United States: Employers Subject to Harsh Penalties if Insured Group Health Plan Favors Highly Paid Employees

Last Updated: November 2 2010
Article by Debra B. Hoffman and Wayne R. Luepker

Originally published October 29, 2010

Keywords: employers, penalties, group health plans, patient protection, affordable care act, highly paid employees

Notice 2010-63 (the "Notice"), released by the US Internal Revenue Service on September 20, 2010, addresses the application of nondiscrimination requirements to insured group health plans as provided by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act (the "Act"). Prior to the Act, self-insured group health plans were subject to nondiscrimination rules, but insured plans generally were not. Although the stated purpose of the Notice is to solicit comments regarding the application of the Act to insured group health plans, the Act and the Notice raise substantive issues regarding application of the nondiscrimination rules to insured arrangements.

Background

Section 105(h) of the Internal Revenue Code of 1986 sets forth nondiscrimination rules applicable to self-insured group health plans. Generally, section 105(h) provides that if a group health plan discriminates in favor of highly compensated employees, the highly compensated employees are required to recognize income equal to the value of the discriminatory benefits. For this purpose, a group health plan is treated as discriminatory unless benefits attributable to employer contributions do not discriminate in favor of highly compensated employees, and plan eligibility does not discriminate in favor of highly compensated employees.

It is generally possible to avoid income inclusion under 105(h) by effectively having the employee pay for the coverage with after-tax dollars. Also because, prior to the Act, the section 105(h) restrictions only applied to self-insured plans, recognition of income could be avoided if the benefits were provided under an insured plan.

Summary of New Rules

The Act extends the substantive nondiscrimination rules of section 105(h) to insured arrangements by providing that nondiscrimination rules "similar" to those applicable to self-insured plans are to apply to insured group health plans. The penalties for failure to comply with the nondiscrimination requirements as applied to insured arrangements, however, are significantly different from the penalties that apply to discriminatory self-insured plans under section 105(h). Specifically, an employer that maintains a discriminatory insured plan may incur tax penalties. These include a monetary penalty of $100 per day per employee discriminated against. Although there are limits on the total penalties that can be imposed, they nonetheless can be significant.

In addition, a civil action may be brought by participants, beneficiaries, plan fiduciaries and/or the Department of Labor to compel the plan to provide nondiscriminatory benefits. It is not clear whether a plan that violated the nondiscrimination requirements of the Act could be compelled to provide enhanced benefits to a nondiscriminatory group of employees or whether it would be sufficient for the discriminatory benefits to be eliminated.

Effective Date

The nondiscrimination requirements apply to insured group health plans other than "grandfathered" plans (certain plans in existence on March 23, 2010) for plan years beginning on or after September 23, 2010 (January 1, 2011 for calendar-year plans).

Issues to Consider

The Notice does not provide substantive guidance as to the application of the new rules to insured arrangements but rather asks for comments on such application. However, the Notice does state the general manner in which the Act is to be interpreted by the IRS, the Department of Labor and the Department of Health and Human Services (collectively, the "Agencies"). That broad statement gives rise to several questions and concerns about its application.

APPLICATION TO INDIVIDUAL ARRANGEMENTS

While it is common for special health care arrangements to be negotiated on an individual basis with executives, it is not clear how the new rules will be applied to individual arrangements. For example:

  • It is not clear whether an individual arrangement entered into after March 23, 2010 would be treated as grandfathered for purposes of the new rules if the underlying group health plan is grandfathered. Conversely, it is not clear whether an individual arrangement that was in effect as of March 23, 2010 could retain the grandfather even if the underlying plan loses grandfathered status.
  • If the arrangement is treated as grandfathered, a grandfathered-plan notice will need to be included in the plan documentation. It is not clear whether this means that this notice will need to be included in the documentation relating to the individual arrangement or whether the notice included in the underlying arrangement would be sufficient. This is likely to depend on whether the individual arrangement and the underlying plan are treated as one arrangement for purposes of the rules.

AVAILABLE REMEDIES

  • Under Notice 2010-63, if a plan provides discriminatory benefits to highly compensated employees, penalties are based on, and remedies are available to, persons who are discriminated against. It is not clear which persons would be considered "discriminated against" for purposes of applying the nondiscrimination provisions. However, it is possible that the Agencies could take the position that the persons "discriminated against" include all employees of all employers in the controlled group of companies who do not receive the discriminatory benefit.
  • The Act, by its terms, provides that persons discriminated against will be entitled to remedies regardless of the extent of the discrimination (for example, regardless of whether the discrimination involves a significant number of highly compensated employees or involves a significant disparity in benefits between the highly compensated and non-highly compensated employees). It is unclear whether future guidance from the Agencies will provide any relief from the penalties if the discrimination is minor, inadvertent and/or is in favor of only a small group of highly compensated employees.

Self-Insured Plans

  • Section 105(h) imposes nondiscrimination restrictions on self-insured arrangements while the Act imposes nondiscrimination restrictions on insured arrangements. The Act also provides that insured plans are to be subject to rules similar to the rules applicable to self-insured plans. However, the Act does not require that the standards used to determine whether a plan is insured correspond to the standards used to determine whether a plan is self-insured under section 105(h). It is unclear whether, under the Act, the presence of a stop-loss arrangement (without any other insurance or risk-sharing components) would cause a group health plan to be treated as insured. (A stop-loss arrangement typically provides insurance protection if the amount of the benefits under the plan exceeds specified levels, and provides for payment directly to an employer and no payments to plan participants.) If the existence of a stop-loss arrangement causes a group health plan to be treated as insured, it could significantly expand the number of plans covered by the Act.
  • It appears that if health benefits discriminate in favor of highly compensated employees, but the employer assumes all of the risk of loss of the discriminatory benefits (and shifts none of it to a third party), the arrangement should not be treated as insured and so should not be subject to the nondiscrimination rules of the Act. However, in many cases, this approach may not be attractive, in part because the discriminatory arrangement may cover only a small group of employees and could expose the employer to risk of significant loss.

Premium Payment by Participant

  • If a highly compensated employee covered by a discriminatory self-insured plan pays the full premium cost of health care coverage with after-tax dollars, section 105(h), which only applies to employer-provided coverage, should not apply to the arrangement. It is not clear whether the same analysis would apply with respect to an insured discriminatory plan if the employee paid for the full cost of the coverage.
  • Although not entirely clear from the Act, if a highly compensated employee purchases insured coverage and is reimbursed by the employer for the amount of the premiums on an after-tax basis, it appears that such an arrangement should not be treated as providing discriminatory benefits. However, if the employer facilitates the purchase of such coverage (for example, because the employee is otherwise unable to obtain the coverage) or reimburses the employee for the coverage on a pre-tax basis, it is more likely that the arrangement would be characterized as providing discriminatory benefits.
  • Under some plans maintained by employers, a terminated employee who elects to receive COBRA continued medical coverage will be reimbursed by the employer for all or a portion of such premium on an after-tax basis. Although not entirely clear from the Act, it appears that such payments should not be treated as discriminatory, since the COBRA coverage is equally available to all similarly situated terminated employees, and the after-tax payment would be treated as additional compensation. However, to the extent that an employee is permitted to continue medical coverage for a period longer than required by COBRA, and longer than offered to other employees, and/or if the employer subsidizes the cost of the COBRA coverage on a more favorable basis for highly compensated employees, it appears more likely that such coverage could be treated as discriminatory.
  • The waiver of generally applicable age and/or service requirements for eligibility for retiree medical benefits for highly compensated employees appears likely to be treated as discriminatory.

Additional guidance issued by the IRS may address the foregoing issues. Given the potential magnitude of the penalties that may be assessed against an employer for failure to comply with the nondiscrimination rules, and the possible extension of these penalties to arrangements that have traditionally been considered self-insured arrangements, it would be prudent for employers to review their executive arrangements to determine what arrangements exist and the terms of such arrangements and to discuss with their counsel possible ways of protecting the terms of the arrangement for as long as possible given the new requirements.

Learn more about our Employee Benefits practice.

Visit us at www.mayerbrown.com.

Copyright 2010. Mayer Brown LLP, Mayer Brown International LLP, Mayer Brown JSM and/or Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. All rights reserved.

Mayer Brown is a global legal services organization comprising legal practices that are separate entities (the Mayer Brown Practices). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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