Attempt to "buy out" a promise of "lifetime benefits" under severance agreements - impermissible 409A acceleration?

[Jaded]

A company has several ex-employees who were promised they could stay on the employer's group health plan until death or, in the alternative, be reimbursed for cost of substantially similar coverage until death. The insurer finally caught on and kicked these people off the group health plan. Company does not want to reimburse these people every year for the next 20+ years and wants to buy out this privilege in a lump sum. They used actuarial calculations for various people's expected demise, and also certain assumptions about how insurance costs will increase over the next 20 years, to come up with rather significant lump sum payouts ranging from $50,000 to $500,000. They want to make these payments to non-employees without paying any tax on them. They asked me to structure it as a legal settlement, and I declined to do so.

I advised this lifetime payment stream was deferred comp and absolutely subject to taxation (after the first 18 months of COBRA, which I understand can be provided tax free). I also advised that by paying a lump sum, they are accelerating the benefits in violation of Section 409A so these people getting a $500,000 check are going to owe self-employment tax, income tax, and an additional 20% excise tax.  Does anybody disagree with this assessment?

So then the employer said they'd bump up the lump sum to cover all the taxes, so that one individual (who is in a 35% tax bracket and a 10% state bracket) would get a 35% fed + 10% state + 20% excise + 15% FICA bump for a cool buy out of $900,000. 

I've been trying to figure out how the employer should report this? I've seen that deferred comp is reported on Box 1 of 1099-NEC. But I've also seen that Section 409A failures and penalty are to be reported on Box 15 of 1099-MISC. Are these people going to get 2 different 1099s? And in my example, would the 1099-NEC show the full $900,000 but the 1099-MISC only report the $500,000 (prior to the bump up for taxes)?

[david rigby]

I'm unsure whether 409A applies but have an example to provide.  Somewhere around 2005, a relative of mine was retired and had life insurance and health insurance thru his/her employer.  The ER decided to discontinue both and paid him/her a lump sum as a "going away gift."   (As far as I can tell, the ER was under no legal obligation to pay anything.)  My retired relative got a check, and it was fully taxable with a W-2.  That meant he/she was responsible for FICA taxes as well as income taxes. 

[EBECatty]

Not sure of all the relevant facts (and the relevant answers) but these are the items I'd look at as potentially affecting the outcome:

• Can the group of former employees continue to receive tax-free employer-based coverage or tax-free reimbursements (based on their status as "former employees") beyond the COBRA period?
• If so, is the arrangement currently subject to 409A or exempt by providing only non-taxable benefits?
• If exempt, would a taxable lump-sum cash payment now subject the arrangement to 409A in a way that would make acceleration impermissible?
• If already covered by 409A, would the arrangement be aggregated with any others or could the employer follow the standard plan termination and liquidation rules to avoid a 409A violation?
• Is there a basis for providing former employees receiving deferred compensation a 1099 and applying SECA (instead of a W-2 and FICA)?

[IM4ERISA]

Based on your summary it appears that the employer did make a binding commitment to reimburse employees for the cost of alternative coverage in the event they were not able to remain in the group health plan.  Since these reimbursements would be taxable, they would not fall under the 409A exception for non-taxable benefits.  As such, I believe this commitment would fall under Section 409A the payment of a lump sum in lieu of the ongoing reimbursement would be an impermissible acceleration.  Since this commitment relates to their prior employment status, I believe the taxable amounts would be reported on Form W-2, Box 12, using Code Z. It is not necessary to withhold for the additional 20% excise tax.

[acm_acm]

Reimbursement for coverage obtained elsewhere is not taxable for retirees, as long as it’s in a “retiree-only” plan. You would at the least need to set up an HRA/Section 105 plan for just retirees. 

Doesn’t solve the OP’s issue though.