By Paul M. Hamburger
What happens if a former employer decides to pay for a qualified beneficiary's COBRA premiums? What happens if a new employer wants to pay for COBRA premiums? These questions are raised by a recent IRS information letter in response to a congressional inquiry on these issues (IRS Information Letter 2006-0042, April 24, 2006, released Sept. 29, 2006; see ¶1810 of Mandated Health Benefits: The COBRA Guide). Although the information letter only addresses the tax issues associated with these payments, several other considerations should be considered before employers decide to pay for someone's COBRA coverage.
Former Employer Pays for COBRA Coverage
In some cases, an employer may choose to pay the COBRA premiums for a former employee for some reason (for example, as part of a severance package, the employer wants to be helpful, etc.). When an employer pays for a former employee's coverage, questions come up on whether the COBRA premium is deemed to be taxable income to the former employee.
The answer will depend on the specific facts as to how the employer pays for that coverage. According to the IRS information letter, if the employer simply gives the qualified beneficiary money with which to pay the premiums, and the use of the funds is not restricted, then the reimbursement is taxable to the former employee as wages (subject to income and employment tax).
Key Points to Consider When an Employer Pays for COBRA Coverage
- If a former employer simply gives money to pay the premiums, and the funds' use is not restricted, then reimbursement is taxable to the ex-employee as wages.
- If the former employer pays the premiums directly to the insurer or reimburses the ex-employee for the actual payment (or otherwise restricts fund use to premium payment), then reimbursement could be excludable from income.
- In the self-insured context, the ability to pay for a former employee's coverage is also likely to be tax favored.
- Generally, a new employer can reimburse a new employee for COBRA premium payments on a tax-free basis under the same theory described earlier.
- For there to be a tax-free reimbursement, the employer must obtain appropriate documentation that the premium payment was actually made.
- Does the employer want the responsibility to make sure that COBRA premiums are paid on time?
- How much will the employer agree to pay?
- Although a former employer might only want to do this for one (or select) ex-employee(s), this may be difficult to do without a more formal arrangement.
- By improperly explaining the arrangement, a new employer could make it seem that it is actually providing coverage as if it were the new employer's plan.
- If the current employer agrees to pay for a new employee's COBRA coverage, it must anticipate what will happen if the other employer's plan changes or is terminated and the employee no longer wants to continue that other coverage.
On the other hand, if the employer pays the premiums directly to the insurer or actually reimburses the ex-employee for the actual payment (or otherwise restricts the use of the funds to premium payment), then the reimbursement could be excludable from income. The key issue here is whether the qualified beneficiary will have an unrestricted right to use the funds for any purpose. If so, the funds are taxable; if not, and the use is restricted to payment for coverage, the funds will likely not be taxable.
In the self-insured context, the ability to pay for a former employee's coverage is also likely to be tax favored. This issue was addressed in IRS Private Letter Ruling (PLR) 9612008 (Dec. 18, 1995). (PLRs are not binding on the IRS in any case other than the individual taxpayer who requested the ruling. Nevertheless, PLRs are often relied upon by other taxpayers as reflections of the IRS thinking on various issues.) In that ruling (see ¶1820 of Mandated Health Benefits: The COBRA Guide), the IRS considered the following facts:
The employer established a severance plan under which it would agree to subsidize the COBRA premiums for the first six months of ex-employees' 18 months of COBRA coverage. If they wish to continue coverage for the rest of the COBRA period, they would have to pay the full amount of COBRA coverage.
Faced with these facts, the IRS was asked whether ex-employees covered by the severance plan could be treated as “employees" for tax purposes. The implication of that treatment would be that the premium subsidies during the first six months of COBRA coverage generally would be tax-free to the ex-employees. Essentially, the IRS concluded that the COBRA premium subsidies generally could be non-taxable benefits for those ex-employees.
One important caveat to PLR 9612008, however, is that if the group health plan in question is self-insured, it is subject to nondiscrimination requirements under Code Section 105(h). (These requirements do not apply to insured plans.) These nondiscrimination rules include rules prohibiting discrimination in terms of plan eligibility as well as benefits provided under a self-insured group health plan. Therefore, any subsidized group health plan coverage for former employees should be evaluated in light of these requirements. (The IRS declined to rule on those implications in the particular case presented for its consideration.)
Aside from the tax issues, however, former employers should consider the following issues in implementing such reimbursement arrangements:
- Does the former employer want the responsibility to make sure that COBRA premiums are paid on time? If they aren't, the qualified beneficiary will be complaining to the ex-employer that the coverage was terminated prematurely. It may be better to structure the arrangement as a reimbursement for premiums actually paid by the qualified beneficiary.
- How much will the former employer agree to pay? COBRA premiums may start out at 102 percent of the total cost and rise to 150 percent of total costs if the qualified beneficiary meets the rules for COBRA's disability extension. Will the former employer agree to pay up to 150 percent of the applicable premium in that situation? What if premiums go up in a subsequent year? Will the former employer just continue to pay no matter what the cost?
- Although the former employer might only want to do this for one ex-employee (or perhaps a select few ex-employees), this may be difficult to do without a more formal arrangement dictating which ex-employees would be entitled to the reimbursement arrangement. This makes it hard to distinguish between ex-employees as a practical matter.
New Employer Pays for COBRA Coverage
In other situation, an employer may hire a new employee who has COBRA coverage available from a former employer. Here, the question is: Can the employer reimburse the new employee for his or her COBRA premium payments on a tax-free basis?
The answer is generally, yes under the same theory described earlier when the former employer pays for that premium. For there to be a tax-free reimbursement, the employer must obtain appropriate documentation that the premium payment was actually made. If the employer provides cash to the employee that could be used for anything, regardless of whether the medical premium was paid, that payment would not qualify as a tax-free premium reimbursement.
Notwithstanding the tax result, however, employers should consider many practical issues that could make paying for an employee's COBRA coverage from another employer a bad idea. In addition to the two key points explained earlier, new employers have to consider the following:
- In some of these arrangements, the current employer may improperly explain the arrangement and make it seem that the employer is actually providing the coverage as if it were the new employer's group health plan. Then, if the employee terminates from the current employer, the employee might have expectations of additional COBRA coverage from the current employer. However, the current employer cannot realistically provide COBRA coverage that is identical to the coverage of another employer for the entire COBRA period. Again, this could lead to litigation with the former employee. Therefore, care needs to be taken to avoid creating a new ERISA/COBRA plan by the new employer.
- If the current employer agrees to pay for the COBRA coverage for a new employee, the employer needs to anticipate what will happen if that other employer's plan changes or is terminated such that the employee no longer wants to continue that other employer's coverage. Will the employer want to offer that employee a special enrollment opportunity in its group health plan? Under HIPAA's special enrollment rules, a special enrollment opportunity must be made available if the employee declines coverage due to the existence of COBRA coverage. However, the employee can only benefit from the special enrollment option if he or she exhausts the COBRA coverage. What will happen if the employee simply does not wish to have the employer pay for that COBRA coverage any longer because it is not as valuable? Will the employer open up its group health plan? If so, will that raise any issues vis-à-vis other employees who were denied enrollment under similar circumstances?
The IRS guidance on tax consequences is helpful. However, tax considerations alone are not a sufficient basis upon which an employer can make the decision of whether to pay for a qualified beneficiary's COBRA coverage. Indeed, tax considerations are arguably the least of the employer's concerns. Therefore, before agreeing to such an arrangement, an employer should consider these issues with the assistance of expert counsel.
Paul M. Hamburger, P.C. is a partner in the Washington, D.C., office of the law firm McDermott, Will & Emery LLP. He is a member of Thompson's Health Plan Advisory Board, and is author and contributing editor of the COBRA Guide, the Pension Plan Fix-It Handbook and the Guide to Assigning and Loaning Benefit Plan Money, all published by Thompson Publishing Group.