The value of employer-provided health insurance coverage under accident or health insurance, is generally not taxable income to covered employees. Special rules apply to accident and health benefits provided by a closely held "C" corporation to its stockholder-employees and to health coverage for partners, sole proprietors, and "S" corporation shareholders. Domestic partnership benefits are also subject to special tax rules.
Self-funded health plans are subject to nondiscrimination rules, but such rules do not apply if the plans that provide health coverage are written through a policy of accident and health insurance.
Certain health plans sponsored by certain employers are subject to the COBRA Continuation Coverage rules, and plans may be subject to portability, access and renewability requirements. These are discussed in detail in this section.
Generally, the value of employer-provided coverage under accident or health insurance is not considered as taxable income to the employee. This includes medical expense and dismemberment and loss of sight coverage for the employee, his spouse and dependents, and coverage providing disability income for the employee (covered elsewhere in this text). There is no specified limit on the amount of the employer-provided coverage that may be excluded from the employee's gross income, and it is tax-exempt to the employee whether it is provided under a group or individual insurance policy.33 In the same vein, critical illness coverage or accidental death coverage is not taxable income to the employee.
When the employer applies salary reduction amounts to the payment of health insurance premiums for employees, the salary reduction amounts are excludable from gross income.34 If the employee pays the premiums on his personally-owned medical expense insurance and is reimbursed by his employer, the reimbursement is also excludable from the employee's gross income.
FHowever, where the employer simply pays the employee or retiree a sum that may be used to pay the premium, but is not required to be so used, the sum is taxable to the employee.
Another rather interesting point: The IRS states that where an employee is offered a choice between a lower salary and employer-paid health insurance, or a higher salary and no health insurance, he must include the full amount of the higher salary in income regardless of his choice. An employee selecting the health insurance option is considered to have received the higher salary, and, in turn, paid a portion of the salary equal to the health insurance premium to the insurance company.35 However, a federal district court faced with a similar fact situation, ruled that for employees that accept the employer-paid insurance, the difference between the higher salary and the lower one is not subject to FICA and FUTA taxes or to income tax withholding.36
Generally, discrimination does not affect exclusion of the value of the coverage. Even if a self-insured medical expense reimbursement plan discriminates in favor of highly compensated employees, the value of the coverage is not taxable—only the reimbursements are affected.
Amounts that are received by an employee under employer-provided accident or health insurance, group or individual, that reimburse the employee for hospital, surgical and other medical expenses incurred for care of the employee, his spouse and dependents, are generally tax-exempt without limit. However, benefits must be included in gross income to the extent that is attributed to employer contributions.37
Where an employer reimburses employees for salary reduction contributions applied to the payment of health insurance premiums, such amounts are not excludable because there are no employee-paid premiums to reimburse. Also, where the employer applies salary reduction contributions to the payment of health insurance premiums, and then pays the amount of the salary reduction to employees regardless of whether the employee incurs expenses for medical care, these are called "advance reimbursements" or "loans" and they are not excludable from gross income and are subject to FICA and FUTA taxes.38
Payments that are not related to loss of income because of absence from work, for the permanent loss, or loss of use, of a member or function of the body, or permanent disfigurement of the employee, his spouse, or dependent, are excluded from income if the amounts paid are computed with reference to the nature of the injury. A lump-sum payment from a group life and disability policy for incurable cancer qualified for tax exemption under this provision.39 On the other hand,
Fbenefits that are determined by length of service, rather than the type and severity of the injury, do not qualify for the tax exemption.40
Benefits that are determined as a percentage of the disabled employee's salary rather than the nature of his injury, are not excludable from income. An employee who has permanently lost a bodily member or function but continues to work and draws a salary, cannot exclude a portion of that salary as payment for loss of the member or function if that portion was not computed with reference to the loss.41
Benefit payments received by an employee under employer-provided critical illness policies, where the value of the coverage was not includable in the employee's gross income, are includable in the gross income of the employee. The exclusion from gross income applies only to amounts paid specifically to reimburse medical care expenses. Since critical illness insurance policies pay a benefit irrespective of whether any medical expenses are incurred, such amounts are not excludable.42
Accidental death benefits under an employer's plan are received income tax free by the employee's beneficiary as life insurance payable by reason of the insured's death.43
Benefits that are paid to a surviving spouse and dependents under an employer accident and health plan, which provided coverage for an employee and his spouse and dependents both before and after retirement, are excludable to the extent that they would be if they were paid to the employee.44
In order for employer's noninsured accident and health plan to be excludable from the employee's income, uninsured benefits must be received under an accident and health plan for employees. There must be a plan for uninsured payments, but there are no legal formats to follow—as illustrated by the fact that a provision for disability pay in an employment contract has been held to satisfy this condition.45 It is not required for the plan to be in writing or that the employee's rights under the plan to be enforceable, as where an employer as a general practice continued wages during disability was held to constitute a plan. But, if the employee's rights are not enforceable, the employee must have been covered by a plan (or program)on the date he became sick or injured, and notice or knowledge of such plan must have been readily available to him.
In order for there to be a plan, the employer must have established certain rules and regulations in respect to payment, such rules must be known to employees as a definite policy before accident or sickness occurs—ad hoc payments by an employer that are at the complete discretion of the employer, does not qualify as a plan.46
The plan must be for employees and may cover one or more employees, and there may be different plans for different employees or classes of employees. But a plan that covers individuals in a capacity other than employee, even thought they may be employees, is not a plan for employees. Self-employed individuals and certain shareholders owning more than 2% of the stock of an S corporation are not treated as employees for the purpose of determining the excludability of employer-provided accident and health benefits.
Uninsured medical expense reimbursement plans for employees must meet nondiscrimination requirements in order for medical expense reimbursements to be tax free for highly compensated employees.
Outside of the rules regarding discrimination based on health status under HIPAA—which concerns itself with both insured and uninsured plans—a plan that provides health benefits through an accident or health insurance policy need not meet the nondiscrimination requirements of IRC Section 105(h) in order for the employees to enjoy the tax benefits previously discussed.
An accident or health insurance policy may be either an individual or group policy issued by a licensed insurance company, or an arrangement in the nature of a prepaid health care plan regulated under federal or state law (such as an HMO). However, unless the policy involved the shifting of risk to an unrelated third party, the plan will be considered by the IRS as "self insured."
FA plan that reimburses employees for premiums paid under an insured plan does not have to satisfy nondiscrimination requirements.
Nondiscrimination requirements do apply to self-insured health benefits. Usually, benefits under a self-insured plan are excluded from the employee's gross income, but if a self-insured medical expense reimbursement plan or the self insured part of a partly-insured medical expense reimbursement plan discriminates in favor of highly compensated individuals, certain amounts paid to the highly compensated individuals are taxable to them.
As stated earlier, a self-insured plan is one which reimbursement of medical expenses is not provided under an accident or health insurance policy.47 The regulations require that a plan that is underwritten by a cost-plus policy or a policy that, effectively, provides administrative or bookkeeping services is considered self-insured.48
A medical expense reimbursement policy cannot be implemented retroactively, as to do so would be in violation of the nondiscrimination requirements of IRC Section 105.
A self-insured plan may not discriminate in favor of highly compensated individuals, either with respect to eligibility to participate, or in benefits.
A self-insured plan discriminates as to eligibility to participate unless the plan benefits 70%, or 80% or more of all employees who are eligible to benefit under the plan if 70% or more of all employees are eligible to benefit under the plan, or such employees as qualify under a classification set up by the employer and found by IRS not to be discriminatory in favor of highly compensated individuals.49
Under the eligibility requirements, the employer may exclude from consideration those employees who
Those employees who are customarily employed for fewer than 35 hours per week are considered part-time; employees who are customarily employed for fewer than 9 months of the year are considered seasonal, if similarly situated employees of the employer are employed for basically more hours or months, as applicable. There are also "safe harbor" rules for employees customarily employed for fewer than 25 hours a week or seven months a year.51
FA plan will be discriminatory as to benefits unless all benefits provided for participants who are highly compensated individuals are provided for all other participants.
Benefits are not available to all participants if some participants become eligible immediately and others after a waiting period. Benefits available to dependents of highly compensated employees must be equally available to dependents of all other participating employees. The test is applied to benefits subject to reimbursement, instead of to the actual benefit payments or claims. Any maximum limit on the amount of reimbursement must be uniform for all participants and for all dependents, regardless of years of service or age.
The plan will be considered as discriminatory if the type of amount of benefits subject to reimbursement is offered in proportion to compensation; and highly compensated employees are covered by the plan. A plan will not be considered discriminatory in operation just because highly compensated participants utilize (or use) a broad range of plan benefits to a greater extent than do other participants.
An employer's plan will not violate nondiscrimination rules just because the benefits may be offset by benefits paid under a self-insured or insured plan of the employer or another employer, or by benefits paid under Medicare or other federal or state law. A self-insured plan may take into account benefits provided under another plan only to the extent that the benefit is the same under both plans.52
F "Highly compensated individuals" are defined differently in respect to the various benefits. For instance, in retirement "golden parachute" plans, the definition of highly compensated individuals is different than what applies in this general discussion of self-insured plans.
For the purpose of self-insured plans, a "highly compensated individual" is so considered if he is a member of any ONE of the following three classification:
The amount that is paid under a discriminatory self-insured medical expense reimbursement plan to a highly compensated individual that is taxable is known as "excess reimbursement."
When a benefit is available to a highly compensated individual but not to all other participants, the total amount reimbursed under the plan to the employee with respect to such benefit is an excess reimbursement.
Where benefits available to all other participants and not otherwise discriminatory, and where the plan discriminates as to participation, excess reimbursement is determined by multiplying the total amount reimbursed to the highly compensated individual for the plan year, by a fraction, which is then applied to the total amount reimbursed to all participants and the total amount to all employees during the year.
Multiple plans may be so designated as a single plan for purposes of satisfying nondiscrimination requirements, such as when an employee elects to participate in an HMO.
Reimbursements that can be attributed to employee contributions are received by the employee on a tax-free basis if the expense was previously deducted (as discussed earlier). Amounts that are attributed to employer contributions are determined by using the ratio that employer contributions bear to the total contributions for the calendar year immediately prior to the year of receipt (up to 3 years, if the plan has been in effect for less than a year).54
The employer does not have to withhold income tax on an amount paid for any medical care reimbursement made to or for the benefit of an employee under a self-insured medical reimbursement plan.55
Domestic partner benefits are benefits that an employer voluntarily offers to an employee's unmarried partner, defined by the employer as either of the same sex or opposite sex. While employers may offer benefits to domestic partners such as family, bereavement, sick leave and relocation benefits—generally speaking, the benefits offered would be restricted to health insurance coverage.
An employee is taxed on the value of the employer-provided health benefits for his/her domestic partner, unless the domestic partner qualified as the employee's dependent under IRC Section 151. The tax is calculated by assessing the fair market value of the coverage provided to the domestic partner, which amount is then reported on the employee's W-2 and is subject to FICA and federal income tax withholding.
Any amount received by the domestic partner as payment or reimbursement of plan benefits will not be included in the employee's income or that of the domestic partner, to the extent that the coverage provided to the domestic partner was paid by the employee's plan contributions; or, the fair market value of the coverage was included in the employee's income.56
Coverage of domestic partners—regardless if they qualify as dependents or not—under an employer-provided health plan will not otherwise affect the ability of employees to exclude amounts paid, directly or indirectly, by the plan so as to reimburse employees for expenses incurred for medical care of the employees, their spouses, and dependents.
A domestic partner may not make an independent election for COBRA coverage, but a domestic partner may be part of an employee's election. (See later discussion of COBRA later in this section.)
As stated earlier, in order to provide tax-free coverage and benefits, an employer's accident or health plan must be for employees. It is difficult at times for the IRS to determine whether a stockholder employee plan is not for employees rather than stockholders. If they cannot establish that the person is not an "employee" then the premiums or benefits are generally treated as dividends with premiums nondeductible by the corporation and premiums or benefits includable in the gross income of the covered stockholder-employees.57
However, the courts have taken the stance that
Fthe tax benefits of employer-provided health insurance are available in a plan that covers only stockholder-employees if the plan covers a class of employees that can rationally be segregated from the other employees, if any, on a criterion other than they are stockholders.58
As a general rule, partners and sole proprietors are self-employed, not employees, and the rules for personal health insurance usually apply. However, partners and sole proprietors can deduct 100% of amounts paid during a taxable year for insurance that provides medical care for the individual, his spouse and dependents during the tax year.59 It should be noted that certain premiums paid for long-term care insurance are eligible for this deduction.60
The deduction is not available for a partner or sole proprietor for any calendar month in which he is eligible to participate in any subsidized health plan maintained by any employer of the self-employed individual or his spouse. This rule is applied separately to plans that include coverage for qualified long-term care services, are qualified long-term care insurance contracts, and plans that do not include such coverage and are not such contracts.
The deduction is allowed in calculating adjusted gross income and is limited to the self-employed individual's earned income for the tax year that is a result of the trade or business in which the plan providing the medical coverage is established. Earned income is usually defined as net earnings from self-employment with respect to a trade or business in which the personal services of the taxpayer are a material income producing factor.
Any amounts that are paid for such insurance may not be taken into account in computing the amount of medical expense deduction.
If a partnership pays accident and health insurance premiums for services rendered by the partners in their capacity as partners and without regard to partnership income, the premium payments are then called "guaranteed" payments by the IRS and are thereby deductible by the partnership and includable in the partners' income. The partner may not exclude the premium payments from income but may deduct the payments to the extent allowable.
In respect to a self-funded medical reimbursement plan set up by a partnership, the IRS determined that payments from the plan made to the partners and their dependents are excludable from the partners' income and premiums paid by the partners for the coverage under the self-funded plans and are deductible, subject to certain limitations.61However, there is no limit on the amount of benefits a partner or sole proprietor can receive tax free.
Basically, the IRS has stated in various rulings that coverage purchased by a sole proprietor or partnership for non-owner-employees, including the owner's spouse, are generally subject to the same rules that apply in any other employer-employee situation.62 Generally speaking, the IRS has taken the position that if the employee-spouse is a bona fide employee, the employer-spouse may deduct the cost of the coverage, and the value of the coverage is also excludable from the employee-spouse's gross income. One should be aware, however, that IRS agents are directed to closely scrutinize whether an employee-spouse qualifies as a bona fide employee and nominal or insignificant services that have no economic substance or independent significance will be challenged.63
A shareholder-employee who owned more than 2% of the outstanding stock or voting power of an S corporation will be treated as a partner, not an employee.64
The general rule is that an employer can deduct all premiums paid for health insurance for one or more employees as a business expense, including premiums for medical expense insurance and dismemberment and loss-of-sight coverage for the employee, his spouse and dependents and disability income for the employee, plus accidental death coverage. Long-term care insurance premiums are also deductible if the plan is a qualified plan.
Premiums are deductible whether the coverage is provided under a group policy or individual policy, but the deductions for health insurance only apply if benefits are payable to employees or their beneficiaries, and not to the employer. A corporation may deduct the premiums that it pays for group hospitalization coverage for commission salespersons, regardless of whether they are employee.65
STUDY QUESTIONS
1. Self-funded health plans are subject to nondiscrimination rules but such rules do not apply if
A. the death benefit provisions are funded by an accidental death policy.
B. the employer posts a bond with the Department of Insurance.
C. the plans that provide health coverage are written through an accident and health insurance policy.
D. there are fewer than 100 employees participating in the plan.
2. Generally, the value of employer-provided coverage under accident or health insurance
A. is considered as taxable income to the employee.
B. does not include medical expense or loss of sight to the employee's spouse or dependents.
C. is not considered as taxable income to the employee.
D. is not considered as taxable income to the employee if the employer pays the employee a
sum that may be used to pay the premium but is not required to do so.
3. Dismemberment benefits that are determined by length of service, rather than the type and severity of the injury
A. qualifies for the tax exemption.
B. do not qualify for the tax exemption.
C. do meet the criterion for "employee benefit" and would not be approved under ERISA.
D. must be paid entirely by the employer in order to qualify for the tax exemption.
4. In order for an employer's noninsured accident and health plan to be excludable from the employee's income,
A. there must be an ad hoc plan
B. there must be a plan, although there are no legal formats to follow.
C. the plan must meet specified wording as supplied by the IRS.
D. the employer can not contribute to the plan.
5. A plan that reimburses employees for premiums paid under an insured plan
A. must satisfy nondiscrimination requirements.
B. need not satisfy nondiscrimination requirements.
C. is never, under any circumstances, a qualified plan.
D. is not considered as a business expense to the employer.
6. A plan will be discriminatory as to benefits
A. unless all benefits provided for participants who are highly compensated individuals are
provided for all other participants.
B. except where highly compensated individuals have better or more expensive plans.
C. if benefits are provided by an insurance policy.
D. only if the plan does not provide substantially equal benefits to similar sized companies
in the same geographical area operating in basically the same industry or business.
7. Domestic Partner benefits provided by an employer offering benefits to a domestic partner of either the same or opposite sex, or an employee
A. would be provided on an voluntary basis.
B. are required in California and Massachusetts only.
C. are not allowed under ERISA regulations.
D. must be removed from the plan document and provided under an ad hoc agreement.
8. For tax purposes, as a general rule, partners and sole proprietors
A. are treated as corporations.
B. cannot deduct amounts paid for insurance providing medical care for the individual,
spouse and dependents.
C. are treated differently in making personal health insurance premium deductions.
D. are self-employed, not employees, and rules for personal health insurance apply, except
they can deduct 100% of premiums for insurance providing medical care for the individ-
ual, spouse and dependants.
9. For tax purposes for the self-employed, net earnings from self-employment with respect to a trade or business in which the personal services of the taxpayer are a material income producing factor, is the definition of
A. an ERISA exemption.
B. earned income.
C. unearned income.
D. personal service deduction.
10. A shareholder-employee who owned more than 2% of the outstanding stock or voting power of an S Corporation
A. will be treated as a partner, not an employee.
B. will be treated as an employee.
C. must consider all income received from the corporation as a dividend.
D. need not report any income so related on his tax report as the corporate taxes
will cover his tax obligations.
ANSWERS TO STUDY QUESTIONS
1C 2C 3B 4B 5B 6A 7A 8D 9B 10A