Pre-Tax Health Insurance Reimbursements/Loans Are Taxable

In Rev. Rul. 2002-80, the IRS concluded that amounts paid to an employee as advance reimbursements or loans, without regard to whether the employee has already suffered a personal injury or sickness, or incurred medical expenses, are not excludible from the employees gross income. (This ruling amplifies Rev. Rul. 2002-3, on reimbursements of employee pre-tax contributions for health insurance; see Neuhauser and Gibson, Tax Clinic, Reimbursements of Pre-Tax Health Insurance Contributions Are Taxable, TTA, May 2002.)

In the more recent ruling, two employers designed their health plans so that a share of the insurance cost is contributed by the employee. Such contributions are pre-tax contributions made through salary reductions and are not subject to FICA and FUTA taxes. The employer applies the salary reduction amounts to the payment of the group health insurance policy during the year. To minimize the additional cost to the employee, the employer pays the employee amounts to equate the employees after-tax pay with the pay had the additional salary reduction not occurred. In situation one, these payments are treated as advance reimbursements; in situation two, as loans.

Situation 1. M provides health coverage for its employees through a group health insurance policy that qualifies for the exclusion under Sec. 106(a). M has a payroll arrangement under which it reduces its employees salaries and applies the salary reduction to the payment of the health insurance premiums. Thus, an employee receives a lower salary in exchange for employer-provided health coverage.

M makes advance-reimbursement payments in amounts that cause an employees after-tax pay to be the same as if there were no additional salary reductions and no advance-reimbursement payments. During the year, the employee submits uninsured medical claims to M, who offsets the employees advance-reimbursement account. To the extent an employee does not have uninsured medical expenses equal to the advanced reimbursements, M treats the excess advanced-reimbursement amounts as forgiven and as additional taxable compensation. Ms position is that the salary-reduction and advance-reimbursement payments are excludible from its employees gross income and not subject to FICA or FUTA.

Situation 2. The facts are the same as in Situation 1, except M  loans money to the employee, which causes the employees after-tax pay to remain essentially unchanged. The loans (which may or may not charge interest) only become due and payable at the time and to the extent that the employee submits claims to M for uninsured medical expenses. To the extent an employee does not have uninsured medical expenses equal to the loans, M forgives the loans; the employee recognizes taxable income equal to the debt relief. Ms position is that the loan repayments are excluded from its employees gross income and not subject to FICA or FUTA.

IRS Analysis

The IRS noted that under Sec. 106(a), gross income of an employee does not include employer-paid health coverage. Sec. 105(b) provides that reimbursed expenses incurred by an employee for medical care for personal injuries or sickness may be excluded from gross income if those amounts are paid through employer-provided accident or health insurance. Also, amounts excluded from gross income under Sec. 105(b) or 106(a) are excluded from income tax withholding requirements, under Sec. 3401. Under Secs. 3121(a) and 3306(b), reimbursed expenses incurred by an employee for medical care are excluded from FICA and FUTA taxes.

Under the Sec. 125 cafeteria plan rules, an employees salary reduction applied to purchase health insurance coverage is not included in gross income; the coverage is excludible from gross income under Sec. 106 as employer-provided accident or health coverage. The Sec. 106 exclusions also apply to an employers reimbursement of an employee for accident and health insurance premiums paid by the employee to an insurer if (1) the employer has an accident and health plan under which it permits such reimbursements and (2) any reimbursement is for premiums actually paid by the employee (Rev. Rul. 61-146).

In Rev. Rul. 2002-80, the IRS concluded that the advanced reimbursements and loans are paid to the employee whether or not he or she actually incurs medical expenses. As a result, under Regs. Sec 1.105-5(a), there is no accident or health plan, because it is not an arrangement to pay  amounts to employees in the event of personal injuries or sickness. In addition, under Regs. Sec. 1.105-2, the exclusion from gross income under Sec. 105(b) applies only to amounts paid specifically to reimburse medical care expenses and does not apply to amounts that the employee would be entitled to receive irrespective of whether he or she incurs medical care expenses. Accordingly, the advanced reimbursements or loans are included in the employees gross income under Sec. 61 and are subject to FICA and FUTA taxes under Secs. 3121(a) and 3306(b).

From Andrew D. Gibson, CPA, J.D., LL.M., and Derrick P. Neuhauser, J.D., Atlanta, GA