View From Morgan Lewis: Executive Health Benefits Under the Affordable Care Act—Time for a Closer Look
By Althea R. Day, Morgan Lewis & Bockius LLP
The Affordable Care Act requires employers to review and, in most instances, revise the health coverage provided to employees. One area of employee health coverage that merits careful attention is executive health care coverage, both for actively employed and for terminated executives.
Many companies have historically offered enhanced or supplemental health benefits to their executives. Because benefits offered to employees through self-insured health plans have long been subject to nondiscrimination rules intended to prevent such plans from providing greater benefits to highly compensated employees than to other employees, many executive health programs have been provided under fully insured plans, which were not subject to nondiscrimination rules.
However, the Affordable Care Act added a requirement that nondiscrimination rules, basically similar to those applicable to self-insured plans but significantly different in many respects, apply to fully insured plans.1 The effective date of these rules has been delayed until the Internal Revenue Service issues guidance or regulations.2 No such guidance or regulations have yet been issued, but now is the time to review existing executive health arrangements in anticipation of these rules.
Nondiscrimination Rules Applicable to Self-Insured Plans: Risk for Highly Compensated Employees
Generally, benefits provided through self-insured medical plans are not included in the taxable income of the employees who receive the benefits.3 However, if benefits are provided under a plan in a manner that discriminates in favor of highly compensated employees as to eligibility for the benefit or the amount of the benefit provided, the highly compensated employee loses the tax benefit and the value of the benefits paid to the executive in excess of the benefits provided to rank-and-file employees is included in the highly compensated employee’s income.4 If nothing is done to address discriminatory benefits under a self-insured health plan, the costs of underlying medical benefits provided (e.g., the costs associated with a surgery or other medical treatment) would be included in the executive’s income. A simple and common fix to avoid this consequence is to have executives pay the fair market value of the coverage (e.g., the Consolidated Omnibus Budget Reconciliation Act (COBRA) cost) for participating in the plan.5 This allows the value of the benefits provided to be provided on a tax-free basis, but it does require the executive to incur a cost to participate.6
Whether a plan discriminates as to benefits depends on whether it provides benefits to highly compensated individuals that it does not provide to all other participants. For purposes of these rules, in general, a highly compensated employee is a 10 percent shareholder of the employer, one of the five highest paid officers, or is among the highest paid 25 percent of all employees.7 Whether a plan discriminates as to eligibility is determined either by a numerical test based on the percentage of all employees eligible to benefit under the plan or a nondiscriminatory classification of employees eligible to participate.8 These rules apply in the same manner to benefits provided to former employees. In evaluating whether benefits provided to former employees are discriminatory, the covered employee’s status as a highly compensated employee is determined as of his or her termination of employment.9
Nondiscrimination Rules Applicable to Fully Insured Plans: Risk for the Employer
We don’t yet know the details of when a fully insured plan will be considered discriminatory, only that such rules will be similar to those applicable to self-insured plans. The consequences, however, of providing discriminatory benefits under a fully insured plan differ significantly from providing discriminatory benefits under a self-insured plan.
As noted above, providing discriminatory benefits under a self-insured plan causes the highly compensated employees to have income tax inclusion for the value of the excess benefits. Under the Affordable Care Act, if a fully insured plan does not comply with the nondiscrimination rules, the sponsoring employer may be subject to monetary penalties of up to $100 per day per nonhighly compensated employee, up to a maximum of $500,000 per year, unless the violation is corrected within 30 days, or could not have been discovered if the employer exercised reasonable diligence.10 In addition, employees may also have a private right of action to enforce the rule. It would appear that a participant who is not a highly compensated employee in a fully insured plan, as well as the Department of Labor, would have the right to file a lawsuit under the Employee Retirement Income Security Act to compel the sponsoring employer to provide nondiscriminatory benefits.11
In addition, although not entirely clear, it appears that having executives pay the fair market value of the coverage (e.g., the COBRA cost) on an after-tax basis under the fully insured plan may not avoid the new nondiscrimination issues.12 We expect this to be clarified in future guidance.
Exceptions Under the Affordable Care Act
The Affordable Care Act potentially excludes two types of fully insured health arrangements from the new nondiscrimination rules, although it is likely that the scope of these exceptions will be clarified by future regulation:
- Grandfathered plans. The new discrimination requirements do not apply to insured plans that are “grandfathered” under the provisions of the Affordable Care Act. A grandfathered plan is generally one that was in effect on March 23, 2010, and continues to maintain benefits and cost-sharing requirements within parameters set by government regulations. These plans are dwindling in number.
- Former employee plans. The new discrimination requirements apparently do not apply to fully insured group health plans that have fewer than two active employees as participants (i.e., no more than one active employee), sometimes referred to as “retiree only” plans. Thus, a stand-alone fully insured plan that covers only former employees (e.g., retirees) appears not to be subject to the nondiscrimination rules. Note, however, that the sponsor of such a plan would need to ensure that the plan does not inadvertently cover more than one active employee. This may require restricting coverage to a spouse or other dependent of the covered former employee if that spouse or dependent is or becomes an employee of the employer, and careful monitoring to avoid inadvertently covering rehired former employees. A separate plan for purposes of this exception requires a separate plan document, Form 5500 filing, etc. For retired and other former executives, plans that meet this exception may be the best solution.
Pending issuance of IRS guidance implementing the nondiscrimination rules applicable to fully insured plans, employers should review existing plans that provide supplemental benefits for executives and plan for compliance with the new nondiscrimination rules.
- Active Employee Plans. For fully insured plans that provide benefits to active employees, employers should first determine if these plans are “grandfathered” for purposes of the Affordable Care Act, and if so, determine whether the employer intends or is able to maintain the grandfather. For a plan that is not grandfathered, or where it is unlikely that the plan will retain its grandfathered status, the discriminatory benefits being provided should be reviewed and an analysis undertaken of whether the value of the discriminatory benefits provided under the plan could be provided in another manner, such as increased cash compensation, or an increase in another nontaxable or tax-deferred benefit.
- Plans Covering Nonactive Employees. Plans that provide fully insured benefits for retired or other former executives should be reviewed as to current coverage to identify any active employees currently being provided with benefits and to review eligibility provisions to ensure that the plan is and remains restricted to nonactive employees.
Because focus on the nondiscrimination rules applicable to self-insured plans and enforcement of those rules is expected to increase once the nondiscrimination rules for fully insured plans are issued, employers should also review the executive benefits being provided under self-insured plans and consider alternatives.
Althea R. Day (email@example.com) is a partner in Morgan Lewis‘s Employee Benefits and Executive Compensation Practice, and she is active in the Employee Benefits Committee of the American Bar Association, Tax Section. Her practice focuses on tax-qualified retirement plans including pension, profit sharing, 401(k) plans, and ESOPs, as well as nonqualified deferred compensation and equity compensation programs. She is resident in the firm’s Washington office.
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