Employer reimbursements to employees for salary-reduction amounts used to pay health insurance premiums were not excludible.

Employer M provides health coverage for its employees through a group health insurance policy. The coverage is accident or health coverage for purposes of excluding employer-provided accident or health coverage under Sec. 106(a).

M has a payroll arrangement under which employees' salaries are reduced, and M applies the salary-reduction amounts to the payment of the health insurance premiums for employees. Thus, employees receive lower salaries in exchange for employer-provided health coverage.

In addition, M makes "reimbursement" payments to employees for the health insurance premiums in amounts that cause employees' after-tax pay from M to be the same as if there were no salary reduction and no reimbursement payments. M takes the position that both the salary reduction and the reimbursement payments are excluded from employees' gross income and not subject to FICA or FUTA taxes.

The salary reduction used to pay for health insurance premiums under M's payroll arrangement could be done with or without employee elections. For example, M could make a unilateral decision to reduce employees' salaries and use those amounts to provide health insurance to employees. Alternatively, M could offer employees the choice under a Sec. 125 cafeteria plan to reduce their salaries to receive employer-provided health insurance.

Analysis

In general, under Sec. 106(a), an employee's gross income does not include employer-provided coverage paid under an accident or health plan. Under that section, an employee may exclude premiums paid for accident or health insurance coverage by an employer. Also, under Sec. 105(b), an employee may exclude amounts received through employer-provided accident or health insurance, if those amounts reimburse expenses incurred by the employee for medical care (of the employee, his spouse or dependents) for personal injuries or sickness.

To the extent amounts are excluded from gross income under Sec. 105(b) or 106(a), they are also excluded from income tax withholding under Sec. 3401. In addition, amounts paid to reimburse expenses incurred by an employee for medical care (of the employee, his spouse or dependents) for personal injuries or sickness are also excluded from FICA and FUTA taxes under Secs. 3121(a) and 3306(b).

Under Sec. 125, an employer may establish a cafeteria plan that permits an employee to choose among two or more benefits, consisting of cash (generally, salary) and qualified benefits, including accident or health coverage. The amount of an employee's salary reduction applied to purchase such coverage is not included in gross income, even though it is available to the employee and the employee could have chosen to receive cash instead. If an employee elects salary reduction, the coverage is excludible from gross income under Sec. 106 as employer-provided accident or health coverage.

Under Rev. Rul. 61-146, the Sec. 106 exclusion applied to an employer's reimbursement of an employee for individual accident and health insurance premiums paid by the employee to an insurer if (1) the employer had an accident-and-health plan under which it permitted such reimbursements and (2) any reimbursement was of premiums actually paid by the employee.

Under Rev. Rul. 61-146, Sec. 106 allows an employee to exclude employer reimbursements for health insurance premiums, but only if the employee actually pays those premiums.

Under both alternative arrangements described, when M applies the amount of employees' salary reduction to pay health insurance premiums, the premium payments are paid by M, not the employees, and are excludible from employees' gross income under Sec. 106, because they are paid by M. Although the Sec. 106 exclusion applies to the health insurance premiums paid by M, there is no employee-paid premium for M to "reimburse." Therefore, the reimbursement payments that M makes to employees are not excluded from gross income under Sec. 106.

Similarly, the reimbursement payments are not excluded from gross income under Sec. 105, because they do not reimburse employees for expenses incurred for medical care. Accordingly, the reimbursement payments are not excluded from income tax withholding under Sec. 3401. In addition, because the reimbursement payments are not reimbursements of expenses incurred for medical care, they are not excluded from FICA taxes under Sec. 3121(a) or from FUTA taxes under Sec. 3306(b).

If instead, the employees actually paid the premium payments out of their salaries, they could not exclude salary amounts from which the payments were made from their gross income, but any payments by M to reimburse the employees for the premium payments would be excludible under Sec. 106.

Holding

The exclusions from gross income under Secs. 106(a) and 105(b) do not apply to amounts an employer pays to employees to reimburse them for their health insurance coverage that are excluded from gross income under Sec. 106(a) (including salary-reduction amounts pursuant to a cafeteria plan under Sec. 125 applied to pay for such coverage). Accordingly, the reimbursement amounts that the employer pays to the employees are included in the employees' gross income under Sec. 61 and are subject to employment taxes under Secs. 3401, 3121(a) and 3306(b). REV. RUL. 2002-3, IRB 2002-1