Structure of Firm Severance Package Can Result in Loss of Federal Health Subsidy

The ABA Journal recently reported that at least 3,500 attorneys and staff ' “and perhaps significantly more” ' lost their jobs in March. (Neil, Marth. “March Mayhem Tally Tops 3,500 After End-of-Month Law Firm Layoffs.” Available at www.abajournal.com/weekly. Posted on March 31, 2009.) That follows reports of at least 2,100 layoffs in February and 1,500 in January. And there are no doubt more to come as law firms continue to assess how to deal with the current economic situation.

Virtually all of these laid-off workers are eligible both for COBRA continuation health care and the new federal subsidy to pay for such coverage. But in an ironic twist, the more generous the firm's severance package with respect to subsidizing COBRA continuation coverage, the less generous the federal subsidy. As a result, firms may want to reconsider the structure of their severance packages.

ARRA

The American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5) (ARRA) amended the Internal Revenue Code and ERISA to establish a federally funded premium assistance payment equal to 65% of the premium an involuntarily terminated employee pays for COBRA coverage. The federal assistance is available with respect to employee-paid premiums on or after, generally, March 1, 2009. The 65% subsidy applies to the full employee-paid premium (generally, 102% of the active-employee health premium) unless the employer subsidizes the premium. In the case of an employer subsidy, the 65% federal subsidy applies to the lower premium (i.e., the full premium minus the employer subsidy). Thus, law firms that subsidize COBRA premiums are turning their backs on federal money.

COBRA in General

COBRA health care continuation coverage is not new. What is new is the ARRA-added federal subsidy for involuntarily terminated workers. COBRA requires that an employer with 20 or more employees provide certain former employees, retirees, spouses, former spouses, and dependent children (“qualified beneficiaries”) the ability to purchase up to, generally, 18 months of continuing health coverage in an employer's continuing health plan if a “qualifying event” occurs.

For employees, a qualifying event is: 1) a voluntary or involuntary termination of employment for reasons other than gross misconduct; or 2) a reduction in the number of hours of employment. For spouses (in addition to the employee events), a qualifying event is: 1) a divorce or separation from the covered employee; 2) death of the covered employee; or 3) the covered employee becoming entitled to Medicare. For dependent children (in addition to employee and spouse events), a qualifying event is loss of dependent status under the plan rules.

An employer must offer qualified beneficiaries health coverage identical to that available to similarly situated active workers. If the employer changes the benefits in the future for active participants, the change applies also to qualified beneficiaries. Qualified beneficiaries must also have the same open enrollment rights as active participants. If the employer stops offering a health plan to active participants or goes out of business, COBRA coverage ends.

Employers must notify plan administrators of a qualifying event within 30 days after an employee's death, termination, reduced hours of employment or entitlement to Medicare. (A qualified beneficiary must notify the plan administrator of a qualifying event within 60 days after divorce or legal separation or a child's ceasing to be covered as a dependent under the plan rules.) The plan administrator must generally send election notices to the qualified beneficiary not later than 14 days after the plan administrator receives notice that a qualifying event has occurred. The qualified beneficiary has 60 days after receiving the notice (or, if later, 60 days after the loss of coverage) to elect continuation coverage, and 45 days after electing coverage to pay the initial premium. The initial premium payment covers the period of coverage from the date of the election retroactive to the date of the loss of coverage.

COBRA Premium Payment Assistance

ARRA provides a 65% COBRA premium subsidy (“premium payment assistance”) for employees (and, if they have family coverage, their spouses and dependents) who are involuntarily terminated between Sept. 1, 2008 and Dec. 31, 2009 and, as a result, lose their health coverage during that time period. Although the triggering event is retroactive, the premium payment assistance is only effective for periods of coverage beginning on or after, generally, March 1, 2009. There is no premium assistance tied to any of the other qualifying events.

The premium payment assistance lasts for the first to occur of: 1) nine months; 2) the end of the person's COBRA eligibility period; or 3) the person's eligibility for other health care coverage. (COBRA coverage itself only ends if the qualified beneficiary “enrolls” in another health plan.) The subsidy is based on the premium the qualified beneficiary pays.

The assistance eligible individual (AEI) receives ARRA COBRA premium assistance by paying 35% of the COBRA premium. The employer pays the other 65% and claims a
reimbursement. (For plans covered only by state mini-COBRA laws, generally the health insurance plan pays the subsidy and claims the reimbursement.) The entity eligible for reimbursement recovers these amounts by subtracting the amount equivalent to the 65% subsidy from the federal withholding and employment tax (federal income tax withholding, FICA, and Medicare) payments/deposits it would otherwise make for its active employees, or, by requesting a refund on the applicable federal employment tax return (e.g., Form 941) for those employees.

Involuntary Termination

Although COBRA health coverage is available based on a number of triggering events, the 65% federal subsidy is only available if the employee has an “involuntary termination” within the proper time period. In Notice 2009-27, the Service clarifies that whether a separation is “involuntary” is a facts-and-circumstances determination. However, The Notice leans very heavily in favor of a termination being treated as involuntary.

The basic test for a termination to be “involuntary” is whether the severance is due to the independent exercise of the unilateral authority of the employer to terminate the employment, other than due to the employee's implicit or explicit request, when the employee was willing and able to provide services. The Notice provides the following examples of terminations that generally are involuntary:

• An employer's failure to renew a contract at the time it expires (if employee was willing and able);
• An employee's termination for good reason due to an employer action that causes a material, negative change in the employment relationship;
• An employee's voluntary termination when the employee knew if he or she did not resign, the employee would have been fired;
• An employee's voluntary termination in response to a reduction in hours that is a material, negative change in the employment relationship (a reduction in hours alone is not enough even if the employee loses health care coverage);
• An involuntary reduction to zero hours ' such as layoff, furlough, or other suspension of employment;
• Retirement, if it was in response to the employee's knowledge that absent retirement, he or she would have been fired;
• Resignation as a result of a material change in geographic location;
• An employee's voluntary resignation in return for a severance package when the employer indicates that if not enough employees voluntarily take the severance package, the employer will involuntarily terminate employees; and
• Lockouts (but not strikes).

Income Eligibility and Annual Information Reporting Requirements

There is both an individual and family income test for COBRA premium assistance eligibility. A qualified beneficiary is not eligible to be an AEI if the individual's adjusted gross income for the tax year exceeds $145,000, or, if the individual files a joint return for the year, the adjusted gross income exceeds $290,000. If the adjusted gross income is at least $125,000 for an individual or $250,000 for a joint return situation, there is a proportional reduction in the subsidy.

The burden for the income test falls almost entirely on the qualified beneficiary and not the employer or insurer. The person who elects COBRA may pay the full amount without subsidy (and so notify the employer, insurer, etc.). If this notification takes place in 2009, the qualified beneficiary may not take advantage of the subsidy even if his or her income falls under the limit in 2010. Thus, it is likely that most participants will use the alternative method. Under the alternative method, the person pays the subsidized amount (the employer must accept the reduced amount even if the employer has knowledge of the qualified beneficiary's income). The IRS then recovers any overpayment of the subsidy (dollar-for-dollar) by increasing the person's income tax liability (not the taxable income) by the amount of the subsidy. This increase in tax cannot be offset by tax credits. (There are no rules preventing higher-income persons from deliberately creating COBRA premium assistance overpayments in order to delay cash layouts.)

Employee Notification Requirements

ARRA has detailed notice requirements for different fact situations. The Department of Labor has published model notices that employers may use to meet these requirements. See www.dol.gov/cobra.

Employer Subsidies

If the employer subsidizes the premium for part or all of the
COBRA period, the 65% applies to the lower subsidized premium the qualified beneficiary pays. For example, normally for a $1,000 monthly premium, the federal subsidy would be $650 and the employee would only have to pay $350. If, however, the employer subsidizes 50% of the COBRA premium, the federal subsidy would only be $325 (65% of the $500 premium) and the employee would pay the remaining $175. Thus, the employer and employee combined have turned their back on $325 of federal money.

Some law firms are subsidizing several months of COBRA as part of their severance packages. Let's assume the firm subsidizes four months of COBRA at 100%. For the first four months, the employee pays no COBRA premium, the firm pays the $1,000, and the federal government pays nothing. After the four months, if there is no further employer subsidy, the federal government will pay five months at $650 (assuming continued eligibility) and the former employee with pay $350 per month (a total of nine months).

Alternatively, the firm could treat the loss of health coverage as occurring four months after the termination of employment. In this case, the firm would pay the $1,000 for four months and the employee would have a full nine months in which the government pays 65% of the $1,000. The design choice is up to the firm.

In either of these cases, however, the firm has paid a $1,000 for four months and received nothing from the federal government. One alternative would be to reduce or eliminate the firm's subsidy. In that case, the firm would be able to benefit from the federal subsidy right away. However, employees would have more of an out-of-pocket expense. Firms could make this up by increasing other severance payments. However, that additional severance cannot be directly tied to the former employee's COBRA premiums or it will continue to be treated as a federal subsidy.

Conclusion

There are several difficulties with trying to create equality while taking advantage of the federal subsidy. How much the employer, employee, or federal government pays is dependent on when the employee becomes eligible for other coverage (at which point the federal subsidy ends even if the employee does not elect the other coverage ' maybe because the employer continues to subsidize). As a result, any reduction in the employer subsidy will be more advantageous to former employees who are eligible for the
COBRA subsidy for a longer period of time relative to a shorter period of time (in direct relation to the period for which the employer subsidizes).

The bottom line, however, is that there is free federal money to be had. And a law firm can maximize access to that money (and reduce its cash outlay) best by eliminating the firm's COBRA subsidy. Then the question becomes whether, and how, to change the remainder of the severance package.

Stuart Sirkin is an Executive Director in Ernst and Young LLP's National Tax Practice's Compensation and Benefits Group. Prior to joining the firm in 2007, Mr. Sirkin had held senior positions in the pension programs of the Department of Labor, the Internal Revenue Service and the PBGC. Mr. Sirkin also served on the staff of the Senate Finance Committee during enactment of the Pension Protection Act of 2006 (PPA). He is a charter fellow of the American College of Employee Benefits Counsel and vice-chair of the Defined Benefit Subcommittee of the ABA Tax Section's Employee Benefits Committee. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

The ABA Journal recently reported that at least 3,500 attorneys and staff ' “and perhaps significantly more” ' lost their jobs in March. (Neil, Marth. “March Mayhem Tally Tops 3,500 After End-of-Month Law Firm Layoffs.” Available at www.abajournal.com/weekly. Posted on March 31, 2009.) That follows reports of at least 2,100 layoffs in February and 1,500 in January. And there are no doubt more to come as law firms continue to assess how to deal with the current economic situation.

Virtually all of these laid-off workers are eligible both for COBRA continuation health care and the new federal subsidy to pay for such coverage. But in an ironic twist, the more generous the firm's severance package with respect to subsidizing COBRA continuation coverage, the less generous the federal subsidy. As a result, firms may want to reconsider the structure of their severance packages.

ARRA

The American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5) (ARRA) amended the Internal Revenue Code and ERISA to establish a federally funded premium assistance payment equal to 65% of the premium an involuntarily terminated employee pays for COBRA coverage. The federal assistance is available with respect to employee-paid premiums on or after, generally, March 1, 2009. The 65% subsidy applies to the full employee-paid premium (generally, 102% of the active-employee health premium) unless the employer subsidizes the premium. In the case of an employer subsidy, the 65% federal subsidy applies to the lower premium (i.e., the full premium minus the employer subsidy). Thus, law firms that subsidize COBRA premiums are turning their backs on federal money.

COBRA in General

COBRA health care continuation coverage is not new. What is new is the ARRA-added federal subsidy for involuntarily terminated workers. COBRA requires that an employer with 20 or more employees provide certain former employees, retirees, spouses, former spouses, and dependent children (“qualified beneficiaries”) the ability to purchase up to, generally, 18 months of continuing health coverage in an employer's continuing health plan if a “qualifying event” occurs.

For employees, a qualifying event is: 1) a voluntary or involuntary termination of employment for reasons other than gross misconduct; or 2) a reduction in the number of hours of employment. For spouses (in addition to the employee events), a qualifying event is: 1) a divorce or separation from the covered employee; 2) death of the covered employee; or 3) the covered employee becoming entitled to Medicare. For dependent children (in addition to employee and spouse events), a qualifying event is loss of dependent status under the plan rules.

An employer must offer qualified beneficiaries health coverage identical to that available to similarly situated active workers. If the employer changes the benefits in the future for active participants, the change applies also to qualified beneficiaries. Qualified beneficiaries must also have the same open enrollment rights as active participants. If the employer stops offering a health plan to active participants or goes out of business, COBRA coverage ends.

Employers must notify plan administrators of a qualifying event within 30 days after an employee's death, termination, reduced hours of employment or entitlement to Medicare. (A qualified beneficiary must notify the plan administrator of a qualifying event within 60 days after divorce or legal separation or a child's ceasing to be covered as a dependent under the plan rules.) The plan administrator must generally send election notices to the qualified beneficiary not later than 14 days after the plan administrator receives notice that a qualifying event has occurred. The qualified beneficiary has 60 days after receiving the notice (or, if later, 60 days after the loss of coverage) to elect continuation coverage, and 45 days after electing coverage to pay the initial premium. The initial premium payment covers the period of coverage from the date of the election retroactive to the date of the loss of coverage.

COBRA Premium Payment Assistance

ARRA provides a 65% COBRA premium subsidy (“premium payment assistance”) for employees (and, if they have family coverage, their spouses and dependents) who are involuntarily terminated between Sept. 1, 2008 and Dec. 31, 2009 and, as a result, lose their health coverage during that time period. Although the triggering event is retroactive, the premium payment assistance is only effective for periods of coverage beginning on or after, generally, March 1, 2009. There is no premium assistance tied to any of the other qualifying events.

The premium payment assistance lasts for the first to occur of: 1) nine months; 2) the end of the person's COBRA eligibility period; or 3) the person's eligibility for other health care coverage. (COBRA coverage itself only ends if the qualified beneficiary “enrolls” in another health plan.) The subsidy is based on the premium the qualified beneficiary pays.

The assistance eligible individual (AEI) receives ARRA COBRA premium assistance by paying 35% of the COBRA premium. The employer pays the other 65% and claims a
reimbursement. (For plans covered only by state mini-COBRA laws, generally the health insurance plan pays the subsidy and claims the reimbursement.) The entity eligible for reimbursement recovers these amounts by subtracting the amount equivalent to the 65% subsidy from the federal withholding and employment tax (federal income tax withholding, FICA, and Medicare) payments/deposits it would otherwise make for its active employees, or, by requesting a refund on the applicable federal employment tax return (e.g., Form 941) for those employees.

Involuntary Termination

Although COBRA health coverage is available based on a number of triggering events, the 65% federal subsidy is only available if the employee has an “involuntary termination” within the proper time period. In Notice 2009-27, the Service clarifies that whether a separation is “involuntary” is a facts-and-circumstances determination. However, The Notice leans very heavily in favor of a termination being treated as involuntary.

The basic test for a termination to be “involuntary” is whether the severance is due to the independent exercise of the unilateral authority of the employer to terminate the employment, other than due to the employee's implicit or explicit request, when the employee was willing and able to provide services. The Notice provides the following examples of terminations that generally are involuntary:

• An employer's failure to renew a contract at the time it expires (if employee was willing and able);
• An employee's termination for good reason due to an employer action that causes a material, negative change in the employment relationship;
• An employee's voluntary termination when the employee knew if he or she did not resign, the employee would have been fired;
• An employee's voluntary termination in response to a reduction in hours that is a material, negative change in the employment relationship (a reduction in hours alone is not enough even if the employee loses health care coverage);
• An involuntary reduction to zero hours ' such as layoff, furlough, or other suspension of employment;
• Retirement, if it was in response to the employee's knowledge that absent retirement, he or she would have been fired;
• Resignation as a result of a material change in geographic location;
• An employee's voluntary resignation in return for a severance package when the employer indicates that if not enough employees voluntarily take the severance package, the employer will involuntarily terminate employees; and
• Lockouts (but not strikes).

Income Eligibility and Annual Information Reporting Requirements

There is both an individual and family income test for COBRA premium assistance eligibility. A qualified beneficiary is not eligible to be an AEI if the individual's adjusted gross income for the tax year exceeds $145,000, or, if the individual files a joint return for the year, the adjusted gross income exceeds $290,000. If the adjusted gross income is at least $125,000 for an individual or $250,000 for a joint return situation, there is a proportional reduction in the subsidy.

The burden for the income test falls almost entirely on the qualified beneficiary and not the employer or insurer. The person who elects COBRA may pay the full amount without subsidy (and so notify the employer, insurer, etc.). If this notification takes place in 2009, the qualified beneficiary may not take advantage of the subsidy even if his or her income falls under the limit in 2010. Thus, it is likely that most participants will use the alternative method. Under the alternative method, the person pays the subsidized amount (the employer must accept the reduced amount even if the employer has knowledge of the qualified beneficiary's income). The IRS then recovers any overpayment of the subsidy (dollar-for-dollar) by increasing the person's income tax liability (not the taxable income) by the amount of the subsidy. This increase in tax cannot be offset by tax credits. (There are no rules preventing higher-income persons from deliberately creating COBRA premium assistance overpayments in order to delay cash layouts.)

Employee Notification Requirements

ARRA has detailed notice requirements for different fact situations. The Department of Labor has published model notices that employers may use to meet these requirements. See www.dol.gov/cobra.

Employer Subsidies

If the employer subsidizes the premium for part or all of the
COBRA period, the 65% applies to the lower subsidized premium the qualified beneficiary pays. For example, normally for a $1,000 monthly premium, the federal subsidy would be $650 and the employee would only have to pay $350. If, however, the employer subsidizes 50% of the COBRA premium, the federal subsidy would only be $325 (65% of the $500 premium) and the employee would pay the remaining $175. Thus, the employer and employee combined have turned their back on $325 of federal money.

Some law firms are subsidizing several months of COBRA as part of their severance packages. Let's assume the firm subsidizes four months of COBRA at 100%. For the first four months, the employee pays no COBRA premium, the firm pays the $1,000, and the federal government pays nothing. After the four months, if there is no further employer subsidy, the federal government will pay five months at $650 (assuming continued eligibility) and the former employee with pay $350 per month (a total of nine months).

Alternatively, the firm could treat the loss of health coverage as occurring four months after the termination of employment. In this case, the firm would pay the $1,000 for four months and the employee would have a full nine months in which the government pays 65% of the $1,000. The design choice is up to the firm.

In either of these cases, however, the firm has paid a $1,000 for four months and received nothing from the federal government. One alternative would be to reduce or eliminate the firm's subsidy. In that case, the firm would be able to benefit from the federal subsidy right away. However, employees would have more of an out-of-pocket expense. Firms could make this up by increasing other severance payments. However, that additional severance cannot be directly tied to the former employee's COBRA premiums or it will continue to be treated as a federal subsidy.

Conclusion

There are several difficulties with trying to create equality while taking advantage of the federal subsidy. How much the employer, employee, or federal government pays is dependent on when the employee becomes eligible for other coverage (at which point the federal subsidy ends even if the employee does not elect the other coverage ' maybe because the employer continues to subsidize). As a result, any reduction in the employer subsidy will be more advantageous to former employees who are eligible for the
COBRA subsidy for a longer period of time relative to a shorter period of time (in direct relation to the period for which the employer subsidizes).

The bottom line, however, is that there is free federal money to be had. And a law firm can maximize access to that money (and reduce its cash outlay) best by eliminating the firm's COBRA subsidy. Then the question becomes whether, and how, to change the remainder of the severance package.

Stuart Sirkin is an Executive Director in Ernst and Young LLP's National Tax Practice's Compensation and Benefits Group. Prior to joining the firm in 2007, Mr. Sirkin had held senior positions in the pension programs of the Department of Labor, the Internal Revenue Service and the PBGC. Mr. Sirkin also served on the staff of the Senate Finance Committee during enactment of the Pension Protection Act of 2006 (PPA). He is a charter fellow of the American College of Employee Benefits Counsel and vice-chair of the Defined Benefit Subcommittee of the ABA Tax Section's Employee Benefits Committee. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.