When our public agency clients negotiate with their collectively bargained employees, both sides strive to make the most of limited compensation and benefits dollars. Sometimes the parties believe they can create greater value by letting the employees choose between two employer-provided benefits. In many cases, the choice between two employer-provided benefits does not include the ability for the employees to receive cash instead of employer-provided benefits.
Such a situation avoids a constructive receipt problem. There are many perils of letting employees choose between cash and nontaxable benefits. However, a lesser known tax problem can arise when a choice is given to employees between additional deferred compensation (an employer contribution to a 457(b) plan or a 401(a) plan) and an additional health insurance subsidy (an employer contribution for health insurance). This lesser-known problem stems from the “assignment of income” doctrine.
Choices May Mean Taxes
A number of U.S. Supreme Court cases uphold the proposition that if a taxpayer who is entitled to receive income in the future gives up that right (generally by surrendering it to another taxpayer), the taxpayer will be treated for tax purposes as having first received the “future income” and then disposing of it. How does the assignment of income doctrine cause a choice between an employer-made 457(b) plan contribution and an employer-made health premium subsidy? It’s because the employee’s choice is between the receipt of future income (amounts that will be taxed when distributed from the 457(b) plan) and a nontaxable current benefit (tax-free employer subsidy of health coverage).
If the employee gives up the right to receive additional 457(b) distributions in the future in exchange for an additional current health insurance subsidy, the IRS views this as an assignment of income and treats it as current taxable income to the employees who elect the additional health insurance subsidy – even though they are not receiving any cash and have elected to receive what appears to be a nontaxable benefit.
A cafeteria plan does not avoid the additional taxable income. Even if the employee could otherwise reduce taxable compensation on a pre-tax basis for health insurance premiums under the cafeteria plan, a cafeteria plan cannot allow a choice between nontaxable health benefits and deferred compensation. Therefore, the employee’s choice is not being made under the cafeteria plan so the choice does not result in a pre-tax health insurance premium deduction.
We have advised several cities about changes they wanted to make to their benefit plans. Fortunately, our clients had city attorneys who were sophisticated (and current) enough to recognize the potential tax issue and worked with us to resolve it. As we all know, novel employee benefit ideas such as the one mentioned above tend to make the “rounds” as cities and districts renegotiate their memorandums of understanding (MOUs). For every public agency that addresses this issue, there probably are dozens more that are unaware of the problem.
Playing It Safe
Employers and their collective bargaining partners should be particularly careful when negotiating and designing benefit changes that involve employee choice. To ensure optimal results with no surprises for employers, collective-bargaining partners and employees, work with benefits law experts at Employee Benefits Law Group.