HEALTH FLEXIBLE SPENDING ACCOUNT PLANS

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1 On February 3, 1999, the Internal Revenue Service issued final and new proposed COBRA regulations. These regulations resolve a number of issues that were left open by the 1987 and 1998 proposed regulations. This memorandum describes the more significant provisions of the final and new proposed regulations. HEALTH FLEXIBLE SPENDING ACCOUNT PLANS The new proposed regulations include rules on COBRA's application to health flexible spending account plans ("health FSAs"). The regulations provide that COBRA coverage is not required to be offered under a health FSA if certain conditions are met: Plan Years After the Year in Which the Qualifying Event Occurs. The regulations provide that COBRA coverage need not be offered under a health FSA for plan years following the plan year in which the qualifying event occurs if both of the following conditions are met: Condition (i) Condition (ii) The plan is not subject to the HIPAA portability provisions because the benefits provided by the plan are "excepted benefits," as defined in HIPAA. 1 In the plan year in which the qualifying event occurs, the maximum amount the plan could require to be paid for a full plan year of COBRA coverage equals or exceeds the maximum benefit available under the plan for the year. Plan Years in Which the Qualifying Event Occurs. The regulations provide that COBRA coverage need not be offered for the remainder of the plan year in which the qualifying event occurs if Conditions (i) and (ii) are satisfied, and a third condition is met: Condition (iii) As of the date of the qualifying event, the maximum benefit available to the qualified beneficiary for the remainder of the 1 In order for the benefits provided by a health FSA to constitute "excepted benefits," (a) the employer must provide another group health plan that offers benefits other than excepted benefits (excepted benefits include, for example, accident or disability insurance), and (b) the maximum reimbursement under the health FSA may not be greater than two times the employee's salary reduction (or the employee's salary reduction plus $500, if greater).

2 - 2 - plan year is less than or equal to the maximum amount the plan could require as payment for the remainder of that year in order to maintain coverage under the plan. Most health FSAs will satisfy Conditions (i) and (ii). Thus, for most health flex plans, COBRA coverage is no longer required to be offered for plan years following the plan year in which the qualifying event occurs. Application of COBRA to the plan year in which the qualifying event occurs will vary from participant to participant. Generally, participants who have contributed more to a health flex plan than they have used during the plan year will be entitled to COBRA coverage for the remainder of the year; those who have used more than they have contributed will not. Employers whose plans satisfy Conditions (i) and (ii), but who wish to avoid making a case-by-case determination for Condition (iii), may simply offer COBRA coverage to all qualified beneficiaries for the year in which the qualifying event occurs. DURATION OF COBRA COVERAGE The final and new proposed regulations clarify the rules governing the duration of COBRA coverage: Termination of COBRA Coverage On Account of Coverage Under Another Group Health Plan. The final regulations incorporate the Supreme Court's 1998 decision in Geissal v. Moore Medical Corp., 524 U.S. 74 (1998), by providing that a plan may terminate COBRA coverage based upon a qualified beneficiary's coverage under another group health plan or entitlement to Medicare only if the qualified beneficiary first becomes covered under the other group health plan or entitled to Medicare after the date of the COBRA election. The final regulations also confirm that: COBRA coverage may not be discontinued on account of coverage under another group health if the other group health plan contains any exclusion or limitation for any preexisting condition of the qualified beneficiary. Coverage under another group health plan includes coverage under a governmental plan. COBRA coverage may be discontinued on account of Medicare entitlement only if the qualified beneficiary is actually enrolled in Medicare Part A or Part B. Mere Medicare eligibility -- without actual enrollment in Medicare -- is not sufficient to terminate COBRA coverage. Termination of Employment Following a Reduction in Hours. The final regulations end the uncertainty over whether a termination of employment constitutes a second qualifying event, if the first qualifying event is a reduction in hours. It is now clear, under the final regulations, that a termination of

3 - 3 - employment does not constitute a second qualifying event for an employee who was entitled to COBRA coverage as a result of an earlier reduction in hours. USERRA. 2 The final regulations provide that coverage under USERRA which gives certain members of the military reserves up to 18 months of continuation coverage when they are called to active duty runs concurrently with COBRA coverage. Other Duration of Coverage Issues. The new proposed regulations reflect various statutory changes that have been enacted since the 1987 proposed regulations were issued, including: the rules on extension of the maximum coverage period to 29 months for qualified beneficiaries who are determined, under Title II or Title XVI of the Social Security Act, to have been disabled at any time during the first 60 days of COBRA coverage; the provision permitting COBRA notice to be provided at the time coverage is lost as the result of a qualifying event, rather than at the time of the qualifying event -- if the plan provides that the COBRA coverage period does not begin until the loss of coverage; the rule for determining the maximum COBRA coverage period if a covered employee becomes entitled to Medicare part A or part B before experiencing a termination of employment or reduction of hours; and the maximum coverage period in the event of the employer's bankruptcy. CORPORATE TRANSACTIONS The new proposed regulations have a lot to say about COBRA in the context of business reorganizations: Asset Sales An employee who terminates employment with the seller as a result of an asset sale, and his or her spouse and children, are generally entitled to COBRA coverage. Coverage must be provided whether or not the employee is hired by the buyer. COBRA coverage must be provided by the seller, if the seller continues to maintain a group health plan after the sale. 3 If the seller does not maintain a group health plan following the sale, the buyer must provide COBRA coverage if the buyer maintains a group health plan and the buyer is a "successor employer" that is, if the buyer continues the business operations associated with the transferred assets without interruption or substantial change. The buyer is not required to 2 The Uniformed Services Employment and Reemployment Rights Act of As under the 1987 proposed regulations, the "seller" maintains a group health plan if any member of the seller's controlled group, or a member of the group of trades or businesses under common control with the seller, maintains a group health plan.

4 - 4 - Stock Sales provide COBRA coverage, however, to employees (and their spouses and children) who go to work for the buyer. Similar rules apply to employees (and their spouses and children) who lose employment or have another qualifying event prior to the sale, but whose last employment prior to the qualifying event was in connection with the assets being sold. A stock sale is not a qualifying event for a covered employee, or his or her spouse or children, if the covered employee continues to be employed by the acquired organization after the sale. This is so even if the acquired organization does not continue to provide health coverage after the sale. If an employee loses employment as a result of a stock sale, the seller is obligated to provide COBRA coverage, if the seller continues to maintain a group health plan following the sale. If the seller does not maintain a group health plan following the sale, the buyer must provide the required coverage, if the buyer maintains a group health plan. Allocation of Responsibility by Contract The parties to a corporate transaction may allocate responsibility for COBRA coverage as they deem fit. Any such agreement will not transfer liability under the statute from one party to the other, although the agreement may permit one party to seek indemnification or other contractual remedies from the other. Thus, if the statute gives the seller responsibility for COBRA coverage in a particular transaction but the buyer assumes the COBRA obligation by contract and then fails to meet the COBRA requirements, the seller will still be liable. The seller may, however, have a claim against the buyer for breach of contract. OTHER PROVISIONS OF THE FINAL AND NEW PROPOSED REGULATIONS The final and new proposed regulations also: Give employers additional flexibility in determining the number of group health plans they maintain for COBRA purposes, by providing that the plan documents or other governing instruments will determine whether two or more benefit packages or options constitute a single, or more than one, health plan. Eliminate the requirement that group health plans that provide both core (health) and noncore (e.g., vision) benefits must allow qualified beneficiaries to elect only core coverage. Except long-term care plans and medical savings plan from COBRA.

5 - 5 - Set forth additional rules for determining who is a qualified beneficiary in the case of newborn and adopted children and employer bankruptcy. Provide that if an individual has been unlawfully denied group health coverage (for example, in violation of HIPAA), and then experiences an event that would have been considered a qualifying event had coverage not been unlawfully denied, he will be considered a qualified beneficiary. Refine the definition of "lose coverage" to include increases in the employee-paid portion of the premium or contribution, and losses of coverage that occur 12 months before or after commencement of bankruptcy proceedings. Revise the provisions that apply if health coverage is changed for similarly situated non-cobra participants. Revise the rules on COBRA deductibles and limits in the case of qualifying events (such as divorce) that split a family into two or more units. Clarify the application of COBRA to participants who move outside an area served by a region-specific plan. Clarify COBRA's application in the context of an open enrollment period. Clarify certain aspects of the COBRA notice, election and premium provisions. Codify the rules set forth in IRS Notice on the interaction between COBRA and the Family and Medical Leave Act of 1993 (FMLA). Prevent an employee from interfering with his or her spouse's COBRA rights by terminating the spouse's health coverage in anticipation of a divorce or legal separation. EFFECTIVE DATES AND GOOD FAITH COMPLIANCE Application Date and Good Faith Compliance with the Final Regulations The final regulations apply to qualifying events that occur in plan years beginning on or after January 1, 2000 (the "Application Date"). Prior to the Application Date, plans must operate in good faith compliance with a reasonable interpretation of the statute. The Service has announced that it will consider compliance with the 1987 and 1998 proposed regulations to constitute "good faith compliance" with the statute, except to the extent inconsistent with an amendment to the statute or a Supreme Court decision. (See the discussion of Geissal v. Moore Medical Corp., above.) Good Faith Compliance with the New Proposed Regulations The preamble to the final regulations states that compliance with the new proposed regulations will constitute good faith compliance with a reasonable interpretation of the statutory requirements addressed in the new proposed regulations until the new proposed regulations are finalized.

6 - 6 - The preamble also states, however, that actions that are inconsistent with the proposed regulations will not necessarily constitute a lack of good faith compliance. Rather, a facts and circumstances test will be applied to actions that are inconsistent with the proposed regulations, but are not inconsistent with the statute or the final regulations. The Courts and the New Proposed Regulations The preamble also points out that, while the IRS will not impose an excise tax if it determines that there has been "good faith compliance" with the new proposed regulations, the courts are not bound by the Service's determinations, and may impose liability under COBRA even if the Service has found good faith compliance. Thus, plans that operate outside the confines of the new proposed regulations risk facing an ERISA claim by employees and other qualified beneficiaries, even if they can successfully argue that they meet the "good faith compliance" standard. Moreover, even actual compliance with the new proposed regulations does not provide complete protection from COBRA liability, since the courts have demonstrated on several occasions that they are willing to rely upon their own, rather than the Service's, interpretation of the statute. Comments on the Regulations Comments on the new proposed regulations must be received by the Service on or before May 14, Covington & Burling Copyright 1999 Covington & Burling