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Are Your Fringe Benefits Legal?

Barbara A. Erickson, Hodges, Loizzi, Eisenhammer, Rodick and Kohn Mary Karagiannis, Hodges, Loizzi, Eisenhammer, Rodick and Kohn

Presented at the 2016 School Law Seminar, April 7-9, Boston, Massachusetts The NSBA Council of School Attorneys is grateful for the written contributions of its members. Because Seminar papers are published without substantive review, they are not official statements of NSBA/COSA, and NSBA/COSA is not responsible for their accuracy. Opinions or positions expressed in Seminar papers are those of the author and should not be considered legal advice.

© 2016 National School Boards Association. All rights reserved.

HODGES, LOIZZI, EISENHAMMER, RODICK & KOHN

3030 Salt Creek Lane Suite 202, Arlington Heights, Illinois 60005 Phone: (847) 670-9000

401 SW Water Street, Suite 106 Peoria, Illinois 61602 Phone: (309) 671-9000

804 West US Highway 50, Ste. 220 O’Fallon, Illinois 62269 Phone: (618) 622-0999

www.hlerk.com Facsimile: (847) 670-7334

The following materials and the presentation made thereon are solely educational in nature and do not constitute legal advice to any person. Nor are the materials or the presentation made thereon intended to form an attorney/client relationship between the presenter, or the presenter’s law firm, and any attendee of the presentation.


Barbara A. Erickson Email: [email protected]

And

Mary Karagiannis Email: [email protected]

tel:3096719000

http://www.hlerk.com/

mailto:[email protected]

mailto:[email protected]

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BARBARA A. ERICKSON - Ms. Erickson is a Partner in the law firm of Hodges, Loizzi, Eisenhammer, Rodick and Kohn. She represents school districts, municipalities and park districts in all areas of the law, with a primary concentration on employee benefits and labor. Ms. Erickson is an accomplished speaker on employee benefit tax implications and has spoken for the National Council of School Attorneys on the implications of Internal Revenue Code Sections 409A, 457(f) and 403(b) in school law. Ms. Erickson has also authored several articles regarding employee benefits and tax law in the public sector. Prior to attending law school, she worked in private industry for seven years as a Project Manager and Manager of Regulatory Compliance and Environmental Control. Ms. Erickson graduated from St. Cloud State University with a B.A. in Biomedical Science. She earned her Masters degree in Industrial Safety and Hygiene from the University of Minnesota, Duluth, and her Certificate in Hazardous Materials Management from the Institute of Hazardous Materials Management. Ms. Erickson received her law degree and Certificate in Labor and Employment Law from Chicago-Kent College of Law, where she also was a student editor for the Illinois Public Employee Relations Report.

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Thursday, April 7, 2016

What is a Fringe Benefit? Basically, a fringe benefit is a form of pay for the performance of services that is in addition to “stated pay”. A fringe benefit may include property, services, cash, or cash equivalents. This definition applies to pay for services of employees and independent contractors. While certain fringe benefits may be paid to both employees and independent contractors, the discussion provided herein focuses mainly on employees. Many employers, including school districts, struggle with understanding what fringe benefits are and how to manage them. In providing fringe benefits to employees, employers likely believe that they are benefitting their employees and making a job more attractive. However, a benefit to an employee can soon become a detriment if the employer misapplies the law while providing that benefit. Oftentimes, employers don’t even realize that they are misapplying the law until it is too late. Perhaps it is a misnomer to use the word “legal” in relationship to whether or not a fringe benefit is allowed. Usually, the concern over fringe benefits is whether or not and to what extent the benefits are taxable; however, with the introduction of the Affordable Care Act,1 and re-emphasis on various provisions of the Internal Revenue Code (“IRC”) relating to nondiscrimination, employers could actually find themselves providing benefits that may result in penalties, excise taxes, and fines. Certain benefit plans could even lose “qualified” status. The following guide is designed to help school district employers understand what fringe benefits actually are and how to determine if they are applying them in accordance with the IRC. It is not meant to be a crash course in accounting or meant to be an exhaustive dissertation of employee benefits. However, it will focus on some of the most popular benefit plan arrangements including, but not limited to, Section 125 Cafeteria Plans, Health Flexible Spending Accounts, Health Savings Accounts, Health Reimbursement Arrangements, and various forms of retirement plans (403(b), 457(b), and 457(f)). It will also focus on how these plans are affected by recent laws including the Affordable Care Act, and provide references to where school district employers can look for guidance. Initially, it is important to gain a general understanding of how the IRC determines whether a benefit is taxable to an employee.

1 Patient Protection and Affordable Care Act (P.L. 111-148) and the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152).

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I. General Concept of Taxability in Employment A. Principles of Taxation of Benefits 1. Default Rule of Taxability2

Fringe benefits for employees are taxable wages unless specifically excluded by a section of the IRC.

2. Reporting and Withholding – General Principles3

i. If a fringe benefit is taxable to an employee, it is subject to withholding when it is made available to the employee.

ii. The employer may elect to add taxable fringe benefits to an employee’s regular wages and withhold on the total, or may choose to withhold using the supplemental wage flat rate rules.

iii. There are special timing of taxation rules that may be applied by employers depending on the type of benefit and the timing of its provision.

iv. In most instances, employers do not have a choice on whether to withhold taxes on a taxable fringe benefit; if it is taxable, withholding is mandatory.

3. Methods for Exclusion4

i. Fringe benefits may be fully taxable, partially taxable, fully nontaxable, or tax deferred.

ii. A fringe benefit provided on behalf of an employee is taxable to the employee even if it is received by someone other than the employee, such as the employee’s child.

iii. The term “taxable” means federal income tax, state income tax, FICA5, and FUTA6 where applicable.

iv. More than one IRC section may apply to exclude a benefit from taxes.

v. The following sections of the IRC (among others) are most commonly involved in excluding fringe benefits from taxes:

2 INTERNAL REVENUE SERVICE, FRINGE BENEFIT GUIDE: OFFICE OF FEDERAL, STATE AND LOCAL GOVERNMENTS at 4 (Jan. 2014) [hereinafter FRINGE BENEFIT GUIDE]; IRC § 61; IRC § 3121, 3401; IRC § 61(a)(1). 3 FRINGE BENEFIT GUIDE, supra note 2 at 7. 4 Id. at 4-6. 5 FICA, or Federal Insurance Contributions Act, generally means Social Security and Medicare. IRC § 3101. 6 FUTA, or Federal Unemployment Tax Act, typically does not apply to public employers such as school districts. INTERNAL REVENUE SERVICE, Publication 15: (Circular E) Employer’s Tax Guide (Dec. 23, 2015).

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1. Section 105 Amounts Received under Accident and Health Plans

2. Section 106 Contributions by Employers to Accident and Health Plans

3. Section 117 Qualified Tuition Reductions 4. Section 119 Meals or Lodging 5. Section 125 Cafeteria Plans 6. Section 127 Educational Assistance Plans 7. Section 129 Dependent Care Assistance Programs 8. Section 132 Specific Fringe Benefits

4. Accountable Plans7 Applicability of one of these sections of the IRC to a type of fringe benefit

is not necessarily enough to render that fringe benefit nontaxable or otherwise worthy of favorable tax treatment. Some IRC sections place limitations on the amount that may receive favorable tax treatment. In addition, some IRC sections require the fringe benefit to meet certain tests. One of those tests is Accountability.

Fringe benefits that are provided as a reimbursement or allowance typically

must be part of and meet the Accountable Plan requirements of the Internal Revenue Service in order to be nontaxable. In order to satisfy the requirements of an Accountable Plan, a reimbursement or allowance arrangement must meet the following rules:

i. There must be a business connection to the expense;

ii. There must be adequate account by the recipient of the expense within a reasonable period of time; and

iii. Excess reimbursements or advances must be returned within a reasonable period of time.8

In order to provide the “adequate account” referenced above, the employee must verify the date, time, place, amount, and business purpose of an expense. Receipts are generally required to substantiate these elements (but see per diem arrangements below).9

While extended times for substantiation and return of excess allowances is unlikely with school employees, the following safe harbor rules may apply

7 FRINGE BENEFIT GUIDE, supra note 2 at 8. 8 IRC § 62(c). 9 Treas. Reg. § 1.62-2; Treas. Reg. § 1.274-5.

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to establish the “reasonable period of time” referenced in the above requirements for substantiation and return of excess:10 i. Fixed Date Method:

1. Advance made within 30 days of when an expense is paid or incurred; and

2. Expense substantiated within 60 days after paid or incurred; and

3. Excess amount returned to employer within 120 days after expense paid or incurred.

ii. Periodic Statement Method: 1. Substantiation and return of excess must be made within 120

days after the employer provides the employee with a periodic statement stating excess must be returned (at least quarterly); and

2. Maximum number of days for repayment is 210. iii. Other Reasonable Method:

1. Not defined but available if reasonable under facts and circumstances (e.g., employee on extended travel assignment out of country may have longer to return excess).

Practice Note: We have seen situations where employers wish to provide travel advances to employees who are leaving for a specific trip. Travel advances may be excludable from wages, but only if paid under an Accountable Plan as described above. Further, the relationship between the time the advance is provided and the time of the trip must be reasonable as well as the timing for substantiation of expenses and any return of excess. Finally, the amount of the advance must be reasonable with the estimate of the expenses.11

5. Non-Accountable Plans12

Generally, a fringe benefit that does not meet the proper accounting rules to be considered nontaxable, either because it does not incorporate such accounting rules or the rules are not followed, must be included in employees’ wages in the year the benefit is received. However, special rules may apply.

10 Treas. Reg. § 1.62-2. 11 Id. 12 FRINGE BENEFIT GUIDE, supra note 2 at 9-10; Treas. Reg. § 1.62-2.

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Any advances, allowances, or reimbursements that are made pursuant to a plan that does not meet the requirements of an Accountable Plan are subject to withholding at the time the advances or reimbursements are made to the employee. For plans that are rendered non-accountable due to the failure of an employee to properly account within a reasonable period of time, any advances, allowances, or reimbursements paid to that employee are subject to withholding no later than the first payroll period following the end of the reasonable period.

6. Listed Property13 Employers often provide employees with equipment for use in their jobs. Certain types of equipment or property lend themselves to personal use; for these items, the IRS has set up strict substantiation requirements where employees are required to account for both the business and personal use of these items. Business use that is substantiated is excludable from wages as a working condition fringe benefit under IRC Section 132. Personal use is included in wages and if substantiation requirements are not met, both business and personal use are included in wages. Typical equipment considered “listed property” includes: entertainment equipment, passenger vehicles, and computers.

7. Cell Phones14

In 2011, the IRS removed cell phones and cell phone allowances from the definition of listed property and these benefits may now be provided on a nontaxable basis without substantiating personal use if certain conditions are met including, but not limited to, being provided for non-compensatory business purposes. Specifically, IRS Notice 2011-72 demonstrated that an employer will be considered to have provided an employee with a cell phone primarily for a non-compensatory business purpose if there are substantial reasons relating to the employer’s business (other than providing compensation) for providing the phone. Examples of non-compensatory purposes provided by the IRS include: (1) the employer must be able to contact the employee at all times for work-related emergencies; (2) the employer requires that the employee be available to speak with clients at times when the employee is away from the office; and (3) the employee must be able to speak with clients in other time zones such that it is not during the normal workday. Practice Note: To take advantage of this guidance, employers should place the provision of the cell phone or allowances in policy or contracts to define

13 FRINGE BENEFIT GUIDE, supra note 2 at 66; IRC § 280F. 14 IRS Notice 2011-72.

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the purpose for which it is given and periodically check to make certain the reason used is actually in compliance with the policy or contract.

8. Per Diem Arrangements15

As described above, under the Accountable Plan rules, an employee must

verify the date, time, place, amount, and business purpose of an expense in order to exclude the benefit from the definition of wages. Receipts are required to substantiate these elements unless the reimbursement is made under a per diem arrangement used to reimburse travel. Per diem arrangements are daily allowances used by employers when employees are traveling on business.

If an employer provides an employee with a valid per diem allowance, the

employee is deemed to have substantiated the amount of expenses equal to the lesser of the Federal per diem rate or the per diem allowance paid by the employer. Federal per diem rates include separate rates for lodging, meals and incidental expenses. These are known as M&IE. While receipts are not required to substantiate the expenses, employee accounting for expenditure of the payments must still meet other requirements, including time and date, place, and business purpose. Per diem allowances do not cover everything. Cab fares, telephone, copy, and fax charges, room tax, and other business expenses are considered miscellaneous expenses and do not constitute covered per diem expenses.16

9. Fringe Benefit Valuation Rules17 If all or any part of a fringe benefit remains taxable, it must be appropriately

valued. Various valuation rules apply to fringe benefits depending on the type. For example, three different valuation rules apply to the personal use of employer-provided vehicles.

B. Section 125 Cafeteria Plans18

Use of a Section 125 Cafeteria Plan for excluding certain fringe benefits from wages is another general method used by employers. In fact, it is the exclusive way an employer can provide an employee a choice between a non-taxable benefit and a taxable benefit without rendering the non-taxable benefit taxable.19 A Section 125 Cafeteria Plan is a

15 FRINGE BENEFIT GUIDE, supra note 2 at 33; Treas. Reg. §1.62-2. 16 FRINGE BENEFIT GUIDE, supra note 2 at 34; Rev. Proc. 2011-47. 17 FRINGE BENEFIT GUIDE, supra note 2 at 55-59; Treas. Reg. §1.62-2; Treas. Reg. §1.132-5; Treas. Reg. §1.61-21. 18 IRB 2007-39. 19 Proposed Treas. Reg. §1.125-1.

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written plan that allows employees to choose among at least one qualified taxable benefit, such as cash, and at least one qualified non-taxable benefit, such as health insurance, without rendering the qualified non-taxable benefit (health insurance) taxable.20 Qualified benefits include: group-term life insurance on the life of an employee (limits apply); employer-provided accident and health plans, including health flexible spending arrangements, and accidental death and dismemberment policies; dependent care assistance programs; adoption assistance programs; contributions to Section 401(k) plans; contributions to certain plans maintained by educational organizations; and contributions to Health Savings Accounts. To be qualified, the benefit provision must comply with the requirements of IRC Section 125 and its associated regulations, as well as the underlying IRC section allowing the benefit. Further discussion of Section 125 Cafeteria Plans is contained in Section III of these materials.

II. Fringe Benefit Exclusion Rules – Who, What, How, How Much?21 A. Exclusion From Taxation

When working with the IRC to exclude certain fringe benefits from the application of tax, the nature of the benefit, who it is provided for, the amount of the benefit, and the method of its provision will all impact whether the benefit is excluded and to what extent it will be excluded. The next part of the discussion will focus on these specific elements with regard to some common types of fringe benefits provided by employers.

B. Typical Fringe Benefits That May Be Excluded 1. Accident and Health Plans22 i. Applies to employer contributions to “accident and health plans”.

ii. Applies to payments employer makes directly or indirectly to an employee under an accident or health plan as payments or reimbursements of medical expenses or payments for specific injuries.

iii. To use this exclusion, the “employee” must be one of the following: a current common law employee, a retired employee, a former employee for whom the employer maintains coverage based on the employment relationship, a widow or widower of an individual who died while an employee or of a retired employee, and certain leased employees.

iv. Discrimination rules may apply. v. While the IRC may allow this benefit to be paid on a pre-tax basis,

employers can suffer a penalty if this benefit is not provided in

20 Id. 21 IRS Publication 15-B Employer’s Tax Guide to Fringe Benefits (2016). 22 IRC §§ 105, 106.

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compliance with various provisions of the Affordable Care Act.23 This will be discussed later in Section VII of these materials.

2. De Minimis Benefits24

i. Applies to any property or service provided to an employee that has so little value in relation to the frequency with which it is provided that accounting for it would be impractical.

ii. For this exclusion, treat any recipient of a de minimis benefit as an employee.

iii. Examples include: certain uses of employer-provided cell phones, holiday gifts that are not cash or cash equivalent, personal use of the copying machine that is almost exclusively used for business purposes, meals, parties or picnics, transportation fare, and occasional tickets for events.

Practice Note: Gift cards (e.g., Visa, American Express) that can be used for general purchases or redeemed for cash will be considered as cash and cannot be excluded. Further, if an employer provides a daily snack each day for its employees worth less than $1 per person, this would likely be taxable. While the amount is small, the frequency is high.

3. Dependent Care Assistance25

i. Applies to household and dependent care services employer provides to employee under dependent care assistance program.

ii. Available to current employees, certain leased employees, sole proprietors, and partnerships.

iii. Maximum annual limits apply. iv. Discrimination rules apply. v. Usually provided in a Section 125 Cafeteria Plan.

4. Educational Assistance26

i. Under IRC Section 127, an employer may exclude up to $5,250 paid or incurred on behalf of an employee from the wages of each employee, if certain requirements are met. The education may be at undergraduate or graduate level, and is not required to be job-

23 Patient Protection and Affordable Care Act (P.L. 111-148); Health Care and Education Reconciliation Act of 2010 (P.L. 111-152). 24 FRINGE BENEFIT GUIDE; IRC § 132; Treas. Reg. §§1.132-1, 1.132-6. 25 IRC § 129. 26 IRC §§ 117, 127, 132.

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related. Plan must be written and cannot discriminate in favor of highly-compensated employees.

ii. Under IRC Section 132, job-related educational expenses may be excludable from an employee’s income as a working condition fringe benefit. For educational reimbursement to qualify as a working condition fringe benefit, the education must be job-related. No written plan is required and employers may discriminate in favor of highly-compensated employees.

Practice Note: In our practice, we have seen school district employers pay for administrators to receive their doctorate degrees or help teachers achieve higher degrees. When determining whether these benefits are taxable, employers must scrutinize the type of education and what the reimbursement is for. Most often, it will qualify as a working condition fringe benefit, however, if it is preparing the person for a new career or providing education for the individual to meet the minimum requirements of their current position, it may be taxable.

5. Group-Term Life Insurance27

i. Applies to group-term life insurance coverage provided to employee.

ii. Must meet specific requirements, including the provision of a death benefit that is not included in income; provided only to group of employees meeting test under IRC; must prevent the provision of insurance amount based on individual selection; must be provided under a life insurance policy.

iii. Limited to $50,000 for non-taxable benefit. Practice Note: If life insurance is provided to retirees, employers should be careful to follow appropriate tax-reporting rules for W-2 reporting. Further, prior to promising a large life insurance benefit in a contract, the employer should check with the group carrier to make certain the policy amount is able to be included in the plan.

6. Lodging28

i. Applies to lodging employer furnishes to employee that is furnished on business premises, for employer’s convenience, and as condition of employment.

ii. If there is a choice of cash against the lodging, then the lodging is taxable.

27 FRINGE BENEFIT GUIDE, supra note 2 at 85-86; IRC § 79. 28 FRINGE BENEFIT GUIDE, supra note 2 at 48-50; IRC § 119; Treas. Reg. § 1.119-1.

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7. Meals29

i. Applies to de minimis meals. ii. Also applies to meals furnished on business premises for

convenience of employer. Meals are provided at the convenience of the employer if they are provided for a non-compensatory reason. For example, if furnished to increase employee morale, then taxable.

8. Transportation30 i. Applies to non-commuting, de minimis, and qualified benefits.

ii. Several ways to provide transportation benefits including providing car, reimbursing expenses, providing mass transit, or parking. There are differing rules applicable to each type of transportation benefit.

Practice Note: In our practice, we have seen arrangements where school district employers will provide their employees with travel allowances for “in-District” travel. In order for this to be non-taxable, the District must follow the rules of an Accountable Plan. Further, the provision of an automobile will follow special rules to determine the taxable nature of the benefit. Employers should not just assume it is non-taxable.

9. Working Condition Benefits31

i. Applies to property and services employer provides to employee so that employee may perform his job.

ii. Applies only to the extent employee could deduct the cost as a business expense or depreciation if he had paid for it.

iii. Applies to current employees, partners, Board of Directors, independent contractors, and volunteers.

iii. Employee must meet substantiation requirements. iv. Examples include: 1. Employee use of employer’s vehicles for business

2. Employer-provided cell phone provided primarily for non-compensatory business purposes

3. Job-related education 4. Cash for expenses for specific pre-arranged business activity

29 FRINGE BENEFIT GUIDE, supra note 2 at 43-48; IRC § 119; Treas. Reg. § 1.119-1. 30 FRINGE BENEFIT GUIDE, supra note 2 at 51-63; IRC § 274; Treas. Reg. §§ 1.132-6, 1.274. 31 FRINGE BENEFIT GUIDE, supra note 2 at 48-50; IRC § 132; Treas. Reg. § 1.132.

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III. Section 125 Cafeteria Plans32 A. Form of Fringe Benefit

1. Provides that, except in the case of certain discriminatory benefits, no

amount shall be included in the gross income of a participant in a Cafeteria Plan solely because, under the plan, the participant may choose among the benefits of the plan.

2. Section 125 is the exclusive means by which an employer can offer

employees a choice between taxable and nontaxable benefits without the choice itself resulting in inclusion in gross income of the employees.

3. Unless a plan satisfies the requirements of Section 125 and the regulations,

the plan is not a Cafeteria Plan. 4. If the Cafeteria Plan fails, depending on the type of failure, all benefits

provided under the plan could become immediately taxable. 5. There are basically three types of Section 125 Cafeteria Plans: Premium

Conversion, Flexible Spending Accounts, and Full Flexible Benefit.

B. Qualified Benefits Under a Cafeteria Plan33

1. In general, in order for a benefit to be a qualified benefit for purposes of Section 125, the benefit must be excludible from employees’ gross income under a specific provision of the IRC and must not defer compensation, except as specifically allowed in Section 125.

2. Qualified benefits include: group-term life insurance on employee (Section

79); employer-provided accident and health plans, including health flexible spending arrangements (Sections 106 and 105(b)); dependent care assistance program (Section 129); contributions to 401(k) plans; adoption assistance (Section 137); and contributions to health savings accounts (Section 223).

C. Benefits Not Qualified Under a Cafeteria Plan34

A Cafeteria Plan must not offer any of the following benefits: scholarships; employer-provided meals and lodging; educational assistance; fringe benefits under Section 132; long-term care insurance; contributions to Archer Medical Savings

32 Proposed Treasury Regulations I.R.B. 2007-39 (Sept. 24, 2007). 33 Prop. Treas. Reg. § 1.125-1. 34 Id.

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Accounts; employer-provided cell phones; group-term life insurance for employee’s spouse, child, or dependent; contributions to Health Reimbursement Arrangements; elective deferrals into Section 403(b) plans. Practice Note: The Affordable Care Act (ACA) has also implicated Section 125 Cafeteria Plans by rendering one of the qualified benefits in the regulations no longer qualified. Specifically, IRS Notice 2013-54 and DOL Technical Release 2013-03 have clarified that as of January 1, 2014, employers will violate the ACA and be subject to excise taxes ($100 per day per employee) if they provide a pre-tax payment (through pre-tax salary reduction via a Cafeteria Plan) or reimbursement to employees to pay for individual policies of health insurance.35 These arrangements are referred to as Employer Payment Plans by ACA guidance and are prohibited. Further, in IRS Notice 2015-17, the IRS also clarified that arrangements that pay for such individualized plans on an after-tax basis will violate the ACA as well and are also prohibited.36

D. Written Plan Requirement37 Section 125 Cafeteria Plans must be in writing. Specifically, the written plan must

include at a minimum: (1) a specific description of each of the benefits available through the plan, including the periods of coverage; (2) the plan’s rules governing participation, and specifically require that all participants in the plan be employees; (3) procedures governing employees’ elections under the plan; (4) the periods with respect to when elections are effective; (5) a structure such that elections are irrevocable, except to the extent that optional change in status rules apply; (6) the method by which employer contributions may be made under the plan, (for example, through an employee’s salary reduction election or by non-elective employer contributions (that is, flex-credits) or both); (7) the maximum amount of employer contributions available to any employee through the plan; (8) the plan year of the Cafeteria Plan; (9) the required ordering rule for use of non-elective and elective paid time off if the plan offers paid time off; (10) the plan’s provisions complying with any additional requirements for flexible spending arrangements (“FSA”) such as the uniform coverage rule and the use-or-lose rules if the plan includes FSAs; and (11) specific rules for FSA distributions to HSAs if the plan allowed for them. Basically, it must set forth all of the material terms and conditions of the benefit structures offered within the plan.

The updated Cafeteria Plan regulations were released in 2007 and have been relied on ever since. They set forth several requirements, including nondiscrimination testing requirements and notice requirements.38

35 IRS Notice 2013-54; DOL Technical Release 2013-03. 36 IRS Notice 2015-17. 37 Prop. Treas. Reg. § 1.125-1. 38 Prop. Treas. Reg. § 1.125-7.

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Practice Note: In our practice, we find that school district employers have adopted plans from various third party administrators that do not fully incorporate all of the benefits the school district actually has available under the plan. For example, the plan may include premium conversion for payment of health insurance on a pre-tax basis but does not reflect the cash option the school district has made available for those electing not to participate. We also find that they have not been properly updated for operation or even law over the years. These plans should be properly audited internally involving legal counsel to assure compliance.

IV. Health Flexible Spending Arrangements39

A. General Criteria

1. Allowed by IRC Section 105 but most often included in Section 125 Cafeteria Plans.

2. Used to reimburse employees, spouses, and dependents in the event of personal

injury or sickness. 3. 213(d) expenses only (but no insurance premiums) 4. No over-the-counter medications unless prescribed. 5. May not discriminate in favor of highly-compensated or key employees with

regard to benefit eligibility or level of benefits. 6. Both employee and employer may make contributions (but see Practice Note

below for limitation on employer contributions).

B. Additional Considerations An employee can choose to contribute pre-tax amounts to an account for medical expenses via salary reduction, as written under an employer plan. These plans are usually associated with Section 125 Cafeteria Plans; however, they may be seen in limited occurrences as stand-alone Section 105 plans (which are likely now prohibited under the ACA – see Practice Note below). The funds in the account generally must be used within the plan year and must be used to pay for certain qualifying medical expenses only. If employees are allowed to salary-reduce to one of these arrangements, the plan must be provided as part of a Section 125 Cafeteria Plan as a health flexible spending arrangement (or “health FSA”) and its terms must comply with Sections 105 and 125 of the IRC. Each

39 FRINGE BENEFIT GUIDE, supra note 2 at 26; IRC §§ 105, 106, 125; Prop. Treas. Reg. § 1.125-5.

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plan year, participating employees are provided the opportunity to elect the amount of salary to salary-reduce (pre-tax) to the health FSA in order to pay for certain qualifying medical expenses.40 The law limits the amount that may be salary-reduced in one plan year. After December of 2015, the maximum salary reduction an employee can request for contributions towards a health FSA is $2,550.41 The salary reductions are spread across the entire plan year with each payroll. For example, if an employee elects $2,400 and is paid over the year in 24 paychecks, $100 will be salary-reduced from each check throughout the year. 100% of the elected amount for salary reduction must be available on the first day of the plan year even though the entire amount will not be collected from the employee until the end of the plan year (through salary-reduction).42 Further, if an employee terminates prior to the end of the plan year, the employer is not allowed to collect any additional funds from that employee (subject to certain continuation rights) to pay for reimbursements already made even if the employer has paid out more than it has collected. In addition, if an employee does not use all of the funds elected by the end of the plan year, he forfeits those unused funds to the employer (subject to carry-over or grace period options that may be available under the employer’s plan).43 C. ACA Implications44 The ACA virtually eliminated the ability for employers to offer “stand-alone” health FSAs to their employees. However, a health FSA offered through a Section 125 Cafeteria Plan that meets the requirements for being an “excepted benefit” is able to continue. To be an excepted benefit, a health FSA must satisfy two criteria: (1) employees eligible to participate in the health FSA must also be eligible to participate in the employer’s group health plan; and (2) the health FSA must limit the maximum reimbursement payable to a participant to two times the participant’s salary reduction or, if greater, the participant’s salary reduction plus $500. Practice Note: Basically, this means that an employer may contribute up to $500 per participant or up to a dollar-for-dollar match of each individual’s employee election (but not both). In our practice, we found several health FSAs that did not comply with one or both of these standards. The penalties for non-compliance can be harsh – including the imposition of $100/day/individual. We have also seen “hidden” Section 105 plans that could implicate the ACA (i.e., employer-paid annual physicals for employees in excess of $500 or tax-free memberships to health clubs.) Either of these could be problematic under the ACA and Section 105.

40 Prop. Treas. Reg. § 1.125-5. 41 Rev. Proc. 2015-53. 42 Prop. Treas. Reg. § 1.125-5. 43 Id. 44 IRS Notice 2013-54.

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V. Health Reimbursement Arrangements (HRA)45

A. General Criteria

1. An HRA is an employer-sponsored, self-funded health plan subject to the IRC.

2. An HRA is 100% funded by employer contributions. 3. An HRA is designed to reimburse participants for eligible medical expenses

(including health insurance premiums) up to a maximum dollar amount for any plan year (as set by the plan).

4. HRA plans may allow unused HRA amounts to be carried forward from

year to year (but carry-over is not mandatory). 5. An HRA must be integrated with another health plan that provides health

benefits other than excepted benefits. 6. Current and former employees, their spouses and dependents, and spouses

and dependents of deceased employees may be eligible to participate in an HRA but only if they are also covered by the integrated health plan.

7. Cash or other benefits cannot be included as a benefit. An HRA can only

reimburse medical expenses and premiums for other health coverage. 8. HRAs are subject to COBRA continuation and other federal laws governing

health plans.

9. Employers have complete control over HRAs with regard to which medical expenses will be eligible (within the 213(d) limits).

10. HRAs can be administered by employers or third-party administrators. 11. There is no limit set by the IRS on the amount of money that may be

contributed to an HRA. 12. HRAs are subject to several reporting obligations. 13. HRAs must be offered pursuant to a written plan.

B. ACA Implications46

45 IRS Publication 969 Health Savings Accounts and Other Tax-Favored Health Plans (2014); IRS Notice 2013-54. 46 IRS Notice 2013-54.

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The ACA and its related guidance declared the nature of HRAs as group health plans and thus, subject to the rules applicable to group health plans. Further, the ACA contains certain insurance market reforms that apply to group health plans. HRAs are not able to satisfy two of these market reforms: (1) the prohibition on annual dollar limits; and (2) the requirement for a group health plan to provide certain preventive services without imposing any cost-sharing. Therefore, stand-alone HRAs are in violation of the ACA. However, in IRS Notice 2013-54, the IRS clarified that HRAs can satisfy these market reform provisions if they are integrated with another group health plan. That group health plan can either be the group health plan offered by the employer offering the HRA or the group health plan of another entity. Specifically, according to IRS Notice 2013-54, an HRA will be integrated with a group health plan for purposes of satisfying the annual dollar limit prohibition and the preventive services requirements if it meets the requirements under one of two methods: (1) Minimum Value Not Required; or (2) Minimum Value Required. In order to qualify under either of these methods, the HRA arrangement must meet the following minimum criteria: (1) the employer must offer a group health plan (other than the HRA) to the employee that does not consist solely of excepted benefits; (2) the employee receiving the HRA is actually enrolled in a group health plan (other than the HRA) that does not consist solely of excepted benefits, regardless of whether the employer sponsors the plan (non-HRA group coverage); (3) the HRA is available only to employees who are enrolled in non-HRA group coverage, regardless of whether the employer sponsors the non-HRA group coverage; and (4) under the terms of the HRA, an employee (or former employee) is permitted to permanently opt out of and waive future reimbursements from the HRA at least annually and, upon termination of employment, either the remaining amounts in the HRA are forfeited or the employee is permitted to permanently opt out of and waive future reimbursements from the HRA. One feature separates the two methods. If the employer does not require the employee opting for the HRA to prove his other coverage provides minimum value pursuant to IRC Section 36B(c)(2)(C)(ii), reimbursements from the HRA must be limited to co-payments, co-insurance, deductibles, and premiums under the non-HRA group coverage, as well as medical care (as defined under IRC § 213(d)) that does not constitute essential health benefits. However, if the employer does require the employee receiving the HRA to prove the other coverage provides minimum value, the HRA may reimburse all IRC Section 213(d) medical expenses without limiting to only those that do not constitute essential health benefits. Practice Note: In our practice we have seen school district employers provide employees with cash benefits and reimbursements of various types of medical expenses if they opt out of employer-sponsored health insurance coverage. We have also seen references to the availability of HRAs. However, if the employer has established a method for reimbursing medical expenses of employees who opt out of the employer’s health plan, that

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reimbursement arrangement must meet the requirements of an integrated HRA under IRS Notice 2013-54 – especially if the benefit amount is over $500 per year to avoid violating the ACA. If an employer establishes one of these HRAs, the employer must be aware of the various reporting and recordkeeping obligations of the HRA including reporting pursuant to the ACA, itself (e.g., IRC Sections 6055 and 6056 reporting). We believe cash opt-outs are still permissible if offered pursuant to a Section 125 Cafeteria Plan. However, employers designing these opt-outs must be careful that they are not reimbursing or otherwise paying for individual coverage of its employees.

VI. Health Savings Accounts (HSA)47

A. General Criteria

1. HSAs are allowed by IRC Section 223. 2. Annual limits apply. 3. Contributed amounts are held in a trust that is owned by the employee. 4. Both employer and employees may contribute. 5. Employee must be covered by a high-deductible health plan in order to

contribute to an HSA and must not be covered by any other health plan that is not a high-deductible plan.

6. Nondiscrimination/comparable contribution rules apply depending on how

the contributions are made. If they are made through a Section 125 Cafeteria Plan, the nondiscrimination rules of Section 125 will apply. If the contributions are not provided through a Section 125 plan, the Section 223 comparable contribution rules will apply.

7. Employers have no control over the accounts. 8. Used to reimburse IRC Section 213(d) medical expenses or excise taxes

apply.

B. ACA Implications

HSAs were for the most part untouched by the ACA with the exception of raising the excise tax if contributions are used for expenses other than IRC Section 213(d) medical expenses. Further, HSA contributions are currently included in the calculation of the Cadillac Tax (see discussion below in Section VII).

47 IRS Publication 969 Health Savings Accounts and Other Tax-Favored Health Plans; IRC § 223.

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Practice Note: If employers are considering offering an HSA and intend on making non-elective employer contributions, it should consider having all contributions made through a Section 125 Cafeteria Plan to avoid the imposition of the IRC Section 223 comparable contribution rules, which can be difficult to administer.

VII. Accident and Health Plans and the Affordable Care Act A. General Principles The ACA drastically changed the landscape for how employers offer health benefits to

their employees. It is beyond the scope of this discussion to examine all aspects of what the ACA did to change the provision of health insurance benefits; however, there are three areas that seem to be garnering most of the attention from employers: (1) the Employer Shared Responsibility requirements; (2) the application of non-discrimination rules; and (3) the imposition of the Cadillac Tax.

B. Employer Shared Responsibility48 IRC Section 4980H and its accompanying regulations set forth the Employer Shared

Responsibility provisions of the ACA. In general, employers that employ at least 50 full-time employees must offer their full-time employees (and their dependent children) affordable health insurance with minimal essential coverage that offers minimum value or risk paying an assessable payment to the government. These rules went into effect on January 1, 2015, unless employers were able to take advantage of the non-calendar year transition rule or the less-than 100 full-time employee transition rule available in the preamble of the regulations.49

An employer will be subject to a Section 4980H assessable payment if either (1) the

employer fails to offer to its full-time employees (and their dependent children) the opportunity to enroll in minimum essential coverage under an eligible employer-sponsored health plan and any of its full-time employees receives a premium tax credit or cost-sharing reduction for coverage at the Exchange (assessable payment (a)); or (2) the employer does offer its full-time employees (and their dependents) the opportunity to enroll in minimum essential coverage under an eligible employer-sponsored health plan and one or more full-time employees waives coverage and receives a premium tax credit or cost-sharing reduction for coverage at the Exchange (assessable payment (b)). Section 4980H(c)(4) provides that a full-time employee with respect to any month is an employee who is employed on average at least 30 hours of service per week.

The assessable payment under section 4980H(a) is equal to the number of all full-time employees (excluding 30 full-time employees) multiplied by one-twelfth of $2,000 (as

48 IRC § 4980H; 79 Fed. Reg. 8,544 (Feb. 12, 2014). 49 79 Fed. Reg. 8,544 (Feb. 12, 2014).

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indexed) for each calendar month. The assessable payment under section 4980H(b) is based on the number of full-time employees who actually receive a premium tax credit or cost-sharing reduction with respect to the employee’s purchase of health insurance for the employee on the Exchange multiplied by one-twelfth of $3,000 (as indexed) for each calendar month. Liability under Section 4980H(b) will not exceed the maximum potential liability under section 4980H(a). Generally, liability under section 4980H(b) will arise because, with respect to a full-time employee who has received a premium tax credit or cost-sharing reduction, the coverage offered by the employer is not affordable or does not provide minimum value within the meaning of IRC Section 36B(c)(2)(C). The IRS has provided methods for employers to determine which employees are considered full-time and methods for designing length of coverage and offers of coverage depending on whether an employee is variable hour or hired as full-time. Further, various transition rules, if applicable, may act to reduce the assessable payment for a limited period of time. Finally, several recordkeeping and reporting obligations are included with the ACA that employers must be ready to comply with. Practice Note: In our practice we have seen school district employers struggle with how to count the hours of staff members such as substitute teachers and those working stipend positions. According to the regulations, for hourly employees, an employer must calculate actual hours of service from records of hours worked and hours for which payment is made or due. For non-hourly employees an employer must calculate hours of service by using one of the following methods: (1) using actual hours of service from records of hours worked and hours for which payment is made or due; (2) using a days-worked equivalency whereby the employee is credited with eight hours of service for each day for which the employee would be required to be credited with at least one hour of service; or (3) using a weeks-worked equivalency whereby the employee is credited with 40 hours of service for each week for which the employee would be required to be credited with at least one hour of service. Until further guidance is provided, it is not advisable for employers to deviate from these hours-counting methods. The IRS continues to release additional guidance in this area identifying special situations. For example, the IRS does have a suggested method for counting the hours of adjunct faculty. Employers have also been controlling the hours of variable hour staff (such as substitute teachers) to maintain an average of less than 30 hours per week. Employers need to be prepared to defend any reduction in hours as having been made for a business purpose rather than in response to employees obtaining premium tax credits. The ACA added a provision to the Fair Labor Standards Act whistleblower prohibitions regarding retaliation for obtaining a premium tax credit.50 Employers should be working with their insurance brokers and payroll companies to structure methods for counting and tracking employee hours and offering appropriate coverage to staff.

50 29 U.S.C. § 218c.

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C. Non-Discrimination Rules Extended to Insured Plans51 The ACA requires group health plans (that are not grandfathered52) to comply with the nondiscrimination rules of IRC Section 105(h).53 Compliance was to be as early as January 1, 2011. These nondiscrimination rules require that group health plan eligibility classifications for participation and benefits offered under the group health plan not discriminate in favor of highly-compensated individuals. Under the ACA, an insured plan that fails to meet these requirements would be subject to a penalty, including an excise tax of $100 per day per individual discriminated against during the time period the plan was out of compliance. Before the ACA was enacted, these nondiscrimination requirements applied only to self-insured health plans and the only penalty for noncompliance was loss of the tax-favored status of the benefits by the highly-compensated individuals.54 In December of 2010, the IRS released Notice 2011-1, which delayed enforcement of the nondiscrimination rules against insured plans until the IRS and Treasury release regulations. The Notice also sought public input on how the insured plans should be regulated. Interestingly, one of these inquiries from the IRS focused on what constitutes nondiscriminatory benefits under IRC Section 105(h)(4) and whether the rate of employer contributions toward the cost of coverage is a “benefit” that must be provided to employees on a nondiscriminatory basis. To date, the IRS has not released regulations and IRS Notice 2011-1 remains current. Of note, IRS Notice 2011-1 only delayed enforcement of the nondiscrimination requirements against insured plans. Self-insured plans are still subject to enforcement under the prior Section 105(h) construct. However, the question may still remain for these plans as well regarding whether the rate of employer contributions for employee coverage under the group health plan must be provided on a nondiscriminatory basis. Frankly, this is not clear. Practice Note: A common practice that we see in school districts is the payment of full-family health insurance coverage by school boards on behalf of certain high-level administrators while teachers and other employee classifications receive paid single coverage or less. Many of these school districts have self-insured plans as well and continue this practice even though the IRC Section 105(h) nondiscrimination rules apply to them. It is not clear to us whether this rate of employer contribution to high-level administrators is a violation of these nondiscrimination rules.55 Guidance from the IRS would be welcome. However, some school districts have been leveling out these

51 IRS Notice 2011-1. 52 Certain group health plans were “grandfathered” from the application of several ACA requirements. Group health plans must satisfy certain criteria to be considered grandfathered under the ACA. 53 IRS Notice 2011-1; Section 10101(d) of the Affordable Care Act added § 2716 to the PHS Act. 54 26 U.S.C. § 105(h). 55 These types of contribution structures could violate Section 125 nondiscrimination rules independently of IRC Section 105(h) depending on coverage levels.

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contributions by changing health plan structures, and, at times, increasing the salary of the administrators to help them pay for their own family coverage under the group health plan. Practitioners should be aware in advising on these matters to look to the potential impact that making these changes could have on other benefits, such as pensions, and make certain that other benefit plans like Section 125 Cafeteria Plans are properly updated to reflect the change. D. Application of Cadillac Tax56 The ACA imposes an excise tax of 40% on excess benefits provided to an employee through certain health coverage. This excise tax was to be effective for taxable years beginning after December 31, 2017. The “excess benefit” to which the 40% excise tax would apply is defined as an excess benefit that is the excess, if any, of the aggregate cost of the applicable coverage of the employee for the month over the applicable dollar limit for the employee for the month.57 Applicable coverage means “with respect to any employee, coverage under any group health plan made available to the employee by an employer which is excludable from the employee’s gross income under section 106, or would be so excludable if it were employer-provided coverage (within the meaning of such section 106).”58 Further, the cost of applicable coverage is to be calculated separately for self-only coverage and other-than-self-only coverage. Of note, health FSAs and HSAs were not spared from determining the cost of applicable coverage. Section 4980I(b)(3)(C) provides for two annual applicable dollar limits — one for an employee with self-only coverage and one for an employee with other-than-self-only coverage. Specifically, the threshold to measure an excess against for 2018 was going to be $10,200 per employee for self-only coverage and $27,500 per employee for other-than-self-only coverage with various adjustments to increase the applicable dollar limits in certain circumstances. A method for increasing these thresholds (possibly annually) is also established in the statute. This excise tax has become to be known commonly as the “Cadillac Tax.” The above paragraph stresses that the Cadillac Tax was going to apply for tax years after December 31, 2017. However, on December 18, 2015, the President signed the Consolidated Appropriations Act, 2016 (“CAA”) which effectively delayed the application of the Cadillac Tax for two years.59 As part of the delay, the government will be reviewing the Cadillac Tax for certain elements outlined in the CAA. Practice Note: While the Cadillac Tax is delayed, it is not dead. In practice, employers should continue to look for methods to reduce costs of health coverage if they wish to avoid this tax in the future. At a minimum, we continue to suggest the inclusion of effective re-

56 IRC § 4980I was added by § 9001 of the ACA, as amended by § 10901 of the ACA, and as further amended by § 1401 of HCERA. 57 IRC § 4980I(d). 58 Id. 59 The Consolidated Appropriations Act, 2016 (Public Law 114–53).

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opener language in collective bargaining agreements that may reach the 2019-2020 school year and employment contracts covering that period of time.

VIII. 457(f) Ineligible Deferred Compensation Arrangements for Local Governments When we think about the term “fringe benefits,” packages including health insurance,

travel reimbursement, and paid vacation come to mind. However, fringe benefits may also include retirement plans and severance packages. These benefits, if provided correctly, often can be provided to employees on a tax-deferred basis. However, if not provided in accordance with applicable tax law, some of these benefits can result in early taxation and even the imposition of excise taxes. For school districts, the most common forms that retirement benefits take are state pension benefits and deferred compensation plans including those pursuant to IRC Sections 457 and 403(b). This discussion begins with one that appears more elusive than the others: IRC Section 457(f) plans.

A. What is Section 457(f)?

IRC Section 457 provides rules for nonqualified deferred compensation plans established by eligible employers.60 State and local governments and tax-exempt organizations are eligible employers. They can establish either eligible plans that meet the requirements of § 457(b), or plans that do not meet the requirements of § 457(b) and that are therefore subject to IRC Section 457(f).61 Compensation paid under 457(b) is not taxed until received (unless subject to ROTH) and compensation paid under 457(f) is taxed when the risk of substantial forfeiture is gone.62 The basic rule of thumb to apply when reviewing a deferred compensation arrangement for application of 457(f) is to look for compensation promised in one tax year that cannot be collected by the employee until a future tax year, and the compensation is not provided pursuant to a 457(b) plan or a qualified plan such as a 403(b). If the compensation is subject to the application of IRC 457(f) and no exception within IRC § 457(f) applies, the compensation is taxable in the year the promise is made rather than the year the employee collects the compensation. However, if the compensation is subject to what is known as a substantial risk of forfeiture, taxation will not occur until that risk of forfeiture is lifted. Section 457(f) defines “substantial risk of forfeiture” as when the rights to the compensation are subject to future performance of substantial services.63 IRC Section 409A may also be implicated in deferred compensation arrangements where the benefit is provided

60 IRC § 457. 61 IRS Notice 2003-20. 62 IRC § 457(f)(1)(A). 63 IRC § 457(f)(3)(B).

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outside of a 457(b) or qualified plan. If applicable, this IRC section could cause early taxation, like IRC Section 457(f), but can also impose excise taxes.64

Practice Note: We often find arrangements in collective bargaining agreements where employers promise employees a dollar value for each year of service worked to be paid after retirement. These benefits can be in excess of $30,000 in some instances. However, when exploring them in operation, we find that the employee can get this benefit at any time as long as he retires and hence, there truly is no substantial risk of forfeiture. Technically, unless the benefit meets one of the limited exceptions under 457(f) or the requirements of 409A, it could be subject to taxation while the employee is still working. Practitioners should be alert to these potential arrangements and be able to assess them for this treatment.

IX. 457(b) Eligible Deferred Compensation Arrangements for Local Governments

A. General Requirements65

1. State and local governments and tax-exempt organizations under IRC § 501(c) may establish 457(b) Plans.

2. 457(b) Plans work by allowing employers or employees through salary

reductions to contribute up to the IRC § 402(g) limit ($18,000 in 2015 and 2016) on behalf of participants under the plan.

3. There are significant tax advantages for participants in a 457(b) plan,

including contributions to a 457(b) plan being tax-deferred and earnings on the retirement money also being tax-deferred.

4. Contributions to 457(b) Plans are not offset by IRC § 403(b) contributions. 5. May be offered to any employee without regard to nondiscrimination rules.

B. Plan Requirements

1. IRC Section 457(b) sets forth specific Plan document requirements and

Revenue Procedure 2004-56 provides model language for such Plans.

2. If loans and hardship withdrawals are allowed, the Plan document must provide for them.

64 IRC § 409A; Treas. Reg. § 1.409A-1. 65 IRC § 457(b).

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3. 457(b) plans of state and local governments may allow catch-up contributions for participants who are aged 50 or older.

4. Special 457(b) catch-up contributions, if permitted by the Plan, allow a

participant for three years prior to the normal retirement age to contribute the lesser of: (1) twice the annual limit ($36,000 in 2015 and 2016); or (2) the basic annual limit plus the amount of the basic limit not used in prior years (only allowed if not using age 50 or over catch-up contributions)

5. Regulations under Section 457 also apply.

Practice Note: In our practice we have not seen many 457(b) plans currently in use. However, for those school districts maintaining these plans, they must be consistently updated for changing laws affecting plans such as 457(b) plans. If a mistake is made, employers should utilize the system established by the IRS for correcting qualified plans called the Employee Plans Compliance Resolution System (EPCRS).

X. 403(b) Plans for Public Education Employers

A. General Requirements

1. A 403(b) plan, also known as a tax-sheltered annuity or TSA plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers.

2. Individual accounts in a 403(b) plan can be any of the following types:

i. An annuity contract, which is a contract provided through an insurance company,

ii. A custodial account, which is an account invested in mutual funds, or iii. A retirement income account set up for church employees.66

3. Regulations governing 403(b) took effect on January 1, 2009.67 These

requirements include, among other things, the adoption of a written plan that includes certain primary information about the plan.

B. Plan Status

403(b) plans are employer-sponsored retirement plans generally referred to as tax-sheltered annuities. They are qualified plans under the IRC and must therefore follow qualified plan rules. On a very basic level, 403(b) plans are funded when dollars are contributed by employers on behalf of employees into 403(b) plan eligible annuities and/or custodial

66 IRS. Publication 571 (Jan. 2016). 67 IRB. 2007-36; 72 Fed. Reg. 41,128 (July 26, 2007).

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accounts up to a maximum statutory annual limit. Those contributions and earnings on the contributions are then distributed to the participant or his/her beneficiary upon the occurrence of a distributable event. The benefits of contributing to a “traditional” 403(b) plan include: (1) the deferred taxation on allowable contributions until the year in which the participant begins making withdrawals from the plan; (2) the deferred taxation on earnings and gains on 403(b) plan amounts until the year in which the participant withdraws them; and (3) the potential tax credit for participant elective deferrals.68 403(b) plans must be in writing and conform to the requirements of the regulations.69

C. Regulation of the Plan Prior to the issuance of the final regulations, public schools were able to offer 403(b) plan arrangements without the aid of plan documents and were subject to very little regulatory control. Around 2007, the IRS began querying school districts around the country to determine whether they are in compliance with the universal availability standard as well as other nondiscrimination requirements and excess contribution rules. On June 21, 2007, the IRS published IR-2007-123 in which it informed the regulated community of its expanded outreach project to ensure eligible public school employees are allowed to participate in retirement annuities. Practice Note: The IRS has been auditing school district plans across the country. School districts should perform periodic internal audits of their plans to make certain they comply with the most recent requirements for 403(b) plans. School districts should not just rely on a third party administrator to make those changes automatically to their plans. But see the discussion below regarding volume submitter plans.

D. Participation is Controlled by the Plan

The 403(b) plan document must set forth the eligibility criteria for participation in the plan. Further, 403(b) plans must satisfy the universal availability rule which requires the ability for all employees (with the exception of limited employee classifications) to salary-reduce to the plan if one is able to salary-reduce to the plan. In addition, employers sponsoring one of these plans must provide eligible employees with meaningful notice of their ability to participate.70 Employers may limit participation in the 403(b) plan, however, by excluding the following types of employees: (1) employees who are eligible under another 403(b) plan or 457(b) eligible governmental plan of the employer which permits an amount to be contributed or deferred at the election of the employee; (2) employees who are eligible to make a cash or deferred election under a 401(k) plan of the employer; (3) employees who are non-resident aliens; (4) employees who are students performing services described in IRC Section 3121(b)(10); and (5) subject to the conditions applicable under section

68 IRS Publication 571, p. 3 (Rev. Jan. 2016). 69Treas. Reg. § 1.403(b)-3. 70 Treas. Reg. § 1.403(b)-5.

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410(b)(4), employees who normally work fewer than 20 hours per week.71 Further, employers cannot condition the right to make salary deferrals upon something else. (For example, the employer cannot condition eligibility on participation in the employer’s health insurance program).

Practice Note: If an employer does not provide any employee with the opportunity to salary-reduce into a 403(b) plan, the nondiscrimination rules of universal availability do not apply. Further, in our practice, we recommend that, with the exception of students, employers should not limit participation. Administrative burden is high to manage such exclusions and the entire 403(b) plan could fail if a mistake is made.

E. Contribution Limits Apply

The 403(b) plan document must recognize the annual limits on the amount of money that may be contributed to a participant’s 403(b) plan account each year and the allowable methods of contribution. Failure to abide by these limits may result in penalties if not appropriately corrected. There are generally two limits that apply to 403(b) plan contributions; which limit applies to a given situation is dependent in part on the types of contributions being made. For purposes of calculating in-service contribution limits, three different types of contributions may be made to a public education employer’s 403(b) plan. They may be any one or a combination of all three where allowed by the employer’s 403(b) plan. They include elective salary deferrals, non-elective employer contributions, and after-tax non-Roth contributions.72

In 2016, for participants who make elective salary deferrals, the limit on elective salary deferrals is the lesser of (1) the IRC Section 415(c) limit (100% of “includible compensation” capped at $53,000); or (2) the IRC Section 402(g) limit for salary deferrals ($18,000).73 For participants with only non-elective employer contributions the limit is 100% of “includible compensation” capped at $53,000 (the IRC Section 415(c) limit). Finally, for participants with both non-elective employer contributions and elective salary deferrals, the employer may contribute an amount up to the Section 415(c) limit (100% of “includible compensation” capped at $53,000 in 2015) less the actual elective salary deferrals (not including the age 50+ catch-up contribution-see below).74

In addition, participants may be eligible to salary-defer additional amounts over and above the 402(g) limit pursuant to the availability of catch-up contributions under the employer’s plan Specifically, if the plan allows, participants may use the 15-years-of-service catch-up ($5,000 per year, aggregate $15,000), and/or the age 50+ “catch-up”($6,000 for 2016) contribution.75

71 Id. 72 IRS. Publication 571, p. 3 (Rev. Jan. 2016). 73 IR-2015-118 (Oct. 21, 2015). 74 IRS Publication 571, p. 4-5 (Rev. Jan. 2016). 75 Id. at 11-12 (Rev. Jan. 2016).

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Practice Note: In our practice, we try to shift the responsibility for watching the contribution limits for participants to the school district’s third-party administrator or the service providers managing the accounts. Practitioners should focus on service provider agreements as well as third-party administrator agreements to make certain the parties understand the responsibilities. Failures can result in taxation as well as operational plan failures that will require correction.

F. Distributions

The 403(b) plan document must provide for the distribution rules. Generally, a distribution cannot be made from a 403(b) plan account until the participant: (1) reaches age 59½; (2) severs employment with the 403(b) plan employer; (3) dies; (4) becomes disabled; (5) suffers a hardship (elective deferrals); or (6) becomes eligible for a qualified reservist distribution.76 Like other qualified plans, 403(b) plans must comply with the required minimum distribution rules set forth in the IRC. Basically, a participant must receive at least a certain minimum distribution of his interest accruing after 1986 by April 1 of the calendar year following the later of the calendar year in which he turns age 70½ or the calendar year in which the participant retires.

G. Transfers/Rollovers/Hardships/Loans

The 403(b) plan document must set forth what types of transactions are allowed under the Plan such as rollovers, transfers, hardship distributions, and loans, if they are available and to what extent they are available. If a transaction is made by a participant that is not allowed by the plan, an operational failure could occur which could result in taxation and qualification failure if not formally corrected. In addition, the plan needs to set forth which vendors and accounts are allowed to receive contributions whether directly from the plan or by way of transfer. Practice Note: Plan sponsors should periodically update the list of vendors approved for receipt of contributions to make certain that list remains accurate. Further, in our practice, we have seen collective bargaining agreements with language in them regarding how vendor selection will be performed and the number of vendors. This language should be scrutinized to make certain it matches the language in the plan.

H. Recent Developments

Since publishing the final regulations, the IRS and Department of the Treasury issued Revenue Procedure 2007-71 providing: (1) model language that public schools may use for developing their 403(b) plans; (2) guidance regarding information sharing agreements; (3) guidance regarding transfers/exchanges of 403(b) plan account funds between service providers made after September 24, 2007 but prior to the employer’s adoption of a 403(b) plan document; and (4) guidance regarding “orphan” 403(b) plan accounts. The IRS has

76 Id. at 13 (Rev. Jan. 2016).

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since released additional guidance, including 403(b) pre-approved plans, prototype plans and volume submitter plans.77

Establishment of the pre-approved plan program for 403(b) was the next logical step for the IRS since, as of 2009, regulations required these qualified plans to be in writing and satisfy certain criteria. The IRS has historically provided qualified plans such as 401(a) plans to obtain determination letters whereby the IRS confirms the plan meets the requirements of the applicable statutes. It seemed only fair that a similar construct became available for 403(b) qualified plans. In April of 2013, the IRS released Revenue Procedure 2013-22 in which it set forth the procedures of the IRS for issuing opinion and advisory letters for 403(b) pre-approved plans (prototype plans and volume submitter plans.) It also established mandatory terms that must be in each type.78 The Notice also clarified that eligible governmental employers who adopt the pre-approved plans (prototype) may rely on the opinion letter issued for that plan that the plan complies in form. There are variations in plan design that will allow employers to adopt plans that provide various non-standard benefits, such as non-elective employer contributions. The pre-approved plan sponsor will be responsible for maintaining compliance through future amendments and potential periodic restatements. Thus, employers adopting these plans from vendors will need to periodically verify with them that compliance is being maintained.79 Practice Note: According to the IRS website, many companies have submitted their plans to gain approval from the IRS. However, it does not appear that any have received confirmation that they are indeed approved. The application window closed this past September. Once approved, however, school district employers may wish to adopt one of these plans once available. According to the IRS, by adopting a 403(b) pre-approved plan by the deadline (the IRS will establish and announce the deadline), the employer may retroactively correct defects in the form of its written 403(b) plan back to the first day of the plan’s remedial amendment period, which is the later of: January 1, 2010, or the plan’s effective date. The employer’s adoption of a pre-approved 403(b) plan that has a favorable opinion of advisory letter automatically corrects any defects in its prior written 403(b) plan but not defects in any documents incorporated by reference into the prior plan). Interim amendments are not required for a plan to be eligible for this remedial amendment period. However, 403(b) plan sponsors who didn’t adopt a written plan before December 31, 2009 can use the 403(b) Voluntary Program Submission Kit to correct this error.80

XI. State Law Considerations 77 IRS Rev. Proc. 2007-71, 2007-51; IRB 1184; IRS Rev. Proc. 2013-22. 78 Rev. Proc. 2013-22. 79 Id. 80 Id.

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Along with the federal requirements outlined above, there are additional state considerations, such as pension funds, that may also need to be considered.

IRS Circular 230 Disclosure: To comply with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained herein (including any attachments), unless specifically stated otherwise, is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein.

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