AGE AND SERVICE REQUIREMENTS

Although not all plans have age or service conditions for entry, many employers prefer such conditions because they help to avoid the cost of carrying an employee on the records as a plan participant when the employee quits after a short period of service. Generally, a plan cannot require more than one year of service before eligibility, and an employee who has attained the age of 21 must be permitted to participate in the plan if the employee has met the other participation requirements of the plan. Both age and service requirements can be imposed. For example, for an employee hired at age 19, the plan can require that employee to wait until age 21 to participate in the plan. However, an employee hired at age 27 cannot be required to wait more than one year before participating in the plan.

As an alternative to the one-year waiting period, a plan may provide for a waiting period of up to two years if the plan provides immediate 100 percent vesting upon entry. The two-year provision is often used by employers with very few employees and a high turnover rate—for example, a self-employed physician with one or two clerical or technical employees who have high mobility in their labor market. With a two-year provision, few of the employees may ever be covered.

One problem with these age and service requirements is that it is often desirable for a plan to have entry dates—that is, specific dates during the year in which plan participation is deemed to begin—to simplify recordkeeping. The regulations provide that no employee may be required to wait for participation more than six months after the plan's age and service requirements are met. Thus, a plan having entry dates must adjust its eligibility provisions accordingly.

The Blarp, Inc., pension plan wishes to have a one-year, age 21 entry requirement and to use an entry date or dates. Any of the following options will meet the requirement in the regulations:

* Two entry dates in the year, six months apart, with participants entering on the next entry date after they satisfy the one-year, age 21 condition

* One entry date, but a minimum entry age of no more than 20½ and a maximum waiting period of six months

* One entry date, with participants entering the plan on the date nearest (before or after) the date on which the one-year, age 21 requirement is satisfied

All qualified plans are subject to the age 21 requirement, except for a plan maintained exclusively by a tax-exempt educational institution as defined in Code Section 170(b)(1)(a)(ii). To avoid coverage of temporary employees such as graduate teaching assistants, such a plan may provide a minimum age of 26, but the plan must have 100 percent vesting after one year of service.

Definition of Year of Service

The term year of service is used in different ways in the qualified plan rules. It is used to define the age and service rules for eligibility that were just discussed, and is also used in connection with the vesting and benefit accrual rules. Because it plays such an important part in these rules, it has a specific definition under the law.

Generally, a year of service is a 12-month period during which the employee has at least 1,000 hours of service. For purposes of determining eligibility, the initial 12-month period must be measured beginning with the date the employee begins work for the employer. For other purposes, the 12-month accounting period used by the plan (the plan year) can generally be used. For example, suppose the plan uses the calendar year as the plan year. If an employee began work on June 1, 2001, the initial 12-month period for determining whether the 1,000-hour requirement had been met would be June 1, 2001, through May 31, 2002. If the employee did not perform 1,000 hours of service during that period, the plan could begin the next measuring period on January 1, 2002, with subsequent years being determined similarly on the basis of the plan year.

The employer may determine hours of service using payroll records or any other type of records that accurately reflect the hours worked. Alternatively, the regulations allow a plan to use "equivalency" methods for computing hours of service. These equivalencies allow employees to be credited with hours worked based on completion of some other unit of service such as a shift, week, or month of service, without actual counting of hours worked.

Breaks in Service

A larger employer may reduce the cost of a plan somewhat by including a break-in-service provision in the plan's eligibility requirements. Under such a provision, an employee whose continuous service for the same employer is interrupted loses credit (upon returning to work) for service prior to the break and must again meet the plan's waiting period for eligibility. For a smaller employer, breaks in service followed by reemployment are relatively rare and such a provision may have no substantial cost impact other than possibly to complicate plan administration.

The rules under which a plan may interrupt service credits for breaks in service are somewhat complicated. The rules are set out in Code Section 410(a)(5) and regulations thereunder, as well as Labor Regulations Section 2530.200b. A one-year break in service for this purpose is defined as a 12-month period during which the participant has 500 or fewer hours of service. Service prior to a break cannot be disregarded until there is a one-year break in service. If the employee then returns to work, prebreak service may be disregarded (and the participant regarded as a new employee for participation purposes) within the following three limitations:

1. Service prior to the one-year break in service does not have to be counted unless the returned employee completes a year of service. Participation is then effective as of the first day of the plan year in which eligibility was reestablished.

2. If the plan has a two-year, 100 percent vesting eligibility provision, prebreak service need not be counted if the employee did not complete two years of service before the break.

3. If the participant had no vested benefits at the time of the break, prebreak service need not be counted if the number of consecutive one-year breaks in service equals or exceeds the greater of five or the participant's years of service before the break. For example, suppose that participant Arlen works for Maple Corporation for eight months, quits, and then returns seven years later. For purposes of determining eligibility in the Maple Corporation Plan, Arlen's eight months of prebreak service do not have to be counted.

Other Eligibility Criteria Related to Age and Service

Because the age and service limitations must be met by the plan document as drafted, the IRS will scrutinize the plan to ascertain whether there are eligibility criteria that indirectly base eligibility on age and service. For example, the employer may wish to exclude part-time employees. The IRS views an exclusion of part-timers as a service-based eligibility provision. If the plan has a one-year service requirement for entry, it will exclude all employees who never work 1,000 hours or more in any year. However, the plan cannot exclude part-timers who work 1,000 hours or more in a year, but less than a full year, because such a requirement would be seen as a service requirement that violated the one-year, 1,000-hour rule. However, even if some part-timers must be included, the plan is allowed to have a benefit formula that provides smaller benefits for them because of their lesser compensation, or because part-time service is given less credit for benefit purposes than full-time service.

The IRS will also look at how a plan is actually operated to make sure that the age and service limitations are not violated. For example. suppose an employer has a plan for Division B of the business, and employment in Division B requires five years of service in Division A. Division B has a qualified plan and Division A does not. This service requirement, although outside the plan itself, could be seen as an attempt to circumvent the service limitation for the plan maintained by Division B.

EXTRA PAYMENTS TO EMPLOYEES | Nonretirement Benefits

Educational Assistance

For several years the Internal Revenue Code has provided favorable tax treatment to employees who receive benefits from their employers for educational assistance. Section 127 of the Code, which allows employees to receive annually the first $5,250 of these benefits on a tax-free basis, is scheduled to expire for courses beginning after December 31, 2001. (However, the date has been extended several times before and will probably be extended again, or the Code section may be made permanent.) For benefits to be tax free, the employer's plan cannot discriminate with respect to eligibility in favor of officers, shareholders, highly compensated employees, or their dependents. In addition, no more than 5 percent of the benefits may be paid out to shareholders or owners (or their dependents) who are more-than-5-percent owners of the firm.

Eligible benefits include tuition, fees, and books. The costs of supplies and equipment are also included as long as they are not retained after completion of the course. Meals, lodging, and transportation associated with educational expenses cannot be received tax free, nor can tax-free educational assistance be provided for graduate-level courses. For purposes of Sec. 127, a graduate-level course is defined as any course taken by an employee who has a bachelor's degree or is receiving credit toward a more advanced degree, if the particular course can be taken for credit by any individual in a program leading to a law, business, medical, or other advanced academic or professional degree. Courses involving sports, games, or hobbies are also ineligible for favorable tax treatment. Although an employer's plan can pay for any of these types of courses, an employee will be taxed on the value of the employer's contribution to their cost.

Many employers provide reimbursement for certain educational expenses that do not qualify for favorable tax treatment under Section 127. While such reimbursements result in taxable compensation for an employee, the employee may be eligible for a federal income tax deduction (subject to the 2-percent-of-adjusted-gross-income floor on miscellaneous itemized deductions) if he or she itemizes deductions. The deduction is allowed for educational expenses that are incurred (1) to maintain or improve a skill required in employment or (2) to meet the express requirements of the employer as a condition for retaining employment. Other types of educational expenses, such as costs incurred to qualify the employee for a new trade or business, are not deductible.

Moving-Expense Reimbursement

To attract new employees and to encourage current employees to move to suit the employer's needs, many businesses provide reimbursement for moving expenses. Such reimbursement is includable in an employee's income, but the employee is allowed certain offsetting income tax deductions if specified rules are satisfied. To receive the deductions, the employee must have moved because of a change in job location. In addition, the employee must satisfy both a distance test and a time test. The distance test requires that the employee's new workplace be at least 50 miles farther from the employee's old residence than the employee's old workplace (or at least 50 miles from the employee's old residence if the employee was previously unemployed). The time test requires that the employee work full-time in the general location of the new residence for at least 39 weeks during the 12 months following the move. An employee may take the applicable deductions in anticipation of satisfying the time test, but additional taxes will be payable if the time test is not ultimately met.

If all the preceding rules are satisfied, an employee may deduct the following expenses:

• Transportation expenses in moving household goods and personal effects

• Travel and lodging (but not meal) expenses in moving to the new residence

An employer may pay for other expenses, such as expenses to sell an old residence, premove travel to look for a new residence, or temporary living costs at the new location. Because these reimbursements will be taxable income without a corresponding deduction, the employer may give the employee a bonus to offset the increased tax.

Suggestion Awards

Some employers, particularly those in manufacturing industries, give awards to employees who make suggestions that will improve the operating efficiency of the firm if implemented. The awards are often a percentage of the firm's estimated savings over some specified future period of time but may be subject to a maximum dollar amount. If a suggestion plan is properly administered, the benefits of the plan may far exceed its costs while at the same time increasing the motivation and involvement of employees.

Suggestion awards are included in an employee's gross income for tax purposes.

Service Awards

Many employers provide awards to employees for length of service. These awards are often nominal for short periods of service (five or ten years) and may consist of such items as key chains, flowers, or pens. Awards typically increase in value for longer periods of service, and employees may actually be given some choice in the award received.

If the value of a service award is de minimis, it is not included in an employee's income. To be de minimis the value of the benefit must be so minimal that accounting for the cost of the benefit would be unreasonable or administratively impractical. Service awards of higher value may also be excludable from an employee's income if they are considered qualified plan awards. However, the total amount excludable from an employee's income for qualified plan awards (which also include awards for safety) cannot exceed $1,600 per year. Qualified plan awards must be provided under a permanent written program that does not discriminate in favor of officers, shareholders, or highly compensated employees. In addition, the average annual cost of all awards under the plan cannot exceed $400.

Productivity and Safety Achievement Awards

Some employers provide awards for productivity and safety achievement. Productivity awards are fully treated as compensation. However, while awards for safety achievement given to professional, administrative, managerial, or clerical employees are fully taxable, such awards are treated as qualified plan awards for other employees and are included in the $1,600 excludable figure mentioned previously under service awards.

Holiday Bonuses and Gifts

Many employers give gifts or bonuses to employees, particularly at Christmastime. Because the value of such gifts is typically small, some employees tend to resent gifts of money. Therefore, gifts such as liquor or a ham are often given.

As with service awards, a holiday gift does not result in taxation for an employee as long as the market value of the gift is small.

EMPLOYER AND EMPLOYEE TAXATION

Deductibility of Premiums
Employer contributions to the Social Security and Medicare programs are tax deductible for federal income tax purposes. Any employee contributions are paid with after-tax dollars. Self-employed persons can deduct one-half of their Social Security tax as a business expense. In addition, Part B premiums are treated the same as other premiums for individual medical expense insurance and may be deductible.

Taxation of Benefits
Benefits received in the form of monthly income under Social Security are partially subject to income taxation for some Social Security recipients. To determine the amount of Social Security benefits subject to taxation, it is necessary to calculate modified adjusted gross income, which is the sum of the following:

- The taxpayer's adjusted gross income (disregarding any foreign income and savings bond exclusions)

- The taxpayer's tax-exempt interest received or accrued during the year

- One-half of the Social Security benefits for the year

If the modified adjusted gross income is $25,000 or less for a single taxpayer ($32,000 or less for a married taxpayer filing jointly), Social Security benefits are not taxable. If the modified adjusted gross income is between the base amount and $34,000 ($44,000 for a married taxpayer filing jointly), up to 50 percent of the Social Security benefit is includable in taxable income. If the modified adjusted gross income exceeds $34,000 ($44,000 for a married taxpayer filing jointly), up to 85 percent of the Social Security benefit is includable in taxable income. The exact amount of the taxable Social Security benefit is determined by complex formulas that are beyond the scope of this discussion.

Medicare benefits and any lump-sum Social Security benefits are received tax free.

CHARACTERISTICS OF SOCIAL INSURANCE

Even though there are variations in social insurance programs and exceptions to the rule always exist, social insurance programs tend to have the following distinguishing characteristics:

- Compulsory employment-related coverage

- Partial or total employer financing

- Benefits prescribed by law

- Benefits as a matter of right

- Emphasis on social adequacy

Compulsory Employment-Related Coverage
Most social insurance programs are compulsory and require that the persons covered be attached—either presently or by past service—to the labor force. If a social insurance program is to meet a social need through the redistribution of income, it must have widespread participation.

Partial or Total Employer Financing
While significant variations exist in social insurance programs, most require that the cost of the program be borne fully or at least partially by the employers of the covered persons. This is the basis for including these programs under the broad definition of employee benefits. The remaining cost of most social insurance programs is paid primarily by the persons covered under the programs. With the exception of Medicare and certain unemployment benefits, the general revenues of the federal government and state governments finance only a small portion of social insurance benefits.

Benefits Prescribed by Law
Although benefit amounts and the eligibility requirements for social insurance benefits are prescribed by law, benefits are not necessarily uniform for everyone. They may vary by such factors as wage level, length of covered employment, or family status. These factors are incorporated into the benefit formulas specified by law, and covered persons are unable to either increase or decrease their prescribed level of benefits.

Benefits as a Matter of Right
Social insurance benefits are paid as a matter of right under the presumption that a need for the benefits exists. This feature distinguishes social insurance programs from public assistance or welfare programs under which applicants, to qualify for benefits, must meet a needs test by demonstrating that their income or assets are below some specified level.

Emphasis on Social Adequacy
Benefits under social insurance programs are based more on social adequacy than on individual equity. Under the principle of social adequacy, benefits are designed to provide a minimum floor of income to all beneficiaries under the program, regardless of their economic status. Above this floor of benefits, persons are expected to provide additional resources from their own savings, employment, or private insurance programs. This emphasis on social adequacy also results in disproportionately large benefits in relation to contributions for some groups of beneficiaries. Under some programs, high-income persons, single persons or small families, and the young are subsidizing low-income persons, large families, and the retired.

If social insurance programs were based solely on individual equity, benefits would be actuarially related to contributions, just as they are under private insurance programs. While this degree of individual equity does not exist, there is some relationship between benefits and income levels (and thus contributions). Within certain maximum and minimum amounts, benefits are a function of a person's covered earnings under social insurance programs. However, the major emphasis is on social adequacy.

REASONS FOR SOCIAL INSURANCE

The existence and scope of social insurance programs are the result of several factors, probably the most significant of which is the need to solve the major social problems that affect a large portion of society. The industrialization of American society and the decreasing self-sufficiency of families resulted in a greater dependence on monetary income to provide economic security. The widespread lack of such income during the Great Depression led to the passage of the Social Security Act as an attempt to provide economic security by attacking the sources of economic insecurity, including old age and unemployment.

A second reason for the existence of social insurance programs is the difficulty of privately insuring against certain types of losses. For example, the inability to predict future unemployment rates and the potential for catastrophic losses make the peril of unemployment virtually uninsurable in the private sector. In addition, broad medical expense coverage for the aged can be marketed commercially only at a price beyond the financial means of many retirees.

Finally, many Americans have come to expect the government to provide at least a degree of economic security against the consequences of premature death, old age, disability, and unemployment. As a result, social insurance programs enjoy widespread public acceptance.

HOW SHOULD THE PLAN BE COMMUNICATED TO EMPLOYEES?

Traditionally, employers placed a low priority on the communication of their benefit plans to employees. They took the attitude that employees appreciated any benefits that were given to them. The little information that was made available tended to be only the literature that had been prepared by the insurance companies providing the coverage. Over the last few years, this situation has changed dramatically. Employers are required by federal law to disclose a substantial amount of information to employees about their benefit plans. In addition, employers have come to realize that many employees take their benefit plans for granted, that they fail to realize the value of these benefits to themselves and their families, and that they are unaware of the employer's dollar outlay. Not only will effective communication solve this problem, it may also minimize the dissatisfaction that arises from misunderstandings about the benefit program, and it may reduce turnover to the extent that employees realize the true value of their benefits. Employers have also learned that effective communication is necessary to obtain employee support if cost-containment efforts are to be successful. Finally, benefit communication is increasingly important as employees are given more choice with regard to their own benefits. This is occurring as more employees have alternative medical expense plans, cafeteria plans and retirement plans that allow investment options.

Most benefit consultants feel an effective communications program should have four primary objectives.

- To create an awareness of and an appreciation for the way current benefits improve the financial security of employees

- To provide a high level of understanding about available benefits

- To encourage the wise use of benefits

- To comply with legal requirements

Effective Communication
Employees will obtain information about benefits in some manner. Without an effective communications program, an employee is likely to rely on the grapevine, which often provides incomplete and inaccurate information. Good communication rarely just happens. Rather, it requires that the employer set objectives in a manner similar to that used for benefit plan design. While any list of objectives is likely to include the clear and concise dissemination of information about current benefits, other objectives may change over time. For example, an employer may want to encourage employees to switch to a managed care plan.

Depending on the circumstance, communication may be ongoing or on a one-time basis. In either case, benefit consultants feel that it is important for employers to design communication materials that convey to employees that they and their needs are important to the firm, that the employer cares what employees think about benefits, and that the employer wants employees to understand their benefits. A successful long-run communications program also has a method for obtaining feedback that allows the employer to determine the effectiveness of the communications program. Steps can be taken to rectify inadequate information, and past experience can be of value in designing future communications.

Several factors can complicate the communication process. For example, an employer may have different benefit plans for different groups of employees and therefore may have to design alternative communication strategies. While it may be possible to have somewhat similar strategies, the sophistication levels of the different employee groups may call for entirely different approaches. A similar problem may occur if an employer has multiple locations. In addition, employers must take the needs of non-English-speaking employees into consideration. Finally, communication strategies may vary for new employees and existing empolyees.

Whatever form a communications plan may take, communication specialists recommend that several basic factors be present:

The communication should be written in a style that is clear and understandable. Legalese and benefit jargon should be avoided.

The communication should make it clear what a benefit means to an employee. For example, if an employer is trying to encourage enrollment in a managed care plan, the lack of any deductibles and minimal (or no) copayments should be emphasized.

The communication should explain why changes are being made. The effectiveness of the communication is likely to be lessened if an employer is not open and honest. Too many employers fail to realize that employees are smart enough to read between the lines of communications that are less than forthright.

The communication should make use of graphics and examples. Too often communication that lacks these features is boring and therefore less effective.

WHAT ARE THE EMPLOYER'S OBJECTIVES?

No benefit plan is properly designed unless it meets the employer's objectives. Unfortunately, these objectives may be unclear or nonexistent, particularly in small firms. However, most large corporations have—and all firms should have—specific written objectives that have been approved by the board of directors or by the owners of the firm. These objectives will vary for each individual organization, depending upon such factors as size, location, industry, the results of collective bargaining, and the philosophy of the employer. Without such objectives, it is difficult for the agent, broker, benefit consultant, or third-party administrator to make recommendations or for the firms's in-house benefit staff (often part of the human resources department) to make decisions.

Types of Objectives
Objectives for benefit plans can be general and part of a firm's overall compensation objective, that is, cash and employee benefits in the aggregate. This may be done to achieve a compensation package that is competitive within the firm's geographic area or industry. Such an average objective usually means that the firm wants both its wages and salaries and its employee benefits to be similar to what the competition is offering its employees. There is usually some, but not much, room for creativity in the design of a group benefit plan, unless the plans of the competition are quite diverse.

Some firms have separate objectives for cash compensation and employee benefits. For example, a growing firm may want its cash compensation to be competitive, but it may want its overall employee benefit plan to be above average in order to attract new employees. A difficulty with this type of objective for the plan designer is determining whether the firm wants all aspects of the employee benefit plan to be better than average or whether it would be willing to accept, for example, an average program of group insurance benefits but a better-than-average pension plan and more vacation time for its employees. Note that most objectives, even when they are very detailed, tend to apply to all employee benefits rather than to specific types.

It has become increasingly common for firms, particularly large firms, to maintain a lengthy and often detailed list of objectives for their employee benefit programs. The following are the objectives of one such firm:

- To establish and maintain an employee benefit program that is based primarily on the employees' needs for leisure time and on protection against the risks of old age, loss of health, and loss of life

- To establish and maintain an employee benefit program that complements the efforts of employees on their own behalf

- To evaluate the employee benefit plan annually for its effect on employee morale and productivity, giving consideration to turnover, unfilled positions, attendance, employees' complaints, and employees' opinions

- To compare the employee benefit plan annually with that of other leading companies in the same field and to maintain a benefit plan with an overall level of benefits based on cost per employee that falls within the second quintile of these companies

- To maintain a level of benefits for nonunion employees that represents the same level of expenditures per employee as for union employees

- To determine annually the cost of new, changed, and existing programs as a percentage of salaries and wages and to maintain this percentage as much as possible

- To self-fund benefits to the extent that a long-run cost savings can be expected for the firm and catastrophic losses can be avoided

- To coordinate all benefits with social insurance programs to which the company makes payments

- To provide benefits on a noncontributory basis, except benefits for dependent coverage for which employees should pay a portion of the cost

- To maintain continual communications with all employees concerning benefit programs

Most lists of objectives contain few, if any, specific details regarding what provisions or what types of benefits should be contained in an employee benefit plan. Rather, they establish guidelines—instead of specific performance goals—within which management must operate. For example, the objectives listed above indicate this firm wants a plan that is understood and appreciated by employees and that is designed with employee opinion in mind. No mention, however, is made of how this is to be done. There may be alternative ways for this firm to achieve its objectives. Similarly, the objectives establish guidelines for the cost of providing benefits. Although the firm wants to have a better-than-average plan, it does not want to be a leader. There is a very specific statement about what the relationship between the cost of benefits for union and nonunion employees should be. However, nothing is mentioned to indicate that the benefits for the two groups must also be identical. If the two groups have different needs, different types and levels of benefits may be desired.

Three additional points about employer objectives should be made. First, as times change, benefit objectives may need revision.

Second, the frequent lack of specific guidelines in benefit objectives gives the in-house benefit staff great latitude to be creative, to come up with innovative solutions to benefit problems, and to respond to the changing benefit environment. Such creativity can often lead to success and financial reward. However, a greater degree of freedom to be creative is also often accompanied by being the scapegoat when benefit decisions do not lead to the desired results.

Third, a firm's primary (and possibly only) objective may be to establish an overall employee benefit plan that channels as large a portion of the benefits as possible to the owner or owners. Although this is a poor objective for an overall plan, it is a reality that must be recognized, most commonly in small firms or in firms that have few owners. Large, publicly held corporations sometimes wish to provide better benefits for their executives than for other employees. These extra benefits are likely to be provided under separate executive compensation plans rather than under the benefit plan that applies to all employees.

Who Should Receive Benefits?
As part of establishing its objectives, an employer must determine its responsibilities to various categories of persons who might be eligible for coverage under the firm's overall benefit program. The list is much longer than one might initially think. It includes the following:

- Active full-time employees

- Dependents of active full-time employees

- Retired employees

- Dependents of retired employees

- Part-time employees

- Dependents of part-time employees

- Disabled employees

- Dependents of disabled employees

- Survivors of deceased employees

- Employees who have terminated employment

- Dependents of employees who have terminated employment

- Employees who are temporarily separated from employment (for example, employees on family leave)

- Dependents of employees who are temporarily separated from em-ployment

Obviously, most benefits are given to employees, and some benefits are given to their dependents, such as medical expense coverage. Whether other groups on the list receive any benefits depends on several factors. These include the attitude of the employer and the degree to which protection is available under other programs, such as Social Security. In addition, federal and state laws play a role. For example, some benefits must be continued because of family leave legislation. In addition, medical expense coverage must be continued in many cases as a result of COBRA.