Small Business Job Protection Act of 1996 (HR 3448)
First, and significantly, the law contains design-based safe harbors for 401(k) plans. But the safe harbors will not take effect until plan years beginning in 1999. This delay exists in order to minimize revenue loss to the federal treasury. The new safe harbors will permit a 401(k) plan to avoid all average deferral percentage ("ADP") testing if the employer makes (i) a fully vested nonelective contribution equal to 3% of compensation or (ii) a fully vested dollar-for-dollar match up to 3% of an employee's compensation and an additional 50% match on elective contributions between 3% and 5% of the employee's compensation. There is also some flexibility in the new law to design additional safe harbors, so long as the aggregate matching contributions at each rate of elective contribution are no less than they would be under one of the two safe harbors just mentioned. Whether this flexibility will benefit employers remains to be seen. ADP testing, as you will recall, is the overly complicated test under which you compare average deferral percentages for highly compensated and nonhighly compensated employees after the close of a plan year and make refunds to some of the highly compensated group after, in many cases, they have already filed their income tax returns for the previous year. An employer who wants to take advantage of this safe harbor should amend its 401(k) plan sometime in 1998.
Second, and effective for plan years beginning on or after January 1, 1997, ADP testing will be simplified by allowing you to use the average deferral percentage for nonhighly compensated employees arising from the plan year that immediately precedes the year in which testing is being done. This will allow you to know exactly how much on average highly compensated employees will be able to contribute to the 401(k) plan each year. You will find this to be of some, but not a lot, of help.
Third, and this is a potentially significant change, ADP refunds (remember, these are the refunds that you make to your highly compensated employees if the 401(k) plan has flunked the ADP test for the previous year) will no longer be made first to highly compensated employees who have the highest percentage deferrals but instead will be made to highly compensated employees "on the basis of the amount of contributions by ... each of such employees." This change will take effect beginning with the 1997 plan year. There are many unanswered questions here, but the clear purpose of the change is to redirect ADP refunds away from the lowest paid of the highly compensated group which is where the refunds typically go and towards the more highly paid of the highly compensated group.
Fourth, the combined defined contribution and defined benefit limitation often referred to as the 415(e) limitation is repealed as of plan years beginning in the year 2000. For employers who maintain both defined benefit and defined contribution plans this will simplify administration of your plans; reduce the costs of administration; and save you from having to understand, let alone explain, why the combined benefits of your most highly compensated employees should be capped by a test that no one but the most skilled of actuaries can apply.
Fifth, effective for plan years beginning in 1998, you will be permitted to include salary deferrals under 401(k) plans and cafeteria plans in the definition of compensation when doing what is called your 415 testing so named because of the tax code section that creates the test. The 415 test says, for example, that an employee may not receive a combined benefit under all of your defined contribution plans of more than $30,000 or 25% of compensation, whichever is less, in any one plan year. Under current law, you have to back out 401(k) and cafeteria plan contributions from the definition of compensation when performing the 25% part of this test, which can sometimes cause some middle to lower paid employees to go over the limit. This is a good change in the law, and will remove a potential trap for employers and their plans.
Sixth, the new law generally eliminates beginning next year the requirement that active employees begin receiving required minimum distributions as of the April 1 following the year in which they turn age 70 1/2. As you know, under current law, you must make these minimum distributions to all participants who have reached this magic date (called the "required beginning date" in the law), even though they may continue to work and accrue additional benefits. The new law now says that with the exception of 5% owners a participant's required beginning date is the later of (i) April 1 of the year following the year in which the participant turns age 70 1/2 or (ii) April 1 of the year following the year in which the participant retires. The law also says that if a participant delays required minimum distributions until the year following his or her retirement, benefits must be "actuarially increased" to catch up, so to speak, on the distributions that the participant deferred during employment. The conference report to the new law says that this catchup rule applies only to defined benefit plans.
Seventh, five-year averaging on lump sum distributions is repealed beginning in the year 2000. We doubt that there are many employees who will notice this change.
Eighth, the rules for leased employees are revised to specify that you need only take leased employees into account for testing purposes if their services "are performed under primary direction or control by the recipient." This change is effective next year, and is long overdue.
Ninth and this also is a potentially significant change a "highly compensated employee" is now defined as any employee who (i) during the current or preceding plan year was a 5% owner or (ii) during the preceding year earned more than $80,000 (adjusted for inflation in future years). There is an additional wrinkle that allows you to limit employees caught by clause (ii) of the test to the top 20% of your work force ranked by pay. But the gist of this test is that in most cases fewer employees will be considered highly compensated employees and you will know as of the beginning of the year who is highly compensated and who is not. This change in the law goes into effect next year.
Tenth, the rules pertaining to waiver of qualified joint and survivor annuities are relaxed, and the IRS is directed to publish a model notice containing spousal consent language. These changes for the most part codify the current IRS position that a participant and spouse may waive the qualified joint and survivor annuity form of payment so long as there is at least a 7 day delay between the date of the waiver and the date distributions begin. These changes go into effect next year.
Eleventh, the family aggregation rules are repealed beginning next year. These rules affected small employers more than large employers. The family aggregation rules were absurd.
Twelfth, for pension and profit sharing plan distributions in 1997, 1998, and 1999, the 15% excise tax on excess distributions is suspended. The federal government views this as a revenue raiser intended to flush out taxable distributions from the retirement system.
Thirteenth, the $5,000 dollar exclusion on employer provided death benefits is repealed for persons dying after the date of enactment of the new law.
Fourteenth, employers with 100 or fewer employees will be permitted beginning next year to establish socalled SIMPLE IRA or 401(k) plans. There are some requirements here that may make SIMPLE plans unattractive for employers who qualify to set them up. Employee contributions are limited to $6,000 annually and the employer is not permitted to maintain any other qualified plan. The employer must also make an annual 2% nonelective contribution for eligible employees or a dollar-for-dollar matching contribution up to 3% of an employee's compensation. The 3% limit can be reduced, but not below 1%, for 2 out of any 5 plan years.
Fifteenth, taxexempt employers may establish 401(k) plans beginning next year.
Sixteenth, the new law makes a technical correction to COBRA which clarifies that if an employee's dependents become eligible to buy COBRA because the employee has retired or terminated employment, and if the employee became entitled to Medicare benefits within the 18 month period preceding his retirement or termination of employment, the employee's dependents are entitled to 36 months of COBRA coverage beginning with the date on which the employee became entitled to Medicare. This change is retroactively effective as of December 31, 1989.
There are a number of other things that the Small Business Job Protection Act of 1996 does in the employee benefits area, such as liberalizing contributions that spouses may make to IRA accounts; modifying the distribution and trust requirements for Section 457 plans; modifying the rules regarding the timing of employee contributions under tax deferred annuity programs; imposition of new requirements on issuers of tax deferred annuity contracts to insure that deferrals do not exceed the annual limit; and repeal of the 401(a)(26) minimum participation rule for defined contribution plans.
One final note about the new law: Plan sponsors may defer amending a plan until the 1998 plan year, provided that the plan is operated in accordance with the new requirements from their effective dates. In some cases, though, it may make sense to adopt amendments before the deferred deadline.
Health Insurance Portability and Accountability Act of 1996
First, the new law authorizes the limited issuance and use of Medical Savings Accounts ("MSA's"). MSA's will work a lot like IRA's, except that an MSA must be used for uninsured medical expenses. Here are some highlights:
- An MSA must be a trust created exclusively to pay for the account holder's uninsured medical expenses. The trustee may be a bank, insurance company, or other entity that demonstrates to the IRS that it can adequately serve as trustee. Earnings on an MSA are not currently taxable, and distributions from an MSA used to pay for medical expenses are not included in the account holder's gross income.
- Employees of "small employers" and selfemployed persons who are covered by "high deductible" health plans may make tax deductible contributions to an MSA. For individuals who have single coverage, the deduction is limited to 65% of the annual deductible under the health plan. For individuals who have family coverage, the deduction is limited to 75% of the annual deductible under the health plan. A "small employer" is an employer that has 50 or fewer employees. Note that, with several limited exceptions, no deduction is allowed if an employee or selfemployed person has health coverage in addition to coverage under the high deductible plan.
- Employers can also contribute to MSA's. Employer contributions are excludable from an employee's gross income and are exempt from Social Security payroll taxes. If an employer contributes to an MSA on an employee's behalf, the employee may not make tax deductible contributions to an MSA during that same tax year.
- A "high deductible" health plan is one where the annual deductible is not less than $1,500 and not more than $2,500 (for single coverage) or not less than $3,000 and not more than $4,500 (for family coverage). Annual out-of-pocket expenses under the plan may not exceed $3,000 for single coverage and $5,000 for family coverage.
- If a distribution from an MSA is not used to pay for uninsured medical expenses, the amount of the distribution is includable in the recipient's gross income. There is also an additional 15% penalty tax that applies unless the distribution is made on account of disability or after the account holder becomes Medicare eligible.
- Rollovers in and out of MSA's are permitted. On the death of the account holder, his or her surviving spouse can also assume ownership of the MSA without any immediate tax effect.
- No more than 750,000 taxpayers may benefit annually from MSA's. If that number is exceeded between now and the close of the year 2000 the categories of individuals eligible to participate in MSA's will be restricted. After the year 2000 the federal government is supposed to conduct a study of MSA's.
- Second, the new law imposes a number of new restrictions on both insured and selfinsured group health plans, effective for plan years beginning on or after July 1, 1997. The more notable of these restrictions are as follows:
- There will be one, and only one, preexisting condition clause that group health plans may apply. It will permit plans to exclude care for a condition (whether mental or physical), regardless of the cause of the condition, if medical advice, diagnosis, care, or treatment was recommended or received within the 6month period ending on a person's enrollment date. The exclusion can run for a period of no more than 12 months or, in the case of a late enrollee, 18 months, and must be reduced by periods of "creditable coverage" that the participant had under a prior group plan or plans (more on creditable coverage later). The 12 or 18 month periods begin to run from the earlier of the participant's enrollment date or the first day of any waiting period that the plan imposes on new employees.
- No preexisting exclusion clause may be applied to an individual who "as of the last day of the 30day period beginning with the date of birth" is covered under "creditable coverage." The intent of this rule is to preclude the application of preexisting condition exclusions to newborns. The law contains no age cap, however. This means that anyone no matter how old who can document "creditable coverage" during the first 30 days of his or her life (without a 63day break in coverage thereafter) will be exempt from the application of any preexisting condition exclusion clause. The significance of the 63day break in coverage rule is discussed below.
- A similar rule applies in the case of adoptions of a child who is younger than age 18 if the child is covered under "creditable coverage" within the 30 day period beginning on the date of adoption or placement for adoption.
- No preexisting exclusion may apply to pregnancy.
- Creditable coverage means coverage under a group health plan, a health insurance contract, Medicare, Medicaid, and a number of more obscure governmental health programs. Periods of creditable coverage preceding a 63day continuous break in coverage are disregarded. Note, though, that when counting this 63 day period we are required to ignore periods of noncoverage attributable to a plan's waiting period.
- Periods of creditable coverage must generally be counted without regard to the specific benefits offered under the prior coverage. There is an exception for employers who are willing to undertake an additional administrative burden. If an employer wishes, it may apply periods of creditable coverage based on categories or classes of benefits "as specified in regulations." This might allow an employer to apply a preexisting condition exclusion to a new employee who has creditable coverage under a plan that did not cover the employee's preexisting condition. For example, if the prior plan did not cover mental and nervous conditions, it might be possible for the successor plan to apply its preexisting exclusion clause to a new hire's claims for treatment of a preexisting mental and nervous condition. An employer who wishes to count periods of prior creditable coverage based on categories or classes of benefits must prominently include a notice to this effect in all disclosure statements concerning the plan.
- As a general rule, the new law says that periods before July 1, 1996, are not taken into account when calculating the amount of an employee's creditable coverage. The law also directs the IRS to establish a procedure by which individuals who "need" to establish creditable coverage for periods before July 1, 1996, can do so "through the presentation of documents or other means." This will be interesting.
- Beginning July 1, 1997, group health plans are required to provide certificates of creditable coverage to covered individuals at the following three times: when the individual goes off the group plan and onto COBRA; when the individual goes off of COBRA; and at the request of the individual if made within 24 months after the individual ceases to be covered under the plan or COBRA. The certificate must specify the individual's period of creditable coverage under the plan and the length of any waiting period that the plan imposed on the individual. Note that the requirement to provide this certificate is imposed on the "group health plan," which means that the "plan sponsor" (in most cases the employer) is legally responsible for seeing that the certificate is prepared and distributed.
- A group health plan must permit an employee or his dependents or both to enroll in the group health plan late if the reason for the delay is the loss of some other coverage that the employee or his dependents had through another source. For example, if one of your employees had declined coverage because he was covered under his wife's plan and he lost coverage under the wife's plan, your plan would be required to allow him to enroll if he applied within 30 days after his loss of coverage. The plan may not treat this as a late enrollment.
- If a group health plan provides dependent coverage, the plan must allow a newly acquired dependent (and the employee if the employee has not already enrolled) to enroll immediately, without imposition of a waiting period, if an application for enrollment is submitted within 30 days after the date of marriage, birth, or adoption. The plan may not treat this as a late enrollment.
- Group health plans will be prohibited under the new law from health underwriting. This means that plans will not be able to exclude sick individuals or charge them higher premiums. It does not appear that this prohibition will apply to stoploss carriers, which may force selfinsured employers to cover individuals whom a stoploss carrier has refused to accept.
- Failure to comply with the new restrictions on group health plans will carry a $100 per day tax on the employer with respect to each individual to whom a failure relates. In the case, though, of a health insurance contract issued to an employer with 50 or fewer employees, the tax is imposed on the insurance carrier.
- All of these new group health plan rules and restrictions will be placed in both the tax code and ERISA. This means that employees will able to sue employers in order to force them to comply with the new rules, and recover attorneys' fees if successful. It also means that employers will be able to raise all of their standard ERISA defenses in such a suit.
Third, COBRA is amended to coordinate the continuation of coverage rules with the restrictions that will apply to preexisting condition clauses next year. This means that COBRA coverage will end as soon as the new plan is required under federal law to cover a qualified beneficiary's preexisting condition.
Fourth, COBRA is amended to provide that, if a qualified beneficiary becomes disabled under Social Security during the first 60 days of the 18-month period of COBRA coverage following termination of employment, the period of COBRA coverage may be extended to 29 months following the employment termination date. This change is effective as of January 1, 1997.
Fifth, new born and adopted children of qualified beneficiaries become qualified beneficiaries in their own right. This means, for example, that a child adopted during the adoptive parent's period of COBRA coverage could make an additional COBRA election if the child lost coverage under the plan on account of the death of the adoptive parent. This change is effective as of January 1, 1997.
Sixth, an employer must, by November 1, 1996, distribute a notice to all of its qualified beneficiaries informing them of the changes that the new law makes to COBRA.
There are a number of other provisions in the new health law that will be of interest to employers and employees. These provisions affect employer-provided long term care; the taxation of long term care benefits to employees; and the tax free receipt of life insurance proceeds by individuals who are terminally ill.
One final observation about the new health insurance law: Our sense is that we will see more of this type of legislation regulating employer-provided group health plans. In retrospect, we suspect that the new health law will be viewed as something of a watershed, leading eventually to a level of regulation comparable to what pension and profit sharing plans now suffer through.
