Introduction

The recent Final Regulations provide that Code Section 409A does not apply to an Archer Medical Savings Account, a Health Savings Account “or any other medical reimbursement arrangement, including a Health Reimbursement Arrangement, that satisfies the requirements of [Code] section 105 and section 106 such that the benefits or reimbursements provided under such arrangement are not includible in income.” Treas. Reg. § 1.409A-1(a)(5). This provision exempts the vast majority of employer-sponsored health plans from the reach of Section 409A’s rules. However, because this provision of the Final Regulations only exempts health coverage and benefits that are excludable from income, Section 409A could apply to any health plans that provide (or potentially provide) taxable coverage or benefits.

Discriminatory Arrangements under Code Section 105(h)

Discriminatory Arrangements. One circumstance that can trigger health benefits becoming taxable is when a self-insured health plan violates Code Section 105(h). Section 105(h) provides that a self-insured health plan must not discriminate in favor of highly compensated individuals (“HCIs”) as to eligibility to participate or as to benefits provided under the plan (either in general or in operation). Code Section 105(h)(5) provides that an HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10% of stock of the employer, or (c) among the highest paid 25% of all employees. Therefore, due to the 25% rule, an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code section 414(q). Arrangements that violate Section 105(h) are referred to in this Alert as “discriminatory arrangements.”

There are a number of self-insured health plan arrangements that can potentially violate Code Section 105(h), thereby making the health benefits taxable to the HCIs. The prototypical example is where the employer provides special health coverage (e.g., supplemental top-hat coverage) for executives and/or directors that is not available to other employees. Most employers maintaining this kind of special coverage are generally aware of the discriminatory character of this kind of design. Traditionally, therefore, many have tried to take the position that they are providing insured coverage. For example, they may purchase coverage that officially describes itself as insurance, even though the premium structure for the arrangement may belie the existence of meaningful risk shifting. See, Treas. Reg. § 1.105-11(b)(1)(ii) (“insurance … that does not involve the shifting of risk to an unrelated third party is considered self insured”). While the lack of real risk shifting (in whole or in part) in the case of this kind of coverage presents exposure under Section 105(h), having something that is officially labeled “insurance” at least permits an argument that Section 105(h) does not apply, and thus that the benefits are non-taxable. Given the level of employer exposure posed by Section 105(h) before Section 409A became effective, many employers considered such an argument to be a sufficient response to Section 105(h)’s nondiscrimination requirements for self-insured health plans. However, unless the employer can avoid running afoul of Section 409A in connection with this kind of an arrangement, 409A significantly increases an employer’s exposure (as well as the covered employee’s exposure).

Another common circumstance that involves exposure under Section 105(h) is where the employer provides post-employment continued coverage under its regular, self-insured health plan on terms that are more favorable to HCIs. In this situation, however, it has been typical for employers to dispense with purchasing coverage that is labeled “insurance.” For example, the following specific cases are relatively common: 

  • Granting retiree health coverage to one or a few HCIs, when providing such coverage is not otherwise a part of the employer’s personnel policies.
  • Granting a period of post-employment health coverage in connection with a severance program to a group of employees who are exclusively or disproportionately comprised of HCIs.
  • Allowing an HCI to qualify for the employer’s retiree health coverage on terms that are preferential. This could be done directly (e.g., waiving a service or age requirement), or it could be done indirectly (e.g., providing an extended leave of absence to permit the HCI to meet the usual age and service requirements, when a comparable leave period would not be available to a non-HCI).

The regulations under Section 105(h) contain relatively undeveloped rules for determining whether post-employment medical coverage is discriminatory. They merely provide that a particular former HCI’s retiree coverage is excludible from income only if all non-HCI retirees have retiree coverage that is at least as rich. Treas. Reg. § 1.105-11(c)(3)(iii). A full discussion of how to apply this facially quite rigid rule is beyond the scope of this Alert. However, taking into account both this rule and the rule prohibiting discriminatory operation (Treas. Reg. § 1.105-11(c)(3)(ii)), it seems reasonable to conclude that the post-employment situations described above would be discriminatory under Section 105(h).

Effect under Section 105(h). Once a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the current or former HCIs (i.e., the medical claims that are paid) are treated as taxable income to these HCIs. See, IRC § 105(h)(7); Treas. Reg. § 1.105-11(e)(2) and (3). Under Treasury Regulation § 31.3401(a)(19)-1, this income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. Notwithstanding the withholding exception, however, the resulting income is still reportable as taxable wages on an employee’s Form W-2 (see, Treas. Reg. § 1.6041-2(a)(1) which provides for reporting of wages and other payments of taxable compensation). Still, the lack of a requirement to withhold on amounts taxable under Section 105(h) has made employers more willing to accommodate employee requests for special health coverage arrangements, because the risk of being discriminatory under Section 105(h) traditionally fell upon the employee.

The Section 409A Impact of Section 105(h) Discrimination

General Rule. In general, Section 409A applies to any plan or arrangement that provides for the deferral of compensation. A plan will provide for the deferral of compensation if under the terms of the plan and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that has not been received and included in gross income, and that pursuant to the terms of the plan or arrangement is payable in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced or eliminated after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation (so-called “negative discretion”) is available or exercisable only upon a condition, or the negative discretion lacks substantive significance, a service provider will be considered to have a legally binding right to compensation. See, Treas. Reg. § 1.409A-1(b)(1).

Application of Section 409A. Section 409A can apply to a discriminatory arrangement due to the interaction of two factors. First, to the extent the arrangement is viewed as providing discriminatory medical benefits under Section 105(h), the medical benefits (which are compensation) become taxable compensation to the HCIs. This satisfies the requirement under Section 409A that the promised payments be taxable compensation. Then, to the extent, the arrangement provides that the HCIs have a legally binding right to be paid a medical benefit in a future year, this satisfies the deferral requirement of Section 409A. Note that coverage in a future year is not required. Rather, it is sufficient if the right to payment carries over to a future year, even if the coverage will not.

Effect of Code Section 409A’s Application

Once Code Section 409A applies to a discriminatory arrangement or other taxable health coverage, the health benefits provided pursuant to the arrangement must comply with the requirements of Code Section 409A. Unfortunately, there is an inherent inconsistency between how medical plans determine the time of payment of reimbursements and how Code Section 409A requires plans to determine the time of payment of compensation that is subject to Code Section 409A. Health plans determine the timing of payments based on when a claim is incurred and submitted for reimbursement. Under Code Section 409A, all payments must be triggered by certain events that qualify under Section 409A or be based on a pre-set schedule. Neither incurring nor submitting a claim is an event that qualifies under Section 409A. Therefore, except to the extent that certain special rules are met, ordinary medical reimbursement plans that make payments based on when claims are incurred and submitted will not comply with Section 409A.

This is a significant issue because the penalties under Section 409A are designed to get attention. If there is noncompliance with Section 409A, then the compensation that is deferred (i.e., the amount of the health benefits paid in each year under the health plan) is treated as taxable income. This is the same rule as provided by Section 105(h), but Section 409A substantially raises the stakes for the employer by making this compensation subject to employer withholding (as well as to the related penalties for failing to withhold). Furthermore, Section 409A triggers compensation inclusion under all plans of the same type. Within the scheme of Section 409A, a health plan will generally be a “nonaccount balance plan.” Thus, if the employer also offers the employee a nonqualified SERP that provides a defined benefit, the failure under Section 409A of the employee’s health coverage can trigger taxation of not just the health benefits, but also the total amount due to the employee under the SERP as well (except for pre-2005 SERP accruals that qualify as grandfathered under Section 409A). Then all of this taxable compensation is subject to a 20% penalty and penalty interest. The penalty interest builds up the longer the amount is deferred. (Indeed, there could eventually be cases where the combination of regular income taxes, the 20% penalty and built-up penalty interest result in the affected employee owing the Service and state tax authorities more than the employer payments the employee is receiving; even today this could happen when the failure of the health plan triggers adverse tax consequences under one or more other plans of the employer.) The regular compensation, the 20% penalty compensation and the penalty interest must be reported on a Form W-2 or 1099 with respect to the affected individual.

In view of this, the special rules discussed below that can prevent the triggering of Section 409A’s adverse tax consequences are especially important (whether they operate by exempting the arrangement from 409A coverage or by permitting the arrangement to comply with 409A).

Special Provisions for Health Plans Under the Final Regulations

If Section 409A applies to a discriminatory arrangement or taxable health coverage, the Final Regulations provide two special rules – the COBRA exemption from 409A coverage and the special compliance rule.

COBRA Exemption. To the extent that a separation pay plan (including a plan providing payments due to a voluntary separation from service) entitles an employee to continued health coverage post-termination, the Final Regulations provide that the employee does not have a deferral of compensation with respect to health coverage that is provided during what would be the applicable COBRA continuation period (assuming the employee elected and paid for COBRA coverage). Treas. Reg. § 1.409A-1(b)(9)(v)(B). On its face, therefore, this provision can exempt from Section 409A health coverage that is continued for the duration of the COBRA continuation period that would apply with respect to the employee (e.g., generally 18 months or, in the case of a qualifying disability, 29 months). As a result, this exemption initially appears to offer a more administrable replacement for a different special exemption for health plans that was included in the proposed regulations. See, Prop. Reg. § 1.409A-1(b)(9)(iv)(A). The proposed regulations’ exception focused on when a benefit payment was made, rather than on when it was incurred (i.e., the payment period rather than the coverage period). The Final Regulations offer an appealing change because it is easier and more predictable to time-limit health plan benefits based on when an eligible expense is incurred.

At the same time, the way the Final Regulations’ COBRA exemption is worded, it appears to pick up all the exceptions that would normally end the COBRA period earlier than the standard 18, 29 or 36 month limits, such as obtaining Medicare coverage or obtaining other group health plan coverage that does not contain certain pre-existing condition exclusions. The specific wording is as follows:

[S]uch plan does not provide for a deferral of compensation to the extent [medical reimbursement] rights apply during the period of time during which the service provider would be entitled (or would, but for such plan, be entitled) to continuation coverage under a group health plan of the service recipient under section 4980B (COBRA). Id.

The fact that the provision specifically provides for disregarding the coverage under the employer’s plan (“such plan”), in determining what would be the duration of COBRA for the employee, draws attention to the fact that there is no similar provision permitting coverage under other plans to be disregarded. Thus, the language of the exception initially would appear to require employers to continuously monitor the coverage to determine if the COBRA period would terminate earlier, rather than simply relying on the standard 18, 29 or 36 month periods. For most employers, this would simply be infeasible.

Nonetheless, even though the literal language of the Final Regulations carries this implication, representatives from the Service and Treasury have all clearly indicated in public remarks that the language is intended to permit continuation coverage to be exempt from 409A for the standard COBRA periods, even if the employee obtains other coverage. In short, the language is not intended to bring into play the various events that would terminate COBRA earlier than the standard COBRA periods (i.e., 18, 29 or 36 months, as applicable). This helpful interpretation is supported by the fact that the discussion of the exemption in the preamble of the Final Regulations reflects that it was intended to be more favorable than the exemption contained in the proposed regulations. While it certainly would have been preferable if the Final Regulations did not present this issue, the interpretation proffered by representatives of the Service and Treasury, backed up by the comments in the preamble, are likely to be enough for most employers.

There are also two other important points to note about the COBRA exemption. First, it applies for what would have been the COBRA period, even if the post-termination health coverage actually extends for longer than the COBRA period. Thus, under the exemption the first 18, 29 or 36 months (as applicable) could be fully exempt from 409A in a case where the coverage continues longer. Second, because the COBRA exemption applies to the period of the extended coverage (rather than the period when reimbursements may be received), this exemption allows the health plan to operate normally during this period. Thus, claims for expenses incurred while coverage was in effect may be filed after the exempted coverage period terminates under the plan’s regular run-out rules, and reimbursements for benefit claims may also be made and received under the plan’s regular rules.

Special Compliance Rule. The Final Regulations also provide a new rule that will allow non-exempt health coverage to be deemed compliant with 409A. The special compliance rule allows the health coverage to comply with the 409A payment rule of a specified date or fixed schedule of payments. To comply with 409A pursuant to this new rule – (1) the health plan must provide an objective, non-discretionary definition of the expenses eligible for reimbursement, (2) the period of coverage provided needs to be specified, (3) there can be no right to any other benefit or any payment in lieu of the specified coverage, and (4) reimbursement must be made not later than the end of the year following the year in which the expense was incurred. Treas. Reg. § 1.409A-3(i)(1)(iv). In addition, while plan benefit limitations are broadly permitted, there cannot be other elements of the arrangement that cause the payments made in one taxable year of the employee to affect the expenses eligible for reimbursement in any other taxable year, i.e., the arrangement should not operate to shift payments between different tax years.

With respect to the first requirement, it should be possible for a plan sponsor to retain the right to make permanent reductions in benefits (pursuant to a reserved amendment authority). On the other hand, benefit enhancements pose a more difficult question. However, it appears that providing the same coverage that is provided to active employees should be an objective definition that would obviate this issue, at least when there is a broad group of covered active employees and any benefit changes to active coverage are done categorically for bona fide business purposes. Thus, reductions and enhancements made to active employee coverage (and that carry-over to coverage provided under this rule) should be acceptable under the first requirement. In any event, the coverage should be pre-specified from the date the deferral is deemed to occur under 409A.

With respect to the second requirement, it is unclear how specific the coverage period must be in order to satisfy the rule. For discriminatory retiree coverage, it would seem sufficient to specify that the coverage is provided for the period immediately following the participant’s retirement and continuing for the life of the participant (with retirement being defined as termination after attaining either specified age and service requirements or just a specified age requirement). For purposes of a discriminatory severance program, a plan sponsor would most likely need to specify the term of years that coverage is provided post-termination. However, note that the special compliance rule does not apply only to post-termination situations. Very importantly, this special rule applies equally to both active employee discriminatory arrangements and post-termination discriminatory arrangements. Further, because the COBRA exemption does not apply to discriminatory coverage for active employees, such active employee coverage (e.g., supplemental top-hat coverage) will need to rely on this special compliance rule to avoid running afoul of Section 409A. As with the first requirement, the coverage period should be pre-specified from the date the deferral is deemed to occur under 409A.

The third requirement – no rights to other benefits or payments – generally should not be a problem. For example, discriminatory health coverage (such as a top-hat supplemental plan) usually would not be provided through a cafeteria plan, but this is still something to watch out for. The fourth requirement – the time limit on reimbursements – will often be difficult to satisfy administratively, because the deadline is not tied to when a claim is incurred, or even to when the claim must be submitted. Rather, it is based on when the payment of the claim may occur. The maximum time period for payment runs from a year plus a day (at the low end) to two years less a day (at the high end). In order to meet the shortest possible payment deadline, a plan will presumably need to move up the claims submission deadline to a time that is likely to be materially earlier than applies under a typical plan’s claims submission deadline today. Specifically, to allow time for claims reviews and appeals, it may be necessary to require claims to be submitted within a relatively short period of time after they are incurred (e.g., six months). Because the health plan will likely have other participants in the plan than those participants that are limited by this payment rule, the plan’s third-party administrator will need to be able to administer one run-out period for regular participants (e.g., two years) and a shorter run-out period (e.g., 6 months) for those participants subject to this special compliance rule.

If the third-party administrator cannot administer two separate run-out periods, an employer may be able to protect itself from withholding liability by having the affected participant sign a written agreement that he/she and all applicable family members will not submit any claims after the shorter run-out period has passed, and that they will repay any payments made after the claims payment deadline applicable under the special compliance rule. Whether this will ultimately be sufficient currently remains unclear. Still, if an employer obtains such a written affirmation and a claim is not paid within the time period required by the special compliance rule, the employer can seek repayment and thus arguably has a reasonable basis not to report the amount as taxable compensation under 409A and thus not to withhold the applicable taxes. It would be critical in this case, however, not to accomplish such a “repayment” by offsetting the repayment amount against amounts due the participant in a subsequent tax year, as this would violate the prohibition on shifting payments between tax years.

Using a shorter run-out period for submitting claims (e.g., 6 months) would mean the plan has approximately 18 months (at the high end) and 6 months (at the low end) to make the payment for the claim. A typical situation that may cause the claim to not be paid within this time frame would be a dispute over the amount or the incurred expenses. In this regard, the Final Regulations allow a delay in the time of payment for bona fide disputes and refusals to pay. See, Treas. Reg. 1.409A-3(g). If this delay rule can be applied to the area of health coverage, it would cover situations of extended disputes regarding benefit claims. While the Final Regulations do not expressly indicate that this delay rule applies for purposes of the special compliance rule, as written it appears to apply in this context, and thus it should help to make the special compliance rule more workable for employers and employees.

105(h) Still Applies. If one or both of the special provisions noted above are satisfied, the discriminatory arrangement would not run afoul of 409A. However, the potential for exposure under Section 105(h) would remain. That exposure may be greater than in years past if Section 409A becomes, as it reasonably could, the catalyst for greater focus by the Service on health plan nondiscrimination. Still, the draconian penalties of Section 409A would not apply.

Other Methods to Avoid Code Section 409A Application

As discussed below, there are two additional methods to avoid the application of Section 409A to a discriminatory or taxable arrangement. In addition, although we have defined a “discriminatory arrangement” to refer only to self-insured health plans, it bears noting that replacing self-insured coverage with genuinely insured coverage can also be an effective way to address the impact of Section 409A on health coverage that may be discriminatory, because Section 105(h) does not apply to insured health plans. As discussed above, the key detail here is to make sure that the coverage in question is really insured within the meaning of Section 105(h). Coverage that is labeled “insurance” but that still exposes the employer to claims risk in a way that is functionally like self insurance (i.e., coverage with a premium structure that does not result in real risk shifting) remains covered under Section 105(h).

Payments of Premiums on an After-Tax Basis. Code Section 105(b) applies to exclude the value of medical benefits from the taxable income of employees who receive medical coverage that is paid for by an employer. Code Section 105(h) then removes this exclusion from income for benefits that are paid to HCIs under a discriminatory medical plan, and treats those benefits as taxable compensation. It is this taxable compensation that triggers the application of Code Section 409A. Therefore, if Code Section 105 did not apply to a discriminatory medical arrangement, the nondiscrimination rules under Code Section 105(h) would not apply and Code Section 409A would not be triggered.

If the HCIs under the discriminatory arrangement pay for the entire premium on an after-tax basis, i.e., both the employer and employee premiums, the medical benefits that are paid would be excluded from the HCI’s gross income by application of Code Section 104(a)(3). In this instance, therefore, Code Section 105(h) does not apply and cannot cause the benefits to be taxable. In turn, because the benefits are tax exempt under Section 104(a)(3), Code Section 409A would not apply. See, Treas. Reg. § 1.409A-1(b)(9)(v)(A). In order for Code Section 104(a)(3) to fully apply in this case (and thus to permit Code Section 409A to be fully avoided), the entire premium – correctly determined – must be paid by the HCI on an after-tax basis. The full COBRA premium (without the 2% add-on for administrative expenses) includes both the employee and employer portions and, thus, should be an appropriate figure to use in this instance. On the other hand, trying to streamline the mechanics of the process by just imputing this premium to the employee likely will not work. The Service could take the position that the imputation was erroneous and ineffective because Section 106(a) automatically excludes the value of the coverage from the employee’s income, and therefore that the correct outcome is instead to tax the benefits under Section 105(h). (However, see the discussion below regarding imputation for domestic partner coverage.

This so-called “after-tax exemption” is not expressly stated in the Final Regulations. However, discussions with the Service and Treasury have confirmed that paying for the total amount of the coverage on an after-tax basis should exempt such coverage from 409A.

Negative Discretion. As provided above, Code Section 409A is triggered when a service provider has a legally binding right to taxable compensation in a future year. A legally binding right does not exist if that compensation may be reduced or eliminated by the company. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation lacks substantive significance, a legally binding right will still exist. If the facts demonstrate that the HCIs do not have a legally binding right because benefit payments under the discriminatory arrangement can be terminated at any time, then the existence of this negative discretion should prevent the application of Code Section 409A to the discriminatory arrangement.

While negative discretion can sound good in theory, there are a number of factors that can apply to limit its application in practice. First, even though most health plans are drafted to permit amendment and termination at any time, special post-employment health coverage arrangements or arrangements that grant special service credit to qualify for retiree health coverage may directly or by implication constrain amendment and termination. For example, these arrangements may be entered into in the context of a severance agreement, and may be drafted to provide enforceable rights in exchange for a release of claims against the employer. This commitment may override or limit the generally applicable right to amend and terminate health coverage.

Second, even in cases where the right to terminate the health plan does apply to an employee with discriminatory coverage, generally such right only applies prospectively to claims that are incurred after the termination of the plan. Therefore, once a specific claim has been incurred, the employee usually would have the legally binding right to be paid for incurred claims beyond the year in which they are incurred. This is enough to bring Section 409A into play.

Third, representatives of the Service and Treasury have downplayed the role of negative discretion in recent remarks. Representatives have indicated that the negative discretion “exception” is a facts and circumstances analysis and that they will closely scrutinize claims of negative discretion. In their view, situations where it appears on paper that negative discretion can be exercised, but where practical realties prevent or significantly reduce the likelihood that the negative discretion would actually be exercised, may not satisfy the rule.

Therefore, when reliance is placed on negative discretion to avoid Section 409A, it is important to understand how broad the scope of the discretion must be and to conclude that the discretion is meaningful in practical terms. Accordingly, due to the uncertainty surrounding negative discretion, many employers will focus on other strategies to address 409A, rather than choosing to rely on negative discretion as a way to exempt their discriminatory arrangement from 409A.

Additional Health Coverage Situations Implicating 409A

In addition to discriminatory arrangements, certain other health coverage may be taxable and potentially subject to Code Section 409A. One example is health coverage for domestic partners. Because employees receive imputed income for their domestic partners’ coverage, Code Section 409A potentially applies to this coverage. For purposes of a discriminatory arrangement under Section 105(h), it is the benefits that are taxable and potentially subject to Section 409A. However, for domestic partner coverage, it is the actual coverage that is potentially subject to Section 409A, not the benefits. For domestic partners, income imputation is mandatory (assuming the domestic partner is not a tax dependent) and the exclusion for employer-provided coverage under Code Section 106(a) does not apply to non-tax dependents. This opens the door for Code Section 104(a)(3) to apply to the reimbursements rather than Code Section 105. The end result of this is that income imputation for domestic partners causes the health benefit reimbursements to satisfy the “after-tax” exception to 409A. Now that the benefits are exempt from 409A, this only leaves the actual coverage – or imputed income – as potentially subject to 409A.

Domestic Partner Coverage for Active Employees. Active employees are promised a stream of future payments of imputed income, but if an active employee terminates employment, the domestic partner coverage and the related imputed income normally also terminates. The Final Regulations provide that 409A does not apply if compensation is paid within 2½ months following the end of the taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. See, Treas. Reg. 1.409A-1(b)(4)(i). Most plan sponsors impute income for domestic partner coverage at each pay period or at the very least once a year at the end of the year so that the amount is added to the employee’s wages and Form W-2. Therefore, the imputed income payment would satisfy the 2½ month rule, to the extent that the employee would not have such compensation in future years because that compensation is subject to a substantial risk of forfeiture.

Under Section 409A, compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services and the possibility of forfeiture is substantial. Treas. Reg. § 1.409A-1(d). Thus, if the services an employee must perform to receive the imputed income are “substantial” the imputed income should be exempt from 409A. In the typical domestic partner coverage situation, an employee is only required to work to the next pay period. At this time, the requirement to perform services terminates and the imputed income is then added to his/her paycheck. However, at the same time, another requirement to perform services begins for the next pay period, and this process continues indefinitely for as long as the employee remains employed and the domestic partner remains enrolled in the plan. Thus, on the one hand, the requirement to perform services could be viewed as only a requirement to work to the next pay period, while on the other hand, the requirement to perform services could be viewed as a requirement to work indefinitely (or at least until the end of each future pay period in which the imputed income is to be added to the employee’s paycheck). The better view would seem to be that this compensation is subject to a substantial risk of forfeiture because it is a ratable payment that requires the performance of services to the end of each future pay period, and this view is generally supported by an example in Treas. Reg. § 1.83-4(c) that provides that ratable vesting over a term of years is considered substantial. Therefore, in the typical domestic partner situation, the imputed income for active employees should be exempt from 409A.

Domestic Partner Coverage for Retirees. Retirees with domestic partner coverage are also promised a stream of future payments of imputed income. However, as opposed to active employees, retirees will receive the imputed income as long as the domestic partner satisfies the eligibility requirements of the plan. Therefore, the substantial risk of forfeiture exception that arguably applies to active employees is unavailable to retirees. This means that the imputed income will need to comply with Section 409A. The special compliance rule discussed above for medical reimbursements will not apply, because that is only available with respect to expenses described in Code Section 105(b). See, Treas. Reg. § 1.409A-3(i)(1)(iv)(B). However, a broader special compliance rule for in-kind benefits (a category that would include taxable health coverage for domestic partners) can apply. In general, the requirements of this special rule are the same as under the special compliance rule for medical reimbursement arrangements, but there is no exception for shifting payments between tax years that results from the application of a plan limit. See, Treas. Reg. § 1.409A-3(i)(1)(iv). The key requirements of this rule provide that the compensation must be objectively determinable and the compensation must be payable at a date or dates that are nondiscretionary and objectively determinable.

The first part of this rule requires an objectively determinable amount. Under the proposed regulations it appeared that providing a variable amount of compensation in each year would not be objective. Therefore, because the imputed income for domestic partner coverage will vary each year, providing in the plan that a retiree will receive an amount of imputed income in each year that will be determined by the plan sponsor in each future year (based on the prior year’s experience and other factors that the plan sponsor uses to determine the cost of the coverage) was questionable under the proposed regulations. However, based on the wording of the Final Regulations and various public statements by Service and Treasury representatives, an amount determined by the plan sponsor could be objectively determinable if the amount is based on the premiums for the entire plan as a whole (or for a category of coverage that includes a significant number of individuals whose premium costs are determined uniformly). Therefore, if a plan sponsor determines the imputed income based on the health plan’s premiums, and the premiums in turn apply generally to retirees, then the imputed income is likely objectively determinable. However, if the plan sponsor determines the imputed income based on a small group of plan participants, the amount will likely not be objectively determinable. The second part of the rule requires that the dates of payment be nondiscretionary and objectively determinable. Most plan sponsors can satisfy this rule, because most plans impute income on a fixed schedule – which for retirees is typically either at each premium payment interval or once a year at the end of the year. However, the requirements of documentary compliance should be considered.

Based on the foregoing compliance rule, most retiree coverage for domestic partners should satisfy the requirements under 409A. In addition, domestic partner retiree coverage also can be addressed by having the domestic partner pay the premiums on an after-tax basis. Assuming the retiree’s premium under the plan is sufficient in amount to cover the entire value of the domestic partner’s coverage, it may be possible for a plan sponsor (that has appropriate plan document provisions) to allocate all of its contributions to the retiree’s coverage, and then allocate all of the retiree’s premium payments to the domestic partner’s coverage. In this situation, the domestic partner would be paying for the coverage on an after-tax basis and income imputation should not be necessary.

Conclusion

As noted above, and as reflected in public comments by Service and Treasury representatives, it is clear that if a self-insured health plan violates Section 105(h), Section 409A issues can arise – and that implicates Section 409A’s daunting penalties. Because it is inherently difficult for a health plan to comply with Section 409A (i.e., without reliance on the available special rules), employers will need to take care to identify discriminatory plans and to carefully strategize their exemption from or compliance with 409A. While a transition period for revising plans extends to the end of 2007, good faith operational compliance is required currently, and full compliance is required in only about six months.