Revisiting Continuation of Health Benefits Following Termination

[401 Chaos]

I recently received a copy of the audio portion of last month's ALI-ABA program in Washington DC on Pension, Profit-Sharing, Welfare and Other Compensation Plans. A portion of that program includes a discussion between Pamela Baker, Sonnenschein, and Bill Schmidt from the IRS regarding lingering 409A questions. One question included a fact pattern / set-up along the lines of the following:

A lot of agreements say something like this: "If you are terminated after age 60, we will provide coverage under our medical plan until age 65 (or for five years after separation from service or some other period that is clearly beyond the maximum COBRA period) and if we cannot do that--if that kind of coverage is not available under the medical plan for whatever reason--then we will provide you the cost of paying for that kind of benefit on your own."

Ms. Baker asked if something like this could be done in a compliant way with 409A. Both she and Mr. Schmidt seemed to agree that it was not. Ms Baker's analysis and chief concern seemed to focus on the fact that the benefit provided was potentially being converted from an in-kind benefit to a cash payment in this case and so ran afoul of the 409A reimbursement rules. Analysis seems to be something like this:

1. The extended coverage goes beyond the COBRA period so not exempt from 409A altogether.

2. If the arrangement cannot fit within the exception, then we should seek to comply with the reimbursement rule.

3. Here though the reimbursement rules would not seem to permit this because one of the conditions of the reimbursement rules is that you cannot convert the benefit to cash and that seems to be exactly what you are doing here.

The discussion went on to note that the outcome could possibly vary depending on whether the health plan is self-insured or fully insured where it may be exempt from tax, etc.

Maybe I am misinterpreting the question / fact pattern here and would appreciate hearing others' thoughts on this, particularly if you heard the discussion live. I agree that there would be a clear problem if, at the end of the COBRA period or other point when coverage under the existing plan ends, the company simply paid the former employee a cash amount without any restrictions and truly "cashed out" the benefit. Shmidt's analysis, however, seems to say that the 409A problem would exist not just if the amount was cashed out but even if the amounts were provided in true reimbursement fashion where the company only reimbursed amounts the participant had paid for comparable coverage under some other policy or plan and was structured as a reimbursement of premiums previously paid.

If that is the case, I guess I have a hard time understanding exactly what the reimbursement rules were intended to do. Couldn't you argue that really the benefit being provided under the Plan was a cash benefit (in the form of the cost of coverage under the plan) rather than in-kind benefits such that continuing to pay cash for same level of coverage under some other policy or plan did not represent a change? As the discussion touched upon, it seems to me true reimbursements should not be viewed as cashouts or cash payments but simply another way to continue the benefit promised--i.e., continuation of health coverage. In this case though, some of those benefits would come from the existing plan and some outside that plan. In the end though the employer is simply doing the same thing for the duration of the coverage--paying the cost of continued health coverage for the terminated employee.

Based on my understanding of the discussion, that does not appear to be acceptable interpretation though. Ms. Baker suggested that one alternative might be to promise the former employee a fixed amount (e.g., up to $1,000 per month) toward medical coverage and if we can do that under the existing plan we will but if not the participant can apply the amount under some other plan. That way, the benefit is always presumably a fixed cash benefit and it doesn't change forms, etc. Again, I don't see how that really differs much from the interpretation above--other than fixing the amount and I'm not sure that is appropriate because it seems continued coverage under the existing plan could / would likely result in increased costs if it went on for any time.

Anybody have other thoughts or interpretations on this or suggestions of better ways to structure benefit continuation provisions?

[Guest George Chimento]

<<I guess I have a hard time understanding exactly what the reimbursement rules were intended to do.>>

This is a common fact pattern. I believe that your arrangement (5 years taxable reimbursement of medical premiums paid by a service provider) is 409A deferred compensation and is not exempt severance. The payments extend beyond the COBRA period permitted by the "reimbursements and certain other separation payments" exception in the severance pay definition.

All is not lost. You can get around this problem by abandoning the reimbursement approach. I would recommend you draft the arrangement so that the reimbursements do not violate the 409A timing rules. Just draft it so that the payment (health insurance or taxable cash) occurs at the same monthly intervals, with no acceleration. In other words, do not leave it up to the participant to "time" the payments according to the date when he submits reimbursement requests.

The agreements I see deal with a similar issue. The employer has agreed to pay for health insurance under a health plan for a period longer than COBRA. And the executive wants a cash replacement if he gets other coverage.

OK clause: "We will pay your health insurance for five years, but if you get other coverage we will continue paying you a monthly taxable cash amount for the balance of the five years at the same intervals as we would have paid the premiums." There is a fixed date for payments.

Not OK clause: "We will pay your health insurance for xxx years, but if you get other coverage we will give you a lump sum equal to the balance of premiums." That violates the anti-acceleration rules.

I hope this helps.

George

[401 Chaos]

George,

Thanks for your response. Again, I'm not sure I am interpreting all of the discussion from the conference correctly but it almost sounds like to me they were saying there might be a problem with the first sample provision you noted because it actually converts coverage to cash--even though it remains on a set or fixed schedule. Hopefully I'm misunderstanding what was said there and your proposal works. They did not get into much of a discussion of what approach actually would work. (I certainly agree with you that the second example where the benefit would get accelerated and paid out in a lump sum would be trouble.)

As to abandoning the reimbursement approach, my concern with that is whether that doesn't raise potential 105(h) and general taxability issues in many cases. Do you gross the executive up if you start paying taxable cash amounts or do they just bear that hit?

[Guest George Chimento]

<<Hopefully I'm misunderstanding what was said there and your proposal works.>>

There is so much wheel spinnig over this stupid law, I suppose I can't be 100% definitive. So let me try 99%. The statute was meant to prevent "timing." There's nothing in it to require that payments otherwise owed for tax free health premiums on a fixed schedule must be forfeited. The citations to the severance exception from 409A are irrelevant. Assume 409A applies, and adhere rigorously to the timing rules.

<<As to abandoning the reimbursement approach, my concern with that is whether that doesn't raise potential 105(h) and general taxability issues in many cases. Do you gross the executive up if you start paying taxable cash amounts or do they just bear that hit?>>

I'm sure you know that 105(h) only applies to self insured arrangements. The taxability problem deals with a more fundamental issue. Can you have tax-free reimbursement of premiums, for an ex-employee who has been away for years? I don't see how that can be allowed. That 1961 (or whatever) revenue ruling which allows tax free reimbursements does not apply to former employees. The proposed 125 regs, which import that ruling into the 125 arena, also would not consider this permissible for a period extending beyond COBRA.

As for grossups, I don't see a 409A violation if an employer voluntarily grants additional taxable gross-up payments to compensate for an originally intended steam of tax-free premium payments. It's a new grant, not a reordering of deferred money.

George