Welfare benefit plans and executive compensation.

• Author: Walker, Deborah
• Position: Current Developments in Employee Benefits & Pensions, part 1

During the past 12 months, numerous cases, rulings and regulations on executive compensation, welfare benefits and qualified plan requirements were issued. This two-part article covers the most significant of these. Part I, below, addresses the funding and payment of welfare benefits, covering flexible spending accounts (FSAs), new Medicare and prescription drug legislation, health savings accounts (HSAs) and disability benefits. It also discusses planning opportunities in executive compensation, including loam, nonqualified deferred compensation, change in control and the IRS's executive compensation audit initiative. Part II, in the December 2004 issue, will focus on retirement plan developments and planning.

Medical Benefits

Reimbursement for Nonprescription Drugs and Exercise Equipment

The IRS issued guidance that may effectively broaden the types of reimbursable expenses under FSAs. Rev. Rul. 2003-102 (1) clarifies that the cost of nonprescription drugs can be reimbursed under an FSA. Previously, in Rev. Rul. 2003-58, (2) the IRS concluded that individuals could not deduct the cost of nonprescription medicines; however, that ruling does not affect the Sec. 105(b) exclusion on which FSA reimbursements rely. Sec. 105(b) only requires that the expense be described in Sec. 213(d), which broadly covers any payment "for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body." Regs. Sec. 1.213-1(e)(ii) excludes cosmetics, toiletries and expenditures "merely beneficial to the general health," but does not distinguish between prescription and nonprescription drugs. Hence, FSAs can reimburse items such as pain relievers, cold remedies and allergy medications, but not vitamins, dietary supplements or health foods.

Most FSAs routinely limit coverage to prescription drugs, but the recent reclassification of a number of medications from prescription to nonprescription has made the nonprescription prohibition too restrictive for many employees. Thus, Treasury and the IRS apparently decided there was a need for guidance distinguishing the deduction and exclusion rules.

In a similar vein, the IRS held in an information letter (3) that the cost of purchasing home exercise equipment used for treating a physician-diagnosed illness, including obesity, could also be deducted. Unlike prescription drugs, these costs can be deducted as a direct result of Rev. Rul. 2002-19, (4) in which the IRS ruled that obesity is a disease and the cost of participating in a weight-loss program to treat it may be a Sec. 213 expense.

Although the new ruling and information letter may encourage liberalized reimbursement rules, which, in turn, may increase costs and administrative burdens, it may also encourage more employees to participate in health FSAs and to contribute greater amounts to them. Increased participation will lower the plan sponsor's payroll tax liabilities, because salary reduction contribution to health FSAs are not subject to Social Security, Medicare and Federal unemployment taxes.

The Medicare Act

In December 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (5) (Medicare Act). In addition to a new Medicare Part D beginning in 2006, the law provides employers, offering retiree prescription drug coverage, a 28% tax-free rebate or the ability to limit retiree benefits, without decreasing the prescription drug coverage for workers. The Medicare Act also gives a boost to consumer-driven health, by establishing annual individual HSAs with balances that can roll over from year to year.

HSAs

The Medicare Act created HSAs, a new savings vehicle intended to succeed the Archer Medical Savings Account (Archer MSA). As promised, Treasury and the IRS issued a significant amount of detailed guidance in late 2003 and 2004 on HSAs, including a fact sheet and numerous revenue rulings and notices, discussed below. The Department of Labor (DOL) also issued guidance on whether HSAs are welfare benefit plans for purposes of the Employee Retirement Income Security Act of 1974 (ERISA), Title I.

Notice 2004-2: (6) This notice summarized the basic statutory rules. Although it filled in a few details, it left many unanswered questions. A summary of key points follows.

An HSA is an investment vehicle that operates similar to an IRA. Banks, insurance companies and other entities eligible to act as IRA or Archer MSA custodians can serve as HSA trustees or custodians. An individual is free to select any provider, without reference to his or her health insurance company or employer. Like an IRA, the account is personal to its owner. Its earnings are tax free, unless it has unrelated business taxable income. The rules governing permissible investments are generally the same as those for IRAs.

An individual is eligible to make HSA contributions only if he or she is covered by an insured or self-insured "high deductible health plan" (HDHP). The plan's deductible must be at least $1,000 for individual coverage or $2,000 for family coverage. Out-of-pocket maximum payments must be limited to $5,000 for individuals or $10,000 for a family. In addition to HDHP coverage, the account owner may have accident, disability, dental, vision, long-term care and some other forms of insurance, but cannot otherwise be covered by a non-HDHP plan. HSA eligibility ends when the account owner becomes eligible for Medicare. The eligibility conditions need to be met only when the account is receiving contributions. A person who creates an HSA and then loses eligibility (e.g., switches to a non-HDHP policy or reaches age 65), still has a valid HSA from which he or she can receive distributions. However, he or she cannot add further funds to the account.

Annual HSA contributions are limited to the lesser of the policy's deductible or an indexed dollar limit ($2,600 for an individual, or $5,150 for family coverage in 2004). Contributions may exceed 100% of compensation income and are fully deductible, whether or not the taxpayer itemizes. If a person is eligible for HSA contributions for only part of the year, the regular contribution limit is prorated on the basis of full months.

Eligibility is determined on the first day of each month. For instance, an account owner with individual HDHP coverage and a $2,000 deductible, who reached age 65 on Sept. 2, 2004, will be able to make a regular contribution of $1,500 (9/12 of the full-year $2,000 limit). In addition to regular contributions, individuals between ages 55 and 65 may contribute...