COBRA Subsidies and Reimbursement Part I: Avoiding Nondiscrimination Issues

Question: How can employers avoid potential nondiscrimination issues when paying all or a portion of the COBRA premium for terminated employees?

Short Answer: Employers often offer COBRA subsidies that are more generous for certain highly compensated employees. Where self-insured, employers should consider the taxable compensation alternative to avoid nondiscrimination issues under Section 105(h). Where fully insured, employers should consider reservation of rights terms to address potential application of ACA nondiscrimination rules.

Note: This is the first in a three-part series addressing COBRA subsidies and reimbursement.

General Rule: COBRA Qualifying Event for Continuation Coverage
Individuals have the right to continue group health plan coverage through COBRA upon experiencing a “qualifying event,” which is a loss of coverage caused by one of the prescribed COBRA triggering events (e.g., termination of employment). Individuals who experience a COBRA qualifying event are referred to as “qualified beneficiaries.”

• For more details: Newfront COBRA for Employers Guide

COBRA Subsidies: An Optional Employer Offering
Employers are generally permitted to charge qualified beneficiaries the full cost of coverage plus a 2% administrative fee to enroll in COBRA, often referred to as 102% of the applicable premium. Employers may choose whether and how to offer COBRA subsidies. Other than the rare situations where Congress has acted to temporarily require COBRA subsidies for an emergency (the Great Financial Crisis in 2009 and the COVID-19 pandemic in 2021), COBRA subsidies are completely optional.

Many employers choose to offer certain employees who lose coverage (typically due to termination of employment) a short duration of subsidized COBRA to defray some or of the applicable premium. Employers can structure COBRA subsidies as a set percentage (e.g., 50% of the premium), an amount targeted to match the employer-share of the premium for active employees (i.e., the COBRA premium mirrors the active employee-share of the premium), as a fully subsidized approach to make COBRA free of charge, or anything in between.

Self-Insured Plans: Section 105(h) Nondiscrimination Rules Apply
The Section 105(h) nondiscrimination rules are designed to prevent discrimination in favor of highly compensated individuals (HCIs) with respect to tax-free benefits provided under self-insured health plans. These rules apply to plans where the benefit is “not provided under a policy of accident and health insurance.” This includes traditional self-insured plans as well as other alternatives such as level-funded plans.

For more details on the Section 105(h) rules more generally:

• Newfront Compliance Considerations for Self-Insured Plans Guide

• Health Benefits by Class

Highly Compensated Individuals (HCIs)
For purposes of Section 105(h), an HCI is:

• One of the top five highest-paid officers;

• A shareholder who owns more than 10% of the value of stock; or

• Among the highest-paid 25% of all employees.

The Section 105(h) Test Components
There are two main components of the Section 105(h) nondiscrimination rules, the Eligibility Test and the Benefits Test. COBRA subsidies implicate the Benefits Test component.

The Section 105(h) Benefits Test
The Benefits Test prohibits self-insured health plans from offering any benefit to HCIs that is not also available to non-HCIs. In the context of COBRA subsidies, offering more generous subsidies for certain HCIs presents an issue because not all non-HCIs may receive the more favorable benefits (i.e., the richer COBRA subsidy).

Failing the Section 105(h) Nondiscrimination Requirements
If the IRS were to audit a self-insured health plan and find a COBRA subsidy arrangement does not satisfy the Section 105(h) Benefits Test, HCIs would be taxed on the discriminatory benefits they received under the plan, referred to as the “excess reimbursement.” The IRS could require “the total amount reimbursed to the highly compensated individual” as a health benefit under the plan be included in the HCI’s taxable income. This could be a significant tax liability depending on the amount and cost of services received by the HCI.

The Section 105(h) Nondiscrimination Issues for COBRA Subsidies
The Section 105(h) Benefits Test prohibits a self-insured health plan from offering any benefit to HCIs that is not also available to non-HCIs. These rules can present an issue for typical COBRA subsidy approaches.

Examples of plan designs that likely do not satisfy the Section 105(h) rules include:

• A more generous percentage of COBRA subsidies for certain HCIs than non-HCIs (e.g., 100% vs. 75%)

• A more generous flat dollar amount of COBRA subsidies for certain HCIs than non-HCIs (e.g., $500 vs. $300)

• Extended duration of COBRA subsidies for certain HCIs versus non-HCIs (e.g., six months vs. three months)

These types of COBRA subsidy arrangements that provide a greater benefit to certain HCIs (e.g., executives, upper management) are a common business practice. In some cases, these more generous subsidy benefits are specifically negotiated in a termination or severance benefit agreement. Employment counsel often tasked with drafting these severance terms may overlook potential Section 105(h) discrimination issues and the straightforward workarounds available to avoid them.

• Note: There are no Section 105(h) issues with a COBRA subsidy approach that is at least as generous to non-HCIs as to HCIs. However, in practice it is common for employers to provide more generous COBRA subsidies to certain HCIs.

The Workaround to Avoid Section 105(h) Nondiscrimination Issues: Taxable Compensation
Employers can pay taxable compensation to terminating employees that is designed to match the intended COBRA subsidy amount. This approach is standard taxable income subject to withholding and payroll taxes and reported on the Form W-2. The employer can choose to gross-up the former employee to cover the taxes.

This approach avoids the Section 105(h) issues described above. Accordingly, employers can be more generous to certain HCIs in this taxable manner without nondiscrimination concerns. Employers may utilize this workaround approach as a stream of payments on regular payroll intervals (e.g., to coordinate with ongoing severance payments) or as an up-front lump sum upon termination for administrative simplicity.

COBRA Subsidy Alternative as Taxable Compensation
Employers often use language similar to the following illustrative provision to describe the taxable income alternative to direct COBRA subsidies:

The Company will pay you an additional amount of [Enter amount—can be in regular intervals or lump sum] in standard taxable compensation, subject to withholding and all applicable payroll taxes, intended to cover the cost of your [Optional: “major medical plan” to exclude all other coverage] COBRA premium for [Enter duration]. This amount is based on [“your full” or “[X percentage] of your”] [Optional: “employee-only”] COBRA premium, including the 2% administrative fee.

[Optional: The Company will also pay you a “gross up” amount intended to cover the tax liability from this additional payment.]

Advanced COBRA Subsidy Approaches

Fixed Formula COBRA Subsidies
Some employers offer a uniform approach for terminating employees based on set factors, such as years of service. For example, terminating employees with five years of service receive three months of COBRA subsidies, while terminating employees with ten years of service receive six months of COBRA subsidies.

The potential concern with this approach is that some employees who are HCIs receive a more generous COBRA subsidy based on the formula than other non-HCIs. Although there is no explicit rule clarifying that this approach is permitted, many employers are comfortable taking this approach as long as the formula itself does not appear to discriminate in favor of HCIs. Nondiscriminatory fixed formula COBRA subsidies are common in practice and likely a low-risk approach.

• Note: Employers often wish to have a more generous COBRA subsidy formula for certain classes of HCIs, such as executives and upper management. This approach likely does not satisfy the Section 105(h) rules if provided on a tax-free basis given that the formula itself is not nondiscriminatory.

COBRA Subsidy Approach Specific to a Reduction in Force (RIF)
Some employers offer distinct COBRA subsidy structures designed to address specific RIF situations. For example, an employer may offer a three-month COBRA subsidy only to employees subject to a particular RIF. The potential concern with this approach is that some employees who are HCIs involved in the RIF will receive a more generous COBRA subsidy than non-HCIs who terminate outside of the RIF.

Although there is no explicit rule clarifying that this approach is permitted, many employers are comfortable taking this approach as long as the subsidy for the non-HCIs in the RIF is at least as generous as the HCI subsidy. RIF specific COBRA subsidies are common in practice and likely a low-risk approach.

• Note: Employers generally are comfortable varying the subsidy approach for each specific RIF as long as it is not clearly intended to benefit certain classes of HCIs (e.g., by increasing the subsidy where the RIF is predominantly HCIs or vice versa).

Baseline Tax-Free Subsidy and a Taxable Enhanced Subsidy
Some employers offer a consistent COBRA subsidy offering for terminating employees and an enhanced taxable “subsidy” for certain employees. For example, all terminating employees receive one month of COBRA subsidies, but certain employees receive additional taxable cash compensation intended to further assist with the COBRA premium based on their situation and negotiations (e.g., six months for HCIs receiving severance).

The potential question is whether the tax-free portion presents Section 105(h) nondiscrimination issues. Although there is no explicit rule clarifying whether this approach is permitted, it is likely a low-risk practice given that the enhanced approach for HCIs utilizes the taxable workaround that is not subject to Section 105(h).

Separate Approaches for Self-Insured and Fully Insured Plan Options
Employers sponsoring self-insured plan options often also offer fully insured alternatives (e.g., regional HMOs). Employers in these situations may utilize a combination of both subsidy approaches: The taxable cash workaround for terminated employees enrolled in a self-insured plan option, and the standard tax-free direct COBRA subsidy approach for employees enrolled in a fully insured plan option. Although there is no explicit rule clarifying whether this approach is permitted, it is likely a low-risk approach given that only the self-insured plan options are subject to the Section 105(h) nondiscrimination rules.

• Note: These approaches create additional administrative burdens that can be more challenging for employers to implement in practice.

Fully Insured Plans: Potential ACA Nondiscrimination Issues (Indefinitely Delayed)
The ACA added Public Health Service Act Section 2716, making fully insured group health plans subject to rules “similar to” the Section 105(h) nondiscrimination requirements. These ACA rules were to apply in 2011 with the first wave of the ACA market reforms. However, the IRS issued Notice 2011-1 at the end of 2010 providing that employers are not required to comply with the ACA fully insured nondiscrimination rules until the Departments issue regulations or other administrative guidance. The DOL and HHS indicated their agreement with the IRS to delay enforcement.

The Notice further states that any such future guidance will not apply until plan years beginning a specified period after issuance. This means that even if the Departments at some point do issue guidance, the nondiscrimination rules for fully insured plans should not take effect until a later date (e.g., six months).

The potential concern is that an extended COBRA subsidy arrangement for a highly compensated employee may run afoul of future Section 2716 guidance. To address this possibility, employers should consider stating in any communications addressing the subsidy (e.g., severance agreement, termination of employment written terms) that the employer reserves the right to modify the COBRA subsidy approach (e.g., to a taxable cash alternative) to comply with Section 2716 if necessary.

Extended Fully Insured COBRA Subsidy to a Highly Compensated Employee
Employers often use language similar to the following illustrative provision to reserve the right to convert an extended COBRA subsidy (e.g., beyond six months) to a taxable cash alternative:

The Company reserves the right to discontinue any COBRA subsidies in the event the nondiscrimination provisions added by Section 10101(d) of the Affordable Care Act, as codified in Public Health Service Act §2716, take effect.

Pursuant to IRS Notice 2011-1, such nondiscrimination provisions do not apply until after regulations or other administrative guidance of general applicability have been issued by the Internal Revenue Service under §2716. If such guidance is issued and takes effect during the period in which the Company intends to subsidize your COBRA coverage, such COBRA subsidies will cease as of the effective date of such guidance to avoid potential excise tax liability to the Company under Internal Revenue Code §9815.

If the Company discontinues your COBRA subsidies pursuant to application of the nondiscrimination provisions described above, the Company will make an additional payment to you in standard taxable compensation, subject to withholding and all applicable payroll taxes, intended to cover the amount of the discontinued COBRA subsidy for the remainder of your intended COBRA subsidy period.

[Optional: The Company will also pay you a “gross up” amount intended to cover the tax liability from this additional payment.]

Reminder: COBRA Subsidies Can Address Inability to Extend Active Coverage
Employers frequently question whether they can continue coverage for an employee after termination or through an extended non-protected leave of absence period (i.e., not protected by FMLA or a state equivalent).

In both of these cases, employers must be cautious to avoid potentially violating the terms of their insurance or stop-loss arrangements. These arrangements typically do not permit any period of active coverage beyond the date of termination or the end of the month following termination, per the standard plan terms. With respect to non protected leaves, insurance and stop-loss arrangements are often more accommodating. For example, many arrangements permit employers to extend active coverage for up to six months. Regardless, once the employee reaches that maximum, employers must also be cautious to avoid violating the arrangement terms.

Failure to terminate coverage within the strict terms of the arrangement could cause the employer to be liable for any claims incurred during the period, creating a potentially unlimited liability. Furthermore, employers generally should avoid creating difficult ERISA plan precedents associated with any such extensions.

The appropriate way for employers to accommodate these types of situations is to instead consider providing COBRA subsidies (or the taxable compensation alternative) intended to cover the additional cost of COBRA. Insurance carriers and stop-loss providers generally have no issue with COBRA subsidy arrangements made available by the employer if the employer timely terminates active coverage.

Summary
The best practice approaches for COBRA subsidies generally depend on the plan’s funding arrangement:

• Self-Insured Plans: The Section 105(h) rules create nondiscrimination concerns with many common employer practices that involve more generous COBRA subsidies for certain highly compensated employees. The common workaround is to provide taxable compensation in the amount of the intended COBRA subsidy (with a gross-up if desired) to avoid the nondiscrimination issues.

• Fully Insured Plans: There is generally no issue with providing direct tax-free COBRA subsidies, but employers should consider steps to address potential Section 2716 ACA nondiscrimination concerns in the future by including a reservation of rights clause for extended duration COBRA subsidies.

Relevant Cites:

Treas. Reg. §1.105-11:

(b) Self-insured medical reimbursement plan.
(1) General rule.
(i) Definition. A self-insured medical reimbursement plan is a separate written plan for the benefit of employees which provides for reimbursement of employee medical expenses referred to in section 105(b). A plan or arrangement is self-insured unless reimbursement is provided under an individual or group policy of accident or health insurance issued by a licensed insurance company or under an arrangement in the nature of a prepaid health care plan that is regulated under federal or state law in a manner similar to the regulation of insurance companies.
…
(c) Prohibited discrimination.
…
(3) Nondiscriminatory benefits.
(i) In general.
(A) Benefits. In general, benefits subject to reimbursement under a plan must not discriminate in favor of highly compensated individuals. Plan benefits will not satisfy the requirements of this paragraph (c)
(3)(i)(A) unless all the benefits provided for participants who are highly compensated individuals are provided for all other participants.
…
(e) Excess reimbursement of highly compensated individual—
…
(2) Discriminatory benefit. In the case of a benefit available to highly compensated individuals but not to all other participants (or which otherwise discriminates in favor of highly compensated individuals as opposed to other participants), the amount of excess reimbursement equals the total amount reimbursed to the highly compensated individual with respect to the benefit.

IRS Notice 2011-1:

Because regulatory guidance is essential to the operation of the statutory provisions, the Treasury Department and the IRS, as well as the Departments of Labor and Health and Human Services (collectively, the Departments), have determined that compliance with §2716 should not be required (and thus, any sanctions for failure to comply do not apply) until after regulations or other administrative guidance of general applicability has been issued under §2716. In order to provide insured group health plan sponsors time to implement any changes required as a result of the regulations or other guidance, the Departments anticipate that the guidance will not apply until plan years beginning a specified period after issuance.

Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).