Health Care Reform May Impact Your Employment and Severance Agreements

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Executives should be aware of the new application of nondiscrimination rules under the Patient Protection and Affordable Care Act of 2010, as amended (“PPACA” or “Act”)—commonly known as health care reform—that will prevent highly compensated employees from being rewarded with more favorable eligibility terms or richer benefit levels in connection with health insurance.

In many employment and severance agreements for executives, the company agrees to provide to the executive, or former executive, tax-free health benefits under the company’s group health plan that are richer than the health plan benefits offered to other active or former employees. Typically, in these instances, the company will pay all or a larger portion of the health care premiums associated with the continued coverage than the company otherwise does for other active or former employees.

Another form of executive health benefits may include the company agreeing to continue health plan benefits for a period of time longer than what the company is otherwise required to do under the Consolidated Omnibus Budget Reconciliation Act of 1986 (COBRA). In these instances, for example, the company may offer tax-free continuation coverage until the executive is eligible for Medicare coverage.

Since the 1980s, employers have used fully insured plans as a vehicle to provide executives and key employees with more generous health benefits. Historically, there were no penalties or tax issues associated with providing a higher level of health benefits to executives if the health benefits were fully-insured through an insurance company. However, with the implementation of PPACA that will no longer be the case. The Act’s nondiscrimination rules will take effect once the Internal Revenue Service (“IRS”) issues further guidance.

Notably, under the Act, “highly compensated” is not defined by the amount of income an executive earns. Instead, a highly compensated individual is generally defined as one of the five highest paid officers or among the highest paid 25% of all company employees.

Under the Act’s nondiscrimination rules, an employer’s health insurance plan must satisfy two separate tests: eligibility and benefits. The eligibility test may be satisfied if: (i) 70% or more of all company employees are covered by the plan; or (ii) 70% of all company employees are at least eligible to participate in the plan and 80% of those eligible employees are covered.

Alternatively, an employer may satisfy the eligibility rules by classifying employees on a nondiscriminatory basis; however, such classifications may have less predictability because they will likely be scrutinized by the IRS on a facts and circumstances basis. It should be noted that certain company employees may be excluded from eligibility testing altogether, including employees with less than three years of service, employees under age twenty-five, and part-time employees.

To satisfy the benefits test, all benefits provided to highly compensated individuals, including their dependents that participate in the company’s plan, must be provided to all other company employees that participate in the plan.

Employers that fail to satisfy these requirements may face an excise tax equal to $100.00 per day during the period of noncompliance for each “affected employee.” For this purpose, the IRS has defined affected employees to include each employee who is discriminated against as a result of the arrangement. If the violation is the result of an unintentional failure the maximum penalty is the lesser of (i) 10% of the total amount paid by the company in the previous year with respect to health insurance, or (ii) $500,000. The penalty is enforced on a voluntary self-reporting basis whereby the IRS requires violating employers to file a special tax return. More draconian penalties apply if the IRS discovers the violation in connection with an audit.

These rules will likely catch executives, and their institutions, by surprise since this portion of health care reform has, to date, received little attention. Depending on exactly how the IRS interprets and implements these new rules, they could have a broad impact across a wide range of employment and severance agreements. In this regard, it is important to note that the new law does not contain an exception for existing arrangements.

Based on recent comments from the IRS that these new rules will be “a very challenging provision to apply,” executives and companies should start to take steps to survey and outline their current health care arrangements. Once further IRS guidance is issued, existing and new health care arrangements will need to be reviewed to ensure that the company may continue to administer the arrangement without incurring significant penalties. If prohibited, these arrangements will need to be restructured in a compliant manner.

We will continue to keep you apprised of new developments. In the meanwhile, please feel free to contact us.