Due to changing economic circumstances, some employers today are being forced to consider reductions in force (RIFs) or layoffs. If severance is on the table, it is often the case that some form of health insurance subsidy or stipend may also be included in the exit package.
This article addresses the compliance and tax issues involved with severance arrangements that include health insurance coverage.
When continued health insurance is to be included in a severance arrangement, there are two primary methods to accomplish this. Each has pros and cons as well as different tax consequences and discrimination considerations.
Option #1: Health Insurance Stipend
| Health Insurance Stipend | |
| What is it? | A health insurance stipend is a flat dollar amount that is added to severance pay that reflects payment for the cost of health insurance for a specific period of time. It is typically calculated as some multiple of the cost for health insurance elected at the time of employment termination. |
| Taxation | A health insurance stipend is taxable (both income taxable and FICA taxable for the employee and employer). A stipend would be any flat payment amount intended to be used for health insurance (but which is not restricted to that use). The lack of restriction renders any such payment to be ordinary wages which are subject to taxation. |
| Pros/Cons | Employee Perspective. Receiving a lump sum of cash up front for health insurance continuation provides the ultimate flexibility. It can provide monies to pay ongoing health insurance premiums if COBRA is elected. Alternatively, if the employee has the option to elect coverage under a spouse’s group health insurance plan, the health insurance stipend could be used for any other purposes. Employer Perspective. The full cost of the stipend is “out-the-door” immediately with no contingencies for reduced payment if other coverage is secured. When payments are taxable, employers needn’t be concerned about the stipend favoring highly compensated or key employees. |
| Discrimination Issues | Since the benefit is taxable, there are no discrimination concerns. This includes providing certain employees with a health insurance stipend and not providing one to other employees. |
Option #2: COBRA Subsidy
| COBRA Subsidy | |
| What is it? | Under this option, the employer provides either a full subsidy or a partial subsidy of COBRA premiums to continue health coverage(s) for a specified duration. |
| Taxation | COBRA subsidies are generally tax free to former employees as long as one of the following conditions is met:
• The employer pays the premium directly to the insurance carrier or TPA
• The employer reimburses individuals for premiums, but only after they provide substantiation of the COBRA payment • A partial subsidy is provided, and the employer allows the terminated employee to pay the balance of the premium on a pre-tax basis from their final paycheck (subject to no plan year crossover and the cafeteria plan allowing this) |
| Pros/Cons | Pros. This option provides coverage for a specified period of time, typically for the coverages elected at the time of employment termination. This arrangement is typically clear for employees. Cons. When an employer provides a 100% subsidy, many employees think once they sign a severance agreement that includes an offer of COBRA subsidy, they become automatically enrolled in COBRA – this is not the case. Employees must take the additional step to elect COBRA with their COBRA provider. It is critical that employees be told and understand that they must affirmatively “elect” COBRA in order to activate coverage, even if no premium payment is immediately required. This can be counterintuitive when there is no premium payment, but it is required. |
| Discrimination Issues | Self-funded and Level Funded Plans. COBRA subsidies must be provided on a nondiscriminatory basis to avoid running afoul of the IRS Section 105(h) discrimination requirements. Specifically, subsidies should not be provided in any manner that disproportionately benefits highly compensated employees, such as providing more generous or longer subsidies to executives. When business decisions necessitate inequitable subsidy arrangements, the nondiscrimination requirements can be avoided by simply taxing the value of the COBRA subsidy to the highly compensated employee. Fully Insured Plans. While health plan discrimination requirements were included in the Affordable Care Act, regulations have yet to be promulgated, so those discrimination testing requirements are not yet in play. |
| Administration and Severance Agreement Issues | Many administrative headaches can result from vague COBRA subsidy language in severance agreements. Employers should aim to be extraordinarily clear about elements relating to health insurance continuation, including the following:
• When active health insurance coverage terminates
• The amount (flat dollar amount or % of premium) and duration of the COBRA subsidy • The date the COBRA subsidy begins (date of termination, end of month, etc.) • The date the COBRA subsidy ends (mid-month or end of month after subsidy ends) • Which health coverages are included in the subsidy (medical only, medical/dental/vision/EAP, etc.) • The coverage tier that is to be sponsored (employee only, employee + spouse, etc.) • Whether the COBRA subsidy will be impacted by changes in coverage or coverage tiers at open enrollment • The requirement to affirmatively elect COBRA coverage to activate COBRA coverage (even when there is a full subsidy) • Any factors that would cause the subsidy to cease, such as becoming eligible for or enrolling in coverage under: o Another group employer sponsored plan
o A spouse’s plan o Medicare When this level of detail is not articulated in the severance agreement and other termination communications, misunderstandings can ensue which can bring liability for employers.
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| Timing Issues | Most COBRA subsidies are contingent on the signing of the severance agreement. Because agreement execution typically allows for an extended window for signing, this can create some confusion from a timing perspective. If the severance agreement has not been signed at the time the initial COBRA notice is sent, the COBRA package will not reflect the COBRA subsidy. When the signed severance agreement is received, the employer must then advise the COBRA administrator so that the COBRA event can be updated to reflect the subsidy. Typically, follow-up correspondence is then sent to the Qualified Beneficiary to clarify the inclusion of a subsidy for the COBRA coverage. Understanding the nuances of this timing can be important for individuals. |
| End of Subsidy Issues | In General. When the maximum duration of COBRA coverage is exhausted, or if the group health plan terminates, a special enrollment right is triggered whereby covered individuals may opt in to a group employer sponsored plan, a spouse’s health plan, or an individual plan without a gap in coverage. Many individuals count on this special enrollment right to enable seamless health insurance coverage. When COBRA Subsidies End – CANNOT Move to Group Health Plan Coverage. Voluntary termination of COBRA mid-way through the 18-month maximum duration, even because a subsidy ends and the out-of-pocket premium becomes more expensive, does NOT trigger a special enrollment right. While the end of an employer subsidy seems like it should trigger special enrollment rights, it does not. If a terminated employee intends to ride out a COBRA subsidy and then jump into other group health plan coverage at the time the subsidy expires, there is no special enrollment right that allows for such a mid-year election. The individual would need to wait until the next open enrollment to elect coverage under a group plan, leaving them to pay the full, unsubsidized COBRA premium for the duration of the plan year. When COBRA Subsidies End – CAN Move to Marketplace Coverage. Individuals seeking coverage under the Marketplace may switch from COBRA coverage to a Marketplace plan at the point when they are required to pay for the full cost of COBRA coverage because a former employer stops contributing, that is, when their subsidy ends. Important Communication. This can come as a big surprise for individuals with COBRA subsidies. While not a required communication, explaining this potential difficulty when other COBRA subsidy information is provided to terminated employees is helpful. |
There are several references confirming that employer COBRA subsidies of a former employee’s COBRA premiums are not taxable.