Reimbursements of pre-tax health insurance contributions are taxable.

In January 2002, the IRS ruled in Rev. Rul. 2002-3 that a company's reimbursement of an employee's pre-tax salary reduction used to pay for health insurance was not excludible from gross income under Sec. 106(a) or 105(b) and was subject to withholding and employment taxes.

In the ruling, an employer designed its health plans so that an employee paid all or a portion of the health insurance premium through pre-tax salary-reduction contributions. That would reduce the employee's FICA and FUTA wage base on which Federal payroll taxes are assessed. The employer then reimbursed the employee for a portion of the contributions.

Example: Employer Z provides health coverage for its employees through a group health insurance policy that qualifies for exclusion coverage under Sec. 106(a). Z has a payroll arrangement under which it reduces its employees' salaries and applies the salary-reduction amounts to health insurance premium payments for the employees. Thus, the employee receives a lower salary in exchange for employer-provided health coverage. In addition, Z makes "reimbursement" payments to its employees for the health insurance premiums in amounts that adjust the employee's after-tax pay from Z to be the same as it would have been if there were no salary-reduction and no reimbursement payments. Z takes the position that both the salary reduction and the reimbursement payments are excludible from its employees' gross income and not subject to FICA or FUTA taxes.

If Z's position were correct, the tax planning advantages would be significant. For example, if a health plan costs $100 a month, an employee would pay 25% of the premiums, or $25 a month on a pre-tax basis. If the employer then restructured the plan so that the employee would pay the entire $100 monthly premium on a pre-tax basis, it would end up reimbursing the employee $75 a month. Thus, each party's share of the premium remains identical. After the plan restructuring, the employee's FICA income is reduced by $100 a month under the assumption that the employee does not pay tax on the $75 reimbursement. As a result, the employer saves over $45 in FICA taxes because of the employee's reduced FICA wage base. The employee would receive similar tax savings. Under this plan structure, a large employer reaps considerable payroll tax savings.

IRS Analysis

The IRS noted that under Sec. 106(a), an employee's gross income does not include employer-paid health plan coverage. Under Sec. 105(b), an employee could exclude from income reimbursed expenses incurred for medical care for personal injuries or sickness, if those amounts were paid through employer-provided accident or health insurance. Also, an employer can exclude from income tax withholding requirements under Sec. 3401 amounts that the employee excludes from gross income under Sec. 105(b) or 106(a). Under Secs. 3121 and 3306, the employee can exclude from FICA and FUTA reimbursed expenses incurred for medical care.

Under Sec. 125 cafeteria-plan rules, an employee excludes from gross income his salary reduction for purchasing health insurance. In addition, the employer also excludes the coverage from gross income under Sec. 106 as employer-provided accident or health coverage. The exclusions under Sec. 106 would also apply to an employer's reimbursement to an employee for accident and health insurance premiums that the employee pays to an insurer if (1) the employer has an accident and health plan that permits such reimbursements and (2) any reimbursement is for premiums that the employee actually paid (Rev. Rul. 61-146).

In Rev. Rul. 2002-3, the Service concluded that an employer can exclude from income premium payments actually paid out of an employee's salary on an after-tax basis and then reimbursed by the employer. However, when an employer reduces an employee's salary on a pre-tax basis under a Sec. 125 cafeteria plan to pay for health insurance premiums, the premium payments are deemed made by the employer, not the employee. Because the premium payment is deemed made by the employer, there is no employee-paid premium to "reimburse" and thus, under Sec. 105, the company cannot exclude payments from income because the employee never incurred a medical cost. Accordingly, the employee includes in gross income the reimbursement amount that the employer pays to the employee under Sec. 61, and this amount is subject to FICA and FUTA taxes under Secs. 3121 (a) and 3306(b).

FROM DERRICK P. NEUHAUSER, J.D., AND ANDREW D. GIBSON, J.D., LL.M., CPA, ATLANTA, GA

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY