The Employee Benefits practice group is pleased to present the Benefits Developments Newsletter for the month of December, 2016. Click through the links below for more information on each specific development or case.

Certain Captive Arrangements Are No Longer Under the Radar

Notice 2016-66, released by the IRS in November, 2016, takes aim at potentially abusive captive insurance arrangements that elect, under § 831(b) of the Internal Revenue Code, to be taxed only on investment income, thereby excluding from taxable income the insurance premiums received by the captive in return for the insurance protection it purports to provide. The Notice designates certain captive insurance arrangements that make an 831(b) election as “Transactions of Interest.” In so doing, the Notice hopes to discourage the marketing of captives that are formed solely for the purpose of evading or avoiding income taxes. Toward this end, Notice 2016-66 requires participants in transactions with 831(b) captives that qualify as “Transactions of Interest” to file IRS Form 8886, Reportable Transaction Disclosure Statement. In addition, “material advisors” must disclose certain information on IRS Form 8918, Material Advisor Disclosure Statement. The forms and instructions can be found here: Form 8886; Form 8886 Instructions; Form 8918; Form 8918 Instruction.

What is a “Transaction of Interest”?

According to the Notice, a “transaction of interest” looks something like this:

• Smith, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) that conducts a trade or business. Insured seeks to purchase insurance to manage a business risk to which it is exposed.
• Smith, the Insured, or persons related to Smith or the Insured directly or indirectly own an interest in a captive insurance company (“Captive”). Instead of purchasing insurance from an independent, unrelated insurance company, Insured either (a) acquires a policy from Captive that Captive and Insured treat as insurance for tax purposes; or (b) reinsures risks that Insured has initially insured with an intermediary, Company C. Insured claims a deduction for the premiums paid to Captive, and Captive excludes the premium income from its taxable income by making a § 831(b) election to be taxed only on taxable investment income.
• Smith, the Insured, or one or more persons related to Smith or the Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive.
• Either (a) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses is less than 70 percent of the premiums earned by Captive, less policyholder dividends paid by Captive; or (b) Captive has directly or indirectly made available as financing, or otherwise conveyed or agreed to make available or convey to Smith, Insured, or a person related Smith or the Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.

What Are the Characteristics of an Abusive Captive Arrangement?

If the policy of insurance issued by a captive in a “transaction of interest” is not insurance (i.e., has certain characteristics that indicate that it is more a tax avoidance and wealth building scheme than a risk management arrangement), the business entity to whom the policy is issued may not deduct the captive premium payments as insurance, and the captive’s 831(b) election is not valid. According to the Notice, potentially abusive captive arrangements have one or more of the following characteristics:

• the insurance coverage provided by the captive insurance company involves an implausible risk;
• the coverage does not match a business need or risk of insured;
• the description of the scope of the coverage in the insurance policy issued by the captive is vague, ambiguous, or illusory;
• the coverage duplicates coverage provided to the insured by an unrelated, commercial insurance company, and the policy with the commercial insurer has a far smaller premium;
• the amount of the insured’s payments under the insurance policy issued by the captive are designed to provide the insured with an income tax deduction under § 162 of a particular amount;
• the premium payments made by the insured to the captive are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;
• the payments are not made consistently with the schedule in the insurance policy;
• the payments are agreed to by the insured and the captive insurance company without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage;
• the payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles;
• if multiple entities in the captive share risk, the allocation of amounts paid to captive among the insured entities does not reflect the actuarial or economic measure of the risk of each entity;
• the captive fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction in which Captive is chartered, the jurisdiction(s) in which Captive is subject to regulation because of the nature of its business, or both;
• the captive does not issue policies or binders in a timely manner consistent with industry standards;
• the captive does not have defined claims administration procedures that are consistent with insurance industry standards;
• the insured does not file claims for each loss event covered by the insurance policy issued by the captive;
• the captive does not have capital adequate to assume the risks that the insurance policy transfers from insured;
• the captive invests its capital in illiquid or speculative assets usually not held by insurance companies; or
• the captive loans or otherwise transfers its capital to the insured, entities affiliated with insured, the owners of the insured, or persons related to the owners of the insured.

Action Steps for Captive Owners and Material Advisors

Captive owners and “material advisors” would be well-advised to have qualified tax counsel review the captive structure they manage, promote, or have adopted, to determine whether they have any reporting obligations, and to engage independent actuaries qualified to provide guidance and actuarial opinions on premium amounts. A “material advisor” is any person who (a) provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction; and (b) who directly or indirectly derives gross income in excess of a specified amount for providing the aid, assistance, or advice. Failure to disclose carries significant penalties.

IRS Proposes Regulations Regarding Minimum Present Value Calculations

Internal Revenue Code Section 417(e) provides rules providing the calculation of the present value of an annuity benefit under a defined benefit plan. One requirement is that the present value shall not be less than the amount calculated using certain prescribed mortality tables and interest rates. These mortality tables and interest rates were amended by the Pension Protection Act of 2006. The IRS has recently proposed regulations that address certain issues that remained unclear under prior guidance. For example, there has been much discussion weather a Social Security level income option was or was not subject to requirements on calculation of present value under Section 417(e)(3). The IRS had indicated in the past that a Social Security level income option was subject to this requirement. In the proposed regulations the IRS makes it clear that if the regulations are adopted, the calculation of Social Security level income option must be done in compliance with use of applicable morality tables and interest rates of Section 417(e). In addition, the proposed regulations would state that it is appropriate to use a pre-retirement morality discount in determining minimum present value for benefits accrued from employer contributions but not for benefits resulting from employee contributions. The proposed regulations would also make other clarifying and clean-up changes to the existing regulations. (IRS Proposed Regs. Under Section 417(e))

IRS Information Letter on Roth IRA Required Minimum Distributions

In a recent informational letter, the IRS discussed the Internal Revenue Code’s (the “Code”) required minimum distribution rules for non-spousal death beneficiaries of Roth IRAs. A required minimum distribution (“RMD”) is a minimum annual withdrawal that must be taken from an individual’s retirement accounts based on specific triggering events. For employer-sponsored qualified retirement plans, IRAs, SIMPLE IRAs, and SEP IRAs, RMDs generally must begin when the plan participant or IRA owner reaches age 70½. RMD requirements also apply to beneficiaries after a plan participant or IRA owner’s death. For Roth IRAs, however, RMDs are only required after the Roth IRA owner’s death.

The RMD rules that apply to Roth IRAs after the owner’s death are different for spouse and non-spouse beneficiaries. The recent informational letter specifically addressed non-spouse beneficiaries. For non-spouse beneficiaries, the RMD rules require distribution of the Roth IRA owner’s full account either (1) in full within five years of the owner’s death (i.e., the 5-year rule) or (2) over a period not longer than the beneficiary’s life expectancy, beginning within one year of the owner’s death (i.e., the life expectancy rule). A Roth IRA agreement can specify which option will apply or allow the owner or designated beneficiary to select one of the two options within a specific period of time. If the agreement does not specify or allow the owner or designated beneficiary to select an option, then the life expectancy rule will apply for the designated beneficiary. If there is no designated beneficiary, then the 5-year rule will apply. If RMDs do not start in a timely manner, the Code imposes a 50% excise tax on the amounts that should have been distributed.

The information letter specifically responded to an inquiry as to whether the failure to start RMDs within one year of death results in the 5-year rule applying and the life expectancy rule becoming inapplicable. The IRS explained that which distribution period applies is based on application of the rules outlined above, and is not impacted by whether the distributions actually begin timely under the applicable rule. (IRS Information Letter No. 2016-0071)

No ADA Violation for Terminating Employees on Retiree-Only Health Plan

Carson v. Lake County, Ind. (2016, N.D. Ind.)

In a recent case out of the US District Court of the Northern District of Indiana, a group of rehired retirees brought an age discrimination claim after they were terminated due to complications associated with their retiree-only health plan coverage. When these individuals were rehired, their continued coverage on the employer’s retiree-only plan presented potential compliance issues with the Medicare Secondary Payer (MSP) rules and threatened the plan’s “retiree-only” status under the Affordable Care Act (ACA). Under the ACA, a “retiree-only” health plan is not subject to many of the insurance market reforms applicable to other medical plans. The MSP rules govern whether Medicare pays primary or secondary to employer sponsored coverage. While Medicare may be the primary payer when a retired individual has both Medicare and employer sponsored coverage, the employer sponsored plan generally must be the primary payer if the individual is rehired. To avoid these compliance concerns and the additional associated expenses, the employer terminated the rehired employees. The court dismissed the age discrimination claim, holding that age was not the only reason for the terminations. Rather, it was motivated by an effort to maintain the retiree-only status of the health plan under the ACA and comply with the MSP rules. This case is significant because it highlights a number of complex issues associated with the administration of retiree health plans. When rehiring former employees, employers are encouraged to consult with their benefits counsel to discuss potential benefit concerns and design solutions. Carson v. Lake County, Ind. (2016, N.D. Ind.)

Court Denies ESOP Participant’s Claim for Additional Benefits

Lee v. Holden Industries, Inc. (N.D. Ill. 2016)

An employee participated in his employer’s employee stock ownership plan (ESOP). When the employee terminated his employment in 2012, approximately 3,770 shares of employer stock were allocated to his ESOP account. In 2013, the employee exchanged the shares allocated to his ESOP account for cash, and received a distribution of his ESOP account balance in the amount of $146,832. The share value was determined using a 2012 stock valuation. Following receipt of his lump-sum cash-out, the employee filed a claim with the ESOP in which he asserted that he had expected his stock would be exchanged for cash using the higher 2013 stock valuation. Had the higher valuation been used, the employee claimed that his ESOP distribution would have been approximately $36,000 higher. The ESOP denied the employee’s claim, and the employee subsequently commenced a lawsuit in which he alleged that the ESOP sponsor, as the administrator of the ESOP, violated its ERISA fiduciary duties and owes him additional benefits. The ESOP sponsor moved for summary judgment on both claims, and a federal district court judge granted the motion.

As to the fiduciary breach claim, the employee contended the ESOP sponsor breached its fiduciary duty by failing to provide clear documents and information. The court was not persuaded by the employee’s assertion that the language of a 2011 summary plan description (SPD) was misleading because it called for the stock to be valued at the stock’s “fair market value” when the value of the stock is distributed. The court ruled that the 2011 SPD does not take the place of the actual ESOP plan document – the ESOP document, as amended, expressly provided that the exchange rate used to purchase the stock allocated to the employee’s ESOP account would be “based on the value determined at the most recent valuation date.” The court also ruled that the ESOP sponsor was not shown to have the intent (i.e., an intent to disadvantage or deceive plan participants) needed to justify the breach of fiduciary duty claim.

As to the employee’s request for relief in the form of additional benefits due to him under the ESOP, the court also denied that claim. The court ruled that the ESOP’s decision to deny the employee’s additional benefit request was “based on a reasonable explanation of relevant plan documents,” and that using the 2012 stock valuation for the exchange rate was “eminently reasonable.” Lee v. Holden Industries, Inc. (N.D. Ill. 2016)