Employee benefit plans, with their arcane web of underlying rules and regulations, have long been an important consideration in M&A transactions. Historically the greatest emphasis has been placed on qualified retirement plans, equity compensation, and since the enactment of Internal Revenue Code Section 409A, nonqualified deferred compensation. But now the Affordable Care Act (ACA) has given group health plans a starring – if not somewhat villainous – role. This article provides some background on the aspects of the ACA that are most likely to raise issues in the M&A context and identifies key considerations at various stages of a transaction.
It is difficult to overstate the breadth and depth of the legal rules created or affected by the ACA and its implementing guidance. And it is beyond the scope of this article to address even a representative sample of the ACA’s substance. But two features of the ACA encompass what we’ll consider here: (1) the insurance-market reforms that apply to health insurance policies and employer-sponsored group health plans, and (2) the employer shared-responsibility mandate.
The insurance-market reforms are federal standards that govern the terms and conditions of group health plans, as well as insurance policies offered in both the individual and group insurance markets. They are codified in the Public Health Service Act, but apply to nongovernmental organizations through ERISA and the Internal Revenue Code. Some of the more important market reforms include:
- Prohibition on preexisting condition exclusions
- 90-day maximum waiting period
- Prohibition on lifetime and annual limits
- Provision of preventive-care benefits without cost sharing
- Coverage of dependent children to age 26
- Requirement for a summary of benefits and coverage
- Nondiscrimination requirements for insured plans
The market reforms garner special attention because the consequences for failure to comply can be substantial. Under Code Section 4980D, an employer sponsoring a group health plan that fails to comply with one of the market reforms is subject to an excise tax of $100 per person, for each day that the failure persists ($36,500 per person, per year). The employer is affirmatively required to report and pay any tax that is due by filing IRS Form 8928, although as a practical matter this rarely happens, leaving the statute of limitations perpetually open. The IRS has the discretion to waive some or all of the excise tax if a compliance failure is due to reasonable cause and not willful neglect and the tax would be excessive relative to the failure. But due to lack of guidance and enforcement experience, very little is known about how or under what circumstances the IRS would exercise this discretion.
The employer shared responsibility mandate (or “play-or-pay”) under Code Section 4980H requires employers with 50 or more employees to offer affordable, valuable health coverage to all full-time employees and their dependents or risk paying a nondeductible penalty. The penalty amount varies depending on the nature and degree of health coverage that is offered and whether one or more employees qualify for premium tax credits to subsidize health coverage obtained on a public exchange.
Beginning in 2015, if an employer fails to offer health coverage to at least 95 percent (70 percent for 2015) of its full-time employees and their dependents and at least one full-time employee obtains subsidized coverage on a public exchange, the employer generally will be subject to an annual penalty of $2,000 for each full-time employee. This is sometimes called the “subsection (a)” penalty, in reference to Code Section 4980H(a), which imposes this penalty.
If the employer offers health coverage to at least 95 percent (70 percent for 2015) of its full-time employees and their dependents, but the coverage is not “affordable” or does not provide “minimum value,” the employer will be subject to an annual penalty of $3,000 for each full-time employee who actually obtains subsidized coverage on a public exchange. This is sometimes called the “subsection (b)” penalty, in reference to Code Section 4980H(b).
Although the subsection (b) penalty is a larger per-person dollar amount than the subsection (a) penalty, the total subsection (b) penalty will generally be less than the total subsection (a) penalty because it is triggered only by those full-time employees who actually obtain subsidized coverage on a public exchange. And in any case, the total subsection (b) penalty will not exceed what the employer would have paid if the subsection (a) penalty applied.
A key issue in complying with the employer mandate (or calculating the penalty that must be paid due to noncompliance) is identifying the employer’s employees who qualify as “full-time.” As a general rule, a full-time employee for ACA purposes means any employee who works (or is paid for) an average of 30 or more hours per week.
Recognizing that employee work schedules can fluctuate from week-to-week and that employers benefit from predictability in understanding who is treated as full-time for a given period of time, IRS regulations allow for identifying full-time employees under a “look-back measurement method” that involves measuring an employee’s hours of service over a prior period of time (the measurement period), determining whether the employee averaged 30 or more hours of service per week over that measurement period, and then assigning the employee a status (full-time or not) that the employee will retain for a fixed future period (the stability period) based on whether the employee averaged 30 or more hours of service during the measurement period.
For example, to identify the employees who will be considered full-time employees during 2016, an employer might measure hours of service over a 12-month measurement period beginning November 1, 2014, and ending October 31, 2015. Those employees who average 30 or more hours of service per week during the measurement period will be considered full-time employees for a 12-month stability period that begins January 1, 2016. Those employees who average less than 30 hours of service per week during the measurement period will be considered non-full-time employees for that same 12-month stability period.
Properly applying the look-back measurement method requires collection and maintenance of detailed information regarding employee hours of service. And it may be necessary to retain that information for many years to establish that the employer has met its obligations under the employer mandate.
Beginning with the 2015 calendar year, employers are required to file annual information returns with the IRS (Forms 1094-C and 1095-C) that will allow the IRS to review compliance with the employer mandate and, if necessary, to assess penalties. Accurate reporting will be critical, because it will set the stage for the IRS’ enforcement activity.
Due Diligence Considerations
With that background, let’s first consider how these features of the ACA may affect the due diligence or other pre-transaction aspects of M&A transactions.
Review of Plan Documents
Collecting plan documents and reviewing them for compliance will already be on the due diligence checklist, but certain plan types deserve extra attention.
Grandfathered plans. Health plans that have been in existence since the ACA was enacted in 2010 may qualify as “grandfathered” plans. Grandfathered plans are exempt from compliance with some of the insurance-market reforms, such as the requirement to provide preventive-care benefits without cost sharing. But stringent rules must be followed to ensure a plan that’s intended to be grandfathered remains grandfathered. These include a notice requirement and limitations on changes to cost-sharing provisions and employee premium contributions.
A plan that has been operated as a grandfathered plan but, in fact, is not (e.g., because it failed to satisfy at least one requirement for remaining grandfathered) will likely have violated one or more insurance-market reforms, perhaps over a period of many years. For example, a plan that is erroneously believed to be grandfathered likely will not have provided all required preventive-care benefits without cost sharing. This leaves the plan sponsor exposed to liability for the $100 per person, per day excise tax under Code Section 4980D, as well as to potential liability for re-processing of claims, which the Department of Labor might require in an ERISA audit.
If a potential M&A target maintains a plan that purports to be a grandfathered plan, the plan’s status as a grandfathered plan should be carefully verified.
Premium reimbursement plans.
Some employers have maintained programs that pay or reimburse (often on a pretax basis) premiums incurred by employees for coverage under individual health insurance policies. Under IRS Notice 2013-54, these arrangements are treated as group health plans. Group health plans are required to comply with the ACA’s insurance-market reforms, but premium reimbursement plans typically violate at least two of the reforms. They generally limit benefits (premium reimbursement) to the maximum amount of premiums due under the individual policy each year, which is a type of prohibited annual limit. And they generally don’t pay for preventive care, thereby violating the preventive-care mandate.
As with grandfathered plans, these violations expose the plan sponsor to significant excise taxes. Steps should be taken to identify any premium reimbursement arrangements and carefully review their terms and provisions.
Health reimbursement arrangements (HRAs).
HRAs are typically account-based plans that allow for reimbursement of medical expenses up to the amount credited to the employee’s account. (They are similar to health flexible spending account plans, except that employees cannot contribute to an HRA.) HRAs are also treated as group health plans under IRS guidance and, when viewed in isolation, will typically violate the annual-limit rule and the preventive-care mandate.
An exception is made for “integrated” HRAs, meaning HRAs that are used only in connection with another group health plan that does satisfy the insurance-market reforms. But specific requirements must be satisfied for an HRA to qualify as an integrated HRA, and compliance with these requirements should be carefully reviewed. Like other plans that violate the insurance-market reforms, an HRA that is not an integrated HRA will expose the plan sponsor to significant excise taxes.
Summary of Benefits and Coverage
The standard list of documents to collect and review with respect to a plan includes the plan document and summary plan description that are required by ERISA. That list now must also include the “summary of benefits and coverage” (SBC) for each group health plan.
The SBC is an additional disclosure document mandated by the ACA’s insurance-market reforms. It provides an overview of key plan information, such as deductibles, copays, covered services, and noncovered services, and is organized in a standard format to facilitate comparison of two or more different plans. It is generally required to be distributed in connection with plan enrollment and at other times upon request.
As a market reform, the failure to properly maintain and distribute an SBC can result in excise-tax liability under Code Section 4980D. In addition, a specific statutory penalty of $1,000 applies to any willful failure to provide an SBC to a plan participant or beneficiary. Regulators have indicated that both penalties can be applied. Thus, verifying that all required SBCs have been prepared and properly distributed is critical.
Target Company Financial Information
If the target company is subject to the employer mandate, due diligence should verify whether the company has taken the necessary steps to avoid penalties under Code Section 4980H. If not, due diligence should include reviewing whether the penalty amounts have been appropriately reflected in the target company’s financial statements.
The catch with respect to the employer mandate penalties under Code Section 4980H is that they likely will not be assessed by the IRS until a significant period of time after the year to which they relate. The IRS has indicated that it will not begin reviewing data from information returns until at least October following the calendar year to which the penalty relates. If the IRS identifies a case in which it believes a penalty is owed, it will then provide the employer with a preliminary letter stating the proposed penalty amount. The employer will then have an opportunity to respond to the preliminary letter before a final assessment is made. It’s not yet clear how long the total process will take (nor is it clear what types of appeal rights or other procedures will be available to an employer challenging a proposed assessment), but it seems reasonable to expect that final assessment will not occur until at least 14–18 months after the close of the year to which the penalty relates.
A target company that keeps its books on a cash basis may not reflect a liability for this penalty until it is finally assessed by the IRS, which could be months, if not years, after the year to which the penalty relates. So it may be necessary to calculate the potential liability independently for any years for which a final assessment has not yet been made.
A target company that keeps its books on an accrual basis may be more likely to reflect liability for a penalty in advance of formal assessment. In fact, there is some anecdotal evidence of auditors requiring a footnote (if not an actual accrual) of the penalty, if a company cannot demonstrate that appropriate steps have been taken to avoid all penalties. Thus, financial statements may also be a useful tool for identifying cases in which closer review of the penalty issue is warranted.
Although ACA compliance issues generally can be addressed in the deal documents in a manner similar to other benefits compliance issues, some items may merit specific attention.
Representations and Warranties
Given the significant penalty exposure for failure to distribute an SBC, a specific representation that the SBC has been properly distributed should be included. Depending on the extent of due diligence conducted, it may also be appropriate to require a representation that copies of SBCs have been provided for at least three years (or as long as the SBC requirement has applied).
Because grandfathered plans present a similar risk of significant penalty exposure, the document should require a representation that any group health plan intended to be a grandfathered plan has continuously satisfied the requirements to be a grandfathered plan since March 23, 2010.
Compliance with the employer mandate requires properly identifying all common-law employees who are full-time employees. The IRS has declined to provide relief from penalties that may be triggered due to misclassification of employees as independent contractors. Thus, if not otherwise addressed in connection with employment or benefit matters, the document should require a representation that all workers have been properly classified and, specifically, that all workers who are common-law employees within the meaning of the ACA and Code Section 4980H have been classified as employees.
Tax compliance. In the representations related to tax filing and compliance, specific reference should be made to timely filing of any required Form 8928 (the excise tax return under Code Section 4980D) and timely payment of the required excise taxes. Reference also should be made to timely and accurate filing of Forms 1094-C and 1095-C, which are the information returns required under Code Section 6056 relating to the employer mandate. Other tax-filing or similar requirements that are unique to the ACA and may warrant specific treatment include:
- The Patient Centered Outcomes Research Institute trust fund tax imposed under Code Section 4376 with respect to self-insured health plans, including the timely filing of IRS Form 720 to report and pay the tax.
- The Transitional Reinsurance Program contribution required under Section 1341 of the ACA and 45 CFR §153.400 with respect to major medical plans for each year from 2014 to 2016.
Covenants and Closing Conditions
Whether through a covenant, closing condition, or similar provision, the deal document should obligate the target to provide the acquirer with the information needed to enable the acquirer to address any enforcement issues that may arise with respect to the employer mandate and to comply with the mandate going forward. This will primarily consist of records related to employee hours of service, but may also include calculations of average hours of service and other documentation regarding determinations of full-time status. As discussed further below, this information may be necessary to ensure the acquirer can properly apply the look-back measurement method following the transaction.
There may be a long period of time between the year in which events occur that establish the basis for ACA-related excise taxes or penalties and the time at which those taxes or penalties are actually assessed. The statute of limitations may never run on excise taxes attributable to market-reform failures, if Form 8928 is not filed. And even in the normal course of business it may take the IRS months, if not years, to evaluate and assess penalties related to the employer mandate. These horizons should be taken into account in determining how long indemnification rights will be available to remedy a breach of representations or warranties related to these matters.
After a transaction closes, some tricky administrative issues may arise in connection with ACA compliance as employees of the target company are integrated into the acquiring company’s workforce. These issues may be especially acute in mergers and asset acquisitions, after which target company employees are employed by a different entity than before the transaction.
Look-Back Measurement Method
Employers using the look-back measurement method to identify full-time employees for purposes of the employer mandate have considerable flexibility in designating the measurement and stability periods they will use. For example, one employer might use a 12-month measurement period beginning October 1 each year, while another might use 6-month measurement periods beginning on January 1 and July 1 each year.
If the acquiring company and the target company in a transaction use different measurement and stability periods, it can be difficult to sort out how target company employees should be treated under the look-back measurement method following the transaction. IRS Notice 2014-49 provides companies in this situation with a couple of options. (This guidance is preliminary, but may be relied on at least until the end of 2016.)
One option is to treat acquired employees as if they transferred to a new position with different measurement and stability periods. Under this approach, if an acquired employee has been employed by the target company for a full measurement period at the time of the transaction, the employee will retain the status dictated by that measurement period through the end of the target company stability period associated with that stability period, after which the acquiring company’s measurement and stability periods apply. And if an acquired employee has not completed a target company measurement period at the time of the transaction, the employee’s status will be determined using the acquiring company’s measurement and stability periods, but applying those periods by taking into account hours of service with the target company.
A second option is to continue applying the target company measurement and stability periods to the target employees during a transition period following the close of the transaction. This transition period begins on the date the transaction closes and ends after the completion of a full measurement period and stability period, using the target company’s measurement and stability periods. (In some cases, this transition period could exceed three years, depending on the length of the target company’s measurement and stability periods and the timing of the transaction.) After the transition period, the acquiring company’s measurement and stability periods apply.
Under either of these approaches, it will be necessary for the acquiring company to obtain detailed pre-transaction information about the target company employees. For example, if the acquiring company’s measurement and stability periods will be applied, it will be necessary to understand the pre-transaction hours of service of the acquired employees, so those hours can be taken into account in applying the acquiring company’s measurement and stability periods. And if the target company’s measurement and stability periods will continue to be used for a transition period, it will be necessary to understand the status of the acquired employees at the time the transaction closes, so that status can be carried forward.
Prior Service Credit
Notwithstanding these special rules, in an asset acquisition it may also be possible to simply treat the target employees as new hires of the acquiring company. If that will be done, attention should be paid to whether or how prior service credit will be granted. For example, if the intent is for target employees to start over under the acquiring company’s measurement and stability periods but the deal documents give target employees a broad grant of prior service credit, it may be necessary to take service with the target company into account when applying the acquiring company’s measurement and stability periods. This may result in many acquired employees being immediately treated as full-time employees of the acquiring company.
The information reporting that large employers are required to do under Code Section 6056 applies on an entity-by-entity (EIN-by-EIN) basis. Each separate entity that has employees during the year is required to file a separate information return, even if it is part of a controlled group.
It is unclear how this reporting is handled when two entities merge during a year. One approach is for the surviving entity to treat itself as a continuation of the merged entity and file a single return reporting information on the acquired employees for the entire year. Another approach is for the surviving entity to file two separate returns with respect to the acquired employees – one under the acquired entity’s EIN for the period before closing and one under its own EIN for the period after closing. The guidance doesn’t tell us which of these approaches is correct.
This conundrum may be illustrative of other challenges that will arise in applying these more arcane features of the ACA in the M&A context.
The ACA has raised the stakes on compliance problems with group health plans, warranting thorough treatment of such plans in both due diligence and risk allocation. Complex administrative and compliance obligations also have been created that will require access to detailed information about acquired employees during and after a transaction. And the landscape is continually developing and evolving, leading to questions and uncertainties that may take time to resolve. All of this is manageable and will become more routine over time. But as the law continues to develop, a thoughtful and cautious approach to ACA issues in transactions is advised.