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.
* If you choose to run additional tests to identify any discriminatory excess, your highly compensated employees will be taxed instead on that cost. Again, you can elect to raise their compensation to cover the additional taxes. Your choice between this option and the preceding one will depend on your estimate of the cost of the testing, weighed against the cost to your employees of the tax hike -- and to you if you decide to cover that expense. Obviously, the tax on the discriminatory excess will be smaller than that on the entire benefit.
* You can change your benefit plans to eliminate the discriminatory excess either by extending coverage to your non-highly compensated employees or by reducing the coverage of your highly compensated employees.
* You can make no effort to comply and tell employees they're on their own so far as taxes are concerned.
* Finally, you can eliminate your benefit plans entirely.
As you can see, Section 89 is complex -- witness the number of workshops, handbooks, and the like that benefit specialists have put together. Your strategy for dealing with the law will depend on your company's particular circumstances and, ultimately, on what you want your benefit plans to accomplish.
JUST WHAT IS AN HCE?
To comply with Section 89, you have to identify your highly compensated employees
According to the IRS, an HCE is:
* Any employee who owns 5% or more of your company.
* Any employee who earns more than $50,000 annually and is in the company's top 20% in compensation.
* Any employee who is an officer of your company and earns more than $45,000 per year. No fewer than one and no more than 50 officers may be included.
Determining whether your plan continues to qualify for tax-free benefits under Section 89 involves several steps
The IRS asks you to measure both who is eligible to receive benefits and whether the benefits are reasonably comparable in order to exempt them from employees' income tax. If you don't qualify under the 80% test described in the text, here are the additional tests:
* At least 50% of employees eligible to participate in a plan must be non-highly compensated. Say you have 10 people in your company, and all receive benefits. If 6 of those meet the IRS definition of highly compensated employees, you would fail the test, because only 40% of those eligible are non-highly compensated. But there's another test you can try. The percentage of non-highly compensated employees eligible to participate must be at least equal to the percentage of highly compensated employees eligible. So, in our example, if everyone in your 10-person company was eligible to participate, you would pass, since 100% of both non-highly compensated and highly compensated employees receive benefits.
* At least 90% of non-highly compensated employees must be eligible for benefits worth 50% or more of what the most highly compensated employees get. For example, an entry-level secretary must be eligible for a benefit worth at least half what the chief executive officer could get.
* A plan can't contain any provision that, by its terms or effects, discriminates in favor of highly compensated employees. For example, the IRS may rule that a plan is discriminatory if it's designed to meet the unusual needs of a few highly compensated employees -- covering a particularly disability, say -- even though the benefits are theoretically available to all.
* What benefits does your plan actually deliver? The new law specifies a test here, too. The average value of benefits for all non-highly compensated employees must be at least 75% of the average value of benefits for highly compensated employees.
* Benefits of employees who terminate after January 1, 1989, must be counted. Benefits to employees who left the company before then need not be counted in the tests -- unless they are rehired after January 1 or the benefits are modified.
HOW TO CALCULATE THE VALUE OF YOUR EMPLOYEE BENEFITS
For now, at least, the procedure is anything but simple
Both the eligibility and benefits tests require that you place a value on the benefits you provide, and the IRS is developing procedures for valuation. In the meantime, here's what you should do:
* Life insurance. Special, complex tests are required for life insurance to which employees contribute. Are you sitting down for this one?
You determine the value of the benefit you provide as a percentage of the employee's compensation. To do that, divide your contribution by your employee's contribution. Then multiply this ratio by the face value of the coverage. Divide the resulting dollar figure by your employee's compensation. Next, find the appropriate value for the resulting percentage in an IRS tax table, and multiply the two figures to calculate a hypothetical standardized annual premium.
It's these IRS-adjusted premiums that are compared to your plan's premiums to determine whether the plan is discriminatory. Group term life insurance won't be treated as discriminatory if the amount of coverage employees receive is an equal percentage of their compensation across the board. For instance, if all eligible employees are covered by life insurance equal to four times their salaries, the law says there is no discrimination.
* Health-care plans. The Treasury hasn't yet come up with workable standard tables of value for health-care plans. So for now, employers can use their actual cost or any other actuarially reasonable method. If you use your actual costs to value the benefits your employees receive, you can make reasonable adjustments to compensate for differences in your costs that are due to location, demographics, or how different employee groups use plans that offer the same benefits. Whatever method you choose, you must use the same one for all your health-care plans and keep good records for IRS audits.