Who Benefits?

New laws require that you test your health- and life-insurance benefit plans this year if they are to remain tax free

One provision of the 1986 Tax Reform Act, which becomes effective in 1989, will probably give you headaches before year's end. New Section 89 of the tax code is designed to ensure that employers who provide tax-free benefits to their employees distribute them fairly. Unfortunately, the tests to determine this are complicated, time consuming, and possibly expensive. Worse still, some of the regulations won't even be out until after the law takes effect. While Section 89 focuses on health- and life-insurance benefits, it sometimes applies to other welfare plans as well.

Failing to comply with Section 89 could have serious consequences. In the worst case, all your plans will be disqualified, and all benefits to employees will be considered taxable income. What's more likely to happen, though, is that your highly compensated employees (see "Just What Is an HCE?," page 2) may have to pay taxes on the difference between what you pay for their benefits and what you pay for the rest of your employees.

Variations, exceptions, and exclusions to the rules abound. Since the regulations take effect on the first day of your 1989 plan year, it's important to develop a strategy. Your best choice will depend on many factors, including your company's size and cash flow. Especially important is the makeup of your work force: the number of part-timers, professionals, and entry-level employees, and their ages. A working knowledge of the law will get you started.

Consider Section 89 as two separate statutes. One section deals with the basic criteria that every plan must comply with to qualify for any tax benefits. If you don't meet these criteria, your employees will have to pay taxes on every benefit -- such as the cost of surgery -- they receive. Fortunately, these criteria are straightforward and relatively easy to satisfy:

* Your plan must be in writing by the end of your 1989 plan year.

* It must give your employees legally enforceable rights. For instance, the plan can't say that you'll provide benefits at your discretion.

* Every employee must have reasonable notice -- posted on a bulletin board, for example -- of the benefits available under the plan.

* You have to maintain the plan for the exclusive benefit of your employees. In some cases, of course, spouses and dependents may also benefit from it.

* The plan must be set up with the idea that it will be maintained indefinitely.

The second section of the statute is a series of tests designed to ensure that your plan does not discriminate in favor of what the Internal Revenue Service calls highly compensated employees. In short, the tests measure who is eligible to receive benefits and whether the benefits are reasonably consistent across all salary levels. (See "Testing, Testing," page 2.) There's also an alternative, simpler test that may apply to your company, particularly if you have a fairly uniform benefit structure. You pass if your plan (or group of comparable plans) provides benefits to at least 80% of your non-highly compensated employees.

If your plan does not meet the tests on the first cut, you should check the law's exceptions to see if they'll help you pass.

Certain employees don't have to be included in your tests: employees who work fewer than 17.5 hours per week or fewer than six months a year, employees who have been with you for less than a year, employees who are under 21 -- or your plans' minimums in any of these areas, whichever is less. In addition, nonresident aliens who have no income from U.S. sources may be excluded, as may employees covered under collective-bargaining agreements, in rare cases. In certain circumstances, you may exclude any employees and dependents covered by another employer's health plan. You'll need to get sworn statements from these employees that they're covered elsewhere.

Although in most cases employees who share the same management must be tested together, employees in different lines of business may sometimes be tested separately. The Treasury Department hasn't yet defined a separate line of business, but it must have at least 50 employees, and you must notify the Secretary of the Treasury that you will be testing employee-benefit plans by line of business. There also are various ways to combine benefit plans or to integrate them with Medicare. In addition, other employee groups may be excluded or tested separately to see if they meet nondiscrimination and eligibility requirements.

If no matter how you separate, aggregate, and exclude your employees, you can't pass all the eligibility and benefits tests, your highly compensated employees will owe taxes on what is called the "discriminatory excess" -- the cost of the benefits they receive, in excess of the comparable amounts provided non-highly compensated employees. You must report this figure as taxable income on their W-2 forms. If you fail to report a discriminatory excess, your company will have to pay tax on that amount at the highest personal tax rate. This penalty applies even if the employees have paid the tax. And you can't deduct the penalty or offset it with other credits or deductions.

What are your options under Section 89? Everyone who offers tax-free benefit plans should make sure to satisfy the basic Section 89 qualification criteria. Doing so is relatively easy, and the consequences of failure are draconian: all employees are penalized.

Failure to comply with most other aspects of the rules has less extreme consequences, so your options are greater.

* If you have a benefit plan that is reasonably standard throughout your company, doing the paperwork to show that you pass the alternative 80% test will probably be your best, most straightforward option.

* If the 80% test doesn't work for you, there are other choices. At a minimum, you'll probably want to identify your highly compensated employees. They'll be taxed on the value of benefits they receive -- that is, what you pay for their premiums. You may want to raise their salaries to cover the additional taxes.