October 2002

Proposed Regulation Defines Experience Rating

By Danae Kehoe, JD, federal legislative consultant

On July 11, 2002, the IRS and Treasury Department released a proposed regulation under IRC section 419A(f)(6) that explains and gives examples for what will constitute experience rating by employers in a 10-or-more multiple employer welfare benefit plan. The regulation zeroes in on plan design features, including actual benefit cost and contribution calculations, accounting, and conventions, that will result in a determination about a given section 419A plan’s experiencing rating. Experience rating by an employer voids the statutory exception in IRC section 419A(f)(6) to the deduction limits in IRC section 419A.

Cost of Benefits

The proposed regulation limits annual deductions for contributions to a 10-or-more welfare benefit plan. The general rule states the following:

A plan maintains an experience-rating arrangement with respect to an employer if the employer’s cost of coverage for any period is based, in whole or in part, either on the benefits experience or on the overall experience… of that employer or one or more employees of that employer.

The proposed regulation specifies that a plan must satisfy the rules prohibiting experience rating by employer “both in form and operation.” It also specifies that “all agreements and understandings (including promotional materials and policy illustrations) will be taken into account in determining whether the requirements of section 419A(f)(6) are satisfied in form and in operation.”

The regulation defines “cost of coverage” as the relationship between an employer’s contributions (including employee contributions) under the plan and the benefits or other amounts payable under the plan with respect to that employer. “Benefits experience” means, “generally, the benefits and other amounts incurred, paid, or distributed (or otherwise provided) in the past.” And, “overall experience” of an employer is defined as “the balance that would have accumulated in a welfare benefit fund if that employer were the only employer providing benefits under the plan.”

The regulation provides that “the process for determining whether a plan maintains an experience-rating arrangement is to inquire whether the past experience of an individual employer or its employees is used, in whole or in part, to determine the employer’s cost of coverage.”

The proposed regulation holds that when life insurance contracts are assets of the fund, “any payments under an arrangement from an employer or its employees directly to an insurance company will be treated as contributions to the fund, and any amounts paid by the insurance company under the arrangement will be treated as paid by the fund.” The proposed regulation further specifies that life insurance cash values are “retained values” in a fund, and that only the cost of the benefit provided in the year the contribution is made is allowable under its proposed definition of experience rating by employer:

Allowing a 10-or-more employer plan to use insurance contracts for an employer’s employees with retained values would provide a financial incentive for the employer to over-contribute to the plan, contrary to [Congress’ intent]… If the retained values of life insurance contracts relating to an employer’s employees are used to determine that employer’s cost of coverage, the arrangement results in a prohibited experience-rating arrangement under these proposed regulations.

Prohibited Arrangements

The proposed regulation provides 13 examples of what the IRS and Treasury Department would or would not consider experience-rated by employers. It also provides the following five characteristics which, if any are present in a plan design, would cause the IRS to consider the plan to be a prohibited experience-rating arrangement, unless satisfactory proof to the contrary is provided:

The proposed regulation requires that plans operating under IRC section 419A(f)(6) contain a provision in the plan document that requires the plan administrator to maintain records sufficient for the Commissioner or any participating employer to readily verify the plan’s compliance. It also requires the plan document to contain a provision granting the Commissioner and each participating employer the right to inspect and copy all such records.

Effective Date

The proposed regulation’s experience rating rules will be effective for contributions paid or incurred in taxable years of an employer beginning on or after July 11, 2002, the date of publication of the proposed regulation in the Federal Register. Contributions made prior to July 11 will be governed by the rules in IRS Notice 95-34, and are subject to the fact that “the IRS has already identified transactions that are the same as or substantially similar to the transactions described in Notice 95-34 as listed transactions for purposes of (the tax shelter regulations) section 1.6011-4T(b)(2) of the Temporary Income Tax Regulations and section 301.6111-2T(b)(2) of the Temporary Procedure and Administration Regulations.” The record-keeping requirements become effective for taxable years of a welfare benefit fund beginning after the publication of final regulations.

The IRS plans a public hearing on the proposed regulation on November 14, 2002. The deadline for comments was October 9, 2002.

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