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 https://focusonpublicbenefits.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.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at firstname.lastname@example.org or (916) 329-3685.