    individual companies in our sample. These industry-wide averages are
                                                    an approximation of the effect of lower marginal taxes on firms in our

                                                    t’nder the industry-average tax rates scenario. the 15-percent excise tax
                                                    failed to offset tax benefits in the majority of our 55 cases(see fig. 11.2).
                                                    The 15~percent excise tax fully offset tax benefits in only 10 cases.The
                                                    offsetting excise tax rates averaged about 24 percent. Among the
                                                     -,                     .-   ,-.

                                                          ,             .

                                                              ,.                                           -I             ---i-h

Figure 11.1: Ottrotting Excise Tax Rates
Associated    With the Current Tar Code

                                               90                  -








                                                *-                   1L L
                                                                   P Jo IS

                                           0 20 puwnt in 4) cases(73 percent),
                                           9 30 pcrccnt in 14 ca.sw(2.4 percrnt). and
                                           l 35 pcrcrnt in 8 cases( 1.5percent).

                                               XI1 things being equal. cstimatcd historic average income tax rates
                                               wsultcd in lower offsetting excise tax rates than the other scenarios. On
                                               average. using the lower tax rates reduced the offsetting es&e tax rate
                                               ;rbout 3.5 percent rclativc to the analysis that used historic statutory

Tax on Retained Earnings                       We did not incorporate the special tax assessedto corporate reserves
                                               when they accumulate beyond specified limits-termed the accumu-
                                               lated earnings tax. This penalty surtax is intended to discourage stock-
                                               holders from using corporations to avoid personal tax on dividends by
                                               retaining carrnngs in the corporation rather than distributing these

                                               Page I6                                 GA01lUtDSQl26T~af        Pension Plan Tenmin~tl~na
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                                               Apprndlx    11
                                               objecUvr.   .Smw.   and McUimdo~ogy

     Figure LLP: Oftsettkg  Excise Tax Rates
     Associated   With Average Tax Rats*        so     Pe#wnaolTdalcna





                                               earrllngs XYdividends. In estimating offsetting excise tax rates. only reg-
                                               ular wrporntc income taxes were assessedon our alternative invesf-
                                               mrnt scenarick

                                               \VP obtain4 information for this report from PRGC. the Departments of
                                               Labor atId t hc Treasury, and private pension plan administrators.

                                               Page If                                    GAO/HBDBDII   Taxing of Pendon Plan Temhutions
                         Donald C. Snyder. Assistant DirwTor I 2oP1535-8358
Human Resources          iVaync D. I’pshaw, I’roject ?Janager
Division,                Sheila H. Sichdson, ~~valuatnr
Washington, D.C.         \‘irginia T. Douglas. iVriter-Editor
                         I~relei I,. Prlzcr. Typist

Office of the Chief

San Francisco                                                                 t

Regional Office

                         Hichard 13.Smith, Evaluator
Dallas Regional Office

(105a14)                 Page 18

- I.,

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