From time to time we are asked about post-retirement health insurance as a fringe benefit in a closely held business. Can it be provided on a discriminatory basis? Is there any problem if the employee pays for the benefit? Can of the benefit to be modified or terminated after someone retires? The answer to these questions may surprise you.
From a legal standpoint, an employer has wide discretion in providing all fringe benefits, including post-retirement health insurance. It is permissible under federal law, for example, to provide insurance benefits on a discriminatory basis. Thus, post-retirement health insurance could be offered to some employees and not others. Additionally, there are no legal requirements that the benefit be paid by the employer. A post-retirement health plan can provide that the employee is responsible for the cost. Finally, the law is clear that post-retirement benefits may be modified or terminated by an employer so long as the employer reserves the right to do so.
However, the fact that something is permissible under law, does not necessarily mean that it can be done. The biggest obstacle to providing post-retirement health insurance to retirees of a closely held business are contractual restraints imposed by the insurance companies. Most health insurance companies impose very specific conditions on a provision of post-retirement health insurance. Frequently, such insurance can only be provided if it is offered to all retirees and if the employer pays a significant percentage (typically, at least 50%) of the annual premium. Insurance companies impose such conditions in order to protect themselves from so-called “adverse selection,” the tendency for insurance to be selected only by those who are quite ill and likely to use its benefits.
Occasionally, an employer will attempt to circumvent the contractual conditions of the insurance contract. For example, coverage is provided to an employee who is paying the entire cost of coverage, while the employer represents that it is paying for the coverage. This is a perilous course of action. When an insured has a large medical claim, the insurance company will typically perform an audit to confirm that the individual is eligible for coverage. If it is determined that the contractual conditions have not been satisfied, the insurance company has the right to deny coverage and deny paying benefits. If the retiree is lucky, the insurance company will return the premiums paid. If he or she is unlucky, they may be charged with insurance fraud.
While traditional health insurance policies only provide the retiree coverage in accordance with specified contractual conditions, there is a way for some individuals to obtain post-retirement health coverage legally. Many professional organizations, including the Ohio State Medical Association (OSMA) and the Ohio State Bar Association (OSBA) offer health insurance coverage to its members’ employers. These policies include specific provisions which permit the individual retiree to maintain coverage at his or her cost after retirement. Employers who have a strong desire to provide post-retirement insurance coverage should consider purchasing health insurance coverage through a professional or trade organization.
Controversy Surrounds Section 412(i) Plans
The “newest” retirement plan idea, the Section 412(i) Plan, represents a come-back of sorts for a retirement plan product that is actually decades old. This time, however, the insurance industry has captured the attention of the Internal Revenue Service. As a consequence, these plans are likely to be under attack by the Service within the next few months. Here’s something you should know if you are evaluating a Section 412(i) retirement plan proposal.
Section 412(i) does not refer to a specific type of retirement plan but rather a specific set of rules governing defined benefit pension plans. Generally, defined benefit pension plans are subject to complex funding rules set forth in Section 412 of the Internal Revenue Code. These rules define both minimum and maximum contributions that can be made in any year to a defined benefit pension plan. The objective of the rules is to assure that the employer contributes neither too little nor too much to a defined benefit pension plan.
Under Section 412(i), defined benefit pension plans that are funded solely through insurance or annuity contracts are exempt from the normal funding rules. Instead, funding is permitted based upon the minimum guaranteed rates included in the insurance con-tract. This generally means that larger tax-deductible contributions to the plan are permitted. Some insurers also assert that this means that larger amounts of cash are available at retirement, assuming that the contract outperforms the minimum guaranteed rate. This is where the problems start. To understand why Section 412(i) plans are in trouble with the Service, there are a small number of irrefutable truths about defined benefit pension plans that you must understand.
1. The maximum amount that can be paid from a defined benefit pension plan is described in Section 415 of the Code. The maximum benefit is the same regardless of whether a plan is funded with insurance or with traditional benefits.
2. The annual contribution required to a defined benefit pension plan is a function of the benefit payable at a specified in normal retirement age and an assumed rate of interest and rate of mortality. Larger contributions are generally permitted to a Section 412(i) plan, because the minimum guaranteed rates in the insurance contracts are generally much lower than interest rates at must be used by retirement plan actuaries under the regular funding rules.
3. When a defined benefit pension plan is terminated, any funds in the plan in excess of the amounts necessary to pay the maximum distributable benefits will revert to the employer. Any such reversion is subject to both ordinary income tax and a 50% excise tax. Thus, in a personal service corporation, the reversion is subject to an 85% tax rate.
Section 412(i) plans can be useful to an employer who desires to accelerate contributions. However, if the plan is to avoid being “overfunded” at termination, the employer must reduce contributions in later years. Many insurance companies believe they have developed a strategy that avoids both the need to reduce contributions and the rest that a large reversion will take place at the time the plan is terminated. The strategy typically involves a sale of the insurance contract from the plan to the insured a short time prior to the time the policy’s cash surrender value substantially increases. For example, we recently reviewed one proposal providing for contributions of more than $1.2 million over five years. At the end of five years, the policy would have a projected cash surrender value of approximately $700,000. The policy would be purchased for that amount by the insured. Two years later, the policy would have a cash surrender value in excess of $2.3 million.
If the strategy sounds too good to be true, the Internal Revenue Service agrees with you. In several recent public forums, including the annual meeting of the American Society of Pension Actuaries (ASPA) and the Annual Meeting of the American Bar Association Section of Taxation, representatives of the Internal Revenue Service has stated that they will soon be undertaking a program to crack down on abusive section 412(i) plans. In the short term, these plans may be added to to the group of “listed transactions” that must be as specifically identified on one’s tax return. One high-ranking IRS repre-sentative has suggested that the more abusive of these programs may implicate criminal laws.
Section 412(i) plans may nevertheless be appropriate in proper circumstances. In employers who anticipate a few years a very high profits followed by years of lower prof-its may want to accelerate contributions. Some individuals may prefer the more aggressive funding rules of Section 412(i) to fund retirement plans for asset protection reasons. So long as a Section 412(i) plan is designed conservatively, it can be a very useful tax planning tool. Used improperly, it can be a disaster.
Reminders About Employed Family Members
Last year we reported that the IRS has been more closely scrutinizing family members who are on company payrolls. The reason for this interest is that recent changes in pension law are making it more attractive than ever for business owners to employ his or her spouse or children. Under the new rules, an employee can make an elective deferral to a section 401(k) plan of up to the lesser of $12,000 or 100% of compensation. If a spouse is placed on the payroll, paid at least $12,000, and committed to participate in a section 401(k) profit sharing plan, it may be possible for the family to contribute another $12,000 to the retirement plan, without any increase in the cost of benefits for rank-and-file employees.
There is certainly nothing wrong with employing family members and providing them with reasonable compensation. However, compensation is only deductible if reasonable and for services actually rendered. The Service has stated that it will closely scrutinize payments of compensation to family members. Therefore, we’re recommending to all of our clients who employ family members to carefully document the nature and amount of work performed by the family members.
As a starting point, determine whether the family member employee is an exempt or non-exempt employee under federal wage and hour laws. A spouse or child may be considered exempt, if he or she is involved in management of the business. Exempt employees can be paid a salary and do not have to be paid time and one half for overtime. Most other employees are non-exempt and are therefore paid on an hourly basis.
At a minimum, time records must be maintained. While such records are generally not required with respect to exempt employees, records should nevertheless be kept for family members regardless of the nature of their duties. Of course, for non-exempt employees, the law requires these records. Additionally, a written log of the services performed by the family member, if prepared on a contemporaneous basis, will provide good evidence to refute an unreasonable compensation claim. Such records are particularly important when the family member works off site or outside normal business hours.
Michael P. Coyne
1991 Crocker Road, Suite 550
Cleveland, Ohio 44145