self insured disability plan

[Guest George Chimento]

Here's an interesting issue.

An employer self-insures its STD. It allows employees to "buy" coverage through their cafeteria plan, either with salary reduction or after-tax premiums. As is typical with cafeteria plans, there is no separate fund and this is OK due to the DOL non-enforcement position for employee contributions made through a cafeteria plan.

The question.

Will the STD payments be tax-free to the employees who contributed on an after-tax basis? Code Section 104(a)(3) provides that payments are tax free if made from insured plans, and "arrangements having the effect of ...insurance." If there is not a separate fund apart from the employer's assets, would this type of self-insured arrangement qualify the participants for the section 104 income exclusion?

I believe the answer is yes, but would love to hear any well-reasoned opposing view.

George

[J Simmons]

George,

Is the entire actuarially-determined cost of coverage for the STD required to be paid by the EE through the cafeteria plan?

If not, then part of the cost of coverage is being borne by the ER and, I'm assuming, was not added to the taxable incomes of the EEs. That proportion of the STD benefit payments would need to be taxable income, while the portion of STD benefit payments attributable the EE after-tax 'premiums' ought to be as you posit, income tax-free.

I would think you'd have to apportion, otherwise a plan could make in essence both the 'premiums' and the benefits tax free by merely requiring a de minimis $1 per year cost to the EEs after-tax.

[Guest George Chimento]

<<Is the entire actuarially-determined cost of coverage for the STD required to be paid by the EE through the cafeteria plan?>>

John,

Although they do not use an actuary, they seem to be basing this on a conservative experience method under which the employee after-tax contributions have covered all of the group's costs.

My concern was that they do not have a separate "fund" and I'm wondering if that causes a problem under 104(a)(3). The only PLR I have found on point refers specificaly to creating a separate fund for 104(a)(3) treatment. Other PLRs on 104(a)(3) are based on 501©(9) trusts, where specific funds are clearly in existence.

Why did they decide not to have a fund? By using the cafeteria mechanism for after-tax contributions, they have relied on the DOL non-enforcement position that employee contributions through a cafeteria plan do not have to be in a separate fund. That exempts them from the actuarial report and financial schedule requirement of form 5500. Other issues, such as accounting to employees for favorable experience (i.e. refunding de facto dividends when premiums are too high and exceed administrative costs) are also sidestepped.

However, without a "fund", can payments from a self insured arrangement qualify for tax-free staus under 104(a)(3), which requires that arrangements have the effect of insurance? There is risk-shifting, but there is no "fund." I think this is probably ok, under the theory that separate funds are not necessary for medical plans under 105, so there's no real consistency to say that self-insured disability plans should have that requirement, even though it seems to be the norm in PLRs.

George

[J Simmons]

I agree with your position. In addition to your consistency observation, IRC 104a3 excludes from gross income of the employee amounts received "through accident or health insurance (or through an arrangement having the effect of accident or health insurance)". From the perspective of the employee, whether the amounts received come from a 3rd party insurer or the employer's general assets, they are amounts from a source other than the employee. The employer self-insuring the obligation out of its general assets does not change the dynamics from the employee's tax perspective. The employee is yet paying for the cost of coverage with after-tax dollars and then receiving benefit payments from someone else.

If it were from the employer's perspective that the amounts need to be paid to the employee "through accident or health insurance (or through an arrangement having the effect of accident or health insurance)", the employer's self-insuring out of its general assets would be problematic. However, the language suggests that it is from the employee's perspective, and either way the employee is receiving payments from another source, the employer or a 3rd party insurer.

[Guest George Chimento]

I agree with your position. In addition to your consistency observation, IRC 104a3 excludes from gross income of the employee amounts received "through accident or health insurance (or through an arrangement having the effect of accident or health insurance)". From the perspective of the employee, whether the amounts received come from a 3rd party insurer or the employer's general assets, they are amounts from a source other than the employee. The employer self-insuring the obligation out of its general assets does not change the dynamics from the employee's tax perspective. The employee is yet paying for the cost of coverage with after-tax dollars and then receiving benefit payments from someone else.

If it were from the employer's perspective that the amounts need to be paid to the employee "through accident or health insurance (or through an arrangement having the effect of accident or health insurance)", the employer's self-insuring out of its general assets would be problematic. However, the language suggests that it is from the employee's perspective, and either way the employee is receiving payments from another source, the employer or a 3rd party insurer.

[Guest George Chimento]

Apologies. I hit the wrong key and just posted your response without my reply.

Thanks for your perspective. Hopefully, this is a case of great minds thinking alike.

George