10 questions about the legality of management carve-outs
Employers value flexibility in designing their group health benefits so as best to attract and retain qualified personnel. One issue that remains perpetually murky, in this regard, is the legality of management carve-outs, whereby an employer offers certain group health insurance options or classes of coverage only to management or other highly paid groups.
The following true or false discusses some of the rules that come into play.
1) The ACA contains a rule that restricts employers’ ability to offer different insured group health benefits to highly compensated employees than to other employees.
True: Under Section 2716 of the Public Health Service Act, which was incorporated into the Affordable Care Act, non-grandfathered, insured group health plans generally must satisfy nondiscrimination rules similar to those that apply to self-insured group health plans under Section 105(h) of the Internal Revenue Code (“Code”). These rules generally require some measure of parity between higher-paid employees, and non-highly paid employees. Limited scope dental or vision plans provided under policies separate from group medical coverage are excepted.
2) However, the IRS is not currently enforcing the ACA nondiscrimination rules for insured group health plans.
True: In 2011, the IRS postponed enforcement of these rules, pending publication of regulations that will guide employers as to how to comply. As we approach the ACA’s eighth anniversary in March 2018, regulations have yet to issue. When regulations do issue they will apply on a prospective (going forward) basis.
3) Therefore employers have free reign to offer different benefits to management employees or other highly-compensated groups of employees.
False: Although there are some circumstances in which employers may offer different and/or better group health insurance to management or other highly-paid employee groupings, the Section 125 cafeteria plan rules do impose some design restrictions. These rules will apply to employers who have any type of Section 125 cafeteria plan arrangement, including premium-only plans (e.g., employees’ share of premiums are paid on a pre-tax basis, with no other cafeteria plan features) and to employers with other cafeteria plan features such as a health flexible spending account or dependent care flexible spending account. The rules are explained in the questions that follow.
4) All management employees are “highly-compensated employees” for cafeteria plan testing purposes.
False: First, the technical term is “highly-compensated individuals,” and it includes the following groups, which will not necessarily overlap 100% with an employer’s management group population:
Officers during the prior plan year
Greater than 5% shareholders (in either the preceding or current plan year)
Highly compensated employees (those earning more than $120,000 in 2017 are highly compensated employees in 2018)
Spouses or dependents of any of the above.
5) If I maintain just a premium-only plan and all employees can participate and elect the same salary reductions for the same benefits, the premium only plan is nondiscriminatory.
True. Proposed cafeteria plan regulations that issued in 2007 provide this safe harbor rule. Employers may rely on the proposed rules.
6) If I maintain just a premium-only plan and don’t meet the requirements of the safe harbor, the POP is automatically discriminatory.
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False. Under these circumstances your premium-only plan will not satisfy the safe harbor mentioned above, but it could still pass nondiscrimination tests under Code § 125(g)(2) or (3). The simpler of these tests is passed if contributions under the plan for all participants equal or exceed 75% of what is spent on the participant with the highest cost medical coverage under the plan. Other tests with more moving parts may apply; different cafeteria plan nondiscrimination tests also use definitions other than highly compensated individuals, as described above.
7) If my cafeteria plan fails all types of nondiscrimination testing, all is lost.
False. The 2007 proposed regulations permit “disaggregation” — breaking up one plan into separate component plans — one benefitting participants who have completed up to three years of employment, and another benefitting those with three or more years of employment. Each component plan must separately pass cafeteria nondiscrimination rules applicable to eligibility, and contributions and benefits. Plans that fail nondiscrimination testing as a whole may pass testing after permissive disaggregation. The proposed regulations did not discuss whether plans may be disaggregated based on factors other than length of employment, and further guidance on this point would be welcome.
8) The IRS does not audit cafeteria plans so it doesn’t matter anyway.
False. Although audits specific to a cafeteria plan are seldom seen, the IRS could expand a payroll audit or other business or benefit plan audit to encompass operation of a cafeteria plan, even a premium-only plan. Therefore it is important to comply with the cafeteria plan nondiscrimination rules.
9) Our company pays 100% of health premiums for highly compensated individuals directly to the carrier (or the employees pay themselves on an after-tax basis), so there is no cafeteria plan nondiscrimination issue.
True. However, any insured group health plan design that provides better treatment for higher paid employees may fall afoul of the ACA nondiscrimination regulations mentioned in questions one and two, when they issue; although the regulations will apply prospectively, neither employers nor their highly compensation staff should assume that preferential health plan designs are more than temporary.
10) A “simple” cafeteria plan is exempt from Section 125 nondiscrimination rules.
True. A nondiscrimination safe harbor applies to “simple” cafeteria plans under Code Section 125(j), however those plans are subject to other design restrictions that may prove unworkable for many employers, including mandated employer matching or non-elective contributions. They are also limited to employers with 100 or fewer employees on business days during either of the two preceding years.