ERISA and tax rules on medical loss rebates; New tax guidance on tips and service charges; Impending limits on health FSAs; Deductibility of local lodging expenses
Focus On Employee Benefits
Health and Welfare: Health Insurers and Employers Sponsoring Insured Health Plans Must Soon Comply with MLR Rebate Rules
Garrett Fenton and Michael Lloyd
Employers that sponsor insured group health plans, as well as individuals who purchase health insurance coverage in the individual market, may soon receive "medical loss ratio" rebates from their health insurance carriers. These rebates can implicate a variety of legal and practical issues for employers and health insurers alike, and some of these issues were addressed in a set of IRS frequently asked questions or "FAQs" released earlier this year. Employers, in particular, would be well-advised to develop procedures to address these issues now, if they have not already done so.
By way of background, a provision in the Patient Protection and Affordable Care Act ("PPACA") requires individual and group health insurers that fail to spend a specified percentage of their premium revenues for a given year on (1) reimbursements for clinical services and (2) certain quality improvement activities to distribute annual medical loss ratio ("MLR") rebates to their policyholders, subscribers, or both. Self-funded group health plans are not subject to these provisions. Health insurers must distribute their first MLR rebates – for the 2011 calendar year – by August 1, 2012. These rebates may be paid in a variety of forms, including cash, credits against future premium payments, reimbursements of the credit or debit accounts that were used to make prior premium payments, and pre-paid debit or credit cards (provided that certain requirements are satisfied). Please note that these MLR provisions could be affected by the Supreme Court's decision on the constitutionality of PPACA, which is expected this week.
Proper Handling of MLR Rebates – ERISA Fiduciary Issues
In most cases, any MLR rebates owed with respect to an ERISA group health plan will be paid to the employer. (Special rules apply to certain non-governmental plans that are not subject to ERISA, such as "church plans," and plans that have been terminated as of the date that the rebate is paid.) The Department of Labor has issued guidance confirming that, under certain circumstances, all or a portion of an MLR rebate may constitute ERISA "plan assets," and thus may need to be handled in accordance with ERISA's fiduciary standards (which generally require plan "fiduciaries," such as employers/plan administrators, to act prudently, impartially, and solely in the interests of plan participants and beneficiaries). The determination of whether some or all of an MLR rebate constitutes plan assets generally will require a fact-specific, case-by-case analysis of all the relevant facts and circumstances, including the governing plan documents. Employers that sponsor insured ERISA group health plans thus may be well-advised to amend their plan documents to specify the character of MLR rebates received by the employer, and to clarify the manner in which those MLR rebates may be used or distributed.
In many cases, employers will need to allocate to the plan, as plan assets, at least a portion of MLR rebates they receive – e.g., based on the source(s) of premium payments – and may need to either pay the plan asset portion of the rebate in cash to individual participants, or, if distributing such cash payments is not cost-effective, utilize the plan asset portion of the rebate for other permissible purposes (like reducing future participant premium payments or enhancing future benefits). MLR rebates that constitute ERISA plan assets need not necessarily be held in trust if they are used to pay premiums or refunds within three months of their receipt by the employer.1 In any event, employers should weigh carefully all the relevant costs and benefits, and document the particular manner in which MLR rebates will be handled and/or distributed.
Tax Implications of MLR Rebates Paid to Employees
The tax treatment of MLR rebates paid to employees was the subject of some uncertainty until the IRS "FAQ" guidance was issued earlier this year. The guidance confirms that where employee premium contributions for coverage are made on a pre-tax basis through a cafeteria plan – as is often the case – any rebates paid to employees with respect to that coverage will be subject to federal income and employment taxes, and related employer wage withholding obligations, in the year in which they are paid. This is true regardless of the form of the rebates – e.g., cash rebates, credits against future premium payments,2 etc. – and regardless of whether an individual receiving a rebate participated in the plan during the preceding year, for which the rebate is provided. For example, assume that on August 1, 2012, an employer receives an MLR rebate from its group health insurance carrier (with respect to the 2011 calendar year), determines that a portion of that rebate constitutes ERISA plan assets, and therefore distributes a proportional amount of the rebate, in cash, to all employees who are currently enrolled in the plan. If those employees/participants who receive a rebate are contributing to their coverage with pre-tax salary reduction contributions through a cafeteria plan, then the rebate will constitute taxable wages subject to federal income and employment taxes, including employer withholding and Form W-2 reporting obligations, for 2012 (regardless of whether the current employees/participants were also enrolled in the plan during the 2011 calendar year).
By contrast, if an employee's premium contributions for coverage are made on an after-tax basis, then an MLR rebate paid to that employee, regardless of form, generally will not be subject to federal income or employment taxes, or employer withholding or Form W-2 reporting obligations. The rebate instead will be treated as an after-tax "purchase price adjustment." However, if the rebate is paid only to employees who participated in the plan during the preceding year (for which the health insurer owes the MLR rebate), and any such employee deducted on his or her federal income tax return the premium payments made for that previous year, then the MLR rebate will be subject to federal income taxes – but not employment taxes – to the extent that the employee received a tax benefit from that income tax deduction. For example, assume the same facts apply as provided above, except that the employer distributes all or a portion of the MLR rebate only to employees who both were enrolled in the plan during 2011 and are enrolled for the current (2012) year, and some or all of those employees are contributing to their coverage with after-tax dollars. The general rule is that the rebate distributed to those employees/participants will not be subject to federal income or employment taxes (or employer withholding or Form W-2 reporting obligations). However, if any such employee had claimed a federal income tax deduction in 2011 for after-tax premium contributions that had been made to the plan for that year, then the amount of the rebate paid to that employee will be subject to federal income taxes, if and to the extent that he or she was able to utilize that deduction to obtain a tax benefit in 2011. It is important to note that even where the amount of a rebate paid to such an employee would be subject to federal income taxes, it would not be subject to any employment taxes, including employer wage withholding and Form W-2 reporting obligations. The onus essentially will be on the employee to determine if and the extent to which the rebate will be taxable to him or her, and to file and pay his or her federal income taxes accordingly.
Tax and Information Reporting Implications for Insurers
The IRS guidance confirms that MLR rebate payments represent "return premiums," and thus operate to reduce the health insurer's taxable income. (The guidance expressly declines to address the timing of deductions for MLR rebates for insurers.)
The guidance also clarifies that, in most cases, a health insurer need not file or furnish to an individual policyholder a Form 1099-MISC, in connection with the payment of an MLR rebate. The only exception is where both the rebate payments made to an individual during the year total at least $600, and the health insurer knows that the rebate payments (or can determine how much of the rebate payments) are taxable to that individual. (For this purpose, an MLR rebate payment is taxable to an individual policyholder only if and to the extent that he or she took a federal income deduction – and received a tax benefit from the deduction – for the premium payments that he or she paid for the coverage in the previous year.) Similarly, a health insurer generally need not file or furnish to an employer a Form 1099-MISC for any MLR rebates paid to that employer in the form of a premium reduction, except where (1) the employer is not an "exempt recipient" (which generally includes corporations, tax exempt organizations, and federal and state governments), (2) the rebate payments made to the employer during the year total at least $600, and (3) the health insurer knows that the rebate payments (or can determine how much of the rebate payments) are taxable to the employer.
Employers that sponsor insured group health plans should, if they have not already done so, begin considering and documenting the manner in which they will handle and/or distribute MLR rebates that they may receive from their health insurance carriers. This could involve amending their plan documents and summary plan descriptions, and should be done in advance of their potential receipt of any MLR rebates, which could occur any time on or before August 1, 2012. Health insurers should also ensure that they are in compliance with any relevant information reporting requirements that may arise, albeit rarely, in connection with MLR rebates issued to individual policyholders and employers.
Employment Taxes: IRS Guidance Distinguishes Tips from Service Charges and Signals Pending Changes to TRAC and Related Programs
Marianna Dyson and Michael Lloyd
It has been over 17 years since the Internal Revenue Service issued formal guidance on the tax treatment of tip income. On Wednesday, June 20, 2012, the Service released three documents – Rev. Rul. 2012-18, 2012-26 I.R.B. (June 25, 2012), a copy of a June 7 memorandum to IRS employment tax examiners instructing them on the application of Rev. Rul. 2012-18, and Announcement 2012-25 requesting comments and explaining why the memorandum was issued to examiners.
Rev. Rul. 95-7, 1995-1 C.B. 185, the last significant formal guidance issued on tips, coincided with the Service's launch of the Tip Reporting Alternative Commitment ("TRAC") for hospitality employers and focused on the procedures for issuance of a "notice and demand" for the assessment of the employer share of FICA taxes under Code section 3121(q). Since that time, the IRS has prevailed in Fior D'Italia, Inc. v. United States, 536 U.S. 238 (2002) and settled one high-profile retroactive TRAC revocation. In addition, Code section 45B has been technically corrected and issues surrounding its application have arisen.
In this latest round of guidance, the IRS adopts the Q&A format of Rev. Rul. 95-7 to address procedures related to the assessment of employer FICA taxes under Code section 3121(q) and the application of the Code section 45B credit. However, unlike that ruling, Rev. Rul. 2012-18 begins with the warning that a determination must first be made that "a payment" is actually a "tip" for FICA tax purposes. Q&A 1 cautions employers that calling a payment from a customer a "tip" does not make it so. Employers are instructed to look back to the principles of Rev. Rul. 59-252 to determine whether the payment is a tip or a service charge—the latter characterization resulting in "wage" treatment for payroll tax purposes and disqualifying the payment from application of the section 45B credit. Rev. Rul. 59-252 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge: (1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) generally, the customer has the right to determine who receives the payment. In other words, it is a facts and circumstances test. As illustration, Example A of Rev. Rul. 2012-18 describes the imposition of an 18% charge on a party of 6 or more as resulting in a service charge. In contrast, Example B concludes that a tip has been paid in a scenario where sample calculations of various tips rates are provided on the charge receipt and the customer selects the amount to add into the total amount.
The accompanying Announcement 2012-25 advises that administrative guidelines are being provided to IRS examiners (SBSE-04-0612-057), because "[t]he Service is aware that some businesses may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges as specified in Q&A 1 of Rev. Rul. 2012-18." When performing a tip examination, examiners are instructed "to ensure that distributed service charges are properly characterized as wages and not tips" using the principles that were originally set forth in Rev. Rul. 59-252.
Ann. 2012-25 further explains that examiners are being directed "to apply Q&A 1 of Rev. Rul. 2012-18 prospectively to amounts paid on or after January 1, 2013, in order to allow businesses not currently in compliance additional time to amend their business practices and make needed system changes." The IRS requests public comments on this interim guidance and whether additional compliance time is needed. The Service's decision to delay enforcement, however, is tempered by its notice to employers that the TRAC program is under review and that comments will soon be requested:
In a future announcement, the Service will also solicit public comments on proposed changes to the Service's existing voluntary tip compliance agreements. Specifically, the Service is considering significant changes to the Tip Reporting Alternative Commitment (TRAC) program and other variations of TRAC agreements…The Service is interested in updating its suite of voluntary tip compliance agreements to place a greater emphasis on computations derived from Point of Sale systems and the use of electronic payment settlement methods, such as credit and debit cards. While employee education will remain a focus of the Service's efforts, these new voluntary tip compliance agreements will increase the participants' reliance on internal control systems to improve employee tip reporting compliance.
In summary, the IRS is not only signaling its intent to step up enforcement in this area, but to increase its scrutiny of how amounts from customers are being characterized. It is also clearly interested in utilizing advancements in technology to impose more responsibility on employers to force the reporting of tips, particularly cash tips.
Garrett Fenton and Fred Oliphant
The IRS recently published guidance regarding the $2,500 limitation on employee salary reduction contributions to health flexible spending arrangements ("health FSAs"), enacted under the Patient Protection and Affordable Care Act ("PPACA"), which will be effective beginning in 2013. The guidance, in Notice 2012-40, generally has been viewed by both employers and employees as providing welcome relief and clarity on a number of issues. Note that the $2,500 limitation could be affected by the Supreme Court's decision on the constitutionality of PPACA, which is expected this week.
PPACA amended the cafeteria plan rules to provide that, in order to maintain their tax-favored status, salary reduction contributions to a health FSA offered under a cafeteria plan must be limited to a total of $2,500 for each "taxable year" beginning on or after January 1, 2013. The consequence of failing to comply with this provision – by not amending the formal plan documents and operating the plan in compliance with the $2,500 limit – is that the plan will not be considered a cafeteria plan, thereby generally causing all salary reduction contributions under the plan to be currently taxable to employees.
The guidance clarifies that the $2,500 limit applies only to employee salary reduction contributions to health FSAs – not to employer "flex credits" or employee or employer contributions to other types of accounts or plans (e.g., health savings accounts ("HSAs"), health reimbursement arrangements ("HRAs"), premium conversion plans, or dependent care FSAs) – and will be adjusted for inflation beginning in 2014. The guidance cautions that flex credits that an employee may elect to receive as cash (or another taxable benefit) under a health FSA are treated as employee salary reduction contributions for this purpose.
The statute provides that the $2,500 limit applies with respect to "taxable years" beginning on or after January 1, 2013, but does not specify whose taxable year – i.e., the employee's or the employer's – is to be taken into account. The guidance clarifies that, for this purpose, the "taxable year" actually refers to the "plan year" of the cafeteria plan. In other words, salary reduction contributions to a health FSA offered under a cafeteria plan must be limited to $2,500 for each plan year, effective for plan years beginning on or after January 1, 2013 (and adjusted for inflation for plan years beginning on or after January 1, 2014). In addition, the guidance notes that where a plan year is changed, and the "principal purpose" of that change is to delay the application of the $2,500 limit, the change will not be deemed to be for a valid business purpose and thus will not be recognized. Where a change in the plan year is for a valid business purpose, and results in a "short plan year" of less than 12 months that begins on or after January 1, 2013, the $2,500 limit will need to be prorated for the short plan year. For plans that provide for a grace period (which can be up to 2½ months) after a plan year, during which medical expenses may be reimbursed from unused salary reduction contributions carried over from the previous plan year, the guidance specifies that such carried-over salary reduction contributions do not count against the $2,500 limit for the subsequent plan year.
The $2,500 limit applies on an employee-by-employee basis, meaning each employee will be subject to the $2,500 limit regardless of the number of other individuals covered under his or her health FSA (e.g., spouses, dependents, or certain "adult children"). Where two spouses participate as employees in the same employer's health FSA, however, each spouse may elect to make salary reduction contributions up to the $2,500 limit. If a single employee participates in multiple cafeteria plans offering health FSAs maintained by related employers, then the employee's aggregate salary reduction contributions under those health FSAs must be limited to $2,500. By contrast, an employee employed by two or more unrelated employers may elect to make salary reduction contributions of up to $2,500 under each employer's health FSA.
The guidance provides some relief with respect to employees who are "erroneously allowed" to make salary reduction contributions in excess of the $2,500 limit, provided a number of conditions are met, including taxing any erroneous salary reduction contributions for the year.
The plan document for a cafeteria plan offering a health FSA will need to be amended, if necessary, to comply with the $2,500 limit. (The plan may specify a limit lower than $2,500.) Although cafeteria plan amendments generally may be effective only prospectively, the guidance states that an amendment to comply with the $2,500 limit may be made effective retroactively, provided that the amendment is adopted before January 1, 2015, and the cafeteria plan is operated in compliance with the $2,500 limit and related guidance as of the first plan year beginning on or after January 1, 2013.
Finally, the guidance states that the Treasury Department and IRS are considering modifying the "use-it-or-lose-it" rule, which generally requires any unused amounts remaining in a health FSA to be forfeited at the end of the relevant plan year (or grace period, if applicable). In light of the $2,500 limit, which restricts the potential for using health FSAs to defer compensation, the guidance requests comments on whether the proposed cafeteria plan regulations should be modified to provide "additional flexibility" as to the operation of the use-it-or-lose-it rule for health FSAs, and how such modifications would interact with the $2,500 limit.
Recently, the IRS has issued proposed regulations [REG-137589-07] relating to the deductibility of expenses for lodging when not traveling away from home (local lodging). Under Proposed Treasury Regulation § 1.162-31, expenses paid or incurred for local lodging generally are treated as personal, living or family expenses that are nondeductible under section 262(a) of the Internal Revenue Code (Code). Notwithstanding this general rule, the proposed regulations provide that under certain circumstances expenses for local lodging may be deductible under Code section 162(a) as ordinary and necessary expenses paid or incurred in connection with carrying on a taxpayer's trade of business, including a trade or business as an employee. Whether local lodging expenses are paid or incurred in carrying on a taxpayer's trade or business is a facts and circumstances determination. One factor to consider is whether the taxpayer incurs the expense because of a bona fide condition or requirement of employment imposed by the taxpayer's employer. In applying this factor, the proposed regulations provide that expenses paid or incurred for local lodging that is lavish or extravagant under the circumstances or that primarily provides an individual with a social or personal benefit are not incurred in carrying on a taxpayer's trade or business.
Under the proposed regulations, a safe harbor is provided in the case of local lodging at business meetings and conferences. Thus, an individual's expenses for local lodging will be treated as an ordinary and necessary business expense if:
- The lodging is necessary for the individual to participate fully in or be available for a bona fide business meeting, conference, training activity, or other business function;
- The lodging is for a period that does not exceed five calendar days and does not occur more frequently than once per calendar quarter;
- If the individual is an employee, the employee's employer requires the employee to remain at the activity or function overnight; and
- The lodging is not lavish or extravagant under the circumstances and does not provide any significant element of personal pleasure, recreation, or benefit.
The proposed regulations include six examples to illustrate situations in which the value of the local lodging is (a) excluded from the employee's income as a working condition fringe or as a tax-free reimbursement under an accountable plan, or (b) includible in the employee's gross income as additional compensation.
The new rules relating to the deductibility of local lodging expenses apply to expenses paid or incurred on or after the date the proposed regulations are published in the Federal Register as final regulations. However, until such date, taxpayers may apply the proposed regulations to local lodging expenses that are paid or incurred in taxable years for which the period of limitation on credit or refund under Code section 6511 has not expired. Proposed conforming amendments to Treas. Reg. § 1.162-1(b)(5) are provided in the Notice. In addition, Notice 2007-47, 2007-1 CB 1393, which provided interim guidance regarding the deductibility of local lodging expenses pending amendments to the regulations, is now obsolete.
Comments on the proposed regulations must be received by July 24, 2012. The IRS notes that the proposed regulations under Code section 262 provide that a taxpayer's costs incurred for local lodging are personal expenses unless the expenses are deductible under Code section 162. Comments are specifically requested on whether the section 262 regulations should be amended to provide that local lodging expenses are not personal expenses if they are deductible under Code section 212.
1 Special rules pertaining to a group policyholder's handling and/or distribution to employees of MLR rebates apply with respect to nonfederal governmental group health plans (such as state, municipal, or local governmental plans) and nongovernmental group health plans that are not subject to ERISA (such as church plans).
2 Employers that wish to distribute MLR rebates to employees in the form of credits against future premium payments will want to ensure that those credits – which effectively would constitute partial "premium holidays" – fit within the provisions of the cafeteria plan regulations that permit mid-year changes to employees' pre-tax salary reduction contributions that are based upon mid-year changes in the cost of coverage.
For more information, please contact:
Fred Oliphant, email@example.com, 202-626-5834
*Former Miller & Chevalier attorney
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