How to comply with Section 89 - Internal Revenue Code. Section 89

Nation's Business, Feb, 1989 by Roger Thompson

How To Comply With Section 89 Section 89 of the Internal Revenue Code denies tax-favored treatment of employer-provided benefit plans that discriminate in favor of employees who are highly paid. The law became effective Jan. 1 and applies to all employers, public and private. Only churches are exempt.

The law has two distinct parts: qualification rules similar to those for pension plans, and non-discrimination rules. The qualification rules are less difficult to handle but more onerous in their penalties. These rules apply to all tax-favored employee benefits.

There are five tests for maintenance of a "qualified" plan. It must be in writing, employees' rights must be legally enforceable, employees must be notified of the plan's benefits, the plan must be exclusively for employees, and the plan must be maintained indefinitely. Employers have until Dec. 31, 1989, to put the necessary documents in order, but they must operate the plan in accordance with its provisions from the beginning of the year.

Failure to meet any of the qualification requirements carrier severe penalties in the form of extra taxes for employer and employees. All employees will be taxed on the payouts they receive from an employer-provided plan. For example, if the company's health plan pays out $50,000 on behalf of an employee with a catastrophic illness, that money becomes taxable income to the employee.

In addition, employers who fail to report benefit payouts on employees' W-2 forms must pay an excise tax on the total payouts, calculated at the highest individual tax rate.

The non-discrimination rules form the heart of Section 89 and apply only to employer-provided health-care, accident, and group life-insurance plans. These rules pose the toughest compliance problems.

Before testing for discrimination, an employer first must assemble a considerable amount of data, including the number of the company's highly compensated employees, the number of employees excluded from testing, and the number of benefits plans subject to testing.

For the typical small business, highly compensated employees are those who are 5 percent owners or who earned at least $52,235 in 1988. The dollar amount will rise yearly to reflect inflation.

Excluded from testing are employees under age 2 anyone who works less than six months a year, anyone who has not completed a year of service (or six months of service for core health benefits), anyone who works less than 17.5 hours a week, and employees subject to collective-bargaining agreements.

Some small businesses--those with nine or fewer employees--may take three years to phase in coverage of part-time employees, defined as those who work at least 17.5 hours a week.

If an employer provides benefits to even one person in an excluded group, the exclusion is denied, and everyone in that group must be included in testing.

For testing purposes, a benefit plan may be viewed as more than one plan. Each variation in coverage, employer or employee contribution, copayment, or deductible creates a benefit plan that must be tested separately. For example, a medical plan that offers single-person and family coverage and two levels of deductibles is actually four different plans for testing.

Employers have two ways to prove that their plans do not discriminate:

* 80 Percent Coverage Test. This is the less complex of the two methods. A plan passes this test if 80 percent of the employees who are not highly compensated actually receive coverage.

* Eligibility And Benefits Tests. As an alternative, an employer may show that the company's plan passes each of the three following tests:

90 Percent-50 Percent Eligibility Test. Ninety percent of the non-highly compensated employees must be eligible for benefits at least 50 percent as valuable as benefits for highly compensated employees.

50 Percent Eligibility Test. At least 50 percent of non-highly compensated employees must be eligible for a benefit under the plan, or the percentage of eligible highly compensated employees is no higher than the percentage of eligible non-highly compensated employees.

75 Percent Benefits Test. Non-highly compensated employees must actually receive an average benefit at least 75 percent as valuable as the average benefit for highly compensated employees.

Cafeteria plans, which allow employees to choose among several options for health and other benefits, are subdivided and tested like any other plan. Each option is a separate plan for testing purposes. Benefits provided through salary-reduction plans also are treated as separate plans for testing.

There is no penalty imposed on the employer for maintaining a discriminatory plan. But the employer must determine the amount of discriminatory excess received by the highly compensated employee and report it to the employee and to the IRS as taxable income. If an employer fails to report the discriminatory excess to the IRS, the penalty is an excise tax, calculated at the highest individual tax rate, on total benefits received by the highly compensated employees.