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					                                         Insurance & Employee Benefits
                                                       Table of Contents
CHAPTER ONE - OVERVIEW .................................................................................................... 1
  EMPLOYEE BENEFIT PLANS ................................................................................................ 1
    PERTINENT AMENDMENTS TO ERISA ........................................................................... 2
  THE EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA)............................... 3
    TYPES OF PLANS................................................................................................................. 3
      Pension Plans ...................................................................................................................... 3
      Welfare Plans ...................................................................................................................... 5
      Multiemployer plans ........................................................................................................... 5
    ERISA PENSION AND WELFARE PLANS ........................................................................ 5
      Title I................................................................................................................................... 5
      Title II ................................................................................................................................. 6
      Title IV ................................................................................................................................ 7
    DEFINITIONS OF PERSONS ASSOCIATED WITH ERISA PLANS ............................... 7
    REGULATORY AUTHORITY ............................................................................................. 8
PENSION PLANS .......................................................................................................................... 8
  BASICS....................................................................................................................................... 8
      Present Value of Future Benefits ........................................................................................ 8
      Individual Taxes.................................................................................................................. 9
      Tax Advantages to the Employer ...................................................................................... 10
    EFFECTS OF ERISA ON BUSINESS PRACTICES .......................................................... 10
      Social Effects of ERISA Plans .......................................................................................... 11
    PENSION PLANS AND CORPORATE FINANCE ........................................................... 12
      Financial Markets.............................................................................................................. 12
  VESTING ................................................................................................................................. 13
      Vesting Requirements-Normal Retirement Benefit .......................................................... 13
      Vesting of Accrued Benefits ............................................................................................. 13
      Forfeiture of Benefit Rights .............................................................................................. 14
      Termination Vesting ......................................................................................................... 15
        Discriminatory Vesting ................................................................................................. 15
      Nonforfeitable Benefits ..................................................................................................... 16
CHAPTER TWO -EMPLOYER PROVIDED HEALTH INSURANCE ............................ 19
    Overview ............................................................................................................................... 19
      Taxation of Benefits for Employees ................................................................................. 19
      Hospital, Surgical & Medical Expense ............................................................................. 20
      Dismemberment and Loss of Sight ................................................................................... 20
      Critical Illness Benefits ..................................................................................................... 20
      Accidental Death Benefits ................................................................................................ 21
      Survivor's Benefits ............................................................................................................ 21
      Employer's Noninsured Accident & Health Plans ............................................................ 21
    NONDISCRIMINATION FOR EMPLOYER PROVIDED HEALTH BENEFITS ........... 21
        Insured Plans ................................................................................................................. 21
      Self-Insured Plans ............................................................................................................. 22



                                                                        i
       Eligibility ...................................................................................................................... 22
       Excludable Employees .................................................................................................. 22
       Part-time and Seasonal Workers ................................................................................... 22
       Benefits ......................................................................................................................... 23
       Highly Compensated Individual ................................................................................... 23
       Taxation of Amounts Paid by Employer to HCEs Under Discriminatory Plan ........... 23
       Contributory Plan .......................................................................................................... 24
       Withholding .................................................................................................................. 24
     "Domestic Partnership" Benefits ...................................................................................... 24
       COBRA ......................................................................................................................... 25
     Taxation of Health Benefits for Stockholder-Employees & Self-Employed.................... 25
     Taxation of Health Benefits-Partners, Sole Props. & S Corp. Shareholders .................... 25
       S-Corporation Shareholder/Employee .......................................................................... 26
   EMPLOYER'S TAX DEDUCTIONS .................................................................................. 26
CHAPTER THREE - HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY
ACT OF 1996 (HIPAA)................................................................................................................ 29
 An Act.. ..................................................................................................................................... 29
 HIPAA GROUP HEALTH INSURANCE REFORMS ........................................................... 29
   PORTABILITY .................................................................................................................... 29
 COBRA ..................................................................................................................................... 29
     Creditable Coverage.......................................................................................................... 30
   CONTINUATION OF COVERAGE DEFINITIONS ......................................................... 30
       Qualified Beneficiary .................................................................................................... 31
     Domestic Partners ............................................................................................................. 31
     Cost of COBRA Continuation Coverage .......................................................................... 31
     Employers Subject to COBRA Continuation Coverage ................................................... 32
   PORTABILITY OF GROUP HEALTH PLANS ................................................................. 33
     Continuous Coverage ........................................................................................................ 33
     Creditable Coverage.......................................................................................................... 34
     Certificate of Coverage ..................................................................................................... 34
     Late Enrollment ................................................................................................................ 34
     Waiting Period .................................................................................................................. 34
     Crediting Prior Coverage .................................................................................................. 35
     Spouse and Children Coverage ......................................................................................... 35
   PORTABILITY WHEN MOVING FROM GROUP TO INDIVIDUAL PLANS .............. 36
   COBRA CONTINUATION ELIGIBILTY .......................................................................... 36
     Eligibility for Group to Individual Coverage.................................................................... 37
     Limitations of Group-to-Individual Portability ................................................................ 37
     Special Enrollment Periods ............................................................................................... 38
     Individual Losing Coverage .............................................................................................. 38
     Dependent Beneficiaries ................................................................................................... 39
   NON-DISCRIMINATION ................................................................................................... 39
     PREMIUM AMOUNTS ................................................................................................... 39
     Guaranteed Issue ............................................................................................................... 40
     Guaranteed Renewability .................................................................................................. 40
   LENGTH OF COBRA COVERAGE ................................................................................... 40



                                                                        ii
        Disability ....................................................................................................................... 41
        Employer Bankruptcy ................................................................................................... 41
   PREEXISTING MEDICAL CONDITION .......................................................................... 41
     Hurricane Katrina Exceptions ........................................................................................... 42
     Pre-existing Exclusions for New Dependants................................................................... 42
   EMPLOYMENT TERMINATED FOR "GROSS MISCONDUCT" ........................... 42
   FEDERALLY MANDATED BENEFITS ............................................................................ 43
     Newborns’ and Mothers’ Health Protection Act .............................................................. 44
     Women’s Health and Cancer Rights Act of 1998 ............................................................. 44
     Excluding Coverage for Specific Risks ............................................................................ 44
     Association-Sponsored Group Health Plans ..................................................................... 45
     State Requirements ........................................................................................................... 45
CHAPTER FOUR -LONG-TERM CARE INSURANCE & GROUP HEALTH INSURANCE 48
 QUALIFIED LONG-TERM CARE INSURANCE CONTRACT .......................................... 48
        Cafeteria Plan LTCI ...................................................................................................... 48
        Flexible Spending Arrangements .................................................................................. 48
        COBRA ......................................................................................................................... 48
        Tax on Qualified LTCI Premiums ................................................................................ 49
        LTCI Employer-Paid Premiums ................................................................................... 49
        Taxation of Benefits ...................................................................................................... 49
     Non-Qualified Long Term Care Insurance ....................................................................... 49
 GROUP HEALTH INSURANCE MARKETING ................................................................... 50
     Agents ............................................................................................................................... 50
     Brokers .............................................................................................................................. 50
     Employee Benefit Consultants .......................................................................................... 50
     Group Representatives ...................................................................................................... 50
   THE SALES PROCESS ....................................................................................................... 51
     Prospecting ........................................................................................................................ 51
     Proposal............................................................................................................................. 51
     Presentation ....................................................................................................................... 51
     Employee Enrollment ....................................................................................................... 52
     Installation of Group ......................................................................................................... 52
     Servicing of the Group ...................................................................................................... 52
     Group Sales Attractive to Agents ..................................................................................... 52
   GROUP UNDERWRITING ................................................................................................. 53
     Predicting Claims .............................................................................................................. 53
     Adverse Selection ............................................................................................................. 54
     Statistical Averages ........................................................................................................... 54
     Premium Rates .................................................................................................................. 55
     Competitive Benefits and Premiums ................................................................................ 55
     Adverse Selection in Small Groups .................................................................................. 55
   SMALL GROUP REGULATIONS ..................................................................................... 56
   ―TURNED DOWN‖ ............................................................................................................. 56
     (1) Low Participation ........................................................................................................ 56
     (2) Fictitious Groups ......................................................................................................... 56
     (3) Administration Difficulties ......................................................................................... 57



                                                                     iii
     (4) Persistency................................................................................................................... 57
   PROJECTING CLAIMS EXPERIENCE ............................................................................. 57
     Age .................................................................................................................................... 57
     Sex..................................................................................................................................... 57
     Dependent Coverage ......................................................................................................... 57
     Type of Business ............................................................................................................... 58
     Income............................................................................................................................... 58
     Geographical Area ............................................................................................................ 58
     Other Problem Indicators .................................................................................................. 58
   EMPLOYEE DEATH BENEFITS ....................................................................................... 59
        Voluntary Death Benefit ............................................................................................... 59
CHAPTER FIVE - GROUP LIFE INSURANCE .................................................................. 62
   GROUP INSURANCE REQUIREMENTS..................................................................... 62
     Participants ........................................................................................................................ 62
     Probationary Period .......................................................................................................... 62
     Coverage Period ................................................................................................................ 62
     Benefit Amount ................................................................................................................. 62
     Convertibility .................................................................................................................... 63
     Waiver of Premium ........................................................................................................... 63
     Type of Insurance ............................................................................................................. 63
     Employee Contributions ................................................................................................... 63
     Supplemental Life Insurance ............................................................................................ 63
     Credit Group Life Insurance ............................................................................................. 63
     Accelerated Death Benefit ................................................................................................ 63
   TAXATION OF GROUP TERM LIFE INSURANCE (EMPLOYER)....................... 64
     (1) General Death Benefit ................................................................................................. 64
     (2) Provided to a Group of Employees ............................................................................. 64
     (3) Provided Under a Policy Carried by the Employer ..................................................... 65
     (4) Insurance Computed Under a Formula Precluding Individual Selection .................... 65
     Group Term Insurance for Groups Under Ten Employees ............................................... 66
   Taxation of Group Term Life insurance Premiums to Employer ......................................... 66
   TAXATION OF GROUP TERM LIFE INSURANCE (EMPLOYEE) ............................... 67
        Exceptions ..................................................................................................................... 68
        Other exclusions............................................................................................................ 68
        Discriminatory Plans ..................................................................................................... 68
        Church Plans ................................................................................................................. 69
     Group Carve-out Plans ...................................................................................................... 69
        Where the Policy Also Contains Permanent Benefits................................................... 70
 SPLIT DOLLAR PLAN ........................................................................................................ 70
        Income Taxation of a Split Dollar Plan ........................................................................ 71
        Economic Benefit Treatment ........................................................................................ 71
        Loan Treatment ............................................................................................................. 72
     Group Paid-up Insurance .................................................................................................. 72
     Group Ordinary Insurance ................................................................................................ 72
     Group Universal Life ........................................................................................................ 73
     Retired Live Reserves ....................................................................................................... 73



                                                                      iv
     Supplemental Coverages ................................................................................................... 73
     Taxation of Death Proceeds .............................................................................................. 73
   GROUP SURVIVOR INCOME BENEFIT ......................................................................... 74
CHAPTER SIX - DISABILITY INCOME INSURANCE .......................................................... 77
 DEFINITION AND OVERVIEW ............................................................................................ 77
     Conditionally Renewable .................................................................................................. 77
 THE NEED FOR DISABILITY INCOME INSURANCE ...................................................... 78
 DEFINITIONS .......................................................................................................................... 80
   INJURY ................................................................................................................................ 80
     Accidental Means vs. Results ........................................................................................... 80
   SICKNESS ............................................................................................................................ 80
   PREEXISTING CONDITION.............................................................................................. 80
   DEFINITION OF DISABILITY .......................................................................................... 81
     Partial Disability vs. Residual Disability .......................................................................... 81
     RESIDUAL DISABILITY INCOME INSURANCE ....................................................... 81
   TOTAL DISABILITY .......................................................................................................... 81
   OWN OCCUPATION .......................................................................................................... 82
     Physician Requirement ..................................................................................................... 82
   PRESUMPTIVE DISABILITY ............................................................................................ 82
   ANY GAINFUL OCCUPATION......................................................................................... 83
   INCOME REPLACEMENT APPROACH .......................................................................... 83
 POLICY PROVISIONS............................................................................................................ 83
   BENEFITS ............................................................................................................................ 83
   ELIMINATION PERIOD ..................................................................................................... 83
     Voluntary Interruption of Elimination Period................................................................... 84
   THE BENEFIT PERIOD ...................................................................................................... 84
     Recurrent Disability Provision.......................................................................................... 84
   THE BENEFIT AMOUNT ................................................................................................... 85
     Participation Charts ........................................................................................................... 86
   BASIC BENEFIT PROVISIONS ......................................................................................... 86
     Rehabilitation Benefit ....................................................................................................... 86
     Non-Disabling Injury Benefit ........................................................................................... 86
     Transplant Benefit ............................................................................................................. 86
     Principal Sum Benefit ....................................................................................................... 87
   OPTIONAL BENEFITS ....................................................................................................... 87
   RESIDUAL DISABILITY BENEFIT .................................................................................. 87
   PARTIAL DISABILITY BENEFIT ..................................................................................... 88
   SOCIAL INSURANCE SUPPLEMENT (SUBSTITUTE) .................................................. 88
   INFLATION PROTECTION ............................................................................................... 89
   SUPPLEMENTAL PROVISIONS FOR INCREASED FUTURE BENEFITS .................. 90
     Automatic Increase Benefit Provision .............................................................................. 90
     Guaranteed Insurability Option......................................................................................... 90
 TYPES OF GROUP DISABILITY PLANS ............................................................................ 90
 SHORT TERM DISABILITY .................................................................................................. 91
   MARKETING OF GROUP SHORT-TERM DISABILITY PLANS .................................. 91
   MARKETING OF GROUP LONG-TERM DISABILITY INCOME PLANS ................... 92



                                                                     v
  TAXATION OF EMPLOYER-PROVIDED DISABILITY INCOME ............................... 92
CHAPTER SEVEN - FLEXIBLE BENEFIT PREMIUM PLANS (CAFETERIA PLANS) .. 95
DEFINITION ............................................................................................................................ 96
    Eligible Participants .......................................................................................................... 96
      Leased Employees ........................................................................................................ 96
      Eligible Employees ....................................................................................................... 97
      Employees of Related Organizations ............................................................................ 97
    Domestic Partner ............................................................................................................... 97
  BENEFITS ............................................................................................................................ 97
    Qualified Benefits ............................................................................................................. 98
    Plan Types of Section 125 ................................................................................................ 98
    Do the Math ...................................................................................................................... 99
  SECTION 106 PREMIUM ONLY PLANS ....................................................................... 100
    Benefits ........................................................................................................................... 100
    Plans That Do Not Qualify ............................................................................................. 100
  SECTION 105 - UNREIMBURSED MEDICAL EXPENSE ............................................ 101
      COBRA ....................................................................................................................... 101
      Amounts Remaining in Account at Year-end ............................................................. 101
      Transferring Money Between Accounts ..................................................................... 102
  SECTION 129 - DEPENDENT CARE (DDC) .................................................................. 103
      Requirements & Tax Consequences of Dependent Care Assistance Programs ......... 104
      Employer's Tax Deduction.......................................................................................... 104
      Reporting Requirements ............................................................................................. 104
      Grace Period................................................................................................................ 105
      HSAs ........................................................................................................................... 105
      Products With Investment Feature & Supplemental Health Policies ......................... 105
      Post-retirement Term Life Insurance for Certain Educational Organizations ............ 105
      Highly-compensated employees and Key Employees ................................................ 105
    Tax Benefits of a Cafeteria Plan ..................................................................................... 106
    Non-Discrimination Requirements ................................................................................. 106
      Date of Employer Contributions ................................................................................. 107
  CHANGING A BENEFIT ELECTION ............................................................................. 107
      Status Change.............................................................................................................. 107
    Consistency Rule ............................................................................................................ 108
    Election Changes Because of Cost or Coverage Changes .............................................. 108
      Applicable Dates ......................................................................................................... 109
      Effect of the Family and Medical Leave Act on Cafeteria Plans ............................... 109
      Health Flexible Spending Account (FSA) .................................................................. 109
      Social Security and Federal Unemployment Taxes .................................................... 110
FLEXIBLE SPENDING ARRANGEMENTS ....................................................................... 110
      Health Coverage.......................................................................................................... 110
      Dependent Care Assistance FSAs ............................................................................... 111
      Other ........................................................................................................................... 111
  INSTALLATION OF CAFETERIA PLAN ....................................................................... 112
    Documentation ................................................................................................................ 112
  Form 5500 ........................................................................................................................... 113



                                                                  vi
           ERISA Plans ............................................................................................................... 113
       FORMS FOR INSTALLATION .................................................................................... 113
CHAPTER EIGHT - DEFERRED COMPENSATION PLANS ........................................ 116
 DEFERRED COMPENSATION............................................................................................ 116
       "Parachute Payments" ..................................................................................................... 116
   "Excess Amount" ................................................................................................................ 117
   FUNDED DEFERRED COMPENSATION (ANNUITIES AND TRUSTS) .................... 117
           Employee Taxation ..................................................................................................... 117
           Employer Taxation...................................................................................................... 118
       Secular Trust ................................................................................................................... 118
           Employer's Deduction ................................................................................................. 119
       Taxation of Trust............................................................................................................. 119
           Relation to ERISA ...................................................................................................... 120
       Employee Taxation on Nonqualified Annuity or Nonexempt Trust .............................. 120
   UNFUNDED DEFERRED COMPENSATION ................................................................ 120
   PRIVATE DEFERRRED COMPENSATION PLAN........................................................ 120
           Statutory Requirements for Distribution ..................................................................... 121
           Timing of Deferral Election ........................................................................................ 121
           Changes in Time or Form of Payment ........................................................................ 121
           Acceleration of Payments ........................................................................................... 122
           Penalties ...................................................................................................................... 122
   CONSTRUCTIVE RECEIPT ............................................................................................. 122
       "Top Hat Plans" .............................................................................................................. 124
   ECONOMIC BENEFIT THEORY .................................................................................... 124
       Informal Funding with Private Deferred Compensation Plan ........................................ 125
   RABBI TRUST ................................................................................................................... 126
       Deferred Amounts Deductible by the Employer ............................................................ 127
   TAX OF DEFERRED COMPENSATION PAYMENTS TO EMPLOYEE/BENEFICIARY
   ............................................................................................................................................. 127
       FICA & FUTA Taxes ..................................................................................................... 128
       Factors Determining the Amount Deferred for a Given Period ...................................... 128
           Account Balance Plan ................................................................................................. 128
           Nonaccount Balance Plan ........................................................................................... 129
       Nonduplication Rule ....................................................................................................... 129
       Self-Employed Persons and Corporate Directors ........................................................... 129
       Taxable Earnings Base .................................................................................................... 129
       Section 457 Plans ............................................................................................................ 130
CHAPTER NINE - EMPLOYEE STOCK PLANS ............................................................. 133
EMPLOYER SECURITIES AND STOCK OWNERSHIP PLANS.......................................... 133
   "ESOPS" ............................................................................................................................. 133
           Employer Securities .................................................................................................... 133
       Value of ESOPs to the Corporation ................................................................................ 134
   LEVERAGED ESOPs ........................................................................................................ 135
   EMPLOYER LOANS & GUARANTEE OF LOANS TO ESOP PLANS ........................ 135
           Primary Benefit ........................................................................................................... 135
       Other ESOP Requirements ............................................................................................. 136



                                                                        vii
   OTHER TAX ADVANTAGES .......................................................................................... 137
       Dividend Deduction .................................................................................................... 137
       Capital Gains Deferral ................................................................................................ 138
   USING ESOPS AS CORPORATE WEAPONS ................................................................ 138
   PROHIBITED TRANSACTIONS ..................................................................................... 139
   EMPLOYEE STOCK OPTIONS ....................................................................................... 139
     ISOs................................................................................................................................. 140
       Taxation for Employee ............................................................................................... 140
       Taxation for Employer ................................................................................................ 140
     NQSO.............................................................................................................................. 140
       Taxation for Employee ............................................................................................... 140
       Taxation for Employer ................................................................................................ 141
       Deferred Compensation .............................................................................................. 141
       Reporting and Withholding......................................................................................... 141
   RESTRICTED STOCK ...................................................................................................... 142
   EDUCATIONAL BENEFITS TRUSTS ............................................................................ 142
   DEPENDENT CARE ASSISTANCE PROGRAMS ......................................................... 143
CHAPTER TEN - MSAs & HSAs ......................................................................................... 146
 MEDICAL SAVINGS ACCOUNTS ..................................................................................... 146
   MEDICAL SAVINGS ACCOUNTS (MSAs).................................................................... 146
     Benefits of MSAs ............................................................................................................ 146
     Qualifications .................................................................................................................. 146
     Small or Growing Employer ........................................................................................... 146
     Portability........................................................................................................................ 147
     HDHP .............................................................................................................................. 147
     Other Health Coverage ................................................................................................... 147
     Contributions to an MSA ................................................................................................ 147
     Limits of Contribution .................................................................................................... 147
     Income Limit ................................................................................................................... 148
     Persons Enrolled in Medicare ......................................................................................... 148
     Reporting Contributions on Tax Return ......................................................................... 148
     Excess Contributions ...................................................................................................... 148
     Distributions from an MSA ............................................................................................ 148
     Insurance Premiums ........................................................................................................ 149
     Deemed Distributions ..................................................................................................... 149
     Recordkeeping ................................................................................................................ 149
     Reporting Distributions on the Tax Return ..................................................................... 149
     Rollovers ......................................................................................................................... 149
     Additional Tax ................................................................................................................ 149
     Balance in an MSA ......................................................................................................... 150
     Death of the MSA Holder ............................................................................................... 150
     Employer Participation ................................................................................................... 150
     Comments ....................................................................................................................... 150
 HEALTH SAVINGS ACCOUNTS (HSAs) ..................................................................... 151
     Requirements of an HSA Instrument .............................................................................. 151
     Availability of HSAs....................................................................................................... 152



                                                                    viii
    Interaction With an IRA.............................................................................................. 152
TAXATION OF HSAs ....................................................................................................... 152
RELATION TO COBRA PLAN ........................................................................................ 152
ELIGIBLE INDIVIDUAL .................................................................................................. 152
  Rollover From an MSA .................................................................................................. 152
  Benefits of an HSA ......................................................................................................... 153
  Qualifying For an HSA ................................................................................................... 153
  HSA HDHP ..................................................................................................................... 153
  Preventive Care Coverage............................................................................................... 153
  Lifetime Limit ................................................................................................................. 154
  Family Plans That do not Meet the High Deductible Rules ........................................... 155
  Other Health Coverages .................................................................................................. 155
  Prescription Drug Plans .................................................................................................. 155
  Exceptions ....................................................................................................................... 155
  Contributions to an HSA................................................................................................. 156
  Contribution Limit .......................................................................................................... 156
  Reduction of Contribution Limit .................................................................................... 157
  Family Coverage with Embedded Deductible ................................................................ 157
  Enrolling in Medicare ..................................................................................................... 157
  Rollovers ......................................................................................................................... 157
  Reporting Contributions to IRS and Form 8889 ............................................................. 158
  Excess Contributions ...................................................................................................... 158
  Distributions From an HSA ............................................................................................ 158
QUALIFIED MEDICAL EXPENSES ............................................................................... 158
  Rules for Insurance Premiums ........................................................................................ 159
  Health Coverage Tax Credit ........................................................................................... 159
  Deemed Distribution from HSA ..................................................................................... 159
  Recordkeeping ................................................................................................................ 159
  Reporting Distribution on Tax Return ............................................................................ 159
  Balance in an HSA .......................................................................................................... 160
  Death of Holder of an HSA ............................................................................................ 160
  HSA From the Employers Prospective ........................................................................... 160
  Comparable Participating Employees ............................................................................. 160
  Excise Tax ....................................................................................................................... 160
  Employment Taxes ......................................................................................................... 160
MEDICARE ADVANTAGE MSAs .................................................................................. 161
FLEXIBLE SPENDING ARRANGEMENTS (FSAs) ...................................................... 161
  Contributions................................................................................................................... 161
  Distributions.................................................................................................................... 162
  Balance in the FSA ......................................................................................................... 162
  Employer Participation ................................................................................................... 162
HEALTH REIMBURSEMENT ARRANGEMENTS (HRAs) .......................................... 162
  Benefits of an HRA ......................................................................................................... 162
  Qualifying for an HRA ................................................................................................... 163
  Contributions................................................................................................................... 163
  Distributions.................................................................................................................... 163



                                                               ix
     Qualified Medical Expenses ........................................................................................... 163
     Balance in an HRA ......................................................................................................... 163
CHAPTER ELEVEN - TAXATION OF DISTRIBUTIONS ............................................. 166
 ANNUITIES ........................................................................................................................... 166
     Basic Rules for Annuity Distributions ............................................................................ 166
     Amount Not Received as an Annuity ............................................................................. 167
       Separate Contract ........................................................................................................ 167
     Lump Sum Distributions ................................................................................................. 167
     Rollovers and Trustee-to-Trustee Transfers ................................................................... 168
       Eligible Rollover Distributions ................................................................................... 168
       Transfer of Funds to New Plan ................................................................................... 168
       Distribution to Spouse................................................................................................. 169
       Possible Withholding Tax ........................................................................................... 169
     Direct Transfer ................................................................................................................ 169
     Additional Tax on Early Distributions............................................................................ 169
     Participation .................................................................................................................... 169
   ACCRUAL OF BENEFITS ................................................................................................ 170
     Accrued Benefits ............................................................................................................. 170
     Anti-backloading Rules .................................................................................................. 171
   AGE DISCRIMINATION RULES .................................................................................... 172
       Top-Heavy Plans ......................................................................................................... 172
   AMENDMENTS AND ACCRUED BENEFITS ............................................................... 172
   CASH BALANCE PLAN................................................................................................... 173
   PROTECTION OF BENEFIT RIGHTS ............................................................................. 174
 NON-RETIREMENT BENEFITS.......................................................................................... 175
   ALLOWED NON-RETIREMENT BENEFITS ................................................................. 175
     Death Benefits ................................................................................................................. 175
     Payments of Accrued Benefits to Plan Beneficiaries ..................................................... 176
   DISTRIBUTION TIMING ................................................................................................. 176
     Start of Distribution ........................................................................................................ 176
     Limits on Delay of Distribution ...................................................................................... 176
     Participant Delay............................................................................................................. 176
   DEATH DISTRIBUTIONS ................................................................................................ 177
   ASSIGNMENT OF BENEFITS ......................................................................................... 177
     Welfare Benefit Plans ..................................................................................................... 177
     Personal Bankruptcy ....................................................................................................... 177
     Qualified Domestic Relations Orders (QDRO) .............................................................. 178
     Other Exceptions ............................................................................................................. 178
CHAPTER TWELVE - NONDISCRIMINATION .............................................................. 181
   COVERAGE ....................................................................................................................... 181
   HIGHLY COMPENSATED EMPLOYEES ...................................................................... 182
       Five-percent Owners ................................................................................................... 182
       Compensation ............................................................................................................. 182
       "Top-Paid" Group ....................................................................................................... 182
       Former Employees ...................................................................................................... 182
   TESTING FOR COMPLIANCE ........................................................................................ 182



                                                                    x
        Single Plans ................................................................................................................. 183
        Disaggregation ............................................................................................................ 183
        Aggregation................................................................................................................. 183
   COVERAGE TESTS .......................................................................................................... 183
        Ratio Percentage Test ................................................................................................. 183
        Nondiscriminatory Classification & Average Benefit Tests ...................................... 184
        Average Benefit Percentage Test ................................................................................ 184
        Compensation ............................................................................................................. 184
        Other Rules ................................................................................................................. 184
        Former Employees ...................................................................................................... 185
   EMPLOYEES TO BE INCLUDED ................................................................................... 185
     Business Aggregation Rules ........................................................................................... 185
     Leased Employees .......................................................................................................... 185
   EXCLUDABLE EMPLOYEES ......................................................................................... 185
        Collective Bargaining Units ........................................................................................ 185
        Minimum Age and Service Requirements .................................................................. 186
        Former Employees ...................................................................................................... 186
   SEPARATE LINE OF BUSINESS .................................................................................... 186
   MINIMUM PARTICIPATION TEST ................................................................................ 187
     Other Exemptions ........................................................................................................... 187
   CONTRIBUTIONS/BENEFITS NONDISCRIMINATION.............................................. 187
     SUMMARY .................................................................................................................... 188
CHAPTER THIRTEEN - TAXATI0N, 401(k) & OTHER PLANS .................................. 191
   QUALIFIED CODAs ......................................................................................................... 191
     Contributions to CODAs................................................................................................. 191
     Other Benefits ................................................................................................................. 192
   STANDARDS FOR NONDISCRIMINATION ................................................................. 192
        Actual Deferral Percentage Test ................................................................................. 192
     Excess Contributions ...................................................................................................... 193
     Catch-Up Contributions .................................................................................................. 193
   SIMPLE 401(K) PLANS .................................................................................................... 193
        Eligible Employers...................................................................................................... 193
 DEDUCTIONS FOR CONTRIBUTIONS ............................................................................. 194
   STOCK BONUS AND PROFIT SHARING PLANS ........................................................ 194
   DEFINED BENEFIT AND MONEY PURCHASE PLANS ............................................. 194
   COMBINATION OF PLANS ............................................................................................ 194
   PENALTIES ....................................................................................................................... 195
 TERMINATION OF THE PLAN .......................................................................................... 195
   REGULATIONS................................................................................................................. 195
     Internal Revenue Code .................................................................................................... 195
     ERISA Title I .................................................................................................................. 195
     ERISA Title IV ............................................................................................................... 196
   PBGC AND BENEFIT GUARANTY................................................................................ 196
     Single-Employer Plan Guaranteed Benefits ................................................................... 196
     Multiemployer Plan Guaranteed Benefits ....................................................................... 197
   PBGC FINANCES.............................................................................................................. 197



                                                                   xi
   PBGC REPORTING ........................................................................................................... 198
   SINGLE-EMPLOYER PLAN TERMINATIONS ............................................................. 198
     (1) Standard Termination ................................................................................................ 198
     2. Distress Terminations ................................................................................................. 199
     3. Underfunding Liability ............................................................................................... 199
   INVOLUNTARY TERMINATIONS ................................................................................ 199
   RESTORATION OF PLAN ............................................................................................... 200
   REVERSIONS .................................................................................................................... 200
   PURCHASING ANNUITIES ............................................................................................. 201
   EMPLOYER WITHDRAWAL .......................................................................................... 202
REFERENCES ........................................................................................................................... 205
  NUMBERED REFERENCES ............................................................................................. 208




                                                                   xii
                           CHAPTER ONE - OVERVIEW

    This text discusses the role of insurance in the providing of employee benefits. It is imme-
diately apparent that considerable attention is paid to the federal taxation of these insurance
products used for the providing of employee benefits by an employer. As everyone is aware,
taxation can be, and generally is, rather complex and regulations can change dramatically from
time to time. Therefore, one should be advised that this text is not to be used as the most up-to-
date or complete authority on taxation of benefits or of the effects of taxes on employers and
employees although tax laws and regulations effective as late as 1/1/2006 are used as reference
and often quoted. In many cases, however, the best service that can be provided to a client is to
encourage them to obtain professional tax assistance if the situation is at all confusing or com-
plex and/or entails a sizeable employee benefit program.
    Please note that throughout this text, the masculine gender is used (he, his, him, etc.) for sim-
plicity purposes only and it should not detract from the contributions, service and expertise of
those of the female gender—it is just less confusing and easier-to-read if, for instance, "he" is
used in a sentence, instead of "he/she," or "he and or she," etc.


                             EMPLOYEE BENEFIT PLANS

    The relationship between insurance and employee benefits is simply that of financing—
employee benefits can be financed through insurance. These benefits are usually broken into
five broad categories:
       1. pension plans for retirement;
       2. group life insurance for death benefits;
       3. group health insurance for illness and accident;
       4. group disability income insurance for loss of income due to illness or accident;
       5. accidental death and dismemberment.
    For those in the insurance profession, these benefits are usually referred to as group health
insurance, group life insurance, and pensions (including group annuity plans).
    Group accidental death is usually provided under a group health plan, but life insurance plans
are used as group life insurance and some pension plans. Life insurance may be either yearly
renewable term insurance or permanent types of insurance (or some combination thereof).
   The employer always bears part of the cost and some may pay it all, and the amounts of the
benefit coverage are determined by formula that attempts to avoid selection against the insurance
company—therefore, those employees in poor health are not allowed to choose the largest
amount of insurance.
   Dental insurance, eyeglass insurance, and legal expense insurance may be included.



                                                  1
   These plans are provided for employee morale purposes, to reduce turnover of the workforce,
and for tax purposes—contributions are usually deductible as business expenses to employers
and not currently taxable income to employees—with some exceptions as noted in the text.
    As discussed in the text, there are certain other benefits that are often provided under the Ca-
feteria Plans, wherein the employee pays for the entire benefit, but with pre-tax dollars.
                           PERTINENT AMENDMENTS TO ERISA
    ERISA (Employee Retirement Income and Security Act of 1974) is the prime federal regula-
tion of employee benefits, and will be discussed in detail. While ERISA is concerned mostly
with protecting employee benefit interests and expectations, and expanding plan coverage, there
were many areas in the regulation of benefits that were either lightly addressed, or simply not
addressed. As such, ERISA has been amended many times since 1974.
   In 1978, for instance, legislation was passed authorizing SEPs and CODAs (described in
more detail later). In 1980, the Multiemployer Pension Plan Amendments Act (MPPAA) was
passed which actually revised ERISA in order for ERISA to be able to deal with the special
problem of multiemployer plans.
    In 1982, an important act, the Tax Equity and Fiscal Responsibility Act (TEFRA) was intro-
duced. It addressed the "top-heavy" plan—defined as a plan in which the proportion of benefits
or contributions for key employees is high, providing for special rules in these situations.
   The Retirement Equity Act of 1984 (REA) amended ERISA that addressed specifically those
special problems involving women, among other things.
    The Tax Reform Act of 1986 (TRAC) actually amended ERISA in order to speed up the sta-
tutory vesting schedules.
    The Single Employer Pension Plan (SEPPA) of 1986 rather strongly revised the plan termi-
nation systems in order to prevent abuse, actual or perceived. Also, legislation enacted in 1992
discouraged employees from cashing out their employee plan interests when they leave their em-
ployment before retirement.
    The Small Business Job Protection Act of 1996 (SBJPA) established SIMPLE plans and ac-
complished several things, among which was changing some rules regarding distributions. It
also responded to a Supreme Court decision regarding the applicability of fiduciary law to insur-
ance companies, plus several other changes which had the welcome effect of simplifying
changes in ERISA.
    The Health Insurance Portability and Accountability Act of 1996 (HIPAA) amended Title I
of ERISA, addressing primarily the portability of health coverage. This has had a more recent
effect on employee benefits, and is addressed in some detail in this text.
   The Taxpayer Relief Act of 1997 (TRA '97) made changes affecting reporting procedures,
IRAs, plan distributions and other situations.
   The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made several
changes in respect to contributions, plan distributions, top-heavy plans, IRAs and other matters.




                                                 2
    THE EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA)
    ERISA has often been amended, as indicated above, and it still is considered as the basic law
of employee benefit plans. Note, however, it is not a law of employee benefits, but of benefit
plans. If pension or welfare benefits are offered in any other fashion other than a plan, then
ERISA, as a general rule, will not apply. Therefore, the starting point in understanding ERISA is
to understand exactly what an employee benefit is.
    One might expect that the regulations would be very precise and specific as to the definition
of an employee benefit plan, actually, it does not define "plan" or other such criteria—it takes
into consideration the assumption that everyone must known what a "plan" is. However, the
provisions of ERISA obviously reflect just what the "plan" is supposed to be. For instance,
ERISA interprets plans basically as employer programs (even though some plans may be union
formed or maintained). The closest definition in ERISA is an indication in the wording that a
plan is a regularly conduced, employment based program or practice, whose existence is solely
to provide certain kinds of benefits to employees.1
    Further, ERISA assumes that a plan is just not a part of an employer's business as it is unique
in providing regulations for a plan to be created as a legal entity different and distinct from the
employer or any other sponsor. It provides for unique situations, such as a plan can be sued or
sue, enter into contracts, go to court or have judgments rendered against it, hire employees, hire
attorneys to represent it, etc.2 As one would expect, like a corporation, a plan is an artificial in-
dividual.
                                      TYPES OF PLANS
    While employee benefits, per se, can be divided into several different types, ERISA divides
employee benefits into pension (benefit) plans and welfare (benefit) plans. Pension plans pro-
vide retirement income for the participant, or provides for the deferral of income until the termi-
nation of the employment of the participant and/or beyond. Welfare plans provide medical and
some other non-pension benefits to employees and their beneficiaries.3
                                         Pension Plans
    ERISA specifies two categories of pension plans: defined benefits plan and defined contribu-
tions plan.
    The defined benefit plan is where employees are promised a level of retirement income ac-
cording to a formula.4 The formula may use as a factor, the employee's years of service—
thereby referred to as a unit benefit plan. A formula of this type could be something like:
"Years of Service x final average salary x 1.5%."
    This is called a "final average" formula, as it is based on the final average salary. Another
type could be the "career average" formula which credits a unit of benefit each year based upon
the compensation for the year. An example of the final average formula could be an employee
that retired after 30 years with a final average salary of $50,000 over the specified average pe-
riod. He would receive 30 times $75,000 times 1.5% = $33,750 per year.
    A defined benefit plan where the formula is independent of years of service is a flat benefit
(or fixed benefit) plan and it would provide either a fixed dollar amount or a fixed percentage of
the final or average pay on retirement.



                                                  3
    When a defined benefit plan is established by an employer, the employer must contribute the
necessary funds to pay the benefits as promised to the employee, and to contribute these funds on
a regular, ongoing basis. If the plan, as many if not most do, invests these funds, the investment
gains or losses affect only the employer's obligations to contribute in future years and has no im-
pact, one way or the other, on the level of benefits to which the participants are entitled.
    In a defined contribution plan (a.k.a individual account plan) the participants are not prom-
ised a particular level of retirement benefits, but each participant has an account in the plan to
which the employer's contributions are directed. The participant's benefit is, therefore, the total
of this account when he retires as determined by the history of the contributions. With this type
of plan, the employer is not obligated to make sure that the plan has enough money to fund any
specific or specified benefit, but his only obligation is to make the promised contributions.
    Another type of pension plan is the defined contribution plan or individual account plan.5
Participants are not promised a particular level of retirement benefits, but each participant has an
account in the plan and the employer allocates contributions to this account. The benefit to the
participant is the value of that account at retirement, such value determined by the contribution
history and the experience of the investments in which the funds are contributed. The employer
has no obligation to guarantee that the plan has enough money to fund any specific benefit, but
has only the obligation to make the contributions that he has promised to make.
    One type of defined contribution plan is the money purchase plan, where the employer is
obligated to contribute a specific amount every year to each participant's account.
    Another type is the target benefit plan, which has the attributes of both the defined benefit
plan and the defined contribution plan. The employer determines a level of benefits and then
determines the amount of contribution that is (actuarially) adequate to fund those benefits. Once
this level is determined, then it may or may not be changed to reflect investment experience as
the level of benefits is only a projection, not a guarantee.
    The most common form of defined contribution plan is the profit sharing plan which pro-
vides for annual employer contributions (if any) and the allocation of those funds to participant's
accounts under a pre-determined formula. The employer's contributions can either be as deter-
mined by formula, or they can be at the discretion of the employer—often with specified limits,
however. In spite of the connotation of "profits," the contributions of the employer does not ne-
cessary have to come from present or accumulated profits.
    A stock bonus plan is a profit-sharing plan that distributes stock as benefits.6 An employee
stock ownership plan (ESOP) is a stock bonus plan or combination stock bonus and money
purchase plan, designed specifically to invest primarily in the stock of the employer.7
    A Cash Or Deferred Arrangement [CODA or 401(k) plan] is a profit sharing plan or stock
bonus plan that gives participants the choice of having the employer contribute money to their
accounts in the plan or pay the same amount to them in the form of compensation. (These plans
are described in detail later in the text.)8 This plan is attractive to the participant because any
money contributed to the plan is not included in taxable income for the year.
    Another plan that is much like the defined contribution plan is the cash balance plan, where
the benefit for each participant is calculated by reference to a hypothetical account, to which the
participant is credited with hypothetical allocated amounts plus interest on the allocation at a
predetermined rate. The eventual benefit to the participant is not affected by any investment gain


                                                 4
or loss, but simply are items in a formula used to calculate the benefit. This can also be used as a
"phantom stock" profit-sharing plan.
    For those interested in minutiae or specificity, in Title I of ERISA, the labor provisions, and
Title II, (tax-related provisions), there is some slight difference in terminology of plans. The IRS
defines a pension plan as a retirement plan in which benefits are "definitely determinable"—
meaning they are fixed by formula or "fixed without being geared to profits."9 Therefore, this
definition would include defined benefit and money purchase plans, but would exclude profit
sharing and stock bonus plans. The IRS (under ERISA Title II) makes a difference between
plans that provide pensions from those that defer income. But for purposes of this text, Title I
terms are used.
                                         Welfare Plans
    ERISA includes a wide array of benefit programs in its definition of "welfare plans," as plans
providing hospital care, severance pay, prepaid legal service, or scholarship programs to its em-
ployees are considered as welfare plans. Basically, however, ERISA limits welfare benefits and
welfare plans to those that are in the form of money and/or services provided to employees on an
individualized basis. Excluded are company cafeterias (not to be confused with "Cafeteria
Plans"), non-compensatory benefits such as rights due to seniority of the right not to be termi-
nated without cause. On the other hand, day-care centers are not excluded.
     Typically bureaucratically, the drafters of ERISA assumed that any covered plan is either a
welfare plan or pension plan, with nothing in-between, except that a single plan can provide both
pension and welfare benefits. But, one might ask, a plan that provides medical benefits to retired
employees, for instance, is neither welfare nor pension (or both)—medical care is a welfare ben-
efit, but since they are provided to retirees, this is a form of retirement income. Under the law in
effect now, however, these plans would be welfare plans, but problems can arise as putting a
plan into either welfare or pension plans can make a big difference as ERISA regulates the two
kinds differently.
                                    Multiemployer plans
    Multiemployer plans are usually established because of collective bargaining agreements,
and are plans that are maintained in accordance with a (or more than one) collective bargaining
agreements, and to which more than one employer is required to contribute.10 (Not to be con-
fused with a multiple employer plan where employees of more than one employer is covered.)
These multiemployer plans are most common in industries with many small companies and in-
dustries—such as construction where work is irregular and employees often move from employ-
er to employer. A multiemployer plan can be either a welfare or pension plan.
                         ERISA PENSION AND WELFARE PLANS
   Contrary to what one might gather, ERISA does not govern every plan that provides pension
and welfare benefits, and some plans are excluded strictly on the basis of the benefits that are
provided.
                                              Title I
    Title I was enacted by Congress pursuant to their right to regulate interstate commerce, there-
fore it only covers plans that are established and/or maintained by employers that are engaged in



                                                 5
commerce or whose industry or activity affects commerce, unions that represent employees en-
gaged in interstate commerce, or in any industry or activity affecting commerce.11
   The subject of Title I is "Protection of Employee Benefit Rights" and consists of two parts,
Subtitle A - "General Provisions;" and Subtitle B - Regulatory Provisions." This is broken into
seven parts, as listed below:
       1) Rules governing information on plans that must be supplied to regulators, participants
          and beneficiaries.
       2) Participation entitlement to pension benefits of the plan, including minimum stan-
          dards for employee eligibility to participate, and other restrictions.
       3) The funding of defined benefit plans.
       4) Fiduciary responsibility and related matters.
       5) Includes criminal civil enforcement provisions, including the provision that preempts
          nearly all state laws that relate to employee benefit plans.
       6) Requirements relating to group health insurance (added to ERISA through later
          amendments).
       7) Group health plans and group health insurance coverages, covering such items as
          preexisting conditions, eligibility standards, benefits for mothers and new-borns, etc.
    ERISA does not apply to any state or local governmental plan—and there are many of them.
Some states have statutes that protect employees of such plans, but some are underfunded—not a
good situation for those anticipating pensions upon retirement from the plan. Some states actual-
ly use the pension funds of their employees for other state expenditures—a situation that ERISA
was designed to eliminate.
    Excluded from ERISA provisions are churches and church associations, plans maintained
"solely for the purpose of complying with workmen's compensation laws, unemployment com-
pensation or disability insurance laws." Another exclusion is for plans that are maintained out-
side of the US primarily for the benefit of persons substantially all of whom are nonresident
aliens.12
    Another exclusion seems to state that ERISA maintains that employees who are well paid can
take of themselves and do not need statutory provisions, as unfunded excess benefit plans are
excluded (defined as a plan providing a high level of benefits to highly compensated employees,
and are, therefore, not entitled to the tax advantages given to pension plans).13
                                             Title II
    Since pension plans involve income and expenses, the basic concept of Title II is plan quali-
fication.14 For the plan to qualify, it must comply with a multitude of standards, but if it does
qualify, then the plan, employer and all employees receive favorable tax treatment regarding
their plan-related income or expenses.
    Title II also provides rules for tax treatment of plan-related income, and expenses, including
the distribution to participants and beneficiaries and deductibility of employer contributions, and
other tax-related matters. It concerns itself only to pension plans, with little attention paid to
welfare plans, but the plans are among those best known to the general public.


                                                 6
    Keogh plans for self-employed persons are covered under Title II, even where the plan does
not include any common-law employees.15 Title I only addresses plans established by employers
or labor organizations for employees, and excludes the Keogh plan which only involves owners
of a business.
    Title II also regulates Individual Retirement Accounts (IRAs), which are tax-favored sav-
ings or investment accounts basically for those persons not covered by pension plans by provid-
ing a method of saving for retirement. It also covers individual retirement annuities—certain
tax-favored annuities used as retirement savings vehicles. IRAs are not considered as "plans"
under ERISA, so they are excluded from Title I coverage.
    Title II also covers simplified employee pensions (SEPs) and savings incentive match
plans for employees (SIMPLE) plans.16 The SIMPLE plan may be either a SIMPLE IRA or a
SIMPLE 401(k) plan, in either case employees make contributions voluntarily on a tax-deferred
basis and the employer makes either matching or non-elective contributions. SIMPLE plans can
be available only for employers having 100 or less employees whose compensation is $5,000 or
more.17
    Title II also allows state and local governments, churches and church organizations and cer-
tain other tax-exempt organizations to establish plans subject to its rules and which will then re-
ceive favored tax treatment.
                                             Title IV
    The next pertinent section of ERISA is Title IV which deals with problems relating to the
termination of defined benefit plans because of insufficient assets to pay all benefits that were
promised by the plan. This section sets up a system of plan-termination insurance and requires
employers to contribute to the funds.
   Title IV also regulates the voluntary termination of defined benefit plans, in particular under-
funded plans and makes provisions for mandatory termination of financial troubles plans, and
makes the sponsor liable for underfunding when termination occurs.
    It regulates the withdrawal of employers from multiemployer plans, plus it established a fed-
erally chartered corporation, the Pension Benefit Guaranty Corporation (PBGC) to oversee the
termination process and to supervise such actions.
           DEFINITIONS OF PERSONS ASSOCIATED WITH ERISA PLANS
    ERISA plans can be quite complex and individuals can be associated with the plan in many
ways. ERISA uses certain terms and definitions to describe the role that the individual may have
in the plan.
     Participant is the person that the ERISA rules protect, and is defined as "any employee or
formerly employee …, or any member of an employee organization who is or may become eligi-
ble to receive a benefit" from a plan, or "whose beneficiaries may be eligible to receive any such
benefit."18 This definition uses the common-law meaning (i.e., the meaning as derived from
judicial edict/definitions, and not from statutes or regulations. (For purposes of this text, it has
little meaning but is mentioned only because the regulations so define the term.)
    A person (or his beneficiaries) may become eligible to receive a benefit from a plan if he has
a "colorable" (appearing to be true, valid or right) expectation that he will prevail in a suit for
benefits or that he will fulfill benefit eligibility requirements in the future.19 A beneficiary is


                                                 7
someone who is either actually or potentially, entitled to receive plan benefits other than the par-
ticipant.20
    The plan sponsor is the individual employer or employee organization that establishes or
maintains the plan. When there are multi-employers or plans established by more than one em-
ployer, the plan sponsor is the committee, board or whatever group of representatives of the enti-
ties that establish and/or maintain the plan.21
     Fiduciaries are individuals responsible for the operation of the plan, and can also be called
named fiduciaries, investment managers or administrators. Named fiduciaries are persons
that are specifically named in the plan that have the authority to control and manage the opera-
tion and administration of the plan.22 ERISA has a rather complete definition of a plan fiduciary
as one that exercises discretionary power/control over management of the plan or disposition of
its assets, a person who renders investment advice with the authority to do so, or has any discre-
tionary responsibility of the administration of the plan. A fiduciary has very stringent standards.
    Another class of persons defined by ERISA is parties in interest. These are people who can
influence plan affairs, or whose dealings can involve a conflict of interest and which include em-
ployees, officers, legal counsel of the plan, service providers, employee organization, owners
(directly or indirectly) of the employer and employee organizations. These are mentioned as
they are subject to scrutiny under the prohibited transaction rules.
                                REGULATORY AUTHORITY
    ERISA is a complex animal, and can be a regulatory nightmare as there are three federal bo-
dies that have enforcement and oversight responsibilities: the Department of Labor, the Depart-
ment of the Treasury, and the PBGC. As an indication of the problem is the fact that Title I is
under the jurisdiction of the Department of Labor (mostly) and Title II is under the jurisdiction of
the Treasury Department (mostly), and they have many identical provisions. However, recogniz-
ing the problems and potential problems, the ERISA Reorganization Plan of 1978 made a deter-
mined effort to avoid confusion in these matters, and determined that the Treasury Department
will be primarily responsible for participation, vesting and funding standard. The Labor De-
partment will have primarily responsibility for fiduciary regulations and prohibited transactions.
Also, it provided that there shall be coordination in certain matters.
    There are three ERISA regulators who have worked, and continue to work, to avoid problems
and have provided standardized forms for plan reporting. They rely upon each other's regula-
tions, and they cooperate on policy statement in respect to various important matters.


                                    PENSION PLANS
                                            BASICS

                             Present Value of Future Benefits
    The basic idea of pension plans is the ability to put aside funds that will grow through in-
vestment— either by the individual, insurer or other parties—until there are sufficient funds
available at a predetermined retirement age or at some other designated time in the future.




                                                 8
    The major question for those first exposed to pension plans, is how much money is it going
to take to reach the retirement goal—what amount must be invested today in order to have exact-
ly the amount needed after specified years. This is simply determining the worth today of the
future necessary funds by determining how much should be invested today, compounded at pre-
vailing interest rates for the length of the investment period so as to create the sufficient fund.
This is accomplished by determining the present value of the necessary amount at retirement.
    (One can purchase a financial calculator for under $25 that will provide present value calcu-
lations.) A person is actually interested in determining the present value of a stream of future
payments made over a certain period, rather than just one payment at one future date. There are
mathematical calculations that one can use to determine this amount—practically, though, these
calculations are performed by actuaries and their statistics.
     These present value calculation formulas are used to value pensions from defined benefit
pension plans, and actuaries do so, but there is one point that should be kept in mind—while
pensions may not seem important to younger workers and they may be more willing than work-
ers that are closer to retirement, to trade pensions for current income——the closer a worker be-
comes to the time of starting to receive pension benefits, the greater is the present value. To state
it in another way, the younger one starts funding a pension, the lower the amount one has to put
into the fund to realize the necessary funds that are available at retirement.

                                        Individual Taxes
    Simply put, if a plan is qualified, then the participant is not subject to tax on the employer's
contributions when they are made. Further, neither the plan nor the participant is subject to tax
on the plan's investment gains. Generally speaking, the participant is generally subject to tax in
respect to his pension, only when he receives it from the plan. This provides for two tax advan-
tages to the participant.
    One advantage is that marginal tax rates are progressive—the higher the income, the higher
the percentage of the income that must be paid in taxes. This means that an individual during his
higher earnings years—while he is actively working—his tax bracket will be higher than during
his retirement years—when his total income is less. The more progressive the marginal tax rate,
the more the difference in taxation between producing years and "spending" years.
     Secondly, investments in a qualified pension plan are not taxed. Again, without using formu-
lae that can be confusing, but looking at it logically, if you are taxed each year on the total in-
come, that would reduce the total amount that can be invested, dramatically (one of the advan-
tages of Cafeteria Plans is purchasing benefits on pre-tax basis, which "ignores" taxes until bene-
fits are paid). There is no additional tax when the individual withdraws the money at retirement.
    If the amount that is paid into a qualified pension plan by the employer instead of being paid
to the employee instead, such payment is not taxed when contributed and it accumulates interest
in the plan without taxes. It is taxed to the individual only when it is withdrawn.
    For example, if interest rates are 10% (for simplicity purposes) and the tax rate is 10%,
$1,000 placed in a taxable savings account for 20 years will yield $5044. However, a qualified
plan will yield $6055 after tax—20% more. At a tax rate of 25%, a qualified plan will yield
58% more. Look further and one will note that at a tax rate of 33%, it will yield 84% more.




                                                  9
                             Tax Advantages to the Employer
    The tax advantages to participants as a result of the qualification of the plan, can be also re-
ceived by the employer in the form of lower salaries or wages. This can best be understood by
an example:
   An employee has annual salary of $20,000, the interest rate is 10%, and the tax rate is 25%.
   If the employee wants to save half of his salary for retirement, he can put it into a savings ac-
   count. If he invests that $10,000 for 10 years and then retires, he will have accumulated
   $15,458 (according to present value formulae)
   The employer would have to contribute only $7,946 to a qualified plan to provide the same
   $15,458 to the employee at retirement. Therefore, the employee would note that $7,946 con-
   tributed to the plan is the same as $10,000 in salary, and he would treat the two as equal
   compensation. The employer would look at the $7,946 contributed to the plan, as a savings
   of $2,054 over what would otherwise have been paid in salary. This means, that with a quali-
   fied plan, the employer can save $2,504 while still providing the employee with a pension
   plan equal to what the employee would have had to pay without the plan.
    There is also another tax advantage—an employer who establishes a qualified plan receives
the advantage because contributions to the plan are deductible when made, instead of when the
employee is subject to tax. This is a real benefit because of the time value of money. This also
points out the difference between a qualified plan and non-qualified plan: taxation principles are
such that the year in which the employee receives the employer contribution (as a pension) in his
taxable income, and the year in which the employer deducts the corresponding payment from its
taxable income, should be the same, and the IRS requires this matching of the employer deducti-
ble and employee inclusion in taxable income.

                  EFFECTS OF ERISA ON BUSINESS PRACTICES
     The economic effects of ERISA pension plans have a decided affect on all parties concerned.
For the participant, the ERISA plan could be a provider of retirement security or compensation in
a form other than immediate cash. For the employer, it is an arrangement that helps to manage
the workforce and at the same time, invest corporate assets. And for public policymakers, im-
agine what chaos there would be if there were no pension plans and elder citizens had to depend
upon Social Security or other government body to provide security and health coverage. Also,
retirement plans are powerful forces in financial markets that help to keep our country afloat.
    Prior to ERISA, pension rights vested only after thirty or more years of continuous service.
In today's mobile world, few workers would ever receive a pension under those plans. For the
business, a pension plan complements systematic retirement as while retirement would eliminate
the undesirable workers, the prospect of a pension attracts, motivates and helps businesses to re-
tain desirable workers.
    ERISA requires that after a few years, a pension plan becomes substantially nonforfeitable,
which, in a way, does not help the retention of some employees as after a few years with an em-
ployer, they can take their vested pension and go to work with another company, building up
credits to vesting in that plan. Today, many persons retire with several retirement checks be-
cause they have changed plans for whatever reasons. Further, the Age Discrimination in Em-




                                                 10
ployment Act (ADEA) has nearly outlawed employer-mandated retirement. This means that
employers can no longer use pension plans to weed out the older workers.
   On the positive side, ERISA does encourage the use of employee stock ownership plans,
which give employees a stake in the business, thereby enhancing productivity and morale, and
encouraging employees to remain loyal to the business. Many new, nice, boats are bought with
funds derived from retirees cashing in their company stock…
    One cannot ignore medical benefit plans, as in some ways they are more important than the
pension plans as hospital and medical costs have increased to unaffordable levels to many work-
ers, even the middle income class of worker. With the medical benefits medical benefit plans
have been transformed into attractions for new workers and quite powerful inducements for cur-
rent employees to stay. Nearly everyone knows someone who "sticks" to a job they would rather
not do, just so that they can have the medical benefits for themselves, and quite often, for their
family.

                                Social Effects of ERISA Plans
    Economists agree that the level of plan coverage today is substantially attributable to the tax
advantages of qualified plans. The policy of the federal government takes the approach that
pension plans must continue to be a source of retirement income and should be encouraged by
the tax laws, but still left voluntary on the part of the employer.
    The Treasury Department estimates that the tax revenue that is lost due to preferential treat-
ment of pension plans for fiscal year 2004 was over $123 Billion. The estimated tax expenditure
for employee contributions relating to employee health care, on the other hand, is over $120 Bil-
lion. Of course, those politicians who are for tax increases wonder whether it is economically
and socially justified. One of the points that is raised is that tax benefits relating to plans go dis-
proportionately to those who need them less, as evidenced by the fact that (in 2001) 76% of em-
ployees who earned $50,000 or more worked for an employer that sponsored a retirement plan,
and 72% of employees earning $50,000 or more actually participated. Conversely, only 39% of
those earning $10,000 to $14,000 worked for an employer that sponsored a plan, and only 21%
participated. However, one must keep in mind that if not for the tax incentives which benefits
the higher income workers, which result in the overall demand for such plans, there would be
fewer plans that cover the lower income employees. And, in a capitalistic society, those lower-
paid workers work hard so that their income will increase and they can then afford to take part in
these retirement plans.
    The question arises, naturally, whether the government should become involved in pension
plans, and to what extent. They already are, as they have long been integrated with Social Secu-
rity, and will continue to be so with the blessings of ERISA.
     One more statistic in this respect: In 2001, employers spent $5.87 Trillion on compensation.
Of this amount, $921 Billion (about 16%) consisted of employee benefits. Contrast that to 1970,
where $617 was spent on compensation of which $66 billion (11%) consisted of employee bene-
fits. A large part of this increase in benefits has, undoubtedly, been attributable to increases in
medical benefits, rather than pensions.




                                                  11
                   PENSION PLANS AND CORPORATE FINANCE
     Pension plans are independent entities that are closely interconnected with the financial as-
pects of the employer, particularly when the plan is a defined benefit plan. The promised bene-
fits are the responsibility of the employer who funds pension liabilities on an ongoing basis and
is liable for a substantial part of the plan's unfunded liabilities upon termination. Therefore, it
behooves the wise investment manager to avoid risky or volatile investments backing up the
pension plan. ERISA requires plans to be independent entities so as to force a separation be-
tween the plan assets and finances and the employer assets and finances.
    This raises the question as to the extent that an employer can use plan assets in the business.
This can happen if the employer needs working capital and wants to borrow funds from the plan,
or issue treasury stock to the plan in exchange for cash or to satisfy current contribution obliga-
tions, or to terminate the fund if it is overfunded and retain the unnecessary funds—all of which
are generally prohibited or restricted by ERISA, except in some specific cases.
    One, indirect, way that an employer can use plan assets is by using the plan's tax-related ad-
vantages. For instance, a plan is not taxed on its investment income. The return to it on the
bonds is higher than the return to most investors who are taxed on interest income. An employer
may wish to capture some of this excess return through arbitrage by issuing bonds, interest pay-
ments on which are deductible from taxable income, to fund plan investment in bonds. Needless
to say, there are sophisticated strategies available to maximize the employer's tax advantage
without suffering much financial risk, and so far, these plans have not been tested. One reason is
that very few pension plans invest heavily in bonds—which is not understood by some who
wonder why.
    Still, employer liability for pensions and other benefits, and the current costs to employers of
those benefits, must be recognized on employer financial statements—which resulted in the Fi-
nancial Accounting Standards Board developing standards requiring unfunded pension obliga-
tions to be reflected on the employer's balance sheet as a liability and prepaid pension expenses
as an asset. This standard also provides for the measurement of the employer's net periodic
pension cost, which must be charged as an expense against income. This allows, among other
things, markets to properly take pension liabilities into consideration when valuing the firm's fi-
nancial instruments. The standards also require a company's unfunded liabilities for retired
health benefits to be reflected in the firm's financial statements.

                                      Financial Markets
    Employee benefit plans are extremely important in investment markets. For instance, in
2001, the total amount of assets in private and public pension plans and IRA accounts, was $10.7
Trillion. Pension plans own a large part of all publicly traded stocks, corporate equity, and taxa-
ble bonds, and a bunch of real estate.
    There has been an increasing amount of stock in pension plans, and the financial markets feel
it. Under ERISA's rules, the fiduciary rules govern the investment practices of the plans and
they seem to promote strategies of seeking short-term gains. This has had the effect of disturb-
ing the ability of corporate financial managers to maximize long-term gains. All-in-all, this has
contributed to some volatility in the financial markets and has helped make financial markets too
unstable for the small investor.



                                                 12
    In actual practice, however, while stock ownership involves the right to participate in deci-
sions about corporate policies and control, this economic power has little influence on corporate
management and policies—probably because plans usually vote in favor of management.
                                            VESTING
    One of the principal purposes of ERISA was to make retirement benefits nonforfeitable
through the process of vesting. Congress was undoubtedly concerned about pension benefits that
were not vested until retirement, or vested after a long period of time (such as 30 years), which
could be considered as an inducement to discharge employees so that benefits would not have to
be paid—resulting in the strangulation of job mobility. Rules pertaining to vesting needed to be
created, as well as other plans beyond vesting.

                  Vesting Requirements-Normal Retirement Benefit
    The simplest method for vesting would have been to make the plans all vest on the first day
of work, but Congress realized that would increase costs, deter the formation of pension plans,
and undermine the ability of employers to use those funds for anything else.
    Under the Age Discrimination Act (ADEA), an employer cannot impose as mandatory re-
tirement age on its employees,23 but a plan may identify a normal retirement age as a standard
for determining retirement benefits. The result is that the "normal" retirement age can be defined
in many ways, such as age 60 with 5 years of service, etc.
    ERISA, however, provides that normal retirement age is the later of age 65 or the fifth anni-
versary of plan participation—or any earlier retirement age specified in the plan, with medical
and certain disability benefits excluded.
   One of ERISA's vesting rules is that a participant's right to his normal retirement benefit must
become nonforfeitable upon his attaining normal retirement age.24 This rule makes a difference
only for those who leave the employer's service on or after the normal retirement age.

                                Vesting of Accrued Benefits
   For those employees who leave the employment before the normal retirement age, the rule
requires that a plan's schedule for the vesting of accrued benefits be at least as rapid as one of
two alternative schedules set out in the statute.
    A vesting schedule can be understood only if one understands the difference between the
vesting of benefits and the accrual of benefits. The degree of vesting in a benefits is the determi-
nation of the extent to which it is nonforfeitable, and is measured by percentage of benefit—0%
meaning no vesting, to 100% which means all, full, or complete vesting. A 50% vesting in a
benefit means that half the benefit (half of its value) is nonforfeitable. Conversely, an accrual
schedule specifies the rate at which a fully vested benefit increases over time. Therefore

   the value of the participant's nonforfeitable (vested) benefit at any time is equal to the
      accrued benefit at that time, multiplied by the nonforfeitable percentage at that time.
    The vesting concept is rather simple as the years of service in the schedule relate to the non-
forfeitable (vested) percentage.



                                                 13
     A couple of points: An employee is always fully vested in benefits derived from his own
contributions A schedule under which benefits jump from full forfeitability to full nonforfeita-
bility is called "cliff vesting."
    There is an alternative, whereby a plan may provide that the extent of nonforfeitability of ac-
crued benefits attributed to employee contributions, increase steadily over time. ERISA requires
that the percentage of nonforfeitability at any time be at least as great as follows:
   Years of Service                                                   Nonforfeitable Percentage
   3                                                                          20%
   4                                                                          40%
   5                                                                          60%
   6                                                                          80%
   7                                                                         100%
       (This is called "graded vesting.")
    For the vesting of employer matching contributions to a cash or deferred arrangement, the
contributions must vest either by a 3-year cliff vesting, or a graduated vesting starting at 2 years
of service and 20% vested, increasing each year of service by 20% until there is 100% vesting
after 6 years of service.
    "Years of service" is defined as any consecutive 12-month period so stated in the plan, gen-
erally either calendar year or fiscal year, during which the participant has completed at least
1,000 hours of service. Any year of service with the employer must be counted toward vesting,
except in a few instances, such as before the employee turns age 18, or years of service before
the employer maintained the plan. The plan always has the right to be more generous.
    Break-in service is defined as a period in which employment with the employer is inter-
rupted, which is treated in ERISA in detail as it has been a major obstacle to vesting in many
cases where the work is cyclic or layoffs are common. A one-year break in service is defined as
a calendar year or other 12-month period designated by the plan, during which the participant has
not completed more than 500 hours of service (excluding time for pregnancy, maternity or pater-
nity leave that may be counted as up to 501 hours of service). Years of service before a one-year
break in service must be counted for vesting purposes, but not until the completion of one year of
service after the employee returns.
   However, ERISA says, a participant with no vested rights can irrevocably lose credit for
years before a break in service if the length of the break exceeds five years or the total number of
years of service before the break, whichever is greater.25

                                Forfeiture of Benefit Rights
   The most common situation of nonforfeitable permits becoming forfeitable occurs on the
death of the employee, because, obviously, the employee no longer needs retirement income.
But in the case of a survivor annuity, this forfeiture is not waived.
   A plan may provide for the suspension of benefits during a period when the employee is re-
employed after his benefits have started. Also, it may provide for the forfeiture of accrued bene-


                                                 14
fits that are attributed to employer contributions, but the benefits may be reinstated if the em-
ployee repays the withdrawn amount with interest.26
    There is another type of forfeiture provision—the "bad-boy" clause—where benefits are lost
because of prohibited conduct, such as the employee's engaging in illegal acts or competing with
the employer after leaving his employ (such as a non-compete clause). The rules do allow for
one vesting schedule for employees who indulge in such prohibited conduct and another for
those who do not so indulge. As one might expect, it is not allowed for one such schedule to use
the 5-year cliff vesting plan and the other to satisfy 7-year graded vesting.
   To avoid any back-door amending of schedules, an amendment changing a vesting schedule
cannot have the effect of reducing the vesting percentage of any employee's accrued benefits.
And to take it one step further, when a vesting schedule is amended, every participant with 3 or
more years of service must be permitted to elect to have his nonforfeitable percentage deter-
mined under the old schedule. 27

                                     Termination Vesting
     A qualified plan must provide that when it is terminated, or partially terminated, the rights of
all affected employees to all of their accrued benefits become nonforfeitable to the extent that is
funded or credit to their accounts. Even those plans that to which the minimum funding standard
do not apply, must provide for vesting of all accrued benefits of all employees upon the complete
discontinuation of contributions. The purpose of these requirements is to prevent discrimina-
tion, as, for example, it would not allow the termination of a plan for a small business at the time
when the president has just retired and most other employees are only partially vested.
    "Freezing the plan" is where no additional employees are allowed to participate and no fur-
ther contributions are made, but the plan is continued to distribute vested benefits on retirement,
and should not be considered as a "termination" or "partial termination." At times this can be
confusing, with the result that often courts have to determine whether the plan is terminated, ful-
ly or partially, or if it is simply "frozen."
     Partial terminations may occur through amendment to or replacement of a plan that either ex-
cludes covered employees or adversely affect the right of participants for vesting in their bene-
fits. They may occur when plants close or there are other reductions in the workforce. In deter-
mining whether there has been a partial termination, the IRS considers whether there has been a
"significant percentage" of the plan's participants that have been affected—as a general rule,
however, a reduction of 20% or less is not sufficient by itself for a finding of partial termina-
tion.28 Terminations are discussed further in Chapter 13

                                     Discriminatory Vesting
    The Code addresses top-heavy plans and produced rules to prevent discrimination thereof. A
plan is determined to be top-heavy for a given year if the present value of accrued benefits for
key employees—or in the case of defined contribution plans, the total value of the accounts for
key employees—exceeds 60% of the values of the accrued benefits or accounts for all em-
ployees. A key employee is a 5% owner (or more), or one of certain other highly paid officers or
other owners.29




                                                 15
    For plans that are top-heavy, the 5-year cliff vesting standard is replaced with a 3-year cliff
vesting provision, and the 7-year graded vesting standard is replaced with a schedule starting
with 2d year of service and 20% nonforfeitable percentage, graded by 20% each year to full vest-
ing at end of 6th year. This schedule applies only for years in which a plan is top-heavy and can
revert back if the plan satisfied the non-top-heavy requirements for vesting, but in any event no
participant's nonforfeitable percentage may be reduced. 30

                                   Nonforfeitable Benefits
    ERISA's vesting standards only apply to pension plans (as contrasted to welfare plans) and
do not include top-heavy plans, plans established by labor unions which do not provide for em-
ployer contributions, excess benefit plans, and some other retirement or deferred-compensation
arrangements. In some cases, severance plans and retiree medical plans (welfare plans) have
been argued in court that they contain important features and should have benefit rights. How-
ever, courts have usually rejected such arguments, holding these rights to be forfeitable unless
there are special circumstances.
   Severance benefits are paid on account of an employee's separation from employer's service
and share the same benefit as providing benefits when separated from service. Still, severance
benefits are welfare benefits and do not, therefore, fall under the ERISA protective umbrella.
They can be eliminated through plan amendment or termination, at any time.
     Retiree medical benefits are quite similar to pension benefits as they are also provided to reti-
rees as forms of retirement financial support. However, since they are welfare benefits, they are
forfeitable under ERISA. In recent years this has produced considerable litigation as because of
the high cost of health care, many employers have had to modify or eliminate retiree health bene-
fits. Courts have also held that retiree benefits should become nonforfeitable under federal
common law.31 However, retiree medical benefits under a given plan may be nonforfeitable un-
der the terms of the plan document or collective bargaining agreement, or because of special fac-
tors.
    When an employer seeks protection of a bankruptcy court, it may petition to modify or ter-
minate payment of retiree health benefits. A court may order a modification if it is necessary for
the reorganization of the company, assures that all interested parties are treated fairly and equita-
bly, and is "clearly favored by the balance of the equities."32
                                      STUDY QUESTIONS
1. The relationship between insurance and employee benefits is
   A.   that of financing, employee benefits can be financed through insurance.
   B.   regulations.
   C.   participants.
   D.   cost.

2. With employee benefit plans, the employer
   A. always contributes to some or all of the cost.
   B. never contributes to the cost.
   C. always contributes all of the cost.
   D. is not allowed by law to contribute more than the employee to the cost.



                                                 16
3. The principal federal regulation of employee benefits is
   A. HIPAA.
   B. TEFRA.
   C. ERISA.
   D. LIMRA

4. A plan where the participants are not promised a particular level of retirement benefits, but
   each participant has an account in the plan to which the employer's contributions are directed
   A. is a deferred compensation account plan.
   B. is a defined contribution plan.
   C. is a defined benefit plan.
   D. is always a profit sharing plan.

5. Plans that provide hospital care, severance pay, prepaid legal services or scholarship pro-
   grams, ERISA considers as
   A. illegal benefit programs.
   B. non-regulated employee programs.
   C. welfare plans.
   D. multiemployer plans.

6. Individuals responsible for the operation of an employee benefit plan are
    A. participants.
    B. employees.
    C. plan directors.
    D. fiduciaries.

7. Simply put, if a plan is qualified, then
   A. the participant is taxed on the employer's contribution.
   B. the participant is taxed on both his contribution and that of his employer.
   C. the participant is not subject to tax on the employer's contributions when they are made.
   D. there is never any taxation on any contributions or earnings by the employer or employee.

8. A tax advantage to an employer in a qualified plan is
   A. lower salaries or wages.
   B. higher salaries or wages.
   C. that he may take deductions for both his contribution and employee's contribution.
   D. he automatically pays his taxes at capital gain rates.

9. One of the principal purposes of ERISA was
   A. making retirement benefits nonforfeitable through the process of vesting.
   B. to provide portability to employees covered under group health plans.
   C. to increase the tax rate on corporations.
   D. to establish federal dominance over state regulation of insurance.




                                                17
10. An employee retirement plan where the employee is always vested in his own contributions
    and a schedule where benefits can immediately jump from full forfeitability to full nonforfei-
    tability, is
    A. graded vesting.
    B. post-employment vesting.
    C. cliff vesting.
    D. a nonforfeiture benefit plan.

ANSWERS TO STUDY QUESTIONS
1A   2A   3C   4B   5C   6D   7C   8A   9A   10C




                                                   18
       CHAPTER TWO -EMPLOYER PROVIDED HEALTH
                     INSURANCE
                                           Overview
    The value of employer-provided health insurance coverage under accident or health insur-
ance, is generally not taxable income to covered employees. Special rules apply to accident and
health benefits provided by a closely held "C" corporation to its stockholder-employees and to
health coverage for partners, sole proprietors, and "S" corporation shareholders. Domestic part-
nership benefits are also subject to special tax rules.
    Self-funded health plans are subject to nondiscrimination rules, but such rules do not apply if
the plans that provide health coverage are written through a policy of accident and health insur-
ance.
   Certain health plans sponsored by certain employers are subject to the COBRA Continuation
Coverage rules, and plans may be subject to portability, access and renewability requirements.
These are discussed in detail in this section.

                           Taxation of Benefits for Employees
    Generally, the value of employer-provided coverage under accident or health insurance is not
considered as taxable income to the employee. This includes medical expense and dismember-
ment and loss of sight coverage for the employee, his spouse and dependents, and coverage pro-
viding disability income for the employee (covered elsewhere in this text). There is no specified
limit on the amount of the employer-provided coverage that may be excluded from the em-
ployee's gross income, and it is tax-exempt to the employee whether it is provided under a group
or individual insurance policy.33 In the same vein, critical illness coverage or accidental death
coverage is not taxable income to the employee.
    When the employer applies salary reduction amounts to the payment of health insurance
premiums for employees, the salary reduction amounts are excludable from gross income.34 If
the employee pays the premiums on his personally-owned medical expense insurance and is
reimbursed by his employer, the reimbursement is also excludable from the employee's gross
income.

        However, where the employer simply pays the employee or retiree a sum that may be
 used to pay the premium, but is not required to be so used, the sum is taxable to the employee.
    Another rather interesting point: The IRS states that where an employee is offered a choice
between a lower salary and employer-paid health insurance, or a higher salary and no health in-
surance, he must include the full amount of the higher salary in income regardless of his choice.
An employee selecting the health insurance option is considered to have received the higher sala-
ry, and, in turn, paid a portion of the salary equal to the health insurance premium to the insur-
ance company.35 However, a federal district court faced with a similar fact situation, ruled that
for employees that accept the employer-paid insurance, the difference between the higher salary
and the lower one is not subject to FICA and FUTA taxes or to income tax withholding.36




                                                19
    Generally, discrimination does not affect exclusion of the value of the coverage. Even if a
self-insured medical expense reimbursement plan discriminates in favor of highly compensated
employees, the value of the coverage is not taxable—only the reimbursements are affected.

                         Hospital, Surgical & Medical Expense
     Amounts that are received by an employee under employer-provided accident or health in-
surance, group or individual, that reimburse the employee for hospital, surgical and other medi-
cal expenses incurred for care of the employee, his spouse and dependents, are generally tax-
exempt without limit. However, benefits must be included in gross income to the extent that is
attributed to employer contributions.37
    Where an employer reimburses employees for salary reduction contributions applied to the
payment of health insurance premiums, such amounts are not excludable because there are no
employee-paid premiums to reimburse. Also, where the employer applies salary reduction con-
tributions to the payment of health insurance premiums, and then pays the amount of the salary
reduction to employees regardless of whether the employee incurs expenses for medical care,
these are called "advance reimbursements" or "loans" and they are not excludable from gross in-
come and are subject to FICA and FUTA taxes.38

                           Dismemberment and Loss of Sight
     Payments that are not related to loss of income because of absence from work, for the per-
manent loss, or loss of use, of a member or function of the body, or permanent disfigurement of
the employee, his spouse, or dependent, are excluded from income if the amounts paid are com-
puted with reference to the nature of the injury. A lump-sum payment from a group life and disa-
bility policy for incurable cancer qualified for tax exemption under this provision.39 On the
other hand,

    benefits that are determined by length of service, rather than 40 type and severity of the
                                                                    the
                          injury, do not qualify for the tax exemption.
    Benefits that are determined as a percentage of the disabled employee's salary rather than the
nature of his injury, are not excludable from income. An employee who has permanently lost a
bodily member or function but continues to work and draws a salary, cannot exclude a portion of
that salary as payment for loss of the member or function if that portion was not computed with
reference to the loss.41

                                  Critical Illness Benefits
    Benefit payments received by an employee under employer-provided critical illness policies,
where the value of the coverage was not includable in the employee's gross income, are includa-
ble in the gross income of the employee. The exclusion from gross income applies only to
amounts paid specifically to reimburse medical care expenses. Since critical illness insurance
policies pay a benefit irrespective of whether any medical expenses are incurred, such amounts
are not excludable.42




                                                20
                                 Accidental Death Benefits
   Accidental death benefits under an employer's plan are received income tax free by the em-
ployee's beneficiary as life insurance payable by reason of the insured's death.43

                                      Survivor's Benefits
    Benefits that are paid to a surviving spouse and dependents under an employer accident and
health plan, which provided coverage for an employee and his spouse and dependents both be-
fore and after retirement, are excludable to the extent that they would be if they were paid to the
employee.44

                  Employer's Noninsured Accident & Health Plans
    In order for employer's noninsured accident and health plan to be excludable from the em-
ployee's income, uninsured benefits must be received under an accident and health plan for em-
ployees. There must be a plan for uninsured payments, but there are no legal formats to fol-
low—as illustrated by the fact that a provision for disability pay in an employment contract has
been held to satisfy this condition.45 It is not required for the plan to be in writing or that the
employee's rights under the plan to be enforceable, as where an employer as a general practice
continued wages during disability was held to constitute a plan. But, if the employee's rights are
not enforceable, the employee must have been covered by a plan (or program)on the date he be-
came sick or injured, and notice or knowledge of such plan must have been readily available to
him.
    In order for there to be a plan, the employer must have established certain rules and regula-
tions in respect to payment, such rules must be known to employees as a definite policy before
accident or sickness occurs—ad hoc payments by an employer that are at the complete discretion
of the employer, does not qualify as a plan.46
     The plan must be for employees and may cover one or more employees, and there may be
different plans for different employees or classes of employees. But a plan that covers individu-
als in a capacity other than employee, even thought they may be employees, is not a plan for em-
ployees. Self-employed individuals and certain shareholders owning more than 2% of the stock
of an S corporation are not treated as employees for the purpose of determining the excludability
of employer-provided accident and health benefits.
    Uninsured medical expense reimbursement plans for employees must meet nondiscrimina-
tion requirements in order for medical expense reimbursements to be tax free for highly compen-
sated employees.

  NONDISCRIMINATION FOR EMPLOYER PROVIDED HEALTH BENEFITS

                                          Insured Plans
    Outside of the rules regarding discrimination based on health status under HIPAA—which
concerns itself with both insured and uninsured plans—a plan that provides health benefits
through an accident or health insurance policy need not meet the nondiscrimination requirements
of IRC Section 105(h) in order for the employees to enjoy the tax benefits previously discussed.




                                                 21
     An accident or health insurance policy may be either an individual or group policy issued by
a licensed insurance company, or an arrangement in the nature of a prepaid health care plan regu-
lated under federal or state law (such as an HMO). However, unless the policy involved the
shifting of risk to an unrelated third party, the plan will be considered by the IRS as "self in-
sured."

   A plan that reimburses employees for premiums paid under an insured plan does not have
                            to satisfy nondiscrimination requirements.

                                      Self-Insured Plans
    Nondiscrimination requirements do apply to self-insured health benefits. Usually, benefits
under a self-insured plan are excluded from the employee's gross income, but if a self-insured
medical expense reimbursement plan or the self insured part of a partly-insured medical expense
reimbursement plan discriminates in favor of highly compensated individuals, certain amounts
paid to the highly compensated individuals are taxable to them.
    As stated earlier, a self-insured plan is one which reimbursement of medical expenses is not
provided under an accident or health insurance policy.47 The regulations require that a plan that
is underwritten by a cost-plus policy or a policy that, effectively, provides administrative or
bookkeeping services is considered self-insured.48
   A medical expense reimbursement policy cannot be implemented retroactively, as to do so
would be in violation of the nondiscrimination requirements of IRC Section 105.
   A self-insured plan may not discriminate in favor of highly compensated individuals, either
with respect to eligibility to participate, or in benefits.

                                            Eligibility
    A self-insured plan discriminates as to eligibility to participate unless the plan benefits 70%,
or 80% or more of all employees who are eligible to benefit under the plan if 70% or more of all
employees are eligible to benefit under the plan, or such employees as qualify under a classifica-
tion set up by the employer and found by IRS not to be discriminatory in favor of highly com-
pensated individuals.49

                                     Excludable Employees
   Under the eligibility requirements, the employer may exclude from consideration those em-
ployees who
       have not completed three years of service at the beginning of the plan year;
       have not attained age 25 at the beginning of the plan year;
       are part-time or seasonal employees;
       are covered by a collective bargaining agreement; and/or
       are nonresident aliens with no U.S.-source earned income.50

                               Part-time and Seasonal Workers
    Those employees who are customarily employed for fewer than 35 hours per week are consi-
dered part-time; employees who are customarily employed for fewer than 9 months of the year



                                                 22
are considered seasonal, if similarly situated employees of the employer are employed for basi-
cally more hours or months, as applicable. There are also "safe harbor" rules for employees cus-
tomarily employed for fewer than 25 hours a week or seven months a year.51

                                             Benefits

     A plan will be discriminatory as to benefits unless all benefits provided for participants
         who are highly compensated individuals are provided for all other participants.
    Benefits are not available to all participants if some participants become eligible immediately
and others after a waiting period. Benefits available to dependents of highly compensated em-
ployees must be equally available to dependents of all other participating employees. The test is
applied to benefits subject to reimbursement, instead of to the actual benefit payments or claims.
Any maximum limit on the amount of reimbursement must be uniform for all participants and
for all dependents, regardless of years of service or age.
    The plan will be considered as discriminatory if the type of amount of benefits subject to
reimbursement is offered in proportion to compensation; and highly compensated employees are
covered by the plan. A plan will not be considered discriminatory in operation just because
highly compensated participants utilize (or use) a broad range of plan benefits to a greater extent
than do other participants.
    An employer's plan will not violate nondiscrimination rules just because the benefits may be
offset by benefits paid under a self-insured or insured plan of the employer or another employer,
or by benefits paid under Medicare or other federal or state law. A self-insured plan may take
into account benefits provided under another plan only to the extent that the benefit is the same
under both plans.52

                               Highly Compensated Individual

         "Highly compensated individuals" are defined differently in respect to the various bene-
 fits. For instance, in retirement "golden parachute" plans, the definition of highly compensated
     individuals is different than what applies in this general discussion of self-insured plans.
    For the purpose of self-insured plans, a "highly compensated individual" is so considered if
he is a member of any ONE of the following three classification:
       1) one of the five highest paid officers;
       2) a shareholder who owns (either actually or constructively through of the application
          of the attribution rules) more than 10% in value of the employer's stock; or
       3) among the highest paid 25% (rounded to the nearest higher whole number) of all em-
          ployees (other than excludable employees as described above who are not participants
          and does not include retired participants ).53

      Taxation of Amounts Paid by Employer to HCEs Under Discriminatory Plan
    The amount that is paid under a discriminatory self-insured medical expense reimbursement
plan to a highly compensated individual that is taxable is known as "excess reimbursement."



                                                   23
    When a benefit is available to a highly compensated individual but not to all other partici-
pants, the total amount reimbursed under the plan to the employee with respect to such benefit is
an excess reimbursement.
    Where benefits available to all other participants and not otherwise discriminatory, and
where the plan discriminates as to participation, excess reimbursement is determined by multip-
lying the total amount reimbursed to the highly compensated individual for the plan year, by a
fraction, which is then applied to the total amount reimbursed to all participants and the total
amount to all employees during the year.
    Multiple plans may be so designated as a single plan for purposes of satisfying nondiscrimi-
nation requirements, such as when an employee elects to participate in an HMO.

                                       Contributory Plan
   Reimbursements that can be attributed to employee contributions are received by the em-
ployee on a tax-free basis if the expense was previously deducted (as discussed earlier).
Amounts that are attributed to employer contributions are determined by using the ratio that em-
ployer contributions bear to the total contributions for the calendar year immediately prior to the
year of receipt (up to 3 years, if the plan has been in effect for less than a year).54

                                          Withholding
    The employer does not have to withhold income tax on an amount paid for any medical care
reimbursement made to or for the benefit of an employee under a self-insured medical reim-
bursement plan.55

                               "Domestic Partnership" Benefits
    Domestic partner benefits are benefits that an employer voluntarily offers to an employee's
unmarried partner, defined by the employer as either of the same sex or opposite sex. While em-
ployers may offer benefits to domestic partners such as family, bereavement, sick leave and relo-
cation benefits—generally speaking, the benefits offered would be restricted to health insurance
coverage.
    An employee is taxed on the value of the employer-provided health benefits for his/her do-
mestic partner, unless the domestic partner qualified as the employee's dependent under IRC
Section 151. The tax is calculated by assessing the fair market value of the coverage provided to
the domestic partner, which amount is then reported on the employee's W-2 and is subject to
FICA and federal income tax withholding.
    Any amount received by the domestic partner as payment or reimbursement of plan benefits
will not be included in the employee's income or that of the domestic partner, to the extent that
the coverage provided to the domestic partner was paid by the employee's plan contributions; or,
the fair market value of the coverage was included in the employee's income.56
    Coverage of domestic partners—regardless if they qualify as dependents or not—under an
employer-provided health plan will not otherwise affect the ability of employees to exclude
amounts paid, directly or indirectly, by the plan so as to reimburse employees for expenses in-
curred for medical care of the employees, their spouses, and dependents.



                                                24
                                             COBRA
    A domestic partner may not make an independent election for COBRA coverage, but a do-
mestic partner may be part of an employee's election. (See later discussion of COBRA later in
this section.)

   Taxation of Health Benefits for Stockholder-Employees & Self-Employed
    As stated earlier, in order to provide tax-free coverage and benefits, an employer's accident or
health plan must be for employees. It is difficult at times for the IRS to determine whether a
stockholder employee plan is not for employees rather than stockholders. If they cannot establish
that the person is not an "employee" then the premiums or benefits are generally treated as divi-
dends with premiums nondeductible by the corporation and premiums or benefits includable in
the gross income of the covered stockholder-employees.57
   However, the courts have taken the stance that

       the tax benefits of employer-provided health insurance are available in a plan that covers
only stockholder-employees if the plan covers a class of employees that can rationally be segre-
   gated from the other employees, if any, on a criterion other than they are stockholders.58

  Taxation of Health Benefits-Partners, Sole Props. & S Corp. Shareholders
    As a general rule, partners and sole proprietors are self-employed, not employees, and the
rules for personal health insurance usually apply. However, partners and sole proprietors can
deduct 100% of amounts paid during a taxable year for insurance that provides medical care for
the individual, his spouse and dependents during the tax year.59 It should be noted that certain
premiums paid for long-term care insurance are eligible for this deduction.60
    The deduction is not available for a partner or sole proprietor for any calendar month in
which he is eligible to participate in any subsidized health plan maintained by any employer of
the self-employed individual or his spouse. This rule is applied separately to plans that include
coverage for qualified long-term care services, are qualified long-term care insurance contracts,
and plans that do not include such coverage and are not such contracts.
    The deduction is allowed in calculating adjusted gross income and is limited to the self-
employed individual's earned income for the tax year that is a result of the trade or business in
which the plan providing the medical coverage is established. Earned income is usually defined
as net earnings from self-employment with respect to a trade or business in which the personal
services of the taxpayer are a material income producing factor.
   Any amounts that are paid for such insurance may not be taken into account in computing the
amount of medical expense deduction.
    If a partnership pays accident and health insurance premiums for services rendered by the
partners in their capacity as partners and without regard to partnership income, the premium
payments are then called "guaranteed" payments by the IRS and are thereby deductible by the
partnership and includable in the partners' income. The partner may not exclude the premium
payments from income but may deduct the payments to the extent allowable.




                                                25
    In respect to a self-funded medical reimbursement plan set up by a partnership, the IRS de-
termined that payments from the plan made to the partners and their dependents are excludable
from the partners' income and premiums paid by the partners for the coverage under the self-
funded plans and are deductible, subject to certain limitations.61 However, there is no limit on
the amount of benefits a partner or sole proprietor can receive tax free.
    Basically, the IRS has stated in various rulings that coverage purchased by a sole proprietor
or partnership for non-owner-employees, including the owner's spouse, are generally subject to
the same rules that apply in any other employer-employee situation.62 Generally speaking, the
IRS has taken the position that if the employee-spouse is a bona fide employee, the employer-
spouse may deduct the cost of the coverage, and the value of the coverage is also excludable
from the employee-spouse's gross income. One should be aware, however, that IRS agents are
directed to closely scrutinize whether an employee-spouse qualifies as a bona fide employee and
nominal or insignificant services that have no economic substance or independent significance
will be challenged.63

                           S-Corporation Shareholder/Employee
    A shareholder-employee who owned more than 2% of the outstanding stock or voting power
of an S corporation will be treated as a partner, not an employee.64

                           EMPLOYER'S TAX DEDUCTIONS
    The general rule is that an employer can deduct all premiums paid for health insurance for
one or more employees as a business expense, including premiums for medical expense insur-
ance and dismemberment and loss-of-sight coverage for the employee, his spouse and depen-
dents and disability income for the employee, plus accidental death coverage. Long-term care
insurance premiums are also deductible if the plan is a qualified plan.
    Premiums are deductible whether the coverage is provided under a group policy or individual
policy, but the deductions for health insurance only apply if benefits are payable to employees or
their beneficiaries, and not to the employer. A corporation may deduct the premiums that it pays
for group hospitalization coverage for commission salespersons, regardless of whether they are
employee.65
                                       STUDY QUESTIONS
1. Self-funded health plans are subject to nondiscrimination rules but such rules do not apply if
   A. the death benefit provisions are funded by an accidental death policy.
   B. the employer posts a bond with the Department of Insurance.
   C. the plans that provide health coverage are written through an accident and health insur-
       ance policy.
   D. there are fewer than 100 employees participating in the plan.

2. Generally, the value of employer-provided coverage under accident or health insurance
   A. is considered as taxable income to the employee.
   B. does not include medical expense or loss of sight to the employee's spouse or dependents.
   C. is not considered as taxable income to the employee.
   D. is not considered as taxable income to the employee if the employer pays the employee a
      sum that may be used to pay the premium but is not required to do so.


                                                26
3. Dismemberment benefits that are determined by length of service, rather than the type and
   severity of the injury
   A. qualifies for the tax exemption.
   B. do not qualify for the tax exemption.
   C. do meet the criterion for "employee benefit" and would not be approved under ERISA.
   D. must be paid entirely by the employer in order to qualify for the tax exemption.

4. In order for an employer's noninsured accident and health plan to be excludable from the em-
    ployee's income,
    A. there must be an ad hoc plan
    B. there must be a plan, although there are no legal formats to follow.
    C. the plan must meet specified wording as supplied by the IRS.
    D. the employer can not contribute to the plan.

5. A plan that reimburses employees for premiums paid under an insured plan
   A. must satisfy nondiscrimination requirements.
   B. need not satisfy nondiscrimination requirements.
   C. is never, under any circumstances, a qualified plan.
   D. is not considered as a business expense to the employer.

6. A plan will be discriminatory as to benefits
   A. unless all benefits provided for participants who are highly compensated individuals are
       provided for all other participants.
   B. except where highly compensated individuals have better or more expensive plans.
   C. if benefits are provided by an insurance policy.
   D. only if the plan does not provide substantially equal benefits to similar sized companies
       in the same geographical area operating in basically the same industry or business.

7. Domestic Partner benefits provided by an employer offering benefits to a domestic partner of
   either the same or opposite sex, or an employee
   A. would be provided on an voluntary basis.
   B. are required in California and Massachusetts only.
   C. are not allowed under ERISA regulations.
   D. must be removed from the plan document and provided under an ad hoc agreement.

8. For tax purposes, as a general rule, partners and sole proprietors
   A. are treated as corporations.
   B. cannot deduct amounts paid for insurance providing medical care for the individual,
       spouse and dependents.
   C. are treated differently in making personal health insurance premium deductions.
   D. are self-employed, not employees, and rules for personal health insurance apply, except
       they can deduct 100% of premiums for insurance providing medical care for the individ-
       ual, spouse and dependants.




                                               27
9. For tax purposes for the self-employed, net earnings from self-employment with respect to a
   trade or business in which the personal services of the taxpayer are a material income pro-
   ducing factor, is the definition of
   A. an ERISA exemption.
   B. earned income.
   C. unearned income.
   D. personal service deduction.

10. A shareholder-employee who owned more than 2% of the outstanding stock or voting power
    of an S Corporation
    A. will be treated as a partner, not an employee.
    B. will be treated as an employee.
    C. must consider all income received from the corporation as a dividend.
    D. need not report any income so related on his tax report as the corporate taxes
        will cover his tax obligations.

ANSWERS TO STUDY QUESTIONS
1C   2D   3B   4B   5B   6A   7A   8D   9B   10A




                                                   28
CHAPTER THREE - HEALTH INSURANCE PORTABILITY AND
       ACCOUNTABILITY ACT OF 1996 (HIPAA)
                                            An Act..
 "…to amend the Internal Revenue Code of 1986 to improve portability and continuity of health
  insurance coverage in the group and individual markets, to combat waste, fraud, and abuse in
health insurance and health care delivery, to promote the use of medical savings accounts, to im-
  prove access to long-term care services and coverage, to simplify the administration of health
             insurance, and for other purposes." Public Law 104-191 - 104th Congress
    NOTE: For the latest HIPAA regulations, Internal Revenue Bulletin 2005-8, TD 9166, pro-
vides the "Final Regulations for Health Coverage Portability for Group Health Plans and Group
Health Insurance Issuers Under HIPAA Titles I and IV" which can be accessed at
http://www.irs.gov/irb/2005-08_IRB/ar07.html
    HIPAA is usually considered as the most important piece of legislation of recent origin in re-
spect to health insurance and employee benefits, as it was specifically designed to address these
issues as evidenced by the preamble (above) of this law.
               HIPAA GROUP HEALTH INSURANCE REFORMS
    The two principal areas of insurance reform addressed by the HIPAA are group health insur-
ance and Long Term Care Insurance (covered in another Chapter). The stated principal raison
d’étre of the Act was the portability problem of an employee moving from one group plan to
another situation where there either is no insurance or the employee does not qualify for the
health plan at the new employer because of health reasons, or the employee is unable to get indi-
vidual insurance after the COBRA period with his former employer.
                                         PORTABILITY
    Under HIPAA’s ―portability‖ protection, once a person obtained creditable health plan cov-
erage (defined later), he can use evidence of that coverage to reduce or eliminate any preexisting
medical condition exclusion period that might otherwise be imposed when the person moved
from one job to another. This applies whether the person moves from one health plan to another,
from a group plan to an individual plan, or from an individual plan to a group plan. Portability is
simply being able to maintain coverage and being given credit for having been insured when
changing health plans. It does not, of course, mean that a person can take his insurance policy
with him from one job to another.
                                            COBRA
    The Consolidated Omnibus Budget Reconciliation Act of 1985, known as COBRA, requires
that businesses with 20 or more employees that offer group insurance to their employees, to offer
continued group health insurance coverage to employees and their dependents after certain
events, which includes a 12 month extension of coverage.




                                                29
                                      Creditable Coverage
    Any insured or self-funded group health plan maintained by an employer to provide health
care, directly or otherwise, to the employer's employees, former employees, or their family must
generally offer COBRA continuation coverage.66 Insured plans are not only those providing
coverage under group policies, but include any arrangement to provide health care to two or
more employees under individual policies.67 These regulations do not apply to plans that are
primarily qualified long-term care to two or more employees under individual policies. COBRA
does not require plan sponsors to offer continuation coverage for disability income. Amounts
contributed by an Archer MSA plan are not considered part of a group health plan and are not
subject to COBRA continuation requirements.
   Creditable coverage applies when an individual is given credit for previous insurance when
applying for a new health insurance plan. Creditable coverage is coverage under any of the fol-
lowing:
       1. Group health plan;
       2. Health insurance coverage including individual health insurance;
       3. Medicare or Medicaid;
       4. Military health care;
       5. Medical care program of the Indian Health Service or a tribal organization;
       6. A state health benefits program;
       7. The Federal Employee Health Benefits Program;
       8. A public health plan (defined in the regulations); or
       9. A health benefit plan as part of the Peace Corps Act.
                     CONTINUATION OF COVERAGE DEFINITIONS
     COBRA continuation coverage must provide coverage identical to that provided under the
plan, to similarly situated beneficiaries in respect to whom qualifying events have not occurred.
If the coverage is modified for some beneficiaries, it must be modified for all beneficiaries of
similar status. Regulations have been "tough," as for example, a court ruled that an employer did
not meet the COBRA requirements for continuation coverage where the only health plan availa-
ble was an HMO that did not operate in the service area of the qualified beneficiary—even
though the plan was no longer available because the self-insured trust under which she had been
insured and to which she had elected coverage, was insolvent.68
    Qualified beneficiaries that elect COBRA coverage are generally subject to the same deduc-
tibles as similarly situated non-COBRA beneficiaries. Any amount that is accumulated towards
deductibles, plan benefits, and plan cost limits prior to a qualifying event, are carried over into
the COBRA continuation coverage period.69
   Usually, a qualified beneficiary who is electing COBRA coverage does not need to have the
chance to change coverage that he had prior to his qualifying for COBRA, even if the COBRA
coverage is not of as much value (or even no value) to the person, except for two situations.
   If the beneficiary was participating in a plan that is "region-specific" but does not provide
coverage in the area where the person is relocating, the beneficiary must be able to elect alterna-


                                                30
tive coverage offered by the employer or employee organization that is made available to active
employees. However, the employer or employee organization is not required to provide the be-
neficiary with coverage if the coverage is not available to active employees in the area to which
the beneficiary is relocating.
   Also, if the employer or employee organization makes an open enrollment period available to
similar active employees, the same open enrollment period rights must be made available to each
qualified person that has COBRA coverage.70

                                     Qualified Beneficiary
    A qualified beneficiary is a covered employee's spouse or dependent child and who has been
such on the day prior to the covered employee's covered event, under a group health plan. A
child born or placed for adoption with the covered employee during the period of continuation of
coverage is also a qualified beneficiary.71
    If the qualified event is a bankruptcy proceeding, then a qualified beneficiary is any covered
employee who retired on or prior to the date of the elimination of coverage because of bankrupt-
cy, and also includes individuals who were covered under the plan as the covered employee's
spouse or dependent children.
    If the qualifying event is an employment change of the covered employee, then the covered
employee and his spouse and dependent children covered under the plan on the day before the
event, are covered beneficiaries.
    If a person marries a qualified beneficiary other than the covered employee, he does not au-
tomatically become a qualified beneficiary because of the marriage, nor does a child born to or
placed for adoption with such a qualified beneficiary, does not, themselves, become a qualified
beneficiary—even if they are covered under the group health plan.
    Obviously, a person who does not elect COBRA continuation coverage is automatically no
longer considered a qualified beneficiary at the end of the COBRA election period.72

                                     Domestic Partners
    Domestic partners that are not dependents are not covered by HIPAA. However, employers
providing health insurance to domestic partners may voluntarily include them in HIPAA certifi-
cation procedures.

                        Cost of COBRA Continuation Coverage
   The plan may require the qualified beneficiary to pay a premium for continuation of cover-
age. Generally, the premium cannot exceed a percentage of the "applicable premium."
    The applicable premium is the cost of the plan for similarly situated beneficiaries with re-
spect to whom a qualifying even has not occurred. This premium must be fixed by the plan be-
fore the determination period begins (determination period is any 12-month period selected by
the plan, consisted from one year to the next). Since this determination period is the same for
any benefit package, each qualified beneficiary will not have a separate, individual, determina-
tion period.73




                                                31
    The percentage of premium charged is usually 102%.74 If the qualified beneficiary is dis-
abled, then the premium can be as high as 150% of the applicable premium for any month after
the 18th month of continuation coverage, and the same amount can be charged if the disabled be-
neficiary experiences a second qualifying even during the disability extension—after the 18th
month period, and it may be charged until the end of the 36th month.

   Coverage cannot be conditioned upon evidence of insurability or contingent upon the
employee's reimbursement of his employer for group health plan premiums paid during a leave
taken under the Family and Medical Leave Act of 1993.
   During the determination period, the plan may increase the cost of COBRA only if the plan
previously charges less than the maximum amount permitted and even after the increase in the
maximum amount will not be exceeded, or if a qualified beneficiary changes his coverage.
     The qualified beneficiary must be allowed to make premium payments on a monthly basis, at
least and any person or entity can make the required premium payment on behalf of the benefi-
ciary. However, COBRA premiums must be paid in a timely fashion—defined as 45 days from
the election for the period between the qualifying event and the election, and 30 days after the
first date of the period for all other periods. An employer has the right to retroactively terminate
COBRA continuation if the initial premium is not paid in a timely fashion. The employer is not
allowed to set off the premium against the amount of any claim incurred during the 60-day elec-
tion period.
    A plan must treat a timely payment that is less than the required amount, as full payment, un-
less the qualified beneficiary is notified on a timely basis and grants a reasonable time for pay-
ment—usually 30 days after the notice is provided. The amount of the premium is considered as
"not significantly less" if the amount not paid is no greater than the lesser of $50 or 10% of the
required amount.75

               Employers Subject to COBRA Continuation Coverage
    As stated previously, church organizations and governmental plans are not subject to
COBRA requirements. In addition, "small-employer" plans are not subject to the COBRA con-
tinuation coverage requirements.76
    A small-employer for purposes of these regulations, is defined as an employer who usually
employed less than 20 employees during the previous calendar year on a typical business day.
An employer is considered to have less than 20 employees during a calendar year if it had fewer
than 20 employees on at least 50% of its typical business days during that year. Only common-
law employees are taken into account for the purpose of this exclusion and self-employed indi-
viduals, independent contractors and directors are not counted.77
    If the plan is a multiemployer plan, a small employer plan is a group health plan under which
each of the employers that contribute to the plan for a calendar year, normally employed less
than 20 employees during the previous calendar year.78




                                                 32
                       PORTABILITY OF GROUP HEALTH PLANS
    HIPAA requires that group health plans offered to an employment-based group—including
both employers and employee organizations—that are covered by the Act meet certain portabili-
ty requirements.

      When a person with prior creditable coverage, first enrolls in a group health plan, the
 plan cannot impose a limitation period on a preexisting condition that is longer than 12 months
                                (or 18 months for late enrollees).
     The length of the allowed preexisting condition limitation is based upon any creditable cov-
erage that the person may have. The plan cannot apply any preexisting condition waiting period
on pregnancy, a covered newborn, or any covered child under age 18 who is adopted (whether or
not the adoption has been finalized). The employer is allowed to require individuals to work for
a period of time (waiting period, not preexisting condition period) before they may participate in
the health plan.
    All employers who sponsor group health plans are required to provide enrollees with a certif-
icate that states the amount of creditable coverage accumulated and whether or not the enrollee
was subject to a waiting period under the employer’s plan. This certificate can be used to dem-
onstrate creditable coverage when moving to another group or to an individual health insurance
plan.
     The Act does not require an employer to continue offering coverage to enrollees who have
left their jobs, except under COBRA continuation provisions.
                                     Continuous Coverage
   In order to benefit from HIPAA, it is important for individuals to maintain health insurance
coverage without experiencing significant lapses in coverage. The portability protection only
applies to people with ―continuous coverage,‖ defined as coverage with no lapses of 63 or more
days, so individuals should not allow their insurance coverage to lapse for more than 62 days.
    If a person moves from one group plan to another group plan, or from individual to group
coverage, the new plan must reduce any preexisting condition limitation period for 1 month for
every month that the individual had creditable coverage under a previous plan, provided they
enroll when they are first eligible and with no break in coverage over 62 days. As an example, if
an individual had creditable coverage for 6 months they could have 6 months of a preexisting
condition limitation period. If they had 11 months of creditable coverage, they could face one
month preexisting coverage limitation coverage. The good news is that once a 12 month limita-
tion is met, no new limitation may ever be imposed provided that continuous coverage is main-
tained and there is no break in coverage lasting longer than 62 days. This would apply even if
there is a change in jobs or in health plans.




        If there is a period of 63 consecutive days during which individuals have no
      creditable coverage, they may be subject to as much as a 12-month preexisting condition
                        exclusion period—or 18 months to late enrollees.  
                                                33
    Persons may be eligible for a waiver of preexisting condition limitations by presenting certi-
fications that document prior creditable coverage. Health insurers and other health plans must
provide the individual with written certifications of the period of creditable coverage under the
plan, coverage (if applicable) under COBRA provisions, and any waiting or affiliation period
imposed. The certification must be provided at any of three times:
       1. When the person is no longer covered under the plan or otherwise becomes covered
          under a COBRA continuation provision;
       2. After the termination of the COBRA coverage; or
       3. Upon a request which is made not later than 24 months after coverage ends.

                                    Creditable Coverage
    "Creditable coverage" is coverage of an individual under several types of health plans, in-
cluding a group health plan, health insurance coverage, Part A or Part B of Medicare, a state
health benefits risk pool, or a public health plan.79

                                   Certificate of Coverage
    A certificate of coverage must be provided to participants or dependents who are or were
covered under a group health plan upon the occurrence of any of several events and must be pro-
vided automatically to COBRA qualified beneficiaries upon the occurrence of a "qualified
event," plus a certificate must be provided automatically to any qualified beneficiary who would
otherwise lose coverage under the plan in the absence of COBRA continuation coverage and is-
sued automatically to other individuals when coverage stops, and in several other situations as
set forth by the regulations.80
                                         Late Enrollment
     ―Late enrollment‖ occurs when an individual enrolls in a group health plan other than the
first period in which the person is eligible to enroll, or a special enrollment period. They should
be aware that a later enrollee could make the person wait for as long as 18 months before a
preexisting condition is covered.
                                         Waiting Period
    The waiting period is the time that an employee must wait before he is eligible to enroll in a
health plan. A typical waiting period is 6 months before health insurance benefits are available
and the Act does not prescribe the waiting period—it is up to the insurer and the employer.
However, the Act does require that the waiting period be applied uniformly without regard as to
the health status of potential plan participants or beneficiaries. Waiting period days are not taken
into account in determining the length of a break in coverage.
   The waiting period is different than the preexisting condition exclusion limitation period
which allows the plans to exclude coverage for certain health conditions for periods up to 12 or
18 months.




                                                34
     The waiting period that an employee or his family member must endure to become
    covered under a health plan, must run concurrently with any preexisting condition limitation
                                              period.


    As an example, if an employer hires a person with no creditable coverage and requires such
person to wait for 5 months before becoming eligible for the group health plan, then the preexist-
ing condition limitation period imposed on the coverage of that individual could not exceed 7
months from the date of actual enrollment of the plan. If the individual had 7 or more months of
creditable coverage, then no preexisting condition limitation period could be imposed on the
coverage under the new plan.
                                     Crediting Prior Coverage
    When a person change plans, sometimes the new benefit package may cover some benefits
that the most recent prior plan did not cover. The Act allows the new plan or issuer some discre-
tion in applying prior creditable coverage to those new benefits. Plans and issuers may choose
between two alternatives when crediting coverage:
       1. They can choose to include all periods of coverage from qualified sources and ignore
          specific benefits, or
       2. They can examine prior coverage on a benefit-specific basis and are allowed to ex-
          clude any categories or classes of benefits not covered under the most recent plan,
          from creditable coverage.
   Under a later (interim) rule, the categories of benefits that may be treated separately, are
              Mental health;
              Substance abuse treatment;
              Prescription drugs;
              Dental care; or
              Vision care.
    Example: If a prior plan did not cover prescription drugs and the new plan includes prescrip-
tion drug coverage, the new plan may exclude prescription drug coverage for up to 12 months
under this (2d) method—and, if this method is chosen, plans or issuers must disclose its use at
the time or enrollment or sale of the plan, and apply it uniformly, i.e., an insurer must not allow
other employees to obtain prescription drug coverage under the same circumstances for a shorter
period of time.
                                 Spouse and Children Coverage
    An employer is not required to offer coverage to an individual’s spouse or family. If the em-
ployer does offer family coverage, the same protection applies to a spouse and dependents and,
for instance, coverage may not be denied because a family member is sick, and preexisting con-
dition restrictions are limited.




                                                35
       PORTABILITY WHEN MOVING FROM GROUP TO INDIVIDUAL PLANS
    HIPAA ―guarantees‖ the availability of a plan and it prohibits preexisting condition exclu-
sions for certain eligible individuals who are moving from group insurance to individual insur-
ance. States are given the right to either accept or enforce HIPAA individual guarantees, (called
the ―federal fallback‖) or they may establish an acceptable alternative state mechanism. For
those using the federal fallback approach, HIPAA requires that all insurers who operate in the
individual health insurance field to offer coverages to all eligible individuals and prohibits the
insurers from placing any limitations of coverage on any preexisting medical condition.
   The issuers (usually insurers) can comply in three ways:
       1. Offer eligible individuals access to coverage to every individual insurance policy that
          they sell in the state; or
       2. Offer eligible individuals access to coverage to their two most-popular insurance pol-
          icies (popularity based upon premium volume); or
       3. Offer eligible individuals access to a lower-level and higher-level coverage. These
          two policies must include benefits that are (substantially) similar to other coverage of-
          fered by the issuer in the state, and must include risk adjustment, risk spreading or fi-
          nancial subsidization,
    Issuers do have the right to refuse coverage for those individuals seeking portability from the
group market if financial or provider capacity would be impaired. For example, an HMO can
show that it is filled to capacity, health providers cannot accept new patients because of the
number of patients they already have, health care within the area in which the individual resides
and works cannot be provided at reasonable cost, etc., all could be advanced as a reasons not to
cover a person, but the exception would have to be applied uniformly without regard to the
health condition of the applicants—for instance they could not accept an individual from the
same geographical area and who would be using health care providers that had been represented
as being overwhelmed by the number of patients.
                           COBRA CONTINUATION ELIGIBILTY
   The COBRA coverage is considered creditable coverage for individuals who move from one
group policy to another group policy or move from a group policy to an individual policy. This
would then allow an individual to move from COBRA to a new health plan without having to
wait for coverage of any preexisting medical condition under the new plan, providing the indi-
vidual does not have a lapse in coverage of 63 or more days.
   For individual coverage, this is a little more complex. In order to be eligible for guaranteed
availability and portability with individual plans, an individual must first have elected and ex-
hausted any available COBRA or other continuation coverage. Eligible persons who do not
qualify for COBRA or other continuation coverage may go directly to the individual plans. It
should be noted, however,



 the insurer who accepts the eligible individual for coverage can charge whatever rate is
    allowed under state law as the Act does not limit the premiums that insurers can charge.



                                                36
   This is not to say, however, that the Act ignored COBRA, actually they made several
changes to the COBRA continuation of coverage provisions.
       A disabled qualified beneficiary and all other qualified family members of the benefi-
        ciary are also eligible for the additional months of COBRA.
       The qualifying event of disability applies in the case of a qualified beneficiary that is
        determined under the Social Security Act to be disabled during the first 60 days of
        COBRA coverage,
       A qualified beneficiary for COBRA coverage includes a child who is born to, or placed
        for adoption with, the covered employee during the period of COBRA coverage; and
       COBRA can be terminated if a qualified beneficiary becomes covered under a group
        health plan which does not contain any exclusion or limitation affecting a participant or
        his or her beneficiaries because of the requirements of the Act.
       Under the Medical Savings Account provisions (discussed later) individuals can with-
        draw funds from their MSA to pay their COBRA premiums, without penalty.
                         Eligibility for Group to Individual Coverage
    For an individual formerly insured under a group plan to be eligible for individual coverage
the individual must have
 creditable health insurance coverage for 18 months or longer, at least the last day of which
  was under a group health plan;
 most recent coverage under a traditional employer group, governmental, or church plan;
 exhausted any COBRA or other continuation coverage;
 no eligibility for coverage under any employment-based plan, Medicare or Medicaid; and
 no breaks in coverage of 63 or more days.
   Persons who purchase insurance coverage on their own, and who do not meet these eligibility
requirements, are not protected by HIPAA’s portability and guaranteed availability options.
However, they may be protected under state laws.
                        Limitations of Group-to-Individual Portability
     The portability provisions of group-to-individual coverage applies only to individuals whose
most recent coverage was provided through traditional employer-based group arrangements, go-
vernmental plans or church-sponsored plans. HIPAA defined group plans as those plans that
meet the ERISA definition and which is limited to those sponsored through employer-employee
relationship or an employment-based association. Governmental plans are defined in ERISA as
plans established or maintained for its employees by the federal, state or political subdivision.
This means that persons whose most recent coverage was sponsored by the military (CHAMPUS
and TRICARE), many college sponsored student plans, the Peace Corps, the Veteran’s Adminis-
tration, the Indian Health Service, Medicare, Medicaid and SCHIP are NOT eligible for the fed-
eral group-to-individual portability and guaranteed availability protections. Again, however,
states may offer these individuals such protections.



                                                37
    States may (a) provide an acceptable state mechanism for coverage of eligible individuals,
(b) must allow a choice of health insurance coverage to all eligible individuals, (c) not impose
any preexisting condition restrictions, and (d) include at least one policy form of coverage that is
comparable to either comprehensive health insurance coverage offered in the individual market
in the state, or a standard option of coverage available under the group or individual health insur-
ance laws in the state.
    In addition, a state may implement certain National Association of Insurance Commissioners
(NAIC) Model Acts; a qualified high-risk pool that meets certain specified requirements, other
risk-spreading or risk-adjustment approach or financial subsidies for participating insurers or eli-
gible individuals, or any other mechanism under which eligible individuals are provided a choice
of all individual health insurance coverage otherwise available.
    Some states have provided for health insurance coverage pools, mandatory group conversion
policies, guaranteed issue of one or more plans or individual health insurance coverage, open
enrollment by one or more health insurance issuers, or a combination of such mechanisms.
     Currently, 10 states (AZ, DE, HI, MD, MO, NV, NC, RI, TN, WV) have adopted the federal
fall-back position, another 24 states adopted an alternative mechanism of a high-risk insurance
pool. The remaining 16 states have various alternative mechanisms, including two that use Blue
Cross/Blue Shield as the guaranteed issue carriers. Florida, for instance, has guaranteed issue to
HIPAA persons, and health plans must offer a choice of conversion plans, one of which must be
the state approved‖ standard policy‖ offered in the small group market. Some states change the
preexisting coverage limit time, adjustments in premium for various risks, retaining pregnancy as
a preexisting condition, separate open enrollment period for HIPAA-eligibles, etc.
                                   Special Enrollment Periods
   The Act provides for two special enrollment periods to make sure that people who lose group
health insurance coverage can have an easier time of obtaining coverage when available. The
two special enrollment periods are for individuals losing coverage and dependent beneficiaries.
                                   Individual Losing Coverage
    Any group health plan or issuer who offers coverage in connection with a group health plan,
must allow an eligible employee (but not enrolled) to become covered under the health plan un-
der the following conditions:
         The employee or dependent had coverage under a group health plan at the time cover-
          age was previously offered to the employee or dependent (which can include coverage
          by a spouse’s health plan) and he had therefore declined coverage under his own em-
          ployer’s plan.
         The employee must have stated (in writing) when they declined enrollment that the
          reason for declining the enrollment was that he was covered under another health plan.
          This condition applies only if the plan sponsor or issuer requires such a written state-
          ment.
         The employee’s or dependent’s previous coverage was under COBRA continuation
          provision that had become exhausted or was under some other coverage that had been
          terminated as a result of loss of eligibility for the coverage for a variety of reasons, in-



                                                 38
          cluding divorce, death, termination of employment, reduction in number of hours of
          employment, or because the employer discontinued contributing to such coverage.
         To use the special enrollment period, the employee would have to request enrollment
          no later than 30 days after the date in which his prior coverage was terminated, or in
          the case of COBRA, exhausted.
Dependent Beneficiaries
    The other special enrollment period applies to those who became dependents because of mar-
riage, birth, adoption or placement of adoption. This provision would apply if the group health
plan makes dependent coverage available, and the new dependent’s spouse or parent is a partici-
pant, or eligible and the waiting period has been satisfied, to participate in the plan. The new
dependent must be allowed to enroll as a beneficiary under the plan provided that enrollment has
been sought within 30 days of the ―qualifying event‖ (marriage, adoption, etc.)
    Employees or their spouses who are eligible but who have not previously enrolled in the
plan, may enroll during this special enrollment period and coverage would be effective on the
date of the birth, adoption, or placement for adoption. For marriage situations, coverage is effec-
tive on the first day of the month beginning after the date the request for enrollment is received.
                                   NON-DISCRIMINATION
    Under HIPAA, a group health plan (and an issuer) cannot offer group health coverage with
rules for eligibility for any individual to enroll in the plan, based on health status of the person.
These are considered as discrimination factors, and include health, medical and mental illnesses,
claims experience, receipt of health care, medical history, genetic information, evidence of insu-
rability, and disability. A rather interesting point is that evidence of insurability includes condi-
tions arising out of domestic violence. Also, a group health plan may not fail to re-enroll a par-
ticipant or beneficiary on the basis of these health status factors. Further, plans may not charge
different premiums for enrollees within a group plan based upon these health related factors.
    An employer cannot require rules of eligibility to enroll when such rules discriminate based
on one or more health-status related factors.
     Further, individuals that engage in ―high-risk‖ recreational activities cannot be denied
enrollment or charged different rates than those that do not engage in such activities. However,
HIPAA only addresses enrollment policies and premiums, and does not address benefits under
the plans. Therefore, there is no federal requirement to cover treatments for injuries associated
with high risk activities even if the treatments are covered under the plan. As an example, a plan
may exclude coverage for a broken leg or arm, etc., if such occurs as a result of a high risk ac-
tivity. Further, under a group health plan, while an employer is not required to offer coverage to
a spouse or children, if they do offer family coverage, then the same non-discrimination provi-
sions apply to the wife and children.
                                     PREMIUM AMOUNTS
    HIPAA does not restrict the premium amounts that an employer or insurer can charge and it
expressly permits an employer or group health insurer to offer premium discounts or rebates or
to modify applicable copayments or deductibles for participation in health promotion and disease
prevention programs. Having said that, HIPAA does prohibit a health plan from charging a



                                                 39
higher premium than the premium charged for another similarly situated individual enrolled in
the plan on the basis of a health-related factor, particularly a preexisting condition.
                                        Guaranteed Issue
    Insurers, Health Maintenance Organizations, and other issuers of health insurance that mar-
ket in the small group market must accept any small employer that applies for coverage, regard-
less of the health status or claims history of the employer’s group. ―Small employer‖ is defined
by the Act as one with two to 50 employees, however many states have reforms where groups of
2 to 25, 35 or 50 persons are considered as small groups, with a few states provide for guaranteed
issue for groups of one.
    On the first day of the plan year, the plan has fewer than 2 employees (when two is the min-
imum) who are current employees, then the plan would not be considered as ―guaranteed issue.‖
―Guaranteed issue‖ means that the issuer must accept every eligible individual in the employers’
group who is eligible for participation in the plan and applies for it on a timely basis. The inte-
rim rules consider the guaranteed issue requirement as applying to all products actively marketed
by an insurer in the small group market.
    There are exceptions noted in the Act for network plans that might otherwise exceed capacity
limits or in the event that the employer’s employees do not live, work, or reside in the network
plan’s area.
    Employer groups who have more than 50 employees are not protected by this requirement
(unless required under state law), primarily because traditionally issues of health insurance did
not, as a rule, examine the health status of employees in large groups during the underwriting
phase. HIPAA does require the Secretary of Health and Human Services and the General Ac-
counting Office to report every three years, starting in December 2002, on access to health insur-
ance in the large group market.
                                   Guaranteed Renewability
    If the group requests renewal from the group health issuer, the issuer must renew the group
regardless of the health conditions of the participants or the amount of use of the services. An
issuer has the right to discontinue coverage for non-payment of premium, fraud, or similar rea-
sons not related to health conditions, such as violation of participation or contribution rules.
                             LENGTH OF COBRA COVERAGE
    Regulations are quite specific as to how long the coverage must be provided. It must be pro-
vided from the date of the qualifying event (termination of employment, etc.) until the earliest
date when any of the following events occur:
      The maximum required period of coverage has been exhausted.
      When the employer ceases to provide any group health plan to any employee.
      The date when the coverage is terminated because timely payment of the premium was
       not made.
      The date when the qualified beneficiary first becomes covered (whether as an employee
       or otherwise) under any other plan that provides health care that does not contain any
       exclusion or limitation because of a pre-existing condition, except in certain specific sit-
       uation.


                                                40
      The date when the qualified beneficiary—who is other than a retired covered employee
       or spouse, surviving spouse, or dependent child of the employee—first becomes entitled
       to Medicare benefits.
      When a qualified benefits who has been disabled at any time during the first 60 days of
       continuation coverage, the month that begins more than 30 days after the date when So-
       cial Security has determined that he is no longer disabled.
    The maximum required period of COBRA coverage is 36 months from the date of the quali-
fying event.81
   When the qualifying event is the employment termination—other than for gross miscon-
duct—of the reduction of the hours of employment, the maximum required period of coverage is
usually 18 months from the date of termination or reduction of hours. But, if another qualifying
event (except for bankruptcy proceedings) following the termination/reduction occurs, the max-
imum required period is extended to 36 months from the date of termination/reduction.82

                                           Disability
    If a qualified beneficiary is determined to have been disabled under the Social Security Act,
at any time during the first 60 days of continuation coverage, the 18-month coverage period is
extended to 29 months, provided the beneficiary has provided the plan administrator with proper
notice of the determination of disability within 60 days of such determination. The beneficiary
must provides the plan administrator with notice within 30 days of determination that he is no
longer disabled.83

                                    Employer Bankruptcy
    The bankruptcy of the employer is the only qualifying event that may extend the maximum
required period to more than 36 months. If the qualifying event is a bankruptcy proceeding and
the covered employee is alive when the proceedings started, then the maximum required period
is extended until the death of the covered employee, and for the spouse, 36 months after his
death. If the covered employee dies before the bankruptcy proceeding, the maximum required
period is extended until the surviving spouse's death.84


                           PREEXISTING MEDICAL CONDITION
    During this 6-month period, a plan may exclude or restrict coverage of a participant’s or be-
neficiary’s preexisting medical condition, but under the Act a group health plan is prohibited
from imposing more than a 12-month preexisting condition limitation period—18 months for late
enrollees—on an eligible participant or beneficiary (see below). (Note: Under HIPAA those in-
dividuals who have individual coverage also have portability protection, but the conditions and
requirement are more complex.)
    HIPAA defines a preexisting condition exclusion as a "limitation or exclusion of benefits re-
lating to a condition based on the fact that the condition was present before the date of enroll-
ment for such coverage, whether or not any medical advice, diagnosis, care or treatment was rec-
ommended or received before such date."85




                                               41
    A group health plan may impose a pre-existing condition exclusion on a participant or bene-
ficiary only under three situations:86
       1) the "six-month look-back" rule, where the exclusion relates to a physical or mental
          condition and regardless of the cause, and for which medial advice, diagnosis, care or
          treatment was either recommended or received within the six months prior to the
          enrollment date;
       2) the pre-existing exclusion extends for no more than12 months after the enrollment
          date or 18 months for a late enrollee (the look-forward rule); or
       3) the exclusion period is reduced by the length of the aggregate of the periods of credit-
          able coverage applicable to the participant or beneficiary as of the enrollment date.
    A group health plan is prohibited from imposing a pre-existing condition exclusion relating
to pregnancy.87

                              Hurricane Katrina Exceptions
    The Dept. of Labor and the IRS have directed employers and employees to waive the dead-
lines under HIPAA for employers and employees in the disaster area, and plan and participants
must disregard the period between Aug. 29, 2005 and Feb. 28, 2006 in calculating any deadlines
under HIPAA.

                     Pre-existing Exclusions for New Dependants
    A preexisting medical condition limit or exclusion may not be imposed on covered benefits
for newborns that are covered under creditable coverage, within 30 days of birth.
    A preexisting medial condition limit or exclusion may not be imposed on covered benefits
for newly adopted children, or children newly placed for adoption if the child becomes covered
under creditable coverage within 30 day of the adoption or placement.
           EMPLOYMENT TERMINATED FOR "GROSS MISCONDUCT "
   If a covered employee is terminated from his employment because of "gross misconduct," no
COBRA continuation coverage is available to him or his qualified beneficiaries.88 If the em-
ployer fails to notify the employee that he is being terminated because of gross misconduct, the
employer may be in a situation where it cannot deny COBRA coverage to the terminated em-
ployee.
    Just because an employer may have grounds to terminate an employee for gross misconduct
does not, in itself, allow a denial of COBRA coverage if the employee voluntarily resigns in or-
der to keep from being fired. Also, an allegation of gross misconduct after a voluntary termina-
tion, cannot be used to evade liability where the employer has not properly processed a COBRA
election and the insurer refuses, therefore, to extend coverage. Interestingly, courts have ruled
that it is not sufficient just for the employer to believe that the employee had engaged in gross
misconduct, but COBRA requires more than a good faith belief by the employer, and the em-
ployee should have been given the right to demonstrate that the employer was mistaken and
therefore, obtain her COBRA rights.89




                                               42
    Gross misconduct is not defined in the statute or in regulations, and the IRS will not issue
rulings on whether an action constitutes gross misconduct for COBRA purpose, effectively leav-
ing it up to the courts to determine through case law.
   As a matter of interest, some of the court decisions indicate the leanings of the courts in this
matter:
      A breach of a company confidence did not constitute "gross misconduct."90
      Mere incompetence is not gross misconduct.91
      An employee did not engage is gross misconduct by falsifying mileage reports, failing to
       attend mandatory meetings, and receiving an unsolicited offer of employment.92
      An employee who admitted stealing the employer's merchandise was considered to have
       been terminated for gross misconduct and was therefore, not entitle to COBRA bene-
       fits.93
      Cash handling irregularities, invoice irregularities, and failure to improve the perfor-
       mance of one of defendant's stores was held to be gross misconduct.94
      In a case where the court concluded that Congress had left the definition of gross mis-
       conduct up to the individual employer (?) two employees who had been terminated for
       refusing to comply with the directions of a supervisor were considered to have been ter-
       minated for gross misconduct.95
      A bank employee who cashed a fellow employee's check, knowing there were insuffi-
       cient funds to satisfy it, and held the check in her cash drawer until the check could be
       covered, was held to have been terminated for gross misconduct.96
      Sometimes the conduct was obviously egregious. Where a security guard deserted his
       post and was found asleep at his residence and he falsified records, creating a fictional
       guard in order to collect another paycheck, was terminated for gross misconduct.97 Also,
       throwing an apple at a co-worker and uttering racial slurs was found to be gross miscon-
       duct.98
      It is also interesting to note that gross misconduct does not need to occur on the job as
       off-duty behavior can also eliminate an employee's right to COBRA coverage. Gross
       misconduct was found when an employee assaulted a subordinate—with whom he had a
       romantic relationship—while at the workplace. Having an accident while driving a ve-
       hicle under the influence of alcohol and while on company business constituted gross
       misconduct for COBRA purposes—although this was only a misdemeanor under the
       state law.99


                            FEDERALLY MANDATED BENEFITS
    In the original Act, HIPAA did not require an employer or issuer of group health insurance to
offer specific benefits, however on two occasions since HIPAA was passed, Congress added
mandated specific benefits, but only for plans that cover certain coverages. (Discussion of State
vs. Federal regulation of insurance is beyond the scope of this text, however does the mandating
of two benefits remind one of the adage of the camel getting its nose under the tent?)



                                                 43
    Health plans may limit the treatment of mental illnesses by covering fewer hospital days and
outpatient office visits, and they can increase cost sharing for mental health care by raising de-
ductibles and copayments. At least 23 (at last count) states have since passed laws that require
health plans to impose the same treatment limitations and financial requirements on their mental
coverage, as they do on medical and surgical coverage. Other states have enacted laws that re-
quire health plans to provide some specified mental health benefits, but not fully the same as for
medical and surgical coverage. Self-insured employers are exempt from state regulation under
ERISA and are, therefore, immune from these state laws.
    Congress in 1996, passed the Mental Health Parity Act (MHPA) which amends ERISA and
the Public Health Service Act by establishing new federal standards for mental health coverage
offered by employer-sponsored plans, and shortly thereafter, the IRS established identical provi-
sions. The MHPA is rather limited and does not require insurers to provide full-parity coverage.
    For group plans that elect to provide mental health benefits, MHPA requires parity only for
annual and lifetime dollar limits of coverage, but the plans are allowed to have more restrictive
treatment limitations and cost-sharing requirements on their mental health coverage. Employers
with 50 or fewer employers are exempt from the law. Also, employers that can show an increase
in claims costs of at least 1% as a result of MHPA, can claim an exemption.
    In 2003, Congress attempted to pass legislation that would amend and expand MHPA by re-
quiring plans that choose to offer mental health benefits to provide full-parity coverage, howev-
er, lawmakers only reauthorized MHPA through Dec. 31, 2002. There have been attempts by
the Bush administration (S.543) that would provide for full parity, but it has been opposed by
employers and health insurance organizations because of concerns that it would drive up health
costs.
                       Newborns’ and Mothers’ Health Protection Act
    The Newborns’ and Mothers’ Health Protection Act was also passed which prohibits group
health plans and issuers offering group coverage from restricting the hospital length of stay for
childbirth for either the mother or newborn child to less than 48 hours for normal deliveries and
to less than 96 hours for caesarian deliveries.
                       Women’s Health and Cancer Rights Act of 1998
    This Act was enacted in 1998 and requires group plans and health insurance issuers provid-
ing coverage in connection with a group plan that provides medical and surgical benefits related
to mastectomy to cover breast reconstruction procedures. It contains a requirement requiring be-
neficiaries to be notified of available coverage for prostheses and treatment of physical compli-
cations of reconstructive procedures.
                            Excluding Coverage for Specific Risks
    Interestingly, federal law does not prohibit employers from excluding treatment of specific
illnesses or conditions from their health benefit plan. However, there are a number of things that
restrict an employer from excluding specific illnesses from coverage. Most states have laws that
require that specific benefits or coverages must be included in insured plans. Also, employers
that purchase insurance products have little or no discretion in choosing or excluding specific
types of services or procedures. The reason for this is that many insurance companies and
HMOs have certain standard plans available that do not various much from one employer to
another. Self-funded plans are under the umbrella of ERISA that prevents state laws from apply-


                                                44
ing and benefits are crafted by each individual employer plan. Therefore only the few require-
ments of HIPAA and subsequent amendments require specific coverage on these self-funded
plans.
                          Association-Sponsored Group Health Plans
    Association plans must also comply with the requirements of HIPAA that relate to group
health coverage. As an example, a sponsor of an association plan cannot drop a group from cov-
erage because of the use or overuse of medical services by its members. The preexisting condi-
tion limitations, creditable coverage and renewability requirements apply except in a few limited
situations. However, HIPAA does not require an association plan to accept for coverage indi-
viduals who are NOT members of the association.
                                       State Requirements
    States are allowed to impose their own requirements but HIPAA requires that state laws do
not prevent the application of its consumer protection provisions. On the other hand, state laws
that regulate rating of risks are exempt from HIPAA. The Act’s provisions relating to portability
override state laws. Exceptions are specific types of state laws that provide for greater portabili-
ty such as state laws that
        define a preexisting medical condition to be one that existed for less than six months
         prior to becoming covered (instead of the 6 months required under the Act),
        provide for preexisting medical condition limitation periods shorter than 12 (or 18)
         months in the Act, and
        allow for breaks in continuous coverage longer than the 62-day period specified under
         the Act.
     An example of a state law overriding HIPAA would be where the state mandates a 6-month
preexisting condition limitation on enrollees, instead of the 12-month HIPAA limit. Conversely,
if the state mandated a 14 month (or period more than 12 months) preexisting condition limita-
tion, this would be overridden by the requirement of the Act.
                                       STUDY QUESTIONS
1. The two principal areas of insurance reform addresses by HIPAA are
   A. life and health insurance.
   B. life and accident insurance.
   C. group health insurance and long-term care insurance.
   D. life and property/casualty insurance.

2. COBRA requires businesses to offer continued group health insurance coverage to employees
   and their dependents after certain events, and this pertains to
   A. only eleemosynary institutions.
   B. any size of business.
   C. businesses with 20 or more employees.
   D. businesses with 100 or more employees.




                                                45
3. Under COBRA, any insured or self-funded group health plan maintained by an employer to
   provide health care to the employer's employees, former employees or their family, must of-
   fer
   A. COBRA continuation coverage.
   B. coverage that approximates some of the better features of the original group health plan.
   C. coverage that costs as much or less than the original group health plan.
   D. an equivalent plan but the employer must pay the full premium.

4. COBRA continuation coverage may require the qualified beneficiary to pay a premium for
   the coverage, but
   A. the premium can be any amount that the insurance company wants to charge.
   B. premiums must be paid by certified check or by bank draft.
   C. the premium must be no more than 50% of the employee's contributions under the
       employer's plan.
   D. the premium cannot exceed a percentage of the applicable premium.

5. COBRA continuation coverage
   A. must be contingent upon the good health of the employee.
   B. cannot be conditioned upon evidence of insurability.
   C. premiums must be paid on an annual basis.
   D. must be written by another insurer if the original plan is an insured plan.

6. HIPAA requires that group health plans offered to an employment-based group that are cov-
   ered by the Act
   A. meet certain portability requirements.
   B. have ample termination provisions so that an ex-employee may not extend the health plan
       after they have terminated from the employer.
   C. be self-funded.
   D. must be 100% funded by the employer.

7. If there is a period of 63 consecutive days during which individuals have no creditable cover-
    age, they may be subject to
    A. an additional 50% of the deductible amount.
    B. they cannot participate in continuation of coverage under any circumstances.
    C. paying the back premium at 10% interest to continue total coverage from date of
        separation.
    D. as much as a 12 month preexisting condition exclusion period (18 month to late
        enrollees).

8. The waiting period that an employee or his family member must endure to become covered
   under a health plan,
   A. must run concurrently with any preexisting condition limitation period.
   B. has no relationship to the preexisting condition limitation.
   C. is no more than 63 days.
   D. is a uniform 6 months in all states.




                                                46
9. Under HIPAA, a group health plan cannot offer group health coverage with rules for eligibili-
   ty for any individual to enroll in the plan
   A. based upon the health status of the person.
   B. based upon their geographical location, including being in foreign countries.
   C. unless the individual is paying the entire premium.
   D. but those engaged in high-risk recreational activities must cover the same identical risks
       as those who do not so engage.

10. "…a limitation or exclusion of benefits relating to a condition based on the fact that the con-
    dition was present before the date of enrollment for such coverage, whether or not any medi-
    cal advice, diagnosis, care or treatment was recommended or received before such date" is
    A. a definition of preexisting condition under HIPAA COBRA reuirements.
    B. medical qualifications for an employer-provided medical reimbursement plan.
    C. the provision that disqualifies a plan for a defined benefit employee benefit plan.
    D. required wording in all group health plans marketed in the United States.

ANSWERS TO STUDY QUESTIONS
1C   2C   3A   4D   5B   6A   7D   8A   9A   10A




                                                   47
CHAPTER FOUR -LONG-TERM CARE INSURANCE & GROUP
               HEALTH INSURANCE
         QUALIFIED LONG-TERM CARE INSURANCE CONTRACT
    In today's market, the vast majority of Long-Term Care Insurance (LTCI) policies are tax
qualified. Those policies issued after 1996 technically meet the definition of a qualified LTCI
policy if the only insurance protection provided under the policy is coverage of long-term care
services, the policy does not cover expenses incurred for services that could be reimbursed under
the Social Security Act, the policy is guaranteed renewable, it does not provide for a cash sur-
render value or other money that can be paid, assigned or pledged as collateral for a loan or bor-
rowed, and all premium refunds and dividends under the policy are to be applied as a reduction
in future premiums or to increase future benefits (except for death of insured or complete sur-
render or cancellation).100
  In addition, there are other consumer protection provisions concerning modal regulation and
model act provisions, disclosure and nonforfeitability.
    In practice, there are several other factors that determine whether a policy is "qualified" or
non-qualified, and there are advantages to both. Basically, the principal difference is whether
long-term care benefits are taxed. This rather important point was never directly addressed by
the IRS until HIPAA provided guidelines for an LTCI policy to become "qualified" and thereby
benefits would not be taxed to the policyholder. Interestingly, there never had been an instance
of the benefits being taxed prior to the legislation, and even after HIPAA there have been no in-
stances of benefits being taxed on "non-qualified" plans. Hard to imagine the IRS going after
some widow with Alzheimer's in a nursing home having their LTCI benefits being taxed!
   Further information as to what constitutes a "Qualified" LTCI policy is available from the
IRS at Internal Revenue Code 7702.

                                     Cafeteria Plan LTCI
   Any product that is advertised, marketed or offered as long-term care insurance is NOT a
qualified benefit under a Cafeteria Plan.101
    However, LTCI premiums can be paid through a Health Savings Account (HSA) included in
a cafeteria plan.

                              Flexible Spending Arrangements
    Employer-provided coverage for qualified long-term care services provided through a flexi-
ble spending arrangement (FSA) is includable in the employee's gross income.102

                                             COBRA
   COBRA continuation coverage does not apply to plans under which substantially all of the
coverage is for long-term care services.103 This is another result of HIPAA.




                                                48
                              Tax on Qualified LTCI Premiums
    As a general rule, amounts paid for any qualified LTCI policy or for qualified long-term care
services are included in the definition of "medical care" and are, therefore, eligible for income
tax deduction subject to some limitations. Amounts paid for the medical care of a taxpayer, his
spouse or dependent are deductible subject to the 7.5% of adjusted gross income.104
    The deduction for eligible long-term care premiums paid during any taxable year for a quali-
fied LTCI policy is subject to an additional dollar amount limitation that increases with the age
of the insured individual (which is indexed). These tables can be found in IRC 213(d)(10).

                                LTCI Employer-Paid Premiums
    Thanks to HIPAA '96, which, among other things, decided that Long Term Care Insurance is
health insurance and must be treated as such. Any plan of an employer that provides coverage
under a qualified LTCI contract is treated as accident and health insurance and therefore, pre-
miums paid for long-term care coverage by an employer are not includable in the gross incomes
of employees.105
   Further, an employer may usually deduct health insurance premiums paid for employees as a
business expense, so, now, premiums for a qualified LTCI policy paid by an employer for em-
ployees are deductible.

                                      Taxation of Benefits
    Again thanks to HIPAA, amounts (other than dividends) received under a qualified LTCI
policy are treated as amounts received for personal injuries and sickness and are treated as reim-
bursement for expenses actually incurred for medical care. Amounts received for personal inju-
ries and sickness are generally not includable in gross income.106
    There is a limit on the amount of qualified long-term care benefits that may be excluded from
income—if the total periodic payments received under all qualified LTCI contracts and any peri-
odic payments received as an accelerated death benefit exceed a per diem limitation, the excess
must be included in income, unless the insured is terminally ill when such a payment is received,
in which case the payment would be ignored.
    The per diem excess is an amount that is the greater of $250 per day (2006 - adjusted annual-
ly for inflation) or the costs incurred for qualified long-term care service provided for the insured
over the total payments received as a reimbursement for qualified long-term care services for the
insured.107

                       Non-Qualified Long Term Care Insurance
    Policies that do not meet the definition of a qualified LTCI contract under IRC Sec 7702B(b)
are considered as "non-qualified" LTCI policies. The Internal Revenue Code does not address
the income taxation of premiums paid or benefits received from these policies. However, since
Congress enacted favorable income tax treatment for qualified LTCI policies, that would lead
one to believe that nonqualified plans will not receive such favorable taxation. Also, there is a
grandfather provision which "qualifies" all LTCI policies issued before January 1, 1997.




                                                 49
                   GROUP HEALTH INSURANCE MARKETING
    Groups insurance basically is nothing more than a method of marketing insurance and similar
products, although in some ways the product itself differs from the individual plans. Group mar-
keting must be addressed by itself if for no other reason than the developments in the product,
tax incentives and, ergo, marketing techniques.
                                              Agents
    Agents are the mechanism that sells the group health products, just like in individual health
sales, however there are some differences. Agents that market group health insurance are often
licensed to sell individual health insurance and many do sell both individual and group. Howev-
er, group requires more than simple product knowledge, so it is more common for agents to be
employees of the insurer or for more than one agent to share in the commission. Agents who
work for one company or who are employed by the insurer, are usually provided with office
space, clerical and backup services, training and fringe benefits.
    Some insurers are too small to have their own group representatives, so they designate all
sales and services responsibilities to contracted agents and brokers.
    Some insurers do not use agents or brokers and only approach prospective policyholders
through their salaried employees—such companies are known as direct writers.
                                             Brokers
    Technically, brokers are independent salespersons, although usually the agent is thought of as
representing the insurer and the broker represents the purchaser. In actual practice, however, this
relationship is more complex. Sometimes a broker will recommend, advise and assist employers
in purchasing the best coverage for their particular situation, they can sometimes receive fees
from employers for their service. But, if an agent sells an insurance plan to an employer, he is
then acting as a representative of the insurer and receives compensation—as an agent.
    A group broker may act as a Third Party Administrator (TPA) —a firm that is neither the in-
surer nor policyholder of a group insurance plan but who takes responsibility for the administra-
tion of that plan. This is generally used in self-insured plans.
                                 Employee Benefit Consultants
    Employee Benefit Consultants are individuals or firms that specialize in group benefits for
employees. They act like brokers inasmuch as they advise employees in finding the right group
coverage and they receive a fee from the employer. The difference is that in most cases, a broker
assists his client in purchasing a group policy, but the consultants focus on making recommenda-
tions to the employer upon which the employer then takes action. Actually, the difference be-
tween brokers and employee benefit consults get rather hazy at times.
                                     Group Representatives
    Basically, group representatives are employees of the insurer that are responsible for the
marketing and servicing of group insurance. In some companies, group representatives are re-
sponsible for sales and group service representatives are responsible for providing service to the
clients.




                                                50
                                   THE SALES PROCESS
    The actual process of marketing group health insurance consists of several steps which may
be taken individually, or combined with other steps, depending upon the situation.
                                            Prospecting
    As with any type of sales, before something can be sold, there must be someone to purchase
the product. This is regarded by many as a special science and is usually done by agents and
brokers (although there are many ―lists‖ of prospects that are sold to marketers). Except for
large groups, group representatives will often do their own prospecting, but generally, at this
stage, they are involved in informing agents and brokers about their programs, motivating them
to sell them, and providing support when needed.
    Sometimes, not often, an employer may issue a request for proposals (RFP) which notifies
insurers that they are seeking coverage and invites them to propose a plan. The RFP is usually
issued by large employers’ benefits section. At this point, it is more of an actuarial contest as
generally for the large employer, there is flexibility in benefits not available to the small or me-
dium size group.
                                              Proposal
    Once an employer becomes a ―prospect,‖ and the necessary information obtained, the first
decision of importance at this point is whether to proceed to the next step—designing a health
insurance plan that meets the needs of the prospect and then packaging the plan into a proposal
to be presented to the prospect. This is the decision of the home office of the insurer in most
cases, although the recommendation of the group representative is very important as the group
representative is the one that must make the determination that the proposal meets the expecta-
tions of the prospect, whether the prospect meets the standards of the insurer’s underwriting
standards, and whether there is a good chance of making the sale (or not).
     If the decision is made to make the presentation, then the plan is designed—usually with the
involvement of the group representative and the home office personnel (underwriting and actuar-
ial primarily). They must evaluate the needs of the prospect, design a plan to meet those needs,
underwrite the plan, and determine the appropriate premium. Obviously, more detailed informa-
tion from the prospect is necessary at this time, such as claims and premium experience of the
prospect, particular hazards present, the objectives of the prospect, and their financial condition.
If the employer is unionized, any collective bargaining agreements affecting the coverage is use-
ful, if not necessary.
    The completed proposal is comprised of a description of each coverage in the plan and the
premiums for each coverage, plus information on the insurer (financial strengths and accom-
plishments, and a list of well-known group policyholders [if any]). For the large group, a cost
illustration must show what part of the premium is used to pay benefits and expenses, and how
much can be returned to the policyholder in the way of an experience refund—not presented to
smaller groups as they usually are not eligible for experience refunds.
                                            Presentation
   The proposal presentation may be made by an individual agent or broker, by the agent and
broker, by the agent and group representative, or by the group representative. Often the proposal
must be submitted to the prospect’s broker or consultant, whose job it is to then analyze the pro-


                                                 51
posals submitted by several insurers and make recommendation to the prospect. As a general
rule, group representatives of the insurer are allowed to participate only by small brokerage firms
   Often, there will be changes in the proposal to meet the requirements or expectations of the
prospect and/or the insurer. When the prospect evaluates the proposal and the reputation and ca-
pabilities of the insurer, and agrees with the proposal, then the sale is made.
                                       Employee Enrollment
    The next step after the acceptance of the proposal by the employer is the enrollment of the
employees. If the participation is optional—the employees have the option of contributing to the
premiums and receiving coverage, or not participating—enrollment is required in order to deter-
mine whether a sufficient number of employees will participate under the participation require-
ments of the plan. However, even if the employees do not have this option, enrollment is neces-
sary for adequate administration and records.
    When an insurer takes over an existing plan provided by another insurer, employees will of-
ten be already enrolled, however often it is still necessary to re-enroll employees. If a new cov-
erage—such as dental or vision coverage—is added, or if the employee contribution is increased
which then gives the employee the option of whether they want to continue, then enrollment is
necessary. Even if there is no particular reason for re-enrollment, some insurers will want to re-
enroll anyway so that the employees will be aware of the plan and to introduce themselves as the
new insurer.
    Regardless, the new insurer will provide information about the new plans, either in the form
of letter(s) or pamphlet. If enrollment is going to be required, the active support of the employ-
er’s personnel is necessary for the insurer to be provided with all of the enrollment cards.
                                        Installation of Group
    After the enrollment process has been completed, the insurer’s group representative sends the
policyholder’s signed application, the employee enrollment cards, and the first month’s premium
to the insurer or field office, for the final acceptance. It is possible at this time that the sale might
―fall through‖ as there may not be an acceptable participation of employees or for some other
reason. Otherwise, the insurer then issues the group policy and the group representative (usually
in the company of the agent or broker) reviews all administrative aspects of the plan with the po-
licyholder, such as premium billing and accounting, claims procedures and benefits. Administra-
tive procedures are established and then the plan goes into effect and is installed.
                                       Servicing of the Group
    The group representative (or service representative) make periodic services calls on the poli-
cyholder to assist in the proper administration of the plan. Usually, a check-off list is completed
that reviews administrative practices and then administrative procedures are established. The
agent is often given responsibility for providing administrative assistance and other necessary
services to small and medium-sized groups.
                                 Group Sales Attractive to Agents
    As a passing thought, group sales are attractive to many agents for a variety of reasons.




                                                   52
    For instance, an agent who sells group insurance makes contacts with prospects for other
business or individual insurance. An agent who services the account that he has sold has oppor-
tunities to market other insurance products, even, in some instance, property and casualty insur-
ance product (by obtaining proper licensing for these products) or working with others who have
the P&C expertise.
    Conversely, there are agents already marketing other products to business clients who now
have the opportunity to add group health and a complete line of products and service. An exam-
ple would be an agent who markets payroll deduction plans (perhaps cafeteria type plans), such
as dread disease policies, short term disability, etc., and can become familiar with the employees
and employer, and may have an opportunity to ―look at‖ or review their group benefits overall, in
particular their group health insurance plan. There have been situations where an agent was able
to convince the client that the agent should become the ―agent-of-record‖ for the company, the-
reby eliminating (for the employer client) the need to be ―bothered‖ by all of the insurers who
are trying to sell him a variety of products, and, in effect, having a unpaid consultant working for
the employer making suggestions and analyzing risk problems. If handled right and professio-
nally, the agent-of-record situation can be beneficial for both the agent/broker and the employer.
    And, of particular interest to those agents who are married, selling group insurance is mostly
a daytime, 9-to-5 type of position, as opposed to agents who sell individual insurance as they
must sell when the individuals are at home, including weekends and holidays.
                                   GROUP UNDERWRITING
    Underwriting is the process of examining, accepting, or rejecting insurance risks and classi-
fying those selected, in order to charge the proper premium for each. Underwriting for group
health insurance is dissimilar to individual health insurance underwriting except for some medi-
cal information areas as discussed. In all cases, the information that is used for underwriting in
the home office is broadly applicable to the underwriting often performed by agents and field
sales personnel. The following discussion addresses medical expense and disability income in-
surance, but the same principles apply for all health insurance coverages.
                                        Predicting Claims
    Underwriting is the process of determining whether to offer coverage and on what terms.
And (as suspected by some agents) the first step is to try to determine if there is any reason that
the insurer should NOT offer coverage. Past that, they must determine what terms are necessary
in order to accept the risk—―terms‖ meaning the benefits to be provided, the premiums that are
charged, and the overall provisions of the contract.
    In actual practice, as opposed to individual health insurance, the group underwriter focuses
mostly on the terms as in most cases, an offer has been made. The underwriter must devise a
policy that has sufficient benefits for the benefit of the prospect, with benefits, premiums and
other provisions so that the insurer will make a reasonable profit. In order to make such an offer,
the underwriter must have fully considered the risks that will be taken and what the level of
claims can be expected. Therefore, it is fair to say that the very heart of underwriting is the pre-
diction of claims.
    In group health insurance, it is nearly impossible for a plan to be in force without having
claims, therefore the fact that there will be claims is a ―given,‖ so the determination must be as to
how many and in what amounts the claims will occur. The underwriter then determines what the


                                                 53
premiums must be to cover such claims experience and make a profit, and the benefit provisions
included in the policy so that the claims do not go above the predicted level.
    Claims prediction is simply predicting with a fair degree of accuracy, the incidence of illness
in a group by looking at past experience and projecting it forward. Therefore, past experience is
the most critical piece of information needed by an underwriter. If the underwriter is looking at a
300-person group and they can find groups of the approximate size, operating in a business quite
similar to the prospect, with a comparable mix of male & female, with similar payrolls, they will
have a good indication as to how the prospect’s claims experience will perform.
    It may be noted that the underwriter does not factor in solely the experience of groups of ap-
proximately the same size, but they take into consideration many other factors. For example, if
the prospect business has a younger average age than like groups, health claims experience
should be better, however if the younger group were heavily female, then there could be more
maternity benefits paid. If the company was more sedentary, such as technical persons—
accountant, computer technicians, data entry staff, etc.—than a similar sized group that was en-
gaged in construction, for instance, then better health claims experience could be expected. The
disparities between groups can cause all kinds of detailed exploration in the search for compara-
ble experience.
   In the majority of cases, however, actual claims experience is available and the group is not
seeking insurance for the first time. Therefore, the underwriter can analyze claims experience
and project that forward under the assumption that the past experience will be repeated.
                                        Adverse Selection
     Adverse selection is the ―grinch‖ in group health insurance underwriting (and other types of
underwriting also). If, for example, the eligible members have the option of having coverage and
paying premiums, or declining the coverage, the members who elect for coverage are more likely
to become ill than those that decline coverage because those that accept coverage are older
and/or in poorer physical condition than the average employee in the group. This can go even
further if the premiums paid by the employee are increased because of the claims experience of
the group, in which case the number of non-participants will increase, leaving a smaller number
of employees covered and those that are covered are, in all likelihood, expecting to use the bene-
fits in the near future.
    If the expected claims are based upon the statistical average, adverse selection can destroy
the assumptions upon which premiums were based. This is a major responsibility of underwri-
ters—to avoid adverse selection.
                                       Statistical Averages
   If a group is newly formed and has no claims experience, then statistical averages must be
used. Actual experience, as indicated before, is always a more accurate predictor than statistical
averages. Conversely, if the body of experience is rather large, then the statistical averages could
be more predictive as experience would be based upon a much larger base of insureds.
    For small groups the actual claims experience of the group may be useful, but since it is such
a small sample, it would not be as accurate a predictor as the average experience of many similar
groups. As an example, if the group is 10 lives, it would not be at all unusual for the group to go
for a year without any person having a serious illness. Conversely, it would not be unusual for
any one person to have very expensive medical treatments and care. If in one year the expe-


                                                54
rience was very low, and the next year very high, in both cases experience could be changed by
the health condition of only one person. For large groups the claims experience is usually rough-
ly the same for every year and the experience can be used to project claims data for each year.
    For small groups insurers may combine the experience of many small groups to establish an
experience pool and claims projections are derived from such a pool. This allows the underwri-
ters for the small group to have one of the advantages of large-group underwriters; that of the
ability to base claims projections on a large body of actual claims experience.
    Claims projections for large groups are, therefore, more accurate, but that does not necessari-
ly guarantee a profit. An inaccurate claims projection for a large group would have a greater im-
pact on the insurer’s profit, than inaccuracy in projecting claims experience on small groups. For
a small group, a 20% higher-than-projected claim ratio would not be the disaster that a 20%
higher claims ratio would be for a large group with a million-dollar annual premium.
                                         Premium Rates
    Premium construction is similar to projecting claims by the use of averages for small groups,
which are derived from rating manuals that have been compiled by rating organizations or actu-
arial firms. Often standard rates for small groups are used, with adjustments (usually annually)
for actual claims experience.
                              Competitive Benefits and Premiums
    Nearly always, the demon of competition arises, particularly if the group is large and the
premiums are substantial. The underwriter must get sufficient premium to make a profit, but at
the same time, they must be competitive with other insurers who would just love to have the
business. The balancing act is very difficult for an underwriter and at times, an insurer will just
―fly in the face of experience‖ and become competitive so as not to lose market share.
    While this competitiveness can reduce the profit on a group, from the viewpoint of the poli-
cyholders, it is a good thing as terms are more favorable if the insurer is more competitive.
There have been instances (and there will probably always be instances) where an insurer will
write a large group on a low-profit or even, no-profit, basis, in order to keep the volume of insur-
ance in force higher (helping the value of the company stock usually). In many large groups,
there is an experience refund whereby the policyholder will share in the profits on the group.
                               Adverse Selection in Small Groups
    Adverse selection was discussed earlier in the context of large groups, but it is of considera-
ble concern for small groups. An example which has been the situation in many small group
cases, is where a small business owner does not have a group health program for his employees.
One of his family members becomes seriously ill and will require expensive treatment. The em-
ployer then gets group coverage for his employees and offers family coverage so his family
members will be covered. In a large group, the experience of a single individual does not have
much of an impact on claims experience, but in a small group there are not so many persons that
can balance the experience of one individual and one such expensive claim can create a signifi-
cant increase in claims.
    Many insurers have addressed the problem of adverse selection in small groups by excluding
preexisting conditions or by requiring evidence of insurability from the individual in the group
and sometime from covered family members also. However, as discussed earlier, HIPAA and


                                                 55
state laws limit the use of preexisting condition exclusions and prohibit the exclusion of individ-
ual employees because of health conditions.
                              SMALL GROUP REGULATIONS
    HIPAA and the small group market reforms that have been enacted by many states in the ear-
ly 1990s require that insurers that write small group health insurance plans must accept any small
group that applies and that is eligible under the law. Therefore, under these laws, the underwrit-
ing function of deciding whether or not to accept a group for coverage has been eliminated since
the insurer does not have a choice. So, in these situations, underwriting includes only ascertain-
ing whether the group is eligible and determining the terms that will be offered.
    Since the insurer is required to accept those in poor health insured in a group health insurance
plan, obviously the claims experience is going to be much higher that it would have been if there
were more flexibility in accepting those in poor health. Since the claims experience is going to
be higher, the premiums are going to be higher also. A person who had been a member of a
large group and who had participated in the premiums, then goes to a smaller company where
they discover that their premium was much higher, may have a hard time understanding why it is
more expensive in a small group—especially since they, personally, have never had a large
health claim. Because of these regulations, in some cases individual health insurance can be less
expensive than the individual’s share of the group premium. However, the employer usually
pays part of the group health premium so the higher cost to the employee is usually not that sub-
stantial.
   Nothing to do with ―regulation‖ per se, but it should be pointed out that small groups have a
higher administrative expense than large groups, therefore insurers usually try to keep the ex-
penses under control by offering simple plans with limited benefit provisions.
                                      “TURNED DOWN”
    Although regulations usually prohibit an insurer from refusing coverage to a small group,
there still are situations where an underwriter will recommend that the insurer not offer coverage.
Note that although regulations may prohibit an insurer from refusing coverage to a small group,
there usually is no restriction as to the premiums that may be charged for the coverage and in
some cases, a high premium may be tantamount to declining to offer coverage. The reasons for
not wanting or accepting a group can be found in the following four reasons:
(1) Low Participation
   If only a small percentage of eligible employees enroll in a plan, the enrolled group will have
a much higher number of those with health problems—adverse selection.
(2) Fictitious Groups
    A ―fictitious group‖ is a group that is formed for the purposes of obtaining insurance for its
members. Underwriting statistics are based upon the assumption that any group considered for
coverage is a random sampling of persons, therefore the group contains a mixture of healthy and
unhealthy people. If a group is formed for other reasons—such as a common employer—this is
the situation. Conversely, if the group is formed just to get insurance, the group will consist of
many persons who have a much higher probability of incurring medical expenses. Adverse se-
lection again.



                                                56
    Imagine the situation where insurers must accept a group, whether they were formed for in-
surance purposes only or for other reasons. Associations of persons with certain medical condi-
tions, such as multiple sclerosis, muscular dystrophy, leukemia, etc., would form groups just so
their medical care could be shared with the insurers. Soon there would be no such thing as group
health insurance (or health insurance companies).
(3) Administration Difficulties
    If a policyholder does not perform the required administrative duties on a timely basis, such
as enrolling employees late or does not keep adequate records of terminations, the insurer can
have frequent and expensive difficulties. If the history of the group, or if because of other in-
formation, indications are that the policyholder cannot perform the required administration, the
underwriter may recommend that coverage be denied.
(4) Persistency
    Insurance companies rely heavily upon proper persistency for profitability. Persistency is the
length of time that an insured risk stays with the insurer. It must be remembered that an insurer
incurs considerable first-year expenses when a group (or an individual, for that matter) is first
insured because of first-year commissions, other sales expenses and administrative (including
underwriting) expenses. The premium for the risk is based upon persistency assumptions that
the risk will remain with the insurer for a length of time whereby the insurer can recoup its high
early year expenses. For most group health insurance plans, a minimum of three years is neces-
sary.
    If the group does not stay with an insurer for a reasonable period of time, then an underwriter
would recommend that the group not be accepted because of poor persistency history. Frequent-
ly a newly-formed business may have difficulties in obtaining insurance if their financial basis is
not strong or if their particular type of business does not stay in business very long, historically.
This is one of the reasons that underwriters usually ask for detailed financial information.
                            PROJECTING CLAIMS EXPERIENCE
    As previously explained, premiums depend upon projected claims experiences, and for small
and medium-sized groups, they are based upon standard averages adjusted for the general cha-
racteristics of the group. The characteristics that are taken into consideration consist mostly of
the following:
                                                Age
    Obviously this is important as older people create more medical expense and disability
claims than younger persons. Adjustments are made on the average age of the group.
                                                Sex
    As a generality, women have more health problems than men and have a higher percentage
of disability—25% higher than men. Men’s claims are usually a factor only for accidental death
and dismemberment insurance. Adjustments are made based on the proportion of men to women
in the group.
                                       Dependent Coverage
    Most groups include dependents so the percentage of the group members who are dependents
has considerable impact on claims experience because dependents are children and spouses, and


                                                 57
age and sex affect claims. In recent years, the proportion of dependants has changed rather dra-
matically mostly because of the increase in single-parent households and the decrease in the av-
erage number of children in a family. Also, the increase in the number of working women has
had a substantial impact, such as the fact that dependant participation may fall below acceptable
levels if many employees have coverage from their spouse’s employer. This is particularly noti-
ceable if the company has a high proportion of married women whose husband’s insurance cov-
ers the children.
    This ―duality‖ of family health insurance in recent years has had an effect on participation
rules and many plans now do not take into consideration those employees who have health cov-
erage under their spouse’s health insurance in determining the required participation level.
                                        Type of Business
    Health insurance, in most cases, does not provide coverage for illnesses and accidents result-
ing directly from the employment of the person as these expenses are usually covered under the
employer’s Workers’ Compensation insurance. However, illnesses that result indirectly from
work activities or the physical environment of the workplace are usually covered under the group
health insurance plan. Back problems from sitting in place for long periods of time, or colds and
other respiratory problems caused by temperature of the workplace, etc., are all factors that must
be taken into considered in underwriting.
    Another situation that must taken into consideration is the fact that some businesses have
higher-paid employees than other businesses, and those in the lower-paying businesses will hire
the less-healthy individuals as a general rule, so these employees do not meet the general health
standards of other companies, and adjustments must be made for these types of groups. For in-
stance, restaurants do not pay as well as technologies company and restaurant employees (as a
general rule) would not be as ―healthy‖ overall.
                                             Income
   Those with higher-than-average income generally get more frequent and better medical care,
which means for underwriting purposes that a group with a large number of high-income em-
ployees will have higher medical claims. Conversely, though, as indicated previously, lower-
paying jobs may involve working conditions that indirectly cause health problems, so groups
with a large number of low-income workers may also have high claims.
                                       Geographical Area
    As a general rule, the geographical location of a business has little affect on the number of
claims made, but it does affect the cost of claims as charges for medical care vary widely by
geographical areas. For instance, medical expenses in New York are much higher than in, as an
example, Des Moines.
                                   Other Problem Indicators
    There are a wide variety of group characteristics which are addressed by experienced under-
writers, and any unusual characteristic comes under close scrutiny. For example, if a business
has a higher-than-average age for businesses of that type because the business hires very few
new employees, then a ―red-flag is raised‖ because this could be an indication of financial diffi-
culties. Conversely, a younger-than-average-age group could show high turnover, which would
mean that the insurer would have a higher-than-average administrative cost for the insurer. An


                                                58
underwriter also looks for often and/or radical changes in turnover of employees which could
dramatically change the characteristics of the group, therefore premiums might be inadequate.

                              EMPLOYEE DEATH BENEFITS
    Prior to 1996, many employers provided up to $5,000 to be paid by or on behalf of an em-
ployer as a death benefit, to the estate of the employee or beneficiary, and such payments was
free of income tax. As of 1996, this death benefit was repealed, but some employers still wish to
provide a death benefit, but now, death benefits payable under contract, or pursuant to an estab-
lished plan of the employer, are taxable income. But, employee death benefits that are payable
by reason of the death of certain terrorist attack victims are excludable from gross income.108
    Often, death benefits are funded by insurance on the life of the employee, with the insurance
owned by and payable to the employer. The death benefits would then come from proceeds re-
ceived tax-free by the employer, but the surviving spouse receives these benefits as compensa-
tion payments from the employer and not as life insurance proceeds. As a rule of thumb, em-
ployee death benefits rarely qualify as life insurance benefits wholly excludable.109
    Contractual death benefits are "income in respect of a decedent," therefore, when an estate
tax has been paid, the recipient of the death payments is entitled to an income tax deduction for
that portion of the estate tax that can be attributed to the value of the payments.110
    With the contractual death benefit, the employer can deduct the death payments provided
they represent reasonable additional compensation for the employee's services. But, payments
can be deducted only in the year that they can be included in the employee's income, regardless
of the accounting method used by the employer.111

                                    Voluntary Death Benefit
    If an employer voluntarily pays a death benefit to an employee's surviving spouse, the IRS
considers such voluntary death benefit as compensation and it is taxable income. A death benefit
paid by an employer is usually considered as a payment for the benefit of an employee, and
therefore, would not be excludable as a gift. Employee death benefits that are paid because of
the death of certain terrorist attack victims, are excluded from gross income.112
    The employer may deduct a voluntary death benefit if it qualifies as an ordinary and neces-
sary business expense and if the circumstances show that it is additional reasonable compensa-
tion for the employee's services, or otherwise qualify as ordinary and necessary business ex-
penses.113
    If the facts indicate that the payment was strictly a gift, or was made for the personal satisfac-
tion of the directors, the deduction will be denied.
     Where a widow is a controlling stockholder, the payments will probably be treated as con-
structive dividends and the entire death benefit would be taxable to her and not deductible by the
corporation.114 However, if the widow does not hold a controlling interest, the payments may
still be treated as dividends if the corporation is a close, family-owned corporation.


                                        STUDY QUESTIONS



                                                 59
1. The principal difference, as far as the policyowner is concerned, between a qualified and non-
   qualified long-term care insurance (LTCI) policy, is
   A. the cost is much higher with the nonqualified plans.
   B. it is illegal to market nonqualified plans.
   C. the waiting periods.
   D. whether benefits are taxed to the policyholder.

2. Any plan of an employer that provides coverage under a qualified LTCI contract is treated as
   accident and health insurance and therefore,
   A. premiums paid for long-term care coverage by an employer are not includable in the
       gross incomes of employees.
   B. premiums are not deductible by either the employee or the employer.
   C. all benefits are taxed under nonqualified and qualified contracts.
   D. are non-commissionable.

3. A group broker who takes responsibility for the administration of a group insurance plan is
   A. always an employee of the insurance company.
   B. the group administration director.
   C. a third party administrator (TPA).
   D. an actuary.

4. After an employer becomes a "prospect," and after the necessary information has been ob-
   tained, the next step in group insurance marketing is to
   A. design a health insurance plan that meets the needs of the prospect.
   B. file a Group Insurance Proposal Outline (GIPO) with the state Insurance Department.
   C. send enrollers to the business to start enrolling.
   D. send the proposal to the NAIC to make sure it conforms to the Model bill.

5. The process of determining whether to offer coverage and on what terms, is called
   A. data processing.
   B. underwriting.
   C. actuarial evaluation.
   D. sales management.

6. If in a group health plan, the eligible members have the option of having coverage and paying
    premiums, or declining the coverage, then the members who elect coverage are more likely
    to be in poorer physical condition than the average employee in the group—this is called
    A. poor marketing.
    B. adverse selection.
    C. discrimination.
    D. cherry-picking.




7. Low participation or fictitious groups and persistency problems can



                                               60
     A.   not have any effect on the issue of group health insurance, by law.
     B.   lead to multiple issuing, i.e., offering different plans within a group.
     C.   only increase the premiums as any other action is illegal.
     D.   lead to the insurer denying the group the coverage it requested.

8. The premium for a group risk is based upon persistency assumptions that
   A. the risk will stay with the insurer for a length of time whereby the insurer can
       recoup its high early year expenses.
   B. credit early withdrawals as positive as group premiums are adjusted only quarterly so the
       insurer keeps the premiums for the lapsed business with no risk.
   C. are always nearly perfect and attested to by the Society of Actuaries.
   D. are determined by the state Department of Insurance.

9. If death benefits are funded by insurance on the life of the employee, with the insurance
    owned by and payable to the employer, then a surviving spouse
    A. would receive these benefits tax free as life insurance proceeds.
    B. would pay taxes on these benefits as compensation.
    C. would not be able to receive these benefits as they would be paid to his estate.
    D. could set up a Rabbi Trust and never pay taxes on insurance proceeds.

10. William and his wife own the majority of the stock in the Acme Corporation which has a
    voluntary death benefit plan coveringn William. When William dies suddenly, his wife be-
    comes the controlling stockholder of the corporation and beneficiary of the death benefit.
    For tax purposes, the benefits paid to the widow
    A. are taxed at the top income bracket as ordinary income.
    B. are subject to capital gains taxes.
    C. would be treated as constructive dividends and the entire amount would be taxable to her.
    D. would be 50% exempt as constructively, she only owned half of the policy benefits.




ANSWERS TO STUDY QUESTIONS
1D   2A     3C   4A   5B   6B   7D   8A   9B   10C




                                                     61
            CHAPTER FIVE - GROUP LIFE INSURANCE

  Group life insurance is an important part of the life insurance industry, accounting for
about 40% of all life insurance in force by amount with an average certificate of
$32,000.
                         GROUP INSURANCE REQUIREMENTS
While the minimum size of a group was typically 50 lives a few years ago, it is now usual for
states to require a minimum of 10 lives required by state law and by insurance companies. The
larger the group, the less expense per person is incurred.

                                           Participants
Generally, only active, full-time employees are eligible for group coverage, usually specified by
occupation classification of those that must be included in the group, such as ―salaried em-
ployees‖ or ―all hourly employees.‖ The employee must be actively at work for a normal num-
ber of hours per week (usually 30 hours) at the employee’s regular job at the date the employee
becomes eligible for coverage.

                                       Probationary Period
Employees usually have a probationary period, usually one to six months, during which they are
not eligible for coverage. After this period, under a contributory plan (the employee pays part of
the premium) the employee has an eligibility period in which they must apply for insurance
without submitting evidence of insurability. This period is usually for 30, 31 or 45 days. If the
plan is noncontributory, then there is no eligibility period as all employees automatically go on
the plan when they have completed the probationary period.

                                         Coverage Period
The coverage period is usually the length of time that the employee remains with the employer
(assuming the plan stays in force with the employer and the employee pays their share of the
premium, if any). The employer has the right to continue coverage for an employee temporarily
off the job and upon termination, coverage is usually afforded for 31 days.

                                         Benefit Amount
Typically, the employee does not specify the benefit amount and the amount is usually (1) a set
amount for all employees, (2) a percentage of the employee’s income with the employer, (3) an
amount that is designated for the position the employee holds (job title), or (4) a function of the
employees length of service. Insurers do not usually write insurance for less than $2,000 on an
employee, most companies require $5,000 or $10,000, or more. Most companies allow for addi-
tional insurance over the normal maximum with evidence of insurability.



                                                62
                                         Convertibility
Employees usually have the option to convert their group life policy into an individual cash val-
ue policy within 31 days after termination of employment or after the employee ceases to be a
member of an eligible position. The death benefit is paid under the group policy within 31 days
after the insured has withdrawn from the eligible group.

                                      Waiver of Premium
A typical waiver of premium is used with group life insurance plans, and the premium will be
waived as long as the insured can prove disability periodically.

                                        Type of Insurance
Group life insurance is basically yearly renewable term insurance. Group premiums are paid
monthly, except with some small groups when premiums may be paid quarterly. Premiums are
usually guaranteed for one year only, but often for competitive purposes, the premiums are guar-
anteed for a longer period of time.

                                    Employee Contributions
For contributory plans employee contributions are usually at a set rate per $1,000 of coverage at
all ages. In most states, employers are required to pay at least a portion of the premium, and
some states restrict the amounts that can be paid by any one employee, commonly 60 cents per
month per $1,000 of coverage, or 75% of the total premium for that employee.

                                 Supplemental Life Insurance
Supplemental life insurance may be provided to employees, normally contributory and the
amounts of insurance available are banded. Generally the maximum is a multiple of the em-
ployee’s salary. (Note: As discussed later, it may be treated differently for tax purposes.)

                                    Credit Group Life Insurance
A common form of group insurance is Credit Life insurance, which provides a benefit that is
equal to the unpaid amount owed to the institution by the consumer. The creditor, which is
usually a bank or a finance company, is both the policyowner and beneficiary of the policy.
Premiums are usually paid by the debtor, but if there are dividends, they are paid to the creditor.
Needless to say, group credit life can be very profitable to the lender and there has been consi-
derable abuse. States have reacted and most states now have maximum rates that can be charged
and most, if not all, states do not allow the purchase of credit life insurance to be a prerequisite
for obtaining a loan.

                                   Accelerated Death Benefit
Group life insurance often includes an accelerated death benefit which pays a portion of the face
amount of the policy in case of the terminal illness of the employee.




                                                 63
       TAXATION OF GROUP TERM LIFE INSURANCE (EMPLOYER)
    Usually, the taxable value of group term insurance in excess of the $50,000 exclusion amount
is determined from tables provided by the IRS. The exclusion is not allowed unless the insur-
ance meets the requirements of "group term life insurance" (as described below). If the insur-
ance provided does not meet the definition of group term life insurance, then the employer's
premium cost is included in the employee's income.
    If the group term plan is discriminatory, the exclusion is not available to key employees and
the taxable cost to the key employee of the entire amount of insurance under the discriminatory
plan, is the higher of the actual cost or the cost under the IRS table as discussed later.
    Generally, the premium paid by the employer is deductible. Group term life insurance may
be provided under term policies or under policies providing a permanent benefit and an employer
may also provide permanent life insurance to employees on a group basis.
   Unless the life insurance that is provided by an employer meets certain requirements, it is not
considered group term life insurance and does not qualify for the special tax exclusion by em-
ployees.115 There are four requirements (discussed below):

(1) General Death Benefit
    The policy must provide a general death benefit, excludable from gross income. Travel in-
surance and accident and health insurance (including double indemnity) do not provide a general
death benefit.

(2) Provided to a Group of Employees
    The insurance must be provided to a group of employees as compensation for personal ser-
vices performed as an employee. A group of employees consists of all employees of an employ-
er, or fewer than all if membership in the group is determined solely on the basis of age, marital
status, or factors of employment (such as members of a union, duties performed, etc.) The pur-
chase of something other than group insurance is not a "factor of employment," while participat-
ing in an employer's pension or accident and health plan is a "factor of employment." Ownership
of stock in the corporation is not a factor, but ownership in an employer's stock bonus plan may
be. The "group of employees" may include stockholder-employees, except the more-than-2%
shareholders in an S corporation.
    The regulations are quite specific as to the difference between an "employee" and an inde-
pendent contractor. Insurance on the life of a self-employed person, whether he is the employer
or independent contractor, is not excludable (meaning that it does not qualify for the tax exclu-
sion), nor is the insurance for a partner or sole proprietor, nor insurance provided for an individ-
ual in his capacity as a corporate owner or director. Insurance on a commission salesperson is
not excludable unless an employer-employee relationship exists between the sales person and the
company that pays the premiums. However, full-time life insurance salespersons that are classi-
fied as employees for social security purposes are considered as employees for group term insur-
ance.116




                                                64
(3) Provided Under a Policy Carried by the Employer
   The insurance must be provided under a policy carried directly or indirectly by the employer,
such as where the employer pays any part of the cost—directly or through another person—or
makes arrangements for payment by employees and charges at least one employee less than his
Table I cost and at least one other employee more than his Table I cost. The "policy" can be a
master policy or a group of individual policies.
    The IRS considers a "policy" as including all obligations of an insurer that are offered or are
available to a group of employees because of the employment relationship, even if they are in
separate documents.117 The employer may elect to an obligation to employees to providing
permanent insurance as a separate policy if (a) the employee buys the policy directly from the
insurer and pays the full premium; (b) the employer only participates by selecting the insurer, the
type of coverage and sales assistance (providing list of employees, for instance); (c) the coverage
is sold on the same terms and in substantial amounts to individuals who do not purchase, and (d)
whose employers do not purchase any other obligations from the insurer; and no employer-
provided benefit is conditions on purchase of the obligation.
    If supplemental group term life insurance is paid for entirely by employees and the supple-
mental insurance and the basic group term life is paid for by the employer, they are considered
the same policy if they are provided by unrelated insurers. However, if these benefits are pro-
vided by the same insurer, the supplemental and basic coverages are treated as one policy.118
Actually, if the premiums are allocated properly, the employer may elect to treat the coverage as
three separate policies—basic coverage, supplement smoker coverage and supplement nonsmok-
er coverage—for the purpose of determining if the policies were carried directly or indirectly by
the employer. Therefore, the employees had no imputed income from the supplemental cover-
age.119

(4) Insurance Computed Under a Formula Precluding Individual Selection
     The amount of insurance that is provided to each employee must be computedunder a formu-
la that precludes individual selection of such amounts. In other words, it must be a guaranteed
issue plan. The formula must be based on age, years of service, compensation or position, how-
ever, employees may have the right to determine the amount of insurance depending upon the
amount that the employee wishes to contribute. Regardless, though, the amount of insurance on
each schedule must be computed under the formula that precludes individual selection.
    One place this could come into contention is when the employee's insurance protection under
the group program is reduced by his death benefit under the employer's pension plan, then a
court determined that the "group" protection was no longer group term life insurance because the
formula for determining the amount was based on a factor other than age, years of service, com-
pensation or position.120
    An employer may select payments of equal installments over a fixed period of time instead
of being paid in a lump-sum, in which case, this would not affect the plan's qualification as group
term life insurance.
    Term life insurance to be provided after retirement, which is offered by certain educational
institutions under a Cafeteria Plan, is treated as group life insurance.



                                                65
   If the employer-provided term life insurance does not qualify as group term insurance, the
premium paid by the employer is includable in the employee's income.121

Group Term Insurance for Groups Under Ten Employees
    Generally, life insurance provided to a group cannot qualify as group term insurance for in-
come tax purposes unless, at some time during the calendar year, it is provided to at least 10 full-
time employees who are members of the group of employees of the employer. However, insur-
ance for fewer than 10 employees can also qualify if (a) the group term life insurance is provided
for all full-time employees; (b) the amount of coverage is calculated as a percent of compensa-
tion or on some other acceptable compensation bracket; and (c) eligibility and coverage amount
are based on evidence of insurability determined only on the basis of a medical questionnaire
completed by the employee and not requiring a physical examination.
    In order to determine how many, and if all eligible employees, are included in the group, em-
ployees who elect not to be covered are considered as included even if they would have to con-
tribute toward the cost of the term insurance. However, if the employee is required to provide
the cost of benefits other than term insurance (such as permanent insurance) in order to get term
insurance, he is not counted in determining if term life insurance is provided to ten or more em-
ployees if he declined the term insurance.123
    Also, if evidence of insurability is not to be taken into consideration, then insurance that
would otherwise not meet the requirements and which provides coverage for less than ten full-
time employees, can still qualify provided it is provided under the same plan to the employees of
two or more unrelated employers, and insurance is restricted to all employees (but not mandato-
ry) of an employer who belong to or are represented by an organization that carries on substantial
activities other than obtaining insurance (e.g., union).
    For plans for less than 10 full-time employees, insurance will not be disqualified simply be-
cause the policy terms require 10 employees and no insurance is provided for those employees
less than 6-months or are part-time employees (less than 20 hours per week or five months in any
calendar year) or those of age 65 or older.124
    In order to determine as to how many employees are provided insurance, all life insurance
provided by policies that are carried by the employer are taken into consideration, even if they
are written with different insurers. This allows, for instance, supplemental coverage on fewer
then 10 employees to be superimposed on group term life insurance that has more than 10 em-
ployees without considering the special requirements for groups under 10 lives.125

        Taxation of Group Term Life insurance Premiums to Employer
   The premiums paid by an employer for group term insurance on the lives of employees are
deductible, even if the plan discriminates in favor of key employees.126
    A corporation may deduct the premium it pays for coverage on the lives of commission sa-
lespersons irrespective of whether an employer-employee relationship exists between the sales-
person and the corporation.
    No deduction will be allowed for the cost of coverage on the life of an employee if the em-
ployer is directly or indirectly a beneficiary under the policy (such as some key-employee poli-
cies). Also, if the group term proceeds are to be used to fund a buy-sell agreement between


                                                66
stockholders of the corporation, the IRS may not allow a corporation to take the premiums as a
business expense deduction. In any event, contributions will not be deductible unless, when con-
sidered with all the employee's other compensation, they are reasonable.
    If the deductions of premiums are paid to a "welfare benefit fund" to provide group life in-
surance to employees, there are several and strict limitations, and which are detailed and com-
plex, requiring expert tax advice.127

         TAXATION OF GROUP TERM LIFE INSURANCE (EMPLOYEE)
    As a general rule, the cost of up to $50,000 of group term life insurance coverage is tax
exempt and the cost of coverage in excess of $50,000 is taxable to the employee. If the em-
ployee is working for more than one employer, he must combine all group term coverage and
exclude the cost for no more than $50,000 of coverage. If the employee contributes toward the
cost of insurance, all of his contribution for amounts up to $50,000 and any excess coverage, are
allocable to coverage in excess of $50,000—he may subtract his full contribution from the
amount that would otherwise be taxable to him. Carryover from year to year any unusual portion
of the contribution is not allowed.128
    The cost of coverage in excess of $50,000 must be calculated monthly by finding the total
amount of group term life insurance for the employee in each calendar month of his taxable year,
subtract the $50,000 from each month's coverage, and to the balance (if any) for each month, ap-
ply the appropriate rate from the following table (called Table I) of monthly premium rates, from
which is subtracted the sum of the total employee contributions for the year, if any.129 The cost
is determined on the basis of the life insurance protection provided to the employee during his
tax year, without regard to when the premiums are paid by the employer.
           TO COMPUTE THE COST OF EXCESS GROUP TERM INSURANCE:
           Uniform Premiums for $1,000 of Group Term Life Insurance Protection
                    Rates Applicable to Cost of Group-Term Life insurance

   5-year age bracket                                             Cost per $1,000 of Protection
                                                                     for one-month period
   Under 25                                                                  $0.05
   25-29                                                                        .06
   30-34                                                                        .08
   35-39                                                                        .09
   40-44                                                                        .10
   45-49                                                                        .15
   50-54                                                                        .23
   55-59                                                                        .43
   60-64                                                                        .66
   65-69                                                                      $1.27
   70 and above                                                                2.06
   (In using this table, the age of employee is attained age on last day of his taxable year.)

   The IRS regulations consider the fact that state laws may differ in amount of insurance in
excess of the $50,000, and the exemption is not available for amounts over $50,000, regardless


                                                    67
of state law. The employee will be taxed on the actual premium for any coverage exceeding the
state maximum.130
    Group term life insurance on the lives of an employee's spouse and dependents is not in-
cluded in the exemption, but the cost of such coverage will be exempt from income tax if the
face amount does not exceed $2,000. When determining whether coverage in excess of $3,000 is
excludable from income, only the excess of the cost over the amount the paid by the employee
on an after tax basis for the coverage is considered.

                                           Exceptions
    There are exceptions where the cost of group term insurance for over $50,000 is tax exempt
to a former employee who has terminated his employment with the employer and has become
permanently disabled, or terminated on or before Jan. 1, 1984, or, if a charitable organization is
designated as beneficiary, or, if the employer is the beneficiary (except if the employer is obli-
gated to pay proceeds over to the estate of the employee).
   Usually, contributions made by an employee toward group term life insurance reduce the
amount included in his gross income, on an equal-dollar basis. Prepayment by the employee for
coverage after retirement may not reduce the gross income,
    The exemption of the cost of up to $50,000 of group term life does not apply to group term
insurance that is purchased under a qualified employee's trust or annuity plan, such amounts for
the protection purchased under a qualified plan does not allow for any part of such cost to be ex-
cludable from the employee's gross income.
    Premiums for supplemental insurance in excess of the $50,000 provided by the employer un-
der a group term insurance plan, are not taxable to the insured employee when paid by a family
member to whom the employee has assigned the insurance. But, if the cost of that excess cover-
age is shared by the employer and the assignee, then the employer's portion of such costs must be
included in the insured employee's gross income.132

                                        Other exclusions
    A former employee who has terminated his employment with the employer and has becomes
permanently disabled, or a charitable organization designated as a beneficiary, or if the employer
is beneficiary (unless the employer is required to pay the proceeds over to the employee's estate
or beneficiary), then the entire amount of group term life insurance is tax exempt.
    If the insurance is purchased under a qualified employee's trust or annuity plan, then none of
the cost is excludable from the employee's gross income as separate regulations apply to the cost
of such protection under a qualified plan.132

                                     Discriminatory Plans
   If the plan covers any "key employees" and it discriminates in favor of them as to eligibility,
kind of benefits or amount of benefits, the key employees may not exclude the cost of the first
$50,000 of coverage and the key employee must include the higher of either the actual cost or the
specified uniform premium (from Table I). Other employees, other than key employees, may
exclude the cost of the $50,000 of coverage even if the plan is discriminatory.133



                                                68
   For this purpose, a "key employee" is an employee who at any time during the employer's tax
year was
       an officer of the employer having annual compensation in excess of $140,000 (2006)-not
        more than the greater of three individuals or 10% of the employees need be considered
        as officers, but never more than 50 employees;
       more-than-5%-owner of the employer, or
       more-than-1%-owner having an annual compensation of more than $150,000 from the
        employer.
     In respect to eligibility, a plan is discriminatory in favor of key employees unless it benefits
at least 70% of all employees of which 85% are not key employees, the plan benefits a class of
employees determined by the IRS not to be discriminatory, or if the plan is part of a Cafeteria
Plan—then the requirements for the Cafeteria Plans are met.
    Employees who do not need to be counted include those with less than 3 years of service,
part-time or seasonable employees, employees excluded from the plan because they are part of a
collective bargaining plan, or certain nonresident aliens.134
    Benefits may be considered as discriminatory unless all of the benefits that are available to
key employees are available to all participants. Benefits will not be discriminatory just because
the insurance amount bears a uniform relationship to the total compensation of the employees, or
to their basic or usual rate of compensation.

                                           Church Plans
    A plan established by a church or convention of churches or association of churches that is
tax exempt is exempt from non-discrimination requirements. A church employee includes the
minister or pastor, or an employee of an organization that is tax exempt, but does not include an
employee of an educational organization above the secondary level (other than a school for reli-
gious training) or an employee of certain hospital or medical research organizations.135

                                    Group Carve-out Plans
    Under a group carve-out plan, an employer removes (or "carves-out") one or more highly
compensated employees from the life insurance coverage by a group term life insurance policy
and such "carved-out" employees are provided life insurance coverage through individual poli-
cies. This plan has become quite popular because there are low term insurance rates on individ-
ual policies and lower minimum premiums on permanent policies, plus the portability of the plan
makes it attractive to highly-compensated executives who are those who are usually asked to par-
ticipate.
    The purchase an ownership of the individual life insurance policies are often structured in
different ways, such as including a split dollar arrangement, an IRC Section 162 bonus plan or a
death benefit-only arrangement.
    Under this type of plan, the income tax consequences to both the employer and the carved-
out employees are the same as if the alternative method of providing life insurance was available
independent of the group term plan. However, the IRS decided that a split dollar plan that was


                                                  69
part of a group carve-out plan should be taxed as group term life insurance, thereby measuring
the benefit to an employee according to Table I rates instead the insurance rates used with the
split dollar arrangement.

                    Where the Policy Also Contains Permanent Benefits
    If the policy provides for a permanent benefit, it may be treated as group term life insurance
only if the policy or the employer identifies in writing the part of the death benefit that is pro-
vided to each employee that is group term life insurance. Further, the part of the death benefit
that is so designated as group term insurance for any policy year is at least the difference be-
tween the total death benefit under the policy, and the employee's "deemed" death benefit at the
end of the year. The "deemed death benefit" is calculated through a mathematical formula using
the net level premium reserve (a function of the actuarial department).
    A permanent benefit is an "economic value extended beyond one policy year … that is pro-
vided under a life insurance policy." 136 Further, if a policy that provides group life insurance
also provides permanent benefits, the cost of the permanent benefits reduced by the amount paid
for them by the employee, (excluding any group term life insurance) is included in the em-
ployee's income (according to a rather complicated formula).
    Suffice it to say that if the policy has permanent benefits, the tax treatment of the premium is
so complicated that it requires an actuarial or accountant (preferably tax accountant) to deter-
mine.
    The employer can deduct the premiums that he pays on group permanent life insurance for
his employees if the employee's right to the insurance on his life is nonforfeitable when the pre-
miums are paid. However, if the employee has only a "forfeitable" right to the insurance, the
employer cannot deduct the premium. If the employee's rights go from forfeitable to nonforfeit-
able, the percentage is pro-rated so the fair market value of the policy is includable in the em-
ployee's gross income. Premiums paid after the employee's rights become nonforfeitable are de-
ductible to the employer when the premiums are paid.137
                                  SPLIT DOLLAR PLAN
    A split dollar plan is an arrangement between an employer and employee whereby policy
benefits are split and the costs/premiums may be split also. They can also be set up between
corporations and shareholders, or between parents and their children (private split dollar plan).
Usually, the employer pays a part of the annual premium equal to the current year's increase in
the cash surrender value of the policy and the employee pays the balance of the premium (if
any). From this simple concept, there have arisen various "hybrid" plans, such as "employer
pays all" whereby the employer pays the entire premium; and level contribution plans where the
employee pays a level amount each year. If the employee dies while the plan is in effect, the
employer receives an amount from the proceeds that is equal to the cash value of the policy or, in
some cases, the amount of premium that has been paid into the policy —the employee's benefi-
ciary receives the remainder.
    Under recent legislation (Sarbanes-Oxley Act of 2002 Public Law 107-204) a question has
arisen as to whether it is legal for a publicly traded company to set up a split dollar plan or con-
tinue paying premiums on an existing plan. Therefore, many publicly traded companies have




                                                 70
ceased making premium payments on split dollar plans, with many of them paying bonuses to
employees covered by the split dollar plans so that the employee can pay the premiums.
    There are basically two plans: the endorsement plan where the employer owned the policy
and the benefit-split is provided by endorsement; or a collateral assignment plan whereby the
employee owns the policy and the employer's interest is secured by collateral assignment of the
policy.
    Newer (2003) treasury regulations define a split dollar life insurance arrangement as any ar-
rangement between an owner and a non-owner of a life insurance contract (a) where either party
to the plan pays all or a part of the premiums on the life insurance contract, including payment
through a loan to the other party that is secured by the life insurance policy; (b) where at least
one of the parties paying premiums is entitled to recover all or part of the premiums and the re-
covery is to be made from or secured by the proceeds of the life insurance policy; and (c) the ar-
rangement is not part of a group term life insurance plan unless the plan provides permanent
benefits.138
    There are certain other arrangements, called "compensatory arrangements" (where the ar-
rangement is part of a service performance agreement and not part of a life insurance plan, the
employer pays all or part of the premium and either the beneficiary is designated as the em-
ployee, or the beneficiary is a person that could be expected to be so designated) or "shareholder
arrangements" that are treated as split dollar arrangements, or "shareholder arrangements" (which
operates similarly but the "employer" is changed to "corporation" and "shareholder" is substi-
tuted for "employee.")

                           Income Taxation of a Split Dollar Plan
    For split dollar arrangements entered into after Sept. 17, 2003, tax treatment will depend
upon whether the life insurance policy owner provides economic benefits to the non-owner, or
the non-owner is making loans to the owner. An owner is usually the one named on the policy as
the owner, and a non-owner is any other person having an interest in the policy (except for a life
insurance company, of course).
    A split dollar arrangement will be treated as a loan if the payment is made by the non-owner
to the owner, the payment is a loan under general tax principles, and the repayment of the loan is
made from or secured by either the death benefit or cash value of the policy, or both.139

                                 Economic Benefit Treatment
    If the arrangement is NOT treated as a loan, then the policy owner is treated as providing
economic benefits to the non-owner (which usually occurs in an endorsement arrangement).
Therefore, in order to arrive at the amount of taxes, the non-owner must take into consideration
the full value of the economic benefits provided to the non-owner by the owner, reduced by any
amount paid by the non-owner—such economic benefits may be compensation income, divi-
dend, gift, or some other transfer. The "value" of the economic benefits is the cost of life insur-
ance protection provided to the non-owner (determined by a life insurance premium factor pro-
vided by the IRS), the cash value amount to which the non-owner has access, and the value of
other benefits provided by the non-owner.140




                                                 71
    Under the economic benefit treatment, the non-owner will not receive any investment in the
contract with respect to a life insurance policy subject to a split dollar arrangement. Premiums
paid by the owner will be included in the owner's investment in the contract. Any amount the
non-owner pays toward a policy will be included in the income of the owner and increase the
owner's investment in the contract.
    Death benefits paid to a beneficiary, other than the owner of the policy, because of death of
the insured, will be excluded from income to the extent that the amount of the death benefit is
allocable to current life insurance protection provided to the non-owner or the benefit of which
the non-owner took into account for income tax purposes.141
    If the policy is transferred to a non-owner, the taxation is rather complicated and the calcula-
tion should be provided by the insurer or qualified tax consultant.

                                         Loan Treatment
    If the split dollar arrangement is treated as a loan, the owner is the considered as the borrower
and the non-owner is considered as the lender for tax purposes. If the split dollar loan interest is
below market loan interest, then the interest will be imputed at the applicable federal rate, with
the owner and non-owner considered to transfer imputed amounts to each other.142 Where the
arrangement is between an employer and employee, the lender is the employer and the borrower
the employee, so the employer transfers the imputed interest to the employee and this amount is
taxable compensation and will generally be deductible to the employer (except in a corporation-
shareholder arrangement). The employee is treated as paying the imputed interest back to the
employer, which will be taxable income to the employer. The imputed interest payment by the
employee will normally be considered as personal interest and therefore not deductible.
    The actual calculation of the amount of imputed interest depends upon the type of below
market loan involved. (Further discussion on this subject is beyond the scope of this text but can
be found under Internal Revenue Code Section 7872(f), subsection 5 and 6.)

                                 Group Paid-up Insurance
    Group paid-up insurance has been popular and is a combination of accumulating
―units‖ of single-premium whole life and decreasing units of group term life. Usually
this is on a contributory plan and the employees contributions go toward units of single
premium whole life insurance. The employer’s contributions provides an amount of d e-
creasing term insurance, when added with the amount the employee pays for, equals the
total amount for which the employee is eligible. Then at retirement, the term insurance
portion is discontinued and the paid-up insurance remains in force on the employee for
the remainder of his/her life.

                                Group Ordinary Insurance
    Group ordinary insurance can be any traditional plan (except group paid-up) that
provides the cash value life insurance to employees, where the cost of the term portion
is paid by the employer, and the cash value portion is paid by the employee (which the
employee may refuse to accept). (Note discussion on permanent benefits above.)




                                                 72
                                    Group Universal Life
    Group Universal Life has the typical guaranteed interest rate, a fixed death benefit and loan
option, plus the flexibility and added returns of the newer life insurance products. Group Uni-
versal Life (UL) is the same as individual UL, except that Group UL is generally issued (up to a
certain amount) without evidence of insurability and is usually high enough to meet the needs of
most employees. Group UL products usually pay low, or no, commission, plus administrative
charges are lower than individual plans. Generally, these plans are 100% contributory; therefore
the plans are totally portable. (Note discussion on permanent benefits, above.)

                                    Retired Live Reserves
    Retired live reserves (RLR) is a group reserve accumulated before retirement in order to pay
premiums on term insurance after retirement. The employer can make tax-deductible contribu-
tions to this reserve on behalf of the employees, and these contributions are not taxed as income
to the employees. RLRs can be administered through a trust or by a life insurance company and
as long as there are employees participating in the plan, the reserve cannot be recaptured by the
employer. If an employee dies (or resigns) prior to retirement, the individual’s reserve value is
used to fund the RLR for others in the plan. The plan must be nondiscriminatory and limits the
amounts to $50,000.
     The includable cost of group term insurance will be included in the income of a retired em-
ployee for the year in which the coverage is received, whether or not the coverage vests upon
retirement.143
    There is no income to an employer for tax purposes, arising out of assigning all rights to a
trust in which the employer maintained a retired lives reserve, an agreement by the trustee with
the insurer that amounts credited to the reserve would be invested in a separate account of the
insurer, or used to purchase annuities, and payments to the trustee under the annuity contracts to
be used to provide group term life insurance for retired employees.
     Interestingly, if the plan provides exclusively life insurance benefits for retired employees,
the plan would be considered as a deferred compensation plan for tax purposes, so the employ-
er's deduction would be limited to the amount includable in the employee's income, and allowed
only if separate accounts are maintained for each covered employee.144

                                  Supplemental Coverages
    Supplemental coverages are generally available, either through the insurer of the group, or
by another insurer that offers supplemental benefits, such as accidental death, or accidental
death & dismemberment.
    Dependent Life insurance may be offered whereby the spouse and/or unmarried dependent
children are insured for usually a small amount of life insurance.

                                Taxation of Death Proceeds
    The death proceeds that are received by individuals are entirely tax exempt regardless if they
are received from group permanent or group term insurance.145 Where group term life insur-
ance is provided to the domestic partner of employees by an employer, death proceeds paid upon
the death of the domestic partner are excluded from income and the same rules apply that are ap-



                                                73
plicable to proceeds under individual policies. There are special rules if the insurance is payable
under a qualified pension or profit-sharing plan.146

                         GROUP SURVIVOR INCOME BENEFIT
    Some plans also offer Survivor Income Benefits where proceeds are payable in
monthly income benefits only. Beneficiaries are not named but are covered by spec i-
fied beneficiaries in the policy, and benefits usually continue as long as there is a sur-
viving beneficiary and sometimes are discontinued if the survivor remarries.
    These plans are also called a "reversionary annuity" or, simply, "life insurance," but regard-
less of name, "any plan that shifts the risk of loss resulting from premature death from the indi-
vidual or the family to a large group contains an essential ingredient of insurance."147
     There are several court cases where an individual "survivorship annuity" was deemed to be
life insurance, and benefits under a self-insured state program were held to be life insurance.148
     However, there have been decisions that appear to contradict the above, for instance, one
self-insured state program was held not to be insurance because of the lack of actuarial sound-
ness and because there was no death benefit if there was a surviving spouse—which makes
sense, because if there is no definite benefit payable in any event upon the employee's death,
there would be no risk-shifting —mandatory in insurance definition.149 Based upon this ruling,
the IRS determined that a program that paid a monthly benefit only to certain survivors upon an
employee's death did not exhibit the risk-shifting necessary for life insurance, so the death bene-
fit was not eligible for tax-free treatment but was taxed as an employee death benefit.150
                                        STUDY QUESTIONS
1. As a general rule, with group life insurance, employees
   A. do not specify the benefit amount.
   B. always pay the full premium.
   C. must make the employer the beneficiary.
   D. have the option to convert their group term insurance into an individual policy at any time
       during their employment.

2. Group Term Life Insurance may be taxable to employees
   A. for amount in excess of $150,000 on the life of the employee.
   B. for amounts in excess of $50,000 on the life of the employee, spouse and dependants.
   C. for amounts in excess of $50,000 on the life of the employee.
   D. unless the basic policy is one of permanent whole life.



3. The premiums paid by an employer for group term life insurance on the lives of employees
   are deductible,
   A. except when it discriminates in favor of key employees.
   B. even if the plan discriminates in favor of key employees.
   C. but for not more than 50% of the amount contributed by the employer.
   D. but only on groups of more than 20 lives.



                                                 74
4. As a general rule, life insurance cannot be qualified as group life insurance for tax purposes
   unless, at some time during the calendar year
   A. the employees present the employer with a petition asking for the coverage with the
       signatures of at least 50% of the employees.
   B. at least 5% of the full time employees either die, or convert at retirement during the year.
   C. it is provided to at least 10 full-time employees who are members of the group of
       employees of the employer.
   D. all employees have completed a physical examination & are insurable.

5. The cost of group term insurance for over $50,000 is tax exempt
   A. if the group has more than 100 employees.
   B. if the group is nondiscriminatory.
   C. for a former employer who has terminated his employment and has become permanently
       disabled.
   D. if the spouse or dependant child is named as beneficiary.

6. A group life insurance plan is discriminatory in favor of key employees unless it benefits
   A. at least 70% of all employees of which 85% are not key employees.
   B. none of the key employees.
   C. only the beneficiaries of the key employees.
   D. the employer.

7. A split-dollar plan
   A. is an arrangement between an employer and employee where the only the policy benefits
       are split.
   B. is a form of pension plan where usually 50% of the premium goes towards mutual funds
       of some other sort of savings element, the remainder purchases term life
       insurance.
   C. is an arrangement between an employer and employee where the policy benefits are split
       and premiums may also be split.
   D. is where half of the life insurance premiums purchase annuity

8. For split dollar plans, tax treatment will depend upon whether the policy owner provides eco-
   nomic benefits to the non-owner or
   A. the total premiums for the plan are less than $5,000 per year per participant.
   B. the employer is either the policy owner or the non-policy owner.
   C. whether the plan is underwritten by a stock or mutual insurance company.
   D. the non-owner making loans to the owner.




                                                75
9. A group paid-up insurance plan
   A. is a combination of accumulating units of single premium whole life and decreasing units
       of group term insurance.
   B. is a non-contributory group term life plan where the employees pays no premiums.
   C. is actually an annuity with the annuitant being the employer and the owner, the employee.
   D. consists of decreasing amounts of whole life insurance and increasing amounts of term
       life insurance.

10. If a retired lives reserve plan provides only life insurance benefits to retired employees,
   A. the plan would be considered as a deferred compensation plan and taxed accordingly.
   B. the employer can make tax-deductible contributions to the plan and the contributions are
        not taxed as income to the employees.
   C. the employer can make tax-deductible contributions to the plan and the contributions are
        taxed to the employee.
   D. contributions to the plan are taxed to both the employer and the employee.

ANSWERS TO STUDY QUESTIONS
1A   2C   3B   4C   5C   6A   7C   8D   9A   10A




                                                   76
         CHAPTER SIX - DISABILITY INCOME INSURANCE

                             DEFINITION AND OVERVIEW
    Disability Income Insurance is health insurance that provides income payments to the insured
wage earner when income is interrupted or terminated because of illness, sickness, or accident.
Basically, there are two types – Long-term and Short-term, the difference being the length of
time that income can be paid. There are other differences also, as will be discussed in this text,
but most Long-term policies are sold on a Group basis, whereas Short-term policies are sold on
an individual or Association Group insurance.
     Disability Income policies are difficult to discuss in general terms and to compare with simi-
lar products. Disability Income policies are specifically designed to allow for maximum flexibil-
ity and to provide for the maximum coverage of the individual needs of the insureds. This flex-
ibility is provided through the availability of benefits and optional coverages. The benefit provi-
sions must be related closely to each other, otherwise there could be unexpected claims. Actu-
aries involved in policy designs for life and health insurance products agree that there is probably
no other type of insurance that relies so much upon the differences and distinctions in the bene-
fits and in the language that is used to describe the benefits.
    In today’s high-tech society, there are constant changes – some changes involving disability
risks. Remember carpal tunnel syndrome that was a result of computer terminal operators spend-
ing long hours at data entry? The modern methods of medical treatment and diagnosis have
changed the practical application of ―disability‖ terminology and with the rapid development of
treatment for many diseases and impairments, there is little doubt that benefits and provisions
will continue to change. Regardless, there are basic criteria that can be used for analyzing and
evaluation of all health insurance policies.
   Disability Income policies that are sold to individuals are issued either on a Guaranteed Re-
newable or Noncancellable basis, or in some cases, Conditionally Renewable.
                                      Conditionally Renewable
    This category is used for Disability Income and medical expense insurance. It gives the in-
sured a limited right to renew the policy to age 65 (or some later age) by the process of simply
paying the correct premium on time. The insurance company may refuse to renew coverage but
only for reasons that are stated in the policy. If the insurer is not going to renew under these
provisions, the insured must be notified 30 days in advance of the due date of the premium. The
insurer retains the right to change premiums and benefits for all insureds of the same class.
    The reasons for not renewing the policy are clearly stated in the policy and vary according to
the type of insurance. However, the insurer cannot refuse to provide coverage because of a
change in the health of the insured once the policy has been issued. The company may refuse to
renew a specific class of insureds (such all those insured under the policy form residing in the
state) or may decide to discontinue a policy series for all insureds in a single jurisdiction.
    On an individual basis, the insurance company may refuse to renew the policy when/if the in-
sured changes to a more hazardous occupation. They may refuse to renew if the economic need


                                                77
for the policy changes, such as the insured becoming incorporated. In particular, with Disability
Income insurance, if the insured becomes over-insured through purchasing other insurance that
will provide benefits in excess of the expected loss, the insurer may decline to renew. This pre-
vents ―stacking‖ of policies, which could lead to an anti-selection situation where the insured
would make more money on disability than by working.
    The conditional Renewable provision is used mostly in specialized business disability in-
come policies (other than overhead expense insurance). In these specialized policies, the insurer
retains the right not to renew on an individual basis when the covered business risk no longer
exists, or when other specific and specified events occur. In these policies, the insurer may re-
tain the right to change benefits, but typically, it guarantees that the premium rates will not
change.
    This renewal provision is used traditionally in those noncancellable and guaranteed renewa-
ble Disability Income policies which provide continuous coverage from age 65 to age 75 while
the insured continues to be employed full-time. The premiums for this period are usually the re-
newal premiums for persons of the same attained age and risk classification (see later discussion
of risk classifications). During this period (called ―conditional renewal period‖) the monthly in-
demnity amounts are usually not reduced, however, the benefit period is usually limited to two
years.
                THE NEED FOR DISABILITY INCOME INSURANCE
    The perception of the general public has been in the past and will probably continue in the
future, that Disability Income insurance is not as useful or necessary to most individuals as Med-
ical insurance or, even, life insurance. Most of the wage-earning population purchases, many
times with the assistance of their employer, insurance that will provide medical coverage for
themselves and their families. Large proportions of the wage-earning population purchase group
or individual life insurance.
    A much smaller share of the wage-earning population has either individual or group Disabili-
ty Income insurance. In fact, only about one in four has any Disability Income insurance of any
kind. The attitude seems to be that there is little chance of one losing his income because of a
disability, and anyway, if they do become disabled, they will recover completely in a short pe-
riod of time.
    It is true that most disabilities are of the Short-term variety, usually lasting less than one
month. However, the probability of sustaining a disability that lasts for 3-months or more is
high during the wage earning years. The probabilities of Disability for periods of 90 days or
more and Probabilities of Death prior to Age 65 (based on 1980 CSO Mortality Table) can be
best illustrated by the following graph.




                                                 78
                          Probability of Disability and Death at various ages
    It should be noted that the probability of a Long-term disability (90 days or more) is consi-
derably greater than the likelihood of death until age 60, when they are about the same.
    Also, it should be noted that if a person is disabled for at least three months, the average du-
ration of disability ranged between five to seven years, as shown in the graph below.




   Years                   Age at inception of disability (1985 Commissioners Disability Table)




                                                  79
   The need for Disability Income insurance has increased for the same reasons that the need for
   Long Term Care insurance coverage has increased, which is basically the fact that as society
   develops economically, support for family members that was formerly provided by other
   family members, declines. Many medical advances have substituted disability for what
   would have previously been death.
   From these basic statistics, it is obvious that the financial implications of disability can be a
   terrible burden for many people, and is even more financially difficult on the family than
   death. A point missed by many in this discussion is that the expenses of a disabled person
   not only continues, but in most cases, increases. With death, all expenses cease. Medical
   expenses are generally covered by insurance, but only Disability Income insurance can cover
   the loss of the income stream.
                                          DEFINITIONS
    Definitions under the policy may be part of the benefit provisions, but usually they are sepa-
rate. The definitions are used to evaluate claims and control the benefit payments. The most
important definitions are those of injury, sickness, preexisting conditions and disability.
                                              INJURY
    Under a Disability Income policy, the word ―injury‖ is defined as accidental bodily injury,
occurring while the policy is in force. Originally this definition used ―accidental means,‖ but the
latest wording uses ―results‖ language. This may seem like nit-picking, but not all accidental
bodily injuries result from accidental means.
                                   Accidental Means vs. Results
    When ―accidental means‖ is used regarding a bodily injury, there are two requirements that
must be met if the loss is to be covered: Both the cause of the injury and the result (the injury)
must be unexpected and unforeseen. In addition, the event must not be under the control of the
insured that results in the bodily injury. Most states prohibit the use of the accidental means
clause in any health insurance contract.
                                            SICKNESS
     The definition of ―sickness‖ is not entirely uniform among companies and their products, but
generally it is defined to mean sickness or disease that first manifests itself during the time that
the policy is in force. Some insurers extend the ―first manifest‖ language to mean a sickness or
disease that is first diagnosed and treated during the time that the policy is in force. There is lit-
tle difference, actually, and the intention in either case is to cover only sickness that is first con-
tracted during the time that the policy is in force.
   If the Disability Income policy contains either a ―first manifested‖ or ―first diagnosed‖ sick-
ness definition, the policy will contain a preexisting condition limitation.
                                 PREEXISTING CONDITION
    Similar to preexisting condition clauses in other types of health insurance, it usually applies
to the first two policy years and is used to exclude benefits for any loss that results from a (medi-




                                                  80
cal) condition – sickness or disability - that had not been acknowledged or reported by the in-
sured, and that occurred prior to the policy date.
   Preexisting condition provisions are tightly regulated in most states and therefore there are
some variances from state to state. Typically the definition would be similar to the following:



    A pre-existing condition means a medical condition that exists on the Effective Date and
    during the past five years either (1) caused you to receive medical advice or treatment; or (2)
      caused symptoms for which an ordinarily prudent person would seek medical advice or
                                               treatment.


                                  DEFINITION OF DISABILITY
    Unquestionably, the most important definition on a Disability Income insurance policy is the
definition of ―disability.‖ Individual Disability Income policies have been called ―loss of time‖
insurance because of the definitions of occupational disability. A disabled person insured under
a Disability Income policy must have suffered a loss of income because they cannot perform the
duties of their job. The definitions of total disability and of partial disability depend upon the
inability of the insured to perform certain occupational tasks.
                             Partial Disability vs. Residual Disability
   Permanent) partial disability is a disability in which a wage earner is forever prevented from
   working at full physical capability because of injury or illness.
   Residual Disability is the inability to perform one or more important daily business duties or
   inability to perform the usual daily business duties for the time period usually required for
   the performance of such duties.

                      RESIDUAL DISABILITY INCOME INSURANCE
     If Residual Disability Income coverage is provided, benefits are usually provided for the un-
used portion of the total disability benefit period, up to age 65. If an individual is at least age 55
at the time of disablement, and total disability lasts less than a year, residual benefits are payable
for the unusual portion of the benefit period for up to 18 months, but not beyond age 65.
    If there is at least a 25% loss in current earnings, the residual benefits will equal the percen-
tage of loss times the monthly benefit for total disability.
    In most policies, the Residual Disability concept has replaced the partial disability provision
as a means of paying a portion of the benefits to an insured who works at reduced earnings as a
result of sickness or injury. It should be noted that the residual concept differs from the usual
indemnity plans as it stresses the protection of the income, rather than the protection of ―occupa-
tional performance.‖
                                       TOTAL DISABILITY
   There are two different definitions used by insurance companies to describe total disability.
The ―any gainful occupation‖ definition, called ―any occ‖ in the industry which is the most lib-



                                                  81
eral coverage – and the most expensive. The other is the ―own occupation‖ definition, which is
called ―own occ‖ in the industry.
                                     OWN OCCUPATION
    The ―own occupation‖ clause defines an insured as totally disabled if they cannot perform the
major duties of their regular occupation, which is further defined as the occupation that the in-
sured was performing when the disability began. Under this definition, an insured could be
working in some other capacity and still be entitled to policy benefits if they cannot perform the
important tasks of their own occupations in the usual way. In most cases, the own occupation
coverage is limited to clients in the highest occupational classes, such as professionals and busi-
ness executives.
    This definition can vary by policy and company. Frequently the "own-occupation" definition
defines one as being totally disabled if
   (a) they cannot perform the major duties of their regular occupation, or
   (b) are not at work in any other occupation.
     Under this variance, if the insured is disabled and cannot perform his regular job, disability
benefits can be terminated if he voluntarily chooses to work at some other occupation. However,
if this provision is used, the insurer cannot require the insured to resume work in another suitable
occupation. This coverage is also known as regular occupation coverage.
    The most comprehensive definition as included in a few policies, would read: ―The inability
to perform the major duties of your occupation; the insurance company will consider your occu-
pation to be the occupation you are engaged in at the time you become disabled.‖ They will pay
the claim even if the insured is engaged in another occupation
    The modern trend seems to be to include both definitions in the Disability Income insurance
policy by using an ―own occupation‖ definition for a specified period of time (usually two to ten
years), and then thereafter, ―any occupation‖ definition comes into play.
    Many insurers will offer own occupation coverage to age 65 for certain preferred classes of
insureds, but this more liberal definition seems to be losing favor with insurers.
                                   Physician Requirement
     Nearly all Disability Income insurance policies require that an insured must be under the care
of a physician to qualify for disability benefits. It might be said that this requirement is ―taken
with a grain of salt‖ as obviously an insurer could not deny benefits if medical care is not essen-
tial to the recovery or well being of the insured. Courts have frequently so stipulated also. The
insurance company simply cannot require that an insured maintain a doctor-patient relationship
just for the purpose of certifying a disability.
                                PRESUMPTIVE DISABILITY
    If a Disability Income policy provides benefits for total disability (as most do), it is quite
common to also include a definition of presumptive disability. Under this provision, an insured
is presumed to be totally disabled (even if he is at work) if sickness/injury results in the loss of
the sight of both eyes, the hearing from both ears, the power of speech, or the use of any two
limbs. Generally the insurer will waive the medical care requirement and will start paying bene-



                                                 82
fits immediately upon the date of the loss. The insured can work in any occupation and benefits
will still be paid to the end of the policy benefit period, as long as the loss continues. With the
developments in new prosthetic devices, mechanical functions of the hands and legs can be res-
tored so as in some cases, the individual can resume their regular occupation.
                               ANY GAINFUL OCCUPATION
    If the policy definition were ―any gainful occupation‖ (or "any occ‖), the insured would be
considered as totally disabled if he cannot perform the major duties of any gainful occupation for
which he is reasonably suited because of education, training, or experience. Since the insured
can work at other jobs, this is obviously a more restrictive definition of disability than the ―own
occ‖ definition. Primarily, it limits the benefits. Used primarily in Group Disability Income in-
surance, this provision may read: ―Because of sickness or injury, you are unable to perform the
material and substantial duties or your occupation, or any occupation for which you are deemed
reasonably qualified by education, training and experience.”
                         INCOME REPLACEMENT APPROACH
    The definitions of disability often revolve around the insured’s ability (or inability) to per-
form certain tasks. Several companies now use an income replacement approach to defining dis-
ability wherein insureds are reimbursed when they lose a percentage of their earned income,
usually 20 or 25%. The earned income must be lost due to an injury or sickness that requires a
doctor’s care.
                                   POLICY PROVISIONS
                                            BENEFITS
     The Benefit provisions of a Disability Income insurance policy may be divided into three
areas regarding the payment of benefits. These areas of benefits form the base of a Disability
Income insurance policy, and other provisions related to them are used to expand or limit bene-
fits. A policy may be judged as to its liberalism (generally making it more marketable) or its
conservatism (generally making it less marketable) by the way that benefits relate to these areas
of benefits.
                                    ELIMINATION PERIOD
     The elimination period is the number of days at the beginning of a disability during which no
benefits are paid – often referred to as the ―waiting period.‖ For those who are familiar with oth-
er lines of health insurance, it is similar to a deductible in other types of policies. The purpose of
the elimination period is to exclude illnesses or injuries that disable the insured for only a few
days and therefore, can be met by the insured from their own funds.
     The typical Disability Income insurance policy elimination period – or at least the most
common – is 3 months or 90 days, however periods from 30 days to as long as 720 days are
available. It is important to remember that benefits are paid at the end of the elimination period,
therefore, using a 90 day elimination period as an example, the insured would not receive the
first benefit payment for 120 days after the sickness began or the injury was suffered, which dis-
abled the insured. Most Long-term Disability Income insurance policies have the same elimina-
tion periods for sickness or injury. Conversely, most Short-term Disability Income insurance
policies will have a longer elimination period for sickness but for accident the waiting period is
either waived or for a relative short period of time, such as 7 days.


                                                 83
                  The longer the elimination period, the lower the policy premium.

   
    Some Disability Income insurance policies require that the elimination period be
satisfied with total disability only, or with consecutive days of disability. Most experts feel
that an elimination period must be satisfied with either a residual or a total disability.
Voluntary Interruption of Elimination Period
    Most of the major Disability Income insurers offer a provision that allows the insured to re-
turn to work for a brief period of time without penalty before the end of the elimination period.
The recovery period is usually limited to either 6 months, or if the recovery period is less than 6
months, to the length of the elimination period. If the insured is then disabled because of the
same or different cause after this interruption, the two periods of disability will be combined to
satisfy the elimination period.
                                   THE BENEFIT PERIOD
    The Benefit Period is simply the maximum amount of time that the benefits will be paid un-
der the Disability Income insurance policy. In most policies, the Benefit Period will be the same
for disabilities caused by sickness, or caused by injury. The length of the period is usually of-
fered for two years, five years or to age 65. Benefits may be provided for ―lifetime‖, but the dis-
ability must be total, continuous and begin prior to age 55 (some policies go to age 60, or 65).
    As discussed earlier, most disabilities are Short-term and statistics show that 98 percent of all
disabled persons recover before one year has lapsed, and the majority recover within 6 months
from the start of the disability. Conversely, if the disability lasts longer than 12 months, the
chances of the insured being able to return to work diminishes drastically. The chance of return-
ing to work is even lower at the older ages. Therefore, a prudent choice would be for the insured
to have as long a benefit period as is available, and of course, affordable.
                                 Recurrent Disability Provision
     Most, if not all, Disability Income insurance policies include a provision that determines if a
recurrent or consecutive disability or episodes of disability, is to be considered as a new disabili-
ty or as a continuing claim. This provision typically provides that recurrent disabilities from the
same cause will be considered as one continuous period of disability, unless each period of disa-
bility is separated by recovery for a period of not less than six months.
     This provision is usually contained in Disability Income insurance policies that have a bene-
fit period to age 65 (or longer). The advantage of this provision to the insured is that a new eli-
mination period is not required for disability that recurs between 6 months and one year after a
brief recovery in a Long-term claim. This provision eliminates the prospect of multiple elimina-
tion periods and the result would be that benefits for a recurring loss due to the same cause is
payable to the insured immediately for the portion of the original benefit period that has not been
used.




                                                 84
    Conversely, if the disability results from a different cause after an earlier disability, or if the
loss recurs due to the same cause after twelve months after recovery, then the insured would
have a new benefit period and a new elimination period.
                                    THE BENEFIT AMOUNT
    Generally, the amount of the disability income is payable on a monthly indemnity basis for a
fixed amount. In essence, the disability income policy is an indemnity policy. (For general ref-
erence, an indemnity agreement is designed to restore an insured to his or her original financial
position after a loss.) One of the fundamental principles of indemnity is that the insured should
neither profit nor be put at a monetary disadvantage for incurring the loss. Since the purpose of
Disability Income insurance is to reimburse the insured for loss of income due to disability;
therefore, in order to understand this product, these fundamentals should be kept in mind.
    Taking this one step further, for total disability under the Disability Income insurance policy,
the indemnity is usually written on a valued basis. This means that the policy benefit as stated in
the policy is assumed to equal the actual monetary loss suffered by the insured because of the
disability. This amount is stated on the policy and is not adjusted to the earnings of the insured,
or for any other insurance payments, at time of claim for either total or partial disability. If resi-
dual disability is involved, the benefit can be reduced in proportions to the loss of earnings of the
insured.
    The benefit amount is extremely important in these policies because of the possibility of ad-
verse selection as indicated previously. Insurers limit the disability income that an individual
may purchase to not more than (normally) 85% of the insured’s earned income. The 85% is
usually used for those in lower incomes as determined by company practices, and will be graded
downwards to 65% - or in some cases, 50% - (or even less) for those in the highest income tax
brackets.
    The benefit amount limits take into consideration any other income to the insured, such as
from other type of sick-pay plans offered by the employer, Government (SSI) disability plans,
and other types of personal &/or group insurance. The limits may also be reduced if an insured
has a significant amount of unearned income, or if they have a high net worth (such as $3-5 mil-
lion).
    Limits may seem severe, but the purpose is to eliminate as much as possible the adverse se-
lection and moral hazard of overinsurance. If the benefits of a Disability Income policy equals
or exceeds the amount of income without the disability, there could be very little reason for an
insured to return to work in case of a claim, with the result that recovery can be stretched out for
a long period of time, or never be attained. As with other insurance products, insurance laws
weigh heavily in favor of the insureds and provide very little recourse for an insurer at time of
claim, therefore the limits of benefits at time of underwriting is about the only control an insurer
has to eliminate the overinsurance hazard. And when the insured is aware of undisclosed sources
of income or knows how much he will need to maintain his present standard of living and is able
to purchase benefits equal or nearly equal to that amount, the element of anti-selection rears its
ugly head.
   One thing to keep in mind where the employer pays the premiums: The monthly benefit will
usually be higher because the benefit is taxable to the employee so the net result will be approx-




                                                   85
imately the same. If the insured has unearned income, such as dividends, interest, etc., the
monthly benefit may be offset by all or some portion of the unearned income.
    Having said all this, the fact still remains that under limits regularly used by Disability In-
come insurance carriers for personal insurance, an insured in the most favorable risk classifica-
tions and with adequate income, may acquire up to as much as $20,000 indemnity a month for
total disability. It should be noted that this amount is usually separate from the limits of special
business Disability Income insurance policies – for example, overhead expense insurance.
                                       Participation Charts
    Most companies use a ―participation chart‖ which determines the maximum monthly benefit
according to the applicant’s annual income. Limits have grown over recent years, and whereas it
used to be 50 or 60 percent of compensation with a monthly cap of $6,000 or so was normal,
these limits are much higher in today’s market.
                              BASIC BENEFIT PROVISIONS
    There are different benefit provisions for total disability and a benefit for waiver of premium,
and they are used by all insurers in spite of any other coverages that may be included in the poli-
cy. The benefit provision will define loss, the method of benefit payment, and determination as
to termination of benefits.
                                      Rehabilitation Benefit
    This benefit is used as an inducement for a disabled insured to return to work. It provides for
payment of a specified amount (typically 12 times the total of the monthly indemnity and any
other supplemental indemnities) to cover the costs, when not paid by other insurance or public
funding, when the insured enrolls in a formal retraining program that will help the insured return
to work. However, the rehabilitation is not mandatory in the greatest majority of the policies.
                                  Non-Disabling Injury Benefit
    This benefit pays ―up-to‖ a specified amount which helps to reimburse the insured for medi-
cal expenses incurred for treatment of an injury that did not result in total disability. The amount
generally is in the range of 25% of the monthly indemnity benefit. The benefit of this provision
to the insured is obvious – additional medical expenses paid – and for the insurer, the payment
can possibly and logically eliminate a disability claim by making it possible for the insured to
treat the injury before it becomes a disability.
                                        Transplant Benefit
     A relatively new benefit, this benefit actually is two-fold. If an insured becomes totally dis-
abled because of the transplanting of an organ from his body to that of another, the insured will
be considered as totally disabled because of sickness. Further, this benefit provides that cosmetic
surgery performed to correct appearance or a disfigurement would be considered as a total disa-
bility because of sickness.
    The wording of this benefit will vary by those companies offering it. It immediately raises
the question as to whether cosmetic surgery coverage would include such (frivolous to many)
surgery as breast implementation. One must remember that there is an elimination period in-
volved, and since it would be treated as a ―sickness,‖ the insured would be deemed to have been



                                                 86
―cured‖ in most cases. However, in the case of reconstruction augmentation surgery because of
breast cancer, it fulfills an important personal and social function.
                                       Principal Sum Benefit
   As in many other types of life and health policies, this benefit pays a lump sum accidental
death benefit amount if the insured is killed in an accident. The death must be caused by injury,
both directly and independently, and it must occur within (usually) 90 (or 180) days of the acci-
dent.
    It also pays a dismemberment or loss of sight benefit in the form of a lump sum, typically 12
times the monthly indemnity plus any additional indemnities. If sickness or injury results in the
dismemberment or loss of sight, however, the insured must survive the loss for 30 days. This
payment is in addition to any other indemnity payable under the policy and will pay the benefit
for two such losses during the lifetime of the insured. However, it is generally limited to the ir-
recoverable loss of one eye, or the complete loss of a hand or foot because of severance above
the wrist or ankle.
                                    OPTIONAL BENEFITS
   Most insurers offer optional or supplemental benefits and some insurers may include one or
more of these benefits in their policy, but usually they are available for an additional premium.
                             RESIDUAL DISABILITY BENEFIT
    As briefly discussed earlier in this text, this benefit provides a lower monthly indemnity in
proportion to the insured’s loss of income, when the insured returns to work at lower earnings. If
the policy’s definition of total disability is ―own occupation,‖ the residual benefit is paid only
when the insured has returned to work in his ―own occupation.‖ It is interesting to note that
about 35% of all Disability Income insurance claims either start or end in a residual claim.
    In most Disability Income insurance policies, the insured may be either totally or residually
disabled for purposes of the elimination period and waiver of premium. In order to determine
residual disability, most policies use test of time and duties, combining both occupational and
income requirements.
    The ―specialty‖ definition of total disability is often used during residual disability in those
situations where the insured is considered as totally disabled for his professional specialty, but is
at work earning a lower income in a general practice. Usually, the specialty type of definition is
used only for regular occupations to avoid equivocation when the definition of total disability is
based upon the ―own occupation‖ provision.
    Typically, a prior period of total disability sustained is not required prior to claiming the resi-
dual benefits, therefore it is possible for a residual claim to commence on the date of the claim
and the reduced indemnity is payable at the end of the waiting period and will continue for the
length of the benefit period. Until recently, there was a ―qualification period‖ which was a pe-
riod of time (30 to 90 days usually) that the insured had to have been totally disabled. Today,
most policies allow the insured to combine periods of total and / or partial disability to satisfy
any qualification period. Practically, however, residual claims nearly always follows a period of
total disability, but in any event, they make up a very small percentage of disability claims, either
from incurrence date or following a period of total disability.



                                                  87
   Residual disability payments are payable for the policy benefit period, or until the loss of in-
come is less than 20% (or 25%) of the insured’s prior income. Residual disability payments
usually cease at age 65.
     Practically speaking, of the two major types of residual claim – loss of income only, or loss
of time and duties – most experts feel that the loss of income type of residual claim provision is
better for the consumer, as under the loss of time and duties, benefits cease when the insured re-
turns to work. However, many people that return to work after disability, do not immediately
start making the income that they did prior to the disability. While in some occupations, such as
technical and some professional jobs, a person is able to immediately start at the same income
after a disability, but if, for example, the insured is in marketing or sales, it will take some time
for him to return to his previous level of performance after a disability.
                              PARTIAL DISABILITY BENEFIT
    There is a distinct similarity between the Partial Disability Benefit and the Residual Benefit,
and most policies have replaced the partial benefit with residual benefit provisions for profes-
sional and white-collar occupations. However, many insurers maintain a partial disability provi-
sion for less-favorable occupations.
    Typically, the Partial Disability Benefit provides 50% of the monthly benefit amount payable
for total disability, and is paid for the lesser of (1) six months, or (2) the remainder of the policy
benefit period, provided the insured has returned to work on a limited basis after a period of cov-
ered total disability. Partial Disability is usually defined in terms of occupation, and refers to
both time and duties.
                SOCIAL INSURANCE SUPPLEMENT (SUBSTITUTE)
    The Social Insurance Supplement (SIS) was created in response to problems in underwriting
Disability Income insurance because of the disability benefits available through workers’ com-
pensation insurance, or for disability and/or retirement under Social Security. These benefits can
be substantial and most insurers take these amounts into account in arriving at a benefit amount.
Most companies limit the amount of Disability Income insurance that will be available to those
with incomes of less than $35,000 per year and in particular, those in less-favorable occupations.
    These riders are usually issued in amounts of $600, $800, or $1,000 per month. Keep in
mind that this rider is designed to provide additional income if the client CAN NOT QUALIFY
for Social Security benefits.
    Many times the insured will not qualify for the social insurance benefits because, for in-
stance, a loss is covered by workers’ compensation insurance. In addition, the requirements for
total and permanent disability under Social Security are very restrictive. This would mean that if
the insurer had limited the benefit amount under a Disability Income insurance policy, the in-
sured could be underinsured each month by several hundred dollars – or even more.
     The Social Insurance Supplement benefit meets this gap in coverage as it provides a monthly
benefit amount that approximates the amount of Social Security Disability benefits for total disa-
bility. Obviously, the SIS is paid when the insured is totally disabled according to the policy de-
finition, but is not receiving benefits from any social service plan. Benefits are paid at a fixed
amount, but if at a later date, the insured starts receiving income from a social service plan, the
insurer will either terminate the benefit payments, or terminate the benefits on a dollar-for-dollar



                                                 88
basis with the social insurance plan. If the latter method is used, there usually is a ―floor‖ below
which the SIS benefit will not be reduced while the insured is on total disability.
    In actual practice, purchasing this rider is more cost-effective than purchasing the same
amount of base disability coverage. Therefore, since the insured will probably never receive So-
cial Security Disability Benefits, the insured can receive additional income at a lower premium.
    As far as the insurance company is concerned, this rider can help protect the company against
overinsurance. An insured could (conceivably) receive 60 percent of income in benefits in addi-
tion to Social Security Benefits. This would hardly provide an incentive for an insured to return
to work.
    Some insurers now offer Social Insurance Substitute Benefits that operate in the same fa-
shion except they cover other federal, state or local benefits the insured receives, such as Civil
Service or Workers’ Compensation, etc., benefits.
                                  INFLATION PROTECTION
    The Cost of Living Adjustment (COLA) benefit under a Disability Income insurance plan
provides for benefits to be adjusted each year during a Long-term claim, to reflect the changes in
the cost-of-living from the time that the claim started. Various methods of determining the
COLA are used, but the most typical are those using the U.S. Consumer Price Index. Originally,
using fixed percentage increases provided the inflation protection, but these plans could increase
the benefit amount faster than the rate of inflation, leading to the overinsurance moral hazard
problem.
    The calculation itself can be rather complex, but simply put; the index for the current claim
year is compared with the index for the year in which the claim began. If the index increased or
decreased since the claim period began, the benefits for the next 12 months are adjusted by
whatever percentage change there was in the index. This percentage change would be limited to
a specified rate of inflation, generally ranging between 5 and 10 percent (compounded annually).
     With these calculations depending upon an index that can rise or fall with the economy, the
adjusted benefits of the policy can increase or decrease each year, however the policy provides
that the benefits cannot be reduced beyond an amount stated and specified in the policy on the
policy issue date. Some policies are capped so as to limit the increase in benefits to a maximum
of 2 or 3 times the original benefit amounts, but others have no limit on the amount that the bene-
fits can increase before insured reaches age 65.
    Many professional Disability Income insurance agents will not recommend this rider if the
insured is over age 45, as after that age, an individual is not as much at risk for inflation as at the
younger ages, when a permanent disability would be tragic.
  Some COLA riders are ―capped,‖ usually at double or triple the monthly amount, but other
COLA riders allow benefits to increase until the insured is age 65.
    There can be a ―buy-back‖ provision, i.e., if the insured returns to work after suffering a dis-
ability and receiving monthly benefits, which increases according to the COLA benefits. If the
client returns to work and then suffers another disability, the monthly benefit payment would re-
turn to the original amount (prior to COLA increases). With the buy-back provision, the cover-
age for the new disability can be what he was receiving under the previous disability with the
COLA advances, by paying an additional premium (depending upon age).


                                                  89
SUPPLEMENTAL PROVISIONS FOR INCREASED FUTURE BENEFITS
                              Automatic Increase Benefit Provision
    This benefit provides for increased benefits as provided by a specified table, in the monthly
benefit payment. Usually these increase in each of 5 consecutive years, at a published fixed rate
(usually 5% or 6%). There are increases in premiums also, with each increase in benefit being
paid for at the attained age rate (for the portion of the benefit that was increased). Usually the
insured has the choice of accepting or rejecting each increase over the five-year period. If he
does so, he usually has the option of continuing the automatic increase over another five-year
period. This option is often provided with no extra charge on policy issue date but other compa-
nies may charge an additional premium for the rider.
    When (if) the insured recovers, the benefits usually revert to those that were in force on the
policy issue date. Some insurers allow the insured after recovery, to continue permanently the
adjusted benefits that he received during the last claim payment year, but the insured will have to
pay the required premium for the age and amount.
                                 Guaranteed Insurability Option
    This option, also referred to as a ―Future Increase Option,‖ is similar to that offered in life in-
surance, i.e., it allows the insured to purchase additional Disability Income insurance at future
policy anniversary dates without evidence of insurability. This type of option would be expected
to have some anti-selection elements, as it would more often be purchased by those who expect
to suffer claims and among those whose insurability is questionable. The increase in benefits
available under this rider varies greatly among insurers, but usually is limited to twice the
monthly indemnity the insured has in force among all insurers on the original policy issue date.
    The purchase options are available annually to the insured, on the policy anniversary date,
usually until age 50 or 55. The amount of the benefit is limited to the insurer’s limitations of
disability income in relation to the earned income, and can also be limited by amount – such as
$500. Some policies allow the purchase of all or part of the total purchase option, on any policy
anniversary date prior to the insured’s age 45 – annual increases thereafter are usually limited to
a maximum of one-third of the original total.
    If the insured is disabled on an option date, the insured can purchase the additional monthly
indemnity but the additional amounts will not apply to the current claim. If the insured is dis-
abled on the date that they could exercise the increased benefit option, the future increase options
are immediately payable. Income requirements, in these situations, are based upon earned in-
come at the start of the claim, and immediate benefit payments are subject to an elimination pe-
riod, beginning on date of issue of the additional insurance coverage.


                       TYPES OF GROUP DISABILITY PLANS
    Disability Income insurance is one of the two medical plans available to employees or mem-
bers of an organization that qualify for group insurance, the other being Medical insurance which
is beyond the scope of this text. Group Disability Income insurance consists of two types: Short-
term and Long-term.




                                                  90
                               SHORT TERM DISABILITY
    As a general rule, Short-term Disability Income insurance is simpler in many respects than
the Long-term plans. Typically, the Short-term Disability Income plans place a maximum dollar
amount on the benefits that will be paid in case of disability, regardless of the earnings of the in-
sured. Some Short-term plans and the majority of Long-term plans apply benefits as a percen-
tage of the total earnings of the insured excluding bonuses and overtime.
    Short-term plans may provide a maximum dollar amount of benefits, regardless of how much
the insured draws in income. For instance the Short-term plan offered might provide a benefit
equal to 75% of earnings, with a maximum of $250 per week. It is common to provide Short-
term benefits on a weekly basis. If the group is large enough, or if the earnings vary greatly
among the various levels of employees, the group policy may have a schedule of benefits that
would so indicate the variances, and the maximum benefit would often be graded by occupation-
al classes, rather than by strictly income.
    In the discussion of elimination periods, it was noted that in most Long-term plans, the wait-
ing period for sickness and injury was the same. With the typical Short-term plan, however,
there is no elimination period of disabilities that results directly from an accident, but there
would be a waiting period for sicknesses (usually one to seven days). The reasoning is that most
sicknesses are of short duration and this would eliminate many ―nuisance‖ claims – otherwise
premiums would be higher because of the short waiting period for injuries caused by accident.
There is actually several other combination of elimination periods available.
    The benefit period for both accident and sickness caused disabilities, are usually payable for
up to a range of 13 to 52 weeks. Twenty-six (6 months) weeks is the most common benefit pe-
riod.
    NOTE: Federal law requires that pregnancy be treated the same as sickness under all fringe
benefit plans (which include disability income insurance) for employers with 15 or more em-
ployees. Various states have even stricter laws in this respect, and the impact of these laws on
the cost has been substantial.
           MARKETING OF GROUP SHORT-TERM DISABILITY PLANS
    One of the most successful methods of marketing Group Short-term Disability Income insur-
ance is by what is termed ―Workplace Marketing‖ or better, "Payroll Deduction." As the name
connotes, the plans are sold at the employers place of business and usually also include other
types of insurance, such as Cancer policies, life insurance, accident policies, etc., with the pre-
miums being paid by the employer and/or by the employee through payroll deduction (which is
usually the case). For further discussion, see "Cafeteria Plan" and "Flexible Benefit Premium
Plans" in the following chapter.
    This type of marketing is not true ―group‖ marketing, but could more precisely be called
―Endorsement Group‖ or ―Franchise Group.‖ The employer endorses the programs offered by
the agent and/or company, who then makes individual presentations of the products at the
workplace to each employee, and it is usually done during, before or after working hours. Many
times the enrollment of the employees in these Short-term Disability Income insurance and other
plans coincides with the enrollment of the employees in an employer-sponsored group health
plan, which provides minimum disruption of the employee’s time.



                                                 91
      MARKETING OF GROUP LONG-TERM DISABILITY INCOME PLANS
     With Group Long-term Disability Income Insurance, the benefits are provided to fulfill the
need for income during a Long-term disability from either sickness or accident, and regardless if
it is job connected. Normally, in Group plans, the definition of disability is that of total disabili-
ty, but a few companies will include a residual disability benefit clause in their policies, and
some also offer a presumptive disability clause (as discussed earlier).
    If the group policy has a residual benefit provision, the insured does not have to be totally
disabled to qualify for benefits, e.g., if the insured suffers a disability that that reduces his in-
come by (normally) at least 20% in the first two years of disability, then the policy will pay a
proportionate benefit. The purpose of this is to be consistent with insurers continuing to place
emphasis on rehabilitation services as part of the overall plan benefits. If the presumptive benefit
provision is provided in the policy, the elimination period is waived, and the total loss of sight,
speech, hearing, or two more of limbs (arms &/or legs) will qualify the insured for long term
benefits de facto.
    Typically, an elimination period of 7 days to 12 months is used. The Long-term policy is ac-
tually designed to provide long-term disability income protection upon the expiration of the
Short-term disability coverage. If the disability continues, coverage will usually be provided to
age 65, however other coverage periods—such as 2 years, 5 years, lifetime accident, etc.,—are
often used.
    The size of the group is the most important factor in underwriting Long-term disability in-
come policies, as a large group will allow much more flexibility in underwriting. Another im-
portant factor in group underwriting for this coverage is the nature of the work that the group
performs. Some insurers refuse to write blue-collar groups, or underwrite them much more cau-
tiously.
          TAXATION OF EMPLOYER-PROVIDED DISABILITY INCOME
    Taxation of health insurance benefits are consistent among various types of health insurance
whereas the premiums contributed by the employer for disability income insurance for one or
more employees, are tax-deductible (usually) for the employer as a business expense and are not
taxable income to the employee.
    Premiums are deductible by the employer whether the coverage is provided under a group
policy or individual policies, however, the deduction is allowed only if the benefits are payable
to employees or their beneficiaries—benefits may not be payable to the employer.151
   By court ruling, the deduction of premiums paid for a disability income policy that insured an
employee-shareholder was prohibited when the corporation was the premium payor, owner and
beneficiary of the plan.
    Employee contributions are not tax deductible by the employee. Therefore, the payment of
benefits under an insured plan (or a noninsured salary continuation plan) are treated as taxable
income by the employee, but only to the extent that the benefits that are received are directly at-
tributable to the employer’s contributions. The benefits are fully includable in gross income.
    If benefits are received under the plan to which the employee has contributed, the portion of
the disability income attributable to the employee's contributions is tax-free. Under an individual
policy, the employee's contribution for the current policy year was taken into consideration. Un-


                                                  92
der a group policy, the employee's contributions for the last three years, if known, are consi-
dered.152
    An employer may allow employees to elect on an annual basis, whether to have the pre-
miums for a group disability income policy included in their income for that year. An employee
who elects to have premiums included in his income will not be taxed on benefits received dur-
ing a period of disability beginning in that tax year. An employee's election will be effective for
each tax year without regard to employer and employee contributions for prior years.153
    Premiums that are paid by a former employee under an earlier long-term disability plan, were
not considered paid toward a later plan from which the employee received benefit payments.
Therefore, the disability benefits were includable in income. If the employer merely withholds
employee contributions and makes none himself, the payments are excludable.154
                                       STUDY QUESTIONS

1. The principal reason that it is difficult to compare disability policies is
   A. because the cost of the plans vary widely, even within the same insurance company.
   B. that some are underwritten, some are not, and most are somewhere in between.
   C. that they are designed to provide flexibility, which leads to a wide availability of
       benefits and optional coverages.
   D. that all such policies are copyrighted and so they have to vary widely.

2. In respect to renewing coverage, disability income and medical expense insurance are (uni-
    quely)
    A. guaranteed renewable.
    B. conditionally renewable
    C. provisionary renewable.
    D. non-cancelable.

3. Most disabilities
   A. are of the long-term variety.
   B. are of the short-term variety.
   C. occur after the wage earning years.
   D. are covered by private or corporate disability insurance.

4. Under a disability income policy, the word "injury" is defined as
   A. accidental body injury caused by accidental means.
   B. accidental bodily injury occurring while the policy is in force.
   C. injury occurring by accidental means, whether intentional or accidental.
   D. an impairment requiring loss of income for a period of not less than 30 days.

5. With a disability income policy, in order for the insured to be considered as "disabled,"
   A. he must have suffered a loss of income because he cannot perform the duties of his job.
   B. he must have received medical attention from a licensed medical professional causing
      mental or physical distress.
   C. an insured must be classified as permanently disabled.
   D. he must be under the care of a licensed medical professional 24 hours a day.


                                                93
6. Insurance companies use two different definitions to describe total disability:
    A. unable to perform any gainful occupation or avocation.
    B. unable to perform any part-time or seasonal work.
    C. immobile or mobile.
    D. any gainful occupation (any occ) or own occupation (own occ).

7. If an individual is insured under a disability income policy, the policy may consider the in-
    sured to be totally disabled even while he is at a work if
    A. he is making at least 50% of the compensation he was receiving prior to the disability.
    B. he is a key man" or highly-compensated.
    C. he can still perform the majority of the duties he performed prior to disability.
    D. he lost the sight of both eyes, hearing from both ears, power of speech, or use of any
        two limbs.

8. Some disability income policies require that the elimination period
   A. be satisfied with total disability only.
   B. be satisfied with total disability or with consecutive days of disability.
   C. include consecutive days of disability.
   D. be waived in case of sickness but at least 30 days in case of disability because of
      an accident.

9. In determining whether a recurrent or consecutive disability or episodes of disability is to be
    considered as a new disability or as a continuing claim, recurrent disabilities will be consi-
    dered as one continuous period of disability
    A. unless each period is separated by recovery for a period of not less than 6 months.
    B. unless each period is separated by recovery for a period of not less than 30 days.
    C. in any event.
    D. unless each disability period was caused by dissimilar incidents, medical conditions, or
        accidents within 1 year of the original disability commencement.

10. It about 35% of all disability claims either start or end
   A. because of an accident.
   B. because of cancer, heart attacks or AIDs.
   C. in a residual claim.
   D. during the first year of coverage.

ANSWERS TO STUDY QUESTIONS
1C   2B   3B   4B   5A   6D   7D   8B   9A   10C




                                                   94
         CHAPTER SEVEN - FLEXIBLE BENEFIT PREMIUM PLANS
                       (CAFETERIA PLANS)

    It should be noted that in the discussion of Flexible Benefit Premium (Cafeteria) Plans, there
are many references to various provisions of the Internal Revenue Service Tax Code. These
plans are designed primarily for tax benefits for employee and employers.
    Flexible Benefit Premium Plans are a result of Title 26, IRS Code Section 125, ―Cafeteria
Plans,‖ and are also frequently called simply ―Cafeteria Plans‖ and/or ""Flex Plans." The Cafe-
teria Plans have developed into an entire new field of employee benefits, particularly with those
products that are paid through payroll deduction where the employer may or may not participate
in the plans offered. Cafeteria Plans are marketed through a group approach even though most
of the plans offered are not "true group" but are employer-endorsed.
    Flexible Benefit plans may offer group and/or individual policies, but usually the benefits of-
fered in the Disability Income insurance area are supplemental benefits – supplemental to group
health (usually major medical plans), pension plans and life insurance, and not necessarily sup-
plement to group Disability Income insurance, although they certain can be and are frequently
offered. Supplemental Disability Income insurance is usually written on an individual basis with
payroll deduction, so even if the policies are individual policies, the payment of premiums to the
insurer by the employer (payroll deduction to the employee) and the fact that marketing is per-
formed at the worksite and during, before or after work, puts a ―group face‖ on the product.
    The products that are usually offered in a Cafeteria Plan will be discussed in more detail lat-
er. The Cafeteria Plan must offer at least one nontaxable benefit (health or accident insurance,
for example) and a minimum of one taxable benefit.
    In the early 1970's, several "Fortune 500" companies formed the "Employers Council on
Flexible Compensation" and were successful in lobbying Congress because of the changes in the
work force and the increasing cost of health benefits. Section 125 was created by Congress in
the Revenue Act of 1978 and added to the Internal Revenue Code. Basically, it allows employ-
ers to establish flexible benefit plans, or Cafeteria Plans, under which employees can choose be-
tween tax-free benefits and taxable benefits.

     The key to the success of Cafeteria Plans is that participating employees may
 redirect a portion of their salaries for the purchase of qualified benefits by pre-tax salary
                   deduction(s) instead of after-tax payroll deduction(s).
   In many instances, the tax savings may offset the cost of the supplemental coverage.




                                                 95
                                          DEFINITION
     The Internal Revenue Section 125(d)(1) described a Cafeteria Plan (or flexible benefit plan)
is a written plan in which all participants are employees who may choose among two or more
benefits consisting of cash and "qualified benefits." A cafeteria cannot provide for deferred
compensation, with certain limited exceptions.155 Cafeteria Plans may provide for salary reduc-
tion contributions by the employee, or some plans provide benefits in addition to salary, but in
any event, the effect is to allow the participants to purchase certain benefits with pre-tax dollars.
   Some plans may allow for automatic enrollment, in which case the employee's salary is re-
duced to pay for the "qualified benefits"—unless the employee elects to receive cash.156
   The plan must be written and must contain the following items:
       1) description of the benefits, including the period of coverage;
       2) eligibility rules for those who participate;
       3) election procedures;
       4) how the employer contributions are to be made, whether by salary reduction or non-
          elective employee contributions;
       5) the plan year; and
       6) the maximum amount of employer contributions to the plan, which must include the
          maximum amount of elective, or salary reduction, contributions to the plan available
          to the employee, and which may be stated as either a maximum dollar amount or
          maximum percentage of compensation, or the method of determining the maximum
          amount or percentage.157

                                     Eligible Participants
    In addition to present employees, former employees may be participants—provided the plan
has not been established primarily for the benefit of the former employees. Self-employed indi-
viduals may not be participants.158
    Interestingly, a full time life insurance salesperson, if treated as an employee for Social Secu-
rity purposes, will be considered as an employee for Cafeteria Plan purposes.159

                                        Leased Employees
    As indicated elsewhere in this text, when a person performs services for another (the reci-
pient) under a "leased employee" agreement, the leased employee is considered to be an em-
ployee for the recipient of the services and further, any contributions or benefits provided by the
leasing organization that are attributable to the services performed by the leased employee for the
benefit of the recipient, are treated as though such contributions or benefits were provided by the
recipient.




                                                 96
                                      Eligible Employees
    All employees of the employer, including those at other locations or with other "divisions"
are eligible for the plan unless specifically excluded by the employer. If employees are excluded
by the employer, the employer should be aware of nondiscrimination regulations.
    Unions and part-time employees, as discussed elsewhere in this text, may not be eligible as
union's employees covered by collective bargaining agreements often have their benefits nego-
tiated between the employer and the union. A cafeteria plan, however, may be considered as a
negotiable benefit. If there are union employees who are excluded, the union must be named in
the plan document, particularly if there are other unions active in the company.
   Employees of nonprofit organizations are eligible for Cafeteria plans.
                            Employees of Related Organizations
    Employees who are employed by a controlled group of corporations, are under common con-
trol, or are members of an "affiliated service group" are considered as being employed by a sin-
gle employer.160

                                     Domestic Partner

     Contributions used to provide coverage for a non-dependent domestic partner are
  treated as taxable income. Benefits under flexible spending accounts may not be provided to
       such a domestic partner, because such accounts can include only nontaxable income.
                                          BENEFITS
   Qualified benefits can include:
    Accident and Health Insurance (Medical and Disability Income)
                      Dental,
                      Vision,
                      Cancer,
                      Intensive Care,
                      Hospital Indemnity,
                      Accident only,
                      Accidental Death & Dismemberment,
                      Short-term or long-term Disability (See Discussion on Disability in this
                       text - with attention to taxation at benefit payment if premium was pre-
                       tax.)
    Group Term Life Insurance
    Dependent Care Reimbursement Account
    Medical Reimbursement Account
    401(k) plans
    Vacation Days
    Health Reimbursement Arrangements (HRAs)



                                               97
    The participants may choose among two or more benefits consisting of cash and qualified
benefits. A cash benefit includes not only cash, but a benefit that can be purchased with after-tax
dollars, or a benefit whose value is usually treated as taxable compensation to the employee, if
the benefit does not defer receipt of compensation.161
                                       Qualified Benefits
    The IRS considers a "qualified benefit" as a benefit that is not included in the gross income
of the employee because of statutory exclusion as provided by the Tax Code, and such benefit
does not deter the participant from receiving compensation.
    As with most such regulations, there are exceptions, notably contributions to Archer Medical
Savings Accounts (MSAs). Certain qualified scholarships, educational assistance programs, or
fringe benefits specifically excluded, are not qualified benefits. It is particularly noticeable that
despite intense lobbying by the insurance and long-term care industry, so far any product that is
advertised, marketed or offered as long-term care insurance is not a qualified benefit.162
    When insurance is offered as a qualified benefit, the actual "benefit" is, of course, coverage
under the plan. Certain accident and health benefits are qualified to the extent that such coverage
is excluded under the regulations.163
    Accidental death coverage offered in a Cafeteria Plan under an individual accident insurance
policy is excludable from the employee's income.164
    A Cafeteria Plan can offer group term life insurance coverage on participants, and coverage
in excess of the $50,000 excludable limit may be offered.165
   Health coverage and dependent care assistance under the plan are qualified benefits if they
meet certain requirements, as described in detail later.
    As a general rule, the Cafeteria Plan cannot provide for deferred compensation of an em-
ployee, allow an employee to carry over unused benefits from one plan year to another, or allow
participants to purchase benefits that will be offered later in the plan year. In certain situations, a
participant may elect to have the employer contribute to a plan in his behalf.

                                  Plan Types of Section 125
   There are three "sub-type" of plans offered under Section 125:
    Section 106 or Premium Only Plans. These are the most popular and also the most basic
plans.
   Section 105 or Unreimbursed Medical Plans.
   Section 129 or Dependent Care Plans.
    These will be discussed in more detail in this section. One of the fastest growing areas is the
"flexible spending accounts" which are also called "full plans.




                                                  98
                                          Do the Math
    Payroll Taxes can be divided into those paid by the employee and that covers FICA
(7.65%), Federal and State taxes (for illustration use 15% federal and 2.5% state). For the em-
ployer, the employer pays an equal FICA of 7.65%, but must also pay Federal Unemployment
Tax (FUTA) and State Unemployment Tax (SUTA), which amounts vary by state (as does
Worker's Compensation Insurance and Liability insurance carried by nearly all businesses). Note
that the total FICA is 15.3%.
    It should be noted, for the sake of accuracy, that all states that have state income tax recog-
nize Cafeteria Plans, but in the case of New Jersey and Pennsylvania at the present time, there is
a question regarding state income tax exemptions so their respective tax officials should be con-
tacted in this matter.
    In the following examples, using $1,000 of compensation, the employee pays insurance pre-
miums after taxes are deducted from gross income, and illustrates how paying those premiums
before taxes (pre-tax) reduces taxable income and increased spendable income. NOTE: This
figures are for illustration only as rate of taxation vary by filing status and amount of deduction.
                                EXAMPLE OF TAX SAVINGS
                                ($1,000 employee compensation)
                                        With State Taxes
WITHOUT SECTION 125                                           WITH SECTION 125
$1,000 Gross (taxable) Income                                 $1,000 Gross Income
   -250 Taxes (using 25% see below)                              -100 Insurance Premiums
$ 750                                                                   (Pre-Tax)
   -100 Insurance Premiums After Tax                               900 Taxable Income
                                                                  -225 Taxes (25%)
$ 650 Spendable Income                                        $ 675 Spendable Income
(25% for taxes includes 7.65% FICA, assumption 15% Federal and 2.5% State)
                                         TAX SAVINGS: $25
                                  ($1,000 employee compensation)
                                       Without State Taxes
WITHOUT SECTION 125                                                   WITH SECTION 125
$1,000 Gross (taxable) Income                                         $1,000 Gross Income
   -220 Taxes (using 22% - see below)                                   -100 Insurance Premiums
$ 780                                                                          (Pre-Tax)
   -100 Insurance Premiums After Tax                                      900 Taxable Income
                                                                         -198 Taxes (22%)
$   680 Spendable Income                                              $ 702 Spendable Income
    22% for taxes includes 7.65% FICA, and 15% Federal)
                                         TAX SAVINGS: $22



                                                 99
    $22 or $25 may not seem like a lot, but remember, this is only for each $1,000 of compensa-
tion. An employee making $20,000 a year could save as much as $500 (or $440) a year which
could pay a considerable portion of their insurance premiums so they are, in fact, getting insur-
ance coverage at an extremely low price.


                                   SAVINGS FOR EMPLOYER
    A figure often used to illustrate the savings for an employer by using the Cafeteria Plan, is
$500,000 annual payroll with 25 employees each earning $20,000 and paying $1,200 annually
for Cafeteria Plan benefits. The employer must pay a matching 7.65% for FICA, for a total
FICA of $38,250.
   If under the Cafeteria Plan, the employees pay a total of $30,000 for their benefits ($1,200
times 25 employees), the taxable payroll can be reduced to $470,000, and therefore, the matching
FICA is reduced by $2,295 (7.65% x $470,000 = $35,955. $38,250 - $35,955 = $2,295)
   Now it starts to get interesting. Dividing the employer's FICA savings ($2,295) by the profit
margin of the company would create the amount that the business would have to generate in rev-
enue to see a net profit of $2,295.
   With Flexible Spending Account arrangements, the result is even more interesting: If the
amount that the employees spend for pre-tax benefits ($30,000) PLUS flexible spending account
(FSA) arrangements of another $50,000, then the employer would gain a tax savings of $6,120.

                        SECTION 106 PREMIUM ONLY PLANS
   The most common and most popular plan type under Section 125 Cafeteria Plans is the Pre-
mium Only Plan whereby the employees pay their share of the cost of health and accident insur-
ance with pre-tax dollars.

                                            Benefits
   These plans include:
       Group medical insurance (which may also include PPO and HMO options)
       Group Term Life Insurance up to $50,000. Of importance at this point is that if any part
        of the group term life premium is for dependent coverage, then the entire premium must
        be considered after-tax.
       Other Supplemental insurance benefits (Dental, Vision, etc.)

                                 Plans That Do Not Qualify
   Certain benefits that do not qualify for Section 125 benefits:
      Deferred compensation plans (excepting 401[k] plans) or other post-retirement life insur-
        ance plans for educational institutions that may be covered in Section 125,
   Dependent life insurance,
   Tuition,
   Meals and lodging for the benefit of the employer,


                                                100
   Life insurance with a savings or investment feature, such as universal life or whole life
    products,
   Health or accident plans with a return of premium,
   Long-term care insurance and/or home health care insurance.
   Certain whole life and term life insurance,
   Medicare Supplement policies,
   Cancer or "dread disease" policies,
   A base insurance policy with a Return of Premium Rider (the rider is the disqualification
    factor for the policy, the absence of which may make the policy eligible for pre-tax treat-
    ment).

               SECTION 105 - UNREIMBURSED MEDICAL EXPENSE
    Section 105 allows employees to set aside funds to be used to reimburse themselves for cer-
tain and specified medical expenses that are not reimbursed from any other source (basically,
insurance plans) or claimed as deductions on their income tax. A taxpayer who itemizes deduc-
tions can deduct unreimbursed expenses for medical care (which includes dental care) and ex-
penses for prescribed drugs or insulin for himself, spouse and dependents, to the extent that such
expenses exceed 7.5% of his adjusted gross income—on a joint return, the 7.5% is based on the
combined adjusted gross income of husband and wife.
     IRC Section 213 outlines the procedure for an individual taxpayer and encompasses individ-
ual income tax reporting, etc., including the definition of "medical care:" … defined as amounts
paid (a) for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose
of affecting any structure or function of the body; (b) for transportation principally for an essen-
tial to such medical care; (c) for qualified long-term care service; or (d) for insurance covering
such care or for any qualified long-term care insurance contract.166
    The entire annual elected amount must be made available to an employee when a qualified
request for reimbursement is submitted under Section 105-unreimbursed medical accounts.
These funds must be available irrespective of the amount contributed by the employee at the time
of request, which could leave the employer at risk if the employee terminates employment before
the end of the plan year. Therefore, an employer may minimize his exposure risk by placing a
low cap on the amount that the employee can elect in any plan year.

                                             COBRA
    For unreimbursed medical accounts that are exempt from HIPAA, it is not required that
COBRA be offered to the participant who has spent more than what is in his account at the time
of the qualifying event. Conversely, if the participant has spent less ("underspent") then COBRA
must be offered—it can be stopped at the plan year-end and it is not necessary to offer re-
enrollment rights.

                        Amounts Remaining in Account at Year-end
    Any money that is remaining in either account can not be returned to the participant (known
as the "use-it or leave-it" rule).



                                                101
                              Transferring Money Between Accounts
    A participant may not transfer money from a health care account to a dependent care account
(or vice-versa). Services must have been incurred during the plan year for which the election
amount was redirected. Therefore, employees who participate in one or both flexible spending
accounts should be aware that they cannot "switch money around" at their pleasure so they
should carefully determine where they want their contributions to go.


        EXAMPLES OF ELIGIBLE REIMBURSEMENT ACCOUNT EXPENSES167

   Artificial limbs and reconstructive breasts implants Counseling, if for medical care**(e.g.,
    psychological, psychotherapy, family counseling for patient only, etc.)
   Dental care, if for medical care (e.g., examinations, cleanings, fillings, crowns, bridges, etc.)
   Diabetic supplies (e.g., blood sugar monitor, syringes, test stripes, etc.)
   Drugs, legally obtained by prescription (e.g., insulin or medicines)
   Drugs, over-the-counter, if for medical care
   Fertility Enhancement (e.g., in vitro fertilization, reverse vasectomy, etc.)
   Guide/leader dog or hearing-assisting animal
   Hearing devices (e.g., hearing aids, hearing aid batteries, hearing aid repair, etc.)
   Insurance copayments and deductibles for medical services
   Nursing care
   Oxygen equipment
   Rental of medical equipment
   Services fees for medical care (consultations, diagnostic lab work, etc.) provided by physi-
    cians, surgeons, specialists, or other medical practitioners, including holistic and Christian
    Science practitioners
   Smoking cessation programs, aids, devices, and medications
   Support or corrective devices (e.g., crutches, braces, etc)
   Medically prescribed therapy treatments (must be primarily for individual's medical care)**
   Vision care (e.g., eye examinations, prescription eye glasses and contact lenses, contact lens
    solution, etc.)
   Vision corrective surgery (e.g., RK surgery, Lasik surgery)
   Weight loss programs, if physician prescribed for a specific medical condition (e.g., obesity)
*To be eligible under a Health FSA/URM account, the medical expense(s) must not be reimbursed from any other
source and must be an expense for medical care as defined by IRC Section 213(d) and not prohibited under appl i-
cable law (e.g., IRC section 125) or the Plan Document and Summary Plan Description (SPD).




                                                     102
     EXAMPLES OF INELIGIBLE REIMBURSEMENT ACCOUNT EXPENSES*
The following expenses are not eligible for reimbursement under a Section 105 Unrei m-
bursed Medical Expense Program.
      Medical insurance premiums
  Counseling (nonmedically related) (e.g., anger management, behavior counseling,
           marriage counseling, etc.)
  Dietary supplements (including vitamins) that are merely beneficial to general
           health
  Drugs, prescribed and over-the-counter, that are primarily for personal, cosmetic,
           and/or for the benefit of the individual's general health
  Elective cosmetic surgery/procedure
  Anti-aging treatments (chemical peels, laser therapy, anti-aging drugs, etc.)
  Breast implants
  Cosmetic dental veneers/teeth whitening
  Electrolysis/hair transplants
  Treatment for varicose veins or spider veins
  Funeral expenses
  Health club membership fees
  Household help
  Maternity clothing
  Qualified long-term care services
  Toiletries and personal care services (e.g., shampoo, deodorant, soap, toothpaste,
           toothbrushes, etc.)
  Weight loss foods that substitute for normal foods or nutritional needs
*This list is intended to be representative of the types of expenses that may not be reimbursed. It is not intended to
be complete, as other expenses may also be ineligible under federal tax law or under the plan. To be eligible under a
Health FSA/URM account, the medical expense(s) must not be reimbursed from any other source and must be an
expense for medical care as defined by IRC Section 213(d) and not prohibited under applicable law (e.g., IRC Sec-
tion 125) or the Plan Document and Summary Plan Description (SPD).

                           SECTION 129 - DEPENDENT CARE (DDC)
    A Section 125 Cafeteria Plan may offer reimbursement for specified dependent care expenses
for participant's eligible children &/or other dependents. For these expenses to be reimbursed,
they must be incurred so as to allow an employee and spouse to work, unless the spouse is a full-
time student or incapable of self-care. These expenses are reimbursed if the dependent is under
age 13, or is a spouse or other dependent (so claimed on the participant's income tax) that is
physically or mentally incapable of self-care, and spends a minimum of eight hours a day in the
participant's household.
     Child care expenses (as eligible under the plan) may be provided either inside or outside of
the home. A person who is claimed as a dependent for tax purposes, may not provide the child
care services. Often these services can be provided by day-care facilities, however, any such fa-
cility that care for seven or more children, must comply with applicable state or local require-


                                                         103
ments and laws and be property licensed as such. Preschool costs for a child may qualify for
reimbursement.
    The maximum dependent day care expenses reimbursed is typically $5,000 per calendar year,
the employee's annual income, or the employee's spouse's annual income, whichever is lower. In
the case of a married individual filing separately, the excludable amount is limited $2,500.
   While there is no financial risk to the employer with these plans, the "use-it or lose-it" rule
applies to an employee so care should be taken to carefully consider the amount of the elections.

     Requirements & Tax Consequences of Dependent Care Assistance Programs
    The dependant care assistance program is a separate written plan of an employer for the ex-
clusive purpose of providing employees with payment for or the provision of services, which, if
paid for by the employee, would be considered employment-related expenses.168
     Non-highly compensated employees may exclude from income a limited amount for services
paid or incurred by the employer under such a program provided during a taxable year. For the
highly compensated employees to have the same income tax exclusion, the program must meet
rather stringent anti-discrimination requirements, including the requirement that the average ben-
efits provided to non-highly compensated employees under all plans of the employer must equal
at least 55% of the average benefits provided to the highly compensated employees under all
plans of the employer.169
    It should be noted that an employee cannot exclude from gross income any amount paid to an
individual with respect to whom the employee or the employee's spouse is entitled to take a per-
sonal exemption deduction, or who is a child of the employee under age 19 at close of the taxa-
ble year.
   If the benefits are provided through a salary reduction agreement, the plan may disregard any
employee with compensation less than $25,000 for purposes of the 55% test (above).
    As with most such programs, the employer may exclude from participation employees under
the age of 21 who have completed one year or service and those employees are covered by a col-
lective bargaining agreement.170

                                  Employer's Tax Deduction
    As a general rule, the employer's expenses incurred in providing benefits under a dependent
care assistance program are deductible to the employer as ordinary and necessary business ex-
penses.171

                                   Reporting Requirements
    The employee cannot exclude from gross income any amount paid or incurred by the em-
ployer for dependent care assistance unless the name, address and taxpayer identification number
of the person providing the services are included on the return. If this information was not pro-
vided and the taxpayer exercised due diligence in attempting to do so, the amount shall not be
included in the employee's gross income.172




                                               104
    It should be noted that the IRS under IRC Section 603D requires the employer to file an in-
formation report annually with the IRS which requires such information as number of em-
ployees, number of eligible employees, number of employees participating in the plan, number
of highly compensated employees (the number of then-eligible to participate and number that
actually are participating), the identity of the employer, and the type of business in which it is
engaged. However, these reporting requirements are suspended for dependent care assistance
plans.173
                                          Grace Period
    A flexible spending arrangement (FSA) may allow a grace period of no more than 2 ½
months following the end of the plan year for the participants to incur and submit expenses for
reimbursement. If a plan document is amended to include a grace period, a participant who has
unusual benefits or contributions relating to a particularly qualified benefit from the immediately
preceding plan year, and who incurs expenses for that same qualified benefit during the grace
period, may be paid or reimbursed for those expenses in the immediately preceding plan year.
The effect of the grace period, therefore, is that the participant may have as long as 14 months
and 15 days (the 12 months in the current plan plus the grace period) to use the benefit or contri-
butions for a plan year before those amounts are forfeited (under the use-it or lose-it rule).174
                                              HSAs
   A person participating in a Cafeteria Plan may elect to have the employer contribute to a
Health Savings Account (HSA [discussed later]) on his behalf; and unused balances in a HSA
funded through a Cafeteria Plan can be carried over from one year to the next.175
           Products With Investment Feature & Supplemental Health Policies
    Basically, life, health, disability or long-term care insurance with an investment feature (such
as whole life insurance) or which provides for the reimbursement for premium payments that ex-
tent beyond the end of the plan year, cannot be purchased. However, supplemental health insur-
ance policies which provide coverage for cancer and other specific diseases do not result in the
deferral of compensation, and are, therefore, properly considered accident and health benefits
under a Cafeteria Plan.176
      Post-retirement Term Life Insurance for Certain Educational Organizations
     As pointed out in "2006 Tax Facts on Insurance and Employee Benefits," an educational or-
ganization that meets the IRS requirements can allow participants to elect postretirement term
life insurance coverage. This coverage must be fully paid up on retirement and is not allowed to
have a cash surrender value at any time. Any life insurance meeting these requirements will be
treated as group term life insurance.177
                    Highly-compensated employees and Key Employees
     Highly compensated and "key" employees may participate in the Cafeteria Plan if the plan
meets certain nondiscrimination requirements and does not allow for the concentration of bene-
fits in key employees.




                                                105
                              Tax Benefits of a Cafeteria Plan
     NOTE: If disability (or "salary continuance") insurance is sold with a pre-tax premium, the
benefits will be payable at time of claim. In such a situation, the employee will be subject to in-
come taxes on the benefits received for the duration of the disability. This benefit would be sub-
ject to FICA taxes for the employee and (matching) for the employer for the first six months of
paid benefits. Some insurers will deduct the employee's FICA tax from the claim check and send
it to the IRS, along with notification to the employer of matching FICA funds. In these cases,
the disability benefit will appear on the employee's W-2 tax form as taxable income.
    In order for an employee to take advantage of the "tax breaks" of a Cafeteria Plan, the partic-
ipant in such a plan is not treated as being in "constructive" receipt of taxable income solely be-
cause he has the opportunity—before a cash benefit becomes available—to elect among cash and
"qualified" (or non-taxable) benefits.-178
    However, the election must be made before the specified period for which the benefit that
will be provided, begins (usually the plan year).179

                            Non-Discrimination Requirements
    Simply put, if the plan discriminates in favor of highly compensated individuals either by
contributions or benefits, then such individuals will be considered as being in (constructive) re-
ceipt of the available cash benefit.180 Those who are "highly compensated" consist of officers,
shareholders owning more than 5% of the voting power of the stock, those who are highly com-
pensated, or a spouse or dependant of any of them.181
     Conversely, the participation will be considered as nondiscriminatory if it does not discrimi-
nate in favor of employees who are officers, shareholders or highly compensated (as determined
by the Secretary of the Treasury). Further, not more than three years of employment may be re-
quired for participation—such requirement being the same for all employees; and the require-
ment that all employees who are eligible begin to participate in the plan by the first day of the
first plan year after the employment requirement, is satisfied.182
    There is another rule that allows that a plan will not be discriminatory in respect to benefits
under the Cafeteria Plan for highly compensated employees as determined by using a percentage
of compensation, if such benefits are not "significantly" higher (or lower) than the total benefits
or nontaxable benefits that are provided for other employees measured by the same basis, and
provided the plan is not otherwise discriminatory.183
    If the Cafeteria Plan offers health benefits, then the plan is not considered as being discrimi-
natory in respect to either contributions and/or benefits, if two requirements are met:
       1) contributions for each participant must include an amount that is either equal to 100%
          of the cost of the health benefit under the plan of the majority of the highly compen-
          sated participants with similar family size, etc., or such contributions are equal to or
          more than 75% of the cost of the most expensive health benefit coverage elected by
          any participants similarly situated (family size, etc.); and
       2) the contributions or benefits in excess of these amount bear a "uniform relationship to
          compensation."184




                                                106
   Note: A plan is considered as satisfying all discrimination requirements if it is maintained
under a collective bargaining agreement between representatives of the employees and one or
more employers.185
    In respect to the nondiscrimination rules, a key employee (as defined in the tax code) will be
considered as not in constructive receipt of the available cash benefit option in any plan year in
which nontaxable benefits that are provided under the plan to key employees exceed 25% of the
total of such benefits that are provided to all employees under the plan. Excess group term life
insurance that is included in income will be considered as a taxable benefit.186
                               Date of Employer Contributions
    Any amount that the employer contributes to a Cafeteria Plan because of and pursuant to a
salary reduction agreement, will be treated for tax purposes as employer contributions to the ex-
tent the agreement relates to compensation that has not been received, either actually or construc-
tively, by the employee as of the agreement date, and does not subsequently become available to
the employee.187
                            CHANGING A BENEFIT ELECTION
    The tax rules are rather stringent as to an employee changing a benefit election. Generally,
an employee may be permitted to revoke an election for coverage under a group health plan and
make a new election as allowed by the tax code188 which pertains to situations where persons
lose other group health plan coverage and dependent beneficiaries.189
    Certain changes can be made in respect to a judgment, decree or other resulting from a di-
vorce, legal separation, annulment, or change in legal custody or qualified medical child support
order—that requires accident or health coverage for the child of an employee or for a dependent
foster child of the employee. The plan may permit the employee to make an election change to
cancel coverage for the child if an order requires the spouse, former spouse, or other individual
to provide coverage for the child (and the coverage is so provided).190
    If an employee, spouse or dependent enrolled in the accident or health plan becomes quali-
fied for Medicare Part A or Part B, the plan may allow the employee to make an adjustment to
the plan accordingly. Conversely, if an employee had been entitled to Medicare or Medicaid
coverage and they lose their eligibility for such coverage, provision may be made to start or in-
crease coverage of that employee, spouse or dependant accident or health plan.191
    An employee that takes a leave pursuant to the Family and Medical Leave Act (FMLA) may
revoke such accident or health coverage and make an election as provided for by the FMLA for
the remaining period of coverage.192
                                         Status Change
    A Cafeteria Plan may allow an employee to revoke an election during a period of coverage in
regards to a qualified benefits plan, and allow them to make a new election for the remaining pe-
riod of coverage if a change in status occurs and the election change meets the "consistency rule"
(as discussed below).193 Such changes in status events are:
       1) the changing of a marital status of the employee—marriage, death of spouse, divorce,
          legal separation, or an annulment;




                                               107
       2) changing the number of dependents—birth, death, adoption or placement for adop-
          tion;
       3) an event that changes the employment status of the employee, spouse or dependant—
          termination/commencement of employment, strike/lockout, starting or returning from
          unpaid leave of absence, and change in work site;
       4) situations where employee's dependent satisfies or ceases to satisfy eligibility re-
          quirements due to age, student status or similar situation;
       5) change of residence of employee, spouse or dependent; and
       6) if adoption assistance is provided under the plan, the starting or termination of an
          adoption proceeding.
                                       Consistency Rule
   The before-mentioned consistency rule states that:

     an election change cannot be made for accident or health coverage or group term life in-
 surance, unless it is on account of or corresponds with a change in status that affects eligibility
                                   for coverage under the plan.
    If a dependent dies or in some other fashion ceases to satisfy the eligibility requirements for
coverage, as an example, then the election by the employee to cancel health insurance for any
other dependent, for himself or his spouse, does not correspond to the change in status.
   There is an exception to the consistency rule in those cases where an employee, spouse or
dependent becomes eligible for COBRA continuation coverage, the plan may allow the em-
ployee to elect to increase payments under the plan to pay for the COBRA coverage.
    For group term life insurance and disability coverage, an election under a Cafeteria Plan to
increase (or decrease) coverage because of the change in status outlined above, is considered as
corresponding to that change in status.194
    The consistency rule is considered to have been satisfied if an election change is because of
and corresponds to a change in status that affects the employees' eligibility for coverage under
the plan. The election change also meets the consistency rule if it is because of and corresponds
with a change in status affecting dependent care expenses, or adoption assistance expenses.195
              Election Changes Because of Cost or Coverage Changes
   (It should be noted that the rules regarding election changes because of significant cost or
change of coverage apply to all kinds of qualified benefits under a Cafeteria Plan, but not to
health flexible spending arrangements [FSAs]).
     If the cost of a qualified benefits plan increases or decreases during a period of coverage, the
plan may automatically make a "prospective" (not retrospective) change in the salary reduction
amount of the employee.196 If the cost of a benefit plan option significantly increases during the
coverage period, the plan may allow the employees to either increase their salary reduction
amounts, or to revoke their election for that particular benefit and elect another benefit option
that offers similar coverage on prospective basis.197 Conversely, if the cost of the qualified bene-
fits significantly decreases during the year, the plan may allow all employees (even if they had


                                                 108
not previously participated in the plan) to elect to participate in the plan for the particular option
that has decreased in cost.198
    If the employee has a significant loss of coverage under a plan during the coverage period
that is, in effect, a loss of coverage, then the plan may allow the employee to revoke his previous
election and elect to receive (prospectively) another option that provides similar coverage. If
there is no similar coverage available, the employee may drop the coverage. A "loss of cover-
age" occurs when there is a complete loss of coverage caused by such as elimination of an op-
tion, an HMO ceasing to operate in the area, or losing all coverage because of an overall lifetime
or annual limitation.199
    If an employee suffers from a significant loss of cover, such as a significant increase in the
deductible, or the copayment, or out-of-pocket expense, the plan may allow the employee to re-
voke his election and elect to receive (prospectively) coverage under another option that provides
a similar coverage.200
    If, on the other hand, the plan adds a new benefit option or improves an existing benefit
package option or other coverage option, during a period of coverage, then the plan can allow
eligible employees—even if they had not previous elected to make an option under the Cafeteria
Plan—to revoke their election and to make a new election (prospectively) for coverage under the
new and/or improved option.201
    If an employee loses coverage under a governmental or educational institution group health
plan, then a Cafeteria Plan may allow an employee to make a (prospective) election change that
would correspond to a change made by another employer plan or to add coverage under the
plan.202
                                         Applicable Dates
   The plan may allow an employee to make a prospective election change that corresponds to a
change made under another employer plan or to add coverage under a plan for the em-
ployee/spouse/dependent if the employee/spouse/dependent loses coverage under any group
health plan sponsored by a government or educational institution.203
              Effect of the Family and Medical Leave Act on Cafeteria Plans
    After consideration, in 2001 the final regulations state that employers may require the em-
ployees to continue coverage if the employer pays the employee's portion of the coverage
cost.204 Further, employers on FLMA leave usually are allowed to revoke or change elections in
the same manner as those employees not on FLMA leave, but they are entitled to be reinstated if
their coverage terminated during their leave, either by revocation or nonpayment of premiums.205
                           Health Flexible Spending Account (FSA)
    The same general rules apply to an health flexible spending arrangement as traditional Cafe-
teria Plans, including the right of an employee on a FLMA leave to be reinstated.
    As long as the employee's coverage under the Health FSA is continued, the entire amount of
his FSA, less any previous reimbursements, must be available for reimbursement of his health
expenses. If the coverage is terminated at any time during the FLMA leave, the employee is not
entitled to reimbursement for expenses incurred while the coverage was terminated.206




                                                 109
   A Cafeteria Plan usually offers employees on unpaid FMLA leave up to three options for
paying for their health coverage under a Cafeteria Plan or Health FSA, and any of the options
can be made on a pre-tax salary reduction basis, to the extent that the employee on FLMA leave
spans two plan years. These three options may also be made on an after-tax basis:
       1) Pre-paid option where the employee pays the amounts due for the FMLA leave period
          prior to the leave starting.
       2) Pay-as-you go option where the employees pay their part of the health care costs ac-
          cording to a payment schedule as outlines in the regulations.
       3) Catch-up option where an employer continues providing coverage during the FMLA
          leave.
   Also, Health FSAs are usually subject to the same payment rules as traditional Cafeteria
Plans.
    Note: Under the regulations, employers are not required to continue an employee's non-
health benefits provided under a Cafeteria Plan—such as life insurance—during an FMLA leave,
but the employee is entitled to continuing non-health benefits on the same basis as employees not
on FMLA leave.207
                     Social Security and Federal Unemployment Taxes
    Since amounts that are received by cafeteria-plan participants or their beneficiaries are not
considered as wages, these amounts are not subject to Social Security or Federal Unemployment
taxes if these payments would not be treated as wages without regard to the plan.208
    Note: In previous years, the employer that sponsors a Cafeteria Plan must file an information
return with the IRS, indicating the number of employees, the number of employees eligible for
participation in the plan, the number actually participating, cost of the plan, etc. However, the
IRS has recently suspended these reporting requirements, with further guidelines from the IRS to
be provided in the unspecified future.
                     FLEXIBLE SPENDING ARRANGEMENTS
    A flexible spending arrangement (FSA) is another program regulated by IRC Section 125
that allows for reimbursement of specified, incurred expenses. This arrangement may be a stand-
alone plan or part of a Cafeteria Plan—the most well-known are Health FSAs and dependent
care assistance FSAs. In order for the FSA coverage to qualify for the exclusion from income,
there are certain requirements that must be met.
                                        Health Coverage
     The FSA health coverage does not need to be provided by an insurance plan, but it must have
the risk shifting and risk distribution characteristics of insurance, particularly an indemnity plan
as it must be paid specifically for the reimbursement of previously-incurred medical expenses.
In fact, a Health FSA is not allowed to provide coverage only for periods when the participants
expect to incur medical expenses, if the period is less than a plan year.209 Also, in keeping with
the "insurance" philosophy, the maximum amount that may be reimbursed must always be avail-
able during the coverage period—except that it can be reduced for prior reimbursements cover-
ing the same period of time. Unlike insurance, the maximum amount of reimbursement must be
available irregardless as to whether the participant has paid the required premium for the cover-


                                                110
age period, plus, there must not be a premium payment schedule based on the rate or amount of
claims incurred during the coverage period.210
     The period of coverage must always be 12 months, of the entire first year in case of a short
first-plan year. Election changes cannot be permitted to increase or decrease coverage during a
coverage, but a.s prospective change may be allowed consistent with certain family status
changes. The plan may be terminated if the employee does not pay due premiums, but only if the
plan terms prohibit the employee from making a new election during the remaining coverage pe-
riod. The plan is allowed to allow a terminated employee to revoke existing elections.
    As with other cafeteria provisions, there may be a grace period of no more than 2 ½ months
following end of the plan year for participants to incur and submit expenses for all reimburse-
ment.
   Medical expenses reimbursement may be provided but

   it may not reimburse for premiums paid for other health plan coverage.211
    The plan may reimburse for non-prescription over-the-counter drugs. Employer-provided
coverage for qualified long-term care services under an FSA is included in the employee's gross
income.
    As an interesting note, the IRS has approved the use of employer-issued debit and credit
cards to pay for medical expenses as incurred, provided that the employer has the means and
procedures in place to substantiate the payments.
                              Dependent Care Assistance FSAs
    The rules for dependent care assistance FSAs are the basically the same as to Health FSAs,
except that the maximum amount of reimbursement need not be available throughout the cover-
age period and the plan can limit the participant's reimbursement to the amounts actually contri-
buted to the plan that is still in the account. The grace period is the same as for the Health FSAs.
In any event, contributions to a dependent care FSA may not exceed $5,000 during any taxable
year.212
    Certain qualified employees may claim a dependent care tax credit on their personal income
tax filing, with $3,000 of employment-related child care expenses for one dependent, or $6,000
for two or more dependents. This will save the taxpayer—depending upon his income—
anywhere from 20% to 35%. An employee who has two or more qualified dependents who has
$6,000 of eligible expenses—and who has received the maximum of Dependent Care Assistance
Plan (DCAP) of $5,000—may be eligible to claim a percentage of the $1,000 difference. Note,
however, employees may not claim the same expense under both the tax credit and the DCAP!
    Since this can mean considerable savings to the lower-income worker who probably needs all
the help they can get, the professional representative should always make a decided effort to en-
sure that employees understand the differences between the tax credit and the DCAP.
                                              Other
   Any experience gain or income of an FSA can be used to reduce premium for the following
year, or returned to the premium payors as dividends or premium refunds, but they may not be
based upon individual claims experience.


                                                111
    The maximum reimbursement amount for a coverage period may not be "substantially" in
excess of the total cost ("premium") for the coverage; "substantially" is where the excess of the
total premium of the maximum amount is less than 500% of the premium.213
    The IRS has provided non-binding guidance in respect to FSAs that indicate that orthodontia
expenses should be treated differently from other medical expenses, and if orthodontia expenses
are paid by a lump sum when the orthodontia work commences (instead of being paid over the
course of the treatment), they may be reimbursed under an FSA when they are paid.
   Further, the IRS has informally ruled that there is no minimum claim amount that need not be
substantiated, which means that employers and plan administrators must substantiate all claims,
even small ones.

                        INSTALLATION OF CAFETERIA PLAN
    The insurance companies that market Cafeteria Plans provide various degrees of administra-
tive assistance and they provide their representatives with documentation as to the various plans
available. They also provide extensive training including in-depth instruction in federal and
state regulations that apply.
    Basically, as stated earlier, a Cafeteria Plan must be a separate written document (insurers
usually furnish sample plan documents) which must be submitted by the employer. All em-
ployees must be informed and usually representatives will inform the employees as to how the
plan works and the advantages to them—either in group meetings or on an individual basis, or
both.
    The plan must offer taxable or qualified nontaxable benefits, and the tax status should be un-
derstood by all employees offered the plan.
    Plan documents and employee salary deduction forms must be formally executed before the
plan becomes effective. Insurance company representatives normally are responsible for the
proper documentation (forms usually furnished by the insurer) and for the enrollment.

                                        Documentation
    The documentation for a Cafeteria Plan consists of a sample plan document, an acceptance
(acknowledgement) form signed by the employer, and a Summary Plan document (which must
be distributed to ALL employees within 120 days of the plan effective date and made available
by the employer to all new hires or plan participants). If there is a Flexible Savings Plan (FSA)
involved, a separate agreement is required (called, for instance, "Reimbursement Services
Agreement")
    In addition to these general documents, the documents must provide the following informa-
tion to the employer and the employees:
       A specific description of each benefit that is available under the plan, including the pe-
        riods during which the benefit is provided,
       Eligibility rules that govern the employee's participation in the plan,
       Description of the procedures that govern the participants election under the plan, show-
        ing which elections may be made, procedures for changing elections, and timing when
        such elections or changes are made,


                                               112
       The procedures whereby employer contributions are made under the plan (payroll de-
        duction agreements between the employee and the employer),
       The maximum pre-tax benefits available to any participant under the plan, and
       The plan year on which the plan operates and which could consist of less than 12
        months but never more than 12 months.. It is fairly common for plan years to coincide
        with group health insurance renewal date, or simply the calendar year, in which case
        there would be a shorter initial year. Consecutive short plan years are in violation of
        IRS regulations, so subsequent plan years should always be 12 months—unless the em-
        ployer terminates the plan. The employer may change the plan year other than at re-
        newal, provided there is valid and supportable business reasons (usually to have the
        plan coincide with the calendar year or fiscal year of the company, or renewal of the
        major medical plan).

     All eligible employees must be enrolled prior to the plan effective date & all insurance
  policies must be effective on the effective date of the plan. New employees must be enrolled
 prior to the end of the eligibility period & the plan must then be effective on date of eligibility.
    During the initial election period, those employees who did not elect to participate in the Ca-
feteria Plan will not be able to participate until the next annual election period, except if there is
a qualified change in status.
    The first pre-tax premium deduction cannot occur until after the effective date of the plan.
For those plans that require underwriting, pre-tax premiums should not be taken until the appli-
cation has been approved.
    There is generally an open enrollment period prior to the anniversary date of the plan, at
which time each participant has the opportunity to make changes or revoke elections for the next
plan year.

                                            Form 5500
     For years, the employer was required to file an information form—Form 5500— with the
IRS and with the Department of Labor. In 2002, the IRS suspended the filing requirement if the
filing would report information only on a Cafeteria Plan, and educational assistance, or an adop-
tion assistance program. However, this does not affect the Department of Labor requirements so
accident, health and welfare benefit plans must still file a Form 5500 (and any other required
forms).

                                           ERISA Plans
    Benefit plans that are subject to Title I of ERISA and are associated with fringe benefit plans,
must continue to file Form 5500. Further information on the filing of this form is provided to the
field representatives by the insurance company, or it may be obtained at www.irs.gov/ep with
reference to "Topics" and "EP Forms & Publications."

                                 FORMS FOR INSTALLATION
    Insurers who are in the group insurance, employee benefit, and/or Cafeteria Plan market have
their forms for the various installation steps based upon their area of interest, state regulations,


                                                 113
and administrative requirements. Insurance representatives and sales persons who are involved
in the employee benefit area must be well educated in the enrolling requirements of the insurer
and more detailed discussion of this would be outside of the scope of this text.
                                     STUDY QUESTIONS

1. Cafeteria Plans are particularly attractive in
   A. the field of payroll deduction employee benefits.
   B. corporations as the employers pay for all of the Cafeteria Plan benefits.
   C. self-employed small firm owners.
   D. the long term disability insurance market.

2. The key to the success of the Cafeteria Plans is that participating employees may redirect a
   portion of their salaries for the purchase of qualified benefits
   A. by after-tax salary deductions.
   B. by pre-tax salary deductions.
   C. which are always paid by the employer.
   D. and where neither the employee nor the employer ever pay taxes on the contributions.

3. An insurance salesperson will be considered as an employee for Cafeteria Plan purposes
   A. in any event.
   B. if he has been a licensed insurance agent for a period of at least 10 years.
   C. if treated as an employee for Social Security purposes.
   D. only after retirement.

4. Contributions that are used to provide coverage for a non-dependent domestic partner
   A. are treated as taxable income.
   B. 50% of the employee contribution is taxable to the domestic partner.
   C. will cause all contributions to Cafeteria Plan benefits to be taxable as ordinary income.
   D. must be paid from the employer's business account used for employee benefits.

5. There are three sub-types of plans offered under Section 125:
   A. the A, B, and C plans.
   B. the qualified, non-qualified and the intermediate plans.
   C. the employer paid, employee paid, and trust paid plans.
   D. the premium only, unreimbursed medical and the dependent care plans.

6. Joe has an unreimbursed medical account with an annual maximum of $5,000. In 2003, he
    used $4,000, in 2004, he used $3,000, how much was in his account as of 1/1/2005?
    A. $8,000.
    B. $3,000.
    C. $7,000.
    D. $5,000.




                                               114
7. A separate written plan of an employer for the exclusive purpose of providing employees with
   payment for or the provision of services, which, if paid for the employee, would be consi-
   dered as employment-related expenses. This would be
   A. a dependent care assistance program.
   B. an HSA.
   C. an MSA.
   D. a short term disability program.

8. Life, health, disability or long-term care insurance with an investment feature
   A. cannot be purchased under a Cafeteria Plan.
   B. can be purchased under a Cafeteria Plan only if the employee pays all the premium.
   C. and cancer or other specific disease policies cannot be purchased under a Cafeteria Plan.
   D. that provides benefits to retired employees, the contributions are never tax deductible to
       either the employee or the employer.

9. If disability insurance is sold with a pre-tax premium
    A. benefits must be payable only for total disability or any contribution from either the em-
        ployer or the employee will be taxable in the year when the contribution is paid
    B. any disability claim payments will show on the employee's W-2 as nontaxable income.
    C. the employee will be subject to income taxes on the benefits received during the duration
        of the disability.
    D. 25% of the pre-tax premium is taxable to the employee in the year of election.

10. Medical expenses under a Cafeteria Plan may be provided
    A. but it may not reimburse for premiums paid for other health coverage.
    B. only to key employees and highly compensated personnel.
    C. for the purpose of reimbursing the employee for premiums for medical insurance.
    D. for the employee, provided the employer pays the entire premium.

ANSWERS TO STUDY QUESTIONS
1A   2B   3C   4A   5D   6D   7A   8A   9C   10A




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  CHAPTER EIGHT - DEFERRED COMPENSATION PLANS
                             DEFERRED COMPENSATION
    Deferred Compensation plans may be classified as "funded" and "non-funded." The value of
these programs depends greatly upon the taxation benefits in most cases. To start, the IRS states
that an employer may deduct all ordinary and necessary business expenses including "a reasona-
ble allowance for salaries or other compensation for personal services actually rendered."214
"Reasonable" compensation is defined as such amount as would ordinarily be paid for like ser-
vices by like enterprises under like circumstances.215 Therefore, a salary that exceeds what is
customarily paid for such services is considered unreasonable or excessive. Compensation does
not necessarily mean "cash" as courts have ruled that, for example, forgiveness of a loan is con-
sidered as compensation.
    If the IRS decides that compensation is unreasonable, then they may consider it as "divi-
dends" and they have a tendency to so rule where there is a sole owner or a group of unusually
highly paid executives. Interestingly, there is an upper limit that a corporation can deduct for
compensation paid to certain executives—$1 million—paid to one of the covered employees (de-
fined further as the corporation's chief executive officer who is one of the four highest paid offic-
ers in the corporation).
    For tax purposes for deferred compensation, "applicable employee remuneration" is the ag-
gregate amount of remuneration paid to the employee for services performed that would be de-
ductible if not for this limitation. This does not include amounts not considered as "wages" un-
der FICA, including payments to a qualified plan, SEP or 403(b) tax sheltered annuity; or
amounts that are considered as salary reduction contributions (contributions by an employer to a
qualified plan on behalf of the employee ).
    Specifically excluded from this definition are commission payments, stock options, stock ap-
preciation rights, and other compensation based solely upon at least one performance goal.

                                   "Parachute Payments"
    "Parachute Payments" are agreements that provide a generous package of severance and ben-
efits to top executives and key personnel in case of a takeover or merger (also called "Golden
Parachutes). Excess parachute payments are subject to no employer deduction for tax purposes,
and the recipient may be subject to a 20% penalty tax.216
    The Code defines a parachute payment as any payment in the nature of compensation to a
disqualified individual (see below) who is either (1) contingent on a change in ownership or con-
trol of the corporation or its assets and the present value of the payments contingent upon these
changes equals or exceeds three times the individual's average annual compensation from the
corporation in the five taxable years ending before the date of the change, or (2) the payment is
the result of an agreement which violates any securities laws or regulations. A transfer of prop-
erty will be treated as a payment and taken into account at its fair market value.217
    A "disqualified individual" is an employee, independent contractor, or other such person who
performs personal services for a corporation, and is an officer, shareholder or highly compen-
sated individual of such corporation. For this purpose, a "highly compensated individual" would



                                                116
be an individual who is a member of the group which consists of the highest paid 1% of the em-
ployees of the corporation or, if less, the highest paid 250 employees of the corporation.
     As a general rule, a payment will not be considered as contingent if it is substantially certain
at the time of change that the payment would have been made whether or not the change oc-
curred, unless the payment is made under a contract entered into within one year of change, then
it would be considered as a parachute payment.218
    Just to make it clear (?) the IRS states that "parachute payment" does not include any pay-
ment to a disqualified individual with respect to a small business corporation (having not more
than l class of stock and not more than 100 stockholders, all individuals (and not nonresident
aliens). It also does not include payments made to a disqualified individual if immediately prior
to the change, there was no stock readily tradable on an established securities market or other-
wise, and shareholder approval of the payment was obtained after adequate and informed disclo-
sure by a vote of persons who, immediately before the change, owned more than 75% of the vot-
ing power of all outstanding stock of the corporation—or—any payment to or from a qualified
pension, profit sharing, or stock bonus plan, or tax sheltered annuity plan, or simplified employee
pension plan.219

                                       "Excess Amount"
    The "official" definition of excess amount for these purposes is "the amount of a parachute
payment which is nondeductible and subject to the excise tax and is the amount in excess of that
portion of the base amount allocable to that payment.
     To calculate this further, the "base amount" is defined in the regulations, and the base amount
is then multiplied by the ratio of the present value of the parachute payment to the present value
of all parachute payments expected, the result of which is then subtracted from the amount of the
parachute payment. Further details of this calculation are beyond the scope of this text.

      FUNDED DEFERRED COMPENSATION (ANNUITIES AND TRUSTS)

                                        Employee Taxation
    The general rule, which is mentioned elsewhere in this text, for taxation of employees and
employers in respect to premiums paid by the employer under a nonqualified annuity plan, or on
contributions to a non-exempt employee's trust, is that the employee is currently taxed on a con-
tribution to a trust or a premium paid for an annuity contract to the extent that his interest is sub-
stantially vested when the payment is made. An interest is "substantially vested" if it is transfer-
able or not subject to a substantial rise of forfeiture.220
     A partner is immediately taxable on his distributive share of contributions made to a trust in
which the partnership has a substantially vested interest, even if the partner's right is not substan-
tially vested.
    If the employee's rights change from substantially nonvested to substantially vested, the val-
ue of his interest in the trust or annuity on the date of change must be included in his gross in-
come for the taxable year when the change occurs. If the trust was exempt under IRC 502(a)
regulations, then the employee would not be taxed on the value of his vested interest in the trust.




                                                 117
    If the employee's rights in the value of a trust or annuity change from forfeitable to nonfor-
feitable, there is no tax liability for him.
    Sometimes an employer may offer the employees a choice of either to provide those partici-
pants in pay status of a lump sum payment of the present value of their future benefits or an an-
nuity securing their rights to the remaining payments under the plan, or a corresponding tax
gross-up payment. Those who would choose the annuity contract would include in gross income
the purchase price for such participant's benefits under the contract and the tax gross-up payment
in the year paid (or made available, if earlier). (Employee taxation of annuity proceeds discussed
elsewhere.) 231

                                         Employer Taxation
    Basically, the employer can take a deduction for a contribution or premium paid in the year
in which an amount attributable thereto is includable in the employee's gross income.232 If an
employee includes only part of a contribution or premium in income in a given tax year, then the
employer can deduct that part of the contribution or premium in that tax year.
    For an independent contractor, contributions or premiums paid or accrued on behalf of an in-
dependent contractor may be deducted only in the year in which amounts attributable thereto are
includable in the independent contractor's gross income.233
    If contributions are made to annuity contracts held by a corporation, partnership, or trust, the
income of the contract for the tax year of the policyholder is generally treated as ordinary income
received or accrued by the contract owner during such taxable year.234
    Note: Corporate ownership of life insurance may result in exposure to the corporate alterna-
tive minimum tax. This is rather complicated but unless the corporation qualified for the small
corporation exemption, a corporation may be subject to this tax as one element of the alternative
minimum tax, known as the adjusted current earnings adjustment, which has a potential effect on
corporate owned life insurance. If this situation arises, expert tax advice is required.

                                            Secular Trust
     A secular trust is an irrevocable trust established to formally fund and secure nonqualified
deferred compensation benefits (and to distinguish it from a Rabbi trust [discussed later]). Funds
that are placed in a secular trust are not subject to the claims of the employer's creditors. Unlike
the Rabbi trust, a secular trust can protect its participants against both the employer's future un-
willingness to pay promised benefits and the employer's future inability to pay promised bene-
fits. These trusts are not as popular as Rabbi trusts as there are some taxation questions.
    Contributions to a secular trust are immediately included in the income of the employee to
the extent that they are substantially vested. Further, in any tax year in which any part of an em-
ployee's interest in the trust changes from substantially nonvested to substantially vested, the
employee will be required to include that portion in income as of the date of the change.235 An
interest is substantially vested if it is transferable, or not subject to a substantial risk of forfeiture.
    The taxation "question" centers around the approach where distributions would be taxable
except to the extent that they represent amounts previously taxed—therefore a highly compen-
sated employee who has been taxed on his entire vested accrued benefit would not be taxed again
upon receipt of a lump sum distribution. On the other hand, the IRS has questioned applying this


                                                   118
measure—relying upon an IRC Section 72 rule mostly pertaining to annuities—to secular trusts
to highly compensated employees (HCEs), therefore they may adopt the stance that HCEs will
be taxed on vested contributions AND on vested earnings on those contributions. Also, the IRS
believes that any right to receive trust payments in compensation for these taxes will also be tax-
able as part of the vested accrued benefits.236
     There can be a 10% penalty for certain premature annuity distributions per IRC Section 72(q)
(which, again, pertain nearly entirely to annuities) that may apply to distributions from employ-
er-funded secular trusts if the deferred compensation plan behind the trust is considered to be an
annuity, i.e. provides for benefits to be paid in a series of periodic payments over a fixed period
of time, or a lifetime.
    If the fund is employee funded, and the employee establishes the trust but it is administered
and contributed to by the employer, then the situation is different for taxation. The employee
usually has a choice between receiving cash or equivalent, or cash contribution to the trust, and
oftentimes, the employee has the choice of withdrawing funds or leaving them in the trust.
When this occurs, the IRS takes the position that the employee constructively received the em-
ployer-contributed cash and then assigned it to the trust, therefore the employee is currently
taxed on employer contributions to the trust.
    In keeping with IRC Section 72, an employee who establishes and is considered to be the
owner of an employee-funded secular trust under the grantor-trust rules, should not have to in-
clude the income on annuity contracts held by the trust in income each year.237

                                      Employer's Deduction
    An employer can take a deduction for a contribution to an employer-funded secular trust in
the year in which it is includable in employee income, but limited to the amount of the contribu-
tion, it can never include earnings on that amount between contribution and inclusion in the em-
ployee's income.238
    If the secular trust covers more than one employee, the employer will be able to take a deduc-
tion only if the trust maintains separate accounts for the various employees. Also, the IRS has
granted employers immediate deductions for trust contributions where participants could choose
between receiving current contributions from the trust or leaving them in the trust.

                                        Taxation of Trust
    The IRS maintains that a security trust can never be an employer-granted trust, therefore an
employer-funded secular trust is a separate, taxable entity. Unless security trust earnings are dis-
tributable or are distributed annually, the trust will be taxed on those earnings.239 It is possible to
avoid trust taxation—and thereby avoiding double taxation—by using employee-funded secular
trusts as they are usually treated as employee-grantor trust, because the trust income is generally
held solely for the employee's benefits with the result that the trust income is usually taxed to the
employee only.




                                                 119
                                        Relation to ERISA
    Using a secular trust will probably cause a deferred compensation plan subject to ERISA to
be funded for ERISA purposes.

        Employee Taxation on Nonqualified Annuity or Nonexempt Trust
    Annuity payments are taxable to the employee under the general rule (in IRC 72) relating to
the taxation of annuities. Basically, the employee's investment in the contract, for purposes of
calculating the exclusion ratio, consists of all amounts attributable to employer contributions that
were taxed to the employee and premiums paid by the employee (if any). Investment in the an-
nuity includes the value of the annuity taxed to the employee when his interest changed from
nonvested to vested.
    Payments under a nonexempt trust are also usually taxed under the rules relating to annuities
extent that distributions of trust income before the annuity starting date are subject to inclusion in
income under the "interest first" rule, but without regard to the "cost recovery" rule retained in
certain cases. For distribution from the trust before the "annuity starting date" is treated as dis-
tributed under 5 scenarios, starting with income earned on employee contributions.
    If the distribution consists of an annuity contract, the entire value of the annuity, less the in-
vestment in the contract, is include in gross income.240

                       UNFUNDED DEFERRED COMPENSATION
    A properly planned deferred compensation agreement postpones payment for currently ren-
dered services until a future date, thus having the effect of postponing the taxation of such com-
pensation until it is received. These agreements consist of an employer promising to pay an em-
ployee fixed or variable amounts for life or for a guaranteed number of years. When the deferred
amount is received, the employee may be in a lower tax bracket. Also, many employers use this
type of plan to provide benefits in excess of the limitations placed on qualified plan benefits.
    Nonqualified deferred compensation plans may be broken into two broad categories, pure de-
ferred compensation plans and salary continuation plans, and both funded and unfunded deferred
compensation plans may be divided into these categories, but the taxation of each plan are so
much alike that the differences are miniscule.
    A "pure deferred compensation plan" is an agreement between the employer and the em-
ployee where the employee defers receipt of some part of his present compensation (or increase
in pay or bonus) in exchange for the employer's promise to pay a deferred benefit in the future.
    A "salary continuation plan" is a benefit plan provided by the employer in addition to all oth-
er forms of compensation whereby the employer promises to pay a deferred benefit, but there is
no corresponding reduction in the employee's present compensation, raise or bonus.

                   PRIVATE DEFERRRED COMPENSATION PLAN
   A private deferred compensation plan is a plan entered into with any employer other than a
governmental organization or an organization exempt from tax. They are usually entered into
with employees of corporations, but they can be entered into with employees of other business
organizations or independent contractors.



                                                  120
     If an employer or service recipient transfers his payment obligations to a third party, efforts
to defer payments from the third party may not be effective.
    The employer may pay deferred amounts as additional compensation, or employees may vo-
luntarily agree to reduce current salary. The plan must provide that the participants have the sta-
tus of general unsecured creditors of the employer, and that the plan constitutes a mere promise
by the employer to pay benefits in the future. The plan should also state that it is the intention of
the parties that it be unfunded for tax and ERISA purposes, and it must define the time and me-
thod for paying deferred compensation for each event that would entitle a participant to a distri-
bution of benefits.

                           Statutory Requirements for Distribution
    In 2004, Congress came up with new additional requirements to avoid constructive receipt.
A participant may only receive a distribution of previously deferred compensation upon one of
six events happening:
      separation from service;
      the date of disability of the participant;
      death;
      a fixed time or according to a fixed schedule, so specified in the plan at the date of defer-
       ral;
      a change in ownership or effective control of the corporation or assets of the corporation,
       to the extent provided in the regulations; or
      the occurrence of an unforeseeable emergency.
   The regulations (IRC Section 409) go into detail in definitions of terminology, such as
"change in ownership," "effective control," unforeseeable emergency," etc.

                                  Timing of Deferral Election
    Participants must make deferral elections prior to the end of the taxable year of the first year
in which the participant becomes eligible to participate in a plan. In the case of performance
based compensation coverage in a period of at least 12 months, a participant must make an elec-
tion no later than 6 months prior to the end of the covered period.241

                            Changes in Time or Form of Payment
    A participant may elect to delay distribution or change the form of distribution from a plan as
long as the plan required the new election to be made at least 12 months in advance. Any elec-
tion to delay a distribution must delay the distribution at least five years from the date of the new
election except when made because of death, disability or unforeseen emergency. Otherwise, an
election related to a scheduled series of distributions made according to a fixed schedule must be
made 12 months in advance of the first of the scheduled payments.
    Participants may elect to delay distribution or change the form of the distribution from a plan
as long as the plan requires the new election to be made at least 12 months in advance. Any
election to delay a distribution must delay the distribution at least five years from the date of the



                                                121
new election (except for death, disability or unforeseen circumstance). Otherwise, all election
related to a scheduled series of distributions must be made at least 12 months in advance of the
first scheduled payment.242

                                   Acceleration of Payments
   A plan can provide for acceleration of payments under certain circumstances:
       1) to comply with a domestic relations order,
       2) to comply with a conflict-of-interest divesture requirement;
       3) to pay income taxes due upon a vesting event subject to IRC 457(f),
       4) to pay the FICA or other employment taxes imposed on compensation that is deferred
          under the plan;
       5) to pay any amount included in income under IRC Sec. 409(a),
       6) to terminate a deferral election following an unforeseeable emergency, or
       7) to terminate a participant's interest in the plan
                after separation from service where the payment is not more than $10,000,
                where all arrangements of the same type are terminated,
                in the 12 months following a change in control event, or
                upon a corporate dissolution or bankruptcy.
    Short-term deferrals, i.e., when amounts are paid within 2 ½ months after the end of the year
in which the employee obtains a legal and binding right to the amounts, this is not considered as
a deferral of compensation.
    Also, these rules do not generally apply to amounts deferred under an arrangement between a
service recipient and an unrelated independent contractor, if, during the contractor's taxable year
in which the amount is deferred, the contractor provides significant services to each of two or
more service recipients that are unrelated, both to each other and to the independent contrac-
tor.243

                                             Penalties
    This section of the Code includes substantial penalties for failing to meet the statutory re-
quirements when deferring compensation. Any violation of these regulations results in retroac-
tive constructive receipt, with the deferred compensation being taxable to the participant as of
the time of the intended deferral.244 In addition to the normal income tax on the compensa-
tion, the participant must pay an additional 20%, as well as interest at a rate 1% higher
than the normal underpayment.245

                                CONSTRUCTIVE RECEIPT
    "Constructive Receipt" is an important concept for tax purposes, not only for deferred com-
pensation, but it applies as well to annuities. The tax deferment under the regulations, will not be
allowed if the employee is in constructive receipt of the income under the agreement prior to the
actual receipt of the payments.


                                                122
    Income is considered as constructively received if the employee can draw on it at any time,
but if there are substantial limitations or restrictions upon the ability of the employee to so draw
upon the funds, it will not be considered as constructively received. Also, as long as the em-
ployee's rights can be forfeited, there can be no constructive receipt.
    As expected, there are (always) exceptions, e.g., an employee will not be in constructive re-
ceipt of income even through his rights are nonforfeitable if the agreement is entered into before
the compensation is earned and the employer's promise to pay is not secured in any way.246
     The 2004 Act created new requirements for elections to defer compensation, with the result
that the IRS now maintains that a deferral election after the earning period commences will result
in constructive receipt of the deferred amounts, even if made before the deferred amounts are
payable. There are other situations where the opposite seems to hold, such as in the case of Rab-
bi trusts (discussed later).
    Courts are more lenient than the IRS, it seems, as they look more favorably upon elections to
defer compensation after the earning period commences but before the compensation was paya-
ble. There are several IRS rulings in such cases, and court rulings that appear contrary. One ra-
ther interesting case was where the court ruled that participants in a shadow stock plan who
chose—after earning their deferred benefits but before those benefits were payable—to extend
the deferral of their benefits by taking them in 10 installment payments, rather than in one lump
sum, did not constructively receive all of their benefits when they received their first install-
ments. The court considered that most significant factor to be that the participants never had un-
restricted rights to a lump sum payment of benefits, because access to their benefits was condi-
tioned upon their cashing in their shares and giving up future participation in the plan.247 Even
with this ruling, many experts believe that this case cannot be relied up too strongly.
    If there is a provision in an unfunded deferred compensation plan that permits hardship with-
drawals upon an unforeseeable emergency, it will not necessarily result in constructive receipt.248
Such a provision will generally be acceptable by the IRS in avoiding constructive receipt if it de-
fines "unforeseeable emergency" as "an unanticipated event beyond the participant's (or benefi-
ciary's)control, which would cause severe financial hardship if early withdrawal were not permit-
ted."249 The plan should provide that any withdrawal will be limited to the amount necessary to
meet the emergency.

      Employees who were permitted to transfer assets from Rabbi trusts to segregated
 bank accounts under their control or to employee-funded security trusts, but declined to do so,
        were in constructive receipt of the amounts that could have been transferred.250
    There are special concerns (by the IRS) if compensation is deferred for a controlling share-
holder. For instance, if the shareholder can (because he controls the corporation) effectively re-
move any restrictions on his immediate receipt of the money, the IRS just might argue that he is
in constructive receipt because nothing really stands between him and the money. It is very dif-
ficult to eliminate these problems in advance as the IRS will not issue advance rulings on the tax
consequences of a controlling shareholder-employee's participating in a nonqualified deferred
compensation plan. The courts, however, may be less willing to impose constructive receipt in
these situations.251
   Another problem: If a nonqualified deferred compensation plan is subject to registration as a
security with the SEC, failure to register the plan may have tax implications, particularly if the


                                                123
participant has the right to rescind the deferral of his compensation—which may cause this to be
considered as constructive receipt by the IRS. Good news, for now, is that the IRS has not re-
solved this problem so action has not been taken as yet. Bad news is that it probably will in the
future and in the meantime, the SEC has NOT formally clarified which nonqualified plans are
subject to the registration requirement.
    These situations plus the fact that the IRS will not issue an advance ruling on many of these
situations, or even issue a private ruling in some cases (such as where an employer retained the
right to pay deferred compensation benefits in either a lump sum or periodic payments) amplify
and explain why expert tax advice is needed when a deferred compensation plan is established
and maintained.
    One more instance to illustrate this rather confusing situation—employees wanted to ex-
change their unfunded nonqualified deferred compensation plan for equal and substitute interests
in a qualified plan. (Makes sense, doesn't it?) But the IRS, in a private letter ruling, held that
employees who elect to cancel their interest in an unfunded nonqualified deferred compensation
plan in exchange for substitute interests in a qualified plan would be taxable on the present value
of the accrued benefits in the qualified plan upon the funding of those new interests, and would
have to include the value of future benefits attributable to future compensation when the cash
(otherwise receivable under the nonqualified plan) would have been includable.252

                                      "Top Hat Plans"
    A "top hat" plan is an unfunded plan maintained primarily to provide deferred compensation
for a select group of management or highly compensated employees.253
    Whether a plan is a "top hat" plan is determined only by the facts and circumstances. Where
a plan was offered to 15% of employees, all management or highly compensated employees, this
was a top hat plan, but where all management employees were eligible for a plan, it was held not
to meet the select group requirement.254
   A top hat plan can be used as a temporary holding device for 401(k) elective deferrals.255

                             ECONOMIC BENEFIT THEORY
    In addition to the Constructive Receipt theory, another rule that can create a tax problem to a
deferred compensation plan is the "Economic Benefit" theory. This states that an employee is
taxed when he receives something other than cash that has a determinable, present economic
value. In respect to deferred compensation plans, an arrangement for providing future benefits
will be considered to provide the employee with a current economic benefit capable of valuation.
Current taxation arises when the assets are unconditionally and irrevocably paid into a fund or a
trust to be used for the sole benefit of the employee.256
    An employer may establish a reserve for the purpose of satisfying its future deferred com-
pensation obligation and at the same time preserving the unfunded and unsecured nature of its
promises, provided that the reserve is wholly owned by the employer and remains subject to the
claims of its general creditors. "A mere promise to pay, not represented by notes or secured in
any way, is not regarded as a receipt of income."257
    Deferred compensation benefits can be backed by life insurance or annuities without creating
a currently taxable economic benefit.258


                                               124
    However, in another case, a court found that the promises of pre-retirement death and disabil-
ity benefits provided the employee with a current economic benefit —current life insurance and
disability insurance protection—even though the corporation was owner and beneficiary of the
policy, which was subject to the claims of its general creditors. The court did not find construc-
tive receipt of the promised future payments, but ruled that the portion of the premium attributa-
ble to life, accidental death, and disability benefits was taxable to the employee.259

           Informal Funding with Private Deferred Compensation Plan
    A deferred compensation plan cannot be formally funded—the employee cannot be given an
interest in any trust or escrowed fund or in any asset, such as an annuity or life insurance poli-
cy—without there being adverse tax consequences. However, the agreement can be informally
funded without losing the tax deferral, such as setting aside assets in a Rabbi trust (discussed be-
low) to provide funds for payment of deferred compensation obligations—as long as the em-
ployees have no interest in those assets and they remain the employer's property (subject to the
claims of the employer's general creditors).260
    An employer may informally funds its obligations by setting aside a fund composed of life
insurance policies, annuities, mutual funds, securities, etc., without adverse tax consequences to
the employee, as long as the fund remains the unrestricted asset of the employer and the em-
ployee has no interest in it.261
    If the securing or distributing of deferred compensation plans are triggered by the failing fi-
nancial status of the employer, including setting aside assets in an offshore trust, the otherwise
deferred compensation is immediately taxable and in some cases, subject to a 20% additional
tax.262
    Keeping in mind that if an unfunded deferred compensation plan is not subject to ERISA re-
quirements, exclusive purpose rule and minimum vesting and funding standards, a court has
ruled that a death benefit only plan backed by corporate-owned life insurance is "funded" for
ERISA purposes.263 This result has been criticized, but if adopted by other courts, could have
far-reaching tax implications. Once a plan is "funded" for ERISA purposes, and once these re-
quirements are met, the plan is no longer informally funded for tax purposes, and adverse tax
consequences may follow. Again, a good reason to bring in expert tax advice when installing or
creating a private deferred compensation plan.
    A couple of other points: An insurance policy used to informally fund a plan should be held
by the employer and not distributed to the employee at any time; otherwise the employee will be
taxed on the value of the contract when he receives it. Also, an employee is not taxable on the
premiums paid by the employer or on any part of the policy or annuity provided the employer
applies for, owns, is beneficiary of, and pays for the policy or annuity contract and uses it only
for a reserve for the employer's obligations under the deferred compensation agreement.
     However, an employee can purchase indemnification insurance to protect his deferred bene-
fits without causing immediate taxation.264
    Whether a promise to pay, either by the employer or a third party, may or may not create a
"funded" situation for the plan, depending upon the details and a wide-ranging group of court
cases, IRS Letter Rulings and IRS regulations. Again, expert advice is required.




                                                125
                                        RABBI TRUST
    A "Rabbi trust" is a method of accumulating assets to support unfunded deferred compensa-
tion obligations. The trust, generally an irrevocable trust, is established by the employer using an
independent trustee and it is designed to provide the employees with some sense of security that
their money will be there when promised and at the same time, it preserves the tax deferral that is
the principal reason for the existence of the plan. The special feature of a Rabbi trust is that its
assets remain subject to the claims of the employer's general creditors in case the employer be-
comes insolvent or enters bankruptcy. (The reason it is called a "Rabbi" trust, in case you were
wondering, is that the first one that was approved by the IRS was set up for a Rabbi).
   The tricky part of a Rabbi trust is that there must be no "trigger" when deferred compensation
was either being secured or distributed because of the failing financial status of the employer.
There have been attempts to create a "hybrid" Rabbi/secular trust where assets are distributed
from the Rabbi trust to secular trusts when triggered by the failing financial difficulties of the
employer. Doesn't work. Under such arrangements, the deferred compensation is taxable and
subject to 20% additional tax plus interest on underpayment of taxes at the normal rate plus
1%.265
    A Rabbi trust can protect an employee against the employer's future unwillingness to pay
promised benefits, but it cannot protect an employee against the inability of the employer to pay
for promised benefits. This, plus the tax deferral, has made Rabbi trusts quite popular. It is so
popular, in fact, that the IRS has released a model Rabbi trust instrument to aid taxpayers and to
assist in the processing of requests for advance rulings on these arrangements. This model is to
be used as a "safe harbor" for employers, but it will not, by itself, cause employees to be in con-
structive receipt of income, or to incur an economic benefit. To obtain this model, see Rev. Proc.
92-64, 1992-2CB 422.
    Other items to be taken into consideration when creating a Rabbi trust:
   The IRS will continue to issue advance rulings on the tax treatment of unfunded deferred
    compensation plans that do not use a trust and unfunded deferred compensation plans that
    use the model trust, but they will not longer (except in rare circumstances) issue advance
    rulings on unfunded deferred compensation arrangements that use a trust other than the
    model trust.
   The model trust language contains all of the provisions that are necessary for the trust to
    operate except for language describing the trustee's investment powers, which must be pro-
    vided by the parties, and the investment powers of the trustee must include some investment
    discretion.
   Interestingly, the employer may add additional text to the model language, as long as it is
    "not inconsistent with" the model trust language.
   The rights of plan participants to trust assets must be merely the rights of unsecured credi-
    tors and cannot be alienable or assignable; further, the assets of the trust must be subject to
    the claims of the employer's general creditors in case of insolvency or bankruptcy.
   The board of directors and the highest ranking officer of the employer must be required to
    notify the trustee of the employer's insolvency or bankruptcy, and the trustee must be re-
    quired to cease benefit payments upon the company's insolvency or bankruptcy.



                                                126
     If the model trust is used properly, it should not cause a plan to lose its status as "un-
      funded—contributions to a Rabbi trust should not cause immediate taxation to employees;
      employees should not have income until the deferred benefits are received or otherwise
      made available. Contributions to a Rabbi trust should not be considered as "wages" subject
      to income tax withholding until benefits are actually or constructively received.
     The IRS has, in the past, allowed a Rabbi trust in conjunction with a deferred compensation
      plan that permits hardship withdrawals, such withdrawals limited to the amount needed to
      satisfy the emergency needs.
    The trust must provide that, if life insurance is held by the trust, (a) the trustee will have no
power to name any entity other than the trust as beneficiary, (b) assign the party to any entity
other than a successor trustee, (d) or to loan to any entity the proceeds of any borrowing against
the policy.
     There is a lot of "fine print" in the establishing of a Rabbi trust—the "model" does not do it
all. There are several other requirements before the IRS will issue a letter ruling that are too
lengthy to discuss in this text but which can be provided by the IRS.266

                     Deferred Amounts Deductible by the Employer
    Basically, the employer can take a deduction for deferred compensation only when it is in-
cludable in the employee's income whether the employer is on a cash or accrual basis, and, fur-
ther, deduction of amounts deferred for an independent contractor can be taken only when they
are includable in the independent contractor's gross income.267
    Payments made under an executive compensation plan within 2 ½ months of the end of the
year in which employees vest do not constitute deferred compensation, and thus may be de-
ducted in the year in which employees vest, rather than the year in which the employees actually
receive the payments.268
   For amounts credited as "interest," under a nonqualified deferred compensation plan, such
deduction for interest must be postponed until such amounts are includable in employee income,
and amounts representing such "interest" cannot be currently deducted by an accrual basis em-
ployer.269
    To be deductible, deferred compensation payments must represent reasonable compensation
for the employee's service when added to current compensation—definition of "reasonable" de-
termined in each case based on fact.

                TAX OF DEFERRED COMPENSATION PAYMENTS TO
                           EMPLOYEE/BENEFICIARY

      Payments from deferred compensation are taxed as ordinary income to the recipient
     when they are actually or constructively received. They are considered as "wages" and are,
    therefore, subject to regular income tax withholding and not the special withholding rules that
                                       apply to pensions, etc.270




                                                 127
    Payments made to a beneficiary are considered as "income in respect of a decedent" and
therefore, are taxed as they would have been taxed to the employee. Benefits that are assigned
by an employee to an ex-spouse in a divorce agreement will be taxed to the employee, not to the
ex-spouse.

                                   FICA & FUTA Taxes
    Under what is called "the general timing rule," amounts taxable as wages are generally taxed
when paid or constructively received. Another rule, the "special timing rule," applies to amounts
deferred by an employee under a regular deferred compensation plan of an employer covered by
FICA. The special timing rule is applicable to salary reduction plans and supplemental plans,
funded plans and unfunded plans, private plans and IRC Section 457 plans, but not to excess or
golden-parachute plans.
   FUTA rules are similar to FICA rules except that the taxable wage base for FUTA is $7,000.
  The following plans and benefits are not considered deferred compensation for FICA and
FUTA purposes:
       Stock options, stock appreciation rights, and other stock value rights, but not phantom
        stock plans or other similar arrangements in which an employee is awarded the right to
        receive a fixed payment equal to the value of a specified number of shares of stock;
       Certain restricted property received in connection with the performance of services;
       Compensatory time, disability pay, severance pay and death benefits;
       Certain benefits provided in connection with impending termination, including window
        benefits;
       Excess (golden parachute) payments;
       Benefits established 12 months before an employee's termination, if there was an indica-
        tion that benefits were provided in contemplation of termination;
       Benefits established after termination of employment; and
       Compensation paid for current services.

          Factors Determining the Amount Deferred for a Given Period
   In order to determine the amount that is deferred for a given period of time, it depends upon
whether the deferred compensation plan is an account balance plan or a nonaccount balance plan.

                                    Account Balance Plan
    A plan is considered as an account balance plan if under the terms of the plan (a) a principal
amount is credited to an employee's individual account; (b) the income that is attributed to each
principal amount is credited or debited to the individual account; and (c) the benefits that are
payable to the employee are based entirely upon the balance that is credited to his individual ac-
count.271




                                               128
    If the plan is an account balance plan, the amount deferred for a period equals the principal
amount credited to the employee's account for the period, increased or decreased by any income
or loss attributed through the date when the principal amount must be taken into account as wag-
es for FICA and FUTA purposes.
    "Income attributable to the amount taken into account" is defined as any amount, that under
the terms of the plan, is credited on behalf of an employee and attributed to an amount previously
taken into account, but only if the income is based on a rate of return that does not exceed either
the actual rate of return on a predetermined actual investment; of a reasonable rate of interest, if
no predetermined actual investment has been specified.

                                  Nonaccount Balance Plan
    A nonacccount balance plan is where the amount that is deferred for a given period equals
the present value of the additional future payment or payments to which the employee has a legal
binding right under the plan, during that period. The present value must be determined as of the
date when the amount deferred must be taken into account as wages (using actuarial assumptions
and methods that are reasonable as of that date).272
     An employee may treat part of a nonaccount balance plan as a separate account balance plan
if that part satisfied the definition of an account balance plan and the amount payable under that
part is determined separately from the amount payable under the other part of the plan. Also, an
amount deferred under the nonaccount balance plan does not have to be taken into account as
wages under the special timing rule until the earliest date on which the deferred amount is rea-
sonably determined-which means that when there are no actuarial or other assumptions needed to
determine the amount deferred other than interest, mortality, or cost-of-living assumptions.273

                                    Nonduplication Rule
    Once an amount is treated as wages, plus any income that can be attributed to it, it will not be
treated as wages for FICA or FUTA purposes in any later year.

                   Self-Employed Persons and Corporate Directors
    Self-employed individuals pay social security taxes through self-employment (SECA) taxes,
rather than FICA taxes. Deferred compensation of self-employed individuals is usually counted
for SECA tax purposes when it is includable in income for income tax purposes. Deferred com-
pensation of self-employed individuals is generally counted for SECA purposes when paid, or
earlier, when it is constructively received.
    Corporate directors who defer their fees generally count those fees for SECA purposes when
paid or constructively received.

                                   Taxable Earnings Base
    The taxable wage base for the old age, survivors and disability insurance (OASDI) portion of
the FICA tax and the taxable earnings base for the OASDI portion of the SECA tax are both
$94,200 for 2006 (was $90,000 for 2005).
    There is no taxable wage base cap for the Medicare hospital insurance portion of the FICA
tax so all deferred compensation counted as wages for FICA purposes is subject to at least the


                                                129
hospital portion of the FICA tax, nor is there an earnings base cap for the hospital insurance part
of the SECA tax.274

                                      Section 457 Plans
    Section 457 plans (government and tax-exempt employers) allow for participants to have re-
ceipt and taxation of compensation for services performed for a state or local government to be
deferred. The Code does not provide for tax-exempt employers and government entitled to main-
tain SIMPLE IRA plans, but they may do so, according to the IRS.
    Section 457 generally applies to deferred compensation agreements entered into with nongo-
vernmental organizations exempt from tax under IRC Section 502, which are mostly nonprofit
organizations serving some public or charitable purpose. There are several types of plans that
are not subject to IRC Section 457 taxation and a list of requirements. These requirements are
too complex and cumbersome for discussion in this text.

                                     STUDY QUESTIONS

1. In a deferred compensation plan, if the IRS decides that the compensation is unreasonable,
    A. they will consider it as reasonable compensation, deductible as a business expense.
    B. they will request that the company restructure the plan and refile.
    C. then all of the employee benefit plans will no longer be qualified.
    D. the IRS may consider it as a "dividend" and tax it as such.

2. Any payment in the nature of compensation to an individual in anticipation of change in own-
   ership of the company is
   A. illegal and a federal offense.
   B. considered just another type of deferred compensation and is taxed like any other plan.
   C. a parachute agreement but there is no penalty with this type of program.
   D. a parachute payment which may be subject to no employer deduction and the recipient
       could be subject to a 20% penalty tax.

3. For taxation of employees and employers in respect to premiums paid by the employer under
   a nonqualified annuity plan or contributions to a non-exempt employee's trust,
   A. the employee is taxed on a contribution to a trust or premium paid for an annuity
       contract to the extent that his interest is substantially vested when the payment is made.
   B. the employer may consider the total contribution that he made as immediate business
       expense and is tax free.
   C. as a general rule, such annuity or contribution to a trust are illegal in most states.
   D. the employer and employee enjoy such annuity or contribution as tax-free.

4. An irrevocable trust that is established to formally fund and secure nonqualified deferred
   compensation benefits, is
   A. a Rabbi trust.
   B. a secular trust.
   C. subject to the claims of the employer's creditors.
   D. illegal in all states except California and New York.


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5. In a nonqualified annuity, in order to determine the taxable portion of an annuity payment, the
    employee's investment in the contract consists of all amounts that can be attributed to the
    employer contributions
    A. that were taxed to the employee and premiums paid by the employee.
    B. that were taxed to the employee and premiums paid by the employer.
    C. less a percentage of the employer contributions that relate to length of service.
    D. discounted at an interest rate that fluctuates with the Dow Jones Averages.

6. The IRS Code is rather strict in respect to penalties for failing to meet the statutory require-
   ments when deferring compensation. Any violations of the requirements may result in
   A. a $10,000 fine for each month the plan has not been in compliance.
   B. retroactive constructive receipt and taxed to the participant when compensation was
       deferred, plus an additional 20% and interest at a rate 1% higher than the normal under
       payment.
   C. the employer and the employee having to forfeit the entire deferred compensation to the
       IRS in penalties.
   D. an immediate IRS audit of both the employer and the employee.

7. A deferred compensation plan that is unfunded and is maintained primarily to provide de-
   ferred compensation for a select group of management or highly compensated employees is
   A. a parachute plan.
   B. a key man plan where contributions from the employer and the employee are not taxed.
   C. called a "top hat" plan.
   D. often used as a vehicle for elimination any discrimination problems with a pension
       plan.

8. A simple IRS rule that states than an employee is taxed when he receives something other
   than cash that has a determinable, present economic value, is known as
   A. the Continuity Adjustable plan.
   B. the economic benefit theory.
   C. the constructive receipt definition.
   D. individual leveling formulae.




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9. When the amount of compensation that is deferred for a given period, equals the present value
   of the additional future payment(s) to which the employee has a legal binding right under the
   plan and during that period, it is called
   A. the account balance plan.
   B. the nonaccount balance plan.
   C. economic benefit theory.
   D. a pyramid scheme.

10. As a general rule, deferred compensation plans for self-employed individuals usually are
    counted for SECA tax purposes
    A. when it is includable in income for income tax purposes when paid or constructively
        received.
    B. and are reported on the individuals 1040A as capital gains and the income is reported on
       Form 1099.
    C. when it is part of a deferred compensation plan that is qualified and has been in existence
       for a period of at least 5 years.
    D. when funded by annuities only.

ANSWERS TO STUDY QUESTIONS
1D   2D   3A   4B   5A   6B   7C   8B   9B   10A




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           CHAPTER NINE - EMPLOYEE STOCK PLANS

 EMPLOYER SECURITIES AND STOCK OWNERSHIP PLANS
     An employer securities and/or stock ownership plan can be quite enticing for prospective
employees, particularly those who are of management caliber and highly-qualified technicians.
By itself, the investment in securities of the employer as part of a plan can create some threats as
it presents opportunities for some employers to enrich themselves at the detriment of employees.
Also, it reduces the participants' economic diversification as if the employer fails, then not only
will employees lose their jobs, they will lose part of their retirement security as well. Therefore,
ERISA prohibits such transactions and closely regulates stock ownership plans.
    On the plus side, plan investment in stock of the employer provides a chance for an employee
to have an ownership stake in the business. Also, there can be no argument that stock ownership
provides an incentive for productivity and commitment. These are powerful arguments in favor
or stock ownership plans, and as a result, ERISA strongly encourages employee stock ownership
plans (ESOPs) which are designed to invest primarily in employer stock.
    ESOPs have an unusual feature—they integrate the employer and the plan, plus ERISA en-
courages them. But, ERISA also demands strong protection of participants and beneficiaries as
it does in all plans. Obviously, this can create a controversial and complex body of law and
regulations.

                                            "ESOPS"

     An employee stock ownership plan (ESOP) may be either a qualified stock bonus
 plan, or a combination bonus and money purchase plan, either of which must be designed to in-
                        vest primarily in qualifying employer securities.

                                      Employer Securities
    "Employer security" is a security issued by the employer of the participants or by an affiliate,
and the word "security" takes its meaning from securities regulation. A "qualifying employer
security" is an employer security that is either stock, a marketable obligation or certain publicly
traded partnership interests.275 These are the only kinds of securities that these plans are al-
lowed to hold.
    To be a "qualified" security, the Code's rules state that a qualifying employer security (or
employer security) is common stock issued by the employer, or by a corporation that is a mem-
ber of the same controlled group, and which is readily tradable on an established securities mar-
ket.276 Where there is no such readily tradable common stock, then employer securities are
shares of common stock that has voting power and dividend rights equal to or greater than the
voting power of dividends of any other class of stock. Also, noncallable preferred stock that is
convertible at any time into common stock of the employer—and at a reasonable price—is also
an employer security.




                                                133
     A "marketable obligation" is a bond, debenture, note, or other evidence of indebtedness that
is either acquired in the market or from an underwriter/issuer at a fair price, and such investment
in this employer obligation is not excessive.
    For plans other than eligible individual accounts plans (described below), stock is a consi-
dered as a qualifying employer security only if (1) immediately after the acquisition of the stock,
no more than 25% of the outstanding stock of the same class is owned by the plan, and (2) at
least 50% of the outstanding stock of the same class is owned by persons independent of the is-
suer. This is a very important distinction as an employer cannot use treasury stock, etc., as the
ownership of at least half of the stock is owned by other than the issuer.277
    Real estate can be used also, and "employer real property" is defined for these purposes as
real property leased by the plan to the employer or an affiliate. "Qualifying employer real prop-
erty" is defined as parcels of employer's real property of which a substantial number are geo-
graphically dispersed; each parcel and its improvements can be adapted (without excessive cost)
to more than one use; and the purchase and retention of the property does not violate any fidu-
ciary standards.278
    Still another concept of the stock ownership plans is the "eligible individual account plan."
This is a profit-sharing plan, stock bonus plan or employee stock ownership plan or similar plan,
which specifically provides for purchasing and holding of qualifying employer securities or qua-
lifying employer real property, and, further, the benefits do not reduce benefits payable under
any defined benefit plan.279

                           Value of ESOPs to the Corporation
    ESOPs can prove to be quite valuable for corporate planning as they can do such things for
the corporation as provide equity capital by purchasing newly issued shares. They can also be
used as an inside purchaser of the interest of a shareholder withdrawing from a close corporation,
thereby keeping the corporation "in the family."
    An ESOP can be used, and has been used, along with other investors in some cases, to take a
company private through a leveraged buyout. In the discussion of employee benefits, it is impor-
tant to know that an ESOP can help the corporation with cash flow by allowing contributions to-
ward retirement benefits to be made in stock rather than in cash.
    In the past when the stock market was very volatile, many companies in certain industries
watched aghast as their stocks tumbled, even among the better financed and well-run firms.
However, one company stood out as the price of their stock held steady and actually showed
some increase in value during this time, contributing greatly to the fact that the company is today
one of the most financially secure companies in the industry. The "secret" was simply a form of
an ESOP where commissioned salespersons received stock options in the company as part of
their compensation, thereby creating a market for the stock even though other companies in that
industry were having a difficult time.
    All is not roses, however, as there are some disadvantages, primarily the fact that the is-
suance of new stock dilutes existing stockholder rights. And it must be noted that ESOPs are
tightly regulated and using an ESOP in corporate financing requires compliance with ERISA's
fiduciary rules and other regulations.




                                                134
                                     LEVERAGED ESOPs
    A "regular" ESOP is formed by the employer either contributing stock, or contributing mon-
ey used by the ESOP to purchase stock, on a yearly basis in amounts that meets current contribu-
tion requirements. A "leveraged" ESOP, on the other hand, borrows the money to pay for a large
block of employer securities and these shares are allocated to the participants' accounts as the
loan is repaid—sort of like borrowing money using securities as collateral. The loan to buy the
stock is obtained from the employer or from another lender and guaranteed by the employer.
The shares can be purchased from the employer or on the open market.
    The tax advantage to the employer can be quite important. If the plan buys securities from
the employer with a loan from a bank, then the employer gets the proceeds of the loan from the
plan, with the effect that the transaction is treated as a loan to the employer. But the annual con-
tribution of the employer to the plan in order to repay the principal and interest of the loan, are
deductible by the employer in an amount up to 25% of the annual compensation of the partici-
pants. The excess can be carried over in subsequent years.280 Compare that tax treatment to an
ordinary loan where only interest payments would be deductible.
    The purpose of this tax treatment is to encourage ESOPs but the favorable tax treatment has
been controversial. The tax advantage is justified in the eyes of most if the ESOP benefits partic-
ipants in ways that regular ordinary plans do not, and at the same time contribute significantly to
society and the economy.

       EMPLOYER LOANS & GUARANTEE OF LOANS TO ESOP PLANS
    Basically, employer loans to plans and guarantees of loans to plans are prohibited (see below
for discussion of other prohibited transactions). Therefore, some sort of exemption is needed if
leveraged ESOPs are to be allowed. ERISA provides for it by stating that a loan to an ESOP by
a party in interest, or guaranteed by a party in interest, is allowed as long as it is an exempt loan,
defined as primarily for the benefit of the participants and beneficiaries, that bears a reasonable
rate of interest, and is secured only by qualifying employer securities (if it is secured at all).

                                         Primary Benefit
    Since the loan must be primarily for the benefit of participants and beneficiaries, the
proceeds must be used within a reasonable time and be used solely for the purchase of qualifying
employer securities, or to repay the loan or prior exempt loan. The purpose of the loan must not
be to negatively affect plan assets and the terms must be at least as favorable as terms of a com-
parable loan that would result from an arm's-length transaction.281
    Further, the loan must be for a specific term and it must be without recourse against the
ESOP as the only collateral may be qualifying employer securities that either were purchased
with the loan or were collateral for a prior exempt loan that was repaid with proceeds of the new
loan. The form of repayment of the loan must be only collateral, contributions—other than em-
ployer securities—that were made for the purpose of meeting loan obligations, and earnings that
can be directly attributed to collateral and investment of the contributions.




                                                 135
    In respect to the amount, the value of the plan assets that are transferred to the creditor in
case of default, can not be more than the amount of the default. And, if the lender is a "party in
interest," the amount transferred may only be the amount necessary to meet the repayment sche-
dule.282
   Another, rather rigid, requirement is that if the securities that are purchased with the loan are
used as collateral, then the loan must provide for a number of securities in proportion to the
amount of the loan repaid in the year, to be released on an annual basis. Formulas are used in the
regulations to determine the number of shares released.283

                                 Other ESOP Requirements
   There are too many requirements to list in this text, but the most important ones are as fol-
lows:
   Designation: The plan must be specifically designated as an ESOP.284
   Integration with Social Security: An ESOP cannot be integrated with Social Security.285
     Assets Allocated to Accounts: All assets that are acquired with the proceeds of an exempt
loan, must be first placed into a suspense account and withdrawn from this account as the lend-
er's security is released. At the end of each year, the ESOP must allocate to participants' ac-
counts units that represent interest in the assets that are withdrawn from the suspense account.
(There are further limitations if the employer is an S-Corporation.)286
     Right to Vote Stock: An ESOP must satisfy conditions on the voting of employer stock.287
If the employer has a registration-type class of securities (i.e., registered under Section 12 of the
Securities Exchange Act , etc.), each ESOP participant or beneficiary must be allowed to direct
the plan in respect to the voting of the shares allocated to his account (known as "pass-through"
voting).288
    If the employer does not have the registration-type of securities, participants and beneficia-
ries may still be able to direct the voting of the shares allocated to their accounts in regards to
mergers, dissolutions, recapitalizations and sales of substantial assets of the business. The voting
requirement is a qualification for defined contribution plans (other than profit-sharing plans) of
employers whose stock is not readily tradable on an established stock market, which have more
than 10% of their assets invested in employer securities. This requirement is allowed if each par-
ticipant has one vote and providing that the trustee should vote the unallocated shares in propor-
tion to the votes of the participants.289
    Distribution Options: An ESOP participant must be able to demand a distribution in the
form of employer securities. This keeps ESOPs from being used to keep employer stock in li-
mited hands. This right does not apply to any part of the participant's stock that he has diversi-
fied. However, if the employer's charter or bylaws restrict the ownership of all or nearly all of
outstanding employer securities to employees or to a plan, or if the employer is an S Corporation,
the ESOP may provide for distribution only in cash.290
    If the securities cannot be easily traded, the distributee must have a put option (a right to de-
mand that the employer repurchase the shares under a fair evaluation system). This makes sure
that the securities will have value to the distributee. The put option cannot "bind" the plan but
the plan may assume the employer's obligation if such action is considered as prudent.291



                                                 136
    Timing of the Distribution: When the participant (or spouse in some situations) elects a
distribution of the account, such distribution of the account balance will start no later than one
year after the close of the plan in the year in which he separates from service because of retire-
ment, disability or death. Or, if he is separated from service for more than five years and is not
reemployed before distribution is required to start. Unless the participant elects otherwise, the
distribution must be in (substantially) equal periodic payments over a period of time not to ex-
ceed one year, and over a period not longer than five years (unless the account balance is very
large). The account balance of a participant does not include securities that were purchased with
an exempt loan until the close of the plan year in which the loan is repaid.292
     Diversification of Investment of Account Assets: An ESOP must offer a special invest-
ment option to any participant who is at least 55 years old, and has completed a minimum of 10
years of participation, which must allow the participant to direct the plan as to the investment of
at least 25% of his account in the first five years, and 50% in the sixth. The plan must provide
three or more investment options, or it must distribute the part of the account that is subject to
the election.293
    Appraisal of Securities: All employer securities that are not readily tradable on an estab-
lished market, must be valued by an independent appraiser.294

                                OTHER TAX ADVANTAGES
    Note: Since tax advantages depend upon the type of corporation, it may be helpful to define
the types of corporations at this point for reference:
   C-Corporation is a corporation whose income is taxed through it rather than through its
   shareholders. Any corporation not electing S-corporation status is automatically a C-
   corporation under the Internal Revenue Code.
   S-Corporation is a corporation whose income is taxed through its shareholders rather than
   through the corporation itself. Only corporations with a limited number of shareholders can
   elect S-corporation tax status under Subchapter S of the Internal Revenue Code.295
   In addition to the tax advantages regarding ESOP loans, there are a couple more tax-related
benefits for ESOPs:

                                      Dividend Deduction
    Dividends are not usually deductible by an issuing corporation, but if the corporation is a "C"
corporation and if the dividends are paid on shares of employer stock held by an ESOP, the em-
ployer may deduct the amount of such dividends that are (1) paid in cash directly to participants
and beneficiaries; (2) paid to the plan and then distributed in cash to participants and beneficia-
ries within 90 days of the end of the plan year; or (3) are used to repay the loan by which the se-
curities were purchased.296
    Dividends are also deductible when the participants and beneficiaries are allowed to elect ei-
ther payment in cash or reinvestment in additional employer stock held by the plan.




                                                137
                                     Capital Gains Deferral
    The sale of stock in a domestic C-Corporation to an ESOP is eligible for deferral of capital
gains tax on the proceeds of the sale provided several requirements are met (Note: all are speci-
fied in IRC § 1042 unless otherwise noted):
       1) The corporation must have no outstanding stock readily tradable on an established se-
          curities market and the stock must not have been received in a distribution from the
          plan (or other specified means)
       2) After the sale, the plan must hold at least 30% of either each class of outstanding
          stock of the corporation, or the total value of all outstanding stock.
       3) The shareholder must elect deferral.
       4) The employer must consent in writing to the application of IRC § 4978 which impos-
          es a tax on it if the ESOP disposes of a certain part of the shares within 3 years, and to
          IRC § 4979(A) which imposes a tax on certain prohibited allocations of the stock.
       5) The shareholder must have held the stock for three years as of the date of sale.
       6) Within a period starting 3 months before the sale and ending 12 months after, the
          shareholder must purchase qualified replacement property, defined as a security of
          any domestic operating corporation, except for the employer or a member of its con-
          trolled group, or certain other corporations.
       7) No part of the assets acquired by the ESOP may accrue to the benefit of the selling
          shareholder or members of his family, for at least 10 years, or to the benefit of a per-
          son who is a 25% shareholder at any time.
       8) The shareholder cannot itself be a C Corporation.
    If the criteria for deferral are satisfied, then the shareholder can recognize long-term capital
gain on the sale only to the extent that the amount that is realized exceeds the cost of the quali-
fied replacement property. There are rules, naturally, that provide for the adjustment of the basis
of the qualified replacement property by the gain not recognized, and for recapture of gain upon
disposition of such property.

                     USING ESOPS AS CORPORATE WEAPONS
    ESOPS are often established for the purpose to defend against proxy fights or tender offers as
an ESOP puts a large block of stock into friendly (management) hands. This has been done so
often that the SEC treats certain ESOPs as "anti-takeover" vehicles and requires that information
about their defensive characteristics be stated in proxy statements.297
    This use of ESOPs creates problems and questions regarding the duties of those in manage-
ment who are responsible for ESOPs, including officers, directors, plan fiduciaries—and those
persons who have an interest in the ESOP, such as the corporation, shareholders, employees, par-
ticipants and beneficiaries.
    The regulations, and in particular court decisions, that have evolved that concern ESOPs in
such corporate control situations, are numerous and details and are beyond the scope of this dis-
cussion. If questions arise regarding legal actions or requirements for these situations, it should
be referred to knowledgeable legal counsel.


                                                138
                              PROHIBITED TRANSACTIONS
   Regulations regarding prohibited transactions in employer securities are broken into two
functions: (1) acquiring and holding the securities, and (2) borrowing the funds to acquire them.
     ERISA has two basic rules in respect to employer securities, the first rule being that a plan
cannot acquire or hold any employer securities that are not qualifying employer securities. Se-
condly, a plan cannot acquire qualifying employer securities or qualifying employer real proper-
ty, if, immediately after the purchase or acquisition, the fair market value of the employer securi-
ty and real property held by the plan is more than 10% of the fair market value of the total as-
sets.298
     The exception to the 10% limitation does not apply to the acquisition or holding of qualifying
employer securities by eligible individual account plans, as such an account can hold as much of
its assets in qualifying employer securities as the fiduciaries elect, as long as it is consistent with
the terms of the plan and ERISA provisions.
    The acquisition or sale of qualifying employer securities is a violation of the prohibited
transaction rule regarding the sale or exchanges of plan property if the transaction is with a party
in interest. On the other hand, ERISA provides for an exemption for eligible individual account
plans where the acquisition or sale of qualifying employer securities is exempt from ERISA if no
commission is charged and the acquisition or sale is for "adequate consideration."
    "Adequate consideration" means a price no less favorable than the price required under
ERISA regulations: If there is a recognized market for the securities, adequate consideration is
then defined as either the prevailing price on a national securities exchange or the offering price
quoted by persons independent of the issuer or any party in interest—sort of a "willing-seller,
knowledgeable buyer" concept (which, incidentally, is part of a new proposed regulation which
defines fair market value and good faith). Where there is no generally recognized market, then
adequate consideration is fair market value determined in good faith by the trustee or named fi-
duciary pursuant to the plan terms.
     It should be noted that ERISA does exempt eligible individual account plans from the diver-
sification requirements or ERISA regarding the acquisition or holding and qualifying employer
securities and real property. As an example, it may not be prudent for an ESOP fiduciary to con-
tinue to invest in employer stock because of changing circumstances, even though the plan doc-
ument permits it to do so.

                               EMPLOYEE STOCK OPTIONS
    An employee stock option plan gives an employee the right to buy a certain number of shares
in the employer's corporation at a fixed price within a specified period of time. The price for
which the employee pays for the option is called the "grant" price, which is usually at or below
the stock's current market value. The idea is that the stock will increase in value, which allows
the employee to profit by the difference. Conversely, if the stock should decrease in value below
the grant price, the option is called "underwater" and the employee does not exercise the option
to purchase the stock—the employee is not at risk for out-of-pocket losses.
    There are two kinds of stock options, each with different rules and tax consequences, the
"qualified" stock options—also known as "incentive stock options" (ISOs) or "statutory stock
options." Non-qualified stock options (NQSOs) are sometimes known as "nonstatutory" stock


                                                 139
options. There are another kinds, used basically for executive plans, which are performance-
based options that provide that the holder of the option will not realize any value from the option
until certain specified conditions are met—for example, the share price exceeding a certain value
above the grant price, or the company outperforming the industry.

                                              ISOs
    For a stock option to qualify as an ISO and receive the attending special tax treatment of IRC
Section 421(a), it must have an exercise price not less than the fair market value of the stock at
the time of the grant, expire within no more than 10 years, and generally be nontransferable and
exercisable only by the grantee.299

                                    Taxation for Employee
    When an employee receives an ISO, he realizes no income upon its receipt or exercise, in-
stead, the employee is taxed when he disposes of the stock acquired with the ISO.299A "Disposi-
tion" means any sale, exchange, gift or transfer of legal title of stock, but does not include a
transfer from a decedent to his estate, a transfer by a bequest or inheritance, or any transfer of
ISO stock between spouses or incident to a divorce.300
    The tax treatment depends upon whether the stock was disposed of within the statutory hold-
ing period for ISO stock, which is defined as the later of two years from the date or one year
from the date when the shares were transferred to the employee upon exercise.301
    If the employee disposes of the stock during the holding period, he is taxed as ordinary in-
come on the difference between the option price and the fair market value of the stock the time
he exercised the sale of the stock, and then, capital gain measured by the difference between the
fair market value of the stock at exercise and the proceeds of the sale. When an employee dis-
poses of ISO stock after the holding period, all of the gain is capital gain and is measured by
the difference between the option price and the sale proceeds.302

                                    Taxation for Employer
    An employer that grants an ISO is not entitled to a deduction in respect to the option when it
is granted or exercised. The amount received by the employer as the exercise price will be con-
sidered as the amount received by the employer for the transfer of the stock. If the employee
disposes of the stock prior to the end of the requisite holding period, the employer may generally
take a deduction for the amount that the employee recognized as ordinary income in the same
year in which the income is so recognized.303
    The employer does not have to pay FICA or FUTA taxes or withhold federal income taxes,
when an option is granted. At this time, the IRS has no taken a position whether the employer is
obligated to pay FICA or FUTA taxes, but there is indication that it is "in the wind."

                                             NQSO
   Basically, an NQSO is an option to purchase employer stock that does not satisfy the legal
requirements of an ISO.

                                    Taxation for Employee


                                               140
    As a general rule, an employee is not taxed on an NQSO at time of grant until it has a readily
ascertainable fair market value and is not subject to a substantial risk of forfeiture. Options do
not have a "readily ascertainable fair market value" unless they are publicly traded. If an NQSO
does not have a readily ascertainable fair market value at time of grant, then it is taxed at time of
exercise, and if there is a substantial risk of forfeiture, then it is taxed when the risk of forfeiture
lapses. When taxed, the employee will recognize the excess of the market value of shares re-
ceivable over the grant price as ordinary income subject to FICA, FUTA and federal income
tax.304
    Within 30 days of the grant of an NQSO that is subject to a substantial risk of forfeiture, an
employee may elect to be taxed currently on the fair market value of the option. Any apprecia-
tion after the election is taxable as a capital gain. If the NQSO is eventually forfeited, no deduc-
tion is allowed for the forfeiture.305

                                      Taxation for Employer
    The employer has a corresponding deduction in the same amount and at the same time, as the
ordinary income recognized by the employee. Usually, compensation that is paid in the form of
stock options trigger the receipt of wages for the purpose of employment tax and withholding
provisions in the amount of the income generated.

                                      Deferred Compensation
     If the NQSO is exercised for less than the fair market value at the date of grant, it will be
subject to the rules governing deferred compensation plans (as discussed earlier). If the exercise
price can never be less than the fair market value of the underlying stock at the date of the grant,
and where there is no other feature for the deferral of compensation, a stock option will not con-
stitute deferred compensation.
    Under an IRS ruling previously expressed, stock options could be "converted" to a deferred
compensation plan free of tax under certain and limited situations. Where the employees could
choose to retain or surrender both ISOs and NQSOs in exchange for an initial deferral amount
under a nonqualified deferred compensation plan, the IRS indicated that neither the opportunity
to surrender the options, nor their actual surrender, would create taxable income for participants
under either the constructive receipt or economic benefit rules.

                                   Reporting and Withholding
    An employer has no obligation to pay employment taxes or to withhold federal income taxes
when NQSOs are granted. When they are exercised, the employer must treat the excess of the
market value of shares received over the grant price as wages which will be subject to FICA,
FUTA and federal income tax withholding in the pay period in which the income arises. The
employer has no obligation to withhold or pay federal income or employment taxes upon the sale
of shares purchased by option.
    Employers must use code "V" in box 12 on Form W-2 to identify the amount of compensa-
tion to be included in an employee's wage in connection with the exercise of an employer-
provided NQSO. Employers are required to report the excess of the fair market value of the
stock received upon exercise of the option, over the amount paid for the stock on Form W-2 in
boxes 1, 3, 5 and 12, when an employee exercises his option.


                                                  141
    As a general rule, an ISO is not subject to the reporting requirements of ERISA and a sum-
mary plan description does not need to be distributed to participants. But the employer must fur-
nish a statement to the employee on or before Jan 31 of the year following the year in which he
exercises the ISO, stating details about the options granted.306

                                    RESTRICTED STOCK
     Restricted stock should be discussed as it is regarded as an employee benefit, and it is popu-
lar among the higher-paid employees. Actually, it is simply an outright grant of shares of stock
by a company to an individual (usually an employee) without any payment by the recipient—or
in some case, only a nominal payment. As a general rule, the shares of stock are subject to a
provision in a contract under which the granting company has the right (but not the obligation) to
repurchase or reacquire the shares from the recipient when a specified event occurs, usually ter-
mination of employment. The right to repurchase expires after a specified period of time; some-
time all at once and sometimes periodically over a period of time. Such expiration of this right
to repurchase/reacquire is called "vesting." During the period that the stock can be repur-
chased/reacquired the recipient is prohibited (restricted) from selling or otherwise transferring
the stock—hence the name, "restricted" stock. In some cases, vesting may depend upon on re-
strictions other than time, such as satisfying corporate goals or reaching certain profitability
goals.
    The taxation is simply that restricted stock does not constitute taxable income to the em-
ployee at the time it is granted unless it is substantially vested upon grant. An employee who
receives restricted stock must include the fair market value of that stock in his income in the year
the stock becomes substantially vested; the amount the employee paid for the stock, if any, must
be subtracted from this amount. Restricted stock becomes "substantially vested" in the year in
which the stock becomes transferable, or the stock is no longer subject to a substantial risk of
forfeiture.307
    Within 30 days of receiving restricted stock, an employee may elect to be taxed on the fair
market value of the stock currently rather than the year the stock becomes substantially vested.
Any appreciation of the value of the stock after the election is taxable as capital gain. But, if the
restricted stock is ultimately forfeited, then there is no deduction for that forfeiture.308
    The employer has a corresponding deduction in the same amount and at the same time as the
ordinary income is recognized by the employee. Compensation paid in the form of restricted
stock normally triggers a receipt of wages for the purposes of employment tax and withholding
provisions in the amount generated.309
   If there are dividends on restricted stock, they are considered as extra compensation to the
employee and the employer includes those payments on the employee's Form W-2. The em-
ployee should receive a Form 1099-DIV showing those dividends.

                           EDUCATIONAL BENEFITS TRUSTS
    An educational benefit trust is a employee benefit by the establishment of a trust to defray the
educational expenses of employee's children. Employer's contributions to such trust when related
to an employee's service, are taxed as compensation to the employee when they are paid to or for
the benefit of children. Some plans may call these benefits "loans," but for tax purposes they are
treated as compensation.


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    Amounts that are paid under such a trust to the children of stockholder-employees, are
treated as compensation, not dividends, where the plan is adopted for business reasons—usually
stated to attract and retain employees.
    As in most cases, an educational benefit trust is considered as a welfare fund, and therefore,
the employer's deduction is effectively deferred until benefits are includable in the employee's
income. This is a recent development, as in the recent past when the benefits under such trust
related to the service of the employee, it was considered a deferral of compensation and there-
fore, the employer's deductions should be taken when benefits are paid out.310

                   DEPENDENT CARE ASSISTANCE PROGRAMS
    A dependent care assistance program is as the name suggests, a separate written plan of an
employer for the exclusive purpose of providing employees with payment for or the providing of
services, which, if paid for by the employee, would be considered employment-related ex-
penses—defined as amounts incurred to allow the taxpayer to be gainfully employed while he
has one or more dependants under the age of 13 (for which he declares as a dependent under his
personal income tax), or a dependent or spouse who cannot care for themselves. The expenses
may be for household expenses or for the care of such dependents. The plan is not required to be
funded.311
    Non-highly compensated employees may exclude from income a limited amount for services
paid or incurred by the employer under such program that were provided during a taxable year.
In order for highly compensated employees to also have the same income tax exclusion, the pro-
gram must meet certain requirements, basically to avoid discrimination.312
    If benefits are provided through a salary reduction agreement, the plan may disregard any
employee with compensation less than $25,000 for purposes of the 55% test.313 Employees who
have not attained age 21 and completed one year of service, and employees covered under a col-
lective bargaining agreement may be excluded.
    The employee may exclude up to $5,000 paid or incurred by the employer for dependent care
assistance provided during the taxable year, or $2,500 in the case of a married individual filing
separately.
    As a general rule, the amount of employment-related expenses by the employer in providing
benefits under such program, are deductible to the employer as ordinary and necessary business
expenses. The employer that maintains a dependent case assistance plan must file an informa-
tion return with the IRS as detailed in IRC Section 6039D.
                                     STUDY QUESTIONS

1. An employee stock ownership plan (ESOP) must invest in
   A. mutual funds.
   B. qualified employer securities.
   C. only in the preferred stock of the employer.
   D. government securities.

2. An ESOP is valuable for corporate planning purposes as it can
   A. be used to hide profits from the IRS.



                                                143
   B. be set up to invest only in off-shore banks, thereby elimination a lot of taxes.
   C. provide equity capital by purchasing newly issued shares
   D. can hide equity that can be used to stall a takeover.

3. When an ESOP borrows money to pay for a large block of employer securities, and these
   shares are allocated to participant accounts as the loan is repaid, this
   A. transaction is known as a "leveraged" ESOP.
   B. is subject to prior approval of the SEC.
   C. transaction must be audited annually by the IRS.
   D. plan is primarily to negatively affect plan assets.

4. An ESOP participant must be able to demand a distribution in the form of employer securi-
   ties, which
   A. is never enforced as the participant actually has no power to demand anything.
   B. can mean securities of Fortune 500 companies only.
   C. would then mean that the employer would have to pay taxes on the entire ESOP with no
       business expense deduction.
   D. keeps the ESOPs from being used to keep employer stock in limited hands.

5. Dividends are deductible by an issuing corporation when the participants and beneficiaries
   A. are not otherwise stockholders of the corporation common or preferred stock.
   B. are sole owners of the corporation.
   C. are trying to avoid taxation by converting dividends and depositing them in off-shore
       banks.
   D. are allowed to elect either payments in cash or reinvestment in additional employer stock
       held by the plan.




                                               144
6. With an ESOP, the acquisition or sale of qualifying employer securities is a violation of the
   prohibited transaction rule regarding the sale or exchanges of plan property
   A. if the transaction is with a party in interest.
   B. if the transaction is with a disinterested third party.
   C. unless prior approval has been granted by the Department of Insurance.
   D. unless a "party in interest" purchases plan property.

7. An employee stock option plan gives the employee the right to buy a certain number of shares
   in the employer's corporation at a fixed price which is called
   A. the grant price.
   B. the negotiable price.
   C. the stone (from "set in stone") price
   D. the immotable consideration price.

8. There are two kinds of stock options:
   A. qualified and less-than-legal.
   B. taxable and non-taxable.
   C. incentive stock options and performance-based stock options.
   D. specific and generic.

9. When an employee receives an ISO,
   A. he realizes no income upon its receipt or exercise, but is taxed when he disposes of the
      stock obtained through the ISO.
   B. he receives taxable income when the ISO stock is received.
   C. there is no tax on the value of the stock until he dies, at which time there is no tax on the
      amount included in his estate.
   D. he must pay capital gains on the value of the stock as determined by the average of the
      last five years of stock activity.

10. Basically, an option to purchase employer stock that does not satisfy the legal requirements
    of an ISO
    A. is a CSO (certified stock option).
    B. is a taxable event for both the employee and the employer (actually double taxation).
    C. has no legal standing unless it is an integral part a qualified pension plan.
    D. is a non-qualified stock option (NQSO)

ANSWERS TO STUDY QUESTIONS
1B   2C   3A   4D   5D   6A   7A   8C   9A   10D




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                      CHAPTER TEN - MSAs & HSAs

                          MEDICAL SAVINGS ACCOUNTS
                      MEDICAL SAVINGS ACCOUNTS (MSAs)
    Congress enacted, in 1996, a law that allowed individuals and small employers to fund medi-
cal expenses by creating up to 750,000 Medical Savings Accounts (MSAs), also known as ―Ar-
cher Medical Savings Accounts,‖ which are defined as savings accounts whose funds are used
exclusively to pay for an individual’s or family’s medical expenses. Tax-deductible contribu-
tions can be made to the account and the interest on the account is tax deferred. Any withdraw-
als for the purpose of paying for medical expenses are not taxable as income.
    MSAs works in the following manner: High-deductible medical expense insurance is pur-
chased, along with the medical savings account, with high deductibles ranging from $1,700 to
$2,600 for unmarried individuals, and $3,450 to $5,150 for families and with out-of-pocket max-
imums of $3,450 for individuals and $6,300 for families (no minimum lifetime benefit is re-
quired). Note: These amounts are indexed for inflation and these figures are for year 2004. The
reasoning is that relatively small medical expenses will be covered by the MSA, with large ex-
penses covered by the insurance.
    Contributions to the MSA have an annual maximum of an amount that equals 65% of the de-
ductible for individuals, and 75% for families—no established minimum.
                                          Benefits of MSAs
    The MSA holder can claim a tax deduction for contributions made by the holder, even if de-
ductions are not itemized on Form 1040. The interest or other earnings of the assets in the Ar-
cher MSA are tax free. Distributions are tax-free if the holder pays qualified medical expenses.
(See Discussion of Qualified Medical Expenses under following discussion of HSAs.) The con-
tributions stay in the Archer MSA from year to year until used by the MSA holder.
                                           Qualifications
    In order for a person to qualify for an Archer MSA, they must be either:
         An employee or the spouse of an employee of a small employer (defined later) that
             maintains an individual or family High Deductible Health Plan (HDHP) for the em-
             ployee or his spouse, or
         A self-employed person or the spouse of a self-employed person, who maintains an
             individual or family HDHP.
    Also, the individual must not have any other health of Medicare coverage except what is
permitted under ―Other Health Coverage” as defined later, plus the person not can be claimed as
a deduction on another person’s tax return, even if the person does not claim the exemption.
                                    Small or Growing Employer
    A small employer is considered an employer who had an average of 50 or fewer employees
during either of the last two calendar years. This definition is modified for new and growing
employers.
    A small employer may begin HDHPs and Archer MSAs for his or her employees and then
grow beyond 50 employees. The employer is considered as meeting the requirement for small


                                              146
employers if he had 50 or fewer employers when the MSA started, made a contribution that was
excludable or deductible as an MSA for the last year he had 50 or fewer employees, and had an
average of 200 or fewer employees each year after 1996.
                                             Portability
    If the holder changes employers, the MSA goes with him but he cannot make any additional
contributions unless he is otherwise eligible.
                                               HDHP
    The person must have an HDHP that has a higher annual deductible than typical health plans
and a maximum limit on the annual out-of-pocket medical expenses that he must pay for covered
expenses as described previously.
    There are some family plans that have deductibles for both the family as a whole and for in-
dividual member members and if the individual meets the deductible for one family member,
they do not have to meet a higher annual deductible amount for the family. If either the deducti-
ble for the family or the deductible for an individual family member is below the minimum an-
nual deductible for family coverage, the plan would NOT quality as an HDHP.
                                      Other Health Coverage
    The MSA holder (and spouse, if family coverage) generally cannot have any other health
coverage except the HDHP, but he (they) may have additional insurance that provides other ben-
efits only for the following:
         Liabilities from Workers’ Compensation laws, torts, or ownership or use of property.
         A specific disease or illness.
         A fixed amount per day (or other period) of hospitalization (in-hospital indemnity).
    They may also have coverage, insurance or otherwise, for accidents, disability, dental care,
vision care and long-term care.
                                     Contributions to an MSA
    Contributions to an MSA must be made in cash—no stock or property. If the individual is an
employee, the employer may make contributions to the MSA and the holder does not pay tax on
these contributions. If the employer does not make contributions to the MSA, or if the person is
self-employed, he can make his own contributions to the MSA. Both the individual and employ-
er cannot make contributions to the MSA in the same year and it is not necessary for the individ-
ual to make contributions to the MSA each year.
    If the spouse is covered by the individual’s MSA and an excludable amount is contributed by
the spouse’s employer to an MSA belonging to that spouse, the individual cannot make contribu-
tions to his own MSA that year.
                                      Limits of Contribution
    There are two limits on the amount that the individual or his employer can contribute to his
MSA, the annual deductible limit and an income limit.
    The annual deductible limit allows the individual or his employer to contribute up to 75% of
the annual deductible of the HDHP (65% if it is a self-only plan) to the MSA. The individual
must have had the MSA for an entire year to contribute the full amount. If he does not qualify to
contribute the full amount for the year, IRS Form 8853 provides instructions as how to determine
the annual deductible.



                                              147
    Simply put, if the individual has an HDHP for his family for an entire year, the annual de-
ductible is $4,000 (for 2004). He can contribute up to $3,000 for the year (75% of the MSA for
the year). If, for instance, the HDHP had been in force for 6 months (July thru December), he
can contribute up to $1,500 for the year ($4,000 x 75% for 6 months [half of the year]).
    If the individual and his spouse each have a family plan, he would be treated as having fami-
ly coverage with the lower annual deductible of the two health plans. The contribution limit is
split equally, unless there is agreement on a different division.
                                            Income Limit
    An individual cannot contribute more than they earn for the year from the employer through
whom he has the HDHP. If the individual is self-employed, he cannot contribute more than his
net self-employment income—defined as income from self-employment less expenses (including
the ½ of self-employment tax deduction).
                                   Persons Enrolled in Medicare
    A person cannot contribute to an MSA effective with the first month enrolled in Medicare.
However, he may be eligible for a Medicare Advantage MSA, discussed later.
                              Reporting Contributions on Tax Return
    All contributions to an MSA must be reported on Form 8853 which is filed with the IRS
Form 1040. All contributions by the individual and/or his employer made for the taxable year,
must be reported.
    The individual should receive Form 5498-SA, HSA, Archer MSA, or Medicare+Choice MSA
Information from the trustee that shows the amount contributed by the individual and/or employ-
er during the year.
                                       Excess Contributions
    If the contributions to the MSA is larger that the limits as discussed, such excess contribu-
tions are not deductible and any excess contributions made by the employer are included in the
gross income of the individual. If the excess contribution is not included in Box 1 on Form W-2,
it must be reported as ―Other Income‖ on the individual’s tax return and the individual may have
to pay a 6% excise tax on excess contributions.
    Some or all of the excess contributions may be withdrawn and no excise tax is payable on the
amount withdrawn if the excess contribution is withdrawn by the due date, including extensions,
on the individual’s tax return, and the individual withdraws any income earned on the withdrawn
contributions and includes the earnings in ―Other Income‖ on the tax return on the year the con-
tributions were withdrawn.
                                    Distributions from an MSA
    The usual procedure is for the individual to pay medical expenses during the year without be-
ing reimbursed by the HDHP until the annual deduction has been reached. When medical ex-
penses are paid during the year that is not reimbursed by the HDHP, the trustee should send the
individual a distribution from the MSA.
    The individual can receive tax-free distributions from the MSA to pay for qualified medical
expenses. If distributions are received for other reasons, the amount may be subject to income
tax and may be subject also to an excise tax.
    If the individual no longer is qualified to make contributions, he may still receive tax-free
distributions to pay or reimburse his qualified medical expenses.


                                              148
    Note: "Qualified Medical Expenses" are defined in the section following the discussion
of the HSA plan.
    The individual cannot deduct qualified medical expenses as an itemized deduction on Sche-
dule A of Form 1040 that are equal to the tax-free distribution from the MSA.
                                         Insurance Premiums
    As a general rule, insurance premiums may not be treated as qualified medical expenses for
an MSA. However, the individual can treat premiums for Long-Term Care Insurance (amount
subject to HIPAA regulations), health care coverage while receiving unemployment benefits, or
health care continuation coverage required under any federal law as qualified medical expenses
for MSAs. Also, the individual cannot claim this credit for premiums that he paid with a tax-free
distribution from the MSA.
                                        Deemed Distributions
    A transaction that is prohibited by section 4975 with respect to any MSA during the year
makes the account a deemed taxable distribution as it ceases to be an MSA. Therefore, the fair
market value of all assets in the account must be shown on Form 8853.
    If the individual used any portion of the MSA as security for a loan at any time during the
year, the MSA ceases and the fair market value of the assets used as security for the loan must be
shown on Form 1040, line 21.
                                            Recordkeeping
    The individual must keep records to show later that (a) the distributions were used exclusive-
ly to pay or reimburse qualified medical expenses, (b) the qualified medical expenses had not
been previously paid or reimbursed from another source, and (c) the medical expenses had not
been taken as an itemized deduction in any year.
    These records are not to be sent with the tax return but kept with tax records.
                            Reporting Distributions on the Tax Return
    If the distribution is used for qualified medical expenses, taxes do not have to be paid on the
distribution but it must be reported on Form 8853.
    If the distribution is not used for qualified medical expenses, tax must be paid on the distribu-
tion and the amount reported on Form 8853.
    If an amount, other than a rollover, is contributed to the MSA by the individual or employer,
he must also report and pay tax on a distribution received from the MSA that year that is used to
pay medical expenses of another person who is not covered by the HDHP, or is also covered by
another health plan that is not an HDHP, at the time the expenses are incurred (Form 8853).
                                               Rollovers
    As a general rule, any distribution from an MSA that is rolled over into another MSA or an
HSA, is not taxable if the rollover is completed within 60 days. Only one rollover a year is per-
mitted.
                                            Additional Tax
    There is a 15% additional tax on the part of the distributions not used for qualified medical
expenses. Tax is calculated using Form 8853 and filed with Form 1040.
    Note: There is no additional tax on distributions made after the date the individual becomes
disabled, reaches age 65, or dies.



                                                149
                                          Balance in an MSA
    An MSA is usually exempt from tax. The individual is permitted to take a distribution from
the MSA at any time, however only those amounts used exclusively to pay for qualified medical
expenses are tax free. Amounts that remain at the end of the year are generally carried over to
the next year. Earnings on amounts in an MSA are not included in the individual’s income while
the earnings are held in the MSA.
                                       Death of the MSA Holder
    A holder of an MSA should always choose a beneficiary because the disposition of the MSA
upon the death of the holder depends upon who is the designated beneficiary.
    If the spouse is the designated beneficiary, the MSA will be treated as belonging to the
spouse after death of the holder.
    If the spouse is not the designated beneficiary, then the accounts stops being an MSA and the
fair market value of the MSA becomes taxable to the beneficiary in the year in which the holder
died.
    If the estate is the beneficiary, the value is included in the final income tax return of the hold-
er
    The amount taxable to a beneficiary other than the estate is reduced by any qualified medical
expenses for the decedent that are paid by the beneficiary within 1 year after the date of death.
                                        Employer Participation
    Please note the discussion of the HSA in the following section in respect to the requirement
affecting employers that want to make the plan available to their employees, as the MSA re-
quirements are identical in this respect.
                                               Comments
    Supporters of the MSA plan to fund individual and small group health care believe that it can
lead to greater individual accountability as individuals will be more vigilant in seeking medical
care if they have to pay for it by money from their MSA. When individuals have medical plans
that are paid by third parties (insurers, for example) there is little incentive to control the expend-
itures and the danger of over-utilization arises.
    In addition to the tax savings and the control of expenses feature, another important advan-
tage is that MSAs will often allow individuals who previously had no health insurance to obtain
it on more favorable terms, with greater freedom of choice in health care providers and in health
care financing. Individuals who may not be eligible for a major medical plan may be acceptable
in many cases if they ―share-the-risk‖ with the insurer through a high deductible that eliminates
many of the smaller claims, thereby favorably affecting both the loss ratio and the expenses of
the policy.
    There are detractors, principally those who maintain that MSAs may discourage insureds
from seeking medical care because of their reluctance to spend their own money. This concern
applies more readily to preventative care. These same persons also argue that adverse selection
will occur inasmuch as the wealthy and healthy will take advantage of the option, which means
that other insuring arrangements will have less healthy groups which, in turn, create higher costs
for those who are not wealthy.




                                                 150
                    HEALTH SAVINGS ACCOUNTS (HSAs)

    The Medicare Prescription Drug, Improvement and Modernization Act of 2003 authorized
the establishment of new health savings accounts, effective January 1, 2004. This section de-
scribes in detail these plans, particularly since there has been such emphasis on these plans by
the Administration and the Congress. These plans have deliberately been made attractive for tax
purposes, therefore, this discussion will concentrate on the tax advantages of the various health
plans. In respect as to the insurance vehicle, in most of these plans a high-deductible health plan
(HDHP) is used. Other than the high deductible, the plans are basically comprehensive major
medical plans.
    These accounts are similar to Archer Medical Savings Accounts inasmuch as they allow eli-
gible individuals to save for, and pay, health care expenses on a tax-free basis. Even though the
MSA—the ―father‖ of these plans—has not succeeded in popularity as much as desired or pro-
jected, these other plans have been added in an attempt to make the concept of an individual pay-
ing for the majority of his medical expenses out-or-pocket—instead of having an insurer pay
nearly all of the cost—as attractive to the consumer as possible.
    An HSA may receive contributions from an eligible individual or any other person, including
an employer or a family member, on behalf of an eligible individual. Contributions, other than
the contributions of the employer, are deductible on the eligible individual’s return whether or
not the individual itemizes deductions. Employer contributions are not included in income. Dis-
tributions from an HSA that are used to pay qualified medical expenses are not taxed.
    Technically, an HSA is a tax-exempt trust or custodial account that is set up with a qualified
HSA trustee to pay or reimburse certain medical expenses that is incurred by the individual or
qualified family member.
    It is not necessary to seek permission or authorization from the IRS to establish an HSA but
the individual must work with a trustee, which can be a bank, insurance company or anyone that
is approved by them to be a trustee of IRAs or MSAs. The HSA can be established through a
trustee that is different from the health plan provider.
    A Health Savings Account (HSA) is a trust that is created exclusively for the purpose of pay-
ing the qualified medical expenses of the account holder.314 An account beneficiary is the indi-
vidual on whose behalf the HSA was created.

                          Requirements of an HSA Instrument
    Regulations as to the creation of the governing instrument in establishing an HSA, require
that it must state that
       (1) no contribution will be accepted unless it is in cash (except for a rollover contribu-
           tion);
       (2) no contribution will be accepted to the extent that if the contribution is added to pre-
           vious contributions to the trust for the present calendar year, it is more than the con-
           tribution limit for the year;
       (3) the trustee is a bank, insurance company, or other person who has been approved by
           the IRS to act an IRA trustee or custodian is who automatically approved to act in the
           same capacity for an HSA.


                                                151
       (4) no part of the assets of the trust will be invested in life insurance contracts;
       (5) the trust assets will not be commingled with other property (there are some limited
           exceptions); and
       (6) the interest of an individual in the balance of his account is nonforfeitable.315

                                     Availability of HSAs
    HSAs are available to any employer or individual for an account beneficiary who has high
deductible health insurance coverage (detailed later). An eligible individual or an employer may
establish an HSA with a qualified HSA custodian or trustee, and no permission or authorization
is needed from the IRS to set up such HSA.

                                    Interaction With an IRA
  While there are similarities between an IRA and an HSA, a taxpayer cannot use an IRA as an
HSA, nor may he combine an IRA with an HSA, or vice versa.
                                      TAXATION OF HSAs
   Contributions may be made to an HSA by an individual, his employer or both. If they are
made by the individual taxpayer, the HSA contributions are deductible from income. If they are
made by the individual taxpayer, then the HSA contributions are deductible from income.
   If they are made by the employers, HSA contributions are excluded from the employee's in-
come.
   The HSA, itself, is exempt from income tax. Contributions may be made through a Cafeteria
Plan under IRC Section 125.
                                RELATION TO COBRA PLAN
   The contributions of an employer are not considered as part of a group health plan subject to
COBRA continuation coverage requirements. Therefore, a plan is not required to make COBRA
continuation coverage available with respect to an HSA.316
                                    ELIGIBLE INDIVIDUAL
    The IRS defined an "eligible individual" for HSA purposes as an individual who is covered
(for that month) under a high deductible plan as of the first day of that month, and is NOT also
covered under any health plan that is not a high deductible plan that provides coverage for any
benefit covered under the high deductible health plan.317
    An individual enrolled in Medicare Part A or Part B may not contribute to an HSA, but just
the fact that the individual is eligible for Medicare, does not preclude HSA contributions.
    An individual may not contribute to an HSA for a given month if he has received medical
benefits through the Department of Veterans Affairs within the previous three months. The fact
that he is eligible for VA medical benefits will not disqualify him from making HSA contribu-
tions.
                                    Rollover From an MSA
   If the individual has an Archer MSA, generally they can roll it over into an HSA tax free.



                                                 152
                                        Benefits of an HSA
     The individual can claim a tax deduction for contributions that he, or someone other than
        the individual’s employer, makes to the HSA even if the deductions are not itemized on
        the IRS Form 1040.
     Contributions to an HSA made by the employer—including contributions made through
        a Cafeteria Plan—may be excluded from the person’s gross income.
     Contributions remain in the account from year to year until used.
     Interest or other earnings on the assets in the account are tax free.
     Distributions may be tax free if the individual pays qualified medical expenses.
     An HSA is ―portable‖ so it stays with the individual even if he changes employers or
        leaves the work force.
                                      Qualifying For an HSA
     (This is where Health Insurance enters the picture, similar to the MSA). To be eligible and
qualify for the HSA, he must have a high deductible health plan (HDHP) (described later), on the
first day of the month. He must have no other health coverage except what is permitted, not
enrolled in Medicare, and not be claimed as a dependant on someone else’s tax return. (Note: If
another taxpayer is entitled to claim an exemption for the individual, the individual cannot claim
a deduction for an HSA contribution—even if the other person does not actually claim the de-
duction.)
     Each spouse who is eligible and who wants an HSA must open a separate HSA – no ―joint‖
HSAs.
                                           HSA HDHP
     An HDHP has a higher deductible than the typical health plans, and a maximum limit on the
sum of the annual deductible and out-of-pocket medical expenses that must be paid for covered
expenses. Out-of-pocket expenses include copayments and other amounts, but do not include
premiums.

                                Preventive Care Coverage
    A HDHP may provide preventive care coverage without the application of the annual deduct-
ible. The IRS has provided information and "safe harbor" guidelines in their definition of "pre-
ventative care" under these regulations.318
    Under the safe-harbor provision, an HDHP may provide for preventative care benefits with-
out a deductible, or with a deductible below the minimum annual deductible. Preventive care
includes (but it not limited to:


          Periodic health evaluation, including tests and diagnostic procedures that are ordered
           in connection with routine examination, such as annual physicals.
          Routine prenatal and well-child care.
          Child and adult immunizations.
          Tobacco cessation programs.
          Obesity weight-loss programs



                                               153
          Screening services, including screening for the following:
               Cancer
               Heart and vascular diseases
               Infectious diseases.
               Mental health conditions
               Substance abuse
               Metabolic, nutritional, and endocrine conditions
               Musculoskeletal disorders
               Obstetric and gynecological conditions
               Pediatric conditions
               Vision and hearing disorders.
    Preventive care may include drugs or medications taken for the purpose of preventing the oc-
currence or reoccurrence of a disease which is not presently present.
   Minimum annual deductible and maximum annual deducible and other out-of-pocket
                           expenses for HDHPs for 2006.
                       Minimum                           Maximum
Type of                 Annual                Annual Deductible and other out-
Coverage               Deductible                  of-Pocket Expenses                     .
Self-only              $1,050                                    $5,250
Family                 $2,100                                   $10,500
(These limits do not apply to deductibles and expenses for out-of-pocket network services if the
plan uses a network of providers. Instead, only deductibles and out-of-pocket expenses for ser-
vices within the network should be used to figure whether the limit applies.)
These deductibles are based on a 12-month period and if the plan is for a period more than 12
months, the deductible may be satisfied for a period longer than 12 months on a pro-rata basis.
Note, also, that these amounts pertain only to HDHPs for HSAs and other such plans. MSAs
have different minimum deductibles and expenses, as discussed earlier.
    ―Self-only‖ HDHP coverage is an HDHP covering only an eligible individual. Family
HDHP coverage is an HDHP covering an eligible and at least one other individual, whether or
not that individual is an eligible individual.
    Note: Some states may require a health plan to provide certain benefits without a deductible
or a deductible that is less than the minimum annual deductible, in which case the plan may not
be an HDHP. However, for years 2004 and 2005, plans that would otherwise qualify will be
treated as HDHP if those benefits were required by state law in effect on Jan. 1, 2004.

                                        Lifetime Limit
    A HDHP may require a reasonable lifetime limit on benefits on those provided by the plan,
but only if the lifetime limit on benefits is not designed to circumvent the annual maximum out-
of-pocket limit requirement. A plan that has no limitation on out-of-pocket expenses does not
meet the criteria to be considered as a high deductible health plan, whether if the plan was so de-
signed or by its terms.319


                                               154
             Family Plans That do not Meet the High Deductible Rules
    There are family plans available that have deductibles for both the family (as a whole) and
for individual family members. Under these types of plans, if the individual meets the individual
deductible for one family member, the individual does not have to meet the higher annual deduc-
tibles for the family. If either the deductible for the family as a whole or the deductible for an
individual family member is below the minimum annual deductible for family coverage, then the
plan does not qualify as an HDHP.
    For example, Jones has a family health insurance plan in force in 2004. The annual deducti-
ble for the family plan is $3,500. This plan also has an individual deductible of $1,500 for each
family member. The plan does not qualify as an HDHP because the deductible for an individual
family member is below the minimum annual deductible ($2,000) for family coverage.
                                  Other Health Coverages
    The individual (and spouse if family coverage) usually cannot have any other health cover-
age that is not an HDHP. However, they may have additional insurance that provides benefits
only for the following items:
        Liabilities incurred under Workers Compensation laws, tort liabilities, or liabilities re-
            lated to ownership or use of property.
        A specific disease or illness.
        A fixed amount per day (or other period) or hospitalization (such as in-hospital in-
            demnification plan).
    However, the individual may have coverages, whether by insurance or otherwise, for acci-
dents, disability, dental care, vision care, and long-term care. Plans in which substantially all of
the coverage is through these items are not considered as HDHPs. As an example, if the plan is a
dread disease policy, it is not considered as an HDHP for the purposes of establishing an HSA.
                                  Prescription Drug Plans
     A prescription drug plan, either as part of an HDHP or as a separate policy or rider, will al-
low the individual to qualify as an eligible individual if the plan does not provide benefits until
the minimum annual deductible of the HDHP has been met. If the individual can receive bene-
fits before that deductible is met, then the eligibility is not present. However, if the individual
can receive benefits during 2004 or 2005 under a separate drug plan or rider before the deducti-
ble of the HDHP has been met, the individual can still qualify. This is a ―grandfather‖ type of
situation and was included as the legislators did not want an individual to go without prescription
drug coverage not covered by the HDHP during the first 2 years of this program.
     As a general rule, an employee covered by an HDHP and a Health FSA or HRA that pays or
reimburses qualified medical expenses generally cannot make contributions to an HSA, Health
FSA or HRA (discussed later).
                                           Exceptions
   An employee may make contributions to an HSA while covered under an HDHP, and one or
more of the following plans:
   A limited purpose Health FSA or HRA may pay or reimburse the items listed under ―Other
health coverage” except for long-term care. These arrangements/plans can pay or reimburse for
preventive care expenses as they can be paid without having to satisfy the deductible.



                                                155
    A suspended HRA —before the HRA coverage starts, the individual may elect to suspend
the HRA. The HRA does not pay or reimburse (at any time) for the medical expenses incurred
during the suspension period except preventative care and items listed under ―Other health cove-
rages.” At the end of the suspension period, the individual is no longer eligible to make contri-
butions to an HSA.
    A post-deductible Health FSA or HRA—these arrangements do not pay or reimburse any
medical expenses incurred before the minimum annual deductible has been met. The deductible
for these arrangements do not have to mirror the HDHP deductible, but the benefits may not be
provided before the minimum annual deductible HDHP deductible is met.
    Retirement HRA—pays or reimburses only those medical expenses incurred after retirement.
After retirement an individual is no longer eligible to make contributions to an HSA.
                                      Contributions to an HSA
    Any eligible individual can contribute to an HSA. If it is an employee’s HSA, the employee
and/or the employee’s employer can contribute to the HSA in the same year. If the HSA is es-
tablished by a self-employed or unemployed individual, the individual can contribute. Family
members or any other person may also make contributions on behalf of an eligible person.
However, all contributions must be made in cash—stock or property cannot be used as contribu-
tions.
                                         Contribution Limit
    The contribution amount that the individual or any other person can contribute to an HSA,
depends entirely upon the type of HDHP coverage and the age of the individual. (There were
exceptions for those who established the plan in 2004, but it does not extend further). The indi-
vidual must be an eligible individual and have the same coverage all year to contribute the full
amount. If the individual does not qualify to contribute the full amount for the year, then the
contribution limit is determined by using IRS Form 8889 instruction.
    These instructions are relatively simple, as, for instance, if the person has an HDHP for the
entire months of July through December and the annual deductible is $4,000 (and the person is
under age 55), and $4,000 is contributed each month, then the total of these amounts ($24,000) is
divided by 12 (months in the year) to determine the contribution limit—$2,000.
    An eligible individual may deduct the aggregate amount paid in cash into an HSA during the
taxable year, subject to a limitation in 2006 of $2,700 for self-only coverage, and $5,450 for
2006 for individuals with family coverage.
    Incidentally, if the individual is age 55 or older, the contribution limit is increased by $500.
Therefore, as an example, if the individual has a self-only coverage, he can contribute up to the
amount of the annual health plan deductible, plus $500, but not more than $3,100. In the exam-
ple in the preceding paragraph, if the person reached age 55 on September of that year, $4,500
would be shown on worksheet for Form 8889, (July through December), $4,500 times 6 =
$27,000, divided by 12 would show contribution limit of $2,250 for the year. (These calcula-
tions are for year 2004, for 2005 the additional contribution amount is $600 — $2,300 contribu-
tion limit.)
    If there are multiple HSAs, the total contributions cannot be more than the limits as discussed
above.




                                                156
                                  Reduction of Contribution Limit
    The contributions to the HSA must be reduced by the amount of any contribution made to an
Archer MSA—including employer contributions—for the year. (Note exceptions for married
persons below.)
    The amount that can be contributed to the individual’s HSA is the amount made by the em-
ployer that is excludable from the individual’s income.
    For married couples, if either spouse has family coverage, then both spouses are treated as
having family coverage. If each spouse has family coverage under a separate plan, both are con-
sidered as having family coverage under the plan with the lower annual deductible. Therefore,
the individual must reduce the limit on contributions before considering any additional contribu-
tions, by the amount contributed to both spouse’s Archer MSAs. After that reduction, the contri-
bution limit is split equally between the spouses unless they agree on a different division.
    If both spouses are age 55 or older and not enrolled in Medicare, each spouse’s contribution
limit is increased by the additional contribution. If both spouses meet the age requirement, the
total contributions under family coverage cannot be more than $6,150.
                           Family Coverage with Embedded Deductible
    An HDHP with family coverage may have deductibles for both the family as a whole (um-
brella deduction) and for individual family members (embedded deductible). The limit of con-
tribution under this situation is the least of:
         1. the maximum annual contribution limit for family coverage ($5,150 for 2004),
         2. the umbrella deductible, or
         3. the embedded deductible multiplied by the number of family members that are cov-
             ered by the plan.
    The following example may clarify this provision:
    In 2004, Jones had an HDHP with family coverage for him, his wife, and two dependant
children. The HDHP will pay benefits for any family members whose covered expenses are
more than $2,000 (the embedded deductible) and will pay benefits for all family members when
the family’s covered expenses exceed $5,000 (the umbrella deductible). The maximum annual
contribution limit is $5,000—the least of $5,150, $5,000 or $8,000 ($2,000 x 4). [If the plan
only covered a married couple, then the maximum annual contribution limit is $4,000—least of
$5,150, $5,000 or $4,000 ($2,000 x 2)]
    A plan will not qualify as an HDHP if either the umbrella deductible or the embedded de-
ductible is less than the minimum annual deductible ($2,000) for family coverage. If there is no
umbrella deductible, the deductible for each family member multiplied by the number of family
members cannot exceed the maximum annual deductible and other out-of-pocket expenses
($10,000) for family coverage.
                                        Enrolling in Medicare
    A person who enrolls in Medicare cannot contribute to an HSA, beginning with the first
month the person enrolls.
                                                Rollovers
    Amounts from Archer MSAs and other HSAs can be rolled over into an HSA without being
limited by annual contribution limits, and they do not need to be in cash. However, the amount
must be rolled over within 60 days after the date of receipt, only one rollover contribution to an


                                               157
HSA is allowed during any one year period, and rollovers from an IRA, an HRA or a Health
FSA into an HSA, are not allowed.
                        Reporting Contributions to IRS and Form 8889
    Employer contributions to an HSA are not included in the individual 1040 tax return. Con-
tributions made and contributions made by any other person (other than employer) can be
claimed as an adjustment to income.
    All contributions to HSAs are reported on Form 8889, Health Savings Accounts (HSAs), and
filed with the Form 1040. The individual should receives Form 5498-SA, HSA, Archer MSA, or
Medicare+Choice MSA from the trustee showing the amount contributed during the year. Em-
ployer’s contributions will also be shown in Box 12 of the employee’s Form W-2, with Code W
shown. HSA deduction is reported on Form 1040 line 28.
                                       Excess Contributions
    Contributions to an HSA that is greater than the limits are considered as ―excess contribu-
tions‖ and are not deductible. If the employer makes excess contributions, they are not reported
in gross income. If the excess contribution is not included in Box 1 on Form W-2, then the
excess must be reported as ―Other Income‖ on the tax return, and as a general rule, the individual
must pay a 6% excise tax on excess contributions.
    In order to avoid the excise tax, all or some of the excess contributions may be withdrawn if
the excess is withdrawn by the due date (including extensions) of the tax return for the year the
contributions were made, or the income earned on the withdrawn contributions are withdrawn
and included in ―Other Income‖ on the tax return for the year that the contributions and earnings
are withdrawn.
                                   Distributions From an HSA
    Any medical expenses occurring during the year are paid by the individual until such time
that the expenses exceed the annual deductible for the HDHP. When medical expenses are paid
that are not reimbursed by the HDHP, the trustee of the HSA can (and should) provide a distribu-
tion from the HSA.
    Any distributions from the HSA used to pay or be reimbursed for qualified medical expenses
incurred after establishment of the HSA, are considered as tax-free distributions. If distributions
are received for any other reason, the amount withdrawn will be subject to income tax and may
be subject to an additional 10% tax. It is not necessary to make distributions from the HSA
every year.
    If an HSA has been established by April 15, 2005, distributions are tax-free for qualified
medical expenses incurred on or after the fist day of the first month that the individual became
eligible.
    Note: If an individual is no longer eligible, they can still receive tax-free distributions to pay
or reimburse for qualified medical expenses.

                            QUALIFIED MEDICAL EXPENSES
    ―Qualified Medical Expenses‖ has been used a lot in this discussion. They are defined as
those expenses that would generally qualify for the medical and dental expenses, as explained in
IRS Publication 502, Medical and Dental Expenses.
    Basically, Qualified Medical Expenses are the costs of diagnosis, cure, mitigation, treatment
and prevention of disease, and the costs for treatment affecting any part or functions of the body.


                                                 158
They include the costs of equipment, supplies and diagnostic devices needed for these purposes.
They also include dental expenses.
     Medical care expenses must be primarily to alleviate or prevent a physical or mental defect
or illness. They do not include expenses that are merely beneficial to general health, such as vi-
tamins or a vacation.
     Medical expenses include premiums paid for insurance that covers the expense of medical
care and the amounts that are paid for transportation to get medical care. Medical expenses also
include amounts paid for qualified long-term care service and limited amount paid for any quali-
fied Long-Term Care Insurance.
     Note: One cannot deduct qualified medical expenses as an itemized deduction on Schedule
A (Form 1040) that are equal to the tax-free distribution from the HSA.
                                   Rules for Insurance Premiums
     While as a general rule insurance premiums are not considered as qualified medical expenses
for HSAs, but premiums for Long-Term Care Insurance, health care coverage while receiving
unemployment benefits, or health care continuation coverage required under any federal law are
considered as qualified medical expenses for HSAs. If the person is age 65 or older, he can treat
insurance premiums (except for premiums for a Medicare Supplement policy) as qualified medi-
cal expenses for HSAs.
     Premiums for Long-Term Care coverage that can be treated as qualified expenses are subject
to the limits as established under HIPAA, which are based on age and are annually adjusted.
                                    Health Coverage Tax Credit
     One cannot claim credit for premiums paid with a tax-free distribution from the HSA.
                                   Deemed Distribution from HSA
     The following are considered as taxable distributions from HSAs:
         The individual engaged in any transaction prohibited by regulation with respect to
            any HSA. If this occurs, the account ceases to be an HSA and the fair market value
            of all assets in the account as of the first of the year must be reported on tax Form
            8889 (line 12a).
         The individual used any portion of any of their HSA as security for a loan at any time
            during the year, if so used, the fair market value of the assets used as security must be
            included as income for Form 1040 (line 21).
                                            Recordkeeping
     Every person who has an HSA must keep records, according to regulations, that shows that
the distributions were used exclusively to pay or reimburse qualified medical expenses, the quali-
fied medical expenses had not been previously paid or reimbursed from another source, and the
medical expenses has not been taken as an itemized deduction in any year. It is not necessary to
send these records with the tax return, but should be kept with the tax records.
Reporting Distribution on Tax Return
     Without going into detail on how distributions are reported to the IRS, basically distributions
are reported on Form 8889.

    Distributions that are not used for qualified medical expenses are subject to an
                                       additional 10% tax.


                                                159
     There is no additional tax on distributions made after the date the individual is disabled,
reaches age 65, or dies.
                                           Balance in an HSA
     As a general rule, an HSA is generally exempt from tax. The individual may take a distribu-
tion from his HSA at any time; however only those amounts used exclusively to pay for qualified
medical expenses are tax-free. Amounts that remain at the end of the year are generally carried
over to the next year. Earnings in an HSA are not included in the individual’s income for tax
purposes while held in the HSA.
                                       Death of Holder of an HSA
     A holder of an HSA should always choose a beneficiary as the disposition of the HSA upon
the death of the holder depends upon who is the designated beneficiary.
     If the spouse is the designated beneficiary, the HSA will be treated as belonging to the
spouse after death of the holder.
     If the spouse is not the designated beneficiary, then the accounts stops being an HSA and the
fair market value of the HSA becomes taxable to the beneficiary in the year in which the holder
died.
     If the estate is the beneficiary, the value is included in the final income tax return of the hold-
er.
                                HSA From the Employers Prospective
     If the employer wants to make HSAs available to their employees, the employees must have
an HDHP, and the employer cannot provide any additional coverage other than those exceptions
listed as ―Other Health coverage.”
     The employer can make contributions to the employees HSAs and these contributions are
listed on the ―Employee Benefit Programs‖ for the year in which the contributions are made.
     If contributions are made, the employer must make comparable contributions to all compara-
ble participating employees HSAs. Contributions are comparable if they are either of the same
amount, or the percentage of the annual deductible limit under the HDHP covering the em-
ployees.
                                Comparable Participating Employees
     The ―comparable participating employees‖ are those who are covered by the employer’s
HDHP and are eligible to establish an HSA, have the same category of coverage (family or self),
and have the same category of employment (part- or full-time). Note however, that compara-
bility rules do not apply to contributions made through a Cafeteria Plan.
                                               Excise Tax
     If the employer makes contribution to the employees that were not comparable, the employer
must pay an excise tax of 35% of the amount contributed.
                                           Employment Taxes
     Amounts contributed to the employees’ HSAs are usually not subject to employment taxes,
but the amount must be shown in Box 12 of the employee’s Form W-2.




                                                  160
                            MEDICARE ADVANTAGE MSAs
    A Medicare Advantage MSA is an MSA designated by Medicare to be used solely to pay the
qualified medical expense of the account holder. The holder must be enrolled in Medicare and
have a high deductible health plan meeting Medicare Guidelines.
    This plan follows the MSA and the HSA plans in respect to operation and tax exemptions of
earnings. Unfortunately, as of this date, no HDHP had been approved by Medicare so there have
not been any Medicare Advantage plans established.

                  FLEXIBLE SPENDING ARRANGEMENTS (FSAs)
    A health flexible spending arrangement (FSA) allows employees to be reimbursed for medi-
cal expenses, and is usually funded through voluntary salary reduction agreements with the em-
ployer. No employment or Federal Income Taxes are deducted from the contribution. The em-
ployer may also contribute. For other information on the relationship between a Health FSA and
an HSA, see ―Other employee health plans” under ―Qualifying for an HSA” earlier.
    The benefits of an FSA include
        Contributions made by the employer can be excluded from the gross income of the
            employee.
        No employment or federal income taxes are deducted from the contributions.
        Withdrawals may be tax free if qualified medical expenses are paid.
        The employee may withdraw funds from the account to pay qualified medical ex-
            penses even if they have not yet placed the funds in the account.
    Health FSAs are employer-established benefit plans, usually offered in conjunction with oth-
er employer-provided benefits as part of a Cafeteria Plan. Employers have complete flexibility
to offer various combinations of benefits in the plan. An employee does not have to be covered
under any other health care plan to participate.
    Self-employed persons are not eligible for an FSA. There are certain limitations that may
apply if the individual is a highly compensated participant or a key employee.
                                           Contributions
    The FSA holder contributes to his FSA by electing an amount to be voluntarily withheld
from his pay by his employer—often called a salary reduction agreement. The employer may
also contribute to the FSA if so specified in the plan.
    The holder does not pay federal income tax or employment taxes on the salary he contributes
or the amounts his employer contributes to the FSA. If the employer contributes towards a long-
term care plan, then those contributions must be included in the income.
    At the beginning of each plan year, the holder must designate how much he wants to contri-
bute. Then his employer will deduct amounts periodically (usually each payday) in accordance
with his annual election. The election can be changed or revoked only if there is a change in
employment or family status and so specified in the plan.
    There is no limit as to the amount of money that the holder or employer can contribute to the
accounts, but the plan must prescribe either a maximum dollar amount or maximum percentage
of compensation that can be contributed to the Health FSA.




                                              161
    Any contributed amounts that are not spent by the end of the plan year, are forfeited. There-
fore, it is important to base the holder’s contribution on an estimate of the qualifying expenses he
will have during the year.
                                            Distributions
    Distributions from a Health FSA must be paid only to reimburse the holder for qualified
medical expenses incurred during the coverage period. He must be able to receive the maximum
amount of reimbursement—the amount that was elected to be contributed for the year—at any
time during the coverage period, regardless of the amount that was actually contributed. The
maximum amount that he can receive tax free is the amount that he elects to contribute to the
Health FSA for the year.
    The individual must provide the Health FSA with a written statement from an independent
third party stating that the medical expense has been incurred and the amount of the expenses.
Also, he must provide a written statement that the expense has not been paid or reimbursed under
any other health plan coverage. The FSA cannot make advance reimbursements of future pro-
jected expenses.
    (Qualified medical expenses are those explained previously from IRS Publication 502, Medi-
cal and Dental Expenses.)
    Basically, he cannot receive distributions from his FSA for any amount paid for health insur-
ance premiums, amounts paid for long-term care coverage or expenses, or amounts that are cov-
ered under another health plan.
    He cannot deduct qualified medical expenses as an itemized deduction on Schedule A, Form
1040, that are equal to the distribution received from the FSA.
                                         Balance in the FSA
    Flexible spending accounts are described as ―use-it-or-lose-it‖ type of arrangements, and any
amount in the account at the end of the year cannot be carried over to the next year and the em-
ployer is not allowed to refund any part of the balance to the individual.
                                      Employer Participation
    Employers must comply with certain requirements that apply to Cafeteria Plans in order for
the Health FSA to maintain the tax-qualified status, such as restrictions for plans that cover high-
ly compensated employees and key employees.

              HEALTH REIMBURSEMENT ARRANGEMENTS (HRAs)
    A Health Reimbursement Arrangement must be funded only by an employer. The contribu-
tion cannot be paid through a voluntary salary reduction agreement on the part of an employee.
Employees are reimbursed tax-free for qualified medical expenses up to a maximum dollar
amount for the coverage period. An HRA may be offered with other health plans, including
FSAs.
                                      Benefits of an HRA
    The employee benefits from the fact that the contributions made by his employer can be ex-
cluded from his gross income. Reimbursements may be tax free if he pays qualified medical ex-
penses. And, any unused amounts in the HRA can be carried forward for reimbursements in lat-
er years.




                                                162
                                      Qualifying for an HRA
    HRAs are employer-established benefit plans and they may be offered in conjunction with
other employer-provided health benefits. The employer has complete flexibility to offer various
combinations of benefits in designing the plan. The employee does not have to be covered under
any other health care plan in order to participate.
    Self-employed persons are not eligible for an HRA. Certain limitations may apply if the in-
dividual is a highly compensated participant.
                                            Contributions
    HRAs are funded solely through employer contributions and may not be funded through em-
ployee salary deferrals under a Cafeteria Plan. These contributions are not included in the em-
ployee’s income. The employee does not pay federal income taxes or employment taxes on
amounts the employer contributes to the HRA.
    There is no limit on the amount of money that the employer can contribute to the accounts,
and also, the maximum reimbursement amount credited under the HRA in the future may be in-
creased or decreased by amounts that are not previous used.
                                            Distributions
    HRA distributions must be paid to reimburse the employee for qualified medical expenses
incurred, such expenses must have been incurred on or after the date of enrollment in the HRA.
If any distribution is, or can be, made for other than the reimbursement of qualified medical ex-
penses, any such distribution (including reimbursement of qualified medical expenses) made in
the current tax year is included in gross income.
    Reimbursements can be made to current and former employees, spouses and dependants of
these employees, or spouses and dependents of deceased persons.
                                    Qualified Medical Expenses
    Qualified medical expenses are discussed earlier in this text. In addition, qualified medical
expenses from an HRA include amounts paid for health insurance premiums, amounts paid for
long-term care coverage, and amounts that are not covered under another health plan.
    Qualified medical expenses cannot be deducted as an itemized deduction on Schedule A
(Form 1040) that are equal to the distribution from the HRA.
                                        Balance in an HRA
    Amounts that remain at the end of the year generally can be carried over to the next year.
The employer is not permitted to refund any part of the balance to the employee and these
amounts may not be used for anything but reimbursements for qualified medical expenses.

   Note: For further and more detailed information on these plans, go to IRS Publication 969,
available through the IRS or on the internet at http://www.irs.gov/publications/p969/ar02.html




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                                    STUDY QUESTIONS

1. In order to qualify the a Medical Savings Account (MSA) the person must be either self-
    employed or the spouse of such a person, who maintains an individual or family high deduct-
    ible health plan (HDHP) or
    A. an employee or spouse of an employee of a small employer who maintains an individual
        or family HDHP.
    B. an employer who has a group of at least 10 employees. and who furnished an HDHP for
        a nondiscriminatory group.
    C. a legally or medically handicapped individual who cannot otherwise be covered under
        a health plan.
    D. a person who is eligible for COBRA continuance insurance.

2. For purposes of an MSA, a small employer is an employer that
   A. has less than 10 full-time employees.
   B. had an average of 50 or fewer employees during either of the last 2 calendar years.
   C. has an annual payroll of under $1 million per calendar year for the last 2 years.
   D. has less than 100 employees including part-time and/or seasonal.

3. If the holder of an MSA changes employers,
    A. the MSA is terminated and the holder is then eligible for COBRA benefits.
    B. the MSA goes with him (portable) and he can continue to make additional contributions
        even if he is not otherwise eligible to do so.
    C. the MSA is transferred automatically to the individual's spouse or dependent(s).
    D. the MSA goes with him but he cannot make any additional contributions unless he
        is otherwise eligible.

4. The annual deductible limit of the MSA allows the individual or his employer to contribute
   A. the entire amount (100%) of the deductible to the MSA.
   B. up to 75% of the annual deductible of the HDHP (65% if it is a self-only plan).
   C. up to 25% of the employee's annual income.
   D. whatever amount they wish.

5. With an MSA, as a general rule, insurance premiums
   A. are treated as qualified medical expenses for an MSA.
   B. of any type are never treated as qualified medical expenses.
   C. are treated as qualified medical expenses except for long-term care insurance premiums.
   D. may not be treated as qualified medical expenses for an MSA (except for long-term care
      insurance premiums, health care coverage while receiving unemployment benefits or
      COBRA premiums).




                                              164
6. Any distribution from an MSA that is rolled over into another MSA
   A. is not taxable if the rollover is completed within 60 days.
   B. is taxed at capital gains rates.
   C. is taxed as ordinary income to the individual.
   D. may be carried over for the next 3 years,

7. To be eligible and qualify for an HSA, the person
   A. must be approved for a high deductible health plan from an insurer, to be issued
       by the first of the next calendar year.
   B. must have health insurance with another insurer to cover the deductible amount.
   C. may be covered as a dependent on another's tax return.
   D. must have a HDHP on the first day of the month, no other health coverage except what
       is permitted, not enrolled in Medicare or be a dependant on another's tax return.

8. The minimum annual deductible and other out-of-pocket expenses for HDHPs for 2006 for a
   family is
   A. $1,050.
   B. $2,100.
   C. $5,250.
   D. $10,500

9. With an HSA, distributions that are not used for qualified medical expenses
   A. are normally ignored if the services contribute in some fashion to the person's
      well-being.
   B. must be returned to the insurance company that issued the HDHP.
   C. are subject to an additional 10% tax.
   D. are not allowed to be carried over.

10. A Health Reimbursement Arrangement (HRA) is
    A. an employer-established benefit plan that is funded solely through employer
       contributions.
    B. an employer-established benefit plan that is funded solely through employee
       contributions.
    C. a plan designed for a self-employed person or a sole-owner of a business, that wants
       to have a tax-free method of paying for health benefits not covered by insurance.
    D. a taxable vehicle for employers to invest excess funds that sets penetration limits so
       high that employees rarely qualify for distributions.


ANSWERS TO STUDY QUESTIONS
1A   2B   3D   4B   5D   6A   7D   8B   9C   10A




                                                   165
     CHAPTER ELEVEN - TAXATION OF DISTRIBUTIONS

     Those who participate in qualified plans are, as a general rule, exempt from tax on the inter-
est that they hold in the plan, until those interests are distributed. The three principal forms of
distribution are annuities, lump sum distributions, and rollovers. These are discussed in this
chapter and even though at times, particularly in the early period of time when employee benefits
have been installed and even earlier—during the installation period—when retirement is the plan
objective, then it is important that the tax ramifications are known to the agent and to the plan
administrator.
                                           ANNUITIES
    Section 72 of the Internal Revenue Code addresses the taxation of annuities, including annui-
ties from plans and certain other distributions. Basically, distributions from a qualified plan oth-
er than rollovers and some lump sum distributions, are taxable in the year in which they are
made.
    The Section 72 is rather complex—too complex to go into much detail in this text—basically
because the annuity payments generally consist of portions to which the annuitant has contri-
buted, and portions where only non-taxable employer contributions were made on behalf of the
participant. Of course, the rule is simple where the employer has contributed the entire
amount——the annuity payments are taxable in full.

                          Basic Rules for Annuity Distributions
    The basic exclusion rule, i.e., the rules that pertain to amounts that are received as an annuity,
applies to those distributions. These are the amounts that are payable at regular intervals for pe-
riods of time of more than one full year from the annuity starting date, and for which the total
amount that is payable can be determined as of that starting date, either because of the terms of
the annuity or from actuarial tables. For further clarification, the annuity starting date is the later
of the date on which the obligations are first fixed, and the first day of the payment of the pay-
ment period that ends on the date of the first payment.320
    For any amount received as an annuity, the exclusion ratio is excluded from gross income.
"Exclusion ratio" is the investment in the contract as of the starting date of the annuity, divided
by the expected return under the annuity as of that date.321 As an example, if the annuity pays
$500 a month, and the exclusion ratio is 10%, then $50 of each monthly payment is excluded
from gross income.
    The investment in the contract is simply the total of the employee's contributions, plus any
amount of employer contribution that was included in the employee's gross income, minus the
amount received to that date under the annuity to the extent it was excludible from gross income.
Or, to put it another way, it is the undistributed amount that has already been taxed. The ex-
pected return is the amount that is expected to be received from the annuity.
     This exclusion continues until the participant's investment in the contract has been totally dis-
tributed, after which time, the entire amount of the annuity payment is subject to tax. If, howev-
er, annuity payments cease because of the death before the full investment in the annuity is re-


                                                 166
ceived, the part that is not received is allowed as a deduction in the participant's final taxable
year.322
    This may appear complicated—and it is—so the IRS allows a simplified method to calculate
the excluded amount from gross income for most single life and joint and survivor annuities
from qualified plans. It is not necessary to go into detail, but participants are grouped into a
number of groups determined by age and an expected number of monthly annuity payments for
each group by age, both by single and by joint & survivor by using combined ages. The invest-
ment in the contract is divided by the expected number of payments for that age group.

                           Amount Not Received as an Annuity
    The Code addresses amounts not received as an annuity under an annuity contract, which are
not technically the same thing as lump sum distributions, and consist of such things as payments
before the annuity starting date, dividends, refund amounts, and other non-periodic distributions.
    Simply put, amounts received on or after the annuity starting date are included in gross in-
come. Amounts received before the annuity starting date are excluded to the extent that they can
be allocated to the investment in the annuity. The IRC furnishes rules as to how to determine the
amount that is so allocated. For defined benefit plans, most often used in employee benefit situa-
tions, the present value of the vested portion of the accrued benefit is the account balance.

                                        Separate Contract
    The IRS rules are applied separately to each distribution with respect to a separate contract—
each distribution under a separate program of the employer that consists of interrelated contribu-
tions and benefits. Therefore, the portion that can be excluded from gross income for tax pur-
poses is the sum of the exclusions for each separate contract that contributes to the entire distri-
bution.
    A separate contract, the IRS points out, is not necessarily a separate plan—but it is possible
that it is a separate plan, but a single plan may have two or more separate contracts, and con-
versely, two plans may constitute a single contract. For instance, a profit sharing plan and a de-
fined benefit plan of an employer constitute separate contracts.
    The IRS does allow that employee contributions under a defined contribution plan may be
treated as a separate contract. Without going into detail, this type of arrangement can be of con-
siderable benefit to a participant who can treat a distribution from a defined contribution plan as
a distribution in respect to that particular separate contract.

                                  Lump Sum Distributions
    Even if the qualified plan pays its distribution in one lump sum, that does not mean that all
such payments are considered as lump sum payments for tax purposes; such as payments because
of the death of the employee, the employee reaching age 59 ½, the separation of the employee
from service, or, for self-employed persons, the employee's becoming disabled.
    Such distribution also need not be directly to the employee. In determining the balance to the
credit of the employee, all pension plans of the employer are treated as a single plan, all profit-
sharing plans are considered as a single plan, and all stock bonus plans of the employer are
treated as a single plan. A cash-out may be a lump sum distribution.


                                                 167
    If a lump sum distribution includes securities of the employer, then the gross income does not
include net unrealized appreciation of those securities (defined as the excess of the market value
of the security at time of distribution, over its cost basis) to the plan. Therefore, the amount of a
lump sum distribution attributed to employer securities that is taxed at time of distribution is the
amount of the original employer contribution. The net unrealized appreciation is subject to tax
later, when the securities are sold.

                       Rollovers and Trustee-to-Trustee Transfers
     A person who leaves an employer may wish to take their plan interests with them, and move
it to an IRA or to the plan of a new employer. There are two ways to accomplish this.
    First, a trustee-to-trustee transfer where the interest is directly transferred from the old plan to
a new plan or an IRA, or (secondly) a rollover distribution where the participant's interest is first
distributed to him so that he can contribute to a new plan or an IRA. ERISA encourages the trus-
tee-to-trustee transfer method as it removes the temptation for the participant to use the amounts
that are distributed for other purposes, instead of for retirement purposes as it was intended.
    Basically, a trustee-to-trustee transfer or a rollover distribution is a distribution than can be
subject to tax, but if it were taxed that would negate the stated IRS and legislators policy of de-
ferring tax on qualified plan interests until retirement. Therefore, trustee-to-trustee transfers are
not taxed, and rollovers are exempt in certain appropriate cases.323

                                 Eligible Rollover Distributions
    An eligible rollover distribution is a distribution to an employee of any of the balance to his
credit in a qualified plan, except for the following:
      a distribution that is a portion of a series of basically equal periodic payments made an-
       nually or more frequently over a period of the life of the employee, joint life of em-
       ployee & beneficiary, or for a stated period of 10 years or more,
      required minimum distributions as specified under the tax code, or
      certain hardship distributions, as specified in the tax code.

                                 Transfer of Funds to New Plan
    If the distributions are to be excluded from gross income, the distribution must be transferred
to an eligible retirement plan within 60 days of receipt.324 This may be waived by the IRS when,
as the code states, it is called for "by equity and good conscience."
   An eligible retirement plan is a qualified trusteed plan, an annuity plan as stated in the tax
code, [IRC 403 (3)(a)], an IRA or annuity, some specified deferred compensation plans of state
and local governments, or IRC §403(b) annuities.
    The maximum amount that can be rolled over and excluded from income, is the part of the
distribution that would be included in gross income if the rollover exclusion rules did not apply.
There is an exception for rollovers to IRAs and annuities.




                                                  168
                                     Distribution to Spouse
    A distribution after an employee's death to the surviving spouse can be rolled over if the sta-
tutory requirements would be met by the treating the spouse as the employee. A distribution
from a qualified plan may be rolled over if the statutory requirements would be met by treating
the alternate payee as the employee.

                                   Possible Withholding Tax
    Even though an eligible rollover distribution is excluded from gross income, it is still subject
to a withholding tax of 20%, and the withholding tax cannot be waived. A recipient who
wants to rollover the entire amount of a distribution must contribute the entire amount to the new
plan within 60 days—they may not contribute part this year and the remainder the following
year, for example. There is NO withholding if the amount is transferred directly to the new plan,
again pointing up the advantage of a trustee-to-trustee transfer.

                                        Direct Transfer
    Every qualified plan must provide that the recipient of an eligible rollover distribution may
elect to have the distribution transferred directly to an eligible retirement plan—which is only a
trusteed plan that is a defined contribution plan which allows acceptance of rollover distribu-
tions. After-tax amounts may be transferred to either a defined contribution plan that separately
accounts for the after-tax amounts, or to an IRA or annuity.
   If the plan allows for voluntary cash-outs, unless the distributee elects otherwise, any such
involuntary distribution in excess of $1,000 shall be transferred directly to a specified IRA or
annuity.325

                         Additional Tax on Early Distributions
    Qualified benefit plans usually do not distribute participant interests before retirement, and
profit sharing and stock-bonus plans are not required to do so either, basically because of
ERISA's stated purpose of promoting retirement security. To enforce this concept, a tax is im-
posed on premature distributions from qualified plans.
     A 10% tax on the amount of the distribution that is includible in gross income is imposed on
distributions made before the day on which the employee reaches age 59 ½. But, as usual, there
are numerous exceptions, such as (a) those made upon the death of the employee, (b) those that
are attributable to the employee's becoming disabled, (c) those that are part of a series of substan-
tial equal periodic payments paid annually or more frequently, (d) those that begin after separa-
tion from service and made for life of the employee and designated beneficiary, (e) those made
to an employee after separation from service after becoming age 55, and (f) those distributions
that constitute dividends on employer stock which fall under provisions of Section 401(k).
There are also other exceptions regarding the recipient of the distribution.

                                          Participation
    A qualified pension plan cannot require an employee the right to participate beyond age 21 or
after completing one year or service, whichever comes first.326 All years of service, except for




                                                169
those excluded because of service break rules, must be counted in respect to vesting require-
ments.
    There are allowable variations, such as plans that provide 100% vesting after no more than
two years of service can require the employee to be 21 years old or to complete 2 years of ser-
vice—a 401(k) plan, however, may not require more than 1 year or service or age 21. For tax-
exempt educational institutions that provide for 100% vesting after one year, they can condition
the vesting on the later of the employee becoming 26 years old or completing one year of ser-
vice.327
    Employees do not necessarily have to participate the day in which they qualify. It is usually
acceptable that an employee's participation start no later than the earlier of the first day of the
plan year after satisfying eligibility standards; or 6 months after the date of the satisfaction of
those standards.328
    Conversely, a pension plan may not exclude employees from participation on the basis of
their having attained a specified age (age discrimination).

                                  ACCRUAL OF BENEFITS
    The need for accrual of benefits rules stem from the possibility of "backloading"—an ar-
rangement where the level of the benefit for the participant grows much faster in later years. To
illustrate this situation, assume that the plan would base the total benefit to be paid at retirement
on one year of service at $1 of benefit, increasing by $1 each year until the 20th year when the
benefit would be the final pay times the years of service times 1.5%. This would in effect, nulli-
fy the importance of vesting in early years as the benefits would be trivial until much later. The
other purpose of the accrual rules is to help prevent age discrimination.

                                       Accrued Benefits
    Accrued benefits are defined differently for defined contribution plans and defined benefit
plans.
     For a defined contribution plan, the employee's accrued benefit is the balance in his account.
However, employees often contribute to these plans and therefore it is important to differentiate
accrued benefits attributed to the employee contributions from the accrued benefits that can be
attributed to employer contributions. If the employer and employee contributions are kept sepa-
rate, then the accrued benefit attributed to the employee contributions is the balance of the em-
ployee-contribution account. However, if separate accounts are not maintained, then the accrued
benefit that can be attributed to employee contributions is equal to the formula of: total accrued
benefit times [(employee contributions less withdrawals) divided by (total contributions less
withdrawals)]. The accrued benefit attributed to the employer contributions would be the re-
mainder—what is left.
     For a defined benefit plan, the accrued benefit is "the individual's accrued benefit determined
under the plan … expressed in the form of an annual benefit commencing at normal retirement
age."329 Simply put, the accrued benefit at any given time is the benefit that the employee would
be entitled to receive at normal retirement age under the plan's benefit formula if the employee
left the employer's service at that time.




                                                 170
                                   Anti-backloading Rules
    The anti-backloading rules for defined benefit plans are simple to explain, but rather compli-
cated to explain mathematically, so for purposes of this text, most mathematics will be ignored.
   The rules fix the minimum standards for the rate of accrual and require that a plan's benefit
formula satisfy at least one of those standards. The standards revolve around the number of
years of participation, rather than the years of service as do vesting standards.
    The "3%" rule compares the accrued benefit at any time with a consistently increasing pro-
portion of the maximum normal retirement benefit of the plan. It is based upon a hypothetical
normal retirement benefit to which a participant would be entitled if he started participating at
the earliest possible age and worked continuously until age 65 or normal plan retirement age.
Three percent (3%) of this amount then becomes the "measuring stick" which is multiplied by
the number of years the employee has participated in the plan, up to a maximum of 33 1/3%. If
the actual accrued benefits is greater than or equal to this amount, then the test is satisfied.329
While this accomplishes what it is intended to do—combat the backloading situation—it consid-
ers the amounts accrued and not the plan's rate of accrual.
    The second rule, the 133-1/3% rule, considers the rate of accrual by requiring that at any time
the rate of accrual for any subsequent year must not be more than 133-1/3% of the rate of accrual
for the years between the first and subsequent year of accrual. The purpose of this rule is to try
to prevent a large acceleration in the rate of growth of the benefit for later years of participation.
   While this second rule works well, plan amendments that increase the rate of benefit accrual
can complicate application of this test. To alleviate such complications, ERISA provides than an
amendment in effect for a given year is treated as if it were in effect for all years.330
    It is rather simple to construct accrual schedules that do not meet this rule—for instance,
suppose the plan provides for accrual of benefits at the rate of 1% of final salary for the first 5
years, 1.25% for the next five years, and 1.5% for all years thereafter. This means that the rate of
accrual in years 11 and later is 150% of the rate in years 1-5, therefore the test is not satisfied.
     The 133-1/3% rule has one more requirement—the accrued benefit payable at normal re-
quirement age must be equal to the normal retirement benefit. While this seems too simple, what
it does is eliminate problems such as, for example, a plan states the normal retirement benefit is
$10,000 per year, while the rate of accrual of benefits is only $100 per year; then if an employee
left employment before retirement (even as little as a year before) he would receive substantially
less than the normal retirement benefit.
     There is a third rule, and it compares a hypothetical normal retirement benefit to actual bene-
fits accrued at the time of separation from service.331 This is a little more complicated as first
one must calculate the "fractional rule benefit" which is the retirement benefit (R) to which the
employee would be entitled were he to continue to work until normal retirement age, presuming
the employee continues to earn the relevant salary until normal retirement age that is used in
computing the normal retirement benefit, as if he had attained normal retirement age on the date
of separation from service. From this, a fraction is formed (F) , which is equal to the years of
actual participation at separation divided by the total number of years the employee would have
participated had she retired at the normal retirement age. If the actual accrued benefit is at least
equal to R times F, then the test is satisfied.



                                                 171
    And then there is a special accrual rule for defined benefit plans that are funded exclusively
through insurance contracts. If the contracts provide for level annual premium starting with par-
ticipation, benefits under the plan are equal to benefits under that contract at normal retirement
age, and benefits are guaranteed by the insurance company to the extent that premiums have
been paid—then the anti-backloading standard has been met as long as the accrued benefit is no
less than cash surrender value according to prescribed actuarial assumptions.332

                              AGE DISCRIMINATION RULES
    In order to prevent age discrimination, ERISA prohibits defined benefit plans from ceasing
accruals or reducing the rate of accrual, because of the age of the employee (with an exception
for highly compensated employees). A defined benefit plan may limit the amount of benefit,
however, or the years of participation used in the benefit formula as long as it is not calculated
on the basis of age.333
   For a defined contribution plan, the usual accrual rules respond to the age-discrimination
problems and provide that contributions to an employee's account may not stop, and the rate of
contribution to the employee's account not be reduced.334

                                        Top-Heavy Plans
   A plan is subject to special accrual rules in the years that a plan is "top-heavy." For those in
such defined benefit plans who are not key employees, the accrued benefit that is attributed to
employer contributions may not be less than the lesser of 2% times years of service with the em-
ployer, or 20% The period of time used for such test is determined by the number of years in
which the plan was top-heavy up to 5 years, in which the participant had the greatest aggregate
compensation.335
    For participants in top-heavy defined contribution plans who are not key employees, the em-
ployer contribution must be at least 3% of the participant's compensation, unless the 3% is larger
than the highest percentage rate at which contributions are made for key employees, in which
case, the contribution percentage for non-key employees must equal the maximum contribution
percentage for key employees.336

                      AMENDMENTS AND ACCRUED BENEFITS
     One should keep in mind that not every benefit from a pension plan is an "accrued" benefit.
For a defined benefit plan, ERISA defines an accrued benefit as a benefit equivalent to "an an-
nual benefit commending at retirement age." For a defined contribution plan, an accrued benefit
is "the balance of the individual's account."337
     However, a plan could offer other benefits, such as life insurance or alternate forms for the
distribution of plan benefits, or it could offer an early retirement subsidy (an amount paid at early
retirement greater than the actuarial equivalent of a pension commencing at normal retirement
age).
    ERISA's anti-cutback rule does not allow plan amendments that reduce accrued benefits.338
Courts have rules that an automatic cost-of-living adjustment and similar provisions for automat-
ic benefit increases, may be considered as an accrued benefit protected against elimination or
decrease.339



                                                172
    Another restriction is that a plan amendment that eliminates or reduces an early retirement
benefit is deemed to reduce accrued benefits to the extent that it reduces benefits attributable to
service before the plan amendment.341
     In case of retirement subsidies, benefits that are attributed to service before the amendment
still cannot be reduced or eliminated, but only for those participants who actually satisfy the con-
ditions that existed prior to the amendment for the subsidy, before or after the amendment. As
an example, if a plan provides an early retirement subsidy for participants who retire at age 55
with 30 years of service, only those participants who meet the age and service conditions at some
time, will be entitled to eliminate it. If 45-year old employee has 20 years of service at the time
of the amendment, he would lose his right to the subsidy should he leave the employer within the
following ten years.
    There are exceptions to the anti-cutback rules, such as where the relevant benefits or subsi-
dies create significant burdens or complexities for the plan and its participants, and the amend-
ment has only a minimum impact on the rights of participants. It also does not apply in some
cases of termination of multi-employer plans, and there are exceptions that pertain to the elimi-
nation of forms of benefit distribution from defined contributions plans.342
    Amendments that reduce future rates of accrual are not prohibited. However, ERISA rules
require that in cases of "significant reduction" in the rate of future accrual, participants and other
parties that could be affected must be notified of the amendment. As an example, an amendment
to a pension plan that eliminates or reduces an early retirement subsidy is considered as reducing
the rate of future benefit accrual for ERISA purposes.343

                                   CASH BALANCE PLAN
    These plans have become rather popular in recent years as a type of defined benefit plan, and
the difference is in the way that the benefits accrue.
   Benefits under a traditional plan usually depend on the product of years of service and final
average pay, both of which increase over time. This can cause the value of the accrued benefit to
grow at an accelerating rate the longer that the participant remains in service.
    A cash balance plan, on the other hand, allow benefits to accrue more steadily, with the result
that the accrual rate for participants in early years of service usually will be larger under a cash
balance plan than under a comparable traditional defined benefit plan.
    Cash balance plans usually result from an amendment of existing, traditional defined benefit
plans to change the accrual formula, and are rarely started from scratch. When a plan is con-
verted to a cash balance plan, it must address the prior accruals under the old defined benefit
plan, and there are two ways in which this can be accomplished: (1) A plan can provide that
every participant immediately start to accrue benefits under the new cash balance plan formula,
and those benefits are added to the benefits accrued under the old formula; or, (2) the plan can
provide for wear away, where a participant does not start to accrue additional benefits under the
new cash balance plan until the amount of benefits that the new formula would provide is more
than the accrued benefit under the old formula.
    As an example, if the participant has accrued a $100,000 benefit under the old formula, addi-
tional benefits under the new plan would not start to accrue until the balance of his hypothetical
account exceeded $100,000. There are two ways to experience "wear away," as with one way,


                                                 173
the plan will retroactively credit his hypothetical account with the amount it would have had if
the plan to use the cash balance formula was used in the beginning. This way, the hypothetical
account could start with a substantial balance and the period during which there are no accruals
would therefore be shortened. The other way would be where the plan fixes the participant's new
hypothetical account at zero (no accrued balance), in which case it could be a long time before
the benefits resumed their accrual!
    When a plan is converted to a cash balance plan, participants that are close to normal retire-
ment age can experience a lower accrual rate than they would have had under the old plan, which
means that with wear away, there could be a period of time in which there are no further accruals
to the participants, in particular, those nearing normal retirement age. The anti-cutback rule does
not protect these expectations, with the result that conversions have been challenged in the
courts. At the present time, the legislature and regulatory bodies are considering standards to
govern cash balance plans and plan conversions

                          PROTECTION OF BENEFIT RIGHTS
   One of the most important functions of ERISA is the protection of benefit rights of the
workplace. For instance, ERISA protects against an employer that has a 5-year cliff vesting plan
and who would be tempted to fire employees after 4 years and 11 months in order to save
pension costs.344
    Specifically, ERISA prohibits an employer from discharging or disciplining an employee or
discriminating against an employee for the purposes of interfering with the "attainment of any
right to which such participant might become entitled under the plan." An employee may, there-
fore, not be discharged for the purpose of preventing vesting or experiencing future accruals on
the plan. This provision basically prohibits employment discrimination for reasons based on
plan rights—an area which preempts state laws, so ERISA entirely governs this provision. Even
state laws for wrongful discharge are preempted by ERISA.
    Section 510 of ERISA requires an employee to show that the employer had the specific intent
to violate his rights and just an impact on benefit rights by itself is not sufficient, but the em-
ployee may show only that the discriminatory reason was the determining factor—the employer
specifically intended to do the discriminatory act and engaged in conduct in furtherance of that
intent.345
    This particular regulation has created many questions, some of them having to be interpreted
by the courts. For instance, this regulation is basically addressed to discrimination against indi-
viduals and/or to conduct directed against a group of employees. The unintended result is that it
may protect one group of workers at the expense of another. When an employer has to reduce
the work force, the question naturally arises as to what extent the employer can consider reduc-
ing pension costs rather than current wage costs. Courts have held that a critical factor in this
determination is whether the desire to reduce pension costs is a "casually determinative factor"—
does it make a difference to the employer's choice?346
   Another problem area consists of medical and disability plans. For instance, if an employee
contracts a disease that is expensive to treat—AIDS, cancer, kidney dialysis, etc., come to
mind—or if the employee is at risk of contracting an expensive illness—heavy smokers, obese
employees come to mind—the employer may be tempted to discharge the employee or otherwise



                                               174
avoid coverage under the plan. ERISA protects rights in benefits, even though such benefits do
not vest.347
    However, courts, in most cases, allow employers to terminate or amend a welfare benefit
plan to eliminate coverage of an expensive illness, even after a participant has contracted it. The
reason is the court's strong desire not to interfere with employer decisions regarding welfare
plans. In addition, some courts have held that Section 510 pertains only to the employment rela-
tionship, and therefore, imposes no constraints on amendments to plans.347
                             NON-RETIREMENT BENEFITS
     A pension plan can furnish more than just retirement benefits, and these non-retirement bene-
fits have special rules to make sure that the tax advantages for qualified plans are not abused.

                       ALLOWED NON-RETIREMENT BENEFITS
    A profit-sharing or stock bonus plan is primarily a plan of deferred compensation, so it can
offer a wide variety of non-retirement plans, basically such distribution would be triggered by
the prior occurrence of some event, such as layoff of workers, illness/injury/disability, retire-
ment, death or severance of employment. In some cases, funds that allocated to a participant's
account may be used to provide him or his family with incidental life or accident or health insur-
ance. (Stock bonus plans allow the allocations for the same purposes.)
    Defined benefit plans and money purchase plans are more restricted, but yet they can provide
for the payment of a pension due to disability or the payment of incidental death benefits through
insurance or otherwise.348 Also, under the same regulation, defined benefit and money purchase
plans may provide medical related benefits to retired employees and spouses and dependent un-
der rather strict conditions—principally the integrity of the plan is kept as medical benefits, for
instance, must be subordinate to the retirement benefits provided. "Subordinate to" rule is ab-
ridged or breached if, after the account is established, contributions for medical benefits for reti-
rees (when added to the contributions for life insurance under the plan) are more than 25% of the
total contributions to the plan (excluding contributions to fund past service credits).

                                         Death Benefits
    A non-retirement benefit often used in qualified plans is a pre-retirement death benefit
funded by life insurance (naturally). However, such a benefit must be "incidental," according to
the IRS. Basically, the cost of the death benefit for a participant cannot be more than 25% of the
total cost of all plan benefits for him. But, if the death benefit is funded through whole life in-
surance, the 25% limitation goes to 50% as half of the premium is considered as being allocated
to pure insurance and the other half to investment.349 A defined benefit plan or money purchase
plan will also satisfy the incidental benefit restriction provided the policy does not create a death
benefit that is greater than 100 times the normal retirement benefit.350 After that time the plan
funds can be used to buy insurance. (Care must be taken because with defined benefit plans, the
failure to meet the incidental benefit standard could mean disqualification of the entire plan.)
    Profit-sharing and stock bonus plans can lose qualification if they do not comply with the in-
cidental benefit rule, but only if the limitations are exceeded with premiums that are paid out of
funds that were contributed less than two yeas previously—in which case, there is insufficient




                                                175
deferral of income before distribution. After that time, then plan funds can be used to buy insur-
ance.

                 Payments of Accrued Benefits to Plan Beneficiaries
     It is possible for a plan to provide for part of an accrued benefit to be distributed to a benefi-
ciary but such payment must satisfy the requirement that it be incidental to the payment of bene-
fits to the participant (the requirement was created by the Tax Reform Act of 1986[TRA]) So
far, the regulatory bodies have not prescribed standards, and are still using the pre-TRA stan-
dards where the incidental benefit rule is satisfied if, when distribution commences, more than
half of the present value of the nonforfeitable accrued benefit is payable to the participant. A
joint and survivor annuity where the amount of the periodic payment to the surviving beneficiary
does not exceed the amount of the periodic payment to the participant, satisfies the standards.351

                                    DISTRIBUTION TIMING
    If the present value of a participant's vested benefit is more than $5,000, before any part of it
can be distributed the participant must consent to the distribution, in writing, before he has ar-
rived at either the retirement age or age 62, whichever is later. Thereafter, the plan may distri-
bute benefits in the prescribed form without any further consent of the participant needed. Con-
sent is not needed for distribution of benefits on the participant's death.352

                                      Start of Distribution
    A participant may be allowed, by plan, to delay the start of the distribution of plan benefits,
but unless he does so delay, the plan must start payments no later than the 60th day after the close
of the plan year during which the participant (a) attains age 65 or normal retirement age; (b)
completes ten years of participation in the plan; of (c) terminates the employment service with
the employer. Some plans may require a participant to file a claim in order to start benefit pay-
ments.

                               Limits on Delay of Distribution
    The plan may allow a participant to delay the start of benefit payments, but if the participant
does not ask to delay the payments, the plan must start payment no later than the 60th day after
the close of the plan year during which the participant complies with provisions (as above).

                                        Participant Delay
    The rules limit the right of the participant to delay the commencement of benefit distribution,
as the plan must provide for the distribution of his entire interest, either by the required begin-
ning date, or starting by the required beginning date and extending over the life of the participant
(or a number of years not greater than his life expectancy). The beginning date is usually April 1
of the calendar year following the calendar year in which the participant turns 70 ½ or retires.353
    Some persons question the purpose of the restrictions on the participant's right to delay pay-
ments. These rules were enacted so as to limit the use of pay-related tax deferral for estate plan-
ning purposes instead of retirement savings purposes—which were the reasons for ERISA to
start with.



                                                 176
                                   DEATH DISTRIBUTIONS
    If the participant dies after his benefit payments have started, but prior to his entire interest
has been distributed, the remaining portion must be distributed to him at least as rapidly as they
were distributed to him prior to his death.354
    There are exceptions, including the exception that any amount that was payable to a desig-
nated beneficiary may be paid over the life or life expectancy of that beneficiary, starting no later
than one year after the death of the participant. Also, if the designated beneficiary is the surviv-
ing spouse, commencement of distribution does not have to start until the date on which the par-
ticipant would have reached age 70 ½. Further, if the surviving spouse dies before her distribu-
tion begins, the 5-year rule and the first exception are applied as if the spouse were the partici-
pant.

                                ASSIGNMENT OF BENEFITS
    Every pension plan must provide that benefits under it may not be assigned or "alienated."
("Alienate" is defined as "To transfer of convey [property or a property right]) to another.")355
This provision is identical in the requirements for qualification.356 The purpose of this rule is to
protect the pension benefits from being dissipated. It does not pertain to benefits that have al-
ready been paid out.
     This provision pertains to voluntary assignments by a participant or beneficiary, and further,
it requires plan fiduciaries not to give them any effect. This provision also governs involuntary
assignments as well. The question is when, if ever, third parties may obtain interests in plans?
ERISA invalidates any state laws that purports to allow anyone to acquire rights in a plan.

                                     Welfare Benefit Plans
    The above restrictions do not apply to welfare plans as welfare benefits (arguably) are less
vital to a participant's long-term economic well-being than pension benefits , and so they do not
have to be protected over long periods of time. Therefore (again, arguably) there is less harm to
participants if welfare benefits are used to satisfy creditors. Besides, some welfare benefits—
hospital and medical benefits come to mind—are intended to be paid to third parties, if for con-
venience if for no other reason.
   Courts have routinely upheld the assignability of medical benefits to health care providers,
and a health care provider can subsequently assign its rights to a collection agency.
   Conversely, courts have also held that ERISA does not bar welfare plans from prohibiting
such assignment. This can create some problems for some providers who relay on participant's
coverage under a plan in rendering treatment, therefore some courts construe this anti-alienation
provision in a medical and hospital plan as applying only to unrelated assignees and not to the
providers of medical or hospital care for which benefits are paid.357

                                     Personal Bankruptcy
   Bankruptcy creates an estate comprising all the legal and equitable interests of the debtor.358
The assets of the estate are then used to satisfy the creditor's claims. However, bankruptcy laws
exclude any beneficial interest of the debtor in a trust that is enforceable under applicable bank-



                                                 177
ruptcy law.358 In 1992, the Supreme Court held that the law excludes all participants in ERISA-
qualified plans from the participant's bankruptcy estate.
    Regardless of the court decisions and ERISA laws, there still are problems, such as the prac-
tice of individuals making substantial contributions to plans shortly before filing for bankruptcy
in order to shield assets from creditors. This is considered by many as an abusive practice—if it
is abusive, then laws should be enacted to correct it.

                    Qualified Domestic Relations Orders (QDRO)
    The anti-alienation provision can interfere with state's laws and/or practices to try to provide
support for a participant's spouse or ex-spouse, or dependents after a divorce or other family-
related legal order. ERISA was amended to create a category of qualified domestic relations or-
der (QDRO) and to require plans to pay benefits with them in accordance with the QDRO.
    A "domestic relations order" is a state court decree that addresses child support, alimony and
marital property rights. A QDRO is a domestic relations order that provides for an alternate
payee's right to receive all or part of the benefits payable with respect to a participant, and that
meets certain requirements as to procedure. An alternate payee is a spouse, former spouse, child,
or other dependent of the participant who has some rights to benefits under the domestic rela-
tions order.360
    The procedural requirements for a QDRO are (a) informational as to name, address of the
participant and alternate payees, amount or percentage of benefits to be paid to each, number of
payments or period to which the order applies, and the plans applicable, and (b) the plan may not
provide any form of benefits not otherwise available under the plan, or may not require the pro-
viding of actuarially increased benefits, and may not require the payments of benefits that are
already required to be paid to a different alternate payee under a previous QDRO.
    In addition, there are other requirements, principally of an administrative matter, and expla-
nation of the authority of the QDRO in requiring payments of benefits, when, and to whom. The
QDRO has the authority to declare an alternate payee (usually a former spouse), as an example,
to be treated as the surviving spouse for purposes of the rules.

                                       Other Exceptions
   There are two other exceptions:
       1) Once a benefit is being paid or in the position to start being paid, a participant may
          make a voluntary and revocable assignment of up to 10% of any benefit, provided
          such assignment is not used to defray plan administration costs. A garnishment or
          levy is specifically not considered as a voluntary assignment.
       2) A plan loan to a participant, secured by his accrued vested benefit, is not treated as an
          assignment, provided that the loan is an exception to the prohibited transactions regu-
          lations contained in ERISA.361
   It should be noted that the Supreme Court held that "since there is a congressional policy
choice … to safeguard a stream of income for pensioners and dependents, which may be and
perhaps usually are, blameless" courts should be reluctant to create equitable exceptions to it.362




                                                178
    In the TPA of 1997, Congress provided for a limited exception to the Supreme Court ruling,
by providing that a participant's benefits may be offset by the amount he is required to pay to the
plan under a conviction for a crime involving the plan, a civil judgment involving a violation of
the fiduciary rule, or a settlement with the IRS or PBGC in respect to a violation of a fiduciary
rule—as long as the judgment or agreement expressly provides for such offset.
    Further, if the survivor annuity requirements apply to the distribution, and where the spouse
is not required to pay an amount to the plan for this violation, either the spouse must consent in
writing to the offset or the judgment or agreement must provide for the spouse to retain the sur-
vivor annuity, subject to a statutory calculation of its amount.363

                                     STUDY QUESTIONS

1. The basic rule of taxation of annuity benefits is
   A. benefits are taxed as accumulated.
   B. benefits are never taxed.
   C. benefits are taxed at the death of the annuitant.
   D. benefits are taxed in the year in which they are made.

2. The investment in the annuity contract is excluded from gross income and is
   A. called the exclusion ratio.
   B. taxed at capital gains rates.
   C. taxed at the net worth of the annuity fund each taxable year.
   D. taxed to the annuitant every 5 years.

3. Except for specified minimum distributions, certain hardship distributions, and a distribution
   that is part of a series of basically annual periodic payments over a specified period of time, a
   distribution to an employee of any of the balance to his credit in a qualified plan is
   A. an eligible rollover distribution.
   B. a qualified distribution.
   C. an ad hoc distributions.
   D. an IRA rollover.

4. Even though an eligible rollover distribution is excluded from gross income,
   A. it is immune to any other form of taxation.
   B. it is no longer subject to a withholding tax.
   C. it is still subject to a withholding tax of 20%, said tax cannot be waived.
   D. each year the distribution must be reduced proportionately or be taxed.

5. The accrual of benefits is subject to certain rather stringent tax rules,
   A. which is an extension of the MSA and HSA legislation.
   B. because of the possibility of "backloading" where benefits grow faster in later years.
   C. but only in respect to benefits that are in excess of $1,000 (gross) per week,
   D. however, such rules are usually ignored as the penalty is miniscule.




                                                179
6. ERISA prohibits defined benefit plans from ceasing accruals or reducing the rate of accruals,
   because of the age of the employee, except for highly compensated employees
   A. and for those employees who have less than 5 years before mandatory retirement.
   B. because ERISA attempts to restrict retirement benefits until the older ages.
   C. in order to prevent age discrimination.
   D. in order to prevent sex discrimination as females live longer than males.

7. Every benefit from a pension plan
   A. is an accrued benefit.
   B. is a consolidated benefit.
   C. is a retroactive benefit.
   D. is heavily and unfairly taxed.

8. When a defined benefit plan allows benefits to accrue rather steadily with the result that the
   accrual rate for participants in early years of service usually will be larger under this plan
   than under other similar plans, this is called
   A. a traditional defined benefit plan.
   B. a cash balance plan.
   C. a deferred compensation plan.
   D. an increasing maturity annuity.

9. If the participant dies after his benefit payments have started and he has a designated benefi-
    ciary, but prior to his entire interest has been distributed, the remaining portion must be dis-
    tributed
    A. at any time within 6 months after death.
    B. at least as rapidly as they were distributed to him prior to his death.
    C. to his estate in a lump sum.
    D. but any amount payable to a designated beneficiary may be paid over the life (or life
        expectancy) of that beneficiary starting no later than one year after the death of the
        participant.

10. Every pension plan must provide that benefits under it
    A. may not be assigned or "alienated."
    B. may be payable only for a period not to exceed 20 years or the life expectancy of the
       participant or designated beneficiary.
    C. shall be payable to the probate court in case of death of the participant.
    D. shall not be more than $3,500 per month (indexed) or less than $1,000.

ANSWERS TO STUDY QUESTIONS
1D   2A   3A   4C   5B   6C   7A   8B   9D   10A




                                                   180
             CHAPTER TWELVE - NONDISCRIMINATION

NOTE: This chapter on nondiscrimination is the shortest chapter in this text but it is one of the
most important and needs to be addressed by itself as the IRS seems to look first at a plan that is
being considered for qualification to see if there is any discrimination within the plan. This can
be troublesome for employers who want to reward outstanding employees with tax-free or tax
deferred benefits as they are usually in a higher tax bracket so such benefit would mean more to
them than a raise in their compensation. Before ERISA there was rampant discrimination and
one of the major purposes of ERISA was to eliminate discrimination among employees as much
as possible. Arguably, the government may have created some "overkill" in order to achieve
their anti-discrimination agenda, but regardless of how much difficulty it may cause, in some in-
stances, it seems to have accomplished it's stated purpose.


                                          COVERAGE
    Nondiscrimination is an exceptionally important feature of a qualified plan and while the
concept of not discriminating against some employees in favor of others is quite simple, in actual
practice it can be rather complex and at time, cumbersome.
   Basically, an employer may want to provide a retirement plan for only some employees, or
perhaps provide coverage for only certain groups of employees. However, differentiation in
coverage can raise the flag for regulators of discrimination as federal law has attempted to pre-
vent discrimination against lower-paid employees for a long time.
    OK, the more an employee contributes to a company, the higher they are paid, so some prefe-
rential treatment is inevitable and is necessary. Obviously, an employee who creates more profit
for an organization because of their knowledge should be rewarded more than those who take his
dictation, clean his floors, or drive his car. With retirement plans, the higher-paid employees
have more money to save and benefit more from the favored tax treatment of qualified plans, so
they are more willing to substitute deferred, plan-based benefits for current income. This is, of
course, what drives these plans in most corporations. The nondiscrimination rules do not say
that an employer may not reward key employees by allowing them to participate in such a plan,
but they do say that employers who establish such a plan for higher-paid employees must pro-
vide some comparable benefits to the lower-paid employees also. This spreads the tax benefits
over higher and lower-paid employees.
   In respect to the coverage, there are specific rules concerning discrimination in plan cover-
age. The principal and basic rule is that a plan must satisfy at least one of two minimum stan-
dards, each of which seeks to make sure that highly compensated employees are not covered dis-
proportionately.364




                                                181
                        HIGHLY COMPENSATED EMPLOYEES
    First, it is necessary to define "highly compensated" employees. The minimum coverage
standards established by regulations limit the discrimination in favor of the highly compensated
employees. Basically, a highly compensated employee is that for a given year (called "the de-
termination year") if the employee was a 5-percent owner in that year or the preceding year—
or—in the preceding year he received compensation from the employer in excess of a specific
sum (which is indexed for inflation and was, for instance, $90,000 in 2003), and, further, if the
employer elects, he was in the top-paid group of employees for that year. Obviously, this re-
quires a lot of "definitions" and explanations.365

                                     Five-percent Owners
    Simply put, a 5-percent owner of a corporation in a given year, is a person who, at any time
in the year, owns more than 5% of the outstanding stock, or stock possessing more than 5% of
the combined voting power. For a non-corporate employee, a 5% owner during any given year
owns more than 5% of the capital or profit interest. The law also states that "ownership" for this
purpose, includes constructive ownership.366

                                         Compensation
    "Compensation" includes wages, salary, commissions and other items that are includible in
gross income, but also elective deferrals and elective contributions to Cafeteria Plans and certain
other plans.367

                                       "Top-Paid" Group
    A "top-paid" employee for a year is one who is in the top 20% for that year, as ranked by
compensation. In determining which employees would be included in that count, there are sev-
eral categories of excluded employees including part-time employees, seasonal employees, mi-
nor (under age 21) employees, certain union employees, and nonresident aliens.368
    An employer may elect less stringent exclusions or have no exclusions, so the "top-20%"
may consist of fewer than 20% of all employees. These exclusions are for determining the size
of the top 20%, not its membership—a top-compensated employee may have only worked there
for 3 months.

                                       Former Employees
   A former employee may be considered as a highly compensated former employee if he left
employment before the determinate year and was a highly compensated employee either for the
year of separation or any year after he turned age 55.

                              TESTING FOR COMPLIANCE
    The process and method for testing a group for nondiscrimination is regulated by a plethora
of rules and regulations, the basic ones are as follows:




                                                182
                                           Single Plans
    The basic unit that must satisfy the minimum coverage standard, is the single, or separate
plan. For these purposes, a plan is a single plan only if on an ongoing basis, all of its assets are
available to pay the benefits under the plan to covered employees and beneficiaries. Sounds
simple, but actually a single plan may have several benefit structures, various & sometimes nu-
merous plan documents, several contributing employers, or several trusts or annuity contracts.
    Conversely, there may be multiple plans (even if it is covered under a single document) if
part of the assets are not available to pay some of the benefits. Regulations state succinctly,
"(s)eparate pools are separate plans."369

                                          Disaggregation
    Certain mandatory disaggregation rules must be applied. [Definition of disaggregate is "to
separate into component parts; to break up or to part.‖370 Disaggregation is the process of break-
ing apart, etc.] For instance, the part of a 401(k) plan that has been separated from the entire
plan, is considered as a separate plan from the remainder. A plan that separates those employees
who are collectively bargained (unionized) must be treated as a separate plan, plus a part that
benefits employees covered other such agreements is a separate plan from one that is covered
under other collective bargaining agreements. Also, a plan that benefits employees of more than
one employer must be disaggregated into separate plans for each employer. In actual practice,
this is a conceptual rule—plans do not have to be rewritten or restructured.371

                                           Aggregation
    An employer may decide to aggregate (to combine-but only conceptually) separate plans so
that they can apply the ratio percentage test and the nondiscriminatory test, except where the
plans are subject to the mandatory disaggregation rules. This would allow an employer to estab-
lish different plans for salaried employees and hourly employees without breaking any of the
coverage rules. But, if an employer elects to aggregate plans for the coverage rules, it must also
aggregate them for purposes of the nondiscrimination rules.

                                      COVERAGE TESTS
    The basic tests of coverage uses the highly-compensated employee and the plan subject to
testing, and are quite straightforward. In order to meet the coverage test, a plan must satisfy ei-
ther (a) the ratio percentage test, or (b) both the nondiscriminatory classification test and average
benefit percentage test. Testing takes all employees into consideration, unless the employer
elects to designate separate lines of business.
    Both tests apply only to employees who benefit under the plan—an employee benefits under
a plan in a given year if he receives an allocation to his account or increase in accrued benefits.
This can also apply to former employees, such as for a defined benefit plan amendment provid-
ing for a cost of living adjustment can benefit former employees.372

                                      Ratio Percentage Test
   The ratio percentage test requires the proportion of the non-highly compensated employees
(NCEs) who benefit under the plan divided by the proportion of the highly-compensated em-
ployees (HCEs) to be at least 70%.373 As an example, if a plan benefits 50% of the HCEs, it


                                                 183
must also benefit at least 35% pf the NCEs. A plan will automatically satisfy the test if it bene-
fits at least 70% of the NCEs.

                 Nondiscriminatory Classification & Average Benefit Tests
    The other, alternative, test is comprised of two sub-tests. First, the nondiscriminatory classi-
fication test requires that the classification used by the plan as a basis for including (and exclud-
ing) employees be both reasonable and nondiscriminatory. The other test (average benefit per-
centage test) requires that the average benefit percentage of the plan be at least 70%.
    The nondiscriminatory classification test states that a classification is reasonable if it is es-
tablished under objective business criteria (an enumeration of covered employees by name is not
a reasonable classification). There are two ways for a classification to meet the additional re-
quirement that it be nondiscriminatory. One method uses a "safe harbor" approach which is too
complicated to go into here, but is based on the 70% rule described earlier.
   The other way that a plan can satisfy this test is by meeting two conditions—again a rather
complicated method of determining the "unsafe harbor percentage." If more information is
needed on this subject, these methods are covered under Treasury Regulation 1.410(b)-4.

                               Average Benefit Percentage Test
     Basically, the average benefit percentage test for discrimination is the actual benefit percen-
tage of the NCEs divided by the actual benefit percentage of the HCEs. These regulations go
into the actual benefit percentage of a group by defining it as the unweighted average of the ben-
efit percentage of each employee in the group, whether or not they participate in any plan.
Again, this test is quite complex, and beyond the scope of this text. Further detailed information
is available under Treasury Regulation 1.410(b) and under Internal Revenue Code 410(b).

                                          Compensation
    For purposes of determining the average benefit percentage test and other nondiscrimination
standards, regulations determine that compensation includes elective deferrals and amounts con-
tributed or deferred by the employer at the election of the employee, and otherwise not includa-
ble in gross income because of Internal Revenue Code 4-2, 125, 132 or 457. Obviously, this is a
rather complicated set of rules that are used to define "compensation" for nondiscrimination pur-
poses

                                           Other Rules
    Some of the rules regarding discrimination are rather simple (believe it or not), such as the
rule that a plan maintained by an employer who has no NCEs automatically satisfies the cover-
age standards, and similarly, a plan that does not benefit any HCEs also satisfy the standards.
Yes, these are obvious, but they must be specified by regulation.374
   Also, a plan that benefits only employees covered by a collective bargaining agreement au-
tomatically satisfies the coverage standards.375




                                                 184
                                       Former Employees
    If a plan benefits former employers in any calendar year, the plan is tested separate in respect
to present and former employees. A plan satisfies the regulations if the group of former em-
ployees benefiting under the plan does not discriminate significantly in favor of the HCEs.

                             EMPLOYEES TO BE INCLUDED
    Another obvious way to discriminate in such plans would be to classify employees in differ-
ent classifications, with some employees in one group receiving more or higher benefits than
those in another group. Obviously, the IRS does not like that type of blatant discrimination, so
the term "employee" for these purposes must be defined.

                                Business Aggregation Rules
    The Internal Revenue Code provides that all employees of all corporations that are members
of a controlled group of corporations shall be treated as being employed by a single employer.
That sounds simple, but the definition of "controlled group" is not so simple. Also, the Code
provides that employees of trades or businesses, whether or not incorporated, that are under
common control shall be considered as employed by one employer—and "common control" de-
finitions are rather complex. Plus, all employees of members of an affiliated service group are
treated as working for a single employer—in this case, an affiliated service group consists of a
service organization and certain other related organizations.376

                                      Leased Employees
    A leased employee is treated as an employee of the person for whom his services are pro-
vided, and benefits or contributions provided by the leasing organization are attributed to the
person for whom the services are performed.377 A leased employee is a person who provides
services to a recipient where (1) the services are provided pursuant to an agreement between the
recipient and the a leasing organization; (2) the person has provided the services on a substantial-
ly full-time basis for at least one year; and (3) the services are performed under the primary di-
rection or control of the recipient.378
    There is an exception to this rule in cases where the leasing organization provides a generous
broad-based money purchase plan with immediate participation and full and immediate vest-
ing.379

                               EXCLUDABLE EMPLOYEES
    Certain employees may be excluded or disregarded when applying the coverage tests, for
various reasons.

Collective Bargaining Units
    If a plan covers only non-union employees, members of a collective bargaining agreement
may be ignored when applying the coverage tests if there is evidence that retirement benefits for
them were the subject of good faith bargaining. There are also some exclusions for plans that
cover both union and non-union employees.380 The union employees will be disregarded, even if
no plan was established for them. Before one jumps to conclusions here, the reasoning for this



                                                185
exclusion is that it permits unions to opt for higher compensation or welfare benefits for its
members instead of retirement benefits, without jeopardizing the ability of the employer to estab-
lish plans for other employees. This exclusion is not available for bargaining units in which
more than 2% of the employees are professionals.381

                          Minimum Age and Service Requirements
     If a plan prescribes minimum age and service requirements, and excludes from participation
all employees not meeting the requirements, then the plan may disregard those employees for
purposes of the minimum coverage tests. This, in effect, allows qualified plans to exclude part-
time employees.
    If some or all of the employees that do not meet ERISA's minimum age and service standards
(or "excludable employees") are covered under a plan, the employer may disaggregate the plan
into one for the otherwise excludable employees, and one for all other employees, and then test
each separately, and when testing, employees covered under the other plan are disregarded.382

                                       Former Employees
    When testing for former employees, the employer may exclude those who terminated em-
ployment before a certain date and those who were or would have been excludable employees
during the plan year in which they became former employees.383

                             SEPARATE LINE OF BUSINESS
     The rules pertaining to separate lines of business comes into play if an employer has a diver-
sified business and wants to offer plans to different parts of the enterprise. The Code allows an
employer that has a qualified separate line of business to have the coverage test applied to em-
ployees of each line of business individually and employees of the various lines of business are
treated as excludable employees.384
    For an employer to take this approach without violating nondiscrimination rules, all the em-
ployer's property and services that are provided to customers must be provided through separate
lines of business and every employee must be treated as an employee of exactly one line of busi-
ness. If the employer elects to test one of its plans under this approach, it must test them all to
satisfy the percentage test.
    Basically, each of the sub-groups are tested individually, but the whole plan must still benefit
employees on the basis of a nondiscriminatory classification as a result of the nondiscriminatory
classification test or the ratio percentage test.
    The regulations get pretty complex thereafter and require the employer to identify each line
of business (LOB) and to prove that they are organized separately from each other (believe it or
not, these are called "SLOBS" - separate lines of business). And then, there are rules for qualify-
ing the SLOBS, with the end result that they are called "QSLOBS." Sometimes acronyms can be
fun… In any respect, these regulations are too detailed and cumbersome to be discussed further
in this text.




                                                186
                             MINIMUM PARTICIPATION TEST
    For defined benefit plans, using the plan aggregation to satisfy the minimum coverage test
requires each qualified defined benefit plan to benefit, on each day of the year, at least the lesser
of (a) 50 employees, or (b) the greatest of 40% of the workforce or two employees. This is de-
signed to prevent discrimination through fragmentation of the workforce into separate and small
plans—it also helps the IRS to monitor compliance with discrimination rules as it applies to em-
ployers with one or a number of plans.385
    The plans that are tested are the separate plans subject to special disaggregation rules, and the
employees that will be taken into account exclude employees covered under collective bargain-
ing agreements and employees who have not met minimum age or length of service require-
ments.

                                       Other Exemptions
   There are a number of exemptions too detailed for present discussion, but they are covered
under IRC Section 401(a)(26) and Treasury Regulation 1.401(a)(26)

                CONTRIBUTIONS/BENEFITS NONDISCRIMINATION
   In addition to minimum coverage tests for discrimination, there are a barrage of tests that
makes sure that a plan does not discriminate in contributions or benefits.
    These regulations are too complex and numerous to discuss in detail here, but basically, un-
der the regulations, every qualified plan must satisfy three conditions:
       1) Contributions or benefits must not be discriminatory in amount;
       2) Benefits, rights and features under the plan must be made available in a nondiscrimi-
          natory manner; and
       3) The effect of plan amendments and plan termination must not be discriminatory.
    For defined contribution plans, there are three basic tests, two safe harbor tests and a general
test and are used for single, nonintegrated plans.
    "Safe harbor" plans are based on plan design, to make sure that the plan does not discriminate
in the amount of contributions if it allocates contributions and forfeitures on the same percentage
of compensation, the same dollar amount, or the same dollar amount per uniform unit of service.
    The second "safe harbor" plan makes sure that in those plans where a contribution is based
on units of annual of compensation, age &/or service, are uniform among all participants.
    The third test is another complex test as it requires any group that cannot satisfy the safe har-
bor rules to satisfy the minimum coverage requirements for each rate group. This test applies to
highly compensated employees and to other employees with equal or greater allocation than
those of the highly compensated employees. In this test a ratio percentage of the plan or the av-
erage of the safe and unsafe harbor percentages of the plan are used.




                                                 187
                                          SUMMARY
    With all of the nondiscriminatory tests in the regulations, it would seem that all bases are
covered, but there are still other tests. As an example, for defined benefit plans, there are five
safe harbor tests and two general tests. Then, in addition, "cross-testing" may be used as for a
plan to be qualified, either contributions or benefits must be nondiscriminatory but not necessari-
ly both. The cross-testing, which can be used for either defined benefit or defined contribution
plans, makes sure that they are equal by using equivalent accrual rates (which, as you can im-
agine, is defined in detail) and minimum allocation gateways (ditto).
     Further, since Social Security benefits favors lower-paid employees with its structure, an em-
ployer might want to skew benefits or contributions under a plan in favor of the more highly-
compensated employees in order to have a more uniform relationship between compensation and
the total of the plan + Social Security benefits (or it could be the total of the plan + the FICA
contributions). Of course, the IRS has a barrage of tests to make sure that discrimination does
not occur, particularly in the defined contribution excess plans and defined benefit excess plans,
with the "excess" referring to benefits above Social Security levels. These regulations are de-
tailed and are contained in the many pages of the Treasury Regulations 1.401(a) and IRC Section
401(a).
    In addition to the nondiscrimination rules as outlined above, there are also limitations on con-
tributions and benefits in respect to the absolute (total) amount that a plan can benefit any em-
ployee.386 The dollar amount that can be contributed is set forth in formulae with a base annual
addition in defined contribution plans of $40,000 or 100% of the participant's compensation,
whichever is the lesser. For defined benefit plans, the annual benefit cannot exceed the lesser of
$160,000 (2003 amount, indexed) or 100% of the participant's average compensation for the
higher consecutive three years.

                                     STUDY QUESTIONS

1. Since some employees create more profit to a company than others, in view of the nondiscri-
   mination laws certain rewards for outstanding performance may still be provided, such as
   A. the employer contributing more towards a pension plan more each year of service.
   B. setting up a "sub-plan" for those employees whose compensation is more than $100,000
       a year.
   C. determining the most profitable employees and increasing their compensation proportion-
       ately to what they have contributed to the profits of the company.
   D. administrative assistants of highly paid employees have more medical expense coverage
       as they tend to have children at home and they spend more time away from their children.

2. The principal rule in respect to nondiscrimination is that highly compensated employees
   A. do not make more money than their counterparts in similar industries in the same area.
   B. must be equally male and female.
   C. are not covered disproportionately.
   D. is that stockownership of the company is not controlled by a family trust.



                                                188
3. A "top-paid" employee for a year is
   A. an employee who is in the top 20% for that year, as ranked by compensation.
   B. an employee who makes more than the President of the corporation.
   C. an employee who has independent income from a family trust and with the combined
       income, his compensation is the highest in the corporation.
   D. the President, Executive Vice President and all Senior Vice Presidents of any corporation.

4. When an employer sets up a benefit plan for all employees except those who are covered un-
   der collective bargaining plans as they receive slightly different plans under their union
   agreement, this is called
   A. disintermediation.
   B. disaggregation.
   C. discontinuity.
   D. discombobulation.

5. In order for a plan to meet the nondiscrimination coverage test, the plan must satisfy one of
    two requirements, one of which requires the proportion of the non-highly compensated em-
    ployees to who benefit under the plan divided by the proportion of the highly compensated
    employees to be at least 70%. This is called
    A. the nondiscriminatory primary test.
    B. the average benefit test.
    C. the ratio percentage test.
    D. the equivalency test.

6. A classification of employees is considered as "reasonable" if
   A. it is established under guidelines provided by the state Department of Insurance.
   B. if more females than males are covered.
   C. they are classified as to visual presentation even though the majority do not interface with
       the public or customers.
   D. it is established under objective business criteria.

7. For nondiscrimination purposes, all employees of all corporations of a controlled group of
   corporations
   A. are considered as individual and separate groups.
   B. are consolidated and then segregated by sex, age, income, race or any other "natural"
       separation.
   C. shall be treated as being employed by a single employer.
   D. are considered as a multiple group, which eliminates any highly-compensated employee
       requirements.




                                               189
8. For nondiscrimination purposes, benefits or contributions for a leased employee provided by
   the leasing organization are
   A. attributed to the leasing company.
   B. attributed to the person for whom the services are performed.
   C. consolidated with all other leased employees of the leasing organization, and then
       segregated by age, sex and/or compensation.
   D. automatically in violation of nondiscrimination laws, so leased employees must
       provide their own individual health and retirement plans.

9. The Acme Corporation purchases three other corporations, each of whom are in a different
   lines of business. To avoid any charges of discrimination on employee benefits,
   A. Acme may segregate their employee benefits by line of business (which they must be
       able to prove).
   B. Acme must combine all of the employee benefit groups into one master group covering
       all of their employees in order to avoid discrimination charges.
   C. Acme may first consolidate all of the employees, and then set up a separate plan for
       each compensation layer, such as one group for those making less than $50,000 per year
       another for those making between $50,000 and $100,000, etc.
   D. The IRS will allow Acme to discriminate by education level if one or more of the lines of
       business requires higher education - such as computer programmers, medical personnel,
       etc.

10. For defined benefit plans, using the plan aggregation to satisfy the minimum coverage test
    requires each qualified defined benefit plan to benefit, on each day of the year
    A. 90% of ALL employees.
    B. 25% of all covered employees.
    C. the lesser of (a) 50 employees, or (b) the greatest of 40% of the workforce or two
       employees; whichever is lesser.
    D. the majority of those who are the 20% lowest compensated.

ANSWERS TO STUDY QUESTIONS
1C 2C   3A   4B   5C   6D   7C   8B   9A   10C




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CHAPTER THIRTEEN - TAXATI0N, 401(k) & OTHER PLANS

    Better known as 401(k) plans, "Cash Or Deferred Arrangements" (CODAs) have become
very popular as retirement vehicles, by themselves or as a supplement to other plans. The beauty
of CODAs is that the employee can elect to receive payment from the employer, either as cash
(normally current compensation) or as a pre-tax contribution to a defined contribution plan. For
the employer, an advantage is the relative ease of administration, and for the employee, an ad-
vantage is the flexibility in allocating income between current compensation and retirement sav-
ings.
     At first blush, this seems so simple that there should be only a minimum amount of regula-
tion and IRS rules. This would be so, except for the problem of discrimination—highly compen-
sated employees are more likely than those not-so-highly compensated employees to elect to re-
ceive a plan contribution instead of current income. Therefore IRC § 401(k) (which is, obvious-
ly, the Code section primarily governing CODAs) is mostly concerned about discrimination, and
nondiscrimination standards will be pointed out in the following discussion of CODAs.

                                    QUALIFIED CODAs
    Definition: A CODA is an arrangement in which an eligible employee may elect to have the
employer make payment either as contributions to the plan (elective contributions) or in cash to
the employee. If the plan is a qualified plan, the CODA will not cause it to be disqualified, pro-
vided the CODA is a qualified cash or deferred arrangement.387
   To be qualified CODA, the plan must satisfy three main requirements:
       1.   The CODA must not allow distribution of amounts attributed to elective contribu-
            tions earlier than age 59 ½ except in case of termination of employment, death or
            disability, some plan terminations, or, in special situations, employee hardship, and
            the distribution of elective contributions just because of the completion of a stated
            period of participation or the lapse of time.388
       2.   The employee's interest in amounts attributed to elective contributions must vest
            immediately.
       3.   The plan may require no more than one year of service as a condition of participa-
            tion.

                                 Contributions to CODAs
    Every CODA must provide for elective contributions, such as permitting an eligible em-
ployee to defer up to 5% of salary or wages per year. The elective contribution may not only be
salary, but it may be a bonus also. There are qualification standards that limit the aggregate
amount that an employee may defer to a specified maximum dollar amount ($12,000 in 2003).
This amount is less than the total limit on contributions to defined contribution plans.
   Other types of contributions are provided by 401(k) such as after-tax contributions. Also, it
may provide for an employer to make matching or partially-matching contributions. A plan, for


                                               191
instance, could provide for elective deferrals of up to 10% of compensation and contributions by
the employer that match (dollar-for-dollar) the first 3% (as an example) of such deferrals. Quali-
fied matching contributions are those matching contributions that meet the investing and distri-
buting requirements applicable to elective contributions for qualified CODAs.
   There are also nonelective contributions for which there is no employee option to have the
contributions paid in cash instead of into a plan. Qualified nonelective contributions other than
matching contributions, satisfy the vesting and distribution requirements that apply to elective
contributions in order to become a qualified CODA.389

                                        Other Benefits
    While a CODA can provide benefits to participants other than those benefits attributed to
elective or nonelective contributions, a qualified CODA can not, either directly or indirectly,
condition any benefit other than matching contributions, on the employee's electing to have the
employer make or not make contributions in lieu of his receiving cash.
   Other benefits may include benefits under a defined benefit plan, nonelective contributions
under a defined contribution plan, life insurance, plan loans and subsidized retirement benefits.

                      STANDARDS FOR NONDISCRIMINATION
    For a CODA to become qualified, the employees eligible to benefit under the arrangement
must satisfy the coverage standards of 401(k), such eligible employee is one who is directly or
indirectly eligible to make an election for all or part of the plan year. As an example, an em-
ployee who must perform additional service to be eligible to make the election is not an eligible
employee unless the service is actually performed.390

                               Actual Deferral Percentage Test
   Before a CODA can be qualified, the "actual deferral percentage" (ADP) must satisfy one of
two tests.
    One test is where the ADP for eligible heavily compensated employees does not exceed
125% of the ADP of all other eligible employees. The other test is where the ADP for eligible
highly compensated employees, and the former percentage does not exceed the latter by more
than two percentage points. There are further definitions as to how to calculate the formulae and
defining the procedures for the tests.
    This can best be understood by using an example. If the actual deferral percentage for eligi-
ble highly compensated employees is 12% and the actual deferral percentage for all other em-
ployees is 9%—then the plan fails both tests. Failure of the second test is because while 12 is
less than twice 9, the difference between the figures is more than the two percentage. The plan
can satisfy that test by decreasing the actual deferral percentage of the heavily compensated em-
ployees by decreasing the ADP of the HCEs to, as an example, 11%.In respect to the first test,
the plan can satisfy that test by increasing the actual deferral percentage of the other employees
to 10%.
    To calculate the actual deferred percentage of a group of employees, first, for each employee,
the ratio of the amount of employer contributions paid to the plan for the year to the employee's
contribution for the year, and the ADP for the group is the average of these ratios for each group


                                               192
member. There are many other considerations, rules and formulae in order to arrive at the ADP
of a group of employees. One of the most important rules is that basically all CODAs included
in a plan are treated as a single CODA for the purpose of these tests—if an employee participates
in two or more CODAs of the employer, for the purpose of determining the deferral ratio of the
employer, all such CODAs are considered as one CODA.391
    One of the easiest rules in this respect, is the Safe Harbor rule that is used for plans that pre-
fer not to use ADP testing. Simply put, a CODA is treated as satisfying the Code requirements if
it meets two conditions: (a) eligible employees must be given written notice of their rights and
obligations under the arrangement, and then (b) the employer must make matching contributions
on behalf of each NCE in an amount equal to either 100% of the elective contributions of the
employee, up to 3% of compensation, plus (b) 50% of the elective contributions that exceed 3%
of compensation, but do not exceed 5% of compensation.

                                     Excess Contributions
     The employer does not have total control of a CODA as far as meeting the ADP test because
it all depends on the employee's decision regarding how much income to defer. Therefore, they
have the option to count qualified matching and qualified nonelective contributions as elective
contributions so as to provide a way for the employer to compensate for a disproportionate level
of deferral by highly compensated employees, but this would create a cost to the employer. The
alternative method for the employer to bring a plan into compliance with the ADP test for a year
is simply to return some or all of the amounts contributed to the plan to the employees.
    As one would expect, there are rules as to how the contributions can be returned to make the
plan qualified. There are similar rules that apply if there are excess aggregate contributions (ag-
gregate matching and employee contributions exceeding the amounts permissible under the test.

                                   Catch-Up Contributions
    CODA rules allow participants who reach age 50 or more in the taxable year to make catch-
up contributions. A catch-up contribution is an additional elective deferral in an amount no
greater than at statutorily specified amount ($2,000 in 2003) and the amount of this additional
deferral is not allowed to be more than the excess of participant compensation over other elective
deferrals.392
    Catch-up contributions are not subject to ADP testing and are not subject to the 401(k) stan-
dards for nondiscrimination in amount of contributions as long as the election is available to all
participants who attain age 50 during the taxable year.393 Further, they are not subject to CODA
contribution limits.

                                   SIMPLE 401(K) PLANS
    Another way for a CODA to meet the requirement of Section 401(k) is for it to be created as
a SIMPLE 401(k) plan.

                                        Eligible Employers
   A SIMPLE 401(k) plan must meet three statutory requirements:




                                                 193
    First requirement pertains to contributions. Under this plan, an employee may elect to defer
a percentage of compensation up to a statutory amount adjusted for inflation ($8,000 in 2003),
the employer must match these contributions up to 3% of salary, and, further, there may not be
any other contributions.394 As an alternative to the 3% match requirement, the employer may
make a nonelective contribution of 2% of compensation for each eligible employee who earns at
least $5,000.395
    The second requirement is that the SIMPLE 401(k) plan be the exclusive one for eligible
employees, therefore there cannot be any benefit accruals or contributions under any other quali-
fied plan of that employer for that year.
   The third requirement is that contributions to the plan be vested immediately.
    A SIMPLE 401(k) plan is not subject to the top-heavy rules for the year. Catch-up contribu-
tions are permitted, but in amounts less than for regular CODAs or other plans.396
                       DEDUCTIONS FOR CONTRIBUTIONS
    Employer contributions to a plan are deductible if they are ordinary, necessary and reasona-
ble business expenses, but there are limits to the amount of deduction allowed.397

                   STOCK BONUS AND PROFIT SHARING PLANS
    Employer contributions to stock bonus or profit sharing plans are deductible in the year in
which they are paid (as opposed to accrued), up to 25% of the total compensation paid or accrued
to participants in the plans for the year.398
    For tax deductible purposes, all stock bonus and profit sharing plans of the employer are
treated as one. For SIMPLE plans, there is a separate limit. Excess amounts may be deducted in
future years, as long as the total amount that is deducted in any one year for contributions (past
and present) to the plans, are not more than 25% or other taxable limitations.
    Compensation for these purposes include all of the compensation paid or accrued except that
for which a deduction is allowable under a qualified plan.399 Compensation does include elective
deferrals which are not subject to the limitation on deductions.400 Regulations allow for an up-
per limit which is indexed ($200,000 for 2003) to the amount of a participant's compensation that
can be taken into account in the computing of contribution limits.

               DEFINED BENEFIT AND MONEY PURCHASE PLANS
     As a general rule, the amount that can be deducted for contributions to a defined benefit plan,
which includes an annuity plan, is the amount necessary to satisfy the greater of minimum fund-
ing standard or either of two alternative amounts. Both of the alternative plans use the amount
necessary to amortize unfunded past service, and there are qualifications to the rule that are de-
tailed and complex and beyond the scope of this text. Money purchase plans, incidentally, are
subject to the IRC Code regarding pension plans—but of recent vintage, money purchase plans
are subject to the same limitations as stock bonus and profit sharing plans.401

                                COMBINATION OF PLANS
    Some employers maintain both defined contributions and defined benefit plans, and some
participate in more than one plan, so in these cases, there are additional limits—the maximum of


                                                194
the total compensation paid or accrued to the participants of the plans, or the amount of contribu-
tions to the defined benefit plans up to the amount that is needed to satisfy the minimum funding
standard for each, with a provision for carryover of nondeductible excess contributions.402

                                          PENALTIES
   There is a ten percent (10%) tax on the amount of nondeductible contributions for a year.
The tax will continue to be imposed each year to the extent a contribution has not yet been de-
ducted under a carryover provision.
    If the contribution was made by a mistake, or if it was conditioned on the plan's initial quali-
fication, or on the contribution's deductibility, then the tax can be avoided by returning the
excess contribution within one year as long as the ERISA rules [(403(c)(2)] and the plan docu-
ment allow its return in such cases.
                             TERMINATION OF THE PLAN
     Terminating an employee benefit plan is more than turning off the lights and locking the door
(so to speak) as the concern for the welfare and continuation of benefits for the employee that
initiated ERISA still remains to some degree. One outstanding example is where the fund may
not have sufficient assets to pay all promised benefits. Or, a situation could arise where the an-
nuity provider may not have the financial wherewithal to meet future obligations
    There are many scenarios of businesses not being able to honor their commitments in provid-
ing employee benefits, with the principal situations discussed below.

                                        REGULATIONS

                                   Internal Revenue Code
    There are several Code provisions dealing with terminations and its impact on plan qualifica-
tion. As discussed earlier, the Code requires any accrued benefits to vest upon termination or
partial termination, plus the code requires that in some cases, a plan must be a permanent and not
a temporary arrangement. "The abandonment of the plan for any reason other than the business
necessity within a few years after it taken effect, will be evidence that the plan from its inception
was not a bona fide program for the exclusive benefit of employees in general."403 Accordingly,
a plan can be retroactively disqualified. This can cause considerable expense to the employer so
the usual practice when a plan is to be terminated, is for the employer or administrator to ask for
a determination letter from the IRS confirming that the termination has not affected its qualified
status.

                                         ERISA Title I
    Title I, as has been noted earlier, deals with fiduciary relationships, so it does not address
plan termination in any great detail, however, the statute does provide that fiduciary standards
govern the transfer of assets from a terminated plan to a replacement plan, and court cases have
made it abundantly clear that misrepresentations concerning termination may constitute a breach
of fiduciary duty.404




                                                195
                                        ERISA Title IV
    ERISA Title IV deals with termination, but basically with problems relating to the termina-
tion of underfunded defined benefit plans. Title IV establishes a program to guarantee benefits
that are due from such plans, it prescribes the conditions under which a plan can be terminated, it
provides for involuntary terminations in cases of severe financial problems, regulates the em-
ployer withdrawals from multiemployer plans, and it specifies the Pension Benefit Guaranty
Corporation (PBGC) as the regulatory authority for plan terminations.

                            PBGC AND BENEFIT GUARANTY
    The PBGC was established by ERISA as an enforcement arm, with principal objectives: (a)
to encourage continuation and maintenance of pension plans, (b) provide for the uninterrupted
payments to beneficiaries, and (c) to maintain premiums at the lowest possible level. One of the
primary objectives is the regulating and enforcement of termination regulations.
    Title IV covers only pension plans and those that have operated as qualified plans for at least
five years, and basically, it governs only single employer defined benefit or multiemployer plans.
It does not cover defined contribution plans, the part of a defined benefit plan at pertains to vo-
luntary employee contributions, "top-hat" plans, excess benefit plans, or plans for professional
service providers that have no more than 25 participants.
    Title IV is called "plan termination insurance," even though is not a social insurance or a
transfer payments programs, it is that of spreading the risk. The PBGC guarantees the payment
of nonforfeitable pension benefit plans in terminated, underfunded single employer plans, and
insolvent multiemployer plans up to a specified limits. This is handled by PBGC by actually
paying guaranteed benefits for single-employer plans, and loans money for multiemployer plans
so that the plan can pay them. These funds come from a tax on annuity contributing employers,
and if necessary, from the US government (read tax-payers). The PBGC does have a right to
reimbursement when it makes guaranteed payments.
    Funds come from revolving funds for single employer plans and for multiemployer plans.
For each single-employer plan, the employer who is or has been responsible for funding the
plan—known as the "sponsor," —ERISA or the administrator must pay an annual premium to
PBGC and which is deposited in the single-employer plan fund. Each member of the contribut-
ing sponsor's group is jointly and severally liable for the premiums. Congress sets the rates, and
currently the rate for single-employer plans is $19 per participant, increasing by $9 per $1,000 of
unfunded vested benefits. The rate for multiemployer plans is $3.60 per participant.

                      Single-Employer Plan Guaranteed Benefits
    Not all single-employer benefits are guaranteed by the PBGC. For starters, only pension
benefits are guaranteed, defined as benefits that are payable in annuity form to a participant or
surviving beneficiary upon the employee permanently leaving employment, and that, either by
itself or when combined with Social Security, Railroad Retirement, or workers' compensation,
provides a substantially level income to the person.405
     Secondly, only nonforfeitable benefits are guaranteed, unless they are nonforfeitable only be-
cause of termination. A nonforfeitable benefit for this purposes, is defined as a benefit for which
all conditions to entitlement under ERISA has been performed by the termination date except for


                                                196
filing of a formal application, retirement, completion of a waiting period, or, in some cases,
death.406
     And the last requirement is that the participant or beneficiary must be entitled to a benefit for
it to be guaranteed. If, for instance, the benefit payment requires consent of the employer, the
absence of such consent before termination defeats entitlement.407
   There are three qualifications to this guarantee:
       1) There is an upper limit which is the actuarial value of an individual's guaranteed ben-
          efits under a plan cannot exceed the actuarial value of a single life annuity, starting at
          age 65, subject to stated times and amounts (Actuarial calculations).408
       2) The guarantee is effective only for plans or a minimum of 60 months duration at time
          of termination, and only for increases resulting from amendments made to the plan or
          effective at least 60 months before the termination, subject to a lesser guarantee if the
          beneficiary does not meet the requirements.
       3) The guarantee is limited to a greater degree for substantial owners (sole proprietor,
          10% partner or 10% stockholder) to an extent as determined by formula.409

                        Multiemployer Plan Guaranteed Benefits
    For multiemployer plans, the PBGC guarantee is triggered by the insolvency of the plan (as
opposed to termination for single-employer plans), and as with single-employer plans, nonfor-
feitable pension benefits are those guaranteed.
     The actual amount of the guarantee is limited to benefits or benefit increases of 60 month du-
ration and the amount of benefit guaranteed is derived from formula using components of the
accrual rate (defined as the monthly amount of normal retirement benefit, expressed as a single
life annuity, divided by years of credited service).

                                       PBGC FINANCES
    There has been considerable publicity in recent years in respect to the concern that there may
not be enough money in the PBGC to pay for retirement benefits for the thousands of employed
persons who are nearing retirement (ala "Baby Boomers") and the financial instability of very
large US corporations causing downsizing and other such problems. But the PBGC having a
deficit is not new, as in 1996, the single employer fund was $2.9 billion which continued to in-
crease until it reached of $9.7 billion in 2000. It should be noted that the multiemployer fund
had consistently been in a surplus situation since 1982.
    The reasons for the deficit to drop and for subsequent years of having a surplus was because
of amendments to ERISA that increased termination insurance premiums, and which was partly
related to the level of plan underfunding. The result was a more of an insurance organization
through the medium of risk-spreading. Other factors were the increase in the rates at which past-
service costs are amortized, the decline in number of terminations, the small number of very
large claims, and a strong economic period.
   In 2001, the PBGC started showing annual deficits as a recession loomed and some large
companies declared bankruptcy, and at the end of 2002, the single employer fund was under-
funded by $3.6 million, with continuing deficit funding in 2003, along with the bankruptcies of


                                                 197
large steel companies and because of 9/11, large airlines found themselves in precarious situa-
tions.
    From the beginning of PBGC through 2002, PBGC had total (gross) claims of $11 billion,
with 10 companies accounting for $5.7 billion of this amount, five which were steel companies
and 3 were airlines. Interesting note: Nearly half of the claims against the single-employer fund
since 1975 have been from plans that were less than 50% funded.

                                     PBGC REPORTING
    In order for the PBGC to do its job, it needs to monitor significant changes in financial condi-
tions. There are a wide variety of events that need to be reported to the PBGC and they are bro-
ken into 15 principal categories of reportable events. These requirements are so detailed it is
outside the scope of this text, but administrators of qualified plans need to be aware of these re-
quirements and to fully comply with them all. Other than the obvious notification to the Secre-
tary of the Treasury that the plan is no longer qualified, or determination by the Secretary of La-
bor that the plan is not in compliance with its requirements (Title I), such "red-flag waving" ac-
tions as amending a plan by decreasing some or all benefits, a substantial decrease in active par-
ticipants, a failure to meet minimum funding standards for the year, a large benefit paid to a sub-
stantial owner who is still alive, etc., provides the significant changes (event) looked for by the
PBGC. In some cases, the plan sponsor must notify the PBGC within 30 days of such an event,
or within 30 days after it has learned of such an event. The PBGC may access a penalty of
$1,000 a day for non-compliance with these and other reporting and notice rules.

                     SINGLE-EMPLOYER PLAN TERMINATIONS
    For single-employer plan terminations, a plan may be terminated either with or without assets
sufficient for the plan to meet all benefits. The types of terminations have been segregated into
three categories and all rules must be complied with strictly, or the plan could be deemed to con-
tinue ongoing.

(1) Standard Termination
    A termination is considered as "standard" when assets are sufficient to meet benefit liabili-
ties—the benefits of employees and their beneficiaries under the plan, which such benefits are
fixed or contingent.410
    The termination is initiated when the administrator gives written notice of the intent to termi-
nate to every participant, beneficiary of a deceased participant, alternate payee and employee or-
ganizations, such notice given at least 60 but not more than 90 days prior to the proposed termi-
nation date. Other such rules require the administrator to send written notice to each participant
or beneficiary specifying and explaining the amount of his benefit. During this period of notifi-
cation, the plan continues to operate as normal, under some restrictions which are designed to
protect the financial ability of the plan to pay benefit liabilities.
    If the administrator has not received a notice of non-compliance within the prescribed period,
he can start the distribution of plan assets as far as they are sufficient to pay plan assets.
    Assets are allocated to priority categories according to ERISA rules, which, in essence, first
distributes the accrued benefit derived from the employee's contributions as they are not guaran-



                                                198
teed by the PBGC. Then the assets are distributed that are derived from each individual's manda-
tory contributions—which may or may not meet the criteria for guaranteed benefits.
     Benefits payable as an annuity that were in pay status or what would have been in pay status
if the participant had retired and elected to commence payments, are distributed next, followed
by other guaranteed benefits and benefits that are not guaranteed because of the substantial own-
er limitation. In addition, there are several other priority categories to be satisfied in distributing
plan assets. Of particular interest to insurance personnel, ERISA requires that in order to distri-
bute plan assets to participants and beneficiaries, the administrator must purchase annuities from
an insurer or otherwise follow the terms of the plan and applicable regulations.411

2. Distress Terminations
    A single-employer plan that is not eligible for a standard termination because of insufficient
assets, may terminate under a "distress termination" in certain situations. Both distress termina-
tion and standard termination are not available if the termination would violate the terms of a
collective bargaining agreement, in which case termination would have to be as the result of an
action by the PBGC.
     The procedures for distress termination are outlined under ERISA regulations, such regula-
tions are numerous and specific as to the distribution of assets. Basically, there are notices re-
quired, investigative actions following to determine which, if any assets, are available, restric-
tions placed on the administrator to avoid distributing assets, and limitations on the distributions
if it is discovered that assets are or will be insufficient to pay guaranteed benefits.412

3. Underfunding Liability
   The basic rule of termination is that if the assets of the plans are sufficient to pay guaranteed
benefits, the contributing sponsor and members of the controlled group remain liable to the
PBGC for the amount of unfunded benefit liabilities as of the termination date, plus interest.413
    Personal liability can occur if the person entered into a transaction, such as selling the busi-
ness for the employees of which the plan was established, for the purpose of avoiding liability
for underfunding. The rules for the payment of liability to the PBGC are specific, with certain
limitations, but in any event, the PBGC can bring civil action in federal district court to enforce
any lien arising from underfunded plan asset liability.
    The PBGC will pay to participants and beneficiaries in a terminated plan, a percentage of the
outstanding amount of benefit liabilities. The average paid is called the "recovery ratio" which is
the average of the percentage of unfunded benefit liabilities recovered by the PBGC.
                               INVOLUNTARY TERMINATIONS
   The PBGC may institute proceedings to terminate a plan if the plan has not met the minimum
funding standards, or the PBGC may be required to initiate termination proceedings if the plan
does not have assets available to pay benefits currently due. While the PBGC cannot initiate
proceedings in a collective bargaining agreement, such restriction does not apply to collective
bargaining agreements in respect to involuntary terminations.
  Initially, the PBGC may have a trustee appointed for the terminating plan, and normally, the
PBGC becomes the trust. If there is no agreement as to trustee, the matter may be settled by a



                                                 199
federal district court. The trustee is then responsible for the administrative and asset manage-
ment for the plan.414
    The termination proceedings start with the PBGC petitioning a federal district court for a de-
cree that the plan should be terminated "to protect the interest of the participants or to avoid any
unreasonable deterioration of the financial condition of the plan or any unreasonable increase in
the liability of the (benefit guaranty) fund."415
    Notice is given to interested parties (administrator, participants, employers who may be sub-
ject to liability, and employees) as soon as practical. However, if the administrator consents to
the termination, notice to the interested parties is not required, and a hearing is not required.416
     Once the decree has been entered, the court then has exclusive jurisdictions of the plan and
its property, and the trustee assumes the power to marshal assets and distribute them to partici-
pants. The trustee has the same duties as would a bankruptcy trustee under Federal law.417
    A contributing sponsor and the members of its controlled group have liabilities to both the
trustee and to the PBGC in case of involuntary termination. The liabilities to the PBGFC for un-
funded liabilities are stated in the regulations and the liabilities to the trustee are for the outstand-
ing balance of the accumulated fund deficiency, the outstanding balance of any funding deficien-
cies that have been waived, plus the outstanding balance or decreases in the accumulated funding
deficiency that resulted from extension of amortization periods, such liability due as of the date
of termination and payable in cash or securities.418

                                   RESTORATION OF PLAN
    The PBGC has the power to destroy, it also has the power to restore. It has the legal authori-
ty to halt a termination process based upon its own determination that relevant situations may
exist, whereupon it may take what action is necessary to restore the plan to its prior status. It
may restore even if the plan had been terminated if the PBGC determines that such action is "ap-
propriate and consistent with its duties (under Title IV)."419
    In some situations, the sponsor has established a "follow-on" plan—a new benefit arrange-
ment of benefits substantially the same as those under the terminated plan—which is combined
with the guaranteed benefits under a terminated plan. The PBGC takes the position that these
follow-on plans are abusive because in the past attempts have been made to use the plan termina-
tion insurance program to subsidize an ongoing retirement program.
    When the PBGC issues a restoration order (as its power to restore has been upheld by the US
Supreme Court) it also issues a payment schedule for the plan sponsor that provides for amorti-
zation of applicable and material of charges and credits for a period of time up to 30 years. Ad-
ditionally, any amount previously paid by the PBGC for guaranteed benefits and related ex-
penses become a debt of the restored plan and must be repaid on terms established by the
PBGC.


                                           REVERSIONS
    A reversion may occur only if funds remain in the plan after payment of all benefit liabilities.
Surplus funds may occur if investment experience or economic factors are more favorable that
those that had been assumed when the plan's funding levels were established. Another cause of


                                                  200
surplus funds is because of the termination procedure, where funding levels necessarily were
based on the assumption of an ongoing plan and were related to projected benefits and future sal-
ary levels, whereas benefit liabilities at termination are based on currently accrued benefits and
current salary levels—which may not be the same. In some ways, this is like finding a $20 bill
in your sofa cushion. In this case, however, employers, employees and the IRS all stake claims
to the "found" money.
    In essence, the employer can claim that plan assets constitute employer money used for a
dedicated purpose, plus, the availability of a reversion is an incentive to plan formation, and as
frequently offered, employers maintain that plan funds represent payments for services rendered,
and that participants have benefit expectations beyond what is determined at termination.
   The IRS maintains that since plan funds represent the tax-free accumulation of money for
which the employer has already obtained a deduction, the tax benefit with respect to any surplus
should be restored.
    Obviously, this is a point worth debate, and there actually is no clear solution to the problem
of residual assets. While Treasury regulations limits the amount of the reversion to amounts re-
sulting from "erroneous actuarial computations," it is limited in application. Interestingly, most
of the law developed so far seems to prefer the position of the employer's interest in surplus as-
sets. There are other regulations as a result of court decisions and the IRS has enacted legislation
to discourage reversions and to recover tax benefits by imposing a 20% tax on the amount of re-
version, with provisions to where the tax could increase to as much as 50% (if the employer fails
to establish a qualified replacement plan or else increase benefits to a prescribed degree).
    The end result is that as of this date, there really is nothing of substance to clarify these situa-
tions, so until some action is taken by the legislature or the IRS, restorations may continue to end
up in the courts.

                                  PURCHASING ANNUITIES
    At the time of termination, assets are usually distributed through the purchase of annuities, as
mentioned earlier. But what happens if an annuity provider—and insurance company—becomes
insolvent (happened several years ago when the large annuity provider, Baldwin United, went
into receivership, followed by Executive Life of California)? There are no ERISA provisions in
this respect as the problems are left to the state insurance regulators.
    This actually makes sense in several ways, including the fact that insurance is regulated by
the states, but more importantly the PBGC would be subject to considerable exposure if it were
to insure against the failure of insurance companies. The PBGC has issued regulations that re-
quire plan administrators of single-employer plans, when notice is given of standard termination,
to include a statement that the PBGC's responsibility ends upon the distribution of the plan's as-
sets and an identification of the insurer from whom annuities will be purchased (if such is the
case).
    The PBGC does not pick the insurer, but leaves the selection of an annuity provider to the
plan administrator under the Title I fiduciary standards.
    The Department of Labor has taken a similar stand—that it is a fiduciary matter. However,
there is concern that an employer-fiduciary may take out the cheapest annuity available, instead
of the safest one, in order to maximize the amount of the reversion. There were suits in this re-


                                                  201
spect, mostly because of the defaults of Executive Life Insurance Company. Thereupon, in
1994, Congress amended ERISA's enforcement provisions to allow the Secretary of Labor, fidu-
ciaries, and former employees and beneficiaries to bring suit for appropriate relieve where buy-
ing annuities or other such insurance contracts, violate fiduciary standards or the terms of the
plan.420

                                EMPLOYER WITHDRAWAL
   The main worry of Title IV in respect to multiemployer plans, is the employer withdrawing
from the plan. Title IV's principal purpose is to make sure that if the plan is withdrawn, an em-
ployer contributes its designated share of the amount of plan underfunding. These rules are very
complex and it would be counterproductive to go into details in this text.
    Suffice it to say that a participating employer completely and totally withdraws from a mul-
tiemployer plan when it permanently stops having an obligation to contribute or permanently
stops all covered operations under the plan. They can partially withdraw if there is a 70% con-
tribution decline or a partial stop of the contribution obligation. There are special standards for
withdrawal with certain industries.
    The basic rule is that if an employer withdraws from a plan, it is liable to the plan for its al-
locable amount of unfunded vested benefits.421 There are complicated formulae for determining
the "allocable amount of unfunded vesting of benefits," the adjusting of the factors if the with-
drawal is partial, etc.
    The PBGC is authorized by statute to establish a fund to be used for reimbursing plans for
uncollectible withdrawal liability payments, but for some reason, it has never exercised this au-
thority.422


                                      STUDY QUESTIONS

1. Where the employee can elect to receive payment from the employer, either as cash (usually
   current compensation) or as a pre-tax contribution to a defined contribution plan, this is a
   A. "cash or deferred arrangement" plan.
   B. simple IRA.
   C. Roth deferred compensation plan.
   D. qualified distribution program.

2. Every 401(k) plan must provide
   A. for compulsory contributions.
   B. for elective contributions.
   C. for Cafeteria Plan inclusion.
   D. for distribution of amounts attributed to contributions prior to age 50.




                                                 202
3. One of the CODA tests for a plan to be qualified is where the ADP for eligible heavily com-
   pensated employees does not exceed 125% of the ADP of all other eligible employees.
   "ADP" is
   A. the annual deferred compensation.
   B. actual deferral percentage.
   C. administratively determined participation.
   D. a dental plan.

4. When the problem of excess contributions arises with a 401(k) plan as the employer does not
   have total control of the plan as to how much income he must defer, one simple way to cor-
   rect the problem is
   A. return some or all of the amounts contributed to the plan to the employees.
   B. abide by a formula that uses percentages correlated with those used by similar businesses
       in the general geographical area.
   C. to set up an escrow plan with the IRS where excess funds go towards future contributions.
   D. dissolve the CODA plan and start a new plan.

5. Employer contributions to a plan are tax deductible if
   A. they are not discriminatory.
   B. they are ordinary, necessary and reasonable.
   C. they contribute a percentage of profit that is less than 125% of the total profits for that
      tax year, as reported to the stockholders.
   D. not more than 85% of the contributions go to no more than 3 employees.

6. Contributions made to a CODA that are nondeductible for a tax year
   A. are not allowed a carryover, therefore one year's excess payments, for instance,
      are allowed.
   B. are subject to a 10% tax each year to the extent that a contribution has not yet been
      deducted under a carryover provision.
   C. are usually ignored by the IRS, but if it is made in a second consecutive year, it will
      be doubly taxed.
   D. must automatically be returned to the employer every six months, and once such
      excess contributions have been made, the employer must file a report to the IRS
      on a semi-annual basis.

7. The IRS requires that any accrued benefits of a CODA plan at time of termination
   A. such benefits must be sent to the IRS for distribution.
   B. be absorbed by the plan and distributed among other employee benefits of similar nature.
   C. be submitted to the Department of Labor as a forfeit.
   D. must vest, and in some cases, the plan must be permanent and not temporary.




                                                203
8. Since a CODA plan can be retroactively disqualified if it terminates and the IRS feels that it
   was not a bona fide program, causing considerable expense to the employer, if an employer
   terminates such plan the usual practice is to
   A. enter into temporary bankruptcy and let the courts sort it out.
   B. obtain a performance bond to cover any possible obligations that may arise because of
       the termination.
   C. retroactively increase the compensation of all participants by the amount that they had
       attributed to their account in their 401(k).
   D. ask for a determination letter from the IRS confirming that the termination has not
       affected its qualified status.

9. One of the primary objectives of the Pension Benefit Guaranty Corporation (PBGC) is
   A. the regulating and enforcement of termination regulations.
   B. the taxation of businesses so that the PBGC can be perpetuated.
   C. to create a bureaucracy so that large businesses cannot intimidate it.
   D. to provide funds so that airlines and other transportation giants will not suffer
      financially in case of war or disaster.

10. The PBGC is very interested in employer's withdrawing from the fund, particularly where
    there are multiemployer plans. The basic rule is that an employer withdraws from a plan,
    A. the entire company will be taken over by the PBGC (or the SEC if its stock is publicly
        traded.
    B. it is liable to the plan for its allocable amount of unfunded vested benefits.
    C. it has no liability as membership in the PBGC is voluntary.
    D. the PBGC can make the employer continue to contribute to the plan from the assets
        that it has recorded with the IRS for tax purposes.


ANSWERS TO STUDY QUESTIONS
1A   2B   3B   4A   5B   6B   7D   8D   9A   10B




                                                   204
                                       REFERENCES

The Handbook of Estate Planning
      Robert Esperti & Renno Peterson
      McGraw Hill Book Co., NY

Principles of Insurance Production
       Peter Kasicky, et al
       Insurance Institute of America, 1986

Black’s Law Dictionary
       West Publishing Company

Annuities Answer Book
       John Adney, Joseph McKeever III, Barbara Seymon-Hirsch
       Aspen Publishing, 2005

Annuities Answer Book, 2004 Cumulative Supplement
       John T. Adney, Joseph McKeever III, Barbara Seymon-Hirsch
       Aspen Publishers, 2004

Annuities
       Continuing Education Insurance School
       Private Printing 1998

Dictionary of Insurance Terms
       Harvey W. Rubin, Ph.D., CLU, CPCU
       Barron’s Educational Series, 1995

Financial and Estate Planning with Life Insurance Products
       James C. Munch, Jr.
       Little Brown & Co. 1990

2006 Tax Facts on Insurance and Employee Benefits
      National Underwriter Company

Employee Benefit Plans in a Nutshell
      Jay Conison
      Thomson West, 2003

Legal Aspects of Life Insurance
       Edward Graves and Dan McGill
       American College 1997



                                              205
Life Insurance
        Kenneth Black & Harold Skipper
        Prentice Hall 1993

McGill’s Life Insurance, Fifth Edition
       Edward E. Graves, Editor
       The American College, 2004

Getting Started in Annuities
       Gordon K. Williamson
       John Wiley & Sons 1999

Ernst & Young, Tax Saver’s Guide, 2004
       Tax Partners and Professionals of Ernst & Young LLP
       John Wiley & Sons, Inc. 2004

The Ernst & Young Tax Guide 2006
       Tax Partners and Professionals of Ernst & Young LLP
       John Wiley & Sons, Inc. 2004

Financial Planning Process Course
       Pictorial Publications
       Pictorial 1997

The Health Insurance Portability and Accountability Act (HIPAA), Overview & Analysis
      Novinka Publishers, 2004
      H.R. Chaikind, J. Hearne, B. Lyke, S. Redhead, J. Stone, C. Franco & G.M.Stevens

The Health Insurance Portability and Accountability Act of 1996, (PL 104-101)(42 USC §1320d)
      Internal Revenue Service

The Health Insurance Primer
      America’s Health Insurance Plans
      John Boni, Elizabeth Denning, Marilyn Finley, Terry Lowe & Bernard Peskowitz

Disability Income Insurance
       Dearborn Financial Services
       Allan B. Checkoway and Harry J, Lew

Personal Finance Planning Guide
      John Wiley and Sons, Publishers
      Ernst and Young

Principles of Insurance Production
       Insurance Institute of America
       Kensicki, Smith, Marshall, Waranch, Close



                                             206
The New Life Insurance Investment Advisor
      Irwin, McGraw Hill
      Ben G. Baldwin

How to Insure Against Your Income
      Merritt Editors
      Silver Lake

Balancing Security and Opportunity; The Challenge of Disability Income Policy
       Jerry Mashaw
       Virginia Reno

Disability Income, the Sale, the Product, the Market
       National Underwriter Co.
       Jeff Sadler

Disability Income and Health Insurance, 2d Ed.
       National Underwriter Co.
       Price Gaines

Occupational Classifications, Health and Life Insurance
      Colonial Life and Health Insurance Co.

Flex One Program
       American Family Life Assurance Company of Columbus (AFLAC)




                                              207
                           NUMBERED REFERENCES

1. Employee Benefit Plans, Jay Conison, published by Thomson/West.
2. ERISA §§ 408,502(d
3. ERISA § 3(1) & 3(2)
4. ERISA § 3(35)
5. ERISA § 3(34)
6. Treas.Reg. § 1.401-1(b)(1)(iii)
7. IRC § 4975(e)(7)
8. IRC § 401(k)
9. Treas Reg. § 1.401-1(b)(1)(i)
10 . ERISA § 3(37)(A)
11. ERISA § 4(a)(1)
12. ERISA § 4(b)(4)
13. ERISA § 3(36)
14. IRC § 401
15. IRC § 401(d)
16. IRC § 408(k)
17. IRC §§ 401(k)(11), 408(p)
18. ERISA § 3(7)
19. Firestone Tire & Rubber Co. v. Bruch (S.Ct. 1989)
20. ERISA § 3(8)
21. ERISA § 3(16)(B)
22. ERISA § 3(16)(A)
23. USC § 623(a)
24. ERISA § 203(a)
25. ERISA 203(b)(3)(D)
26. ERISA § 203(a)(3)(D)
27. ERISA § 203(c)(1)
28. Halliburton Co. v. Commissioner (Tax Ct.1993)
29. IRC § 416(i)(1)
30. Treas Reg § 1.416-1, at V-7
31. Alday v. Container Corp. or America, (11th Cir. 1990) and others.
32. 11 ISC § 1114(g)
33. IRC Sec. 106(a)
34. IRC Sec 106
35. Let Rul 9406002
36. Express Oil Change, Inc. v. U.S.,78 AFTR2d 96-5476 (N.D.Ala.1996)
37. IRC Sec 105(b)
38. Ibid.
39. Rev Rul 63-181, 1963-2 CB 74
40. Beisler v. Comm., 814 F.2d 1304 (9th Cir. 1987) and others
41. Laverty v. Comm.. 61 TC 160 (1973)
42. IRC Sec 105(b)
43. Treas Reg 1.101-1(a)
44. Rev Rul 82-196


                                           208
45. Andress v. U.S., 198 F.Supp.371(N.D.Ohio, 1961)
46. Est. of Kaufman, 35TC 663(1961) aff'd 300 R.2d 128(6th Cir.1962) and others.
47. IRC Sec. 105(h)(6)
48. Treas Reg 1.105-11(b)
49. IRC Sec. 105(h)(3)(A)
50. IRC Sec 105(h)(3)(B)
51. Treas Reg 1.105-11(c)(2)
52. Treas Reg 1.105-11(c)(1)
53. IRC Sec 105(h)(5)
54. Treas Reg 1.105-11(i)
55. IRC Sec 3401(a)(20)
56. Let Rul 9850011
57. Larkin v. Comm., 48TC629 (1967, aff'd 394 F.2d 494 (1st Cir. 1968) and others
58. Bogene, Inc. v. Comm., TC Memo 1968-147 and others.
59. IRC Sec 162(1)
60. IRC Secs 162(1)(2)(C); 213(d)(1)
61. IRC Sec 162(1)
62. Rev Rul 71-588, 1971-2 CB 91
63. IRS Settlement Guidelines, 2001 TNT 222-25 (Nov. 16, 2001)
64. IRC Sec 1372
65. Rev Rul 565-400, 1956-2 CB 112
66. IRC § 4980B(b)(2)
67. Treas Reg § 54.4980B-2, A-1
68. Coble v. Bonita House, Inc., 789 F. Supp 320 (ND Cal 1992)
69. Treas Reg §§ 54.4980B-a, A-2, 54.4980B-5, A-3
70. Treas Reg § 54.4980B-5, A-4
71. IRC Sec 4980B(g)(1)(A)
72. Treas Reg §54.4980B-3, A-1
73. Treas Reg § 54.4980B-8, A-2(a)
74. IRC Sec 4980B(f)(2)(C)
75. Treas Reg § 54.4980B-8, A-5(b)
76. IRC Sec 4980B(d)
77. Treas Reg § 54.4980B-2, A-5
78. Treas Reg § 4980B-2, A-5
79. IRC Sec 9801(c) (2)(B)
80. Temp Treas Reg 54,9801-5T
81. IRC Sec 4980B(f)(2)(B)(i)(IV)
82. IRC Sec 4980B(f)(2)(B)(ii)(II)
83. IRC 4980B(f)(2)(B)(i)
84. IRC Sec 4980B(f)(2)(B((i)(III)
85. IRC Sec 9801(b)(1)(A)
86. IRC Sec 9801(a)
87. IRC Sec 9801(d)(3)
88. IRC Sec 4980B(f)(3)(B); ERISA Sec 603(2)
89. Kariotis v. Navistrar Int'l Transp. Corp., 131 F.3d 672 (7th Cir. 1997)
90. Paris v. Korbel & Bros, 751 F. Supp.834(ND Cal.1990)



                                             209
91. Mlsna v. United Com.,Com, 91 F.3d 876(7th Cir 1996)
92. Cabral v. The Olsten Corp, 843 F.Supp.701 (MD Fla. 1994)
93. Burke v. American Stores Employee Benefit Plan, 818 F.Supp 1131 (ND Ill. 1993)
94. Avina v. Texas Pig Stands, 1991 US Dist LEXIS 13957 (WD Tex. 1991)
95. Bryant v. Food Lion, Inc. 100 F. Supp.2d 346 (DSC 2000)
96. Moffitt v. Blue Cross & Blue Shield Miss., 722 F. Supp. 1391 (ND Miss. 1989)
97. Adkins v. United Int'l Investigative Servs, 1992 Dist LEXIS 4719 (ND Cal. 1992)
98. Nakisa v. Continental Airlines, 26 EBC 1568 (SD Texas 2001)
99. Collins v. Aggreko, 884 F.Supp. 450 (D. Utah 1995)
100. IRC Sec 7702B(b)(2)(C)
101. IRC Sec. 125(f)
102. IRC Sec 106(c)(1)
103. IRC Sec 4980B(g)(2)
104. IRC 213
105. IRC Sec 106(a) & House Comm. Report on Sec. 321 of HIPAA '96, P.L. 104-191
106. IRC Sec 7702B(a)(1-2)
107. IRC Sec 7702B(d)(2-5)
108. IRC Sec 101(i)
109. IRC Section 101(a)
110. Estate of Wright v. Comm., 336 F.2d 121 (2d cir.1964) and others
111. IRC 404(a)
112. IRC Section 101(i)
113. Rubber Assoc. Inc. v. Comm. 335 F.2d 75(6th Cir. 1964) and others
114. Lengsfield v. Comm., 241 F.2d 508(5th Cir. 1957) and others.
115. Treas Reg §1.79-1(a)
116. IRC Sec 7701(a)(20); Treas Reg §1.79-0
117. Treas Reg §1.79-0
118. IRC Section 79
119. Let Rul 9227019, 9149033
120. Let Rul 8342008
121. Treas Reg §1.61-2(d)(2)(ii)(A); Let Rul 8636018
123. Treas Reg §1.79-1(c)(5)
124. Treas Reg 1.79-1(c)(4)
125. Ibid
126. IRC Sec 162(a)
127. IRC Secs 419(a), 419(b),and other sections; Tem Treas Reg 1.419-1T, A-1; 1.419-   1T, A-4
128. IRC Sec. 79
129. Treas Reg 1.79.3
130. Treas Reg §1.79-1(e)
131. Rev Rul 730174, 1973-1 CB 43.
132. IRC Sec 79(b)(3)
133. IRC Sec 79(d)
134. IRC Sec 79(d)(3)(B)
135. IRC Sec 79(d)(7)
136. Treas Reg §1.79-0
137. IRC Sec 6041 & 6041(A)



                                             210
138. Treas Reg 1.61-22(b)(1)
139. Treas Reg 1.782-15(a)(2)
140. IRS Treas Reg 1.161-22(d)(2)-(3)
141. Treas Reg 1.161-22(g)
142. IRC Sec 7872
143. IRC Sec. 79 and 83(e)(5)
144. TRA '84, IRC Sec 404(a)(5)
145. IRC Sec 101(a)
146. IRC Sec 101 &101(a)
147. Helvering v. LeGierse, 312 US 531 (1941)
148. Cowles v. US, 59 F.Supp 633 (S.D.NY 1945) and others.
149. Davis v. US, 27 AFTR2d71-844(S.D.W.Va.1971)
150. TAM 9117005
151. Treas Reg § 1.162-10(a) & various Revenue rulings
152. Treas Reg § 1.105-1(d)
153. Rev Rul 2004-55, 2004-26 IRB 1081
154. Rev Rul 73-3476, 1973-2 CB 25
155. IRC Sec 125 (d)(2)
156. Rev.Rul.2002-27, 2002-2 CB 925
157. Treas.Regs §§.125-1, A-3, 1.125-1, A-3
158. Reg. § 1.125, A-4
159. IRC Sec 7701(a)(20)
160. Sec 125(g)(4)
161. Reg. § 1.125-2, A-4(b)
162. IRS Sec 125(f)
163. Reg §1.125-2, A-4(a)(2)(i)
164. IRC Sec 106
165. IRS Sec 79
166. IRC Sec 213(d)(1)
167. AFLAC Training Manual
168. IRC Sec 129(d)(1)
169. IRC Sec 129(d)
170. IRC Sec 129(d)(9)
171. IRC Sec 162
172. IRC Sec 129(e)(9)
173. Notice 2002-24, 2002-16 IRB 785, Notice 90-24,1990-1 CB 335
174. Notice 2005-42, 2005-53 IRB 1204
175. Sec 1254(d)(2)(D)
176. IRC Section 106, Technical Advice Memorandum 199936046
176A. 2006 Tax Facts on Insurance and Employee Benefits( National Underwriter Organization
       p.83
177. IRC Section 79, 125(d)(2)(C)
178. Sec § 1.125-2, A-2
179. Sec § 1.125-1, A-15
180. Sec. 125(b)(1)
181. Sec 125(e)



                                           211
182. IRC Sec. 125(g)(3)
183. (H.Rep.No.95-1445)
184. Sec 125(g)(2)
185. Sec 125(g)(1)
186. Sec 125(b)(2)
187. Treas Reg § 1.125-a, A-6
188. IRC Section 9801(f)
189. Reg § 1.125-4(b)
190. Reg § 1.125-4(d)
191. Reg § 1-125-4(e)
192. Reg § 1.125-4(g)
193. Reg § 1.125-4(c)
194. Reg § 1.125-4(C)(3)
195. Ibid.
196. Reg § 1.125-4(f)(2)(i)
197. Reg § 1.125-4(f)(2)(ii)
198. Reg § 1.125-4(f)(2)(ii)
199. Reg § 1.125-4(f)(3)(ii)
200. Reg § 1.125(4)(3)(i)
201. Reg § 1.125-4(f)(3)(iii)
202. Reg § 1.125-4(f)(4)
203. Reg § 1.125-4(j)
204. cost.204. Reg § 1.125-3, A-1
205. Reg § 1.125-3, A-1.
206. Reg §1.125-3, A-6(b)(1) and A-6(b)(2)(i)
207. Reg § 1.125-3, A-7
208. IRC Sec 3121(a)(5)
209. Reg §1.125-2, A-7(a)
210. Reg § 1.125-2,A-7(b)(2)
211. Reg § 1.125-2,A-7(b)(4)
212. Sec. 129(a)(2)(A)
213. Reg § 1.1256-2, A-7
214. IRC Sec 162(a)(1)
215. Treas Reg §1.162-7(b)(3)
216. IRC Sec 499
217. IRC Sec 280G(B)(2)
218. IRC Sec 280(G)(b)(2)(c)
210. IRC Sec 280(G)(b)(5)
230. IRC SECS 402(b)(1), 403(c) and 83(a)
231. Let Rul 9713006
232. IRC Sec 404(a)(5)
233. IRC 404(d)
234. IRC Sec 72(u)
235. IRC Sec 402(b)(1)
236. Variety of Letter Rulings, such as 9206009, 9302017, 9212019, etc.
237. Ltr. Ruls. 9322011, 9316018.



                                             212
238. Treas Reg §1.404(a)-12(b)(1)
239. Ltr Rul 9502030 and others
240. Treas Reg §1.402(b)-1(c)(1)
241. IRC Sec. 409(1)(4)
242. IRC Sec 409(a)(4)(c)(iii)
243. The Acceleration of Payments Section pertains to proposed Treasury Regulation
       §1.409A-1
244. IRC Sec 409A(a)(1)(A)
245. IRC Sec 409A(a)(1)(B)
246. Rev Rul 60-31, 1960-1 CB 174, and subsequent modifications, plus several court rulings.
247. Martin v. Comm., 96 TC 814 (1991)
248. Rev.Proc. 92-65, Sec 3.01(c), 1992-2 CB 428
249. Treas Reg §§1.457-2(h)(4) & 1.457-2(h)(5)
250. Let Rul 9337016
251. Rev Proc 2003-3, Sec 3.01(34), 2003-1 URB 113, 116
252. Let Rul 9436051
253. ERISA Sec 201(2)
254. Carrabba v. Randalls Food Mkts, Inc., 252 F.3d 721 (5th Cir. 2001), cert denied , 26
       EBC 2920 (US Sup Court 2001)
255. Let Rul 2001116406
256. Sproull v. Comm., 16 TC 244 (1951)
257. Rev Rul 60-31, 1960-1 Cb 174, 177
258. Casale v. Copmm., 247 F.2d 440(2d Cir.)
259. Goldsmith v. US, 586 F.2d 810, 78-1 USTC(9804 Ct.Cl. 1978)
260. Minor v, US 772 F2d 1472, 85-2USTAC 9717 (9th Cir 1985)
261. Rev Rul 72-25, 1972-1 CB 127 & 193
262. IRC Sec 409A(b)
263. Dependabl v. Falstaff Brewing Corp 491 F.Supp 1188 (E.D. Mo 1980)
264. Let Rul 9344038
265. IRC Sec 409A(b)(4)
266. Rev Proc 2003-3, Secs 3.01935), 4.01(33), 2003-1 IRB 113; Rev Proc 92-64, Secs 3 & 4,
1992-2 CB 422,423.
267. IRC Sec 404(a)(5) & IRC Sec 404(d)
268. Let Rul 199923045
269. IRC Section Sec 163
270. IRC Sec. 3401(a)
271. Treas Regs 31.3121(v)(2)-1(c)) and 31.3306(r)(2)-1(a)
272. Treas Regs 31-3121(v)(2)-1(c)(2), 31.3306(r)(2)-1(a)
273. Treas Regs 31.3121(v)(2)-1(d)(2); 31.3306(r)(2)-1(a)
274. IRC Sec 3121(a)(1)
275. ERISA § 407(d)(5)
276. IRC § 409(l)(1)
277. ERISA § 4078(d)(5)
278. ERISA §407(d)(4)
279. ERISA § 407(d)3)
280. IRC § 404(a)(9)



                                             213
281. Treas Reg 54.4975-7(b)(3)&(4)
282. Treas Reg 54.4975-7(b)(5)&(6)
283. Treas Reg 54.4975-7(b)(8)
284. Treas Reg 54.4975-11(a)(2)
285. Treas Reg 54.4975-11(a)(ii)
286. Treas Reg 54.4975-11(d)(2)
287. IRC § 4975(e)(7)
288. IRC § 409(e)(2)
289. IRC § 409(e)(5)
290. IRC § 409(h)(2)
291. IRC §409(h)(1)(B)
292. IRC § 409(o)(1)(B)
293. IRC § 401(a)(28)(B)
294. IRC § 401(a)(28)(c)
295. Black's Law Dictionary, Seventh Edition.
296. IRC 404(k)
297. Security Exchange Act Release No. 15230
298. ERISA § 407(a)(2)
299. IRC Sec 422
299A. IRC Sec 422(a)
300. IRC Sec 424(c)(1), 424(c)(4)
301. IRC Sec 422(a)(1)
302. IRC Sec 1001(a)
303. IRC Sec 421(b)
304. IRC Sec.83(b)(1)
305. Ibid.
306. IRC Sec 6039(a)
307. IRC Sec 83(a)
308. IRC Sec 83(b)
309. IRC Section 83(a)
310. IRC Sec 419. Let Rul 8737022
311. IRC Sec. 129(d)(5)
312. IRC Sec 129(d)
313. IRC Sec 129(d)(8)(b)
314. IRC Sec 223(d)(1)
315. Ibid.
316. IRC Sec 106(b)(5)
317. IRC Sec 223(c)(1)(A)
318. Notice 2004-23, 2004-15 IRB 725
319. Notice 2005-50, 2004-33 IRB 196, A-17
320. Treas Reg. § 1.72-4(b)(1)
321. IRC § 72(b)(1)
322. IRC § 72(b)(3)
323. IRC § 402(c)
324. IRC § 402(c)(3)(A)
325. IRC § 402(a)(31)(B)



                                            214
326. ERISA § 202(a)(1)(A)
327. ERISA § 202(a)(1)(B)(ii)
328 . ERISA § 202(a)(4)
329. ERISA § 3(23)(A)
330. ERISA § 204(b)(1)(A)
331. ERISA § 204(b)(1)(B)(i)
332. ERISA § 204(b)(1)(C)
333. ERISA §204(b)(1)(F)
334. ERISA § 204(b)(1)(H)
335. ERISA § 204(b)(2)
336. IRC § 416(c)(1)
337. IRC § 416(c)(2)
338. ERISA § 3(23)
339. ERISA § 204(g) & Treas Reg 1.411(d)-4
340. Hickey v. Chicago Truck Drivers, Helpers & Warehouse Workers Union (7th Cir.   1992)
341. ERISA § 204(g)(2)(A)
342. ERISA §204(g)
343. ERISA § 204(h)(9)
344. ERISA § 510 Gavalik v. Continental Can Co. (35d Cir 1987)
345. Nemeth v. Clark Equipment Co. (WD Mich 1987)
346. Inter-Modal Rail Employees Ass'c v. Atchison, Topeka & Santa Fe Railway Co.
        (S.Ct.1997)
347. Deeming v. The American Standard, Inc. (7th Cir 1990)
348. Treas Reg 1.401-1(b)(1)(i)
349. Rev. Rul. 74-307
350. Rev.Rul.6-83
351. Treas Reg 1.401(a)(9)-2
352. ERISA § 203(e)(1)
353. ERISA § 401(a)(9)(C)
354. IRC §401(a)(9)(B)(ii)
355. Black's Law Dictionary
356. IRC §401(a)(13)
357. University of Tennessee William F. Bowld Hospital v. Wal-Mart Stores, Inc.
        (W.D.Tenn.1996)
358. 11 USC § 541(a)
359. USC § 541(c)(2)
360. ERISA § 206(d)(3)(k)
361. ERISA § 206(d)(2)
362. Guidry v. Sheet Metal Workers National Pension Fund (S.Ct.1990)
363. ERISA § 206(d)(5)
364. IRC § 410(b)(1)
365. IRC § 414(q)(1)
366. IRC § 414(q)(2)
367. IRC § 414(q)(4)
368. IRC § 414(q)(5)
369. Treas Reg 1.410(b)-7(b)



                                           215
370. Webster Collegiate Dictionary
371. Treas Reg 1.410(b)-7(c)
372. Treas Reg 1.410(b)-3(b)(1)
373. IRC § 410(b)(1)(B)
374. Treas Reg 1.1410(b)-2(b)
375. Treas Reg 1.1410(b)-2(b)(7)
376. IRC § 414(m)(2)& (5)
377. IRC § 414(n)(1)
378. IRC§ 414(n)(2)
379. IRC § 414 (n)(5)
380. IRC § 410(b)(3)(A)
381. Treas Reg 1.410(b)-6(d)(2)(ii)(B)
382. IRC § 410(b)(4)(B)
383. Treas Reg 1.410(b)-6(h)
384. IRC § 401(b)(5)
385. IRC § 401(a)(26)
386. IRC § 415 and 401(a)(16)
387. IRC § 401(k)(1)
388. IRC § 401(k)(2)(B)(i)
389. IRC § 401(m)(4)(C)
390. Treas Reg 1.401(k)-1(g)(4)
391. IRC § 401(k)(3)(A)
392. IRC § 414(v)(1) &(2)(A)
393. IRC § 414(v)(3)(A)
394. IRC § 401(k)(11)(B)(i)
395. IRC § 401(k)(11)(B)(ii)
396. IRC § 414(v)(2)(B)(ii)
397. IRC §404(a)
398. IRC §404(a)(3)(A)(i)(I)
399. Treas Reg 1.414(a)-9(b)
400. IRC § 404(n)
401. IRC § 404(a)(3)(A)
402. IRC § 404(a)(7)(B)
403. Treas Reg 1.401-1(b)(2)
404. ERISA § 404(d)(1)
405. ERISA §4022(a)
406. ERISA § 4001(a)(8)
407. Hackett v. PBGC (D.Md.1980)
408. ERISA § 4022(b)(3)
409. ERISA § 4022(b)(5)(B)
410. ERISA § 4001(a)(16)
411. ERISA §4041(B)(3)(A)
412. ERISA § 4041(c)(3)(D)
413. ERISA § 4069(a)
414. ERISA § 4042(d)(1)(A)
415. ERISA § 4042(c)



                                         216
416. Jones & Loughlin Hourly Pension Plan v. LTV Corp. (2d Cir.1987)
417. ERISA § 4042(d)(1)(B)
418. ERISA § 4062(c) (and as stated in Employee Benefit Plans in a Nutshell, Jay Conison, p
       475)
419. ERISA § 4047
420. ERISA § 502(a)(9)
421. ERISA § 4211
422. ERISA §4222




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