Internal Revenue Code Section 409A introduces new rules governing non-qualified retirement plans and other deferred compensation arrangements. In this continuing series of articles, we take an in-depth look at some of the crucial issues involved with bringing your plans and arrangements into compliance with Section 409A.
This article examines continued insurance coverage, reimbursement and in-kind benefit commitments and how they are treated under Section 409A.
Internal Revenue Code Section 409A regulates "deferred compensation" which, in many instances, is easy to identify. If an employer has a legally enforceable commitment to pay money to an employee in some future year, that generally is deferred compensation.
However, what if an employer doesn't agree to pay a specified amount of money at a specified time in the future? Let's say the employer instead agrees to reimburse the employee's country club dues for the five years after employment, or pay the employee's life insurance premiums or provide the employee with use of a car for a certain period of time post-termination. How are such items analyzed under Section 409A?
What may not immediately look like deferred compensation may well be, and the employer must be mindful that making a coverage, reimbursement or in-kind benefit commitment may have implications under Section 409A. Such commitment—given as part of an employment or separation agreement or on some stand-alone basis—must be carefully structured.
This article focuses mainly on commitments made by an employer to provide post-termination insurance coverage, reimbursements or in-kind benefits. These commitments typically are made in an employment or separation agreement.
THE GENERAL RULE
As a general proposition under Section 409A, "deferred compensation" exists if an employee has a legally binding right to compensation that, pursuant to the term of the plan or arrangement, is or may become payable to (or on behalf of) the employee in a later taxable year. Compensation consists not only of cash pay, but also includes benefits and perquisites, provided in cash or in-kind, and reimbursements that derive from the employment relationship. Accordingly, if a plan or agreement—such as a separation agreement—provides a legal entitlement to continued medical plan coverage, use of the corporate jet, and reimbursement of moving expenses or similar items, then there is deferred compensation subject to Section 409A, unless an exception is available.
Identifying the Compensation Element
To analyze reimbursement and in-kind benefit commitments under Section 409A, it is first necessary to identify the "compensation" element of the arrangement. If an employer agrees in a separation agreement to provide a certain type of post-termination insurance coverage—such as health, life or disability insurance—the compensation element generally is the premium paid by the employer for the coverage. This is a proxy for the value of the coverage to the employee.
If an employer "self-funds" a benefit—that is, it commits to paying for benefits out of operating assets or through a funding trust rather than through insurance—the benefit generally is taxable as compensation to the former employee. For example, if an employer pays for a medical procedure, it is the amount paid for the medical procedure that is compensation, while it would have been the premium payment for medical insurance if the arrangement had been insured by a third party.
With reimbursement commitments, the compensation element associated with in-kind benefits generally is the value of the benefit to the employee. For example, absent an available exclusion, an employee is taxed on the fair market value associated with use of an automobile, use of day-care facilities or use of corporate aircraft.
Section 409A generally demands that the timing of deferred compensation be strictly defined, either by reference to a specified date or by reference to a permissible payment event, i.e., "Monthly installments will be paid starting with the first day of the third calendar month following separation from service for a period of ten years."
Variability poses problems under Section 409A. If a former employee has "compensation" at the time his or her employer pays for a given medical procedure under a self-funded plan, then, unless one can predict the future as to exactly when a medical procedure will occur—and document it in the separation agreement—the variable nature of the timing of that compensation raises a concern.
Accordingly, for coverage, reimbursement and in-kind benefit commitments, it is important to look for ways to escape Section 409A by falling within an exclusion, not making a given commitment, or looking for alternative ways to comply with Section 409A.
APPLICABLE EXCLUSIONS FROM SECTION 409A
There are a number of coverage, reimbursement and in-kind benefit commitments that avoid deferred compensation status under Section 409A because of a specific exception in the regulations.
Section 409AConcerns Itself with Taxable Compensation
Section 409A applies only to amounts that are "compensation" for services rendered to the employer and affiliates—and only if the compensation is taxable for federal income tax purposes. Accordingly, the two-part threshold question to ask is: What is the compensation element, and is it taxable?
Consider an example involving two separate employers. One employer commits in a separation agreement to pay the former employee's premium under an individual life insurance policy held by the employee. The second employer commits to continuing the former employee's coverage under the group-term life insurance plan of the company. In both cases, the compensation element is the insurance premium or the value of the coverage, not the death benefit itself. Accordingly, it is not necessary to look to the death benefit itself to determine whether the arrangement provides for deferred compensation or, if it does, whether the arrangement complies with Section 409A. Payment by an employer of the premium on an individual policy is taxable compensation, and this scenario may involve deferred compensation. Providing group-term coverage to a former employee may or may not result in taxable compensation. Only if it does or potentially could result in taxable income do the parties need to be concerned with Section 409A.
- Exclusions Available to Former Employees
Not all benefits provided to active employees on a tax-free basis can be provided to former employees on a tax-free basis, but many can. Those that can be provided to former employees on a tax-free basis if properly structured include:
- Medical coverage under Section 105 and 106;
- Dependent care under Section 129;
- Legal services under Section 120;
- Group-term life insurance up to $50,000 under Section 79.
The above list is not exclusive of the types of benefits that can be provided to former employees on a tax-free basis or the circumstances under which they can be provided. Before committing to a coverage or benefit, however, it is essential that the parties determine the tax status of the coverage or benefit to the employee.
- Exclusions Conditioned on Non-Discrimination Rules
Many types of benefits can be provided on a tax-free basis to employees or former employees only if certain defined non-discrimination rules are satisfied. If the non-discrimination rule is violated, the coverage or the benefit (if that is the compensation element) becomes taxable.
It is these non-discrimination tests that can be particularly challenging under Section 409A. If providing a post-termination benefit commitment to a given person violates the non-discrimination rules applicable to a given type of benefit, then what is otherwise a non-taxable compensation element becomes taxable and thus potentially subject to Section 409A.
Continued Medical Coverage
Section 409A does not provide an automatic exclusion for continued medical coverage or benefits. However, Section 409A concerns itself only with taxable compensation, and if an arrangement satisfies the requirements of Sections 105 and 106 of the Code so that neither the medical coverage nor the benefits provided are taxable to the former employee, then the arrangement is not considered deferred compensation subject to Section 409A. This could encompass insured or self-funded arrangements:
- Under an Insured Arrangement
Coverage and benefits under an employer-sponsored insured medical plan generally are non-taxable under Sections 105 and 106, and employer-provided insurance coverage thus can continue indefinitely without being considered deferred compensation under Section 409A. This assumes the employer can arrange for such coverage with its insurer.
In this regard, there are certain benefit and contract structures where there are special considerations, and each situation should be examined on its facts. For example, under current law, the coverage provided to domestic partners who don't qualify as dependents under an insured arrangement is taxable to the employee or former employee and not excludable under Section 106. Thus, providing domestic partner coverage post-termination may raises issues under 409A.
Group insurance arrangements are within the exclusion of Section 105 and 106. Also, under appropriate circumstances, use of an individual insurance policy may qualify under Sections 105 and 106, and a contractual commitment to provide for such a policy may provide an option when continued coverage under a self-funded plan does not.
- Under a Self-Funded Arrangement (Indefinitely)
Coverage under an employer self-funded plan, including those run through a voluntary employees' beneficiary association (VEBA), or a medical expense reimbursement arrangement, generally is tax free under Section 106. Again, the exception is coverage provided to domestic partners. However, in order for the benefits provided under such an arrangement to avoid tax, the arrangement must satisfy certain non-discrimination requirements under Section 105(h). To avoid deferred compensation status under Section 409A, both the coverage and the benefits must be tax free.
A full discussion of the non-discrimination rules of Section 105(h) is beyond the scope of this article, but generally, Section 105(h) requires that a plan not discriminate in favor of officers and higher-paid employees with respect to eligibility to participate or in the benefits provided. These tests are applied separately for retiree and for active employee coverage. Because the circumstances we are considering often involve "special deals" in terms of eligibility for post-termination benefits for the employee in question, compliance with Section 105(h) must be considered. If the continued coverage complies with Section 105(h) and is otherwise nontaxable under Sections 105 and 106, then the continued coverage under a self-funded plan is not subject to Section 409A.
It is the uncertainty that stems from application of the non-discrimination rules of Section 105(h) that may cause an employer to seek an alternative position under Section 409A by providing coverage only for a limited period of time.
- Under a Self-Funded Arrangement (For a Limited Period of Time)
The regulations provide an alternative means of avoiding deferred compensation status for continued medical benefits under a self-funded plan for those who would prefer not to translate a Section 105(h) risk into a Section 409A risk. If a reimbursement right under a self-funded medical plan or medical expense reimbursement arrangement derives under a separation pay plan, such a right is not considered deferred compensation subject to Section 409A provided that arrangement:
- Covers only amounts that are not reimbursed by someone other than the employer, i.e., not covered by insurance or a new employer's plan
- Covers only amounts that would be allowable as a medical/dental expense deduction under Section 213 without regard to the 7.5 percent floor
- Does not extend beyond the COBRA continuation coverage period that would apply to the employee if the employee had elected COBRA and paid the premiums
There are two important points to consider about this exception.
First, the exception only applies to the "period of time during which the service provider would be entitled" to COBRA continuation coverage. Thus, it appears the maximum period for reimbursement under this exception is limited to the time period the former employee would be permitted to receive COBRA and would not include any extended coverage period that may apply to another qualified beneficiary.
Second, the exception only applies if the right to reimbursement arises under a separation pay plan, which is any plan where the right to the payment of compensation—in this case, the reimbursement—is conditioned upon separation from service, as defined for purposes of Section 409A.
Term Life Insurance and Other Death Benefit Coverage
As noted above, Section 409A concerns itself only with taxable compensation. Section 79 provides an exclusion from gross income for the value of group-term life insurance coverage up to $50,000, and this exclusion is available for coverage provided to former employees. Accordingly, to the extent the coverage commitment is limited as necessary to fall within the scope of Section 79, there is no deferred compensation under Section 409A. However, Section 79 contains rules that prohibit coverage discrimination in favor of key employees, and these rules apply separately to former employees. Again, while a full discussion of these rules is beyond the scope of this article, even if post-termination coverage is limited to $50,000, the non-discrimination rules may result in taxable coverage to former employees who are extended coverage on a selective basis.
Section 409A and the governing regulations exclude "death benefit" coverage from being deferred compensation. What constitutes a death benefit generally is defined by reference to the standards in place under FICA, but with the condition that the benefits can be provided through insurance and that the value of the term life insurance component of the benefit is not included in measuring the lifetime benefits payable under the plan. This death benefit exclusion thus would operate to exclude group-term life insurance coverage from the reach of 409A, regardless of whether the value of the coverage is taxable to the individual or not.
The death benefit exception under Section 409A also would extend to "self-funded" death benefits—that is, a benefit that is paid from the assets of the employer on the death of the former employee. The compensation element in this case is the benefit payment itself. (Note: Section 101(b) used to provide a death benefit exclusion for employer paid death benefits up to $5,000, but that exclusion is no longer available). While there is no cap on this exception, a death benefit includes only amounts that are payable exclusively on the death of the individual and are not payable during the lifetime of the individual. For example, the mere fact that a deferred compensation benefit is accelerated on death does not make that payment a death benefit.
A former employee may have an individual insurance policy, and the employer may make the commitment to reimburse the employee for the premium on that policy or pay the premium directly. That payment would not qualify for the death benefit exception under Section 409A and would be required to comply with Section 409A unless another exception applied.
Because Section 409A does not apply to nontaxable benefits, educational assistance benefits that qualify as tax free under Section 127 are not subject to Section 409A. For example, a program that is adopted to provide job training to employees affected by a downsizing that qualifies under Section 127 is not deferred compensation under Section 409A. However, like self-funded medical and group-term life insurance, to qualify as tax free under Section 409A, a non-discrimination requirement must be satisfied. This requirement may preclude reliance on the tax exemption as a means to avoid application of Section 409A.
Regulations under Section 409A have a broad savings clause, however, for taxable amounts that satisfy the definition of educational assistance under Section 127. Accordingly, educational assistance as defined in Section 127 is not subject to Section 409A, regardless of whether it is or is not taxable under Section 127.
Section 127 allows only benefits to employees or former employees, not spouses or beneficiaries. Furthermore, the special rule for taxable education assistance under Section 409A is not available with respect to amounts paid for a spouse or dependent.
Outplacement Expense Reimbursements (or In-Kind Benefits)
Section 409A does not apply to the reimbursement of reasonable outplacement expenses actually incurred by the former employee and directly related to his or her separation from service with the employer to the extent that such reimbursement rights apply during a limited period of time. To satisfy the limited period of time condition, the expenses must be incurred before the last day of the second year following separation from service and the reimbursement must be made before the last day of the third year following separation from service.
Reimbursement rights may extend beyond the limited period of time referenced above, and to that extent, the arrangement provides for deferred compensation subject to Section 409A and must be handled as described below for reimbursement arrangements.
The outplacement expense exception is available only if the reimbursement right is provided under a separation pay plan—that is, the right is triggered by separation from service. Providing in-kind services is treated the same for this purpose as providing a reimbursement of third-party expenses.
Moving Expense Reimbursements
Section 409A does not apply to reimbursement of reasonable moving expenses actually incurred by the former employee and directly related to his or her separation from service with the employer, to the extent such reimbursement rights apply during the limited period of time (as referenced above for outplacement). The reimbursement of reasonable moving expenses includes the reimbursement of all or part of any loss the former employee actually incurs on sale of his or her primary residence in connection with a separation from service.
As with outplacement, reimbursement rights for moving expenses may extend beyond the limited period of time referenced above. To the extent the arrangement extends beyond the limited period, it provides for deferred compensation subject to Section 409A and must be handled as described below for reimbursement arrangements.
This exception also is available only if the rights arise under a separation pay plan.
Other Taxable and Deductible Reimbursements
Another exception under Section 409A is available for taxable reimbursements of amounts that the employee could otherwise deduct under Section 162 or 167—without regard to applicable limitations based on adjusted gross income—as business expenses incurred in connection with the performance of services for the employer. As above, the expense must be incurred before the last day of the second year following separation from service, and the reimbursement must be made before the last day of the third year following separation from service. This exception is available only if the rights arise under a separation pay plan.
Indemnification and Liability Insurance
An arrangement providing for the indemnification of the former employee—or the purchase of an insurance policy providing for payments of damages or expenses incurred by the former employee—for claims related to his or her actions or failure to act in his or her capacity as an employee of the employer is not deferred compensation subject to 409A.
AVAILABILITY OF SHORT-TERM DEFERRAL RULE FOR LIMITED DURATION ARRANGEMENTS
Under what is referred to as the "short-term deferral rule," compensation that is paid within the same calendar or employer fiscal year in which the right to the compensation vests, or within two and one-half months after the end of such calendar or fiscal year, is not considered deferred compensation under Section 409A. Certain separation agreements that provide for reimbursement of expenses incurred and paid within the short-term deferral period may escape Section 409A on this basis. Such limited duration arrangements are not common, but the short-term deferral rule would be an option in limited circumstances.
COMPLYING WITH CODE SECTION 409A
In any case where an insurance coverage, reimbursement or in-kind benefit commitment falls outside of one of the exceptions described above, the commitment is subject to Section 409A. This includes instances where the period over which the reimbursement is to be paid exceeds the limited period specified in the applicable exception.
Such instances result in two primary consequences:
- In the case of a "specified employee" of a public company, the insurance coverage, reimbursement or in-kind benefit cannot be provided until six months following separation from service
- In the case of any employee, the timing of the arrangement must be structured to be payable in accordance with a "fixed schedule" when measured by reference to the separation from service
The Six-Month Delay Rule
As with any cash payment that is triggered upon separation from service, any other taxable compensation element in the form of a coverage, reimbursement or in-kind benefit that is triggered by separation from service and is not otherwise exempt from Section 409A will be subject to the six-month delay rule to the extent it is provided to a specified employee of a public company. This may require that reimbursements be accumulated for such six-month period, and may, in limited circumstances, make the arrangement lose its value in the separation package.
A commitment that is not triggered by separation from service, but instead is structured to be paid solely per a "specified time/fixed schedule," need not comply with the six-month delayed payment requirement. However, several of the special exceptions available from deferred compensation status—such as the special exception for self-funded benefits provided during the COBRA period— are conditioned upon the commitment arising under a separation pay plan. A separation pay plan, by its nature, provides benefits triggered by separation from service. Accordingly, reliance on the "specified time/fixed schedule" payment event is of limited value in those circumstances.
Complying with the Payment Timing Rules
Insurance coverage can potentially be deferred and reimbursements accumulated for six months if need be. However, compliance with the fixed-schedule rule is more difficult. There are two elements to the rule. First, the time of payment must be objectively determinable at the time the amount is deferred. This is may be difficult for reimbursements when it is not known whether or when the expense eligible for reimbursement will be incurred. However, requiring that an individual submit expenses within 45 days following the date such expenses are incurred, and requiring payment within 30 days thereafter, may resolve this issue. Second, the amount of the payment also must be objectively determinable, which again poses a significant problem for changing coverage or in-kind benefit values and for indeterminate reimbursement amounts.
- Use of Defined Payments
In the case of insurance coverage provided to a former employee, it may be possible to restructure the arrangement to provide a determinable cash amount to the employee on a periodic basis to equate with the premium amount. For example, the employer could commit to provide a specified dollar amount to the employee each month to cover the cost of the premium for an individual life insurance policy, with the dollar amount subject to some form of cost-of-living escalator each year. Of course, in the case of a specified employee of a public company, the payments would be suspended for six months following separation from service.
A reimbursement arrangement similarly could be restructured to provide some level of equivalent value on a fixed and determinable basis.
- Special Rules for Reimbursement Arrangements
The final regulations offer a reasonable solution that would allow reimbursements to comply with the fixed schedule requirements of Section 409A. The regulations provide that a reimbursement arrangement satisfies the fixed schedule requirements of Section 409A if the following requirements are met:
- The expenses eligible for reimbursement must be clearly and objectively defined
- The reimbursement must be available for expenses incurred during a defined time period such as "five years" or "for life"
- The amount of expenses reimbursed in one year cannot affect the amount that will be reimbursed in another year (it is acceptable to reimburse $1,000 per year for five years, but it is not permissible to reimburse a total of $5,000 over five years)
- The reimbursement must be made no later than the end of the year after the year in which the expense was incurred
- Cash or any other benefit cannot be substituted for the reimbursement right
A reimbursement arrangement that satisfies the above conditions still is deferred compensation subject to Section 409A, but the reimbursements made under the arrangement comply with the payment timing rules of Section 409A. The six-month delayed payment requirement continues to apply to specified employees where the reimbursement right is triggered as the result of separation from service and other rules of the regulations under Section 409A must also be satisfied.
There is no guidance as to what would constitute a "clearly and objectively defined" expense. As a result, agreements should be drafted with as much specificity as possible. Instead of requiring "reimbursement of automobile expenses for five years," an agreement might more properly provide for "reimbursement for gas, regularly scheduled maintenance, and repairs up to a maximum of $2,500 per year over five years."
Special Rule for Tax Gross-Ups
The final regulations specifically address the circumstances under which a tax gross-up reimbursement provision will meet the "fixed schedule" requirement. A tax gross-up provision will be treated as providing for a fixed schedule of payment if the plan or agreement provides that the payment will be made, and the payment is actually made, by the end of the individual's tax year following the tax year in which the executive pays the tax. Permissible tax gross-up payments may be made with respect to any federal, state, local or foreign taxes, and may include expenses for tax audits or litigation regarding the existence of a tax liability.
The language of the agreement should specify that reimbursements will be made no later than the date allowed.
ISOLATION OF REIMBURSEMENTS UNDER A SEPARATE "PLAN"
Section 409A generally is applied by reference to the "plan" under which a given employee is covered, with "aggregation" and "disaggregation" rules applying to define the applicable plan. If any component of an aggregated plan fails to comply with Section 409A, then all deferred compensation under that aggregated plan (but not other deferred compensation) is considered to be noncompliant. The consequences of noncompliance extend to, but not beyond, the tainted aggregated plan.
The commitment to provide in-kind benefits and expense reimbursements is considered to be a "plan" separate from any other deferred compensation plan in which the employee participates, provided that the right to in-kind benefits and reimbursements is not a significant portion of the overall compensation of the employee or the overall compensation received due to a separation from service. Assuming these requirements are satisfied, if a reimbursement commitment that is deferred compensation fails to satisfy the payment schedule requirements of Section 409A, it does not "taint" any other deferred compensation of the individual. The consequences of such a failure are limited to the in-kind benefit and reimbursement plan.
There is no guidance on what portion of an overall severance package can consist of in-kind and reimbursement commitments before it is considered "significant," so caution is advisable.
The other positive consequence of the disaggregation rule is that in-kind benefits and reimbursements are not taken into account in determining whether other regulation rules are satisfied. For example, a "safe-harbor" separation pay plan is not considered to provide deferred compensation subject to Section 409A, with one of the conditions of safe-harbor status being that benefits under the plan be appropriately limited. Because in-kind benefits and reimbursements are deemed to be provided under a separate plan, they do not count toward the limits applicable to safe-harbor separation pay arrangements.
It is vital to properly structure insurance coverage, reimbursement and in-kind benefit commitments to either avoid deferred compensation status under Section 409A or to comply with the rules of Section 409A. The regulations under Section 409A provide much flexibility to make such commitments workable, at least with respect to most commonly provided commitments. As with everything about Section 409A, proper analysis and planning is important.