February 2008 E-Alert

BENEFITS ADDRESSED IN THIS MONTH’S E-ALERT:

Performance-based compensation issued by public companies
Retiree health plan coordination with Medicare
Family Medical Leave Act (FMLA) rights

IRS Drastically Changes its View of Performance-Based Compensation

In a recent Private Letter Ruling (PLR 200804004), the IRS announced a significant shift in its interpretation of Section 162(m) of the Internal Revenue Code (“162(m)”) relating to the performance-based compensation exception to the $1 million dollar limitation on compensation paid by publicly held companies. The regulations under 162(m) specifically allow payment of performance-based compensation upon death, disability, or a change in control. Using the logic that it was analogous to death, disability, or a change in control, previous private letter rulings determined that performance-based payments made as a result of involuntary terminations by the employer without cause or by the executive for good reason did not fail to qualify as 162(m) performance-based compensation. This meant that the performance-based payment was still deductible under 162(m), even though the performance goal had not been met at the time of payment for these types of events (e.g. a bonus that is automatically paid at target upon termination for good reason, regardless of actual performance). According to the new Private Letter Ruling, however, this rationale is no longer being used by the IRS in analyzing performance-based compensation.

The new Private Letter Ruling published on January 25, 2008 states that if performance-based pay could become due under a plan or agreement upon an involuntary termination by the employer without cause or by the executive for good reason, and would be payable regardless of whether performance goals are met, then any pay from such plan or agreement does not qualify as 162(m) performance-based compensation and is not eligible for exclusion from the 162(m) $1 million compensation limit (regardless of whether the pay actually becomes payable as a result of a termination without cause or for good reason).

As there is no transition period applicable to this type of informal guidance, any plans or agreements that contain performance-based compensation should be reviewed immediately and amended, if needed, to preserve a public company’s ability to exclude performance-based compensation from the compensation limits of 162(m). It is not yet known how far this ruling will reach, and whether equity incentives, such as stock options whose vesting accelerates upon certain terminations, will be affected.

President Signs New FMLA Military Provisions on January 28, 2008

On January 28, 2008, President Bush signed the National Defense Authorization Act (H.R. 4986). This Act, which annually authorizes funding for the Department of Defense, includes the first expansion of the Family and Medical Leave Act (FMLA) since 1993. With bipartisan support in the House and the Senate, this Act adds substantive new rights for employees who are members of military families. Specifically, this legislation adds two new types of FMLA leave, extends the length of available FMLA leave from 12 weeks to 26 weeks for the care of seriously ill or injured service members, and adds an additional category of employee that is eligible for FMLA leave.

Active Duty – Under the provisions of this Act, an eligible employee may now take FMLA leave for up to 12 work weeks because of a “qualifying exigency” related to the fact that an employee is or has been called to active duty in the U.S. Armed Forces. While the Department of Labor (DOL) is encouraging employers to voluntarily provide this type of leave now, because this Act does not define what constitutes a qualifying exigency, this section of the Act will not be effective until the DOL issues regulations defining this term.

Combat-Related Injury –A second type of leave, also added to the FMLA by this Act, is effective immediately. An eligible employee may take FMLA leave to care for a service member who has a combat-related serious injury or illness. This leave may extend for up to 26 work weeks in a single 12-month period, and may be used intermittently. One caution for employers is that the definition of “serious illness or injury” for purposes of this leave differs from the current FMLA definition of a “serious health condition.” While FMLA currently defines a serious health condition as an illness, injury, impairment or physical or mental condition that involved inpatient care or continuing treatment by a health care provider, the definition of a “serious illness or injury” for purposes of this new FMLA leave differs significantly. It provides that an injury or illness that the service member incurred while on active duty and that leaves the service member unfit to perform the duties of the member’s office, grade, rank or rating is considered a serious illness or injury. This new legislation does provide a process for employers to certify these new types of FMLA leaves.

‘Next of Kin’ Eligibility – This Act also adds a new category of employee that is eligible for FMLA leave to care for a service member. Under the Act, an eligible employee who is the “next of kin” of a service member of the U.S. Armed Forces may take FMLA leave to care for that service member. “Next of kin” has been defined as the “nearest blood relative of the service member.” Currently, the FMLA does not provide rights based on this concept. Determining whether an employee is the nearest blood relative may add complications to the already complex process of processing and approving requests for FMLA leave.

Until additional guidance is provided by the DOL, employers should operate in good faith compliance with this Act by utilizing existing FMLA procedures for these new types of leave.

EEOC Issues Final Regulations Allowing Retiree Health Coverage to Coordinate with Medicare Eligibility
On December 26, 2007, the Equal Employment Opportunity Commission (EEOC) issued its long awaited final regulations allowing employers who offer retirees group medical coverage to coordinate this coverage with Medicare eligibility without violating the provisions of the Age Discrimination in Employment Act (ADEA). (Generally, the ADEA protects employees who are at least 40 years old from age discrimination in employment. In prior guidance, the EEOC extended this protection to retirees.)
As background information, while employers are not required to offer group health coverage to their retirees, many companies have elected to voluntarily provide such coverage. To manage the high costs of retiree health coverage, many employers designed this coverage to provide two levels of benefits: one for retirees under age 65, and another for retirees age 65 and older. This arrangement reduces costs because the coverage offered to those retirees age 65 and older coordinates with Medicare coverage. However, coordinating retiree health coverage with Medicare has been a controversial practice subject to protracted litigation over the past several years.

Proposed regulations were published by the EEOC in April 2004 in response to the Third Circuit Court of Appeals decision in Erie County Retiree Association v. County of Erie. In that case, the Third Circuit held that the ADEA required that retiree medical coverage received by Medicare-eligible retirees must be of either “equal cost” or “equal benefit” to other retirees’ medical coverage, or the arrangement would not be exempt from the requirements of the ADEA. While the EEOC initially adopted this reasoning, after considering the objections of employers, many of whom began to terminate all retiree medical coverage, the EEOC reversed its position and adopted the regulations mentioned above, exempting these types of employer-provided retiree medical plans from the requirements of the ADEA.

The AARP, however, sued the EEOC to prevent these regulations from taking effect. In March 2005, in AARP v. EEOC, a federal district court in Pennsylvania agreed with the AARP and concluded that the EEOC exemption was invalid and that the practice of coordinating retiree medical coverage with Medicare violated the provisions of the ADEA unless the plan met either the “equal cost” or “equal benefit” test mentioned above. Subsequently, a decision of the U.S. Supreme Court in an unrelated case caused the district court to reverse its position, allowing the EEOC to implement the regulations, providing for the coordination of retiree medical coverage with Medicare. The AARP appealed the federal district court’s decision and the Third Circuit Court of Appeals upheld the EEOC regulations. However, the AARP has now asked the U.S. Supreme Court to review the Third Circuit’s decision. As of the date of this newsletter, the Supreme Court has not yet decided whether to accept this case.
In light of this uncertainty, employers should review their existing retiree health plans for compliance with the EEOC final regulations and watch for updates on the final chapter in this ongoing struggle between the EEOC and the AARP.

COMING UP NEXT MONTH…….

State Laws Impacting Health Plans – Do you sponsor an ERISA-governed group health plan? If so, have you considered the impact of state laws? Although ERISA preempts many state laws, over the past year or so a disturbing new trend has been developing. States such as Vermont and Massachusetts, and cities such as San Francisco, have passed health care mandates that force employers to provide a minimum level of health coverage to employees, or face penalties. And courts have upheld the application of some of these laws to group health plans! What states have adopted these laws? What should you do to comply?
Qualified Default Investment Alternatives (QDIAs) — Plan sponsors who properly implement these new investment vehicles can avoid liability for their 401(k) plan’s default investments. Should you consider adopting a QDIA for your plan? What’s involved?
Your Severance Program and Code Section 409A — Many small and mid-sized employers believe they are not impacted by the new Internal Revenue Code Section 409A. But if you provide severance to your employees, you are most likely covered by 409A. How does this new tax law affect your severance payments? What are some easy solutions that will ensure your compliance?