Accounting, Funding and Tax Consequences

Investment earnings on reserves held by the IRC 501(c)(9) trust for retirees are subject to tax as ordinary income

DEFRA established that investment earnings on reserves held by the IRC 501(c)(9) trust for retirees are subject to tax as ordinary income. Additionally, retiree contributions are limited, actuarial inflation adjustments are not allowed, and a 100% penalty tax is imposed on any disqualified benefits.

To force existing state MEWAs into funding mechanisms where states have direct and significant regulatory control

The primary thrust of such statutes (as in Florida) is to force existing state MEWAs into funding mechanisms where states have direct and significant regulatory control. The state's regulatory authority would be deemed a negative for self-funded plans and will likely be found only when such a vehicle is forced upon the plan by the state.

Setting the specific and aggregate stop-loss deductible levels for all plans using the mutual assessable insurer

The state's regulatory authority includes: rate regulation and review, requiring mandated benefits, and controlling maximum premiums when justified. The course does not identify state control over stop-loss deductible levels as one of the regulatory powers exercised through mutual assessable insurers.

A reinsurance captive (a fronted program using a licensed carrier to issue policies) and a true insurance captive (which issues its own policies directly with no intermediary carrier)

Two basic types of captives exist: the reinsurance captive, which is a fronted program whereby the insured obtains a licensed insurance carrier to issue policies, and the true insurance captive, which issues its own policies on a direct basis with no intermediary carrier.

Elimination of all state and federal regulatory requirements

The advantages of captive insurance listed in the course include: improved cost control, increased profits, better cash flow, stability of premiums, customized coverage, more effective risk management, wider access to reinsurance, and elimination of financial trauma of unfunded loss. Elimination of regulatory requirements is not listed; in fact, captives must comply with insurance laws in their domicile.

The premium ratio of employer welfare premiums to captive insurer total premiums must not exceed 5%

ERISA provides an exemption from what would otherwise be a prohibited self-dealing transaction. The premium ratio test requires that the employer welfare premiums relative to the captive insurer's total premiums must not exceed 5%. If it exceeds 5%, the plan fails the statutory exemption, though an administrative exemption may still be available.

50%

The 1979 DOL class exemption increased the permitted ratio from 5% (in the ERISA statute) to 50%. The test is applicable only where the captive is at least 50% controlled by the employer, and the class exemption applies only to domestic insurance company subsidiaries.

The courts had rejected the economic family theory, and IRS inspectors would no longer invoke it

In 2001, the IRS conceded that the courts had rejected the economic family theory and stated that IRS inspectors would no longer invoke it. The economic family theory had held that a policyholder, its subsidiaries, and its captive form one economic family, making premiums non-deductible. Starting in 2002, the IRS began relying on different tests.

Less than $2.2 million in annual premiums

A micro-captive insurance company elects to be taxed only on its investment income under Section 831(b) of the IRC and must receive less than $2.2 million in annual premiums to qualify. The IRS has identified certain micro-captive transactions as potentially abusive, lacking genuine insurance attributes.

Premiums charged by the captive must be at parity with the market, and the arm's-length nature of the parent-captive relationship must be annually approved by an independent fiduciary

The Columbia Energy Group ruling (DOL, 2001) established that employers may gain approval of using captives for welfare benefits beyond the 50% test if (1) premiums the captive charges its owners are at parity with the market, and (2) the arm's-length nature of the parent-captive relationship must be annually approved by an independent fiduciary.

Approximately 10% of total costs

Three costs must be borne by the employer when self-funding disability: managerial costs (approximately 30% of total), expected claims (approximately 60% of total), and catastrophic or shock claims (approximately 10% of total). Where possible, stop-loss coverage should be purchased for shock claims.

Because safe harbor rules do not apply to reserves for disability benefits, allowing employers to establish large reserves in the trust

Of particular interest to employers in self-funding disability benefits is the opportunity to establish large reserves in the IRC Section 501(c)(9) trust because safe harbor rules do not apply to reserves for disability benefits. Other motivations include design flexibility and increased cash flow control.

The employer assumes only part of the risk (such as six to 18 months) or assumes 100% but purchases stop-loss or reinsurance benefits

Partial self-funding helps control the dangerous upside because the employer assumes only part of the risk (six months to 18 months, for example) or assumes 100% but buys stop-loss or reinsurance benefits. Additionally, funding the LTD through a 501(c)(9) trust affords an excellent opportunity to build up trust assets.

Choose among two or more benefits, including the ability to purchase nontaxable benefits by forgoing taxable cash compensation

The essence of a cafeteria plan is that it permits each participating employee to choose among two or more benefits. In particular, the employee may purchase nontaxable benefits by forgoing taxable cash compensation, making the cafeteria plan an attractive means of offering benefits.

DOL treats employee salary reductions as a plan asset and an employee contribution, though such plan assets are excused from being trusteed

A premium conversion plan (POP or premium-only plan) is a flexible spending account with only a single benefit—participant plan contributions. While salary reduction payments are employer contributions for purposes of IRC Sections 105 and 125, the DOL treats employee salary reduction as a plan asset and thus an employee contribution. However, such plan assets are excused from being trusteed.

Qualified scholarships and educational assistance programs

Certain nontaxable benefits may not be optioned under a cafeteria plan, including qualified scholarships, educational assistance programs, meals and lodging, fringe benefits (transportation, discounts, parking), and dependent group life insurance. Benefits that may be optioned include accident and health, short-term disability, group life up to $50,000, dependent care, and paid vacation.

All participants are taxed on benefits they would have received, not just the highly compensated

Two basic discrimination rules apply: (1) if the plan fails form and substance rules, ALL participants are taxed on benefits they would have received; (2) if the plan gives more to highly compensated, only the highly compensated are taxed on their extra benefits. The form/substance failure has the broader impact.

Federal income tax, Social Security tax, and unemployment tax

At the federal level, salary reductions under a cafeteria plan are free of federal income, Social Security, and unemployment taxes. At the state level, they are free of state income tax except in New Jersey and Pennsylvania, with uncertainty existing as to state unemployment taxes in certain states.

A MEWA (Multiple Employer Welfare Arrangement)

Because A and B are controlled within the meaning of ERISA (A owns 35% of B), they may share a plan as a joint venture. However, were A's ownership less than 25%, the plan would be classified as a MEWA, subject to different regulatory requirements.

Each employer's plan remains a single plan under ERISA, and each employer is responsible for its own claims so that losses of one must not affect the others

Under Method 3, any two or more employers may have what appears to be a single plan (common document, booklet, plan supervisor, managed care rules, stop-loss) except for two critical distinctions: (1) each employer's plan remains a single plan under ERISA, and (2) each employer is responsible for its own claims—the losses of one must not affect any of the others.

B (Miami, Retail), D (Seattle, Rx Mfg), and E (St. Louis, Trucking) each fail either the geographic test, the employment commonality test, or both

A non-association VEBA requires geographic and employment commonality. A (Miami, Rx Mfg) and C (Miami, Rx Mfg) meet both tests. B (Miami, Retail) has geographic commonality but fails employment commonality. D (Seattle, Rx Mfg) has employment commonality but fails geographic. E (St. Louis, Trucking) fails both.

The geographic test is not applied when the plan is sponsored by a trade or industry association, allowing members from different locations to participate

Under Method 5, the employees of A, C, and D may become members of a VEBA sponsored by these employers not as employees but as members of a national trade or industry association. The geographic test is not applied when the plan is sponsored by a trade or industry association, allowing employers from different locations (Miami and Seattle) to participate.

The Patient-Centered Outcomes Research Institute (PCORI) fee

Self-funded health plans are required to pay the PCORI fee, which funds the Patient-Centered Outcomes Research Institute's research to evaluate and improve healthcare outcomes. This applies even though self-funded plans are generally free of state premium taxes due to ERISA preemption.

Because of ERISA preemption and the National Carriers' Conference Committee v. Heffernan court decision

Self-funded plans are generally free of premium or other state-imposed taxes because of ERISA preemption and the National Carriers' Conference Committee v. Heffernan court decision. However, some states have found ways to impose indirect assessments or surcharges.

When must the employer register its plan with the state insurance department for tax compliance?

The six key tax questions for self-funded plan sponsors involve: (1) taxability of employer contributions to participants, (2) deductibility of employer contributions, (3) trust earnings exemption, (4) tax-free receipt of benefits, (5) deductibility of medical expenses by participants, and (6) special tax challenges with death/disability benefits or defined contribution plans. Registration with state insurance departments is not one of these tax questions.

IRC Section 106

IRC Section 106 provides that employer contributions to finance health care plans are not taxable to the employees. This is distinct from IRC Section 105, which governs the exclusion of benefits received from employer-paid health care plans, and IRC Section 104, which deals with workers' compensation and personal injury exclusions.

To the extent that benefits are for reimbursement of medical expenses, not contributions

Under IRC Section 105, gross income excludes benefits (not contributions) received from employer-paid health care plans to the extent that benefits are for reimbursement of medical expenses. This distinction between benefits and contributions is critical for determining tax treatment.

IRC Section 162

IRC Section 162 allows employers to deduct the cost of providing self-funded benefits as ordinary and necessary business expenses, including amounts paid for employees' medical claims, administrative costs, and contributions to trusts funding future benefits.

Section 419 recognizes funded plans and requires qualified costs for deductions, while Section 419A defines and sets the limits on qualified costs and qualified asset accounts

IRC Section 419 recognizes that a health care plan may be funded as an insured or self-funded plan and requires specially defined qualified costs and qualified asset accounts for employer tax deduction purposes. IRC Section 419A then defines and sets the specific limits on those qualified costs and qualified asset accounts.

IRC Section 501(c)(9)

IRC Section 501(c)(9) gives tax incentives to VEBAs by qualifying them for tax-exempt status. VEBAs that meet the requirements of Section 501(c)(9) are exempt from federal income tax on their investment income and contributions, as long as those funds are used exclusively for providing welfare benefits.

IRC Section 4976

IRC Section 4976 imposes a tax on the full amount of any disqualified benefit. IRC Section 4980B deals with COBRA infractions, IRC Section 4999 refers to Golden Parachute Payments, and IRC Section 5000 penalizes nonconforming group health plans.

Employer payments made directly to employees rather than to the plan

While employer contributions to a self-funded health care plan are generally not taxable to the participant whether the plan is a trusteed plan or a general asset plan, there must be some tangible funding vehicle (fund, insurance policy, trust, etc.). Employer payments made directly to employees are taxable to those employees.

The $200 is taxable income to the participant

Absent a cafeteria plan, when a participant opts out of the employer's self-funded plan and receives a $200/month pay increase that is paid by the employer as a premium for an individual health care policy, the $200 is taxable income to the participant. The exclusion under IRC Section 106 requires that contributions go from employer to plan, not from employer to participant.

$50,000

IRC Section 79 allows the cost of an employee's first $50,000 of group term life insurance coverage to be excluded from the employee's gross income. This applies regardless of whether the coverage is provided through a VEBA, insurance policy, or general assets of the employer. Coverage exceeding $50,000 is subject to income tax.

The contribution must be split for tax purposes between health care and life insurance components

A contribution by the employer for both health care and life insurance must be split for tax purposes. This ensures proper application of IRC Section 106 (health care exclusion) and IRC Section 79 (group term life insurance exclusion with the $50,000 limit).

Benefits from employee-paid (after-tax) accident or health insurance arrangements

IRC Section 104(a)(3) allows exclusion from gross income for benefits from employee-paid (after-tax) accident or health insurance arrangements, along with workers' compensation benefits, personal physical injury/sickness damage payments (other than punitive damages), and certain government disability pensions.

They are generally included in gross income unless a specific exclusion applies, such as reimbursement for medical expenses or payments for permanent injury

Under IRC Section 105, the general rule is that amounts received by an employee through an employer-provided accident or health plan are included in gross income unless a specific exclusion applies. Key exclusions include reimbursements for medical expenses under Section 105(b) and payments for permanent injury or loss under Section 105(c).

The payments are not calculated based on lost wages

Under IRC Section 105(c), amounts received due to the permanent loss or loss of use of a body part or function, or for permanent disfigurement, are excluded from gross income provided the payments are not calculated based on lost wages. This ensures the exclusion applies to compensatory payments for the injury itself, not wage replacement.

The excess need not be declared as taxable income, provided it is consistent with the nature of the policy

A person is not penalized tax-wise by over-insurance. If an individual pays for two premiums and over-collects on a medical charge, the excess collected over the charge need not be declared as taxable income, provided it is consistent with the nature of the policy.

The disability payments are received tax-free because the arrangement is deemed employee-paid

When an employer-sponsored short-term disability plan is 100% participant-funded with after-tax contributions, the arrangement is deemed to be employee-paid. As a consequence, the disability payments are received tax-free under IRC Section 104(a)(3).

Three years, though shorter periods can apply for new plans, recent changes, or limited participation

The burden is on the participant to demonstrate that the participant made contributions for the benefits; otherwise, the IRS will assume such disability benefits were 100% employer-paid. While a three-year look-back period is the general rule, shorter periods can apply in cases involving new plans, recent changes, or limited participation.

Unfunded plan (general asset plan) and funded plan (usually a trusteed plan)

Employer deductions to a self-funded health care plan must be viewed from two perspectives: the unfunded plan (so-called general asset plan) where benefits are paid from current operating revenue, and the funded plan (usually but not necessarily a trusteed plan) where contributions go into a separate fund.

There are no tax advantages for reserves, since contributions to a trust like a VEBA are often tax-deductible for funded plans but no such benefit exists for unfunded plans

Unlike funded plans where contributions to a trust such as a VEBA under Section 501(c)(9) are often tax-deductible, unfunded plans do not provide this benefit. Additionally, unfunded plans face increased financial risk, no investment growth opportunity, difficulty managing long-term obligations, and potential negative impact on employee morale.

The contributions are ordinary and necessary business expenses and the fund is a separate tax-reporting entity

Under IRC Section 162(a), employers can generally deduct contributions made to a special fund used to provide benefits to employees, provided those contributions are ordinary and necessary business expenses. This applies to both qualified and non-qualified trusts as long as the fund is a separate tax-reporting entity.

Employers abused VEBAs and similar structures by overfunding plans and taking large tax deductions for contributions not actually being used to provide employee benefits

Before IRC Section 419 was enacted in 1984, some employers abused VEBAs and similar structures by overfunding these plans and taking large tax deductions for contributions that were not actually being used to provide employee benefits. This led to inconsistent treatment and concerns over potential abuses in the tax system.

Claims incurred but not yet paid, premiums for insurance policies funding the benefits, and reasonable administrative expenses

Under IRC Section 419, the qualified asset account can include reserves for claims incurred but not yet paid, premiums for insurance policies funding the benefits, and reasonable administrative expenses related to the plan. These contributions are deductible by the employer.

They are not deductible in the year made but may be deductible in future years when they align with qualified benefit costs or are used to pay actual benefits

Under IRC Section 419, contributions that exceed the plan's qualified costs are not deductible in the year they are made. However, these excess amounts may be deductible in future years when they align with qualified benefit costs or are used to pay actual benefits. This prevents employers from using welfare benefit plans as tax shelters.

If the contributions would otherwise be deductible under those sections, they are deductible under IRC Section 419 to the extent of the fund's qualified cost for the taxable year

The IRC code carefully sets forth that employer contributions to a welfare benefit fund are generally not deductible under IRC Section 162 or 212. However, if the contributions would otherwise be deductible under one of those sections, they are deductible under IRC Section 419 for the taxable year of the employer in which paid, to the extent of the welfare benefit fund's qualified cost for such taxable year.

The reserve must be based on actuarial projections of future benefit liabilities and the deductible amount is capped

For plans offering post-retirement medical or life insurance benefits, IRC Section 419 allows the deduction of contributions to fund these future benefits, but only within narrow limits. The reserve must be based on actuarial projections of future benefit liabilities and the amount deductible is capped, preventing excessive pre-funding.

Medical, disability, unemployment or severance, and life insurance

Under IRC Section 419A, qualified asset accounts can be established to set aside assets for the payment of medical, disability, unemployment or severance, and life insurance benefits, subject to the limitations of the section.