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Current Developments (Part I) This two-part article provides
an overview of current developments in employee benefits,
including welfare benefit plans, executive compensation
and retirement plan requirements. Part I
focuses on welfare benefit plans and executive
compensation. Deborah Walker, CPA James Lutz, CPA For more information about this article, contact Ms. Walker at debwalker@deloitte.com or Mr. Lutz at jalutz@deloitte.com. Executive Summary
During the past 12 months, numerous cases, rulings and regulations on executive compensation, welfare benefits and qualified plan requirements were issued. This two-part article covers the most significant of these. Part I, below, addresses the funding and payment of welfare benefits, covering flexible spending accounts (FSAs), new Medicare and prescription drug legislation, health savings accounts (HSAs) and disability benefits. It also discusses planning opportunities in executive compensation, including loans, nonqualified deferred compensation, change in control and the IRS’s executive compensation audit initiative. Part II, in the December 2004 issue, will focus on retirement plan developments and planning. Medical Benefits Reimbursement for Nonprescription Drugs and Exercise Equipment The IRS issued guidance that may effectively broaden the types of reimbursable expenses under FSAs. Rev. Rul. 2003-1021 clarifies that the cost of nonprescription drugs can be reimbursed under an FSA. Previously, in Rev. Rul. 2003-58,2 the IRS concluded that individuals could not deduct the cost of nonprescription medicines; however, that ruling does not affect the Sec. 105(b) exclusion on which FSA reimbursements rely. Sec. 105(b) only requires that the expense be described in Sec. 213(d), which broadly covers any payment “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” Regs. Sec. 1.213-1(e)(ii) excludes cosmetics, toiletries and expenditures “merely beneficial to the general health,” but does not distinguish between prescription and nonprescription drugs. Hence, FSAs can reimburse items such as pain relievers, cold remedies and allergy medications, but not vitamins, dietary supplements or health foods. Most FSAs routinely limit coverage to prescription drugs, but the recent reclassification of a number of medications from prescription to nonprescription has made the nonprescription prohibition too restrictive for many employees. Thus, Treasury and the IRS apparently decided there was a need for guidance distinguishing the deduction and exclusion rules. In a similar vein, the IRS held in an information letter3 that the cost of purchasing home exercise equipment used for treating a physician-diagnosed illness, including obesity, could also be deducted. Unlike prescription drugs, these costs can be deducted as a direct result of Rev. Rul. 2002-19,4 in which the IRS ruled that obesity is a disease and the cost of participating in a weight-loss program to treat it may be a Sec. 213 expense. Although the new ruling and information letter may encourage liberalized reimbursement rules, which, in turn, may increase costs and administrative burdens, it may also encourage more employees to participate in health FSAs and to contribute greater amounts to them. Increased participation will lower the plan sponsor’s payroll tax liabilities, because salary reduction contributions to health FSAs are not subject to Social Security, Medicare and Federal unemployment taxes. The Medicare Act In December 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 20035 (Medicare Act). In addition to a new Medicare Part D beginning in 2006, the law provides employers, offering retiree prescription drug coverage, a 28% tax-free rebate or the ability to limit retiree benefits, without decreasing the prescription drug coverage for workers. The Medicare Act also gives a boost to consumer-driven health, by establishing annual individual HSAs with balances that can roll over from year to year. HSAs The Medicare Act created HSAs, a new savings vehicle intended to succeed the Archer Medical Savings Account (Archer MSA). As promised, Treasury and the IRS issued a significant amount of detailed guidance in late 2003 and 2004 on HSAs, including a fact sheet and numerous revenue rulings and notices, discussed below. The Department of Labor (DOL) also issued guidance on whether HSAs are welfare benefit plans for purposes of the Employee Retirement Income Security Act of 1974 (ERISA), Title I. Notice 2004-2:6 This notice summarized the basic statutory rules. Although it filled in a few details, it left many unanswered questions. A summary of key points follows. An HSA is an investment vehicle that operates similar to an IRA. Banks, insurance companies and other entities eligible to act as IRA or Archer MSA custodians can serve as HSA trustees or custodians. An individual is free to select any provider, without reference to his or her health insurance company or employer. Like an IRA, the account is personal to its owner. Its earnings are tax free, unless it has unrelated business taxable income. The rules governing permissible investments are generally the same as those for IRAs. An individual is eligible to make HSA contributions only if he or she is covered by an insured or self-insured “high deductible health plan” (HDHP). The plan’s deductible must be at least $1,000 for individual coverage or $2,000 for family coverage. Out-of-pocket maximum payments must be limited to $5,000 for individuals or $10,000 for a family. In addition to HDHP coverage, the account owner may have accident, disability, dental, vision, long-term care and some other forms of insurance, but cannot otherwise be covered by a non-HDHP plan. HSA eligibility ends when the account owner becomes eligible for Medicare. The eligibility conditions need to be met only when the account is receiving contributions. A person who creates an HSA and then loses eligibility (e.g., switches to a non-HDHP policy or reaches age 65), still has a valid HSA from which he or she can receive distributions. However, he or she cannot add further funds to the account. Annual HSA contributions are limited to the lesser of the policy’s deductible or an indexed dollar limit ($2,600 for an individual, or $5,150 for family coverage in 2004). Contributions may exceed 100% of compensation income and are fully deductible, whether or not the taxpayer itemizes. If a person is eligible for HSA contributions for only part of the year, the regular contribution limit is prorated on the basis of full months. Eligibility is determined on the first day of each month. For instance, an account owner with individual HDHP coverage and a $2,000 deductible, who reached age 65 on Sept. 2, 2004, will be able to make a regular contribution of $1,500 (912 of the full-year $2,000 limit). In addition to regular contributions, individuals between ages 55 and 65 may contribute an extra $500 in 2004 (prorated in the same manner as regular contributions). The permitted “catch-up contribution” will increase by $100 a year until it reaches $1,000 in 2009. HSA contributions may be made by the owner’s employer through a Sec. 125 cafeteria plan or by members of his or her family, as long as the aggregate does not exceed the annual limit. Employer contributions are excluded from taxable income. Contributions by family members are deductible by the account owner. All contributions must be made in cash, no earlier than the beginning of the year and no later than the due date (excluding extensions) of the account owner’s return. There is no penalty for contributions in excess of the annual limit if they are withdrawn, with attributable income, by the due date (including extensions) of the return for the year in which made. Excess contributions not timely withdrawn are subject to a 6% annual excise tax until distributed. Cash or property contributions may be rolled over into an HSA from Archer MSAs and other HSAs. HSA distributions are tax free to the extent used to pay medical expenses (as defined in Sec. 213(d)) of the account owner or his or her spouse or dependents. Insurance premiums are permissible expenses only if paid for continuation coverage under the Consolidated Omnibus Reconciliation Act of 1985, qualified long-term care insurance or health insurance coverage during a period in which the individual is receiving unemployment compensation. Distributions used for any other purpose would be taxed as ordinary income and subject to a 10% excise tax if the owner is not yet Medicare-eligible. The account owner may name a beneficiary of any balance remaining in the HSA at death. If the beneficiary is a surviving spouse, the account becomes his or her own HSA. Any other beneficiary pays ordinary income tax (but no excise tax), and the account ceases to be an HSA. Notice 2004-23:7 This notice sketched the “preventive care benefits” that HDHPs may cover without imposing their standard deductibles. Presented as a “safe harbor,” it provided assurance that a variety of medical services will be classified as preventive. Included are routine physical examinations, routine prenatal and well-baby care, immunizations and screening procedures (e.g., pap smears, colonoscopies, HIV tests, etc.). It also classified weight loss and tobacco cessation programs as preventive. Notice 2004-25:8 This notice responded to the difficulties created by the very short lead-time between the passage of the Medicare Act and its effective date. Individuals already covered by HDHPs have had little time to find HSA custodians and create accounts. To reduce the need for haste, the notice provided that, as long as an individual’s HSA is established by April 15, 2005, he or she may withdraw funds to pay medical expenses incurred after 2003. After that, the normal rule (no payment of expenses that antedate the account) will be in force. Rev. Rul. 2004-389 and Rev. Proc. 2004-22:10 This ruling and revenue procedure offered relief to persons covered by both an HDHP and a separate prescription drug policy that does not meet the HDHP deductible conditions. The ruling confirms that prescription drugs are not an exception to the standard HDHP requirements. The procedure suspends that rule until Jan. 1, 2006, permitting first-dollar prescription drug coverage (i.e., before the HDHP deductible is satisfied) in 2004 and 2005, without affecting HSA eligibility. Rev. Rul. 2004-45:11 The ability to make deductible contributions to an HSA hinges on coverage by a HDHP, which may be supplemented by other health coverage to only a very limited extent (e.g., dental, vision, preventive care and certain forms of special-purpose insurance). Rev. Rul. 2004-45 confirmed that individuals generally may not fund HSAs when they also are covered by a health FSA or HSA that they can use to pay medical expenses below the HDHP deductible. But the ruling does identify a number of ways employers can offer health FSAs and HSAs to employees without jeopardizing their ability to fund HSAs. Notice 2004-43:12 Several states impose benefit mandates that prevent in-state insurers from issuing the HDHPs required to fund an HSA. Colorado and Kansas have modified their rules to ensure that HDHPs will be available to their residents. But problems remaining in other states prompted the IRS to issue a temporary, limited exception to the HDHP requirement, so that residents in those states can begin funding HSAs in 2004. The special exception applies to individuals participating in plans that would have been HDHPs, but for the fact that they complied with a state’s first-dollar or low-deductible mandates in effect on Jan. 1, 2004. The IRS will treat these individuals as eligible for months before 2006, giving states an opportunity to review their laws and make appropriate modifications. Notice 2004-50:13 Many open HSA questions were resolved in this notice, released July 23, 2004. The following selected items are interesting, unexpected or particularly important: 1. Individuals eligible for Medicare, but not actually enrolled in Part A or B, remain eligible to make regular and catch-up HSA contributions. 2. Employee assistance, disease management and wellness programs in their most common forms (Notice 2004-50 includes examples) are consistent with HSA eligibility. The key is whether the program provides “significant medical benefits” beyond screening and preventive care. 3. A “family” HDHP policy is one that covers anyone in addition to the primary insured, whether or not the others are relatives. Hence, plans under which certain employees can add coverage for nonspouse nondependents are not precluded from qualifying as HDHPs. 4. Clarifying an issue left in doubt by an earlier notice, Notice 2004-50 states that anyone may contribute to anyone else’s HSA. Third-party contributions are not limited to employers and family members. 5. Income attributable to excess HSA contributions (which must be withdrawn along with the excess contributions to avoid excise taxes) is computed in the same manner as for IRAs. 6. When “there is clear and convincing evidence that amounts were distributed from an HSA because of a mistake of fact due to reasonable cause” (e.g., if a beneficiary mistakenly believes that an expense is eligible for payment by the HSA or receives an unanticipated insurance reimbursement), the distribution may be repaid to the HSA by April 15th of the following year without tax consequences. If it is not repaid, it is includible in taxable income and may be subject to a 10% excise tax. HSA custodians are not obligated to accept repayment; if they do, they may rely on the beneficiary’s representation that the distribution meets the mistake-of-fact standard. 7. There is no deadline for taking an HSA distribution to reimburse eligible medical expenses. The expense must have been incurred after the HSA was established and must not have been otherwise reimbursed or claimed as an itemized deduction. 8. Employers can make employees’ HSA contributions if the employees contribute through a cafeteria plan. In all other cases, employer contributions must be equal for all HSA-eligible employees who have the same type of coverage (self-only or family), with adjustments for part-time employment and differences in plan deductibles. Employer contributions that violate the “comparability” rule incur a 35% excise tax under Sec. 4980G. 9. HSA contributions via cafeteria plans are not subject to the restrictions that apply to FSA contributions. Rather, they follow the Sec. 401(k) deferral rules, so that they can be started, stopped or changed prospectively at any time, without the need for a “change of status.” Negative elections are also allowed. 10. An employer that contributes to employees’ HSAs is not responsible for verifying that the account owners are HSA-eligible. Of course, the employer cannot knowingly contribute for those who are obviously ineligible because they have low-deductible coverage under an employer plan. 11. HSA trust or custodial agreements may not provide that distributions may be made solely to reimburse eligible medical expenses. The beneficiary must have the option of withdrawing funds for other purposes and paying tax. An agreement may, however, set reasonable restrictions on the frequency and minimum amount of distributions. Thus, companies that contribute to workers’ HSAs will not be able to prevent their contributions from being treated like ordinary compensation and immediately withdrawn. FAB 2004-1:14 The DOL concluded that HSAs generally will not constitute employee welfare benefit plans established or maintained by an employer when employer involvement with the HSA is limited. Specifically, it will not find that employer contributions to HSAs give rise to an ERISA-covered plan when the establishment of the HSAs is completely voluntary on the employees’ part and the employer does not (1) limit eligible individuals’ ability to move their funds to another HSA; (2) impose conditions on use of HSA funds; (3) influence the investment decisions for funds contributed to an HSA; (4) represent that the HSAs are an employee welfare benefit plan established or maintained by the employer; or (5) receive compensation in connection with an HSA. Disability Benefits Three-Year Lookback Rule The IRS does not require lookback when a disability plan switches from pre- to after-tax contributions. Benefits received under a short- or long-term disability plan are exempt from tax if they were paid for entirely by after-tax employee contributions. Benefits wholly or partly funded through employer (or pre-tax employee) contributions are wholly or partly taxable. According to Regs. Sec. 1.105-1(d)(2), when the employee and employer both contribute, the taxable portion is determined by looking back to their relative contributions over the three calendar years preceding the year in which the employee became disabled. Rev. Rul. 2004-5515 announced an important exception to the three-year lookback rule previously applied by the IRS, but not included in published guidance. It considered an insured long-term disability plan funded entirely with pre-tax employee contributions. The plan was amended to allow participants to elect, before the beginning of each year, between pre- and after-tax contributions. Elections for a particular year could not be changed in the course of the year, although a different election could be made for the following year. All contributions had to be made with either pre- or after-tax contributions. The ruling concluded that the lookback rule applies only to classes of employees whose benefits are, in a specific year, funded through both employer and employee contributions. Because the amended plan has no such class, participants’ disability benefits will be either fully taxable or nontaxable, depending on whether contributions in the year of disability were made on a pre- or an after-tax basis. Also, when an employee participates in both short- and long-term disability plans, the tax treatment of benefits under the two arrangements is determined independently, based on how each is funded. The annual election approach has the advantage of giving employees the flexibility to change their minds about paying disability premiums on a pre- or after-tax basis as they become more (or less) concerned about becoming disabled. As such, the ruling may offer a low-cost way for employers to enhance the value of their disability benefits, as perceived by employees. Executive Compensation Loans The IRS issued Rev. Rul. 2004-3716 to clarify that debt elimination is taxable. The targeted transaction typically involves an executive exercising options by giving the company a promissory note. If the stock value later falls below the note’s face amount, the company agrees to reduce the insider’s debt. Under Rev. Rul. 2004-37, the debt that does not have to be repaid is subject to tax under Sec. 83. By forgiving part of the purchase price, the company has increased the amount the executive has received. In addition, a reduction in the interest rate under the note or a change in the note relieving the executive of personal liability, would also result in compensation income. Transfer of Options and Deferred Compensation Rev. Rul. 2002-2217 held that Sec. 1041, rather than the assignment-of-income doctrine, applies when a divorce decree requires one spouse to transfer nonqualified options or rights to receive nonqualified deferred compensation to the other. As a result, income is taxable to the recipient spouse, rather than the employee. That ruling did not address FICA, FUTA or income tax withholding, but was accompanied by a proposed ruling on these subjects, in Notice 2002-31.18 Rev. Rul. 2004-6019 adopted the proposed ruling, with some additions and clarifications. Rev. Rul. 2004-60 provided that the principle of Rev. Rul. 2002-22 does not apply to FICA and FUTA. For purposes of Social Security, Medicare and unemployment taxes, the employee has wages; thus, both the employer and employee are liable for employment taxes. The employee’s share may be withheld from the payments to the transferee spouse, so the employee will not be affected. The transferee spouse cannot exclude the withheld taxes from income; in effect, that spouse pays the employee’s FICA. The ruling specified that the employer must also withhold income taxes at the flat rate for withholding on supplemental wages. Because the payment does not arise from an employment relationship between the payer and the recipient, the wages and withholding are reportable on Form 1099-MISC, Miscellaneous Income, instead of Form W-2. The employee’s Form W-2 will correspondingly reflect nothing in Box 1 as a result of the payment. Rev. Rul. 2004-60 is effective Jan. 1, 2005. Until then, employers may rely on a reasonable, good faith interpretation of Notice 2002-31 and Rev. Rul. 2004-60. Hedging Nonqualified Deferred Compensation with Derivatives Letter Ruling 20041500920 concerned the use of derivative contracts to hedge risk on future compensation payments under a nonqualified deferred-compensation plan. In the ruling, a taxpayer entered into a cash-settled swap with an unrelated third party. Under the contracts, the employer was to pay the third party the London Interbank Offering Rate (LIBOR) plus a spread, multiplied by the aggregate deferred-compensation amount. The third party was to pay the employer the excess, if any, of the net asset value of the deferred compensation in the deemed investments under the nonqualified deferred-compensation plan over the aggregate deferred compensation. The taxpayer must match the recognition of income, deductions, gains and losses from the derivative contracts with the recognition of corresponding deductions for future compensation under the plan. The ruling stated that nonqualified deferred-compensation obligations are ordinary obligations that can be hedged. Although Regs. Sec. 1.1221-2(d)(5) precludes hedging of equity securities, debt instruments or annuity contracts, the ruling concluded that the derivative contracts are none of these and, thus, qualify as a hedging transaction, assuming that other Sec. 1221 requirements and the regulations are met (e.g., advance identification as a hedging transaction). The ruling noted that, assuming the transaction qualifies as a hedging transaction, matching income, deductions, gains and losses from the derivative contracts with the deductions for the nonqualified deferred-compensation arrangement will clearly reflect income for Regs. Sec. 1.446-4(b) purposes. Change in Control Merger of equals—pre-2004 transactions: Letter Ruling (TAM) 20041500321 considered whether a corporation, X, had a change in control under Q&A-29 of the 1989 proposed Sec. 280G regulations. X merged into corporation Y. After the transaction, the former X shareholders held less than 50% of the surviving corporation shares when the X shareholders were deemed to be acting as a group as to their X shares, but more than 50% of the surviving corporation when the X shareholders were deemed to be acting as a group as to their pre-transaction holdings in both X and Y. The TAM interpreted Q&A-29 as providing that X’s shareholders are deemed to be acting as a group only as to their X shares, and further concluded that the facts did not demonstrate any formal or informal agreement among the X shareholders who owned Y shares to acquire ownership of Y. The TAM concluded that the X shareholders, acting as a group, acquired less than 50% of the surviving corporation; thus, X underwent a change in control under Q&A-29. The TAM’s conclusion, while considered controversial by tax advisers, is not unexpected. With the issuance of the reproposed regulations under Sec. 280G, the IRS formally indicated that it did not agree with the merger-of-equals analysis. The TAM implies that a facts-and-circumstances approach could be used to determine whether a change in control agreement exists if there is an agreement among the X shareholders as to their Y holdings. This approach is not adopted in the final 280G regulations,22 however, so it would be applicable only for transactions before 2004. Square D:23 This Tax Court case was the first in many years to involve Sec. 280G. The taxpayers revised existing employment and change-in-control agreements after the transaction in an attempt to reduce or eliminate the executives’ excise taxes and lost corporate deductions arising from parachute payments to be made to them. The taxpayers’ argument was that payments under the new agreements were not subject to Sec. 280G, because they had been entered into after the change in control. The taxpayers further argued that even if the payments were subject to Sec. 280G, they were reasonable compensation for services rendered after the change in control and, thus, not subject to Sec. 280G. The court held that the new agreements merely recast promised payments under the original agreements and, thus, were still subject to Sec. 280G. In addition, it determined that the Sec. 280G reasonable compensation analysis should apply the multifactor test used for determining reasonable compensation under Sec. 162. This opinion provides a road map for practitioners and taxpayers as to what the court considers appropriate reasonable compensation analysis for Sec. 280G change-in-control payments. Executive Compensation Audit Initiative The IRS initiated a pilot program to examine executive compensation issues as part of corporate audits. Initially, it targeted 24 companies for audit, but expanded the population after finding widespread errors. The initiative focuses on the timing of the employer’s deductions and its compliance with reporting and withholding obligations. It targets officers and other highly paid individuals, possibly including former employees. If errors are found with specific items, the group would expand to all employees with such types of payments. The initiative specifically targets the following eight issues: 1. Nonqualified deferred compensation. 2. Stock-based compensation, including stock appreciation rights, phantom shares, nonstatutory options, restricted stock and statutory options. 3. Sec. 162(m). 4. Secs. 280G and 4999. 5. Split-dollar life insurance arrangements. 6. Notice 2003-4724—sales of options to family limited partnerships. 7. Notice 2003-2225—offshore leasing companies. 8. Fringe benefits, particularly personal use of corporate aircraft and automobiles, and relocation benefits. For some issues, such as personal use of corporate aircraft, the rules are very specific; for others, such as deferred compensation, they are less specific. Thus, a careful review of the plan and its operation is needed to determine compliance. The amounts involved can be significant and can have not only tax, but also Securities and Exchange Commission reporting, implications. Schedule M-3 On July 7, 2004, Treasury and the IRS issued a new draft of Form 1120, Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, along with a frequently asked questions (FAQ) document, and Rev. Proc. 2004-45.26 The FAQ is intended to provide additional guidance while Treasury and the IRS are finalizing the instructions. Although the new Schedule M-3 is labeled a “draft,” it is the final version. It was released in draft format to allow taxpayers, practitioners and programmers time to gather the necessary data and make the software programming changes needed to comply with its reporting requirements. Rev. Proc. 2004-45 eliminated the overlap between the revised return disclosure regulations and new Schedule M-3 and simplified the reporting of book-tax differences by businesses not required to complete it. Schedule M-3 must be included in the Form 1120 filing for a corporation’s tax year ending on or after Dec. 31, 2004. Special transition rules for the first tax year that the corporation must file Schedule M-3 provide that only Part I and Columns B and C of Parts II and III must be completed. For any subsequent tax years, the taxpayer must complete the entire schedule. Taxpayers should be preparing for these new reporting requirements now. Conclusion In the December 2004 issue, Part II will focus on retirement plan developments and planning. |
