Auditing Employee Benefit Plans. Josie Hammond
such plans presents unique issues to the auditor because these umbrella plans frequently include fully insured options that would not otherwise be subject to audit but for their inclusion in an umbrella plan.
Welfare benefit plans can be separated into the categories of defined benefit and defined contribution, just like pension plans. It is most common to see defined benefit welfare plans. The plan promises to provide a certain benefit, like health coverage. Plan assets, if any, are commingled for the plan as a whole. Typically, there are no separate accounts by participants. More recently, a trend has emerged of defined contribution welfare plans in which individual participant accounts are maintained and participant benefits are limited to what is in their account. The most typical of such arrangements are medical flexible spending accounts, medical reimbursement accounts, or health savings accounts.
Unfunded, insured, or funded
Because this course is aimed at plans that are subject to audit, it is important to understand the ERISA exemptions from the financial audit for fully insured and unfunded plans. These exemptions generally apply to welfare plans because funding is voluntary for such plans.
Unfunded plans are those in which the benefits are paid entirely from employer general assets (self-insured or self-funded plans), where all benefits are covered by an insurance contract or a combination of both employer general assets and insurances. For this purpose, employee contributions are treated the same as the general assets of the employer as long as the employee contributions are used to pay benefits or premiums within the timeframe set by the ERISA regulations.
Insured plans are those arrangements in which, through the payment of premiums, the obligation to provide plan benefits has passed from the employer to the insurer.
What constitutes a funded plan is not entirely clear under ERISA. It is clear that if a trust has been established in the plan’s name, the plan is funded. This is true even if the trust has no assets. Similarly, if the plan holds assets in its name, such as a checking account, it may be considered funded. If questions arise on whether or not a plan is funded, the auditor should not make that determination. The plan or plan sponsor’s legal counsel should make that determination.
The point is that once any portion of an ERISA plan is funded, the entire plan becomes subject to the ERISA audit requirements. The audit is not limited to the funded portion of the plan, but must cover all plan activities. Further, because the plan is funded, plan assets must be held in trust and are subject to ERISA’s fiduciary conduct standards and non-exempt transaction standards with respect to such assets.
401(h) accounts
Some health care coverage arrangements involve a unique form of funding. The assets are actually held by a pension plan of the sponsor. These are referred to as 401(h) accounts, named for the tax code section that authorizes their creation. These assets must be accounted for separately within the pension plan, but they do not have to be physically segregated from the pension assets. This is an advanced topic, which is outside the scope of this program.
Cafeteria plans
A cafeteria plan is a funding vehicle for a welfare benefit plan. The cafeteria plan is not a welfare benefit plan. A cafeteria plan is defined by Section 125 of the IRC. A cafeteria plan allows employees to choose between cash and certain benefits.
Two items about cafeteria plans that are important to remember include:
1 Definition of wages for any plan that uses compensation as a variable. Retirement plans are permitted to base benefit accumulations or to test for nondiscrimination based upon a compensation figure that is calculated before or after cafeteria plan employee contributions. Thus, it is important for the auditor to know whether a cafeteria plan exists and how compensation is defined in the plan.
2 Certain cafeteria plan benefits are ERISA plans. For example, a medical flexible spending account or a health savings account could be part of an ERISA plan. A dependent care flexible spending account generally would not be an ERISA plan. If the plan under audit is the employer’s health plan, depending upon the plan’s terms, the scope of the audit may include the activity of the cafeteria plan accounts.
Cafeteria plans are subject to a special rule when it comes to the requirement that plan assets be held in trust and, thus, funded. ERISA generally treats participant contributions as plan assets. Where a plan has assets, ERISA generally requires that such assets be held in trust. The current tax rules, however, require that cafeteria plan contributions be subject to a use-it-or-lose-it rule. This means that if the participant does not spend his or her cafeteria plan contribution by the end of the year, the employer gets to keep the money. These two rules are incompatible and the DOL has granted relief from the requirement to hold cafeteria plan contributions in trust.8 Similarly, the DOL has granted limited relief from the trust requirement for health savings accounts.9
It is important to note that the IRS issued updated proposed regulations governing cafeteria plans in 2007. As of the date of this publication, these regulations had not yet been issued in final form. The IRS, however, did issue Notice 2012-40, which permits taxpayers to rely on the proposed regulations pending the publication of final regulations. The auditor is advised to watch for future amendments in client’s cafeteria plans as these regulations become final.
Knowledge check
1 Common examples of defined contribution pension plans are which of the following?Profit-sharing plans, 401(k) plans, cash balance plans.403(b) plans, employee stock ownership plans, cafeteria plans.Cash balance plans, cafeteria plans and collectively bargained plans.Profit-sharing plans, employee stock ownership plans, 403(b) plans.
2 Which type of plan is subject to universal availability eligibility requirement?401(k).401(h).403(b).401(a).
3 If an ERISA welfare plan is considered funded, which of the following consequences results?The plan becomes subject to ERISA audit requirements.All assets must be held in a custodial account.The plan is subject to vesting and distribution notices.The plan is exempt from ERISA as long as there are sufficient funds to cover the benefit obligation.
Tax compliance elements
As noted earlier, the operation of a benefit plan is substantially controlled by the tax code. Thus, the auditor is advised to have a working understanding of these elements. Most of the rules for pension plans are found in Sections 401 through 416 of the IRC. Welfare benefit plans have fewer code rules, and those rules are scattered throughout the IRC.
GAAS does not require that the auditor have a thorough understanding of the intricacies of these tax rules. GAAS limits the auditor’s duty for compliance matters to those that could affect a significant financial statement account. It is important for the auditor to be able to identify the type of elements involved in the operation of the plan and where they might have financial statement effect. It is important for inquiries to be made as to whether the appropriate tests have been conducted and whether the tests have been passed or failed. Where such tests have been failed, the auditor needs to understand the effect on the plan’s financial statement. This may involve a contribution receivable or a payable to refund impermissible amounts. In addition, the auditor needs to be able to recognize that other items uncovered during the audit may have an effect on the tax status of the plan. Where such events are discovered, the auditor needs to assess the effect on the financial statements and obtain appropriate representations that any actions required to retain the plan’s exempt status will be taken.
The easiest way to understand these tax rules is to approach them from the formation through annual operations to termination of a plan.
Even though benefit plans are typically exempt from income taxes, it is important for the auditor to assess whether or not there are any uncertain tax positions. This is because the plan can face uncertainty with respect to retaining its tax-exempt status, or where the plan’s investment activity generates unrelated business