Typically, when we terminate a management or executive employee, we agree to pay all or part of their COBRA premiums for a period of time. What compliance concerns should we consider?
While an employer may subsidize COBRA for terminated employees, including management and executives, there are potential compliance traps for the unwary. These include COBRA notice and election procedures, the impact on eligibility for enrollment in an exchange/marketplace plan and mid-year election events under the Internal Revenue Code's ("Code") Section 125 rules, as well as navigating nondiscrimination rules and potential deferred compensation tax issues under Code Section 409A.
When the underlying group health plan is self-insured, the tax issues are particularly thorny when highly compensated individuals disproportionately benefit from these arrangements, as it is unclear how the Code Section 105(h) nondiscrimination regulations apply to former employees. (It's easier for fully insured groups to avoid the Non-Discrimination Testing (NDT) issues, since Section 125 NDT would only be implicated if former employees could pay COBRA premiums pre-tax from severance pay.) A tax advisor or experienced legal counsel should always be involved when structuring the agreement.
Accordingly, a simpler route to the desired goal can be to provide a lump sum payment that qualified beneficiaries can use to either purchase COBRA or other coverage, e.g., through a spouse's employer or through the individual marketplace.
Employers need to comply with applicable COBRA notice and election procedures, such as ensuring that employees make a formal COBRA election even if the COBRA premium is 100% subsidized.
When crafting these arrangements, employers need to comply with applicable COBRA notice and election procedures, such as ensuring that employees make a formal COBRA election even if the COBRA premium is 100% subsidized. If the employee has not followed all of the procedures to elect COBRA, then problems with the insurer and/or stop-loss provider could arise, potentially leaving the employer ultimately responsible for self-insuring claims. Thought should also be given to what departing employees will do after the COBRA subsidy expires, regardless of whether it's a bridge to Medicare or if the former employee will be looking for private coverage at the end of the subsidy. Sponsors of self-funded health plans must also contend with the Code Section 105(h) nondiscrimination rules (and fully insured plans are still subject to Section 125 nondiscrimination rules, which could pose a testing problem if former employees are permitted to make pre-tax contributions through the cafeteria plan).
Some employers have assumed, incorrectly, that if they are subsidizing COBRA coverage for the entire COBRA period there would be no need for a notice or election. Even here, the formal election process should be followed. There have been instances where a stop-loss carrier has examined the large claims of a former employee; even when all claims were incurred within the COBRA period, the stop-loss carrier successfully claimed that COBRA was not properly elected because no COBRA election form was completed, making the employee ineligible for coverage under the terms of the applicable plan. Accordingly, the stop-loss carrier was able to claim that it had no liability, resulting in the employer having to self-fund claims above the stop-loss attachment point. This liability can be enormous.
The same issue could arise with a fully insured plan, and the plan's insurer could refuse to provide coverage for an employee who is ineligible under the terms of the insurance policy because COBRA was not properly elected. In addition, consideration should be given to future insurers/stop-loss carriers, since they may not be willing to honor agreements the current vendor(s) are willing to accommodate.
In short, employers should make sure they have properly documented timely and complete COBRA notices and elections even where COBRA coverage is 100% subsidized.
In the question posed, the subsidized coverage typically lasts for a specified period of time, but presumably not for the entire time that COBRA should be available. What will the executive do after the subsidy expires? Of course, one option is to pay the full COBRA rate for the remainder of the COBRA period. Or, perhaps, the COBRA payment was a "bridge" to Medicare and the former executive will be enrolling in Medicare when first eligible.
However, there are instances where former employees will find that coverage on an exchange/marketplace is less expensive than paying the full amount for COBRA coverage after the subsidy ends. Whether the former employee would have to wait for an open enrollment period on the exchange/marketplace or whether they would have a special enrollment right is an open question.
In reviewing the regulations and applicable guidance, there is no reference to a COBRA subsidy as a qualifying event for special enrollment rights on an exchange/marketplace.1 While the termination of employment is a special enrollment qualifying event, there are time limits for the election. The end of the entire COBRA period, however, would be a qualifying event.
Even in the absence of specific guidance with respect to the end of a COBRA subsidy being a qualifying event for special enrollment in an exchange/marketplace, the healthcare.gov website has listed it as an enrollment opportunity: https://www.healthcare.gov/unemployed/cobra-coverage. In particular, the website states that an employee will be eligible for special enrollment "if your COBRA costs change because your former employer stops contributing and you must pay [the] full cost."
Even though that language is on the healthcare.gov website, anecdotal accounts indicate that the U.S. Dept. of Health and Human Services might not be administering the federal exchange/marketplaces to provide special enrollment at the end of a subsidy. Also, a state-run exchange/marketplace might not permit special enrollment.
In short, at this point, there is no guarantee that an employer or former employee can rely on the end of a COBRA subsidy as a special enrollment opportunity in an exchange/ marketplace. The most conservative approach would be to plan as if the end of the COBRA subsidy will not be a special enrollment event, meaning the employee could be locked out of the exchange/marketplace until the next open enrollment period and locked into paying the higher COBRA rates until other coverage is available.
Similarly, the departing executive may find employment with another employer and not elect coverage with that employer because of the subsidized COBRA coverage. Can that executive then elect coverage under the other employer's plan as a mid-year qualifying event on the expiration of the subsidy? Though some plans might nonetheless permit it, if premiums would be deducted on a pre-tax basis, the expiration of an employer COBRA subsidy is not generally considered a permissible mid-year event under Code Section 125 regulations.
For example, HIPAA special enrollment rights are available for the termination of employer contributions for nonCOBRA coverage or for the exhaustion of COBRA coverage, but not for the termination of employer contributions/subsidy to COBRA coverage prior to the exhaustion of the maximum COBRA period. Accordingly, the employee may not be permitted to enroll in the other employer's plan following the loss of the COBRA subsidy and may again be locked into paying the higher COBRA premiums until the employer's next open enrollment period.
While some experts do take the position that a midyear election may be permitted under Code Section 125 regulations based on the qualifying event of a change in coverage under another employer's plan, because this situation could inadvertently harm the employee that the employer is trying to benefit, legal counsel should be consulted to review the exact terms of the Section 125 plan document and to help weigh potential risks.
If the plan is self-funded, there are a number of additional tax considerations. For highly compensated individuals (HCIs) to receive tax-free benefits from a self-insured medical plan, that plan must be non-discriminatory as provided in Section 105(h) of the Code. How the regulations under Section 105(h) apply to former employees is unclear, complex, and in the view of many, seriously flawed.
The regulations address "retirees" and state that there is no discrimination for a retired employee if "the type, and the dollar limitations, of benefits provided retired employees who were highly compensated individuals are the same for all other retired participants."2 Very few retiree medical plans meet this standard.
There is no guarantee that an employer or former employee can rely on the end of a COBRA subsidy as a special enrollment opportunity in an exchange/marketplace.
And, if the terminated executives in this question are treated as retirees, then they clearly do not meet this standard since the COBRA subsidy appears to only be available to management or executive employees. Even if grouped with active employees for coverage, the HCIs in this question are receiving benefits and contributions (the COBRA subsidy) not received by other employees, so there would be a discrimination issue.
The solution often used by employers in this situation is to turn to another Code section to establish that payment of any benefits is non-taxable. Under Code Section 104(a)(3), benefits paid under a medical plan will be non-taxable to the extent that the cost of the coverage was taxable to the employee. In other words, as long as the departing executive pays fair market value on an after-tax basis for the coverage then benefits should be non-taxable. The IRS, however, has never determined what constitutes fair market value. Many employers use the COBRA rate for the coverage for this purpose, excluding the additional 2% administrative fee. The IRS has informally been asked whether this is a correct calculation of fair market value and has refused to respond either way. Even without official IRS guidance, some employers do impute the income for the subsidy to the departing employee under this arrangement, although there are still questions as to whether this is appropriate or whether the departing employees should pay the entire amount and then be reimbursed as taxable income.
While fully insured plans are not subject to the nondiscrimination provisions of Section 105(h), Code Section 125 nondiscrimination rules would if COBRA premiums are made pre-tax through a Section 125 plan. If a Section 125 plan is drafted to allow for this arrangement, employees making pre-tax salary reduction contributions may be able to continue making these pre-tax contributions under the plan for COBRA coverage under a severance agreement if certain conditions are met. However, allowing these pre-tax payments for COBRA coverage can raise potential discrimination issues under the Section 125 plan, which would be problematic if they discriminate in favor of highly compensated individuals.
In addition, severance agreements that call for the reimbursement or payment of subsidized group medical coverage after termination of employment are subject to Code Section 409A unless an exception applies. This Code Section sets forth strict and complex rules for "deferred compensation" that is not paid pursuant to the terms of a qualified retirement plan. Section 409A's definition of "deferred compensation" is extremely broad and touches most severance agreements or severance plans (if only to try and fit the agreement/plan into an exception to 409A's provisions). Accordingly, legal counsel should review all individual severance agreements and severance plans.
Code Section 409A does not apply to the following types of medical reimbursement arrangements:
While there are several other exceptions, such as a shortterm deferral exception and a limited severance pay exception, those listed above are the most frequently used in the Code Section 409A context for post-severance medical. If an employer cannot meet an exception, there are also specific methods of complying with Code Section 409A for in-kind benefits, including continuation of medical coverage.
In particular, (1) the benefits must be nondiscretionary and objectively determinable; (2) the benefits must be paid over an objective and specific time period; (3) the benefits in one taxable year cannot affect the benefits in another taxable year;(4) the reimbursement of any expense must be made before the last day of the taxable year following the year in which the expense was incurred; and (5) the right to the benefits cannot be subject to exchange or liquidation for another benefit.
Generally, employers providing employees with taxable compensation to cover COBRA (or any other health insurance costs) will want to structure these arrangements to fall within an exception to Code Section 409A. Again, legal counsel should be consulted with any severance agreement for Code Section 409A compliance. Employers need to look at both the benefits being provided as well as the taxable reimbursement of any "premiums" for Code Section 409A purposes.
Subsidized COBRA for terminated employees is permissible and a common part of many severance packages. However, employers need to consider not only the COBRA rules and departing employees' choices for coverage after the subsidy expires but also potential complications under nondiscrimination rules, as well as potential deferred compensation issues under Code Section 409A. Accordingly, legal counsel or a tax advisor should be consulted on the matters discussed in this Q&A when structuring these arrangements.
McGriff Employee Benefits Compliance Team
