Chapter 25: The Salary Continuation Trap

We often are asked to review the tax and employee benefits provisions of employment agreements between public agencies and their key executives. Because we recently have come across the same problem in several of these contracts, I decided to share with you what I will refer to as the “salary continuation trap.”

Experienced and capable chief executives can be hard to find, particularly when it comes to leadership positions of a limited duration – such as oversight of a large public works project or filling a key management position on an interim basis. Usually, these contracts provide for a specified term of employment, which invariably gets modified and extended. They also often contain provisions that allow the executive or the agency to cut short or terminate the agreement in certain cases. Under the circumstances, it is understandable that the executive would want the agreement to contain protections against the premature or unanticipated termination of the contract by the hiring agency.

Sometimes these protective provisions take the form of “severance pay benefits” that provide for the payment of additional monies to the executive following a unilateral termination of the executive’s employment by the agency without cause. Sometimes they just call for the payment of additional monies. As is explained below, it is important for these payments to be characterized as “severance pay” and not as “deferred compensation.”

If future payments of compensation, provided by a State, local government or tax-exempt entity, fall into the category of deferred compensation, they will be subject to taxation under Internal Revenue Code (IRC) section 457(f). This means that any amounts of compensation that are “deferred” under the agreement – that is, payable in the future – will be taxable as and when they are no longer subject to a substantial risk of forfeiture. In other words, if an executive’s contract provides for the payment of deferred compensation (not severance pay) at a specified time in the future and the executive’s rights to such payments are fully vested, the executive will be taxable at the time his vested rights to such compensation were created (i.e., when the contract was formed) even though he or she may not be entitled to actual payment of the monies until sometime in the future. How’s that for a trap?

In case the nature of the trap was not made clear, I’m talking about the fairly common practice of providing for between six and 24 months of so-called “salary continuation” following the expiration or termination of the executive’s contract. The contracts that we have seen simply provide that upon the expiration or termination of the contract by either party (and for whatever reason), the executive will continue to receive “salary continuation” for the specified period. Unless these payments are properly structured as a “bona fide severance pay plan” under IRC section 457(e)(11) – that is, payable only upon the unanticipated termination of employment – the executive and the agency likely have an income tax (or income tax reporting) problem.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 24: 457(b) Plan Fees And Revenue Sharing

Many public agencies pay little attention to their 457(b) plans because the agencies are not “paying” for them out of their own budgets. See Have You Checked Your Retirement Plan Fees Lately?

Plan fiduciaries are legally required, at least in California, to make sure that plan assets are used only to provide benefits and to defray the “reasonable expenses of administering” the plan. See California Constitution, article XVI, section 17(a). Therefore, it is surprising that so many public agencies have little or no idea how much is being “taken” from their plans as custodian/trustee, recordkeeping, third-party administration, fund management, and investment advisory fees. To compound the confusion, many 457(b) plans are provided through “bundled” arrangements where various plan services are provided by a single third party (e.g., an insurance company) and the fees for those services are “bundled” together (arguably, for the convenience of the plan sponsor). Such arrangements make it difficult to determine exactly how much the plan and its participants are paying for each of the services being provided.

How does “revenue sharing” factor into the mix? Revenue sharing is a common practice where mutual funds pay some of their revenue to the plan providers who perform recordkeeping functions for 457(b), 401(k), 401(a) defined contribution and 403(b) plans. These payments are to compensate plan recordkeepers and third-party administrators for providing plan accounting and participant servicing functions that the mutual funds would normally provide. However, revenue sharing makes it more difficult for plan sponsors and fiduciaries to figure out exactly how much is being paid for recordkeeping and plan administration assistance and exactly who is paying those fees. The “how much” question arises because shared revenue is always defined as a percentage of plan assets (i.e., a set number of basis points). Under this approach, the amount of shared revenue can increase over time to a point where it bears no real relationship to the level of services provided. Sometimes, the plan provider recognizes that it has taken too much revenue out of the plan and refunds some of that revenue into a “plan expenses account.” The problem with such accounts is that the plan fiduciaries must decide how to prudently and fairly allocate these amounts among the participants. The “who” question arises because the amount of revenue shared can vary by mutual fund. In such cases, participants who have invested in certain funds are paying a disproportionate share of the plan’s recordkeeping fees.

Does your plan’s service arrangement provide for revenue sharing? And, do you really understand how it works? Are you leaving too much money on the table?

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 23: Have You Checked Your Retirement Plan Fees Lately?

Many public agencies’ 457(b) plans, where all fees are paid by the plans, may be neglected for years or even decades.  And while this neglect may not cost the district or the city any more money, it is definitely costing plan participants.

Recently, we advised a number of public agencies that for one reason or another had not reviewed their 457(b) plan fees and expenses for quite a number of years. Here’s what we found:

  • Recordkeeping and investment advice fees often are structured to yield a targeted amount of revenue – an amount that may be grossly inappropriate if the plan’s assets increase dramatically. Unsophisticated plan sponsors often permit recordkeepers to express their fees as a percentage of plan assets. For example, take a small special district’s 457(b) plan with 20 participants and $1,000,000 in total assets.  While it might be reasonable for a recordkeeper to initially charge something like 50 basis points for its annual recordkeeping services (the equivalent of $250 per participant), it would be inappropriate and unreasonable for the recordkeeper to continue to receive 50 basis points ten years later when the plan’s assets have increased to $3,000,000.  The plan still only has 20 participants. However, due to plan contributions and investment earnings, the average balance is now $150,000 (not $50,000). If you recognize that the recordkeeper’s job is largely an accounting function, the fee for keeping track of participants’ accounts should remain the same no matter how large the account grows. In this case, plan participants are paying approximately three times too much for the recordkeeping services they are receiving.
  • A large number of public agencies maintain multiple 457(b) plans.  Usually, this situation has evolved to accommodate employee calls for more investment choices.  Apart from the likely compliance problems associated with multiple uncoordinated plans, the plan participants often lose out because the fees they are paying are based on three smaller pools of assets rather than on one larger pool of assets.  In one recent case involving three 457(b) plans with total assets of $10,000,000, the participants were paying “retail” costs for their mutual fund choices when they could have been “wholesale” through the use of institutional class funds. A single larger plan has more purchasing power.
  • Excess fees and expenses matter.  According to the SEC, a participant investing $100,000 over a 20 year period and earning a 4% annual return will end up with $30,000 less if his/her fees are just 75 basis points higher than what might be considered normal (.25%).

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 22: Social Security Replacement Plans – An Introduction

For many American workers, the Old-Age, Survivors, and Disability Insurance (OASDI) program serves as an important component of their retirement savings. This is not necessarily the case for the millions of workers whose State, local government and public agency employers have “opted out” of OASDI’s combined (employer and employee) 12.4% payroll taxes and are instead participating in a Social Security replacement plan (SSRP).  This article provides a brief introduction to such plans.

In a back-handed way, Section 3121(b)(7)(F) of the Internal Revenue Code states that most individuals’ employee services performed for a State, a political subdivision thereof, or of any instrumentality of a State or a wholly owned political subdivision or instrumentality thereof will be subject to OASDI provided that such individuals are not members of a “retirement system” of such State, political subdivision, or instrumentality.  The term “retirement system” is defined in Section 218(b)(4) of the Social Security Act (Act). These are SSRPs.

So, how does a governmental employer determine whether it must participate in OASDI or if it can opt out by providing some or all of its employees with benefits under a SSRP?

Steps for analyzing OASDI coverage:

  1. If the employee’s position is covered by an agreement under Section 218 of the Act (Section 218 Agreement) and no exclusion applies, the employee is covered. A Section 218 Agreement is a written agreement in which a State or local government voluntarily agrees to participate in Social Security. Note that once a State or local government agency becomes covered by a Section 218 Agreement, it is not permitted to withdraw or cancel its participation.
  2. If the employee’s position is not covered under a Section 218 Agreement and the employee is covered by a SSRP, the employee’s coverage under OASDI is not mandatory – the sponsoring employer can opt out of OASDI.

Based on numerous cases and inquiries involving these issues, we’ve noticed that:

  • Many public agencies do not know whether they and their employees are subject to a Section 218 Agreement. To find out, an agency can contact the State Social Security Administrator for its State. A list of State contacts can be found here.
  • Many agencies do not understand whether their retirement plans satisfy all of the requirements for being SSRPs. There are different requirements for defined contribution SSRPs and defined benefit SSRPs.
  • Many public agencies that use defined contribution SSRPs do not operate or invest them in accordance with applicable IRS guidelines.

In future posts, I’ll address more of the specific problems that can arise with SSRPs.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 21: Auto-Enrollment For Some Non-ERISA Plans

One of the more compelling recent trends in the world of tax-deferred savings (i.e., 401(k), 403(b) and 457(b) plans) has been the growth in the use of automatic enrollment, or auto-enrollment, features.  In a typical auto-enrollment situation, the employer enrolls the employee without the employee’s consent at a predetermined level of employee contributions and a default investment option. Under applicable rules, employees must be given notice of the arrangement and the ability to “opt-out.” There is a growing body of research pertaining primarily to 401(k)s that strongly suggests that once employees “automatically” set aside part of their wages in their employer-sponsored retirement plan, they will tend to stay the course and continue the savings practice on their own.

So, if auto-enrollment is such a great idea, why isn’t everyone using it? Like so many things, the answer is, “there may be legal problems.”

In the past, the problem with most auto-enrollment features was that many states’ laws restricted or prohibited an employer from deducting amounts from an employee’s paycheck without the employee’s written consent.  For example, California Labor Code section 221 prohibits such unilateral wage reductions and is punishable both as a misdemeanor crime and through civil penalties. This problem of state laws conflicting with what seemed like a good concept was resolved (partially) as part of the Pension Protection Act of 2007 (PPA), which expressly preempted conflicting state laws as they applied to ERISA plans.

So, the state law problem with auto-enrollment was removed for ERISA-covered plans; but not for non-ERISA plans (those maintained by state and local governments, public agencies and most churches).  The non-ERISA plans are still required to comply with state laws that prohibit deducting amounts from an employee’s paycheck without consent. Despite these impediments, we see news reports and studies suggesting a few local governments, at least, have adopted, or are in the process of adopting, auto-enrollment features in their 457(b) plans. The most notable is the City of Los Angeles.

They’re a non-ERISA plan sponsor, so how come they can do it? It appears that L.A. is relying on an exception contained in California Labor Code section 224 that provides that a wage deduction for pension plan contributions should not violate section 221 as long as it is expressly approved in a collective bargaining agreement.  This strategy/technique appears to open the possibility of auto-enrollment to a much larger potential audience including sponsors of non-ERISA plans like state and local governments, public agencies and churches.  Because of the potential criminal and civil penalties, non-ERISA employers in California should get legal advice before adopting such an arrangement.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 20: Opting Into A Pick-Up Plan

A recently issued IRS private letter ruling (PLR) puts the kibosh on the fairly common practice of allowing public agency employees to elect whether and at what level to participate in the agency’s mandatory contribution pension plan.

This plan design stems from several PLRs issued in the early 2000s that implied, without explicitly approving, that such elections did not cause income tax problems for the participants or plan qualification problems for the employer. Basically, eligible employees were given a one-time, irrevocable election of whether to participate and, if participating, the specific level of mandatory (picked‑up) employee contributions the employee would make.  In theory, if the employee mandatory contributions, which are normally after-tax, were properly picked up by the employer, such amounts would be treated as pre-tax contributions – not currently taxable to the employee.

In what to some of us is not a particularly surprising ruling, the IRS clarifies that:

1.    Giving an employee the choice of receiving a certain amount of cash or contributing that amount to a retirement plan would generally constitute a cash or deferred arrangement within the meaning of the 401(k) rules.

2.    Unless the adopting employer is eligible to maintain a “grandfathered 401(k) plan,” it is not possible for a governmental employer to offer such an arrangement as part of a tax‑qualified, or section 401(a), plan. Note, this ruling and discussion has no application to 457(b) plans of governmental employers.

3.    Although there is an exception under the cash or deferred arrangement rules for irrevocable, one-time elections that are made “no later than the employee’s first becoming eligible under the plan or any other plan or arrangement of the employer,” this exception does not apply when the employees are already participating in another qualified plan (or 403(b) plan) of the employer – such as CalPERS.

The result of this ruling is that plans with this feature need to be carefully examined to determine how participants will be treated from an income tax perspective and how the plan itself may need to be restructured or fixed in order to maintain its tax-favored status.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 19: Get the IRS’ Blessing for Your 401(a) Plan – Before It’s Too Late

The IRS has just announced major changes to its program for reviewing and approving the qualified status of certain retirement plan documents (see, Announcement 2015-19).  Essentially, the Service is doing away with its program for issuing determination letters as to the qualified status of so-called “individually-designed plans,” except upon initial qualification and plan termination.  Because practically every “governmental plan” intended to be a section 401(a) tax-qualified plan is an individually-designed plan, this means that most sponsors of such plans have a limited opportunity to seek one more IRS review and “blessing” for their plans.  Most public agencies with a tax-qualified plan that does not have a current determination letter will have until January 31, 2016 by which to review, update and submit the plan.

Virtually all benefits practitioners recommend that clients with individually-designed plans obtain a current determination letter with respect to their plan. Having a current determination letter provides legal and tax assurance (as well as peace of mind) that your plan document complies with numerous Internal Revenue Code requirements that apply at the time.  Failure of a governmental plan to meet the qualification requirements could at a minimum result in:

  • Immediate taxation of participants’ vested benefits
  • Loss of favorable tax-free rollover treatment
  • Withholding and payroll tax problems
  • Required financial audit disclosures and explanations

Although having a current determination letter does not prevent a plan from jeopardizing its tax-qualified status due to an operational failure, it certainly helps a plan sponsor (and the plan’s administrator) by providing them with an IRS-approved document to work with.

As mentioned earlier, almost all governmental qualified plans are also individually-designed plans, even if they have been prepared or provided by a nationally recognized plan servicer such as Lincoln, Great-West or VALIC.  If you are a governmental qualified plan sponsor, you should immediately determine whether your plan is individually-designed and whether it is eligible to be submitted to the IRS for approval “one last time.”

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 18: It’s Supposed To Go To Whom? Beneficiary Designation In Governmental Defined Contribution Plans

Here’s an interesting difference between public and private industry plans that we were reminded of recently and that we’d like to share with our governmental clients and their advisors because it can be so problematic.

In most private industry plans, federal law requires that the spouse be the automatic death benefit beneficiary of the participant’s interest under the plan or that the spouse consent to any beneficiary designation that doesn’t name them as the sole primary beneficiary. Not always so in governmental plans.

Take for example the designation of a death benefit beneficiary or beneficiaries under a governmental defined contribution plan or 457(b) plan in a community property state like California. We’ve found that in many cases, local governments are using generic plan documents that don’t even recognize the fact that the respective interests of the participant and the spouse may be governed by state community property laws.

California courts recognize that a defined contribution plan account balance that was accumulated during the course of a marriage is community property and may be subject to division upon marital dissolution.  As importantly, the courts also recognize that the participant may only be able to clearly designate the death benefit beneficiary as to the participant’s one-half community property interest and that the spouse has a one-half interest in the account, based on community property laws.

This can be a huge problem in the case of any governmental plan in a community property state where the plan’s document, forms and procedures do not adequately explain the rights of the participant and those of the spouse to decide how their respective community property interests under the plan will be distributed in the event of their deaths.

The best way to handle this is to make sure that the relevant plan document, plan summary, applicable procedures and beneficiary designation forms and instructions all clearly spell out the respective rights of the participant and the spouse in connection with any beneficiary designation. A commonsense, best practice would be to not allow any beneficiary designation to be made or changed by one spouse without the knowledge and express written consent of the other spouse.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or email us at jcc@seethebenefits.com.

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Chapter 17: Bankruptcy Ruling Cuts CalPERS Down To Size

On February 4, 2015, the Judge overseeing the City of Stockton bankruptcy issued an opinion, overruling Franklin Templeton’s lone objections to the City’s plan of reorganization and, very pointedly, clarifying the true role of CalPERS – at least in a bankruptcy context.

For those new to the case, some quick background. When the City filed for chapter 9 protection in 2012, it successfully negotiated away over $2 billion in long-term debt with all of its creditors except one. Facing a potential loss over $32.5 million, Franklin Templeton rejected the City’s settlement offer and filed suit, arguing against CalPERS’ claim of public pension inviolability and basically asserting that the pension giant needed to get in line with its hand out for its money like everyone else.

According to the judge’s ruling, Franklin Templeton may have been right, but it didn’t win. And in the sense of a “win,” neither did CalPERS, which Judge Klein characterized as a bully with a glass jaw (really, read the opinion).

So what does it all mean? Here are my takeaways:

  1. A careful examination of the relationships between CalPERS, a participating employer and its employees reveals that CalPERS is not a major creditor of any participating employer because it does not guarantee the funding of employees’ pensions. “CalPERS is merely a servicing agent that does not guarantee payment.”
  2. In evaluating the respective rights and responsibilities of various chapter 9 creditors, it is the employees and retirees of a city who are one of the largest, if not the largest creditor. An insolvent city must negotiate with them to obtain appropriate wage and benefits concessions.
  3. Because CalPERS does not guarantee the pensions it “services,” CalPERS appears to lack standing to object to pension modifications in a chapter 9 proceeding.
  4. Provisions in the Public Employees Retirement Law that purportedly forbid the rejection in bankruptcy of a CalPERS contract and provide for a CalPERS lien for termination liabilities are both ineffectual in a federal bankruptcy context.
  5. The vaunted “vested rights” doctrine under both California case law and the state and federal Constitutions does not prevent Congress from enacting a law (the federal bankruptcy act) impairing a state or local government’s obligation of contract.

How will this all affect other pending and future municipal bankruptcies? Stay tuned.

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Chapter 16: Same-Gender Spouse Ruling Requires Review Of Public Retirement Plans

On June 26, 2013, in United States v. Windsor (Windsor), the Supreme Court decided that section 3 of the Defense Of Marriage Act (DOMA) was unconstitutional.  DOMA had limited “marriage” to opposite-gender couples for purposes of federal law.  As result of this decision, the IRS has taken the general position that where a provision in the Internal Revenue Code (Code) refers to marriage, husband, wife, or husband and wife, the IRS will interpret the Code to include a valid same-gender marriage and the individuals of the same gender in that relationship.  A same-gender marriage is valid if it was validly entered into in a State whose laws authorize the marriage of two individuals of the same gender even if the married couple is now domiciled in a State that does not recognize the validity of same-gender marriage.  Therefore, employers and plans in States that do not currently recognize same-gender marriages may be required to recognize same-gender marriages performed in different States.  “Marriage” does not include individuals (whether of the opposite gender or the same gender) who have entered into a registered domestic partnership, civil union or other similar, formal relationship under State law that is not treated as a “marriage” under the laws of the State.

More recently, in Notice 2014-19 (Notice), the IRS issued guidance on what sponsors of qualified retirement plans may need to do in order to maintain the tax-qualified status of their plans in light of Windsor.  The Notice generally gives plan sponsors until the end of 2014 to make any necessary amendments to bring their plans into compliance.  The Notice also clarifies that a plan will not be treated as having a qualification failure if, prior to September 16, 2013, it only recognized same-gender spouses of participants domiciled in a State that recognized same-gender marriage.

An amendment is required if your plan’s current terms do not agree with the way in which the plan is to operate in light of Windsor.  Even if your plan does not currently define “spouse,” you may want to amend your plan in order to clarify exactly how you want to operate your plan with respect to same-gender spouses.

In the case of a governmental 401(a) plan, the deadline is the close of the first regular legislative session of the legislative body with the authority to amend the plan that ends after December 31, 2014.  For many public agencies whose governing boards meet on a monthly basis, compliance is required by January 2015. For 403(b) plans and 457(b) plans, the plan should be amended as soon as possible.  We recommend the following actions:

1.         Review the administration of your plan, starting on June 26, 2013, and confirm that your plan has complied with the Windsor case and the IRS guidance.  Once you have made this determination, document it.

2.         If your plan has not complied with the Windsor case and the IRS guidance in operation, take appropriate actions under the IRS’s Employee Plans Compliance Resolution System to correct the administration of the plan.

3.         Review your plan documents to determine if any of your plans contain a definition that is inconsistent with the Windsor case.  If so, amend the plan by the deadline stated above (e.g., January 2015).

4.         Even if your plan’s definition is consistent with IRS guidance (or the plan does not define “spouse” specifically), consider adopting a plan amendment to make clear the effective date of the change and the application of these requirements.  It is easier to administer new plan rules and requirements that are expressly spelled out.

5.         Review and update your plan summary and your employee communications as appropriate.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 15: Giving Employees Choices Can Sometimes Lead To Problems

Because many of our public agency clients have collectively-bargained employees, we continue to see a variety of efforts by employers and their bargaining partners to make the most of limited compensation and benefits dollars.  Sometimes, the parties believe that they can get more mileage from limited dollars by letting the employees choose between two employer-provided benefits.  In many cases, because the parties are working with monies earmarked for employee benefits (not salaries), these choices do not include the ability for the employees to receive cash instead of the employer-provided benefits.

For those of you who have guessed that such a situation does not create a constructive receipt problem – congratulations! You’ve been paying attention to our other writings about the perils of letting employees choose between cash and nontaxable benefits (see http://www.seethebenefits.com/).  So, if there is no constructive receipt tax problem, what is the concern?  Unfortunately, another lesser-known tax problem can arise when a choice is given to employees between additional deferred compensation (an employer contribution to a 457(b) plan or a 401(a) plan) and an additional health insurance subsidy (an employer contribution for health insurance).  This lesser-known problem stems from the “assignment of income” doctrine.

Without digressing too much into the case law, there are a number of U.S. Supreme Court cases that stand for the proposition that if a taxpayer who is entitled to receive income in the future gives up that right (generally by surrendering it to another taxpayer), the taxpayer will be treated for tax purposes as having first received the “future income” and then disposing of it.  How does the assignment of income doctrine cause a choice between an employer-made 457(b) plan contribution and an employer-made health premium subsidy to become taxable?  If you look more carefully at what is going on, you will see that the employee’s choice is between the receipt of future income (amounts that will be taxed when distributed from the 457(b) plan) and a nontaxable current benefit (tax-free employer subsidy of health coverage).  If the employee gives up the right to receive additional 457(b) distributions in the future in exchange for an additional current health insurance subsidy, the IRS views this as an assignment of income and has stated on several occasions that such a choice would result in current taxable income to the employees who elect the additional health insurance subsidy – even though they are not now receiving any cash and have elected to receive what appears to be a nontaxable benefit.  Having a cafeteria plan does not avoid the additional taxable income, even if the employee could otherwise reduce taxable compensation on a pre-tax basis for health insurance premiums under the cafeteria plan, because a cafeteria plan cannot allow a choice between nontaxable health benefits and deferred compensation.  Therefore, the employee’s choice to forego the deferred compensation contribution in favor of additional health insurance premiums is not being made under the cafeteria plan and, as a result, the choice does not result in a pre-tax health insurance premium deduction.

The takeaway from all of this is that employers and their collective bargaining partners need to be particularly careful when negotiating and designing benefit changes that involve employee choice.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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Chapter 14: Not Everyone Wants To Share – How Many OPEB Trusts Do You Need?

Now that the general economic situation and public agency finances appear to be improving, a number of municipalities and special districts are once again looking at their unfunded OPEB (other post-employment benefits) liabilities with an eye to getting these liabilities under better control.  One obvious way to control the amount of such unfunded liabilities is to fund, or set aside money to pay for, emerging retiree health obligations. When evaluating and establishing appropriate OPEB funding vehicles, it is important to consider whether the employee groups who may be contributing to such funding (typically through negotiated wage reductions) will be willing to “share” a single trust or not.

To put a sharper point on this, picture me, a husky older teenage brother, sitting down for dinner with my three younger, much smaller siblings.  Our family frequently dined “family-style” – where one large (or sometimes not so large) plate of the main course was placed in the middle of the table for all to share.  I’m learning now, many years later, that my siblings often felt they were in a race with me to get their share of the main course.  If they waited too long, Jeff would eat it all up!

I mention this not-so-flattering story to illustrate the important question of whether a public agency should use only one, or more than one, OPEB trust to fund its retiree health obligations.  What got me thinking about this was a municipal client of ours that participates in the CalPERS-sponsored California Employers’ Retiree Benefit Trust (CERBT).  In discussing the situation with the client and representatives of CERBT, I realized that the current offerings of CERBT may not be a good fit for many public agencies – particularly those with more complicated retiree health benefit structures.

Here’s why.  Currently, CERBT provides and allows for only a single funding account, as part of its large multiple-employer trust, for each participating employer.  So, for example, a very large city (e.g., Los Angeles) would have one account and a small municipal water district would also have one account.  The problem is that a big city typically has many unions with which it negotiates, each with a different level of employee cost sharing and perhaps a differing level of retiree heath benefit.  If the firefighters are “contributing” more of their paychecks towards the funding of their retiree health benefits than the police officers are, but the police officers are retiring and drawing on benefits at a faster rate, one can see the beginnings of a “family-style” dilemma as described above.  That is, if you have only one trust, then everyone shares in the same funding – regardless of whether they are contributing the same amounts and whether they are withdrawing the same levels of benefits.  If asked about it, most unions would not be willing to share their retiree health trusts with a number of other unions.

What can be done? By far, the easiest thing to do is to establish multiple OPEB trusts (or, OPEB sub-trusts).  That way the contributions, funding level, and participant utilization will be separate and distinct for each bargaining group.  Although the CalPERS CERBT currently does not offer the option of allowing each participating employer to establish multiple sub-trusts for this purpose, there are a number of reputable providers that do provide for such an option, such as the multiple-employer OPEB trust offered by PARS.  Our understanding is that there are relatively little if any start-up costs for an agency or city to set up multiple trusts of this sort and that the ongoing costs are very competitive with those charged by CalPERS.  Of course, it is up to each employer to determine what is best for it employees, but it may be ill-advised to assume that all of your bargaining groups will be happy with “family-style” retiree health funding.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

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