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ERISA Payroll Practice Exception for Disability Benefits

Question: How can employers determine whether their disability benefits are subject to ERISA?

Short Answer: Many employer-sponsored short-term disability benefit programs are exempt from ERISA as a “payroll practice,” but the program must meet several strict limitations to qualify for the exemption.

General Rule: ERISA §3(1) Defines Which Benefits Qualify

The employer-sponsored health and welfare benefits that meet ERISA’s definition of an “employee welfare benefit plan” are subject to ERISA.

ERISA §3(1) defines an “employee welfare benefit plan” to include any plan, fund, or program established or maintained by an employer that provides:

  • Medical, surgical, hospital benefits (e.g., medical, dental, vision, health FSA, HRA, EAP, and wellness programs);
  • Benefits in the event of sickness, accident, disability, death, or unemployment (e.g., disability, life, AD&D, severance);
  • Vacation benefits;
  • Apprenticeship or other training programs;
  • Day care centers;
  • Scholarship funds; or
  • Prepaid legal services.

Disability is a listed benefit in §3(1), and therefore any employer-provided disability benefits are subject to ERISA unless an exception applies.

Common Potential Exception for Disability Benefits: Payroll Practices

The DOL’s regulations implementing ERISA include a significant exception from the definition of an “employee welfare benefit plan” for “payroll practices.”  Employers often structure their short-term disability benefits program to meet this exception.

The disability-related payroll practice exception applies to “[p]ayment of an employee’s normal compensation, out of the employer’s general assets, on account of periods of time during which the employee is physically or mentally unable to perform his or her duties, or is otherwise absent for medical reasons (such as pregnancy, a physical examination or psychiatric treatment)”.

To meet this exception, a disability program generally must:

  • Not be insured: Payment of benefits by an insurance carrier fails to meet the payroll practice requirement that payment be from the employer’s general assets.
  • Not be funded by a trust: Payment of benefits from a trust fails to meet the payroll practice requirement that payment be from the employer’s general assets.
  • Not pay more than normal compensation: Payment of benefits that exceed 100% of salary or wages fails to meet the payroll practice requirement that payment be of an employee’s normal compensation. The DOL has confirmed that payment of less than normal compensation—as is standard for most disability benefits—is still within the payroll practice exception.
  • Not cover terminated employees: Payment of benefits to former employees fails to meet the payroll practice requirement that the individuals receiving benefits be current employees.  A payroll practice disability program therefore must cease all benefits upon termination from employment.
  • Not declare ERISA status in plan reporting/disclosure materials: Courts may find that an employer’s designation of a disability benefits program as an ERISA benefit (e.g., in an ERISA SPD or on the Form 5500) causes the program to be subject to ERISA.  Courts have taken different positions on this issue.

Uncommon Potential Exception for Disability Benefits: Must be a Plan, Fund, or Program to Qualify

ERISA §3(1) states that an “employee welfare benefit plan” is a “plan, fund, or program” providing one of the listed benefits.  This “plan, fund, or program” component is most commonly at issue with respect to severance benefits.  The U.S. Supreme Court addressed the question of when an employer severance payment is an ERISA plan in the 1987 seminal case Fort Halifax Packing Company v. Coyne.

In that case, the court reviewed an employer’s one-time severance payment upon a plant closure.  The court stated that an employer’s severance benefits will give rise to an ERISA severance plan only if it “requires an ongoing administrative program to meet the employer’s obligation.”

The court found (in a narrow 5-4 decision) that the employer’s approach in that case was not subject to ERISA because it simply required a one-time obligation of the employer, with no need for an ongoing administrative program for processing claims and paying benefits.  The court’s majority opinion made clear that “[s]ome severance benefit obligations by their nature necessitate an ongoing administrative scheme, but others do not.  Those that do not, such as the obligation imposed in this case, simply [are not subject to ERISA.]”

  • For more details, see our prior post: Severance Benefits May be Subject to ERISA.

Most employer-sponsored disability benefits are clearly part of an ongoing administrative scheme, and therefore this exception is not likely to apply.

Main Advantages of Exception from ERISA

  • Not subject to ERISA plan document requirements
  • Not subject to ERISA SPD disclosure requirements
  • Not subject to Form 5500 reporting requirements
  • Not subject to ERISA claims and appeals requirements
  • Not subject to ERISA fiduciary duties

Main Disadvantages of Exception from ERISA

  • No ERISA preemption of state laws that relate to benefits
  • Program-related lawsuits litigated in state court under less predictable state law
  • Restricted to payment of benefits from general assets
  • Restricted to payment of benefits to current employees

Summary

The ERISA payroll practice exception provides employers with a rare plan design opportunity to choose whether to offer an ERISA or non-ERISA program for benefits listed in the ERISA §3(1) definition of an “employee welfare benefit plan.”  This decision most often arises with respect to short-term disability benefits, which is a nice fit for the payroll practice exception given that (unlike long-term disability benefits) it is frequently self-insured.

However, there are a few complicating factors in the decision of whether to structure a disability program as subject to ERISA or meeting the payroll practice exception.  Chief among them is whether any of the restrictions on the exception will be problematic, such as whether the employer desires to continue to make its disability benefits available to participants following termination of employment.

The other key consideration will be the “careful what you wish for” idiom.  Although employers frequently view ERISA as an administrative burden, there are significant advantages to ERISA’s application to disability benefits.  For example, employers may find the prospect of state law application and state court litigation with respect to disability benefits to be a source of confusion and frustration for all parties.

Regulations

ERISA §3(1):

(1) The terms “employee welfare benefit plan” and “welfare plan” mean any plan, fund, or program which was heretofore or is hereafter established or maintained by an employer or by an employee organization, or by both, to the extent that such plan, fund, or program was established or is maintained for the purpose of providing for its participants or their beneficiaries, through the purchase of insurance or otherwise, (A) medical, surgical, or hospital care or benefits, or benefits in the event of sickness, accident, disability, death or unemployment, or vacation benefits, apprenticeship or other training programs, or day care centers, scholarship funds, or prepaid legal services, or (B) any benefit described in section 302(c) of the Labor Management Relations Act, 1947 [29 USC §186(c)] (other than pensions on retirement or death, and insurance to provide such pensions).

29 CFR §2510.3-1(b)(2):

(b) Payroll practices.

For purposes of Title I of the Act and this chapter, the terms “employee welfare benefit plan” and “welfare plan” shall not include—

(2)   Payment of an employee’s normal compensation, out of the employer’s general assets, on account of periods of time during which the employee is physically or mentally unable to perform his or her duties, or is otherwise absent for medical reasons (such as pregnancy, a physical examination or psychiatric treatment); and

DOL Advisory Opinion 1993-02A:

https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/advisory-opinions/1993-02a

It is the position of the Department that an employer’s payment of less than normal compensation from the employer’s general assets during periods in which an employee is absent for medical reasons may constitute a payroll practice that is not an employee welfare benefit plan.

DOL Advisory Opinion 1993-20A:

https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/advisory-opinions/1993-20a

Based on the information you submitted, it is the position of the Department that the STD Plan is a payroll practice described in regulation section 2510.3-1(b)(2) and does not constitute an employee welfare benefit plan within the meaning of section 3(1) of ERISA. The benefits under the STD Plan are paid out of the Employer’s general assets, are paid only for periods of time during which the employee is disabled and thus unable physically or mentally to perform his or her duties, and do not exceed the employee’s normal compensation.

DOL Advisory Opinion 1996-16A:

https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/advisory-opinions/1996-16a

In the preamble of the regulation, the Department stated that “[s]ection 2510.3-1(b) distinguishes welfare plans from employer payroll practices which, although related to benefits described in [section 3(1) of ERISA], are more closely associated with normal wages or salary,” and that “[p]aragraphs b(2) and b(3) of §2510.3-1 are designed to deal with payment of compensation out of general assets of the employer during periods of employee absences.” 40 Fed. Reg. 34526 (August 15, 1975) (emphasis added). It is thus evident that the “sick pay” exclusion is intended to apply to arrangements in which compensation continues to be paid to individuals who are absent from service, but who remain employees during the periods for which their compensation continues to be paid. This payroll practice exception is not intended to apply to arrangements that continue cash payments to individuals, in amounts related to the individuals’ prior compensation for services, after the individuals have ceased to be considered employees, such as when they resign or retire.


About the author

Brian Gilmore

Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans. Brian also presents regularly at trade events and in webinars on current hot topics in employee benefits law.


The information provided is of a general nature and an educational resource. It is not intended to provide advice or address the situation of any particular individual or entity. Any recipient shall be responsible for the use to which it puts this document. Newfront shall have no liability for the information provided. While care has been taken to produce this document, Newfront does not warrant, represent or guarantee the completeness, accuracy, adequacy, or fitness with respect to the information contained in this document. The information provided does not reflect new circumstances, or additional regulatory and legal changes. The issues addressed may have legal, financial, and health implications, and we recommend you speak to your legal, financial, and health advisors before acting on any of the information provided.

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