Focus On Employee Benefits
Last week the U.S. House of Representatives and Senate each unanimously passed the Heroes Earnings Assistance and Relief Tax Act of 2008 (H.R. 6081) ("Act") in an effort to provide benefits for military personnel, veterans, and their families. We anticipate that the President will sign the Act into law as there has been no indication to the contrary from the White House, although the actual date of his signing is still uncertain. When enacted, the Act will amend various sections of the Internal Revenue Code that impact employee benefits. Most provisions will take effect on the date of enactment. This newsletter provides a discussion of the benefits-related changes included in the Act.
Health & Welfare: Health FSA and Mental Health Parity
Fred Oliphant & Susan Relland
The Act includes two provisions related to health plans. First, under the Act, an employer has the option to amend its health Flexible Spending Arrangement ("FSA") to allow for individuals called to active duty to receive a distribution of their health FSA balances. Typically FSA participants may only receive distributions for reimbursement of qualified medical expenses and any amount remaining at the end of the year will be forfeited. Under Section 114 of the Act, a plan won't fail to be a cafeteria plan or health FSA merely because it provides for a "qualified reservist distribution." A qualified reservist distribution is any distribution to a health FSA participant of all or a portion of the participant's balance if (1) the participant is a reservist called to active duty for more than 179 days (or for an indefinite period) and (2) the distribution is made during the period beginning with the call to active duty and ending on the last day of the FSA coverage period that includes the date of the call to active duty. For example, if an employee elected to participate in an employer's health FSA for the 2008 calendar year and had a balance in his FSA on July 1 when he was called to active duty for an indefinite period, between July 1 and December 31, 2008, the employer could distribute all or part of the remaining balance to the individual regardless of whether he incurred qualified medical expenses. Note that if the employer distributes the balance of the FSA to the individual, presumably that would need to be reported as income. In this connection, there are a number of related issues (e.g., possible use of the balance for medical expenses incurred after being called for active duty) regarding this provision that will likely need resolved through future guidance. Finally, note that if an employer wants to take advantage of this optional provision, the cafeteria plan regulations proposed in August 2007 would require the employer to amend the plan before providing benefits under this provision. See Prop. Treas. Reg. § 1.125-1(c)(5).
Section 401 of the Act extends the effective date of the Mental Health Parity provisions under Code Section 9812 to the period between enactment of the Act and December 31, 2008. Section 9812 prohibits health plans that provide mental health benefits from imposing annual or lifetime limits on mental health benefits that are more restrictive than those that apply to medical and surgical benefits. As a practical matter, this amendment is not likely to require any employer action as most plans were not amended to reflect the expiration of the mental health parity rules on December 31, 2007.
Qualified Plans: Differential Pay Now Compensation Under Code Section 415 and New Distribution Feature
Anthony Provenzano & Veronica Rouse
The term "differential pay" generally refers to the compensation that an employer pays to an employee during the employee's active military duty (whether continuing the employee at the full rate of pay or merely providing the differential from the employee's military pay). Currently, the regulations under Section 415 permit, but do not require, that a tax-qualified plan or a contract under Section 403(b) include such differential pay as compensation for purposes of the Section 415 benefit limitations. Effective for plan years beginning on or after January 1, 2009, Section 105 of the Act amends Section 415 to now require that a participant's compensation include such differential pay.
There is a potential pitfall when permitting contributions and benefits based on differential pay. Section 414(u)(1)(C) generally provides that a plan will not be treated as failing the minimum coverage or nondiscrimination requirements due to the special treatment for employees in the military pursuant to USERRA. The Act extends this relief to the provision of contributions or benefits based on differential pay but only to the extent that all employees within the controlled group are treated on a reasonably equivalent basis with respect to both the entitlement to differential pay and the right to make contributions based on such differential pay under the applicable plans.
The Act also modifies the definition of severance from employment under Sections 401(k), 403(b), and 457(b) plans for participants in the military. In short, if an employee is on active duty for more than 30 days, the employee is deemed to have severed from service under the plan and therefore is then generally eligible for a distribution. In the event the employee receives such a distribution, the participant is then not allowed to make an elective deferral or employee contribution during the following six-month period.
These requirements are effective for plan years beginning on or after January 1, 2009. Plan amendments generally must be made no later than the last day of the first plan year beginning on or after January 1, 2010.
Qualified Plans: Military Survivor and Disability Benefits Under Tax-Qualified Plans
Anthony Provenzano & Veronica Rouse
Previously, USERRA generally required plans to count qualified military service of a reemployed veteran as service to the employer for vesting and benefit accrual purposes. The Act looks to expand these rights in two significant ways. Section 104(a) of the Act provides that if a tax-qualified plan provides for additional survivor benefits that are contingent upon the participant's termination of employment on account of death (e.g., accelerated vesting, ancillary life insurance benefits, etc.), the plan must grant those benefits to the beneficiaries of a participant who dies during qualified military service as though the participant had resumed employment with the employer and then terminated employment on account of death.
Further, under Section 104(b) of the Act, tax-qualified plans are now permitted (but not required) to treat a participant who has left the employer for qualified military service and who cannot return to the employer due to death or disability, as though the participant had been rehired by the employer as of the day before death or disability occurred and then had terminated employment on account of such death or disability. Providing this additional accrual is not mandatory and a plan may provide such additional accruals either partially or fully (or not at all). Such additional accruals, if provided, will generally not cause a plan to fail the minimum coverage or nondiscrimination requirements otherwise applicable to tax-qualified plans. However, as noted above with respect to differential pay, such relief only applies if, among other requirements, all employees within the employer's controlled group who perform qualified military service and who die or become disabled as a result are treated on a reasonably equivalent basis.
These new provisions are effective for deaths and disabilities occurring on or after January 1, 2007. Plan amendments must generally be made on or before the last day of the plan year beginning on or after January 1, 2010.
Exec Comp: New Code Section 887A Impacting Withholding on Certain Expatriates' Deferred Compensation
Fred Oliphant & Adrian Morchower
Section 301 of the Act amends the Internal Revenue Code by inserting new Section 877A, relating to the tax responsibilities of certain expatriates (generally, certain United States citizens who relinquish their citizenship, or long-term residents who cease to be permanent residents of the United States and who, subject to certain exceptions, meet certain net income tax or net worth requirements). The new provision generally treats, for federal tax purposes, all property of the expatriate as being sold on the day before the expatriation date for its fair market value. However, there are special rules for treating the expatriate's interest in deferred compensation, as well as specified tax deferred accounts (e.g., IRAs, HSAs, Section 529 accounts) and nongrantor trusts. Of particular interest for employers and plan administrators are the rules for taxing the expatriate's interest in deferred compensation items that impose special withholding tax rules on the payors of eligible deferred compensation items.
In the case of an eligible deferred compensation item (generally, a deferred compensation item with respect to which the payor is, or is treated as, a United States person and the expatriate notifies the payor of his expatriate status), the payor must collect a special 30% withholding tax on the amount of the payment that would have been taxable if the individual had not expatriated. Deferred compensation items that are not eligible deferred compensation items and specified tax deferred accounts generally are treated as having been received or as vesting on the day before the expatriation date, and are not subject to the special 30% withholding requirement.
For these purposes, a deferred compensation item is (1) any interest in a plan or arrangement described in Code Section 219(g)(5), which includes plans qualified under Section 401(a), annuity contracts under Section 403(b), SEPs, and SIMPLEs; (2) any interest in a foreign pension plan or similar arrangement; (3) any item of deferred compensation; and (4) any property or right to property which the individual is entitled to receive in connection with the performance of services to the extent not previously taken into account under Section 83 or in accordance with Section 83.
The provisions discussed above apply to any individual whose expatriation date (as defined in the legislation) is on or after the date of enactment.
Payroll Tax & Fringe Benefits: Revised Federal Income Tax Withholding Treatment of Differential Pay
For remuneration paid after 2008, Section 105(a) of the Act subjects differential pay to federal income tax withholding and treats such amounts as compensation for years beginning after 2008 for both retirement plan purposes and IRA contribution rules. (See discussion above of qualified plan changes in the Act.) Prior to the Act, differential pay was not treated as wages for federal income tax withholding, FICA tax, or FUTA tax purposes under Rev. Rul. 69-136. The IRS' rationale for the non-wage treatment in Rev. Rul. 69-136 was that payments companies made to former employees while they were in military service were not "wages" for services performed in "employment" for the companies.
The Act will change the Federal income tax withholding, but not the FICA or FUTA tax treatment, of differential pay. Towards this end, the Act amends Code Section 3401 by adding Section 3401(h)(1), which specifically provides that a "differential wage payment" is wages for Federal income tax withholding purposes. Section 3401(h)(2) then defines "differential pay" as any payment that (i) is made by an employer to a individual with respect to any period during which the individual is performing services in the uniformed services while on active duty for a period of more than 30 days and (ii) represents all or part of the wages that the individual would have received from the employer if the individual were performing services for the employer.
Payroll Tax & Fringe Benefits: U.S. Employer Status for Domestically-Controlled Foreign Entities Working for U.S. Government
Anne Batter & Patricia Szoeke
Section 302 of the Act provides that amounts paid to certain employees working outside the United States for a foreign employer are subject to FICA taxation. The FICA taxation can arise when a foreign company or other entity is part of a U.S.-controlled group and is providing services under a contract between any member of the controlled group and the U.S. government. Before the Act, FICA taxation would not apply to amounts the foreign employer paid to its employees because, under Code Section 3121(b), FICA taxation generally applies only to amounts paid for (1) services performed within the United States and (2) services performed outside the United States for an American employer (meaning, generally, a corporation organized in a U.S. state).
The Act applies FICA taxation to payments to employees working outside the United States for a foreign corporation or other entity in connection with a contract between the U.S. Government and a member of the controlled group that includes the foreign corporation or entity by adding Section 3121(z) to the Code. Under the newly added Code Section 3121(z), for services performed in calendar months beginning more than 30 days after the Act's enactment date, a foreign corporation or other entity shall be treated as an American employer with respect to an employee of the foreign person who is performing services in connection with such a contract. For purposes of determining whether a domestically controlled group of entities exists, controlled group concepts under Code Section 1563 apply, except that (i) a 50% ownership threshold is applied and (ii) Code Sections 1563(a)(4) and (b)(2) are disregarded.
The Act provides that the exceptions under Code Sections 3101(c) and 3111(c) for wages not subject to FICA as a result of a totalization agreement apply under the new Code Section 3121(z). Furthermore, Code Section 3121(z)(1) shall not apply (i) to services covered by an agreement under Code Section 3121(l) or (ii) if the employer establishes to the satisfaction of the Internal Revenue Service that the remuneration paid by the employer for such services is subject to a tax imposed by a foreign country that is substantially equivalent to FICA.
Joint and several liability for the FICA taxes for which the foreign person is liable under Code Section 3121(z) applies to the common parent of the domestically controlled group of entities. In addition, the common parent is liable for any penalty imposed on the foreign person for failure to pay FICA taxes or failure to file any return or statement with respect to such tax or wages subject to the tax. The Act denies the common parent a deduction for any liability imposed as a result of the joint and several liability rules.
For further information, please contact any of the following lawyers:
Fred Oliphant, email@example.com, 202-626-5834
Anthony Provenzano, firstname.lastname@example.org, 202-626-1463