Current developments in employee benefits.
This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part I, published in November, focused on current developments affecting qualified retirement plans, including the effect of the Revenue Reconciliation Act of 1993 (RRA); the Voluntary Compliance Resolution program and other plan qualification issues; fiduciary responsibilities, including the Department of Labor (DOL) regulations under Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA); and distribution rules. Part II, below, will focus on the RRA provisions that affect compensation and benefits; the Family and Medical Leave Act (FMLA); Securities and Exchange Commission (SEC) disclosure requirements for executive compensation; the recent Financial Accounting Standards Board (FASB) proposal on accounting for stock compensation; SFAS 112 concerning the reporting of benefits for former or inactive employees; and other regulatory guidance concerning compliance with the Americans With Disabilities Act (ADA) and the taxation of insurance benefits.
The Revenue Reconciliation Act of 1993
Generally, no deduction will be allowed for any corporation required to register its stock with the SEC for compensation in excess of $1 million paid to the chief executive officer or any of the four other highest paid officers for whom compensation must be reported under SEC rules. However, the disallowance will not apply to any performance-based compensation, such as stock options or stock appreciation rights, that is paid after achieving goals previously set by a directors' compensation committee and approved by the shareholders in a separate vote. It also will not apply to commissions based on income generated directly by the employee, qualified retirement plan contributions (including salary reductions) or nontaxable benefits.(27) The disallowance applies to amounts otherwise deductible in tax years beginning on or after Jan. 1, 1994. There is an exception from this deduction limit for remuneration paid under a written contract in effect on Feb. 17, 1993, and unchanged in any material respect thereafter.
The cap on wages or self-employment income subject to the 1.45% (2.9% for self-employment income) hospital insurance portion of the social security (FICA) tax is eliminated for wages and income received after Dec. 31, 1993.(28) This change will also create an issue for deferred compensation. Under Sec. 3121(v), deferred compensation is treated as FICA wages at the later of the time the services are performed or when there is no longer a substantial risk of forfeiture. In the past, most individuals receiving deferred compensation had already reached the FICA wage caps; hence, the additional deferred compensation was not subject to FICA. With the elimination of the cap, employers will have to pay closer attention to the point in time at which the deferred compensation will be subject to the hospital insurance portion of FICA taxes.
The deduction allowed self-employed individuals for 25% of the amount paid during the tax year for health insurance for themselves and their families is extended through Dec. 31, 1993, retroactive to July 1, 1992. Whether an individual is disqualified for the deduction because of coverage under an employer's plan is determined on a month-by-month basis, for tax years beginning after Dec. 31, 1992. Previously, such coverage at any time during the year disqualified the deduction for the entire year.(29)
The income exclusion for educational assistance provided under an employer plan that expired July 1, 1992 is retroactively reinstated for payments and expenses incurred after June 30, 1992 and through Dec. 31, 1994.(30) In IR-93-85,(31) the IRS issued a special procedure under which employers and employees can claim refunds for taxes paid on excludible educational assistance benefits provided to employees in the second half of 1992 and in 1993. Many employers and employees began treating educational assistance payments as taxable compensation for Federal income, social security and Medicare tax purposes after June 30, 1992 when the annual exclusion under Sec. 127 for up to $5,250 of employer-provided benefits under an education assistance program expired.
IR-93-85 states that employees who are entitled to refunds of 1992 income taxes can claim them by filing a Form 1040X, Amended U.S. Individual Income Tax Return, with the IRS. To do this, they will need from the employer a Form W-2c, Statement of Corrected Income and Tax Amounts, showing the corrected amount of wages. In most cases, employees claiming a refund under the special procedure need only write their name, address, social security number and "1992 tax year" on the Form 1040X, sign the form and attach the Form W-2c. Writing "IRC 127" on the form's top margin will expedite the processing of the claim.
Some employees with a Form W-2c showing corrected wages of $22,370 or less may now qualify for the earned income credit.
Employees should request from their employers reimbursement of social security and Medicare taxes withheld on excludible benefits for 1992 and 1993. In the unusual case in which an employee is not able to obtain a refund of these amounts from the employer, the employee may file a Form 843, Claim for Refund and Request for Abatement, with the IRS. Writing "IRC 127" in the top margin will expedite processing.
IR-93-85 says that the rules governing the payment of social security and Medicare tax refunds from an employer to its employees are not being changed. Under those rules, after refunding social security and Medicare tax overwithholdings to their employees, employers may be able to reduce their Federal income tax liability and deposits for both the employer and employee portions of these taxes. Adjustments should be reported on Form 941, Employer's Quarterly Federal Tax Return, and can be explained on Form 941c, Supporting Statement to Correct Information.
IR-93-85 further states that the rules governing employer social security and Medicare tax refunds to employees, as well as rules governing refunds to employers of any social security, Medicare and unemployment tax also remain unchanged under the special procedure, except that an employer filing a Form 843 to claim a refund of social security, Medicare and unemployment taxes can ensure expedited processing by writing "IRC 127" in the top margin.
The RRA also provides that for tax years beginning after Dec. 31, 1988, employer-provided education or training not excludible under Sec. 127 is excludible only if it qualifies as a working condition fringe benefit, i.e., it maintains or improves skills for a job one already has, but does not prepare one for a new job.
No business travel deduction will be allowed for the expenses of a taxpayer's spouse, dependent or companion, unless those expenses would have been deductible without regard to the taxpayer. This change applies to expenses paid or incurred after Dec. 31, 1993.(32) The current deduction disallowance for 20% of business meal and entertainment expense is increased to a 50% disallowance, effective for tax years beginning after Dec. 31, 1993.(33)
No deduction will be allowed for amounts paid or incurred as club dues after Dec. 31, 1993 (including dues for airline, hotel, business, social, athletic, luncheon and sporting clubs). The disallowance will not apply to amounts paid for specific services (such as meals) provided by the club.(34)
The income tax withholding rate is increased from 20% to 28% on bonuses and similar supplemental wage payments made after Dec. 31, 1993.(35)
Effective Jan. 1, 1993, a new 36% tax rate will apply to taxable income of more than $140,000 for a married couple filing a joint return and $115,000 for an unmarried individual.(36) A surtax of 10% will apply to taxpayers with taxable income of more than $250,000, whatever their filing status (however, married individuals filing separately will pay the surtax beginning at $125,000 of taxable income).(37) The current law phaseout of personal exemptions and disallowance of a portion of itemized deductions are both made permanent.(38) These higher tax rates will enhance the attractiveness of deferred compensation programs of all types, including incentive stock options. Tax-free benefits such as health care, dependent care and life insurance also become more valuable.
The new law provides that any group health plan that provided coverage for pediatric vaccines on May 1, 1993 will be subject to an excise tax penalty if the plan reduces that coverage after May 1, 1993. The tax will apply for plan years beginning after the date of enactment of the law.(39) This is the first "mandated" health care benefit imposed by the Federal government.
To promote the Department of Health and Human Services's (HHS) ongoing program to make Medicare a secondary payer under the Medicare Secondary Payer statute and to provide assistance to those states seeking to make Medicaid a secondary payer, the Omnibus Budget Reconciliation Act of 1993 (of which the RRA is a part) creates a new Medicare and Medicaid Coverage Data Bank and requires employers providing group health plans to report information for each calendar year beginning Jan. 1, 1994, and extending through 1997. These reports are to be made at the same time Forms W-2 are filed.
The employer is required to report information for each current or former business associate (except domestic employees as defined in Sec. 3121(a)(7)(B)) electing coverage under the plan. The reports must provide the name and taxpayer identification number (TIN) of the electing individual; whether single or family coverage is elected; the name, address and identifying number of the health plan elected; the name and TIN of other individuals covered by the election; the period of coverage; and the employer's name, address and TIN. Employers failing to report this information will be subject to penalties. The burden of reporting this data will depend on HHS's approach in reporting and the level of coordination with Form W-2. Employers can require insurers and other third parties with the information to provide the information directly to the Data Bank.
New ERISA Section 609 sets up a procedure that requires group health plans to honor a "qualified medical child support order" issued under state domestic law and requiring health benefits be provided to a child. The process for issuing and honoring such an order is similar to that provided for "qualified domestic relations orders," and the plan cannot be required to provide any types or forms of benefits not otherwise provided for under the plan.
New ERISA Section 609(b) addresses the interaction of state Medicaid programs and group health plans. The section requires the employer plan to honor any assignment of rights to the Medicaid program made by the employee or other beneficiary. The section also prohibits employers providing group health plans from taking into account in determining eligibility or payment for benefits under the plan the fact that participants or beneficiaries are eligible for Medicaid. Finally, group health plans must provide that, if the state Medicaid plan has paid for medical assistance in any case in which the plan has a legal liability to pay for that medical assistance, the plan will pay for such assistance in accordance with state laws that provide for Medicaid subrogation rights.
If a group health plan provides coverage for dependent natural children of participants or beneficiaries, the plan must also provide coverage under the same terms and conditions for adopted children under age 18 from the time the child is placed for adoption, regardless of whether the adoption has become final. Coverage cannot be restricted for such children solely on the basis of a preexisting condition at the time the child becomes eligible for coverage.
The changes made under new ERISA Section 609 are effective Aug. 10, 1993. Plans need not be amended before the first day of the plan year beginning on or after Jan. 1, 1994.
Family and Medical Leave Act of 1993
The law requires employers of 50 or more employees to provide 12 weeks of unpaid leave for certain eligible employees for the birth or adoption of a child or placement of a foster child, caring for a spouse, son, daughter or parent with a "serious health condition," and the employee's own serious health condition.(40) The law was effective Aug. 5, 1993. Regulations were issued in June.
Eligible employees are those who have worked for the employer for at least a year, worked at least 1,250 hours during the previous 12 months, and work at a worksite having 50 or more employees or having 50 or more employees within 75 miles of that worksite.(41) If an employer has outlets in 17 locations widely dispersed across the country and employs 20 employees in each location, for example, the employer technically is covered under the Act, but none of the employees are eligible for leave because none of them work at a site that has 50 employees within 75 miles of each other.
Designation of the "employer" can be extremely important for applying the rules to determine whether the employer is covered by the FMLA. The regulations do not impose a bright-line test. The legal entity employing the employee will be treated as the employer. This will ordinarily be a corporation. Unlike the IRS rules under Sec. 414, a "controlled group" test is not applied. When one corporation has an interest in another corporation, it is still a separate employer, unless both corporations are "joint employers" directing the employee's activities or they are "integrated employers."(42) Whether the corporations are integrated employers will depend on the entire relationship, but factors that will be considered are common management, interrelation between operations, centralized control of labor relations and the degree of common ownership/financial control. "Successors in interest" to a covered employer are considered covered employers.
"Serious health condition" is defined as a condition involving hospitalization or other institutionalization or continuing treatment by a health care provider.(43) The employer may ask for certification of serious health conditions and may, in certain circumstances, at the employer's expense, seek a second or even third opinion on the status of the health condition.
The employer can place some restrictions on the leave. If paid leave is available, the employer can require the employee to count the paid leave as part of the 12-week period.(44) If any employee is entitled to sick leave, an employer may require the employee to count such sick leave as part of the 12-week leave period if the reason for the leave is the employee's or family illness. The sick leave would have to be available for nonemployee illness in order to count as part of the 12-week period in a family illness situation.(45)
"Intermittent" or reduced-hours leave is not required f or the birth or adoption of a child, but in cases of serious health conditions intermittent leave must be provided when medically necessary. If intermittent leave is sought based on foreseeable treatments for a health condition, the employer may require the employee to transfer to an equivalent position that can more easily accommodate recurring periods of leave.46
The employer must restore the employee to his job or an equivalent job.47 This restoration requirement will not apply to any employee who is among the highest paid 10% of employees within 75 miles of the employee's worksite, if denying the job restoration is necessary to prevent substantial and grievous economic injury to the employer's operations.(48)
Any group health plan, including self-insured plans, provided by the employer must be continued for the employee on leave on the same terms such coverage would have been provided if the employee had continued employment.(49) Employees who fail to return to work (except in cases of continued serious health conditions of the employee or family or other circumstances beyond the employee's control) must repay the premium costs of the health care coverage.(50)
The employer must also make and retain records showing compliance with the law.(51) Note that because an employer who employs 50 or more employees is covered under the FMLA, such an employer will need to keep records even if the geography of the employment sites is such that none of the employees are eligible for the leave.
State and local laws providing more generous leave policies are not superseded or preempted by this law.(52) Because some heavily populated areas, such as California and the District of Columbia, already have more generous leave requirements, nationwide employers may not have the luxury of uniform leave policies.
Employees may bring an action on their own for damages for compensation lost or, if compensation was not lost, for monetary losses sustained by the employee as a result of the employer's violation of the law, up to a sum equal to 12 weeks of salary, plus interest on these amounts. In addition, liquidated damages up to an amount equal to the amount awarded for lost compensation or other loss plus interest may also be awarded, unless the employer can show reasonable grounds for believing no violation was being committed and acted in good faith. Reasonable attorneys' fees and other costs can be awarded to the prevailing plaintiff at the discretion of the court. The Secretary of Labor can also bring an action either administratively or in court for similar damages.(53)
Fortunately, the law does not require major changes for employers. No specific notification rules are required by the law. Employers should review their current leave policies, including sick leave and vacations. The goal should be to use those programs as efficiently as possible to mesh with the required family leave. Disability programs should also be reviewed. Employers who have provided leave policies for executives but not for rank-and-file employees need not eliminate the executive programs. There are no "nondiscrimination" provisions in the FMLA. But such employers now will need to provide leave for all employees.
Employers should examine policies with health care, disability and life insurance providers regarding reinstatement procedures, if any, for employees who have used the full 12 weeks of leave. Under the regulations, returning employees must receive the same benefits they would have been entitled to had they remained at work. Physical exams, waiting periods and preexisting condition clauses may not be imposed on employees returning from FMLA leave, regardless of the provisions of the insurance contracts or plans. The regulations acknowledge that some insurance contracts may have to be modified or the employer must arrange for the employee or the employer to continue paying the costs of such coverage to keep the employee in the plan.(54) Note that in the case of health care benefits, the employer must continue the same benefits the employee would receive if he was at work. Problems could arise in this context if the employee neglected to pay his portion of the premium, was dropped from the plan and then had to be reinstated when returning to work.
The only guidance these regulations provide on cafeteria plans is to note that the employee-paid portion of health care due during an FMLA leave could be prepaid under a cafeteria plan. Presumably this would be acceptable to the IRS to protect the tax qualification of a Sec. 125 plan since the proposed regulations under Sec. 125 do not require equal salary reductions on a fixed basis throughout the plan year. However, if this method is used, in most cases the cafeteria plan document would have to be amended to provide for such prepayments.
Executive Compensation Disclosure
On Oct. 16, 1992, the SEC issued new rules on Executive Compensation Disclosure and Communications Among Shareholders for proxy statements and other information filings.(55)
Executive compensation information is now presented in a series of tables, rather than in the long, narrative, legalistic discussions used previously. A report from the Compensation Committee and a Performance Graph showing the performance of the company's stock relative to other benchmarks will be presented. Companies will be required to disclose compensation for the chief executive officer (CEO) (regardless of the amount of compensation) and the four most highly paid senior executive officers, other than the CEO, who earn more than $100,000 per year in salary and bonus.
The rules provide for a new comprehensive table disclosing the annual salary, bonuses and all other compensation awards and payouts made to the named officers. Stock options will be disclosed as a number awarded and will not be assigned a value. The table covers a three-year period, although two of the columns ("Other Annual Compensation" and the catch-all "Other Compensation") may be phased in by companies over the first three years of reporting. The rules require three additional tables detailing options/SAR grants and exercises plus awards under other stock-based and nonstock-based compensation plans.
The rules require a new report to shareholders by the members of the compensation committee that generally discusses the company's compensation policies for executive officers and the committee's bases for determining the compensation of the CEO for the past fiscal year. The report must also include a discussion of the relationship of executive compensation and CEO compensation to corporate performance. Nonetheless, the report should not disclose specific quantitative or personal factors or confidential information. It will have the same status as the annual report to shareholders, i.e., shareholders dissatisfied with the report should act through their power to elect directors, not through litigation.
The rules require a performance graph of the cumulative total return to shareholders (stock price appreciation plus dividends) during the previous five years in comparison to returns on a broad market index (such as the Standard & Poors (S&P) 500) and a peer group index (such as the S&P Retail Index, depending on the company's line of business) or a peer index constructed by the company. Companies must provide a table giving the estimated annual benefits payable on retirement under pension and other defined benefit or actuarial plans for the named executives. Companies must disclose the terms of employment and severance agreements with payments of more than $100,000 with respect to the named officers. Disclosure is also required regarding standard compensation arrangements for directors, as well as any other compensation for services, such as consulting contracts.
Accounting for Stock Compensation
On June 30, 1993, amid much publicity and controversy, the Financial Accounting Standards Board issued an exposure draft of a Proposed Statement of Financial Accounting Standards, "Accounting for Stock-based Compensation." The proposed statement would supersede APB Opinion 25, "Accounting for Stock issued to Employees." it would apply to all transactions in which an employer grants shares of its common stock, including restricted stock, stock options or other equity instruments, to employees and would effectively eliminate the current accounting distinction between "fixed" and variable" stock-based compensation plans.
Changes to current accounting practice under the proposed statement include the following: F-I Compensation cost would be recognized for virtually all stock-based compensation arrangements. Currently, compensation cost is recognized only if the quoted market price of the underlying stock exceeds the amount the employee is required to pay (intrinsic value) on the measurement date.
* Compensation cost for all stock-based compensation awards would be measured on the date of grant. This is a significant change for performance-based or variable awards, for which compensation cost is now ultimately measured when the performance conditions are met.
* Compensation cost would be measured based on the estimated fair value of the equity instrument awarded. The estimated fair value of stock options would be measured using a pricing model that considers specified factors. Currently, compensation cost is determined by the intrinsic value at the measurement date.
* Fluctuations in underlying stock price after the date of grant would not change compensation cost determined at grant date. Currently, for performance-based or other variable stock-based awards, fluctuations in the underlying stock price are reflected in compensation cost until the performance conditions are met.
* Awards granted for future services would be recorded as an asset amortized ratably over the vesting period. Currently, compensation cost related to future services is recorded as a contra-equity amount, or not recorded until compensation expense is recognized (i.e., as services are performed).
* Dividends paid on restricted stock awards that are not expected to, and do not, vest would be recognized as additional compensation cost during the vesting period. Currently, dividends paid on restricted stock awards during the vesting period are charged to retained earnings.
* Cash settlements of awards qualifying as equity instruments would be charged to equity to the extent of the fair value of the instrument repurchased. Currently, cash settlement of an earlier stock-based award represents the final measure of the related compensation cost.
* Primary earnings per share calculations would consider only those dilutive common stock equivalents expected to vest. Currently, all dilutive common stock equivalents outstanding are considered in the primary earnings per share calculation.
The changes required by the proposed accounting standard could affect employers' financial statements in a number of ways. Entities that historically have provided fair value stock options to key executives or have established broad-based plans, such as Sec. 423 stock purchase plans, would experience a negative earnings impact. Conversely, compensation cost would generally be reduced for entities that rely predominantly on performance-based or other variable plan awards. The impact on earnings, whether positive or negative, would be amplified for entities that rely on stock-based compensation awards as a critical element in their overall compensation strategy. Entities that grant stock-based compensation awards may also be affected by the complexities involved in administering and accounting for such awards. Such entities may need to make systems modifications to accumulate information necessary for valuation purposes and to provide accurate accounting information for the life of individual grants.
Compensation plan design and strategies should be reviewed to determine what effect the proposed statement may have on long-term incentive programs. While a cost would be associated with stock options, fair value stock options will still be a cost-effective means of rewarding executives, compared to other cash and equity long-term incentives. Assuming a moderate increase in share value over time, options would be more cost-effective under the proposed statement than cash stock appreciation rights (SARs), restricted stock performance shares or performance units. From a compensation strategy standpoint, a positive aspect of the proposed statement is that, with modified grant date accounting, the bias against performance-based long-term incentives would be removed. Companies would be able to attach performance criteria to stock options and restricted stock awards, thus making these programs more sensitive to shareholder value creation.
The FASB has proposed an extended transition period to enable employers to become familiar with option-pricing models and consider whether they should modify their stock-based compensation plans before income statement recognition would be required. The transition provisions are also expected to provide financial statement users time to become accustomed to the results of the proposed rules. Disclosure provisions under the proposed statement would be effective for fiscal years beginning after Dec. 31, 1993. Disclosure of the pro forma effects on net income and earnings per share of recognizing compensation cost would be required for awards granted after Dec. 31, 1993. Recognition of compensation cost in the employer's income statement would be required for years beginning after Dec. 31, 1996 for awards granted after that date.
SFAS No. 112 - Accounting for Benefits
to Former or Inactive Employees
Who Are Not Retirees
Effective for fiscal years beginning after Dec. 15, 1993, employers subject to FASB accounting standards will be required to comply with SFAS No. 112, requiring accounting for certain postemployment benefits provided after employment but before retirement to former or inactive employees, their beneficiaries and covered dependents. SFAS No. 112 covers benefits provided in cash or in kind that may be paid as a result of disability, layoff, death or other events. SFAS No. 112 essentially requires accounting for these benefits as they are accumulated rather than on the "pay-as-you-go basis" currently used by most employers. Such benefits would typically include disability payments, supplemental unemployment benefits, job training and counseling, COBRA benefits, other health care continuation programs, or life insurance that may be continued after an employee leaves the employer or is on leave.
In brief, SFAS No. 112 requires that expenses for benefits to former or inactive employees be accounted for under either SFAS No. 43, Accounting for Compensated Absences (which previously applied only to active employees on vacation, sick days and holidays), or SFAS No. 5, Accounting for Contingencies. Postemployment expenses are to be accounted for under SFAS No. 43 at the time the employer's obligation to provide the employee's benefit in the future is attributable to services already rendered by the employee; the obligation relates to rights that accumulate or vest; payment of the obligation is "probable"; and the amount can be reasonably estimated.
If the postemployment benefits do not meet all four of the above criteria, liability for these benefits should be reported under SFAS No. 5, which requires reporting such liabilities when it is probable the obligation has been incurred, and when the amount of the obligation can be reasonably estimated. If the conditions for application of neither statement can be fulfilled because the amount of the obligations cannot be reasonably estimated, the employer's financial statements must disclose that fact.
Plan design changes can reduce employers' liabilities under SFAS No. 112, and one way to do so is to eliminate benefits that "accumulate" and move to benefits that are not dependent on length of service. While such changes may be a good accounting practice, they may be bad human resources and benefits policy for employers who wish to use benefits to reward service. Such changes may also result in a considerable increase in the cost of such benefits. In advising clients on the benefits policy aspect of SFAS No. 112, practitioners will need to weigh a number of complex issues, including whether plan design changes to improve financial statements are worth the increased expense of benefits that now become available immediately and the changed benefits philosophy.
Requiring the accrual of a liability for rights to postemployment benefits that vest or accumulate is a significant departure from previous practice for most companies. Some respondents to the Exposure Draft indicated that postemployment benefits generally do not vest and that an employer usually does not have an obligation until a future event occurs (e.g., the closing of a plant or a disablement event). The FASB specifically responded to these comments by stating that for benefits that accumulate over the employee's service period, the event that creates a liability and affects the amount of the benefit is the rendering of services by an employee. Thus, the fact that a benefit does not vest is not a sufficient reason for not recording a liability. A benefit that accumulates with an employee's service is enough reason to require SFAS No. 43-type accounting if the other criteria are met.
SFAS No. 112 is effective for fiscal years beginning after Dec. 15, 1993. Any unrecorded liability as of the beginning of the fiscal year of the adoption of SFAS No. 112 (i.e., the cumulative effect) should be reported in the year of adoption in a manner similar to the cumulative effect of a change in accounting principle. SFAS No. 112 does not offer a "phase-in" method of adoption. Previously issued financial statements cannot be restated and pro forma presentation of the retroactive application of the provisions of the statement is not required.
Under SFAS No. 112, if obligations for postemployment benefits are not accrued under either SFAS No. 43 or 5 only because the amount cannot be reasonably estimated, the financial statements are required to disclose that fact. Employers that either have significant liabilities recorded or, if not recorded, are exposed to significant liabilities should consider disclosing a general description of the "postemployment plan" similar to the disclosures currently required under SFAS Nos. 87 and 106, such as the types of benefits available to employees, the extent of coverage and the employer's accounting treatment (i.e., whether benefits are being accrued over the service life of the employee or on the occurrence of an event).
One of the most difficult aspects of applying SFAS No. 112 will be assessing the probability of payment. Previously, under the terminal accrual method, a company recorded an estimated liability when the event occurred, such as the injury leading to an employee's disability or the announcement of a plant shutdown or work force reduction program. Under the statement, the probability of payment must be assessed for benefits that vest or accumulate and that otherwise meet the other criteria of SFAS No. 43.
Actuarial data can be developed with respect to medical or disability types of benefits offered by some employers such that a reasonable estimate of the cost as well as an assessment of the probability of payment can be made. Consequently, these employers should be accruing these costs over the employees' service periods under SFAS No. 112 if they also meet the first two conditions of SFAS No. 43.
DOL Enforcement Policy for Cafeteria Plans
In August 1993, the Department of Labor announced that it is extending the "no action" policy outlined in ERISA Technical Release 92-1(56) for cafeteria and certain other participant contribution welfare plans not held in trust.(57) This no-action policy, originally scheduled to expire at the end of 1993, will be extended until final regulations are adopted or until further notice.(58)
The Americans With Disabilities Act of 1990
The Americans With Disabilities Act prohibits employers from discriminating against individuals on the basis of disabilities. On June 8, 1993, the Equal Employment Opportunity Commission (EEOC) issued "Interim Enforcement Guidance" on the application of the ADA to disability-based distinctions in employer-provided health insurance. Although written for EEOC personnel evaluating charges of ADA discrimination with respect to such benefits, the guidelines can also be of use to employers in evaluating their health care plans for ADA compliance.
ADA Section 102(a) prohibits employers from discriminating against individuals with disabilities with regard to "job application procedures, the hiring, advancement, or discharge of employees, employee compensation, job training, and other terms, conditions, and privileges of employment." Section 1630.4(f) of the guidelines clarifies that this prohibition applies to fringe benefits, including health insurance, available by virtue of employment, whether or not administered by the employer. At the same time, however, ADA Section 501(c) allows employers, insurers and plan administrators to establish and/or observe the terms of an insured health insurance plan that is "bona fide" based on "underwriting risks, classifying risks, or administering such risks that are based on or not inconsistent with State law," and that is not being used as a "subterfuge" to evade the purposes of the ADA. Section 501(c) also allows employers, insurers and plan administrators to establish and/or observe the terms of a bona fide self-insured health plan that is not used as a subterfuge.
The guidelines provide the following examples of plan provisions that are not "disability-based distinctions": broad distinctions in coverages, such as between "physical" and "mental/nervous" conditions; blanket preexisting condition clauses (assuming such conditions are not disability-based); universal limits or exclusions from coverage of all "elective surgery" or experimental drugs or treatments; coverage limits on specific medical treatments, such as limitations on the number of transfusions or X-rays, so long as the treatments are not exclusively or nearly exclusively used for a specific disability, even though these limits may have an adverse effect on those with certain disabilities; and annual universal dollar caps on medical benefits, e.g., $25,000 per year per individual.
Examples of plan provisions that are disability-based distinctions include provisions that exclude coverage for a particular disability, such as "deafness," or for a group of disabilities, such as "kidney diseases"; caps on coverages specifying particular illnesses; and exclusions for coverages for conditions applying to a discrete group of disabilities, such as exclusions for "blood disorders" (such an exclusion would apply to disabilities such as leukemia and AIDS and, hence, be disability-based).
Note that even in these examples, the employer or other plan sponsor would have the opportunity to show that such provisions satisfied Section 501(c)'s requirement of being risk-related; however, the burden of proof would be heavy. Also, the guidelines caution that there is no "safe harbor" for health plans adopted before July 26, 1990, the date of the ADA's enactment. If a plan provision is found to be disability-based, the burden of proof will be on the plan sponsor to show that the plan satisfies the requirements of ADA Section 501(c), because the plan sponsor has the data necessary to show the plan is based on risk-related or other financial considerations and that the plan meets applicable state laws. The plan sponsor must show that the plan is "bona fide" (i.e., it exists and pays benefits and has been accurately communicated to the participants), complies with state laws (if an insurance plan) and is not a "subterfuge."
Employers should carefully review their health care plans for provisions that appear to limit coverage for disability-based illnesses. If such limits exist, the client should be prepared to support their necessity, bearing in mind the EEOC guidelines' strict definition of "necessary" as existing only when no other changes in the plan could be made. If employers are concerned about the cost of coverage for various conditions, the adoption of an overall cap for coverage either on an annual or lifetime basis (or both) will eliminate concerns about the costs and will reduce the possibility of ADA challenges to the plan.
Taxability of Retiree Medical Benefits
The IRS has confirmed in Letter Ruling 9242012,(59) that a health insurance subsidy for retirees will be treated as nontaxable only if paid directly to the insurer and will be treated as taxable if included in the retiree's pension payment (absent any requirement that the retiree verify that the subsidy was used to buy health benefits). The ruling also provides a helpful history of earlier rulings on the issue. As employers consider innovative ways of moving from a defined benefit approach to a defined contribution approach to retiree medical care, the IRS's position on direct medical or insurance payments versus subsidies paid to the retiree becomes more important.
A state's treasury included a trust fund to defray the cost of health insurance premiums paid by retirees of the state or of local governments. State and local governments that employ participants in the state retirement system are the sole contributors to the trust fund. The trust fund is not prefunded, and payments are not guaranteed; they may be reduced or canceled if funding is inadequate.
Participants in the state retirement system receive payments from the state's defined benefit plan. In addition, if retirees submit an application with proof that they are covered by health insurance, they are eligible for the health insurance subsidy from the trust fund. Health insurance coverage may be obtained through individually purchased coverage or employer-sponsored group plans. Retirees are not required to document that the health insurance remains in force or the amount of the premium payments. The amount of the subsidy bears no relationship to the cost of a retiree's health insurance, but is based solely on a fixed dollar amount for each year of service.
Distributions from the retirement plan and from the health insurance trust fund are combined in a single monthly check. If a retiree is insured by an insurer on the state's payroll deduction list (i.e., employer-sponsored group plans), the state automatically deducts the subsidy from the monthly check and pays it directly to the insurer. If a retiree is insured by a carrier who is not on the payroll deduction list (i.e., individually purchased coverage), the retiree receives the retirement pension plus the health insurance subsidy in a single monthly check. Once qualified, the retiree will receive the monthly health insurance subsidy automatically as long as the retirement benefits are paid, or until the state is notified that the health insurance has been discontinued.
In numerous rulings, the IRS has determined that benefits provided under an accident or health plan to a retiree, his spouse or dependents may be excluded from gross income under Sec. 106.(60) The IRS has also ruled that benefits provided under an accident or health plan to a deceased retiree's surviving spouse or dependents may be excludible from gross income.(61)
Under Regs. Sec. 1.106-1, employcr-provided coverage under an accident or health plan for individuals other than the employee (or retiree), his spouse or his dependents is includible in the employee's (or retiree's) gross income. When the particular coverage provided to the nonspouse or nondependent is group medical plan coverage, the amount includible in the employee's (or retiree's) gross income is the fair market value (FMV) of the group medical coverage.
In Rev. Rul. 61-146,(62) the employer paid a share of insurance premiums for hospital and medical insurance directly to the insurance company for those employees who were covered by the employer's group policy. For those employees who were not covered by the employer's group policy but had other types of hospital and medical insurance, the employer paid a part of the premiums on proof that the insurance was in force and that the employees had paid the premiums for the period. The ruling held that the amounts the employer paid directly to the insurance company and as reimbursements to the employees were excludible from the employees' gross income under Sec. 106. By contrast, in Rev. Rul. 57-33,(63) the IRS ruled that certain weekly payments made by employers directly to employees, under a union contract, to purchase individual hospitalization and surgical insurance coverage were "wages" for Federal employment tax purposes and includible in the employees' gross income. There, the employers had no accident or health plan of their own in effect; and as to the payments they made directly to employees, the employers did not require an accounting either by the employees or the union that the funds were used to buy insurance coverage.
In Letter Ruling 9242012, as in Rev. Rul. 61-146, the health insurance subsidy paid directly by the state to the insurer for the retiree, his spouse or dependents qualifies as employer-provided coverage under an accident and health plan and is excludible from the retiree's gross income. if the amount of the subsidy exceeds the amount of the premium payment, the excess paid directly to the retiree in the monthly check is includible in the retiree's gross income. Further, the exclusion does not apply to that portion of the health insurance subsidy attributable to the purchase of coverage for an individual who is neither a spouse nor a dependent of the retiree. The FMV of the subsidy attributable to an individual who is not a spouse or dependent of a retiree is, therefore, includible in the retiree's gross income.
As in Rev. Rul. 57-33, the health insurance subsidy paid directly to a retiree in a single monthly check is made without documentation as to whether health insurance is in force or as to the amount of premium payments. Thus, in this situation, the subsidy does not qualify as employer-provided accident and health coverage under Sec. 106. The total amount of the subsidy is includible in the retiree's gross income.
Life Insurance Benefits
On Dec. 15 1992, the IRS issued proposed regulations(64) providing that insurance payments received as qualified accelerated death benefits are considered paid by reason of death, and thus are excludible from gross income, and that a life insurance contract may contain accident and health benefits, referred to as "additional benefits," provided the cost of the benefits is accounted for separately. The proposed regulations provide guidance on the definition of a life insurance contract under Sec. 7702; the treatment of life insurance contracts under Sec. 7702A; and the tax treatment of amounts received as qualified accelerated death benefits under Sec. 101. The proposed regulations would generally be effective for contracts issued or entered into after June 30, 1993.
Over the last few years insurance companies have been offering a new form of life insurance product. The products go by various names - life insurance for the living, living needs and accelerated death benefits. Like traditional life insurance, these products pay beneficiaries on the death of the insured. However, they also provide for certain pre-death payments to the insured if the insured meets certain health-related conditions. These new insurance products were developed to assist policyholders with the rising costs of medical care in their later years. The products may generally be divided into two types of living benefits-accelerated death benefits and accident and health benefits.
Accelerated death benefits address the needs of terminally ill individuals who may incur substantial medical and living expenses before death. This benefit allows the policyholder, under a life insurance contract insuring a terminally ill individual, to "accelerate" the death benefit paid under the contract. Generally, the accelerated death benefit is equal to all or a portion of the death benefit discounted for the remaining life expectancy (generally 12 months or less) of the terminally ill individual. The second type of living benefit is provided on the occurrence of certain morbidity risks, for example, a condition requiring a long-term stay in a nursing home or certain dread diseases. The accident and health benefit is a specified amount determined by reference to all or a portion of the death benefit otherwise payable.
The proposed regulations allow "qualified accelerated death benefits" under an insurance contract to be treated as amounts paid by reason of the death of the insured for purposes of Secs. 101(a) and 7702. This treatment allows an insurance contract including these benefits to continue to meet the definition of a life insurance contract under Sec. 7702. The regulations also permit a person who receives a qualified accelerated death benefit to exclude the benefit from gross income under Sec. 101(a). Further, the regulations provide that "certain other additional benefits" (i.e., accident and health benefits) that do not meet the definition of a life insurance contract can be sold in conjunction with a life insurance contract provided certain conditions are satisfied.
Prop. Regs. Sec. 1.7702-2(d) defines "qualified accelerated death benefit" as a benefit payable under a contract on the life of an insured who becomes terminally ill, if the amount of the death benefit made available cannot be discounted by more than 12 months at a rate of interest specified in the regulations. An individual is terminally ill if the individual has an illness or physical condition that, notwithstanding appropriate medical care, is reasonably expected to result in death within 12 months from the date of payment of the accelerated death benefit.(65) Because the 12-month determination is subjective to some extent, the IRS is considering whether to develop further guidance that would create a presumption of terminal illness in certain circumstances.
Prop. Regs. Sec. 1.7702-2(f) provides that "certain other additional benefits" are benefits that are payable solely on the occurrence of a morbidity risk, the charges for which are separately stated, are not included in the determination of the investment in the contract and are not taken into account for premiums paid under Sec. 7702(f)(1). This treatment of the additional benefit charges is necessary to ensure that contracts providing both accident and health and life insurance benefits continue to qualify as life insurance contracts under Sec. 7702.
Restricted Stock Plans
The IRS has ruled in Letter Ruling 9308022(66) that a provision in an employer's restricted stock plan that causes the restriction to lapse on the occurrence of a public offering or change in control does not preclude the restriction from functioning as a nonlapse restriction, provided the event's occurrence is highly speculative.
Employer established a supplemental executive retirement plan under which Employer's board of directors may grant share awards to officers and key employees (participants). There are two types of share awards: current share awards and deferred share awards.
Current share awards grant participants shares of common stock. Although the participants do not have to pay for these awards, they must enter into an agreement restricting the shares. The shares are nontransferable and the participant must sell the common shares to Employer for book value if the participant terminates employment. If there is a public offering or change in control of Employer, the restrictions no longer apply. However, if there is a change of control, the participant will be required to vote with the majority of the common shares.
A deferred share award is an agreement that entitles a participant either to receive or to buy shares of common stock at a future date. If a participant has to buy the common shares, the price is set at book value. The right to receive or buy the shares is contingent on continued employment. Prior to the date the participant receives or buys the shares, the participant has no voting or other ownership rights in the common shares. The shares, when granted, are subject to the same restrictions as the common shares granted as current share awards.
In general, Sec. 83(a) provides that if property is transferred to a service provider, the excess of (1) the property's FMV (determined without regard to any restriction other than a restriction that by its terms will never lapse) over (2) the amount (if any) paid for such property will be included in the service provider's gross income in the first tax year in which the rights of the service provider are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. According to Sec. 83(d)(1), in the case of property subject to a restriction that by its term will never lapse, and that allows the transferee to sell the property only at a price determined under a formula, the price determined is deemed to be the FMV of the property unless established to the contrary by the IRS.
Regs. Sec. 1.83-3(h) provides that, for purposes of Sec. 83, a restriction that by its terms never lapses is a permanent limitation on the transferability of property that (1) will require the transferee of the property to sell, or offer to sell, it at a price determined under a formula and (2) continues to apply to and be enforced against the transferee or any subsequent holder (other than the transferor). Sec. 83(d)(2) sets out the tax consequences to the service provider and service recipient in the event a nonlapse restriction is canceled by the service recipient.
The IRS concluded that because Sec. 83(d)(2) recognizes that, under normal business practice, nonlapse restrictions can in the future be canceled by the service recipient, the fact that a restriction lapses on the occurrence of an event provided for in a plan does not prohibit it from functioning as a nonlapse restriction, provided the event's occurrence is highly speculative. The IRS went on to rule that the plan did not violate the single-class-of-stock requirement of Sec. 1361(b)(1)(D).
In Weaver v. Phoenix Home Life Mutual Insurance,(67) the Fourth Circuit refused to allow an insurance company to deny benefits to an employee based solely on a statement that the utilization reviewer had authorized lesser coverage. Phoenix Home Life Mutual Insurance provided medical coverage for employees and dependents of Stoller Chemical. Robert Weaver, a Stoller employee, admitted his son to a hospital for treatment for alcoholism, a covered expense. Cost Care, a utilization review firm hired by Phoenix for preadmission review, authorized 12 days of care. At the advice of the hospital physician and an independent physician, Weaver's son stayed in the hospital for 30 days.
When Weaver submitted his claim, Phoenix denied the additional days on the ground that "confinement lasted longer than the time authorized." Weaver then submitted a letter asking for the medical reasons for limiting coverage to 12 days. Weaver claimed he never received an answer, and he sued. Both parties filed a motion for summary judgment in the Federal district court; the court granted summary judgment for Phoenix.
The Fourth Circuit reversed and granted the Weavers summary judgment on the ground that Phoenix violated ERISA Section 503, which requires written notice of specific reasons for denying benefits and the opportunity for a full and fair hearing when benefits are denied. The court ruled that Phoenix's denial of benefits on the ground that the hospital stay exceeded the authorized stay was a "conclusion and begs the question of why the entire period of confinement ... was not authorized." Phoenix noted that Cost Care's specific reasons for the claim denial "were unavailable because they were |proprietary interests' of Cost Care." The court ruled that this unavailability could not shield Phoenix from its duties under ERISA, saying, "Plan administrators may not evade their responsibility under ERISA by contracting to third parties the obligations they have under ERISA." Phoenix may use Cost Care, but to do so, it must "ascertain from Cost Care or whatever outside source it may use, the specific reasons for the denial of claimed benefits and provide such reasons to the beneficiary."
Phoenix argued that, as a fiduciary, its decisions must be upheld absent an abuse of discretion. The court agreed, but pointed out, "It is not for Phoenix Home Life to decide whether to provide participants with specific reasons for claim denials."
Employers using utilization review must be prepared to justify denials of benefits by those utilization reviewers, even when made before the fact, with specific reasons why those denials occurred. The court did not suggest how detailed those reasons must be, but obviously the reasons must be more detailed than simply, "because we said so." For example, Phoenix did not at any time present a report of a physician suggesting that 12 days of care was a reasonable standard. Indeed, Phoenix admitted it did not know the standards used to deny the claim and produced no evidence that it considered any specific facts in denying the claim.
Several recent cases appear to have clarified the issue that a stop-loss provision does not affect a self-insured plan's ERISA preemption. As a result, self-insured plans with stop-loss guarantees do not become subject to state laws.
One recent example is Hampton Industries, Inc. v. Sparrow.(68) Mary Sparrow was injured in a car accident and recovered $25,000 in a settlement with the other driver. Sparrow was covered by her husband's health care plan through his employer, Hampton, which paid approximately two-thirds of her expenses. Hampton sought to attach the settlement amount under a subrogation clause in the health care plan, but Sparrow refused to release the funds. Hampton sued for the funds. The health plan was self-insured but had a stop-loss policy that applied after an annual per-person claim of $60,000, or $75,000 in later years.
Sparrow cited North Carolina law limiting the application of any subrogation agreement to no more than 50% of the recovery. Hampton argued that ERISA preempted this law and its subrogation agreement with the Sparrows should be honored. Both the district court and the Fourth Circuit agreed with Hampton that ERISA preempted the state law. Thus, Hampton was entitled to all the money Sparrow had received through the settlement.
The court acknowledged that ERISA Section 514(b)(2)(A)'s "savings clause" does not apply ERISA preemption to states' regulations of insurance. But the court moved on to ERISA Section 504(b)(2)(B), the so-called deemer clause, which provides that no employee benefit plan will be deemed to be an insurance company for purposes of state law regulation. Applying these provisions, the North Carolina law clearly related to an employee benefit plan in the court's view. The court relied on FMC v. Holliday(69) for the proposition that the deemer clause exempts self-insured plans from state law.
The court cited Thompson v. Talquin Building Products Co.,(70) an earlier Fourth Circuit case decided not long after FMC. That case provides more analysis of the Fourth Circuit's reasoning on stop-loss insurance and its effect on self-insured plans. In Talquin, the stop-loss covered Talquin "on employee claims in excess of $25,000." It is not clear from the facts whether the $25,000 was per employee or a cumulative claims figure.
In Advisory Opinion No. 93-04A,(71) the DOL ruled that the New Jersey no-fault law, requiring coordination of benefits between auto insurance and health care plans, may not be interpreted to apply to ERISA welfare plans until the plans receive an advisory opinion from the DOL specifically stating that the New Jersey law is preempted by ERISA. The DOL stated that ERISA Section 514(a) is self-executing and has broad preemptive powers. Any attempt by a state to alter the scope of preemption is, itself, subject to that preemption.
The above discussion does not determine the meaning of "self-insured" for purposes of Sec. 105(h), which requires nondiscrimination testing for self-insured medical reimbursement plans. Regs. Sec. 1.105-11(b)(2) specifically states, "The rules of this section apply to a self-insured portion of an employer's medical plan or arrangement even if the plan is in part underwritten by insurance." Thus, in the case of stop-loss arrangements for self-insured plans, the nondiscrimination rules would be applied to the portion of the plan supplied below the stop-loss provision, but presumably would not be applied to amounts covered by the stop-loss provision. How this would be determined when the stop-loss provision applied after the cumulative figure was reached by the employer is unclear.
(27) RRA Section 1321 1, adding Sec. 162(m). (28) RRA Section 13207. (29) RRA Section 13174. (30) RRA Section 13101. (31) IR-93-85 (9/16/93). (32) RRA Section 13272. (33) RRA Section 13209. (34) RRA Section 13210. (35) RRA Section 13273. (36) RRA Section 13201. (37) RRA Section 13202. (38) RRA Section 13205. (39) RRA Section 13422. (40) Regs. Sections 825.100(a) and 825.112(a). (41) Regs. Section 825.110(a). (42) Regs. Section 825.104(c). (43) Regs. Section 825.114. (44) Regs. Section 825.208(a)(1). (45) Regs. Section 825.207(c). (46) Regs. Sections 825.203(a) and 825.204(a). (47) Regs. Section 825.214. (48) Regs. Sections 825.216(c) and 825.217. (49) Regs. Section 825.209(a). (50) Regs. Section 825.213. (51) Regs. Section 825.500. (52) Regs. Section 825.701(a). (53) Regs. Section 825.400. (54) Regs. Sections 825.209(b) and (e) and 825.215(d). (55) SEC Act Release No. 6962 (10/16/92), as amended by SEC Act Release No. 6966 (11/16/92); SEC Regs. Section 229.402. (56) ERISA Technical Release 92-1 (6/2/92). (57) 58 Fed. Reg. 45359 (8/27/93). (58) See Walker, "Current Developments in Employee Benefits (Part I)," 23 The Tax Adviser 743 (Nov. 1992), at 749, for a discussion of ERISA Technical Release 92-1 and the background of this issue. (59) IRS Letter Ruling 9242012 (7/20/92). (60) Rev. Ruls. 62-199, 1962-2 CB 38, and 75-539, 1975-2 CB 45. (61) Rev. Rul. 82-196, 1982-2 CB 53. (62) Rev. Rul. 61-146, 1961-2 CB 25. (63) Rev. Rul. 57-33, 1957-1 CB 303. (64) Prop. Regs. Secs. 1.7702-1, 1.7702-2, 1.7702A-1 and 1.101-8. (65) Prop. Regs. Sec. 1.7702-2(e). (66) IRS Letter Ruling 9308022 (11/25/92). (67) Weaver v. Phoenix Home Life Mutual Insurance, 16 E.B.C. 1961 (4th Cir. 1993). (68) Hampton Industries, Inc. v. Sparrow, 981 F2d 726, 16 E.B.C. 1361 (4th Cir. 1992). (69) FMC v. Holliday, 498 US 52, 12 E.B.C. 2689 (1990). (70) Thompson v. Talquin Building Products Co., 928 F2d 649 (4th Cir. 1991). (71) DOL Opinion Letter 93-04A (3/9/93).
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|Title Annotation:||part 2|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 1993|
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