Prop. regs. clarify tax treatment of certain health insurance payments

The IRS issued proposed regulations (REG-120730-21) that would clarify that the Sec. 105(b) exclusion from gross income does not apply to amounts received by an employee from accident or health insurance that pays an amount or distributes a benefit without regard to the actual amount of Sec. 213(d) medical expenses, where the premiums for coverage were paid on a pre-tax basis. Amounts that would not be excluded from an an employee’s gross income under this rule would be wages subject to FICA, FUTA, and income tax withholding.

The proposed regulations also clarify that, for amounts to be excluded from income under Sec. 105(b), the payment or reimbursement must be substantiated. Some have interpreted the existing language to mean that substantiation is not required, the IRS said.

Sec. 105(b) excludes benefits received through employer-provided accident or health insurance if those amounts are paid to reimburse an employee for expenses incurred for medical care of the employee, the employee’s spouse, the employee’s dependents, or children of the employee who are age 26 or younger irrespective of whether they are dependents.

The proposed regulations were made public Friday and are scheduled to be published Wednesday in the Federal Register.

The IRS explained in the preamble that it interprets Sec. 105(b) “to not apply to benefits paid without regard to the actual amount of incurred and otherwise unreimbursed section 213(d) medical expenses. Because payment of these amounts is not a reimbursement of section 213(d) medical expenses, the amount of reimbursement is immaterial, with the result that the payment is not excluded from gross income under section 105(b) of the Code. The benefits would, therefore, be included in the taxpayer’s gross income.”

This interpretation applies even when the taxpayer uses the money to pay medical expenses, according to the preamble to the proposed regulations. 

“For example, even if a benefit payment is used to reimburse an employee’s medical expenses, if the amount of the payment is not tied to the amount of the expense incurred and the employee is entitled to keep any amounts by which the benefit payment exceeds the incurred expenses, that would indicate that the benefit is not actually a reimbursement for medical expenses,” the preamble states.

The IRS says it is proposing these amendments to the regulations in response to ongoing questions about the proper tax treatment certain arrangements that purport to avoid income and employment taxes by characterizing income replacement benefits or other cash benefits as amounts paid for reimbursement of medical care, even though those amounts are paid without regard to the actual amount of any incurred, and otherwise unreimbursed, medical expenses.

While these arrangements are sold under a variety of names, they are commonly sold as fixed-indemnity excepted-benefits coverage or specified-disease excepted-benefits coverage. However, the changes in the proposed regulations would not be limited to these types of coverage, and the IRS says it will look past the label given an arrangement in determining the correct treatment of payments made under it.

Assuming the amendments are finalized as proposed, the IRS said that the amendments would apply as of the later of the date of publication of the final regulations or Jan. 1, 2024.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.