It is common for executive employment, severance and change of control agreements to include post-employment medical benefits or features. These provisions can take myriad forms, but the most common include the following:
1. The executive is provided subsidized coverage under a plan that covers active employees for some period of time (e.g., two years). Where the employer’s plan is self-funded, the premiums are often treated as taxable income, and they are sometimes gross-up for taxes to comply with the non-discrimination rules under Internal Revenue Code § 105(h).
2. The executive elects COBRA coverage, and the employer pays all or some portion of the premiums on a pre-tax basis.
3. The terminated executive purchases individual market coverage, which the employer pays for (if properly structured, this can be accomplished on a pre-tax basis).
Beginning in 2011 (for calendar year plans), changes made by the Patient Protection and Affordable Care Act as amended the Health Care and Education Reconciliation Act (together, the "Act") will call into question the approaches described in options 1 and 2 above in the case of fully insured group medical plans.
This and other changes are included in the Act’s individual and group insurance market reforms, which include amendments to the Public Health Service Act ("PHSA"). These rules also apply generally to group health plans (both insured and self-funded) under amendments to ERISA and the Internal Revenue Code.
In particular, new PHSA § 2716 for the first time imposes non-discrimination rules or insured group health plans that are similar to current rules governing self-funded plans, but with some important differences relating to enforcement.
Before the Act, no benefits-related, non-discrimination rules applied to fully insured group health plans. The reasons for this are historical. Congress was originally of the view that insurance underwriting considerations generally preclude or effectively limit abuses in insured plans. As a result of advances in insurance underwriting and increasing competition in the health insurance markets, however, Congress had a change of heart.
The Tax Reform Act of 1986 added Code § 89, which established a comprehensive set of nondiscrimination rules that applied to a broad range of welfare and fringe benefit plans, including employer-provided group-term life insurance plans and accident and health plans (dependent care plans were subject to special rules).
Code § 89 was the subject of intense criticism. Despite some delays in the effective dates and earnest attempts at simplification, intense lobbying pressure particularly by small business interests ultimately doomed the measure. Code § 89 was repealed in 1989, and the prior rules were reinstated.
Before the Act, a fully insured group health plan could cover management and other highly paid employees under terms that were more favorable than those applicable to rank-and-file employees with impunity.
This made it relatively easy to provide post-termination medical benefits to executives on a discriminatory basis—although this task was made marginally more difficult with the addition of Code § 409A in the American Jobs Creation Act of 2004.
In contrast to their insured counterparts, self-funded plans were and are subject to the non-discrimination provisions of Code § 105(h) that govern self-insured medical reimbursement arrangements.
The Act, for the first time, extends nondiscrimination rules similar to those that already apply to self-funded group medical plans to fully insured arrangements for plan years beginning after Sept. 23, 2010. These include a bar on discrimination based on "eligibility" or "benefits."
Importantly, however, the new rules don’t import that Code § 105(h) penalties under which benefits become taxable in whole or in part.
Rather, the penalties are those found in the PHSA, ERISA and in the Code—i.e., $100 per day penalty imposed on the carrier (under the PHSA), the employer (under the Code) and a potential private right of action on the part of participants who are discriminated against (under ERISA).
Penalties are capped in instances where the violation is unintentional, but it’s not clear that the adoption of a plan design that is discriminatory will be deemed "unintentional" for these purposes.
In addition, employers with fewer than 50 employees are exempt from the penalties under the Code, but only in instances where the violation is the fault of the carrier. Thus, this exception is not likely to be available where the employer designates the eligible group.
Simply put, it seems that the new insurance non-discrimination rules generally prohibit employers from providing special health insurance coverage to their executives whether on a pre-tax or (perhaps even an) after tax basis, with perhaps the following exceptions:
• Grandfathered plans: Arrangements in effect on March 23, 2010 will not be disturbed, provided that they are not modified in a way that would result in the loss of grandfather status (this is a very high bar, which is described at length in interim final regulations issued earlier this year).
• Retiree-only plans: Stand-alone retiree health plans are not subject to the Act’s insurance market reforms. Thus, to the extent that an executive post-termination benefit is (or can be designed to be) a stand-along retiree benefit, it may pass muster.
• Under guidance dating back to 1961 (which is still good law), it should be possible for an employer to provide a subsidy to purchase individual market coverage on a pre-tax basis.
• The employer could increase severance pay to enable (but not require the) departing executive to purchase COBRA coverage under the employer’s plan. These amounts would be taxable.
The road ahead
Until the Internal Revenue Service and the Departments of Labor and Health and Human Services issue guidance implementing the new non-discrimination rules, there will be more questions than answers where executive post-employment medical benefits are concerned.
At the moment, we know only that the fully-insured group health plans are now subject to rules that look something like the rules that have governed self-funded plans for some time, but which are still not all that clear in many respects.
Pending the issuance of guidance, all that can safely be said is that compliance with the new rules will likely be more expensive, either because the underlying benefit will cost more to purchase (i.e., individual vs. group coverage) or because the benefit will no longer enjoy favorable tax treatment.
Alden J. Bianchi can be reached at email@example.com.
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