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Employee Benefits

Employee Benefits Developments February 2009

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New Guidance for Code § 409A Violations

The sheer complexity of the Internal Revenue Code (IRC) § 409A regulations governing nonqualified deferred compensation means that a certain number of unintentional violations of the rules is inevitable, resulting in accelerated taxation, interest, and penalties for participants. In December, the Internal Revenue Service (IRS) issued several pieces of new guidance addressing IRC § 409A violations: an updated notice providing limited relief and methods of correcting certain operational errors; proposed regulations addressing the calculation of includible amounts and additional taxes resulting from failure to comply with the requirements of IRC § 409A, and interim guidance governing the reporting and wage withholding responsibilities of employers and employees.

Corrections of IRC § 409A operational errors. Clarifying and expanding on a limited correction program first established in 2007 (Notice 2007-100), Notice 2008-113 provides additional guidance for correcting certain operational violations of IRC § 409A. The program expands on the ability to correct some operational failures after the end of the year in which the failure occurs, provided the failure is corrected during the following year and the affected participant is not an insider. The new program also provides special transitional relief for failures occurring before 2008, continues to provide some relief for corrections of limited amounts, and provides additional procedures for correcting certain errors regardless of the amounts involved. The ability to correct errors involving insiders of both public and private companies is limited (or even eliminated), and, beginning in 2010, employers will be required to demonstrate they have taken commercially reasonable steps to prevent further failures if they wish to use the correction procedures. The correction program still does not provide an opportunity to correct errors in plan documents, although the IRS has requested comments on a potential correction program for documentary failures. IRS filings by both employer and employee continue to be required.

Proposed regulation for income inclusion for IRC §409A failures. The IRS has proposed regulations regarding the calculations of the amounts to be included in income and the additional taxes that result if a deferred compensation arrangement fails to comply with requirements of IRC § 409A. The proposed regulations provide for a year by year calculation of the amount to be included in income. The amount to be included in income is the total value of the amount under the deferred compensation arrangement less the portion of the amount that is not vested or that was previously included in income in prior years. All calculations, including determination of the vested amounts, are made as the end of each year.

With respect to account-based plans, the total value of the deferred compensation is equal to the value of the account. With respect to non-account based plans, reasonable actuarial assumptions and methods must be used to determine the value of the deferred compensation. If reasonable assumptions or methods are not used, the IRS may determine the amount by using the applicable federal rates and the applicable IRC § 417(e) mortality tables. The regulations provide general rules necessary to determine present value where payments may commence on alternative dates and where alternative forms of payment are available.

With regard to stock-based compensation, the total value of the deferred compensation element is the “spread” between the fair-market value of the underling stock over the exercise price reduced by any amount paid for this stock. If option or stock appreciation right was exercised during the course of the year, the calculation is made of the date of exercise.

The proposed regulations also provide guidance with respect to other arrangements that are treated as deferred compensation under the IRC § 409A rules, such as separation pay and reimbursement and in-kind benefit arrangements.

As the reader may be aware, in addition to the additional 20 percent income tax on these amounts, there is an interest component to be paid that is known as the premium interest tax. The premium interest tax applies to amounts that are included in income under IRC § 409A but were first not subject to the substantial risk of forfeiture in earlier years. With respect to amounts that are included in income under IRC § 409A, the employee/service provider receives “basis” that is recovered when the related amounts are paid out. The proposed regulations provide for a generous rule providing that amounts previously included in income are deemed to be the first amounts distributed.

One area that the proposed regulations do not address is the failures under IRC § 409A(b) related to funding a deferred compensation in offshore trusts, funding on the change of an employer’s financial situation or amount contributed to so-called rabbi trusts when the employer has a defined benefit plan that is in an “act risk” situation. (IRS Prop. Reg. §1.409A-4; 73 Fed. Reg. 74380)

Reporting and wage withholding. Notice 2008-115 provides interim guidance on reporting and wage withholding requirements for nonqualified deferred compensation amounts subject to IRC § 409A. The guidance is effective for calendar year 2008 and remains in effect for subsequent years until further guidance is issued. A key feature for employers is the extension of the prior waiver of reporting requirements for annual deferrals of compensation — until further guidance is issued, an employer or payer is not required to report on a Form W-2 or Form 1099 amounts deferred during the year under a nonqualified deferred compensation plan. The notice also provides interim guidance to employers and other service recipients on their income tax reporting and tax payment requirements with respect to amounts required to be included in income because of § 409A violations. Generally extending earlier guidance provided in prior notices, Notice 2008-115 explains how to calculate the amounts includible in gross income under IRC § 409A(a), including how to calculate the wage payment date. When the proposed regulations governing income inclusion and the calculation of additional taxes are finalized, the regulations will obsolete this notice with respect to those topics. In the interim, an employer who complies with the rules of the notice regarding calculations, reporting, and withholding will not be liable for additional income tax withholding or penalties, or be required to file subsequent corrected returns as a result of future guidance. Employers who are later found not to have been in compliance with the requirements outlined in the notice, however, will be subject to additional reporting and withholding liabilities, including penalties. Finally, the notice also addresses the income tax reporting and payment obligations of employees and other service providers with respect to amounts that are includible in income because of § 409A violations. Compliance of employees is determined independently of employer compliance, and additional income taxes and penalties may be imposed on the individual if it is determined that the amount of taxes reported and paid for 2008 was underreported or underpaid.

New Review Standard for Self-Insured Medical Plan Appeals

When the documents governing an ERISA plan give an administrator the discretionary authority to decide claims, benefit denials rendered by the administrator, if brought to court, will be upheld if the court finds that the administrator’s decision was rendered in accordance with ERISA and was reasonable. In Metropolitan Life Insurance Company v. Glenn, the U.S. Supreme Court held that where an employer (or insurance company) both funds and administers an employee benefit plan, there is an inherent conflict of interest that courts must consider in determining whether an administrator’s decision to deny a claim is reasonable. Although other courts around the country had already adopted the Glenn approach, this was not the case in the Second Circuit (the federal appeal court governing New York, Vermont, and Connecticut). Under the law in the Second Circuit at the time Glenn was decided, the mere existence of a conflict of interest would not alter the standard of review; a claimant was required to establish that the administrator was in fact influenced by the conflict. Applying the Supreme Court’s framework from Glenn, the Second Circuit in McCauley v. First UNUM Life Insurance Co. abandoned its prior rule holding that a conflict of interest must be taken into account in determining whether an administrator’s decision is reasonable even if there is no evidence that the administrator was, in fact, influenced by the conflict. In light of McCauley, employers who self-insure benefits should review the process by which claims are decided to determine whether any steps can be taken to minimize (or erase) the impact of the conflict that arises when the employer both administers and funds claims. For self-insured employers, this may mean delegating complete authority for final benefit determinations to a third party. (McCauley v. First UNUM Life Insurance Co. (2d Cir., December 2008))

Fiduciary Prudence Maintained with Troubled Employer Stock Fund

The U.S. District Court for the Western District of New York has dismissed a lawsuit challenging the fiduciary actions of corporate managers who continued an employer stock fund in its 401(k) plan in the face of several adverse corporate developments. The plan fiduciaries were also challenged on their failure to provide critical corporate information to 401(k) plan participants before it was made available to public shareholders. The Bausch & Lomb 401(k) Account Plan included an employer stock fund along with 13 other diversified investment options for participants. A matching contribution as well as a base employer contribution to the plan were made in shares of employer stock. Participants could move out of the employer stock fund at any time. Several developments occurred in 2005 and 2006 that had an adverse effect on the employer stock value. In 2005, the company announced its investigation into alleged misconduct by managers in its Brazil and Korea operations. Then later in 2005 and 2006, the company ran into significant problems with a major product that ultimately resulted in a global recall and suspension of shipments. These events had a serious impact on the value of the employer stock. Through the period in question, the plan continued to maintain the employer stock fund in the plan. This lawsuit was filed by plan participants who alleged that the plan fiduciaries breached their responsibilities in allowing the stock fund to continue and in failing to give plan participants advance notice of the corporate developments before the information was made public. The District Court issued a summary judgment in favor of the plan and its fiduciaries and dismissed the participants’ claims. The basis of the decision is found first in the design of the plan itself, which prescribed the use of the employer stock fund. The risk of investments in employer stock was well-described in the plan’s summary plan description, and participants were not constrained in any manner in diversifying out of the employer stock fund. Finally, the court found that advance notice to participants would have violated SEC insider trading rules and would have been inappropriate. While the case, so far, supports a well-maintained plan, it is a reminder of the risks of having employer stock in a 401(k) plan and the need to be careful in participant communications regarding investments in employer stock. (In re Bausch & Lomb Inc. ERISA Litigation ( W.D.N.Y. 2008))

IRS Extends Deadline for Implementation of Healthcare Debit Card Rules

The IRS recently issued Notice 2008-104, delaying the effective date for the addition of new restrictions on the use of healthcare debit cards. Sponsors of health flexible spending accounts (health FSAs) and health reimbursement arrangements (HRAs) have, for years, allowed participants to use debit cards to pay for eligible medical expenses. Debit cards are convenient for participants because incurred expenses can be deducted directly from their health FSA or HRA accounts, in some cases, without retaining and remitting receipts to the plan administrator. Although convenient, the use of debit cards raises concerns that some expenses being reimbursed might not be for eligible medical expenses. The IRS requires that all medical expenses reimbursed through HRAs and health FSAs are properly substantiated.

To address this concern, the IRS included provisions in its 2007 guidance that placed greater restrictions on the use of the debit cards. Although these restrictions were originally intended to be effective January 1, 2009, the IRS has delayed this compliance deadline for an additional six months.

Effective July 1, 2009, debit cards may not be used at stores coded within the Drug Store and Pharmacies merchant category unless the establishments:

• use an inventory information approval system, or
• have 90 percent of their store gross receipts from the prior taxable year qualify as expenses for medical care.

Plan administrators reimbursing expenses incurred at establishments using the 90 percent gross receipts method, must treat the reimbursements as conditional until the reimbursements can be substantiated through additional third-party information describing the goods or services, the date of the service or sale, and the amount of the charge. If the charge is not substantiated, the health FSA or HRA administrator must recoup the charge from the employee and suspend the card until the payment is recouped. (Notice 2008-104)

Participants in Retiree Health Plan Were Entitled to COBRA Notice

The U.S. District Court for the Western District of Virginia recently held that a group of retirees were entitled to receive notice of their rights under the Consolidated Omnibus Budget Reconciliation Act (COBRA) when they terminated employment, even though they immediately received coverage under their employer’s retiree health plan. Eight hospital employees accepted an early retirement package that included coverage under their employer’s retiree health plan until they reached age 65. The retiree health plan provided significantly different benefits from those they received as participants in the group health plan for active employees.

Generally, employers must provide qualified beneficiaries with a COBRA notice following a qualifying event, such as termination of employment, which results in a loss of coverage. The regulations define a “loss of coverage” as any change in the terms or conditions of coverage. In this case, because the retiree group health plan was not identical to the coverage available under the health plan for active employees, the court considered the change from participation in the active plan to the retiree plan as a “loss of coverage.” As a result, the retirees should have been provided notice of their COBRA rights when they terminated their employment.

This case highlights one of the more complicated areas of COBRA compliance. Often employers with retiree medical plans do not consider the provision of a COBRA notice because most employees prefer coverage under a retiree plan to electing, and often paying for, COBRA coverage. However, even if a retiree plan is superior to COBRA coverage, if there is “any change in the terms or conditions of coverage,” employers should nonetheless provide retirees with a COBRA notice. A failure to provide a timely COBRA notice could cost an employer up to $110 a day in penalties. (Phillips v. Wythe County Community Hospital (W.D. Va., 2008))

Drunk Driving is No Accident

The U.S. Supreme Court recently declined to review, and thus left standing, a federal appeals court ruling from the U.S. Court of Appeals for the First Circuit under an ERISA life insurance plan. The underlying case involved a severely intoxicated driver who died after slamming into a tree. An official report after his death showed a blood alcohol level of 0.265 percent, more than three times the legal limit. The report also classified the death as “accidental.” The decedent was employed and covered in an employer group life insurance plan subject to ERISA. The plan administrator acted to have the normal death benefit paid out to the decedent’s widow and beneficiary. The plan also provided additional benefits for “accidental death.” But, after review, the plan administrator concluded that this death was not an accident. In reaching its conclusion, the plan administrator followed a review procedure used in similar cases which examined both a subjective inquiry into the expectations of the insured at the time of the incident as well as an objective inquiry into whether a reasonable person would consider physical injury as highly likely to occur as a result of the insured’s conduct. Based on this review, the plan administrator concluded that under the circumstances—a severely intoxicated person driving a car—a serious injury was highly likely and thus not accidental. The widow’s ERISA lawsuit challenged the decision of the plan administrator. The plan’s denial of the additional benefits was upheld as not arbitrary and capricious. (Stamp v. Metropolitan Life Insurance Co., cert. denied, 2008)