Legal Issues Regarding Section 125 Plans

1. Legal Issues Regarding Section 125 Plans Patricia A. Butler, JD, DrPH SCI/NASHP/NGA Section 125 Plans: Policy and Implementation Issues, Boston June 20, 2008

2. Presentation Outline • Section 125 Plan requirements • Application of other federal laws: • HIPAA • COBRA • ERISA • State health policy implications

3. Section 125 Plan Requirements • Internal Revenue Code Section 125: • The only way to exclude health insurance payments from employee income • Allows employees to buy coverage in individual insurance market with pre-tax $ • If health insurance is the only benefit, plan can be called “premium only plan” (POP) • For purposes of tax code, these individual premium payments (“salary reduction”) are considered employer contributions

4. Section 125 Plan Requirements • Revised proposed regulations published August 2007 • Final regulations expected before the end of 2008 • Written plan document lists specific benefits and maximum amounts for which payroll deduction is allowed, employee eligibility, etc. • In the case of individually purchased benefits, employers must verify that employee funds are used for qualified coverage (ie health insurance) [reg proposes 3 ways] • Employee annual election = irrevocable • Applies only to employees(not self-employed, partners and certain small corporation shareholders) • Failure to meet tax law requirements subjects employer and employees to tax liabilities

5. Nondiscrimination Provisions • Cafeteria plans cannot discriminate in favor of “highly compensated individuals” or “key employees” [defined in the regs] regarding eligibility for the plan or contributions and benefits (including actual use of a salary reduction) • Favoring these employees doesn’t disqualify plan but subjects them to the foregone taxes • Employers need to assess plan at end of tax year

6. Nondiscrimination Provisions: Highly Compensated Employees • Eligibility: if all employees are eligible for cafeteria plan, plan meets this test • Contributions: any employer contributions must be at same level for HCEs and non-HCEs • Benefits: actual use of caf. plan contribution or salary reduction cannot favor HCEs • Ratio of aggregate amount of benefits elected by HCEs as a % of total compensation cannot exceed aggregate amount of benefits elected by non-HCEs as % of their total compensation • “Safe Harbor” if POP plan meets eligibility test, but may not apply to salary reduction for purchasing individual insurance products

7. Nondiscrimination Provisions: Key Employees • More than 25% of total tax-advantaged benefits cannot benefit key employees (if they do, Keys do not receive tax benefit) • “Safe Harbor” if POP plan meets eligibility test, but may not apply to salary reduction for purchasing individual insurance products

8. Application of other federal laws: COBRA • Because even employee-only premium payments are considered to be “employer contributions,” these cafeteria plans are considered “group health plans” under COBRA • COBRA allows employees (of firms with 20 or more workers) leaving group coverage to stay in the group for 18 months (paying the full premium) • This continuation authority is irrelevant to individually purchased health insurance, but would permit employees to use severance pay to buy coverage with pre-tax funds from former employer or to pay premium for the individual coverage under cafeteria plan of a new employer during insurance eligibility waiting period

9. Application of other federal law:HIPAA • Prescribes permissible pre-existing condition exclusion periods, special enrollment periods, portability and renewability for employer groups of 2+ • Prohibits discrimination in health coverage eligibility and premiums based on health status, claims experience, etc. • Applies to section 125 plans because HIPAA defines group health plans like COBRA • Therefore, to avoid tax law penalties, employers must be sure that insurers selling individual plans to employees under a cafeteria plan meet HIPAA standards

10. Application of other federal law:HIPAA • Some state individual insurance product laws do not meet HIPAA pre-ex standards • Most do not prohibit health status discrimination in eligibility or premiums in individual market

11. Application of other federal law:ERISA • Federal Employee Retirement Income Security Act regulates private-sector employer-sponsored health plans • Clearly applies if employers contribute to employee insurance premiums • Also applies if employers sponsor a plan to which they don’t contribute

12. Application of other federal law:ERISA • Relevant to Section 125 plan discussion if health coverage purchased individually through a 125 plan is considered employer-sponsored: • US DOL has said cafeteria plans not ERISA plans • If individual policies are considered employer-sponsored, employers must meet disclosure, reporting and fiduciary requirements • Also, it could be argued that a state requirement for all employers to offer such cafeteria plans is an employer mandate preempted by ERISA

13. Application of other federal law:ERISA • Whether health insurance purchased individually via a cafeteria plan is an ERISA plan depends on extent of employer “endorsement” of individually purchased products under DOL regulation • Courts and DOL have defined employer endorsement to include selecting, creating, promoting, or administering employee insurance plans • Objective is to avoid misleading employees to believe employers are responsible for a plan • Some courts (in health plan damages law suits) have held that allowing insurance to be purchased individually via a cafeteria plan (among several other factors) constitutes endorsement

14. Application of other federal law:ERISA • While not completely clear from written DOL policy or case law, it is possible to argue that • Health insurance purchased individually through a cafeteria plan is not an ERISA plan if employers do nothing more than payroll deductions • ERISA does not preempt a state requirement that employers offer cafeteria plans (DOL informally sanctioned the MA law)

15. Primary Cafeteria Plan Issues for State Health Policy Makers • Uncertainty regarding application of nondiscrimination requirements regarding HCEs and Keys and safe harbor • HIPAA compliance • ERISA • Whether individual policies become ERISA plans • Preemption challenge potential

16. State Policy Responses • To assist employers to offer cafeteria plans, states could • provide technical assistance and model cafeteria plan materials, including awareness of nondiscrimination rules • Provide guidance on how to avoid the appearance that employers are ‘endorsing’ insurance purchased individually through the cafeteria plan • To assist employers to comply with HIPAA, states could • evaluate their individual health insurance market standards for consistency with HIPAA and • revise insurance standards and/or • condition insurer participation in a state purchasing pool on complying with HIPAA

17. State Policy Responses • States could create a purchasing pool/exchange through which individuals may purchase health coverage • Helps to distance employer from insurance products and minimize ‘endorsement’ arguments and avoid ERISA requirements and preemption challenge • Provides a way for employers to assure products bought under a cafeteria plan meet HIPAA requirements