Play or Pay Proposals, Maintaining Plan Administrative Documents, Employment Settlements, and Discounted Options
Susan Relland, Fred Oliphant
Many clients have been asking questions about the “play or pay” employer mandates in the various health reform bills, so we thought it would be helpful to provide a brief summary of them here. Although it remains unclear whether health reform will be enacted this year, to the extent employers have concerns about the following provisions, now is a good time to express those concerns to members of Congress.
Tri-Committee House Bill
Under the Tri-Committee bill in the House of Representatives, to “play” an employer generally must provide health coverage that is at least as generous as the “Basic Option” under the proposed public plan (details to be determined by regulations) to all full-time employees, all part-time employees, or both. (An employer may also distinguish between separate lines of business.) The employer must also contribute an amount equal to at least 72.5 percent of the cost for self-only coverage and 65 percent of the cost for family coverage of the lowest cost plan the employer provides that satisfies the Basic Option requirements. If the employer offers any health plan on December 31, 2012, the employer may simply continue to offer access to that plan (without conforming the plan to the requirements of the Basic Option) until 2018, after which time the employer’s plan design would have to meet the Basic Option requirements.
Beginning in 2013, if the employer does not offer the coverage and contribute the minimum amounts described above, the employer will have to pay 8 percent of average aggregate payroll for the employees who are not offered coverage. In addition, part-time employees and employees who would have to make a contribution to the employer plan that exceeds a certain percentage of family income may opt out and enroll in the public plan option, and the employer will have to pay 8 percent of their payroll as a penalty (even if the employer offered such employees coverage and contributions that satisfied the “play” requirement).
Senate Health, Education, Labor, and Pensions Committee Bill
Under the bill passed by the Senate Health, Education, Labor, and Pensions (HELP) Committee, to “play” an employer must provide coverage that is at least as generous as the Basic Option under the proposed public plan (details to be determined by regulations). The employer must contribute an amount equal to at least 60 percent of the monthly cost of coverage. Employer plans that are offered on the date of enactment (which could be later this fall) will be grandfathered with respect to employees who are covered under the plan at that time. It is unclear whether the grandfather will apply to individuals who elect coverage under that plan after the date of enactment.
As of a date to be determined (perhaps 2012 or 2013), if the employer does not offer the coverage and contribute the minimum amounts described above, the employer will have to pay an annual fee of $750 for each uncovered full-time employee and $375 for each uncovered part-time employee. Certain employees are eligible to opt out of employer coverage and enroll in the public plan option, but it appears that an employer will not have to pay a penalty for those employees as long as the employer offered such employees coverage that satisfies the play requirements.
Note that the Senate HELP bill also includes a number of “market reform” mandates that will apply to insured and self-insured plans offered after the date of enactment. In other words, if the final bill includes these market reforms and is signed into law later this fall, the employer will have to incorporate the requirements into a new plan offered January 1, 2010, for example. Under the market reform requirements, plans must include certain provisions to improve quality, cover dependents to age 26, provide preventive care without any cost sharing, not include annual or lifetime limits, and not limit coverage for preexisting conditions. A grace period is available for employer plans that are offered on the date of enactment until the employer makes significant changes to the coverage or contributions to the plan.
Senate Finance Committee
The Senate Finance Committee has not yet introduced a bill or provided details on provisions that may be included. However, one option under consideration is a requirement that an employer would have to pay a penalty if it did not offer access to health coverage. It is rumored that the “play” provision would not impose any minimum coverage or contribution requirements. The amount of the penalty is also still under consideration.
Another alternative is a “free rider” penalty that would require employers to make a payment for individuals who receive tax credits to purchase coverage under a public plan option or who receive coverage under Medicaid. The speculation is that no other employer “play” requirement would be included in the bill.
Elizabeth Drake, Gary Quintiere
Our last article was a reminder of fast-approaching plan amendment deadlines. This article deals with the need to ensure that the plan’s administrative documents remain consistent with plan amendments. The formal plan document is only one of the documents that must be properly maintained. Companies must also take care that their plan administrative documents, such as administrative manuals maintained by third-party recordkeepers, are consistent with the official plan document. The failure to do so often results in operational errors that create tax-qualification problems.
At the outset, the administrative documents are often carefully established. Given the complexity inherent in administering tax-qualified plans, though, these documents can quickly “drift” from the official plan document. This drift might occur as the administrative documents are updated to address issues that arise in day-to-day plan administration. For example, a question may arise about whether a specific type of pay should be included in plan-eligible compensation. The company employees responsible for working with the recordkeeper decide that it should be excluded, consistent with company benefits policies, and the recordkeeper updates the administrative manual in accordance with this decision. Several years later, it is discovered that because the plan’s compensation definition was not also changed to expressly exclude this type of pay, benefits were understated for a large group of employees.
Drift may also occur when the plan document is amended but the amendment is not provided to the recordkeeper as required under the services agreement. Although the company may have informally notified the recordkeeper of the change, the recordkeeper may not bear responsibility under the services agreement if it did not administer the plan in accordance with the amendment.
To avoid the complications created by drift, companies should implement a process under which recordkeepers are required to provide notice of any changes to the plan’s administrative documents and periodic reviews of those documents are conducted to ensure that they comport with the plan document. Furthermore, any time the company amends a plan, it needs to be sure that the amendment is immediately provided to the recordkeeper. These seemingly easy steps can go a long way in avoiding administrative errors that could be quite costly and time consuming to correct.
Lee Spence, Fred Oliphant
As promised by Lynn Camillo, Chief of Employment Tax Branch 2 at the ABA Tax Section meeting in Washington in May, the IRS has released the text of a highly anticipated technical assistance memo (provided to IRS program managers last fall) that sets forth step-by-step instructions on how to determine the proper tax treatment and reporting of payments made pursuant to employment-related judgments and settlements. Although the memorandum is aimed only at judgments and settlements of disputes arising out of employment with the IRS, the issues addressed are largely relevant to the private sector as well. Moreover, although not answering all technical tax issues that may arise -- and expressly ducking some issues such as the tax treatment and reporting of restoration of benefits -- the memorandum does provide the IRS perspective on the key classification issues that are likely to arise
The memorandum and convenient accompanying chart are particularly useful roadmaps for company tax and employment specialists to have on hand for analyzing such issues. There are few surprises in the IRS positions on these issues, and the memorandum does point out where there are splits in the circuits on specific issues, e.g., with respect to the employment tax treatment of back and front pay awards and settlements. Moreover, the memorandum includes some lesser known points, such as the impact of fee-shifting statutes and the need for special reporting to the Social Security Administration with respect to payments to employees of back pay.
The memorandum suggests a four-step process for determining the correct treatment of employment-related payments pursuant to judgments and settlements. First, determine the character of the payment and the nature of the claim that gave rise to the payment (e.g., based on a claim for back pay, punitive damages, and/ or emotional distress for Title VII discrimination) -- an analysis familiar to practitioners under the U.S. Supreme Court’s “origin of the claim” doctrine as enunciated in United States v. Gilmore, 372 U.S. 39 (1963). This analysis takes into consideration all of the facts and page 3 circumstances surrounding the nature of the litigation and the terms of the judgment or the parties’ settlement. Second, determine whether the payment is income or conversely whether it is nontaxable to the employee. This step involves such matters as determining applicability to the facts of the limited exclusion of Code section 104(a)(2) for amounts of damages (other than punitive damages, which are taxable) received on account of physical personal injuries or physical sickness. Qualification for the section 104(a)(2) exclusion no doubt makes up a large segment of tax litigation related to proper treatment of payments pursuant to employee lawsuits, and in our experience there is a considerable amount of confusion among practitioners as to the proper reach of this exclusion where there is an emotional distress component of the judgment or settlement. Third, if the payment is income, determine whether or not the payment also constitutes wages, since employment tax treatment is required if wages are involved. Fourth, determine the appropriate reporting, e.g., Form 1099 or Form W-2, of the payment, as well as the appropriate reporting of any attorneys fee component.
As noted, the IRS memorandum for its field managers does not cover all possible issues associated with the income/wage distinctions. Nor does it delve into all of the complex judgments on reporting with respect to payments to attorneys under section 6045(f). Nevertheless, it is a must read for those called upon to make the correct evaluations of the nature and character of payments pursuant to judgments and settlement payment and to properly apply employment taxes and report the results to the IRS and the payee.
Anne Batter, Fred Oliphant
In a Generic Legal Advice memorandum (GLA) dated July 6, 2009, the IRS National Office provided the field with direction regarding the treatment under Code section 162(m) of certain options under examination by the field. At issue in the GLA were options issued generally before 2002 that had resulted in a restatement of earnings because they were viewed as discounted options for financial accounting purposes.
The GLA considers the exception from the deduction disallowance under Code section 162(m) for options if “under the terms of the option or right, the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the date of the grant or award.” Treas. Reg. § 1.162-27(e)(2)(vi). The specific issues addressed in the GLA were how to determine the grant date for purposes of this exception to section 162(m), and whether taxpayers could cure any discount by obtaining the payment of additional exercise price from the option holders. Perhaps not surprisingly, the GLA adopts a very pro-government view of these issues. Companies that have undergone a restatement of earnings because of irregularities in their option granting process should be prepared to confront these views on exam, if they have not already, and, if the issue has been raised at the examination level, they can expect to have more difficulty resolving the issue at that level.
Grant Date Issue
With respect to the grant date issue, the IRS National Office in the GLA acknowledges that there is no guidance on when a grant occurs for section 162(m) purposes, but page 4 nonetheless concludes that taxpayers should have known to follow the standards in the incentive stock option (ISO) and section 409A regulations. This conclusion is reached notwithstanding that section 409A had not been enacted and no regulations under section 409A had been issued when the options at issue were granted, and the ISO regulations were still in proposed form at that time. Moreover, there is no discussion of the fact that the ISO regulations suggest an effective grant to a class of employees can occur before the individual employees are notified of the grant. See Treas. Reg. Section 1.421-1(c)(1). Further, there is no discussion of the possibility that, in the absence of regulations on point, the more logical place to turn for guidance would be to state law principles regarding when the optionees’ rights were created.
The GLA further concludes that, although the financial accounting standards for determining a measurement date are less stringent than the standards in the ISO and 409A regulations, it is reasonable for the field to use the measurement date as the grant date. In reaching this conclusion, the GLA seems not to recognize that the financial accounting standards were, in fact, applied very rigidly so that the measurement date generally was the date all corporate action was completed to make the grants, or in the absence of clear, formal documentation, the date the options were entered into the equity compensation software system. Few would argue that this latter date had any true legal correlation to the grant date, other than to serve as final acknowledgment that a grant had previously occurred. Yet, the GLA blesses the field’s use of this latter date as a proxy for the grant date.
One issue that is not addressed at all in the GLA is what methodology can be used to value the employer’s stock on the grant date (however that date is determined). Given the National Office’s use of the section 421 and 409A regulations as standards for the section 162(m) grant date, it seems likely the National Office would also point to the section 409A regulations for guidance as to how an employer might determine the stock’s fair market value as of that date. Even the section 409A regulations allow limited use of a past average for determining the option price. Arguably, this sort of flexibility should be illustrative of what might be permissible under section 162(m); inasmuch as it is not at all clear that taxpayers should be bound to those standards for purposes of Code section 162(m).
The GLA also addresses whether an option that is treated as discounted for section 162(m) purposes based on the discussion above can be remedied either before or after exercise by the employee paying additional exercise price. The National Office in the GLA concludes that the employee’s payment of additional exercise price does not cure the section 162(m) problem because, for section 162(m) purposes, one looks to the facts as of the date of the option grant, and does not look at separate transactions such as additional payments by the employee, in order to determine whether the performance-based exception from section 162(m) applies. The implication is that, if there existed in the grant an exercise price that was not equal to or greater than the fair market value of the stock (however that is determined) on the grant date (or measurement date), the option is subject to deduction disallowance under Code section 162(m). The possibility that the stated exercise price was simply a mistake and could be reformed, because, for example, the terms of the plan required a fair market value exercise price, is not satisfactorily dealt with in the GLA.
Although the GLA mentions the taxpayer argument that the option is merely being corrected to meet plan requirements that the option exercise price be set at fair market value, and that state law may have required reformation of the grant, it does not address those arguments other than to say the option’s qualification as performance-based compensation is determined at option grant, a point which assumes, but does not meaningfully address whether the option, by its terms, really is a discounted option.
It appears the National Office’s GLA will encourage IRS examiners to press ahead with adjustments disallowing a deduction for options that have been the subject of a financial accounting restatement, regardless of how punitive this result is in light of the level of mistake made in setting the exercise price, and regardless of whether the mistake is corrected and, if so, how quickly. Taxpayers whose agents take this position should not lose heart, however. The GLA does not address hazards of litigation, although the position set forth therein clearly has many, and it may yet be possible to resolve the issue with a reasonable Appeals Officer or District Counsel attorney.
For additional information, please contact any of the following lawyers:
Frederick Oliphant, firstname.lastname@example.org, 202-626-5834
Elizabeth Drake, email@example.com, 202-626-5838
Gary Quintiere, firstname.lastname@example.org, 202-626-1491
Lee Spence, email@example.com, 202-626-5965
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