When are employer-provided health benefits taxable?

Editor: Rochelle Hodes, J.D., LL.M.

Employer–provided health coverage is one of the most widely relied–upon tax–favored benefits in the Internal Revenue Code. Under Sec. 106, employer contributions toward accident or health coverage are generally excluded from an employee’s gross income, and reimbursements for qualifying medical expenses are likewise excluded under Sec. 105(b).

These provisions are often treated by employers as broadly applicable without limitation; however, the assumption that all employer–provided health benefits are tax free can lead to costly errors. In practice, important exceptions to the exclusion from income are frequently overlooked. When these exceptions apply, the result is not only unexpected taxable income to the recipient but also payroll tax exposure and reporting obligations for the employer. Common risk areas include coverage for nonemployees and business owners, domestic partner benefits, and discriminatory self–insured plans.

The general rule: Tax-free treatment of health benefits

Sec. 106(a) provides that employee gross income does not include employer–provided coverage under an accident or health plan. This income exclusion applies broadly to employer contributions for health insurance premiums and other coverage, making it one of the most significant tax savings available in employee compensation. The exclusion extends beyond current employees and their spouses and dependents to include former or retired employees and deceased employees’ surviving spouses and dependents (Rev. Rul. 82–196).

In addition to health coverage, reimbursements for medical care expenses under an employer’s accident or health plan are excluded from income under Sec. 105(b), provided they are tied to expenses described in Sec. 213(d) (relating to the deduction of medical expenses) (Regs. Sec. 1.105–2).

Employees may fund their share of premiums on a pretax basis through a Sec. 125 cafeteria plan, avoiding both income and employment taxes on those amounts. Under this arrangement, employees elect to reduce their compensation in exchange for qualified benefits, including health coverage.

These rules under Secs. 105, 106, and 125, however, apply only where an employer–employee relationship exists. The exclusion does not apply to coverage provided to individuals who are not treated as employees, as discussed below.

Exceptions to the general rule

Coverage for nonemployees and certain owners: Independent contractors, directors, and other nonemployee service providers are not eligible for the tax–favored treatment afforded under Secs. 105 and 106. As a result, employer–paid health coverage provided to these individuals is includable in gross income. For example, if a company pays health insurance premiums on behalf of an independent contractor, those payments are treated as additional compensation rather than excludable fringe benefits. The fair market value (FMV) of the coverage must be included in the contractor’s income. Likewise, independent contractors, directors, and other nonemployee service providers cannot participate in a Sec. 125 cafeteria plan (Sec. 125(d)(1)).

The treatment of health benefits for partners in a partnership presents another common area of confusion. Partners are not considered employees of the partnership for purposes of the fringe–benefit rules (see Rev. Ruls. 56–326, 69–184, and 91–26). Consequently, the exclusions under Secs. 105, 106, and 125 do not apply. Instead, when a partnership pays for a partner’s health coverage, the payment is generally treated as a guaranteed payment under Sec. 707(c). The amount is included in the partner’s gross income and is subject to self–employment tax. However, if certain requirements are met, partners may be eligible for a Sec. 162(l) deduction for health insurance costs on their individual income tax returns when premiums are paid by the partnership. This can be the case, for example, where the health insurance policy is established by the partnership; the amount is generally included in the partner’s gross income as a guaranteed payment; the deduction does not exceed the partner’s net earnings from self–employment from the partnership; and the partner is ineligible to participate in a subsidized health plan maintained by an employer of the partner, spouse, dependent, or qualifying child.

Similar complexities arise in the S corporation context. Under Sec. 1372, a shareholder who owns more than 2% of the S corporation’s stock (a 2% shareholder) is treated as a partner for purposes of applying fringe–benefit rules. This means that health coverage provided by the S corporation on behalf of a 2% shareholder–employee must be included in the shareholder’s W–2 wages. While the value of the fringe benefit is subject to federal income tax withholding, it is not subject to FICA (Federal Insurance Contributions Act) or FUTA (Federal Unemployment Tax Act) taxes if structured properly (Sec. 3121(a)(2)(B); Notice 2008–1). Similar to partners in a partnership, 2% shareholders may be eligible for a Sec. 162(l) deduction on their individual income tax returns provided that certain requirements are met (Sec. 162(l); Rev. Rul. 91–26).

These rules often create confusion in practice, particularly for small businesses that assume all individuals they consider employees, including owner–employees, receive identical tax treatment. Failure to properly include health benefits in wages or to report the benefits correctly can result in IRS scrutiny and potential penalties.

Domestic partner coverage: Employer– sponsored health coverage for nonmarried domestic partners is another area where employers frequently encounter unexpected tax consequences. Health coverage provided to an employee’s domestic partner (who does not qualify as the employee’s legally married spouse) may be excluded from the employee’s income only if the partner qualifies as the employee’s dependent under Sec. 152 as modified by Sec. 105(b) (see, e.g., Private Letter Ruling 200339001 and Correspondence/Exchange 2016–0008 (March 25, 2016)). To meet this standard, the individual generally must:

• Be a member of the employee’s household for the entire tax year;
• Receive more than half of their financial support from the employee;
• Not be a qualifying child of the employee or any other taxpayer; and
• Be a citizen, national, or legal resident of the United States (see Secs. 152(a)(2), (d)(1), and (d)(2)(H)).

If these requirements are satisfied, the value of employer–provided health coverage for the employee’s domestic partner is treated similarly to coverage for an employee’s spouse and is excluded from the employee’s gross income under Sec. 106. In practice, however, few domestic partners meet all the dependency requirements, making tax–free treatment the exception rather than the rule. If an employee’s domestic partner does not qualify as a dependent under Sec. 152, the value of employer–provided health coverage is includable as wages to the employee whose domestic partner is covered.

The amount included in income is the FMV of the coverage attributable to the domestic partner, less any after–tax contributions made by the employee. Employers must determine the appropriate value, which is often based on the incremental cost of adding the partner to the plan. This imputed income is subject to federal income tax withholding and employment taxes, including Social Security, Medicare (FICA), and FUTA. As a result, employers must properly account for the additional taxable wages in payroll systems and reporting.

Domestic partner coverage can introduce administrative complexity, particularly when employees pay a portion of premiums through a cafeteria plan. While an employee may use pretax salary reductions under Sec. 125 to pay for their own coverage, the premium amount attributable to coverage for a nondependent, nonspouse domestic partner is treated as an after–tax contribution paid by the employee. Employers must properly allocate and report these amounts to avoid payroll errors.

Discriminatory self–insured plans: A third important limitation on the tax–free treatment of health benefits involves self–insured health plans. If a self–insured plan favors highly compensated individuals (HCIs) in eligibility or benefits, Sec. 105(h) may require those individuals to include part of the benefit in income.

Fully insured plans, where the employer buys coverage from an insurer, are subject to different rules. Although the Affordable Care Act (ACA), P.L. 111–148, extended nondiscrimination rules to these plans, enforcement has been delayed. So, unlike a discriminatory self–insured plan, a discriminatory fully insured plan currently does not create the same income–inclusion issue for HCIs.

HCIs generally include:

• The five highest-paid officers;
• Shareholders owning more than 10% in value of the employer’s stock; and
• The highest-paid 25% of employees who are eligible to participate.

If a self–insured plan is discriminatory, HCIs must include in taxable income any “excess reimbursement” upon the occurrence of a medical claim (Regs. Sec. 1.105–11(e)). However, the amount included in income is not considered wages for FICA tax purposes and is not subject to federal income tax withholding or FUTA. How the excess reimbursement is calculated depends on whether the plan is discriminatory as to eligibility, benefits, or both. However, the rules for such calculations are beyond the scope of this item.

To avoid the potential required income inclusion of a very high–dollar amount upon a significant medical claim, most employers impute income to HCIs annually equal to the value of the coverage. If HCIs are taxed on the value of the coverage, any future medical reimbursements should be nontaxable (see Sec. 105(a)). Notably, while HCIs are negatively affected by a discriminatory plan, rank–and–file employees (non–HCIs) continue to receive tax–free treatment.

Because the consequence for discrimination is imposed through income inclusion to the HCI rather than a tax imposed on the employer, it can be easily overlooked. Taxpayers with self–insured arrangements should conduct nondiscrimination testing annually and document the results.

Fully insured plans and ACA considerations: As noted, the ACA extended nondiscrimination requirements to fully insured health plans. However, the ramifications of a discriminatory fully insured plan are different from those for a self–insured plan. Instead of an income inclusion for HCIs, a discriminatory fully insured plan will result in tax being assessed on the plan or plan sponsor. Notice 2011–1 delayed enforcement of these rules until regulations or other administrative guidance of general applicability is published. As a result, at present, fully insured plans can be discriminatory without any negative tax consequences. Nonetheless, tax practitioners should be aware that this relief may be temporary. If enforcement begins, employers with discriminatory fully insured arrangements could face penalty taxes.

Special situations practitioners should watch

In addition to the primary exceptions discussed above, several less–common scenarios can create uncertainty concerning the tax treatment of employer–provided health benefits. These situations often arise in executive compensation planning and post–employment benefit arrangements.

COBRA benefits for executives: Continuation coverage under the Consolidated Omnibus Budget Reconciliation Act (COBRA), P.L. 99–272, as amended, is generally offered on a nondiscriminatory basis. However, issues can arise when employers subsidize COBRA premiums for key executives but not other employees. If these arrangements are provided through a self–insured plan and favor HCIs, the value of the employer–subsidized COBRA coverage should be taxable to the key executives as W–2 wages.

Coverage for former employees and survivors: As noted earlier, Sec. 106 allows the exclusion from income of employer–provided health coverage for former employees, retirees, and their surviving spouses and dependents. This rule provides planning opportunities for employers seeking to offer retirees health benefits or extend coverage to survivors without triggering taxable income. However, these benefits must be provided through a qualifying accident or health plan to preserve the income exclusion. For example, if post–employment coverage is provided predominantly for HCIs through a self–insured plan, the plan would be discriminatory, and nontaxable treatment to the former HCIs (including the HCI’s dependents and surviving spouses) would be lost.

Careful review and proactive measures

The general rule that employer–provided health benefits are excluded from income under Secs. 105 and 106 is well established and widely relied upon. However, these rules are not absolute. Misapplication of these provisions can result in unexpected taxable income to employees and payroll tax exposure and reporting failures for employers.

The key takeaway is that the tax treatment of health benefits depends not only on the nature of the benefit but also on the recipient’s status and the plan’s structure. A careful review of these factors is essential. To mitigate risk and avoid unexpected consequences, employers should:

• Confirm worker classification before extending tax-favored benefits;
• Evaluate ownership structures to identify partners and 2% S corporation shareholders;
• Review domestic partner coverage policies and payroll treatment of imputed income;
• Perform nondiscrimination testing for self-insured health plans annually; and
• Review executive benefit arrangements, including COBRA subsidies and post-employment coverage.

By proactively addressing these issues, employers can preserve the intended tax advantages of employer–provided health benefits while avoiding common compliance pitfalls.

Editor

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, DC.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Unless otherwise noted, contributors are members of or associated with Crowe LLP.