COBRA Subsidy, Hardship Withdrawals Administrator Discretion, Nonqualified Plan Death Benefits

Focus On Employee Benefits

Audit Alert for Executive Compensation, Fringe Benefits, Employment Taxes, and the New COBRA Subsidy

Thomas Cryan and Michael Lloyd

On March 11, 2009, President Obama signed the federal budget for Fiscal Year 2009 increasing the IRS operating budget to $11.5 billion. This represents an increase of $630 million over the 2008 budget. IRS Commissioner Doug Shulman has announced that the IRS will be undertaking the largest hiring initiative in decades in an effort to enhance taxpayer compliance.

As a result of this hiring initiative, we are expecting a significant increase in IRS audit activity commencing calendar year 2010. Based on discussions we have had both with members of the IRS and with members of the Administration, we expect that one of the primary focuses of this increase in audit activity will be “recession proof” taxes, i.e., taxes that can be collected even when a company is in a net operating loss position. As examples, this would include (1) the new Tier 1 cross-border payment withholding tax issue, (2) compensation-related withholdings issues (accountable plans, nonqualified deferred compensation plans, nontaxable fringe benefits, company cafeterias, worker classification, etc.), and (3) excise taxes imposed based on weight or the amount paid for an item. Further, Congress and the IRS are concerned about the existence of fraud related to the new COBRA subsidy, and it is anticipated that the IRS will conduct audits of those claiming a credit for the subsidy to ensure compliance.

Taxpayers with potential exposure to these types of “recession-proof” taxes may want to take steps to mitigate their exposure. In this connection, it is important to remember that the IRS will consider a taxpayer’s prior efforts to correct plan issues or withholding procedures in assessing whether penalties are appropriate for back years. Therefore, we strongly recommend that companies take steps now to comply with IRS requirements prior to the IRS discovering the issue on audit. We have been working with a number of clients to conduct internal audits of both their plans and withholding procedures in an effort to discover and correct any plan or procedure deficiencies. Please let us know if we can be of assistance.


Health & Welfare: New Agency Guidance on the COBRA Subsidy

Susan Relland and Gary Quintiere

On Tuesday, March 24, 2009, staff from the Departments of Labor and Treasury held a two hour webcast to provide information regarding the COBRA subsidy, which was included in the American Recovery and Reinvestment Act of 2009 (“ARRA”). The webcast is available for viewing on the DOL COBRA webpage. While much of the information had already been communicated publicly in other venues they did provide a few new interesting pieces of information. They also confirmed that the Treasury Department’s Notice (including 30-40 questions and answers) is expected to be published next week. Note that informal guidance is not binding, however, staff comments often provide valuable insight as to the agency’s current thinking about particular issues. The following summary highlights a few key topics that were discussed during the call and some other new agency information.

Involuntary Termination

The staff provided the following examples that all qualify as involuntary terminations:

  • An individual is laid off.
  • An individual who was hired on a seasonal or temporary basis is let go.
  • The employer reduces an individual’s hours down to zero and such reduction results in loss of health coverage. (For example, if the employer tells an employee not to report to work for the next six weeks and, as a result, the individual is no longer eligible to participate in the company’s health plan, the individual will be considered to have been involuntary terminated.)
  • An individual agrees to an early retirement or volunteers to accept a severance agreement in connection with a reduction in force.
  • An individual quits in response to an employer closing a plant and telling employees they may remain employed if they are willing to move to another state.
  • An individual quits in response to an involuntary reduction in hours from full-time to part-time.

In summary, any “material negative change in employment” triggered by employer action will qualify as an involuntary termination. The Treasury Notice expected next week is likely to provide additional detail regarding that standard. Note that the DOL had previously been saying that, if in doubt, the conservative answer is to deny the subsidy. The Treasury Department is now reportedly saying that, if in doubt, the conservative answer is to provide the subsidy. Employer groups are asking the departments to publish a “good faith standard” such that, if an agency later audits and makes a different determination regarding involuntary termination than the one the employer had made, the employer will be held harmless if the employer acted in good faith.

Non-Qualified Beneficiaries

The staff also provided new information with regard to the treatment of an individual who is not a qualified beneficiary, such as a domestic partner who does not qualify as a tax dependent. In this regard, the staff noted that although an employer may allow such domestic partner to make an independent election for COBRA-like coverage, even though the employer is not required to do so under COBRA, the domestic partner would not be eligible for the subsidy.

In some cases the domestic partner is covered under a family election that is made by the employee. In that case, the question becomes whether the subsidy is available for the full cost of family coverage. Treasury staff pointed to Notice 2005-50 to help determine whether the subsidy is available for the full cost of coverage or whether it needs to be bifurcated. Generally, if the employee has to pay more to cover the non-qualified beneficiary, the premium must be bifurcated and the subsidy would be available only on the portion of the premium that the employee would have paid without covering the domestic partner. However, if the employee does not pay more to cover the domestic partner, the subsidy is available on the full premium. For example, if the plan provides only single or family coverage levels and the employee covers both children and a domestic partner, the employee does not pay more for the domestic partner’s coverage than the employee would pay for covering him or herself and the children. Therefore, the subsidy is available on the full premium for family coverage.

Automatic Premium Reduction

A new question and answer on the IRS website for the COBRA subsidy asks whether an employer can automatically reduce the premiums to 35 percent for individuals who were involuntarily terminated from employment since September 1, 2008, and who are currently enrolled in COBRA. The answer is no, because an individual might not be eligible for the subsidy. For example, the individual might be eligible for coverage under another group health plan and therefore is not eligible for the subsidy. This is important because it implies that individuals are required to confirm their eligibility for the subsidy before the employer or insurance company may reduce their premiums. The DOL’s model COBRA notices include a form for individuals to verify whether they are eligible for the subsidy.

Eligibility for Other Group Health Plan Coverage

The general rule is that an individual becomes ineligible for the subsidy when the individual becomes eligible for other group health plan coverage. Agency staff clarified that the individual will lose subsidy eligibility only if the individual can actually enroll in and receive coverage under the other plan. For example, if the individual is only eligible for another group health plan that includes a three-month waiting period, the individual will remain eligible for the subsidy during the waiting period. Similarly, if an individual was eligible to enroll in a spouse’s plan when terminated from employment last fall (and chose not to) , but was not eligible to enroll as of March 1 when the subsidy would be available, if the individual made a special enrollment election, then the individual would be eligible for the subsidy.

Gross Misconduct

Many employers have been asking questions about the gross misconduct standard. Under the COBRA rules, an employer does not have to offer COBRA coverage to an employee who is fired for gross misconduct -- such an individual is not a qualified beneficiary. However, only qualified beneficiaries are eligible for the subsidy. Rather than having to make a determination of whether an individual’s actions rise to the level of gross misconduct, many employers simply offer COBRA to all individuals who terminate employment. This raises the question of whether the employer now has to determine which involuntary terminations were for gross misconduct. The staff’s reaction to this issue is that the government will rely on the facts and circumstances determination that the employer has made regarding whether the termination was for gross misconduct and not second guess that decision for purposes of determining subsidy eligibility.

Model Notices

DOL staff provided several comments about the model notices that were published last week. First they clarified that the model notices and forms may be amended to suit an employer’s needs. For all individuals who have already received a COBRA notice and now are required to receive one of the notices about the subsidy, notices should be sent by April 18. (The models state only that the extended election notice has to be sent by April 18 -- the guidance is silent on when the others must be sent.) For individuals who have not yet received any COBRA notice, a notice that includes information about the subsidy must be sent within the normal COBRA timeframe (i.e., within 44 days of the qualifying event or related loss of coverage).

Note that the DOL has revised its website to clarify that the Full Version of the General Notice must be sent to qualified beneficiaries who experienced a qualifying event at any time from September 1, 2008, through December 31, 2009, regardless of the type of qualifying event, AND who either have not yet been provided an election notice or who were provided an election notice on or after February 17, 2009 that did not include the additional information required by ARRA. (Information in italics was recently revised.) According to DOL staff, a plan does NOT have to send a notice to an individual who had a qualifying event since September 1, 2008 and is not currently enrolled in COBRA, if that event did not involve the individual’s involuntary termination of employment. Note, however, that such a position is inconsistent with the requirements in the model notices and the DOL’s explanatory statement as published in the Federal Register, as well as the requirements in ARRA. Hopefully, the DOL will clarify its position by conforming all of its documents to reflect a consistent standard. Until then, employers may want to err on the side of sending notices to all individuals who had qualifying events since September 1, 2008. For more information regarding the model notices and which individuals must receive each notice, please see our March 20, 2009, Employee Benefits Alert.

Appeal Rights

ARRA provides a new appeal right for individuals who are denied the COBRA subsidy. DOL staff said that appeals related to ERISA plans will be reviewed by the DOL and appeals related to state continuation requirements will be reviewed by the Department of Health and Human Services.

Comparable State Continuation Coverage

The Centers for Medicare and Medicaid Services (“CMS”) has just created its own dedicated COBRA website and has newly posted a document that provides “Helpful Information about State Continuation Coverage (“Mini-COBRA” Programs).” In order for a mini-COBRA law to be eligible for the subsidy, it must be “comparable” to federal COBRA. The guidance does not include (and none of the agencies are expected to provide) a list of which state laws are comparable. The guidance does seem to require state laws to limit the monthly premiums based on a specified percentage of the plan’s cost of providing the coverage in order to be considered comparable. In addition, some had been speculating that a state law might not be comparable if it only provides a few months of continuation coverage, such as six or nine months. That does not seem to be the position that CMS has taken (see Q&A 5).

Consistent with information provided by DOL, the CMS guidance expressly requires the notice regarding the potential state continuation subsidy to be sent to qualified beneficiaries by “the issuer of the group health plan.” Note that the notice must be provided “within the timeframes specified under State law.” However, most states do not currently have post-termination notice requirements, which makes the deadline for providing notice unclear.

Agency Websites

The following are links to the COBRA webpages established by the various agencies:

  • DOL website (
    • Frequently asked question
    • Model notices
  • CMS website (
    • Information about state Mini-COBRA laws
  • IRS website (,,id=204505,00.html)
    • Frequently asked questions (that are being updated regularly)
    • Form 941(
    • Instructions(
  • For guidance on depositing employment taxes and reporting employment tax information, refer to IRS Pub 15 (

We will continue to provide additional information as it becomes available.


Qualified Plans & Exec Comp: Handling Increasing Requests for Hardship Withdrawals

Gary Quintiere and Elizabeth Drake

Given the current economic conditions, plan administrators will likely be seeing an increase in the number of requests for in-service and hardship withdrawals. Generally, a qualified profit sharing or stock bonus plans may afford actively-employed participants the right to withdraw employee and employer contributions from the plan if they have completed a stated period of participation or as a result of a lapse of a fixed number of years (popularly known as the “2 year/5 year rule”). In contrast, 401(k) plans (with respect to employee pre-tax contributions) and nonqualified deferred compensation plans may generally not provide for in-service distributions unless the employee-participant can demonstrate a financial hardship. Plan administrators need to review their plans and other documentation to be sure that they properly state the basic rules and consequences of hardship distributions. But even where plan documentation is accurate, adverse tax consequences can arise from errors in plan administration.

The IRS has identified 401(k) plan hardship withdrawals as one of the areas in which it commonly finds mistakes during plan audits, and this is our experience as well. For example, the plan document might properly set forth the criteria under which hardship withdrawals are available but the plan’s third-party recordkeeper may not adhere to these criteria when processing hardship withdrawal applications (especially where the plan does not incorporate IRS safe harbor provisions) or it may not properly substantiate the participant’s reason for the hardship withdrawal request. Another common mistake arises where the plan imposes a six-month suspension on employee contributions following a hardship withdrawal, but employees are allowed to restart their contributions before the six-month suspension period is scheduled to end. Other problem areas include making post-1988 earnings on employee pre-tax contributions, qualified non-elective contributions, and qualified matching contributions available for hardship, and not requiring participants to demonstrate a hardship once they reach age 59-1/2 even though the plan does not allow in-service withdrawals (without demonstrating a financial hardship) at this age. In addition to these recurring issues, optional hardship withdrawal features permitted under the Pension Protection Act and certain provisions under the HEART Act create further potential for plan operations to deviate from the plan document.

With respect to nonqualified plans, employers face a set of materially different rules. Prior to Code Section 409A, an employee’s access to amounts credited to his account under a nonqualified deferred compensation plan was limited by the “constructive receipt” doctrine. In general, an employee would not be immediately taxable on such deferred amounts if his ability to withdraw them were subject to a substantial limitation or restriction. Prior to Section 409A, if a nonqualified plan permitted a hardship withdrawal, but only on the condition that the employee’s hardship rose to the level of an “unforeseeable emergency” as defined in Treas. Reg. Section 1.457-6(c)(2), that generally was considered a sufficient limitation or restriction to avoid constructive receipt consequences. Nowadays, if distributions under the plan are covered by section 409A, the plan may not permit a hardship distribution unless it would satisfy the “unforeseeable emergency” requirements of 409A as set forth in Treas. Reg.Section 1.409A-3(i)(3). These rules are virtually identical to the 457 rules.

So what if an employee, with an account in both the employer’s 401(k) plan and its deferred compensation plan, requests a hardship distribution because he’s having difficulty meeting his mortgage payments? Under the 401)(k) plan, he must demonstrate the existence of an “immediate and heavy financial need”. Under applicable regulations, a distribution will be deemed to alleviate an “immediate and heavy financial need” if it is necessary to avoid foreclosure on the mortgage of the employee’s principal residence. In contrast, under Code Section 409A, the rule is not quite the same: here the employee would need to demonstrate that the distribution is necessary to avoid “imminent” foreclosure on his principal residence.

Given the likely increase in hardship withdrawal requests, now is the time to review plan processes and documentation to ensure that the plan document, summary plan description, administrative forms, and plan operations are in line with one another. Companies that don’t take these steps can be sure that the IRS will.


ERISA Litigation: Discretionary Language in SPD Will Not Control if Plan Is Silent

Garrett Fenton, Susan Relland, Elizabeth Drake

The U.S. District Court for the District of Oregon recently ruled, in McHenry v. PacificSource Health Plans, No. CV-08-562- ST, 2009 U.S. Dist. LEXIS 18578 (D. Ore. May 5, 2009), that language in an SPD granting discretionary authority to a plan fiduciary is not sufficient to invoke a deferential standard of review if the plan document is silent on the issue. According to the court, when an SPD contains language with respect to a particular issue, but the plan does not, the two documents will generally be deemed to be “in conflict.” As such, in accordance with Ninth Circuit precedent, the document with the provision that is more favorable to the participant will control with respect to the issue.

Because the SPD language at issue in McHenry granted discretionary authority to the plan administrator in making benefit decisions, and the plan did not contain a corresponding provision, the latter’s lack of such language was considered to be “more favorable” to the participant. Accordingly, the court refused to apply a deferential standard of review in connection with the plaintiff ’s challenge of the plan’s denial of payment for behavioral therapy received by her son.

Given the holding in McHenry, plan sponsors should ensure that all material provisions integral to the administration of the plan and/or the protection of the plan sponsor, especially those provisions granting the plan administrator or fiduciary committee discretionary authority to determine benefit claims, be expressly included in the relevant plan document as well as the SPD. Otherwise, the documents may be deemed to be “conflicting” with respect to the issue, and, when read in favor of the plan participant, could result in an award of benefits that the plan sponsor did not intend to provide.


Payroll Tax and Fringe Benefits: IRS Revises Procedures for Reporting Death Benefits Paid Out of a Nonqualified Plan

Thomas Cryan

After years of confusion over the proper information reporting applicable to death benefits paid to a former employee’s estate or designated beneficiary, the IRS has revised the procedures for reporting death benefits, including gratuitous post-death salary continuation payments, paid out of nonqualified deferred compensation plans. Because these payments are considered “income in respect of a decedent,” the recipient of the payments, rather than the deceased employee, is subject to income taxes on the payment. However, there has been considerable confusion over the proper IRS form to use in reporting these payments.

As a result of a series of older rulings, death benefits paid out of a nonqualified plan have historically been reported to the recipient of the payments on a Form 1099-R - “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” despite the fact that this form appears to apply only to qualified plan payments. Beginning in 2009, death benefits from nonqualified deferred compensation plans paid to the estate or beneficiary of a deceased employee should be reported on Form 1099-MISC instead of Form 1099-R. Despite the older rulings that refer to Form 1099-R, employers should now rely on the revised instructions for Forms 1099-MISC and 1099-R which explicitly alert employers to this change.

For further information, please contact any of the following lawyers:

Michael Lloyd,, 202-626-1589

Gary Quintiere,, 202-626-1491

Elizabeth Drake,, 202-626-5838

Garrett Fenton,, 202-626-5562

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