Understanding Employee Benefits and key developments in the employee benefits field and items of interest to our clients. MORE

In many cases where the IRS claims that compensation is not “reasonable,” the focus is on whether the compensation is too high to be deductible by the employer. The arguments are often reversed in the S corporation context. Because there is only one level of tax in the S Corporation, some owners try to minimize the amounts paid to them as wages and maximize the non-wage distributions paid because the wages are subject to employment taxes and the distributions are not. So in its audits of S Corporations, the IRS sometimes finds itself in the position of arguing that the compensation paid to an owner was unreasonably low, particularly in situations where the S Corporation owner is a service professional (e.g., lawyer or accountant) and the revenue of the business is generated in large measure by the owner.

 That is the situation of Watson v.United States, a recent Eighth Circuit decision involving an accountant’s S Corporation. In that case, the court held that the IRS could recharacterize dividends paid to the S shareholder as wages and subject those dividends to FICA (Social Security) taxes. In doing so, the Eighth Circuit held for the first time that the concept of “reasonable compensation” applies for FICA tax purposes, as well as for income tax purposes, and that the employer’s intent not to pay wages or salary, but instead to make a non-wage distribution, is not dispositive of whether an amount paid is compensation for tax purposes.

 S Corporation owners should keep in mind the requirement that “reasonable compensation” be paid in structuring their compensation arrangements. They should also keep in mind that under qualified retirement plan rules, only the wage payments can be “compensation” for purposes of 401(k) deferrals or other qualified plan contributions. Unreasonably low compensation can also result in low retirement plan benefits.

I am of an age to be contemplating retirement (and I work in the field so that age may come sooner for me than for others).  My parents are both in their late 80s; I had a grandmother who died a few weeks shy of her 100th birthday.  So I have a personal interest in the risk of outliving one’s retirement assets.

The IRS recently issued two sets of proposed regulations and two notices that attempt to address these issues.  One set of proposed regulations, if finalized, will permit plan participants (and IRA holders) to use up to the lesser of 25% of their account balances or $100,000 to purchase what is being called a “Qualifying Longevity Annuity Contract” or QLAC, which is a type of annuity contract purchased before age 70 to begin paying benefits at between ages 80 and 85.  The goal would be to allow participants to use a portion of their retirement assets to ensure that they will have a stream of lifetime income if they outlive their life expectancy so that they can better manage the remaining assets between the time that they retire and the time that the QLAC begins.

The QLAC has a number of requirements and restrictions attached to it; I am assuming that once the IRS finalizes these regulations, the insurance industry will develop products that meet the requirements.  But will employers sponsoring 401(k) plans add them either as an investment option for active participants or as a distribution option for retired participants? Because plan sponsors may have access to institutional pricing of annuities and because plans must provide annuities on a unisex basis, policies available through a plan may provide a better value (particularly for women) than policies available through an IRA, where pricing is more likely to be retail pricing and where gender based rates could be used. 

The reason that plan sponsors may be reluctant to offer QLACs in their plans is fiduciary risk.  The Department of Labor (DOL) places strict standards on plan sponsors/fiduciaries that provide annuities under an individual account plan, such as a 401(k) plan.  The sponsor must engage in an objective, thorough and analytical search for the right provider; must obtain sufficient information to assess the ability of the annuity provider to make all future payments; must consider the costs (fees and commissions) in relation to the benefits and services provided under the contract; and must conclude that the provider is financially able to meet its obligation to make future payments and that the costs are reasonable.  If necessary, the fiduciary must hire an expert to assist it in evaluating the products.

To date, plan sponsors have been reluctant to take on the responsibility of providing annuities to plan participants.  In addition to this IRS guidance, the DOL may also need to provide guidance to plan sponsors that convinces them that the benefits of the QLACs will outweigh the fiduciary risks of QLAC selection. 

I can hope that the guidance comes before I retire.

This is one of several posts we intend to make on the recently issued guidance on the Summary of Benefits and Coverage (SBC).  This is the four (double sided, so actually eight) page uniform summary that will be required for group health plans, as well as for individual insurance policies.  It is intended to provide a way for enrollees to compare coverages more easily.

The statutory effective date to provide the SBC is March 23, 2012.  The regulators were required to issue regulations at least one year in advance of that date. Proposed regulations were issued in August of 2011; final regulations and other guidance, including templates and forms, were formally published on Valentine’s Day, February 14, 2012.

An important question was the effective date:  Under the final regulations, the effective date is postponed for group health plans until the first day of the first open enrollment period that begins on or after September 23, 2012.  For employers with calendar year plans, this probably means that the SBC will be needed for the 2013 open enrollment season.  For plan years that begin in October, November or December of 2012, compliance might not be needed until the plan year beginning in 2013, if open enrollment for the upcoming year begins before September 23, 2012. 

But there is more to the effective date provisions than the above paragraph.  The SBC requirement is also effective as of the first day of the plan year that begins on or after September 23, 2012, for newly eligible enrollees and for enrollees entering the plan under special enrollment rights.  This means that plans with October 1 (and maybe  November 1 or December 1) plan years will have to be prepared to provide the newly eligible and special enrollees with the SBC ahead of the general eligibility date. 

In some cases, the plan may have a little extra time to comply with the requirement.  Under the regulations, special enrollees must receive the SBC by the date that they are required to receive the Summary Plan Description (SPD) for the plan.  That date is 90 days after enrollment.  However, that regulatory exception does not include newly eligible enrollees who are not also special enrollees.  This means that a newly hired (and therefore newly eligible) employee who enters the plan on or after September 23, 2012 and on or after the first day of the plan year beginning after that date must receive the SBC.

Plan sponsors of health plans with October, November or December plan years should pay special attention to these effective date rules.

Those of you interested in data regarding the prevalence of certain features in 401(k) plans may find of interest the Interim Report on the Section 401(k) Compliance Check Questionnaire.  This is the first report of the IRS on the extensive questionnaire that it sent to sponsors of 401(k) plans a year or so ago.  The IRS sent the questionnaire to a random sample of 1,200 401(k) plan sponsors.  Ninety-eight percent of the plan sponsors responded.  Most answers are based on the 2008 plan year so the information is a few years out of date.  Nevertheless, the report contains good statistics on age and service requirements, entry dates, plan limits, plan contributions, etc. 

The IRS intends to issue a final report that will contain more information by size of plan.  In the meantime, 401(k) wonks can mine this data for insights on the 401(k) plan market.

There has been a lot of talk in Washington about deficit reduction, tax expenditures and tax reform. One of the largest identified tax expenditures is the exclusion for employer provided retirement plans, both defined contribution and defined benefit. I was at a seminar recently where the reported number for 2011 was $112 billion for fiscal year 2011. Among the alternatives offered to raise revenue is to reduce the amount that can be contributed to a defined contribution plan from the current $50,000 or 100% of compensation to $20,000 or 20% of compensation, in either case, whichever is less.

What is missed in this debate about tax expenditures, deficit reduction and retirement plans is the fact that — except for Roth contributions — retirement plan contributions are a tax deferral, rather than a tax exclusion. Ultimately, the taxes deferred are paid by the participants who receive the benefits. Those interested in the considerations that can go into quantifying the difference between a tax deferral and a tax exclusion may be interested in a brief published by the Center for Retirement Research at Boston College entitled “What’s the Tax Advantage of 401(k)s?” That analysis shows that the tax cost for 401(k) plans is $50-70 billion per year. It makes for interesting reading and raises important policy considerations for those of us working with retirement plans.

Most qualified domestic relations order (QDRO) cases are fights that affect the formerly married spouses and the plan sponsor or plan administrator. They do not typically affect the other participants in the plan. The case of Milgram v. Orthopedic Associates Defined Contribution Pension Plan (No. 10-862-cv. 2d Cir. Nov. 29, 2011) is different. In that case, plan participants may be adversely affected by the QDRO. 

In Milgram, the employer sponsored two defined contributions plans. In connection with their 1996 divorce, the former husband (Robert) and former wife (Norah) agreed that Norah would receive one half of Robert’s account in one of the plans and a fixed sum, plus earnings, from the other plan. Due to a clerical error, one-half of Robert’s accounts in both plans was transferred to Norah, resulting in an overpayment to her of approximately $764,000. Norah withdrew her accounts in 1998. Robert had retired in 1991, but kept his accounts in the employer’s plans until 1996 when he moved his accounts into an IRA. 

Robert was not paying close attention to his finances and failed to notice the missing $764,000 until 1999. Robert then asked the plan for the missing money, which asked Norah for the money and sued when she failed to pay. After two years of litigation, the plan had not recovered the money from Norah so Robert sued the employer, the plan, the trustees, the third party administrator (who had made the error) and Norah. Fifteen years after the erroneous transfer, the case wound up in front of the Second Circuit Court of Appeals with Robert trying to enforce a judgment against the plan for approximately $1.5 million (his original $764,000 plus about $736,000 of earnings) and the plan saying that it should not have to pay Robert until it has received repayment from Norah – who had been ordered to repay the plan $1.5 million but had failed to do so. 

The Second Circuit upheld the judgment against the plan and affirmed the order that the plan pay Robert $1.5 million. On the one hand, it is appropriate that Robert should receive his $764,000 from the plan since the plan erroneously paid his account to Norah. And since the money was improperly transferred fifteen years ago, it may also be appropriate for Robert to receive earnings on the money. However, since the plan had not yet recovered the overpayment from Norah, satisfying the judgment will require the plan to take the money from the accounts of the other participants. In other words, the other participants will bear the burden of this error.  

The court did not seem troubled by this fact. In the court’s view, the risk that litigation will deplete a participant’s account is inherent in a defined contribution plan, where participants bear investment and other risks. The court also noted that the plan had a judgment against Norah, enforceable through a constructive trust, giving the court “some confidence that no innocent party will suffer in the long run.”  

If I were one of the participants, I might be worried about Norah’s repaying the $1.5 million. During the years of litigation, she has yet to repay the amount. Because of some ERISA technicalities, the courts have generally not allowed claims against participants for overpayments unless the overpaid amount can be traced to a specific account under the participant’s control. Money damages against plan fiduciaries (often including plan sponsors and plan administrators) have also been restricted. The Supreme Court has recently started to allow such claims against plan fiduciaries, but at the time of the Second Circuit’s opinion, there was no lawsuit pending against the employer or third party administrator who had actually made the mistake. It would seem more appropriate for one of those entities to bear this expense than for the other plan participants, who had nothing to do with the error, to have their accounts reduced to pay Robert. Of course, in light of the more recent Supreme Court decisions, perhaps the participants whose accounts are reduced to pay Robert will bring their own lawsuit against the plan fiduciaries for reimbursement. If the participants are lucky, it will not take another fifteen years to resolve the matter.

Most of us have heard that Congress finally extended the 2% payroll tax holiday for two months, namely, through February 29, 2012. In order to prevent highly paid employees from front loading their wages to take advantage of the payroll tax holiday for the entire $110,100 social security wage base, the legislation includes a recapture provision. Individuals must pay with their 2012 income tax return an additional 2% tax on wages received during the period January 1, 2012 through February 29, 2012 that exceed $18,350, which is 2/12ths of $110,100, the social security wage base for 2012. This additional tax is not subject to reduction by credit or deductions. In other words, if Congress does not extend the payroll tax holiday through the entire year, employees who are paid more than a proportionate amount of the wage base during the two month holiday period will be able to benefit from the payroll tax holiday only for the first $18,350 of their wages. Presumably, if the payroll tax holiday is extended for the entire year, this recapture provision will not be needed.

This is the twelfth in a series of articles about health care reform.

One year after the enactment of the health care reform legislation on March 23, 2010, changes are still being made on both the federal and state levels. This article addresses one recent federal policy and one state law change from the State of Minnesota.

Further Delay of Federal Enforcement of Claims Procedures

The U.S. Department of Labor issued Technical Release 2011-01 on March 18, 2011. In it, the Department of Labor, Department of the Treasury and Department of Health and Human Services (the Departments) indicated that they will not take action against nongrandfathered health plans for failure to comply with certain elements of the benefit claims review process discussed below. Under the health care reform law, nongrandfathered plans were to be subject to revised claims review procedures for plan years beginning on or after September 23, 2010. Technical Release 2011-01, issued September 20, 2010, stated that no action would be taken for failure to comply with certain elements of the revised claims review procedures until July 1, 2011. Technical Release 2011-01 further delays some of these requirements.

The Departments will not take any actions against a nongrandfathered plan for noncompliance with elements of the claims process noted below before the listed dates:

1.  Urgent care claims must be decided within 24 hours of receipt (formerly 72) in most cases. Enforcement is delayed until plan years beginning on or after January 1, 2012.

2.  Notices must be given in a “culturally and linguistically appropriate manner.” If a significant portion of employees are not able to read in English, substitute notifications in a non-English language must be provided. Enforcement is delayed until plan years beginning on or after January 1, 2012.

3.  A plan’s failure to strictly adhere to all of the internal claims process will result in “deemed exhaustion” by a claimant of internal claims procedures. Claimants can then pursue external review or judicial review without further exhaustion of the claims procedure and any decision by the plan or insurer will be reviewed de novo rather than under a more plan friendly abuse of discretion standard. Enforcement is delayed until plan years beginning on or after January 1, 2012.

4.  Notices to claimants must provide additional content. Specifically:

a) Any notice of adverse benefit determination or final internal adverse benefit determination must include information sufficient to identify the claim involved, including the date of the service, the health care provider, the claim amount (if applicable), the diagnosis code and its corresponding meaning, and the treatment code and its corresponding meaning.
b) The plan or issuer must ensure that the reason or reasons for an adverse benefit determination or final internal adverse benefit determination includes the denial code and its corresponding meaning, as well as a description of the plan’s or issuer’s standard, if any, that was used in denying the claim. In the case of a final internal adverse benefit determination, this description must also include a discussion of the decision.
c) The plan or issuer must provide a description of available internal appeals and external review processes, including information regarding how to initiate an appeal.
d) The plan or issuer must disclose the availability of, and contact information for, an applicable office of health insurance consumer assistance or ombudsman established under PHS Act section 2793.
Enforcement of this fourth provision is delayed until plan years beginning on or after July 1, 2011. However, no enforcement of the requirement to include the treatment and diagnosis codes and their corresponding meanings will be taken until plan years beginning on or after January 1, 2012.

In addition to the delayed enforcement of the above mentioned claims provisions, the Technical Release stated that the delay is not predicated on the plan’s use of good faith efforts to comply with the listed provisions. However, the Technical Release makes it clear that it does not address the rights of private parties in private litigation or enforcement by the states, but only the enforcement delay on the part of the Departments. Therefore, it may be prudent for plans to put forth a good faith effort to comply with all of the claims review elements promptly.

Finally, the Departments indicate that they intend to amend the final interim regulations published on July 23, 2010, “in the near future.” The amendment will take into account comments provided in response to the previously issued final interim regulations.

Change in State Income Taxation of Health Benefits in Minnesota

On March 21, 2011, Minnesota Gov. Mark Dayton signed into law H.F. 79. This legislation addresses the treatment of employer provided health benefits for adult children for purposes of Minnesota state income taxation. While the federal tax law was previously amended to permit coverage of children under the age of 27 through an employer sponsored health plan on a pre-tax basis from March 30, 2010, forward, Minnesota’s state tax law was not similarly amended. This discrepancy would have resulted in the fair market value of the nondependent child’s health coverage (including reimbursements through medical flexible spending accounts) constituting wages for the employee. However, the new legislation eliminates this discrepancy for 2010. It does so by incorporating the federal Internal Revenue Code as amended through December 31, 2010, for purposes of determining Minnesota taxable wages earned during 2010. Minnesota has yet to address the state tax treatment of such health coverage for tax years after 2010. Employers who distributed 2010 W-2 forms that included the amount of health coverage provided to adult children under the age of 27 as income are not required to distribute corrected W-2s.

This is the eleventh in a series of articles about health care reform.

In October of this year, we published an article, available here, describing the new health care reform requirement that non-grandfathered fully insured health plans must not discriminate in favor of highly compensated individuals. We mentioned that it was unclear how that new requirement would apply to insured plans, and that the penalty for noncompliance is an excise tax of $100 per day per nonhighly compensated individual against whom the discrimination occurs.

Just in time for the holidays, the IRS has released Notice 2011-1, informing employers that ( B – until guidance is issued, compliance with the new rule will not be required—and no excise tax will apply).

The IRS has again invited public comment on the new requirement, including the extent to which an employer’s premium subsidy is a benefit that must be nondiscriminatory, how the rules can apply to an employer that operates in different states with different health insurance polices available, and whether there are any “safe harbor” plan designs that should be available.

In light of the new guidance, employers can wait to redesign their plans to comply with the new nondiscrimination requirement and, if they have already attempted to redesign their plans, can revert to the former design so long as that design is consistent with the insurance policy for the plan.

 

This is the ninth in a series of articles about health care reform.

This article addresses a provision of the Health Care Reform Law that has not gotten as much press as some of the other provisions, such as the requirement to cover adult children to age 26 or the elimination of lifetime limits on coverage. It focuses on the high penalties that an employer may face if it pays a greater portion of the premiums for health insurance coverage for its executives than it pays for its other employees.

Before health care reform, the tax code imposed no limits on the extent to which an employer could subsidize fully insured health insurance policies. So long as the amount the employer paid towards the premiums was consistent with the terms of the insurance policy itself, an employer could discriminate in favor of its executives by paying 100% of the health insurance premiums for an executive while requiring other employees to pay all or a portion of the premium for health plan coverage. There are already nondiscrimination rules that apply to self-funded plans, which cause the benefits received under a discriminatory plan to be taxed to the executives who received them.

The Health Care Reform Law extended the nondiscrimination rules that apply to self-funded plans to fully insured plans that are not grandfathered. The effective date of this change is the first day of the first plan year beginning on or after September 23, 2010, or January 1, 2011, for a calendar year plan. The regulations that define these nondiscrimination rules are more than 20 years old and many aspects of their application are not clear. Because the regulations were written at a time when few employers provided major medical coverage on a self-funded basis, it is difficult to know how they will be applied in complex situations, such as related employers providing different health insurance plans for different businesses. However, one employer practice that is not likely to survive these new rules is the practice of an employer’s paying a higher portion of the premium for executives than for other employees. It is likely that such a difference in premium structure will be considered discriminatory under health care reform.

The IRS recently requested comments on how to apply this extension of the nondiscrimination rules to fully insured plans. In its request, the IRS also clarified that the penalty for failure to meet the nondiscrimination rules is the imposition of an excise tax on the employer sponsoring the plan in the amount of $100 per day for each employee against whom the plan discriminates. In other words, the excise tax will apply on a daily basis for each employee who is not highly compensated and who does not receive the discriminatory benefit. This can result in very high penalties for employers who provide larger insurance premium subsidies to their executive team than to other employees. (In contrast, the same non-discrimination rules applied to self-funded health plans result in taxable income to the highly paid participants). The employer is required to self report this excise tax on Form 8928. Because this new nondiscrimination rule is also a requirement under ERISA, a participant can sue to enforce it. So in addition to the excise taxes, an employer could face a lawsuit by participants demanding the same premium subsidies as the executives.

We can hope that the IRS clarifies the manner in which these nondiscrimination rules will apply to employer plans, including the identity of the non-highly compensated employees against whom plans are not permitted to discriminate. In the meantime, however, employers with insured, non grandfathered health plans should carefully review their insurance policies and strongly consider a uniform premium structure across all employee classifications.