CRS SUMMARIZES SECTION 89'S APPLICATION; NOTES LIKELIHOOD OF NONCOMPLIANCE BY SMALL EMPLOYERS.

                             88-470 EPW

The tax-favored treatment of employee benefit plans reduces both the Federal income tax base and budget receipts. Congress considers these costs justifiable if they fulfill important social policy objectives such as increasing accident or health insurance coverage to those who would otherwise not purchase it or could not afford it. The Tax Reform Act of 1986 added complex nondiscrimination rules to section 89 of the Internal Revenue Code to ensure that "statutory employee benefit plans" are broadly based and do not discriminate in favor of business owners and highly paid employees. This report summarizes the rules, discusses their impact, and lists proposed changes being considered during deliberations on the Technical Corrections Act of 1988.

CONTENTS

I. INTRODUCTION II. BACKGROUND III. NONDISCRIMINATION RULES IV. IMPACT OF NEW RULES V. PROPOSED AMENDMENTS

SECTION 89 NONDISCRIMINATION RULES FOR EMPLOYEE BENEFITS

I. INTRODUCTION

Individual taxpayers may exclude the value of certain employer- provided employee benefits from their gross income. Employers are entitled to a business deduction for the expense of providing these benefits. This tax-favored treatment of employee benefit plans -- including health benefits -- reduces both the Federal income tax base and budget receipts. According to the general explanation of the Tax Reform Act of 1986 (P.L.99-514) prepared by the staff of the Joint Committee on Taxation, "Congress believed that these costs are justifiable if such benefits fulfill important social policy objectives, such as increasing health insurance coverage among taxpayers who are not highly compensated and who otherwise would not purchase or could not afford such coverage." ¹

II. BACKGROUND

The nondiscrimination rules added to section 89 of the Internal Revenue Code by section 1151 of the Tax Reform Act of 1986 are designed to ensure that "statutory employee benefit plans" are broadly based and do not discriminate in favor of the owners of a business or highly compensated employees. The term "statutory employee benefit plan" includes accident or health plans and group- term life insurance plans. At the election of the employer, the term also includes qualified group legal services plans, educational assistance programs, and dependent care assistance programs. All other types of tax-favored employee benefit plans, such as pensions, must meet the nondiscrimination tests set forth in the Internal Revenue Code sections authorizing their special tax status. Under prior law an employer could insure a special health plan just for executives. Starting in 1989, those executive medical reimbursement plans will no longer be tax-free benefits. Moreover, the nondiscrimination rules that had previously applied to self-insured health benefit plans (where the employer assumes the risk of paying health claims directly) were revised and extended to insured plans (where the employer purchases a health insurance policy from a commercial insurance company or from Blue Cross/Blue Shield). While large employers frequently self-insure their health benefit package, smaller firms offering health insurance usually purchase an insured plan.

III. NEW NONDISCRIMINATION RULES

The Tax Reform Act of 1986 requires statutory employee benefit plans, including group health plans, to apply a series of complex tests to the eligibility and benefit provisions. Alternatively, a special test may be applied. Under this alternative test, a plan would generally satisfy the new nondiscrimination rules if it benefits at least 80 percent of an employer's nonhighly compensated employees. If a plan fails to comply with these rules, all highly compensated employees in the plan will be taxed on the value of the discriminatory portion of the benefit. ² Highly compensated employees include owners, officers, and individuals earning over $75,000 (or above $50,000 if among the top 20 percent by compensation).

Congress provided rules regarding the definition of the discriminatory excess, how to allocate the excess among highly compensated employees, and the year of inclusion. Employers who fail to report in a timely manner that a plan is discriminatory are liable for an excise tax. The rules are effective for years beginning January 1, 1989, unless the Secretary of the Treasury issues regulations earlier. ³

All plans subject to section 89 must also comply with the following rules:

o the plan must be in writing;

o employees' rights under the plan must be legally enforceable;

o employees must be notified of the benefits for which they are eligible;

o the plan must be maintained for the exclusive benefit of the employees; and

o the plan must be established with the intent to maintain it indefinitely.

IV. IMPACT OF NEW RULES

According to one survey of small employers, more than half would fail the least complex test included in the nondiscrimination requirements. ⁴ Employers who fail the test have several options. Those with large numbers of workers not participating in the plan might choose to fail the tests because the cost of compliance would be too high. If they did so, they would have to treat the excess benefit as income to the highly compensated employees. However, the increased taxes of the employees could be offset by a pay increase. Employers are also likely to reduce the number of insurance options, thereby reducing the likelihood of failing the tests because of employee elections. This would also reduce the administrative costs associated with testing the plan for compliance. Employers with noncovered part-time workers are likely to take one or more actions. One approach would be to cut the hours of part-timers below 17-1/2 hours per week, the current threshold for excluding employees in applying the nondiscrimination tests. Another option would be to consolidate part-time jobs into fewer full-time jobs and provide benefits. Still another approach would be to extend coverage to the part-timers.

The section 89 nondiscrimination rules have generated a considerable amount of controversy. In addition to private sector employers, section 89 rules apply to tax-exempt organizations and plans maintained by State and local governments. With the nearing of the 1989 effective date, some employers may still need more time to coordinate multiple payroll and human resource information systems to handle the section 89 nondiscrimination test requirements. Besides budgetary constraints of plan sponsors, the new complex nondiscrimination rules significantly expand administrative and legal requirements. ⁵

V. PROPOSED AMENDMENTS

The Ways and Means Committee is currently studying amendments to the nondiscrimination rules to facilitate ease of compliance. Chairman Dan Rostenkowski has proposed a possible amendment as part of the Technical Corrections Act of 1988 (H.R. 4333). The proposal would include provision for (1) phased-in implementation, (2) disregarding employees who separated from service prior to January 1, 1987, (3) permitting the nondiscrimination rules to be applied on the basis of one consistent date designated by the plan, rather than during the entire year, (4) using a common 12-month period for testing multiple plans, (5) demonstrating compliance by using an appropriate statistical sampling method, (6) modifying the rules relating to the valuation of benefits, (7) permitting employers to elect to determine their highly compensated employees under a simplified method, (8) using a simplified method of determining the number of hours an employee is considered to normally work in a week, (9) increasing the permissible range in the value of benefits offered by a group of plans offered by an employer when they are aggregated in applying the 80-percent test, and (10) permitting employers to disregard individuals based on core health coverage received from another employer of any family member. In addition, the Secretary of the Treasury would be required to issue rules by October 1, 1988, providing guidance under section 89 on which employers may rely.

² The changes are estimated by the Joint Committee on Taxation to increase fiscal year budget receipts by $72 million in 1988, $128 million in 1989, $140 million in 1990, and $154 million in 1991.

³ For plans covering employees under collective bargaining agreements, section 89 applies for the first plan year beginning after expiration of the longest running contract ratified on or before March 1, 1986, but not beyond the start of the 1991 plan year.

A letter calling for clarification and guidance on nondiscrimination rules governing health and welfare plans was sent to Treasury Secretary Baker on June 17, 1988, by 10 members of the Senate Finance Committee.

⁴ Survey conducted by The Principal Financial Group, Des Moines, Iowa, and reported in the Bureau of National Affairs Pension Reporter, June 7, 1988.

⁵ For a further discussion, see Dearth, William H. A Primer for Section 89 Compliance. Pension World, June 1988. p. 44-46.