Introduction The recent Proposed Regulations provide that Code Section 409A does not apply to an Archer Medical Savings Account, a Health Savings Account or any other medical reimbursement arrangement (including a Health Reimbursement Arrangement) that satisfies the requirements of Code Sections 105 and 106. See, Prop. Treas. Reg. § 1.409A-1(a)(5). This provision exempts the vast majority of employer-sponsored health plans from the reach of Section 409A’s rules. However, because the Proposed Regulations only exempt health coverage and benefits that are excludable from income under Sections 105 and 106, Section 409A could apply to any health plans that provide taxable coverage or benefits. One of the cases that can trigger health benefits becoming taxable is when a self-insured health plan violates Code Section 105(h). Section 105(h) provides that a self-insured health plan must not discriminate in favor of highly compensated individuals (“HCIs”) as to eligibility to participate or as to benefits provided under the plan (either in general or in operation). [1] Arrangements that violate Section 105(h) are referred to in this Legal Alert as “discriminatory arrangements.” Code Section 105(h) Discriminatory Arrangements Discriminatory Arrangements. There are a number of self-insured health plan arrangements that can potentially violate Code Section 105(h), thereby making the health benefits taxable to the HCIs. Some examples are listed below and then are discussed in more detail – > Post-employment health coverage that is granted to an HCI under the employer’s regular health insurance plan for active employees, where the coverage is not part of the employer’s standard applicable personnel policies. > Granting special service credit to an HCI to allow the HCI to qualify for the employer’s retiree health coverage. > Special top hat health coverage (active and/or retiree) for executives and/or directors that is not available to other employees. Discriminatory Arrangements under the Employer’s Regular Health Plan. As listed above, if a former employee or group of employees are granted post-employment health coverage under the employer’s regular health plan, these individuals could be viewed by the Service as receiving coverage under an arrangement that is not a standard part of the employer’s generally applicable personnel practices. In addition, if special service credit is granted to an employee in order to qualify for retiree medical coverage, the Service could take the position that the employee is not a bona fide retiree based on the generally applicable requirements to be a retiree. Both of these cases may be positioned as accomplished through leaves of absence. However, because issues of this sort are likely to arise in connection with audits related to compliance with Section 409A, the skepticism that Treasury has informally indicated that it will apply in evaluating opportunistic leave arrangements for purposes of Section 409A may reasonably carry over in evaluating similar leaves under Section 105(h). On this basis, the Service could take the position that these special and facially discriminatory modifications of generally applicable procedures constitute discrimination in operation. The Section 105(h) regulations indicate that the prohibition on operational discrimination reaches cases where “the duration of a plan (or benefit) has the effect of discriminating in favor of highly compensated individuals.” See, Treas. Reg. § 1.105-11(c)(3)(ii). In this case, the continuation of coverage for a group, which is disproportionately or entirely composed of HCIs, on terms that go well beyond the continuation of coverage that would apply to employees generally, appears subject to attack under this provision because it extends the duration of coverage for these HCIs in a discriminatory manner. At the same time, if post-employment health coverage or special service credit is provided to HCIs in order to bridge them to qualify for retiree medical coverage, these arrangements are unlikely to pass muster as retiree coverage. Treas. Reg. § 1.105-11(c)(iii) provides a special rule for retirees. Under this rule, benefits provided to a retired employee are treated as being nondiscriminatory when the type and the amounts of benefits provided to retired employees who were HCIs are provided to all other retired employees. However, in this situation, the Service seems unlikely to accept that the individuals qualify as bona fide retirees. Alternatively, the Service could state its objection by noting that the benefits provided to these individuals are not provided to all others who would be considered retirees, if the same standards for being a retiree that were applied to the individuals were applied to all other former employees. Special Top Hat Health Plans. Some companies have traditionally sponsored special health plans for their executive officers and/or directors. This may consist of special active coverage that is in addition to the officer’s or director’s coverage under the company’s regular group health plan. Other times, it may consist of retiree coverage that is granted to officers and directors under either a separate group health plan or offered through the company’s regular active group health plan, where this retiree coverage is not available to other employees. In all these situations, if the coverage is not bona fide insured coverage, these types of arrangements will violate the Section 105(h) discrimination rules because the benefits are not available to non-HCIs. Effect of Discriminatory Arrangements. Once a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the HCIs (i.e., the medical claims that are paid) are treated as taxable income to the HCIs. See, IRC § 105(h)(7). If, as discussed above, discriminatory operation with respect to the continuation of coverage for the HCIs is found to exist, the likely effect is that all of the benefit reimbursements provided to the HCIs as a result of the continued coverage will be deemed to be includible in income. See, Treas. Reg. § 1.105-11(e)(2). Treasury Regulation § 31.3401(a)(19)-1 provides that this income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. Notwithstanding the withholding exception, however, the resulting income is still reportable as taxable wages on an employee’s Form W-2, (see, Treas. Reg. § 1.6041-2(a)(1) which provides for reporting of wages and other payments of taxable compensation). Section 409A Impact of a Section 105(h) Violation General Rules. In general, Section 409A applies to any plan or arrangement that provides for the deferral of compensation. A plan will provide for the deferral of compensation if under the terms of the plan and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that has not been received and included in gross income, and that pursuant to the terms of the plan is payable in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced or eliminated after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation (so-called “negative discretion”) is available or exercisable only upon a condition, or the negative discretion lacks substantive significance, a service provider will be considered to have a legally binding right to compensation. See, Prop. Treas. Reg. § 1.409A-1(b)(1). Application of Section 409A. Section 409A can apply to a discriminatory arrangement due to the interaction of two factors. First, to the extent the arrangement is viewed as providing discriminatory medical benefits under Section 105(h), the medical benefits (which are compensation) become taxable to the HCIs. This satisfies the requirement under Section 409A (discussed below) that the promised payments be taxable compensation. Then, to the extent, the arrangements provide that the HCIs have a legally binding right to be paid a medical benefit in a future year, this satisfies the deferral requirement of Section 409A. Note that coverage in a future year is not required. Rather, it is sufficient if the right to payment carries over to a future year, even if the coverage will not. In some cases, compensation that has been deferred is excluded from coverage under Section 409A because of a specific exception, e.g., the exception for certain post-termination expense reimbursement arrangements. This exception exempts from Section 409A medical expense reimbursements that are provided in connection with a termination of employment and that do not continue beyond the end of the second calendar year beginning after the termination, i.e., a period that encompasses the remaining portion of the current calendar year combined with the next two complete calendar years (the “two and a fraction year period”). This applies even though the medical reimbursements may be taxable under Code Section 105(h), so long as the reimbursements are limited to medical expenses within the meaning of Code Section 213. See, Prop. Treas. Reg. § 1.409A-1(b)(9)(iv)(A). However, a problem with this exception is that it is structured based on when payments may be made, rather than based on when the underlying claims are incurred. Because medical coverage is primarily time-limited based on when claims are incurred, this exception may not be very workable to exempt a discriminatory arrangement from the reach of Section 409A. However, if the discriminatory arrangement was provided in connection with an HCI’s termination of employment and did sufficiently limit the period during which the HCI could be entitled to receive payments (so that no medical reimbursements could be received after the end of the second calendar year following termination), any such arrangement should not be covered by Section 409A. The potential for exposure under Section 105(h) would remain. That exposure may be greater than in years past if Section 409A becomes, as it reasonably could, the catalyst for greater focus by the Service on health plan nondiscrimination. Still, the draconian penalties of Section 409A (discussed below) would not apply. As a practical matter, given the long lead times that can be necessary for complete resolution and payment of health claims under many plans, the need to limit all payments to the “two and a fraction year period” greatly limits the utility of this exception. For example, some claims administrators do not have the mechanical ability to apply a distinct reimbursement time limit to a particular former employee or group of former employees. If an executive employment contract provides for two years of extended coverage following termination of employment, it may not be possible to limit the right to reimbursements in accordance with the “two and a fraction year period.” Another problem with the exception for post-termination expenses reimbursement arrangements is that it only covers payments that are provided in connection with termination of employment. Thus, this exception would not be available with respect to a plan that provides discriminatory health coverage while the HCI is still rendering services to the employer. In these cases, there is a different exception that can apply based on when payments are made (the short-term deferral exception), but it requires payments to be made much more quickly, i.e., no later than 2½ months after the end of the “year” in which the right to payment arises (either the calendar year or the applicable fiscal year of the employer, whichever ends later). Thus, for expenses that are incurred right before the end of the relevant year, this rule allows only 2½ months for all reimbursements to be completed. Effect of Application. Once Code Section 409A applies to a discriminatory arrangement, the health benefits provided pursuant to the arrangement must comply with the requirements of Code Section 409A. Unfortunately, there is an inherent inconsistency between how medical plans determine the time of payment of reimbursements and how Code Section 409A requires plans to determine the time of payment of compensation that is subject to Code Section 409A. Health plans determine the timing of payments based on when a claim is incurred and submitted for reimbursement. Under Code Section 409A, all payments must be triggered by certain events that qualify under Section 409A or be based on a pre-set schedule. Neither incurring nor submitting a claim is an event that qualifies under Section 409A. Therefore, ordinary medical reimbursement plans that make payments based on when claims are incurred and submitted will not comply with Section 409A. Indeed, the awareness of this fact by Treasury and the Service is what led to the inclusion of the special exception for post-termination medical reimbursement arrangements (described above) in the recently issued Proposed Regulations. Ultimately this is a significant problem because the penalties under Section 409A are designed to get attention. If there is noncompliance with Section 409A, then the compensation that is deferred (i.e., the amount of the health benefits paid in each year under the health plan) is treated as taxable income. This is the same rule as provided by Section 105(h), but Section 409A makes this compensation subject to employer withholding. Even more significantly, Section 409A triggers compensation inclusion under all plans of the same type. Within the scheme of Section 409A, a health plan will generally be a “nonaccount balance plan.” Thus, if the employer also offers the employee a nonqualified SERP that provides a defined benefit, the failure under Section 409A of the employee’s health coverage can trigger taxation of not just the health benefits, but also the total amount due to the employee under the SERP as well (except for pre-2005 SERP accruals that qualify as grandfathered under Section 409A). Then all of this taxable compensation is subject to a 20% penalty and penalty interest. The penalty interest builds up the longer the amount is deferred. (Indeed, there will be cases where the combination of regular income taxes, the 20% penalty and built-up penalty interest will result in the affected employee owing the Service more than the employer payments he is receiving.) The regular compensation, the 20% penalty compensation and the penalty interest must be reported on a Form W-2 or 1099 with respect to the affected individual. See, IRS Notice 2005-1 Q&A-32 and 33. Although not clear, the amount of the compensation may be subject to applicable FICA withholding as well. Methods to Avoid Code Section 409A Application As discussed below, there are two effective methods to avoid the application of Section 409A to a discriminatory arrangement. In addition, although we have defined a “discriminatory arrangement” to refer only to self-insured health plans, it bears noting that replacing self-insured coverage with insured coverage can also be an effective way to address the impact of Section 409A on health coverage that may be discriminatory, because Section 105(h) does not apply to insured health plans. The key detail here is to make sure that the coverage in question is really insured within the meaning of Section 105(h). Nominally insured coverage that still exposes the employer to claims risk in a way that is functionally like self insurance can be covered under Section 105(h). Payments of Premiums on an After-Tax Basis. Code Section 105(b) applies to exclude the value of medical benefits from the taxable income of employees who receive medical coverage that is paid for by an employer. Code Section 105(h) then removes this exclusion from income for benefits that are paid to HCIs under a discriminatory medical plan, and treats those benefits as taxable compensation. It is this taxable compensation that triggers the application of Code Section 409A. Therefore, if Code Section 105 did not apply to a discriminatory medical arrangement, the nondiscrimination rules under Code Section 105(h) would not apply and Code Section 409A would not be triggered. If the HCIs under the discriminatory arrangement pay for the entire premium on an after-tax basis, i.e., both the employer and employee premiums, the medical benefits that are paid would be excluded from the HCI’s gross income by application of Code Section 104(a)(3). In this instance, therefore, Code Section 105 and Code Section 409A would not apply. In order for Code Section 104(a)(3) to fully apply (and thus to permit Code Section 409A to be fully avoided), the entire premium – correctly determined – must be paid by the HCI on an after-tax basis. The full COBRA premium (without the 2% add-on for administrative expenses) includes both the employee and employer portions and, thus, should be an appropriate figure to use in this instance. In this regard, we should note that there is an implication in the Proposed Regulations that even 100% tax excludible income of this sort can be subject to Section 409A if it is continued beyond the “two and a fraction year period” discussed above. However, Treasury personnel have repeatedly stated since the publication of the Proposed Regulations that the referenced implication is not intended and that 100% excludible income will be exempt from Section 409A unless it is obtained by way of a trade for deferred compensation. Negative Discretion. As provided above, Code Section 409A is triggered when a service provider has a legally binding right to taxable compensation in a future year. A legally binding right does not exist if that compensation may be reduced or eliminated by the company. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation lacks substantive significance, a legally biding right will still exist. If the facts demonstrate that the HCIs do not have a legally binding right because benefit payments under the discriminatory arrangement can be terminated at any time, then the existence of this negative discretion should prevent the application of Code Section 409A to the discriminatory arrangement. However, even though most health plans are drafted to permit amendment and termination at any time, special post-employment health coverage arrangements or arrangements that grant special service credit to qualify for retiree health coverage may prevent amendment and termination. For example, these arrangements may be entered into in the context of a severance agreement, and may be drafted to provide enforceable rights in exchange for a release of claims against the employer. This commitment may override the generally applicable right to amend and terminate health coverage. Even in cases where the right to terminate the health plan does apply to an employee with discriminatory coverage, generally such right only applies prospectively to claims that are incurred after the termination. Therefore, once a claim has been incurred in a case like this, the employee usually would have the legally binding right to be paid for incurred claims beyond the year in which they are incurred. This is enough to bring Section 409A into play. Therefore, if reliance is placed on negative discretion to avoid Section 409A, it is important to understand how broad the scope of the discretion must be. Conclusion As noted above, and as reflected in public comments by Treasury representatives, it is clear that if a self-insured health plan violates Section 105(h), Section 409A issues can arise – and that implicates Section 409A’s daunting penalties. Because a discriminatory health plan will not easily fit within one of the exemptions from Section 409A, and because it is inherently difficult for a health plan to comply with Section 409A, employers will need to take care to identify and address non-exempt discriminatory plans promptly. While a transition period for revising plans extends to the end of 2006, operational compliance is required currently and so time is of the essence. If you would like additional information about Section 409A, please contact: Office Name Phone Email Atlanta Jennifer Schumacher 404-815-6298 JSchumacher@KilpatrickStockton.com Raleigh Lois Colbert 919-420-1722 LColbert@KilpatrickStockton.com Washington, DC Mark D. Wincek 202-508-5801 MWincek@KilpatrickStockton.com Washington, DC Mark L. Stember 202-508-5802 MStember@KilpatrickStockton.com Winston-Salem Bill E. Wright 336-607-7424 BWright@KilpatrickStockton.com [1] Code Section 105(h)(5) provides that an HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10% of stock of the employer, or (c) among the highest paid 25% of all employees. Therefore, due to the 25% rule, an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code section 414(q).
Code Section 105(h) Discriminatory Arrangements
Discriminatory Arrangements. There are a number of self-insured health plan arrangements that can potentially violate Code Section 105(h), thereby making the health benefits taxable to the HCIs. Some examples are listed below and then are discussed in more detail –
> Post-employment health coverage that is granted to an HCI under the employer’s regular health insurance plan for active employees, where the coverage is not part of the employer’s standard applicable personnel policies. > Granting special service credit to an HCI to allow the HCI to qualify for the employer’s retiree health coverage. > Special top hat health coverage (active and/or retiree) for executives and/or directors that is not available to other employees. Discriminatory Arrangements under the Employer’s Regular Health Plan. As listed above, if a former employee or group of employees are granted post-employment health coverage under the employer’s regular health plan, these individuals could be viewed by the Service as receiving coverage under an arrangement that is not a standard part of the employer’s generally applicable personnel practices. In addition, if special service credit is granted to an employee in order to qualify for retiree medical coverage, the Service could take the position that the employee is not a bona fide retiree based on the generally applicable requirements to be a retiree. Both of these cases may be positioned as accomplished through leaves of absence. However, because issues of this sort are likely to arise in connection with audits related to compliance with Section 409A, the skepticism that Treasury has informally indicated that it will apply in evaluating opportunistic leave arrangements for purposes of Section 409A may reasonably carry over in evaluating similar leaves under Section 105(h). On this basis, the Service could take the position that these special and facially discriminatory modifications of generally applicable procedures constitute discrimination in operation. The Section 105(h) regulations indicate that the prohibition on operational discrimination reaches cases where “the duration of a plan (or benefit) has the effect of discriminating in favor of highly compensated individuals.” See, Treas. Reg. § 1.105-11(c)(3)(ii). In this case, the continuation of coverage for a group, which is disproportionately or entirely composed of HCIs, on terms that go well beyond the continuation of coverage that would apply to employees generally, appears subject to attack under this provision because it extends the duration of coverage for these HCIs in a discriminatory manner. At the same time, if post-employment health coverage or special service credit is provided to HCIs in order to bridge them to qualify for retiree medical coverage, these arrangements are unlikely to pass muster as retiree coverage. Treas. Reg. § 1.105-11(c)(iii) provides a special rule for retirees. Under this rule, benefits provided to a retired employee are treated as being nondiscriminatory when the type and the amounts of benefits provided to retired employees who were HCIs are provided to all other retired employees. However, in this situation, the Service seems unlikely to accept that the individuals qualify as bona fide retirees. Alternatively, the Service could state its objection by noting that the benefits provided to these individuals are not provided to all others who would be considered retirees, if the same standards for being a retiree that were applied to the individuals were applied to all other former employees. Special Top Hat Health Plans. Some companies have traditionally sponsored special health plans for their executive officers and/or directors. This may consist of special active coverage that is in addition to the officer’s or director’s coverage under the company’s regular group health plan. Other times, it may consist of retiree coverage that is granted to officers and directors under either a separate group health plan or offered through the company’s regular active group health plan, where this retiree coverage is not available to other employees. In all these situations, if the coverage is not bona fide insured coverage, these types of arrangements will violate the Section 105(h) discrimination rules because the benefits are not available to non-HCIs. Effect of Discriminatory Arrangements. Once a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the HCIs (i.e., the medical claims that are paid) are treated as taxable income to the HCIs. See, IRC § 105(h)(7). If, as discussed above, discriminatory operation with respect to the continuation of coverage for the HCIs is found to exist, the likely effect is that all of the benefit reimbursements provided to the HCIs as a result of the continued coverage will be deemed to be includible in income. See, Treas. Reg. § 1.105-11(e)(2). Treasury Regulation § 31.3401(a)(19)-1 provides that this income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. Notwithstanding the withholding exception, however, the resulting income is still reportable as taxable wages on an employee’s Form W-2, (see, Treas. Reg. § 1.6041-2(a)(1) which provides for reporting of wages and other payments of taxable compensation). Section 409A Impact of a Section 105(h) Violation General Rules. In general, Section 409A applies to any plan or arrangement that provides for the deferral of compensation. A plan will provide for the deferral of compensation if under the terms of the plan and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that has not been received and included in gross income, and that pursuant to the terms of the plan is payable in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced or eliminated after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation (so-called “negative discretion”) is available or exercisable only upon a condition, or the negative discretion lacks substantive significance, a service provider will be considered to have a legally binding right to compensation. See, Prop. Treas. Reg. § 1.409A-1(b)(1). Application of Section 409A. Section 409A can apply to a discriminatory arrangement due to the interaction of two factors. First, to the extent the arrangement is viewed as providing discriminatory medical benefits under Section 105(h), the medical benefits (which are compensation) become taxable to the HCIs. This satisfies the requirement under Section 409A (discussed below) that the promised payments be taxable compensation. Then, to the extent, the arrangements provide that the HCIs have a legally binding right to be paid a medical benefit in a future year, this satisfies the deferral requirement of Section 409A. Note that coverage in a future year is not required. Rather, it is sufficient if the right to payment carries over to a future year, even if the coverage will not. In some cases, compensation that has been deferred is excluded from coverage under Section 409A because of a specific exception, e.g., the exception for certain post-termination expense reimbursement arrangements. This exception exempts from Section 409A medical expense reimbursements that are provided in connection with a termination of employment and that do not continue beyond the end of the second calendar year beginning after the termination, i.e., a period that encompasses the remaining portion of the current calendar year combined with the next two complete calendar years (the “two and a fraction year period”). This applies even though the medical reimbursements may be taxable under Code Section 105(h), so long as the reimbursements are limited to medical expenses within the meaning of Code Section 213. See, Prop. Treas. Reg. § 1.409A-1(b)(9)(iv)(A). However, a problem with this exception is that it is structured based on when payments may be made, rather than based on when the underlying claims are incurred. Because medical coverage is primarily time-limited based on when claims are incurred, this exception may not be very workable to exempt a discriminatory arrangement from the reach of Section 409A. However, if the discriminatory arrangement was provided in connection with an HCI’s termination of employment and did sufficiently limit the period during which the HCI could be entitled to receive payments (so that no medical reimbursements could be received after the end of the second calendar year following termination), any such arrangement should not be covered by Section 409A. The potential for exposure under Section 105(h) would remain. That exposure may be greater than in years past if Section 409A becomes, as it reasonably could, the catalyst for greater focus by the Service on health plan nondiscrimination. Still, the draconian penalties of Section 409A (discussed below) would not apply. As a practical matter, given the long lead times that can be necessary for complete resolution and payment of health claims under many plans, the need to limit all payments to the “two and a fraction year period” greatly limits the utility of this exception. For example, some claims administrators do not have the mechanical ability to apply a distinct reimbursement time limit to a particular former employee or group of former employees. If an executive employment contract provides for two years of extended coverage following termination of employment, it may not be possible to limit the right to reimbursements in accordance with the “two and a fraction year period.” Another problem with the exception for post-termination expenses reimbursement arrangements is that it only covers payments that are provided in connection with termination of employment. Thus, this exception would not be available with respect to a plan that provides discriminatory health coverage while the HCI is still rendering services to the employer. In these cases, there is a different exception that can apply based on when payments are made (the short-term deferral exception), but it requires payments to be made much more quickly, i.e., no later than 2½ months after the end of the “year” in which the right to payment arises (either the calendar year or the applicable fiscal year of the employer, whichever ends later). Thus, for expenses that are incurred right before the end of the relevant year, this rule allows only 2½ months for all reimbursements to be completed. Effect of Application. Once Code Section 409A applies to a discriminatory arrangement, the health benefits provided pursuant to the arrangement must comply with the requirements of Code Section 409A. Unfortunately, there is an inherent inconsistency between how medical plans determine the time of payment of reimbursements and how Code Section 409A requires plans to determine the time of payment of compensation that is subject to Code Section 409A. Health plans determine the timing of payments based on when a claim is incurred and submitted for reimbursement. Under Code Section 409A, all payments must be triggered by certain events that qualify under Section 409A or be based on a pre-set schedule. Neither incurring nor submitting a claim is an event that qualifies under Section 409A. Therefore, ordinary medical reimbursement plans that make payments based on when claims are incurred and submitted will not comply with Section 409A. Indeed, the awareness of this fact by Treasury and the Service is what led to the inclusion of the special exception for post-termination medical reimbursement arrangements (described above) in the recently issued Proposed Regulations. Ultimately this is a significant problem because the penalties under Section 409A are designed to get attention. If there is noncompliance with Section 409A, then the compensation that is deferred (i.e., the amount of the health benefits paid in each year under the health plan) is treated as taxable income. This is the same rule as provided by Section 105(h), but Section 409A makes this compensation subject to employer withholding. Even more significantly, Section 409A triggers compensation inclusion under all plans of the same type. Within the scheme of Section 409A, a health plan will generally be a “nonaccount balance plan.” Thus, if the employer also offers the employee a nonqualified SERP that provides a defined benefit, the failure under Section 409A of the employee’s health coverage can trigger taxation of not just the health benefits, but also the total amount due to the employee under the SERP as well (except for pre-2005 SERP accruals that qualify as grandfathered under Section 409A). Then all of this taxable compensation is subject to a 20% penalty and penalty interest. The penalty interest builds up the longer the amount is deferred. (Indeed, there will be cases where the combination of regular income taxes, the 20% penalty and built-up penalty interest will result in the affected employee owing the Service more than the employer payments he is receiving.) The regular compensation, the 20% penalty compensation and the penalty interest must be reported on a Form W-2 or 1099 with respect to the affected individual. See, IRS Notice 2005-1 Q&A-32 and 33. Although not clear, the amount of the compensation may be subject to applicable FICA withholding as well. Methods to Avoid Code Section 409A Application As discussed below, there are two effective methods to avoid the application of Section 409A to a discriminatory arrangement. In addition, although we have defined a “discriminatory arrangement” to refer only to self-insured health plans, it bears noting that replacing self-insured coverage with insured coverage can also be an effective way to address the impact of Section 409A on health coverage that may be discriminatory, because Section 105(h) does not apply to insured health plans. The key detail here is to make sure that the coverage in question is really insured within the meaning of Section 105(h). Nominally insured coverage that still exposes the employer to claims risk in a way that is functionally like self insurance can be covered under Section 105(h). Payments of Premiums on an After-Tax Basis. Code Section 105(b) applies to exclude the value of medical benefits from the taxable income of employees who receive medical coverage that is paid for by an employer. Code Section 105(h) then removes this exclusion from income for benefits that are paid to HCIs under a discriminatory medical plan, and treats those benefits as taxable compensation. It is this taxable compensation that triggers the application of Code Section 409A. Therefore, if Code Section 105 did not apply to a discriminatory medical arrangement, the nondiscrimination rules under Code Section 105(h) would not apply and Code Section 409A would not be triggered. If the HCIs under the discriminatory arrangement pay for the entire premium on an after-tax basis, i.e., both the employer and employee premiums, the medical benefits that are paid would be excluded from the HCI’s gross income by application of Code Section 104(a)(3). In this instance, therefore, Code Section 105 and Code Section 409A would not apply. In order for Code Section 104(a)(3) to fully apply (and thus to permit Code Section 409A to be fully avoided), the entire premium – correctly determined – must be paid by the HCI on an after-tax basis. The full COBRA premium (without the 2% add-on for administrative expenses) includes both the employee and employer portions and, thus, should be an appropriate figure to use in this instance. In this regard, we should note that there is an implication in the Proposed Regulations that even 100% tax excludible income of this sort can be subject to Section 409A if it is continued beyond the “two and a fraction year period” discussed above. However, Treasury personnel have repeatedly stated since the publication of the Proposed Regulations that the referenced implication is not intended and that 100% excludible income will be exempt from Section 409A unless it is obtained by way of a trade for deferred compensation. Negative Discretion. As provided above, Code Section 409A is triggered when a service provider has a legally binding right to taxable compensation in a future year. A legally binding right does not exist if that compensation may be reduced or eliminated by the company. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation lacks substantive significance, a legally biding right will still exist. If the facts demonstrate that the HCIs do not have a legally binding right because benefit payments under the discriminatory arrangement can be terminated at any time, then the existence of this negative discretion should prevent the application of Code Section 409A to the discriminatory arrangement. However, even though most health plans are drafted to permit amendment and termination at any time, special post-employment health coverage arrangements or arrangements that grant special service credit to qualify for retiree health coverage may prevent amendment and termination. For example, these arrangements may be entered into in the context of a severance agreement, and may be drafted to provide enforceable rights in exchange for a release of claims against the employer. This commitment may override the generally applicable right to amend and terminate health coverage. Even in cases where the right to terminate the health plan does apply to an employee with discriminatory coverage, generally such right only applies prospectively to claims that are incurred after the termination. Therefore, once a claim has been incurred in a case like this, the employee usually would have the legally binding right to be paid for incurred claims beyond the year in which they are incurred. This is enough to bring Section 409A into play. Therefore, if reliance is placed on negative discretion to avoid Section 409A, it is important to understand how broad the scope of the discretion must be. Conclusion As noted above, and as reflected in public comments by Treasury representatives, it is clear that if a self-insured health plan violates Section 105(h), Section 409A issues can arise – and that implicates Section 409A’s daunting penalties. Because a discriminatory health plan will not easily fit within one of the exemptions from Section 409A, and because it is inherently difficult for a health plan to comply with Section 409A, employers will need to take care to identify and address non-exempt discriminatory plans promptly. While a transition period for revising plans extends to the end of 2006, operational compliance is required currently and so time is of the essence. If you would like additional information about Section 409A, please contact: Office Name Phone Email Atlanta Jennifer Schumacher 404-815-6298 JSchumacher@KilpatrickStockton.com Raleigh Lois Colbert 919-420-1722 LColbert@KilpatrickStockton.com Washington, DC Mark D. Wincek 202-508-5801 MWincek@KilpatrickStockton.com Washington, DC Mark L. Stember 202-508-5802 MStember@KilpatrickStockton.com Winston-Salem Bill E. Wright 336-607-7424 BWright@KilpatrickStockton.com [1] Code Section 105(h)(5) provides that an HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10% of stock of the employer, or (c) among the highest paid 25% of all employees. Therefore, due to the 25% rule, an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code section 414(q).
> Granting special service credit to an HCI to allow the HCI to qualify for the employer’s retiree health coverage. > Special top hat health coverage (active and/or retiree) for executives and/or directors that is not available to other employees. Discriminatory Arrangements under the Employer’s Regular Health Plan. As listed above, if a former employee or group of employees are granted post-employment health coverage under the employer’s regular health plan, these individuals could be viewed by the Service as receiving coverage under an arrangement that is not a standard part of the employer’s generally applicable personnel practices. In addition, if special service credit is granted to an employee in order to qualify for retiree medical coverage, the Service could take the position that the employee is not a bona fide retiree based on the generally applicable requirements to be a retiree. Both of these cases may be positioned as accomplished through leaves of absence. However, because issues of this sort are likely to arise in connection with audits related to compliance with Section 409A, the skepticism that Treasury has informally indicated that it will apply in evaluating opportunistic leave arrangements for purposes of Section 409A may reasonably carry over in evaluating similar leaves under Section 105(h). On this basis, the Service could take the position that these special and facially discriminatory modifications of generally applicable procedures constitute discrimination in operation. The Section 105(h) regulations indicate that the prohibition on operational discrimination reaches cases where “the duration of a plan (or benefit) has the effect of discriminating in favor of highly compensated individuals.” See, Treas. Reg. § 1.105-11(c)(3)(ii). In this case, the continuation of coverage for a group, which is disproportionately or entirely composed of HCIs, on terms that go well beyond the continuation of coverage that would apply to employees generally, appears subject to attack under this provision because it extends the duration of coverage for these HCIs in a discriminatory manner. At the same time, if post-employment health coverage or special service credit is provided to HCIs in order to bridge them to qualify for retiree medical coverage, these arrangements are unlikely to pass muster as retiree coverage. Treas. Reg. § 1.105-11(c)(iii) provides a special rule for retirees. Under this rule, benefits provided to a retired employee are treated as being nondiscriminatory when the type and the amounts of benefits provided to retired employees who were HCIs are provided to all other retired employees. However, in this situation, the Service seems unlikely to accept that the individuals qualify as bona fide retirees. Alternatively, the Service could state its objection by noting that the benefits provided to these individuals are not provided to all others who would be considered retirees, if the same standards for being a retiree that were applied to the individuals were applied to all other former employees. Special Top Hat Health Plans. Some companies have traditionally sponsored special health plans for their executive officers and/or directors. This may consist of special active coverage that is in addition to the officer’s or director’s coverage under the company’s regular group health plan. Other times, it may consist of retiree coverage that is granted to officers and directors under either a separate group health plan or offered through the company’s regular active group health plan, where this retiree coverage is not available to other employees. In all these situations, if the coverage is not bona fide insured coverage, these types of arrangements will violate the Section 105(h) discrimination rules because the benefits are not available to non-HCIs. Effect of Discriminatory Arrangements. Once a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the HCIs (i.e., the medical claims that are paid) are treated as taxable income to the HCIs. See, IRC § 105(h)(7). If, as discussed above, discriminatory operation with respect to the continuation of coverage for the HCIs is found to exist, the likely effect is that all of the benefit reimbursements provided to the HCIs as a result of the continued coverage will be deemed to be includible in income. See, Treas. Reg. § 1.105-11(e)(2). Treasury Regulation § 31.3401(a)(19)-1 provides that this income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. Notwithstanding the withholding exception, however, the resulting income is still reportable as taxable wages on an employee’s Form W-2, (see, Treas. Reg. § 1.6041-2(a)(1) which provides for reporting of wages and other payments of taxable compensation). Section 409A Impact of a Section 105(h) Violation General Rules. In general, Section 409A applies to any plan or arrangement that provides for the deferral of compensation. A plan will provide for the deferral of compensation if under the terms of the plan and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that has not been received and included in gross income, and that pursuant to the terms of the plan is payable in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced or eliminated after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation (so-called “negative discretion”) is available or exercisable only upon a condition, or the negative discretion lacks substantive significance, a service provider will be considered to have a legally binding right to compensation. See, Prop. Treas. Reg. § 1.409A-1(b)(1). Application of Section 409A. Section 409A can apply to a discriminatory arrangement due to the interaction of two factors. First, to the extent the arrangement is viewed as providing discriminatory medical benefits under Section 105(h), the medical benefits (which are compensation) become taxable to the HCIs. This satisfies the requirement under Section 409A (discussed below) that the promised payments be taxable compensation. Then, to the extent, the arrangements provide that the HCIs have a legally binding right to be paid a medical benefit in a future year, this satisfies the deferral requirement of Section 409A. Note that coverage in a future year is not required. Rather, it is sufficient if the right to payment carries over to a future year, even if the coverage will not. In some cases, compensation that has been deferred is excluded from coverage under Section 409A because of a specific exception, e.g., the exception for certain post-termination expense reimbursement arrangements. This exception exempts from Section 409A medical expense reimbursements that are provided in connection with a termination of employment and that do not continue beyond the end of the second calendar year beginning after the termination, i.e., a period that encompasses the remaining portion of the current calendar year combined with the next two complete calendar years (the “two and a fraction year period”). This applies even though the medical reimbursements may be taxable under Code Section 105(h), so long as the reimbursements are limited to medical expenses within the meaning of Code Section 213. See, Prop. Treas. Reg. § 1.409A-1(b)(9)(iv)(A). However, a problem with this exception is that it is structured based on when payments may be made, rather than based on when the underlying claims are incurred. Because medical coverage is primarily time-limited based on when claims are incurred, this exception may not be very workable to exempt a discriminatory arrangement from the reach of Section 409A. However, if the discriminatory arrangement was provided in connection with an HCI’s termination of employment and did sufficiently limit the period during which the HCI could be entitled to receive payments (so that no medical reimbursements could be received after the end of the second calendar year following termination), any such arrangement should not be covered by Section 409A. The potential for exposure under Section 105(h) would remain. That exposure may be greater than in years past if Section 409A becomes, as it reasonably could, the catalyst for greater focus by the Service on health plan nondiscrimination. Still, the draconian penalties of Section 409A (discussed below) would not apply. As a practical matter, given the long lead times that can be necessary for complete resolution and payment of health claims under many plans, the need to limit all payments to the “two and a fraction year period” greatly limits the utility of this exception. For example, some claims administrators do not have the mechanical ability to apply a distinct reimbursement time limit to a particular former employee or group of former employees. If an executive employment contract provides for two years of extended coverage following termination of employment, it may not be possible to limit the right to reimbursements in accordance with the “two and a fraction year period.” Another problem with the exception for post-termination expenses reimbursement arrangements is that it only covers payments that are provided in connection with termination of employment. Thus, this exception would not be available with respect to a plan that provides discriminatory health coverage while the HCI is still rendering services to the employer. In these cases, there is a different exception that can apply based on when payments are made (the short-term deferral exception), but it requires payments to be made much more quickly, i.e., no later than 2½ months after the end of the “year” in which the right to payment arises (either the calendar year or the applicable fiscal year of the employer, whichever ends later). Thus, for expenses that are incurred right before the end of the relevant year, this rule allows only 2½ months for all reimbursements to be completed. Effect of Application. Once Code Section 409A applies to a discriminatory arrangement, the health benefits provided pursuant to the arrangement must comply with the requirements of Code Section 409A. Unfortunately, there is an inherent inconsistency between how medical plans determine the time of payment of reimbursements and how Code Section 409A requires plans to determine the time of payment of compensation that is subject to Code Section 409A. Health plans determine the timing of payments based on when a claim is incurred and submitted for reimbursement. Under Code Section 409A, all payments must be triggered by certain events that qualify under Section 409A or be based on a pre-set schedule. Neither incurring nor submitting a claim is an event that qualifies under Section 409A. Therefore, ordinary medical reimbursement plans that make payments based on when claims are incurred and submitted will not comply with Section 409A. Indeed, the awareness of this fact by Treasury and the Service is what led to the inclusion of the special exception for post-termination medical reimbursement arrangements (described above) in the recently issued Proposed Regulations. Ultimately this is a significant problem because the penalties under Section 409A are designed to get attention. If there is noncompliance with Section 409A, then the compensation that is deferred (i.e., the amount of the health benefits paid in each year under the health plan) is treated as taxable income. This is the same rule as provided by Section 105(h), but Section 409A makes this compensation subject to employer withholding. Even more significantly, Section 409A triggers compensation inclusion under all plans of the same type. Within the scheme of Section 409A, a health plan will generally be a “nonaccount balance plan.” Thus, if the employer also offers the employee a nonqualified SERP that provides a defined benefit, the failure under Section 409A of the employee’s health coverage can trigger taxation of not just the health benefits, but also the total amount due to the employee under the SERP as well (except for pre-2005 SERP accruals that qualify as grandfathered under Section 409A). Then all of this taxable compensation is subject to a 20% penalty and penalty interest. The penalty interest builds up the longer the amount is deferred. (Indeed, there will be cases where the combination of regular income taxes, the 20% penalty and built-up penalty interest will result in the affected employee owing the Service more than the employer payments he is receiving.) The regular compensation, the 20% penalty compensation and the penalty interest must be reported on a Form W-2 or 1099 with respect to the affected individual. See, IRS Notice 2005-1 Q&A-32 and 33. Although not clear, the amount of the compensation may be subject to applicable FICA withholding as well. Methods to Avoid Code Section 409A Application As discussed below, there are two effective methods to avoid the application of Section 409A to a discriminatory arrangement. In addition, although we have defined a “discriminatory arrangement” to refer only to self-insured health plans, it bears noting that replacing self-insured coverage with insured coverage can also be an effective way to address the impact of Section 409A on health coverage that may be discriminatory, because Section 105(h) does not apply to insured health plans. The key detail here is to make sure that the coverage in question is really insured within the meaning of Section 105(h). Nominally insured coverage that still exposes the employer to claims risk in a way that is functionally like self insurance can be covered under Section 105(h). Payments of Premiums on an After-Tax Basis. Code Section 105(b) applies to exclude the value of medical benefits from the taxable income of employees who receive medical coverage that is paid for by an employer. Code Section 105(h) then removes this exclusion from income for benefits that are paid to HCIs under a discriminatory medical plan, and treats those benefits as taxable compensation. It is this taxable compensation that triggers the application of Code Section 409A. Therefore, if Code Section 105 did not apply to a discriminatory medical arrangement, the nondiscrimination rules under Code Section 105(h) would not apply and Code Section 409A would not be triggered. If the HCIs under the discriminatory arrangement pay for the entire premium on an after-tax basis, i.e., both the employer and employee premiums, the medical benefits that are paid would be excluded from the HCI’s gross income by application of Code Section 104(a)(3). In this instance, therefore, Code Section 105 and Code Section 409A would not apply. In order for Code Section 104(a)(3) to fully apply (and thus to permit Code Section 409A to be fully avoided), the entire premium – correctly determined – must be paid by the HCI on an after-tax basis. The full COBRA premium (without the 2% add-on for administrative expenses) includes both the employee and employer portions and, thus, should be an appropriate figure to use in this instance. In this regard, we should note that there is an implication in the Proposed Regulations that even 100% tax excludible income of this sort can be subject to Section 409A if it is continued beyond the “two and a fraction year period” discussed above. However, Treasury personnel have repeatedly stated since the publication of the Proposed Regulations that the referenced implication is not intended and that 100% excludible income will be exempt from Section 409A unless it is obtained by way of a trade for deferred compensation. Negative Discretion. As provided above, Code Section 409A is triggered when a service provider has a legally binding right to taxable compensation in a future year. A legally binding right does not exist if that compensation may be reduced or eliminated by the company. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation lacks substantive significance, a legally biding right will still exist. If the facts demonstrate that the HCIs do not have a legally binding right because benefit payments under the discriminatory arrangement can be terminated at any time, then the existence of this negative discretion should prevent the application of Code Section 409A to the discriminatory arrangement. However, even though most health plans are drafted to permit amendment and termination at any time, special post-employment health coverage arrangements or arrangements that grant special service credit to qualify for retiree health coverage may prevent amendment and termination. For example, these arrangements may be entered into in the context of a severance agreement, and may be drafted to provide enforceable rights in exchange for a release of claims against the employer. This commitment may override the generally applicable right to amend and terminate health coverage. Even in cases where the right to terminate the health plan does apply to an employee with discriminatory coverage, generally such right only applies prospectively to claims that are incurred after the termination. Therefore, once a claim has been incurred in a case like this, the employee usually would have the legally binding right to be paid for incurred claims beyond the year in which they are incurred. This is enough to bring Section 409A into play. Therefore, if reliance is placed on negative discretion to avoid Section 409A, it is important to understand how broad the scope of the discretion must be. Conclusion As noted above, and as reflected in public comments by Treasury representatives, it is clear that if a self-insured health plan violates Section 105(h), Section 409A issues can arise – and that implicates Section 409A’s daunting penalties. Because a discriminatory health plan will not easily fit within one of the exemptions from Section 409A, and because it is inherently difficult for a health plan to comply with Section 409A, employers will need to take care to identify and address non-exempt discriminatory plans promptly. While a transition period for revising plans extends to the end of 2006, operational compliance is required currently and so time is of the essence. If you would like additional information about Section 409A, please contact: Office Name Phone Email Atlanta Jennifer Schumacher 404-815-6298 JSchumacher@KilpatrickStockton.com Raleigh Lois Colbert 919-420-1722 LColbert@KilpatrickStockton.com Washington, DC Mark D. Wincek 202-508-5801 MWincek@KilpatrickStockton.com Washington, DC Mark L. Stember 202-508-5802 MStember@KilpatrickStockton.com Winston-Salem Bill E. Wright 336-607-7424 BWright@KilpatrickStockton.com [1] Code Section 105(h)(5) provides that an HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10% of stock of the employer, or (c) among the highest paid 25% of all employees. Therefore, due to the 25% rule, an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code section 414(q).
> Special top hat health coverage (active and/or retiree) for executives and/or directors that is not available to other employees.
Discriminatory Arrangements under the Employer’s Regular Health Plan. As listed above, if a former employee or group of employees are granted post-employment health coverage under the employer’s regular health plan, these individuals could be viewed by the Service as receiving coverage under an arrangement that is not a standard part of the employer’s generally applicable personnel practices. In addition, if special service credit is granted to an employee in order to qualify for retiree medical coverage, the Service could take the position that the employee is not a bona fide retiree based on the generally applicable requirements to be a retiree. Both of these cases may be positioned as accomplished through leaves of absence. However, because issues of this sort are likely to arise in connection with audits related to compliance with Section 409A, the skepticism that Treasury has informally indicated that it will apply in evaluating opportunistic leave arrangements for purposes of Section 409A may reasonably carry over in evaluating similar leaves under Section 105(h).
On this basis, the Service could take the position that these special and facially discriminatory modifications of generally applicable procedures constitute discrimination in operation. The Section 105(h) regulations indicate that the prohibition on operational discrimination reaches cases where “the duration of a plan (or benefit) has the effect of discriminating in favor of highly compensated individuals.” See, Treas. Reg. § 1.105-11(c)(3)(ii). In this case, the continuation of coverage for a group, which is disproportionately or entirely composed of HCIs, on terms that go well beyond the continuation of coverage that would apply to employees generally, appears subject to attack under this provision because it extends the duration of coverage for these HCIs in a discriminatory manner.
At the same time, if post-employment health coverage or special service credit is provided to HCIs in order to bridge them to qualify for retiree medical coverage, these arrangements are unlikely to pass muster as retiree coverage. Treas. Reg. § 1.105-11(c)(iii) provides a special rule for retirees. Under this rule, benefits provided to a retired employee are treated as being nondiscriminatory when the type and the amounts of benefits provided to retired employees who were HCIs are provided to all other retired employees. However, in this situation, the Service seems unlikely to accept that the individuals qualify as bona fide retirees. Alternatively, the Service could state its objection by noting that the benefits provided to these individuals are not provided to all others who would be considered retirees, if the same standards for being a retiree that were applied to the individuals were applied to all other former employees.
Special Top Hat Health Plans. Some companies have traditionally sponsored special health plans for their executive officers and/or directors. This may consist of special active coverage that is in addition to the officer’s or director’s coverage under the company’s regular group health plan. Other times, it may consist of retiree coverage that is granted to officers and directors under either a separate group health plan or offered through the company’s regular active group health plan, where this retiree coverage is not available to other employees. In all these situations, if the coverage is not bona fide insured coverage, these types of arrangements will violate the Section 105(h) discrimination rules because the benefits are not available to non-HCIs.
Effect of Discriminatory Arrangements. Once a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the HCIs (i.e., the medical claims that are paid) are treated as taxable income to the HCIs. See, IRC § 105(h)(7). If, as discussed above, discriminatory operation with respect to the continuation of coverage for the HCIs is found to exist, the likely effect is that all of the benefit reimbursements provided to the HCIs as a result of the continued coverage will be deemed to be includible in income. See, Treas. Reg. § 1.105-11(e)(2).
Treasury Regulation § 31.3401(a)(19)-1 provides that this income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. Notwithstanding the withholding exception, however, the resulting income is still reportable as taxable wages on an employee’s Form W-2, (see, Treas. Reg. § 1.6041-2(a)(1) which provides for reporting of wages and other payments of taxable compensation).
Section 409A Impact of a Section 105(h) Violation
General Rules. In general, Section 409A applies to any plan or arrangement that provides for the deferral of compensation. A plan will provide for the deferral of compensation if under the terms of the plan and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that has not been received and included in gross income, and that pursuant to the terms of the plan is payable in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced or eliminated after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation (so-called “negative discretion”) is available or exercisable only upon a condition, or the negative discretion lacks substantive significance, a service provider will be considered to have a legally binding right to compensation. See, Prop. Treas. Reg. § 1.409A-1(b)(1).
Application of Section 409A. Section 409A can apply to a discriminatory arrangement due to the interaction of two factors. First, to the extent the arrangement is viewed as providing discriminatory medical benefits under Section 105(h), the medical benefits (which are compensation) become taxable to the HCIs. This satisfies the requirement under Section 409A (discussed below) that the promised payments be taxable compensation. Then, to the extent, the arrangements provide that the HCIs have a legally binding right to be paid a medical benefit in a future year, this satisfies the deferral requirement of Section 409A. Note that coverage in a future year is not required. Rather, it is sufficient if the right to payment carries over to a future year, even if the coverage will not.
In some cases, compensation that has been deferred is excluded from coverage under Section 409A because of a specific exception, e.g., the exception for certain post-termination expense reimbursement arrangements. This exception exempts from Section 409A medical expense reimbursements that are provided in connection with a termination of employment and that do not continue beyond the end of the second calendar year beginning after the termination, i.e., a period that encompasses the remaining portion of the current calendar year combined with the next two complete calendar years (the “two and a fraction year period”). This applies even though the medical reimbursements may be taxable under Code Section 105(h), so long as the reimbursements are limited to medical expenses within the meaning of Code Section 213. See, Prop. Treas. Reg. § 1.409A-1(b)(9)(iv)(A).
However, a problem with this exception is that it is structured based on when payments may be made, rather than based on when the underlying claims are incurred. Because medical coverage is primarily time-limited based on when claims are incurred, this exception may not be very workable to exempt a discriminatory arrangement from the reach of Section 409A. However, if the discriminatory arrangement was provided in connection with an HCI’s termination of employment and did sufficiently limit the period during which the HCI could be entitled to receive payments (so that no medical reimbursements could be received after the end of the second calendar year following termination), any such arrangement should not be covered by Section 409A. The potential for exposure under Section 105(h) would remain. That exposure may be greater than in years past if Section 409A becomes, as it reasonably could, the catalyst for greater focus by the Service on health plan nondiscrimination. Still, the draconian penalties of Section 409A (discussed below) would not apply.
As a practical matter, given the long lead times that can be necessary for complete resolution and payment of health claims under many plans, the need to limit all payments to the “two and a fraction year period” greatly limits the utility of this exception. For example, some claims administrators do not have the mechanical ability to apply a distinct reimbursement time limit to a particular former employee or group of former employees. If an executive employment contract provides for two years of extended coverage following termination of employment, it may not be possible to limit the right to reimbursements in accordance with the “two and a fraction year period.”
Another problem with the exception for post-termination expenses reimbursement arrangements is that it only covers payments that are provided in connection with termination of employment. Thus, this exception would not be available with respect to a plan that provides discriminatory health coverage while the HCI is still rendering services to the employer. In these cases, there is a different exception that can apply based on when payments are made (the short-term deferral exception), but it requires payments to be made much more quickly, i.e., no later than 2½ months after the end of the “year” in which the right to payment arises (either the calendar year or the applicable fiscal year of the employer, whichever ends later). Thus, for expenses that are incurred right before the end of the relevant year, this rule allows only 2½ months for all reimbursements to be completed.
Effect of Application. Once Code Section 409A applies to a discriminatory arrangement, the health benefits provided pursuant to the arrangement must comply with the requirements of Code Section 409A. Unfortunately, there is an inherent inconsistency between how medical plans determine the time of payment of reimbursements and how Code Section 409A requires plans to determine the time of payment of compensation that is subject to Code Section 409A. Health plans determine the timing of payments based on when a claim is incurred and submitted for reimbursement. Under Code Section 409A, all payments must be triggered by certain events that qualify under Section 409A or be based on a pre-set schedule. Neither incurring nor submitting a claim is an event that qualifies under Section 409A. Therefore, ordinary medical reimbursement plans that make payments based on when claims are incurred and submitted will not comply with Section 409A. Indeed, the awareness of this fact by Treasury and the Service is what led to the inclusion of the special exception for post-termination medical reimbursement arrangements (described above) in the recently issued Proposed Regulations.
Ultimately this is a significant problem because the penalties under Section 409A are designed to get attention. If there is noncompliance with Section 409A, then the compensation that is deferred (i.e., the amount of the health benefits paid in each year under the health plan) is treated as taxable income. This is the same rule as provided by Section 105(h), but Section 409A makes this compensation subject to employer withholding. Even more significantly, Section 409A triggers compensation inclusion under all plans of the same type. Within the scheme of Section 409A, a health plan will generally be a “nonaccount balance plan.” Thus, if the employer also offers the employee a nonqualified SERP that provides a defined benefit, the failure under Section 409A of the employee’s health coverage can trigger taxation of not just the health benefits, but also the total amount due to the employee under the SERP as well (except for pre-2005 SERP accruals that qualify as grandfathered under Section 409A). Then all of this taxable compensation is subject to a 20% penalty and penalty interest. The penalty interest builds up the longer the amount is deferred. (Indeed, there will be cases where the combination of regular income taxes, the 20% penalty and built-up penalty interest will result in the affected employee owing the Service more than the employer payments he is receiving.) The regular compensation, the 20% penalty compensation and the penalty interest must be reported on a Form W-2 or 1099 with respect to the affected individual. See, IRS Notice 2005-1 Q&A-32 and 33. Although not clear, the amount of the compensation may be subject to applicable FICA withholding as well.
Methods to Avoid Code Section 409A Application
As discussed below, there are two effective methods to avoid the application of Section 409A to a discriminatory arrangement. In addition, although we have defined a “discriminatory arrangement” to refer only to self-insured health plans, it bears noting that replacing self-insured coverage with insured coverage can also be an effective way to address the impact of Section 409A on health coverage that may be discriminatory, because Section 105(h) does not apply to insured health plans. The key detail here is to make sure that the coverage in question is really insured within the meaning of Section 105(h). Nominally insured coverage that still exposes the employer to claims risk in a way that is functionally like self insurance can be covered under Section 105(h).
Payments of Premiums on an After-Tax Basis. Code Section 105(b) applies to exclude the value of medical benefits from the taxable income of employees who receive medical coverage that is paid for by an employer. Code Section 105(h) then removes this exclusion from income for benefits that are paid to HCIs under a discriminatory medical plan, and treats those benefits as taxable compensation. It is this taxable compensation that triggers the application of Code Section 409A. Therefore, if Code Section 105 did not apply to a discriminatory medical arrangement, the nondiscrimination rules under Code Section 105(h) would not apply and Code Section 409A would not be triggered.
If the HCIs under the discriminatory arrangement pay for the entire premium on an after-tax basis, i.e., both the employer and employee premiums, the medical benefits that are paid would be excluded from the HCI’s gross income by application of Code Section 104(a)(3). In this instance, therefore, Code Section 105 and Code Section 409A would not apply. In order for Code Section 104(a)(3) to fully apply (and thus to permit Code Section 409A to be fully avoided), the entire premium – correctly determined – must be paid by the HCI on an after-tax basis. The full COBRA premium (without the 2% add-on for administrative expenses) includes both the employee and employer portions and, thus, should be an appropriate figure to use in this instance. In this regard, we should note that there is an implication in the Proposed Regulations that even 100% tax excludible income of this sort can be subject to Section 409A if it is continued beyond the “two and a fraction year period” discussed above. However, Treasury personnel have repeatedly stated since the publication of the Proposed Regulations that the referenced implication is not intended and that 100% excludible income will be exempt from Section 409A unless it is obtained by way of a trade for deferred compensation.
Negative Discretion. As provided above, Code Section 409A is triggered when a service provider has a legally binding right to taxable compensation in a future year. A legally binding right does not exist if that compensation may be reduced or eliminated by the company. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation lacks substantive significance, a legally biding right will still exist. If the facts demonstrate that the HCIs do not have a legally binding right because benefit payments under the discriminatory arrangement can be terminated at any time, then the existence of this negative discretion should prevent the application of Code Section 409A to the discriminatory arrangement.
However, even though most health plans are drafted to permit amendment and termination at any time, special post-employment health coverage arrangements or arrangements that grant special service credit to qualify for retiree health coverage may prevent amendment and termination. For example, these arrangements may be entered into in the context of a severance agreement, and may be drafted to provide enforceable rights in exchange for a release of claims against the employer. This commitment may override the generally applicable right to amend and terminate health coverage.
Even in cases where the right to terminate the health plan does apply to an employee with discriminatory coverage, generally such right only applies prospectively to claims that are incurred after the termination. Therefore, once a claim has been incurred in a case like this, the employee usually would have the legally binding right to be paid for incurred claims beyond the year in which they are incurred. This is enough to bring Section 409A into play. Therefore, if reliance is placed on negative discretion to avoid Section 409A, it is important to understand how broad the scope of the discretion must be.
Conclusion
As noted above, and as reflected in public comments by Treasury representatives, it is clear that if a self-insured health plan violates Section 105(h), Section 409A issues can arise – and that implicates Section 409A’s daunting penalties. Because a discriminatory health plan will not easily fit within one of the exemptions from Section 409A, and because it is inherently difficult for a health plan to comply with Section 409A, employers will need to take care to identify and address non-exempt discriminatory plans promptly. While a transition period for revising plans extends to the end of 2006, operational compliance is required currently and so time is of the essence.
If you would like additional information about Section 409A, please contact:
Office Name Phone Email
Atlanta Jennifer Schumacher 404-815-6298 JSchumacher@KilpatrickStockton.com
Raleigh Lois Colbert 919-420-1722 LColbert@KilpatrickStockton.com
Washington, DC Mark D. Wincek 202-508-5801 MWincek@KilpatrickStockton.com
Washington, DC Mark L. Stember 202-508-5802 MStember@KilpatrickStockton.com
Winston-Salem Bill E. Wright 336-607-7424 BWright@KilpatrickStockton.com
[1] Code Section 105(h)(5) provides that an HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10% of stock of the employer, or (c) among the highest paid 25% of all employees. Therefore, due to the 25% rule, an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code section 414(q).
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