covert taxes: spying issues in health & welfare benefits

Covert Taxes: Spying Issues in Health and Welfare Benefits

Larry Grudzien

Attorney at Law

Health and Accident Benefits

• Hospital benefits

• Surgical benefits

• Accident and sickness benefits

• Major medical benefits

• Dental benefits

• Vision Care benefits

• Prescription drugs benefits

• Mental health benefits

• Alcohol and drug dependency counseling

• AD&D

• Certain disability benefits


Types Included

• Plans provide for the payment of benefits to employees in the event of personal injury or sickness.

• These benefits can be provided though an insurance contract or self-insured by the employer.

• Employers can deduct health and accident payments as ordinary and necessary business expenses.

• These payments are also excluded from the employee’s gross income.


Introduction

• Amounts paid by an employer to finance sickness and injury benefits for its employees are generally tax deductible ordinary and necessary business expenses, provided they are used to pay accident and health insurance premiums or are otherwise actuarially determined. - Code §162

• Timing of deductions depends on whether the employer pays taxes on a cash or accrual basis.

• Accrual basis - in the taxable year on which all events have occurred that determine the liability and the amount of the liability can be determined with reasonable accuracy.


Employer Deduction

Self-Employed Individuals:

• Taxpayer Relief Act of 1997 amended the Self-Employed Health Insurance Act of 1995 to extend and to expand the percentage of the deduction that self-employed individuals may take for the cost of health insurance premiums .

Code § 162(l)(1)(B)

• For tax-years 2003 and thereafter, a self-employed individual may deduct 100% of the health insurance premiums.

• Amount of deducted cannot exceed the taxpayer’s net earnings from self-employment.

• Deduction does not reduce the amount of income subject to Social Security Tax.

• Remember, self-employed individuals, partners and sub-chapter S shareholders may not participate in a cafeteria plan or a health reimbursement arrangement.


Employer Deduction

Reasonableness of deduction

• Because sickness and injury benefits are forms of compensation, deductibility generally depends on the reasonableness of the amounts in each case.

Deductible Medical Expenses

• Code §213(d) determines the types of medical expense that individuals are permitted to deduct when filing personal income taxes and which employer-provided benefits qualify for exclusion from an employees gross income.

• “Eligible medical expenses” are defined as payments to cover either:

The diagnosis, cure, mitigation, treatment or prevention of disease, or

Transportation ”primarily for essential to” medical care.

In addition, IRS has indicated that these expenses include those incurred primarily for the “prevention or alleviation” of a physical or mental defect for illness.


Employer Deduction

Cosmetic Surgery

• Is not tax deductible nor can payments for these expenses be excluded from employee’s wages.

• What is defined as “Cosmetic Surgery?

Surgery intended to correct physical deformity resulting from congenital abnormality, accident or trauma or disfiguring disease is not considered cosmetic.

Medicine and Drugs

• Includes items that are legal and generally accepted by the medical community, whether or not they require a doctors prescription

• Items such as toiletries and certain dietary supplements are deemed “merely beneficial to the general health of an individual” and not deductible

• Amounts paid for nonprescription drugs –such as antacids, allergy medicines, pain relievers and cold medicines are not reimbursable through an FSA


Employer Deduction

• Capital Expenditures

A deductible under certain conditions

Examples

• Transportation Expenses

Deductible if paid for transportation that is “primarily for and essential to” medically-necessary care

Does not include meals or lodging if incurred while away form home receiving medical treatment

• Institutionalization

Some types are considered medical care


Employer Deduction

General - Exclusions of health care benefits governed by Code §§ 104, 105, and 106• 104(a)(3) - excludes from personal income benefits received from

accident or health plans and sickness or disability fund if premiums or contributions are paid by employees,

• 105(a) - includes in gross income benefits from employer provided health plans

• 105(b) - exempts amounts paid by an employer to reimburse medical expenses

• 106 - Excludes the value of employer provided health and accident coverage


Employee Personal Income Tax Exclusions

Dependents and Spouses

• Payments to dependents and spouse for medical expenses are excluded from the employee’s income.

• Dependents must meet the requirements of Code §152 as modified by Code §105 - non-custodial parents can exclude benefit payments.

• Child up until age 26 can be covered.

• Marital status is determined under state law.

Retiree Health/Long-Term Care

• Generally, payment to retirees to help with medical costs are includible in personal gross income.

• LTC coverage is treated as other accident and health contracts.



Nondiscrimination Rules

• Accident and health benefits provided though insurance contacts are not subject to any nondiscrimination requirements.

• Self-insured medical reimbursement plans are considered discriminatory if they favor highly compensated individuals with regard to eligibility to participate or type of benefits provided.

Under Code §105(h), a plan is discriminatory for eligibility unless it benefits either:

• 70% or more of all employees

• 80% of employees eligible to benefit, as long as 70% or more employees are eligible to benefit under the plan

• a nondiscriminatory classification of employees



• Under Code §105(h), a plan must also pass a benefits test.

• The Benefits Test tests whether the plan is discriminatory on its face and in operation.

• Generally, to pass the Benefits Test as it relates to discrimination on the plan’s face, employee contribution levels must not favor HCIs; maximum benefit and employer contribution levels may not vary based on age, compensation or years of service; types and amounts of reimbursable medical expenses must not favor HCIs; and waiting periods that favor HCIs may not be imposed.



• Under Code §105(h), a self-insured medical expense reimbursement plan is discriminatory for benefits if the type and amount of benefits available to highly compensated participants are not also available on the same basis to other participants.

• The comparison is based on benefits subject to reimbursement, rather than actual benefit payments or reimbursements under the plan, and on dollar amounts, rather than percentages of pay.

• Highly compensated employees are those who are either:

among the five highest-paid officers of the employer,

shareholders who own more than 10 percent in value of the employer's stock

the highest paid 25 percent of all employees



The penalty under section 105(h) for failure to meet the nondiscrimination tests is that highly compensated individuals will have to include in taxable income the value of “excess benefits” they receive.

These vary depending on whether the Eligibility or Benefits Test is not met.



• Health plan included in a cafeteria plan – using a salary reduction contribution –Code §125

• Employee contributions excluded from income tax

• Employee contribution not subject to Social Security or Medicare taxes

• Advantages and disadvantages


Employer/Employee Premium Contributions

Disability Benefits

Generally payments are includible in the employee’s income. - Code §105(a)

• Benefits financed by after tax contributions - Reg. Sec. 104-1(d)

Exceptions - Code §§105(b) & (c)

• Any payments made to reimburse employee for qualified medical expenses are excludible.

• Any payment made to reimburse loss body function or limb or permanent disfigurement are also excludible.


Disability Benefits

• Employer deduction for benefits Proper deduction as ordinary and necessary business expenses –

Reg. § 1.162-10(a)

No direct authority for deduction, but IRS has held that disability payments constitute amounts received through accident and health insurance - Rev Ruling 75-499

• Income tax withholding Taxable payments made by the employer - IRS Reg. § 31.3401(a)-

1(b)

• FICA and FUTA Taxation Taxable payments are subject - IRS Reg. § 31.3402(a)-3(i))


Disability Benefits

Group Term Life Insurance

Code §79 (a) provides inclusion in income of an employee for the life insurance but only to the extent that such cost exceeds the sum of the following:

• The cost of $50,000 of such insurance

• The amount (if any) paid by the employee toward the purchase of such insurance


In General

Revised Uniform Premium Table I, July 1999

Age Monthly Cost Per $1,000

Under 25 $0.05

25 to 29 0.06

30 to 34 0.08

35 to 39 0.09

40 to 44 0.10

45 to 49 0.15

50 to 54 0.23

55 to 59 0.43

60 to 64 0.66

65 to 69 1.27

70 and above 2.06

Source: IRS Reg. §1.79-3(d)(2)


Tax for Coverage?

• Coverage of spouse and dependents are not covered by the exemption

• Such coverage has an exemption if face amount does not exceed $2,000 - IRS Notice 89-110

• An exception for coverage over $50,000 - For former employee who as terminated and has become permanently disabled

Source: Code §79(b); IRS Reg. §1.79-2


Other Cost Rules

• If plan discriminates in favor of “key employees” either eligibility or benefits available, these employees are taxed on the entire cost of coverage

• Cost of coverage is the higher the actual cost or the cost under Table 1

• Who is a key employee?

An employee who during the prior year was an (1) officer with compensation in excess of $1750,000, (2) a 5 percent owner, or (3) a 1 percent owner with compensation in excess of $150,000

Source: Code §79(d)(6)


Nondiscrimination Requirements

A plan does not discriminate as to eligibility under Code §79(d)(3)(3)(B) if it meets one of three tests:

• it benefits 70% or more of all employees of the employer

• at least 85% of plan participants are not key employees

• the plan benefits employees under a classification set up by the employer and approved by the IRS as nondiscriminatory

• if the group-term life plan is part of a cafeteria plan, it meets the nondiscrimination requirements for cafeteria plans under Code §125.


When is a Plan Nondiscriminatory?

• Four types of employees are excluded from consideration in determining if a plan discriminates as to eligibility:

employees who have not completed three years of service

part-time or seasonal employees

employees not included in the plan who are included in a unit of employees covered by a collective bargaining agreement, provided that group-term life insurance benefits were the subject of good faith bargaining

nonresident aliens who receive no U.S. source earned income from the employer

• Under Code §79(d)(5), a plan is not considered discriminatory as to benefits merely because the amount of life insurance provided to participants bears a uniform relationship to participants' total compensation or their basic regular rate of compensation

• Under Code §79(d)(7), church plans maintained for church employees are exempt from the application of Code §79(d)


When is a Plan Nondiscriminatory?

Severance Benefits

• Severance payments are taxable to employees and in some cases are considered wages subject to federal income withholding and Social Security and Medicare hospital insurance taxes (FICA taxes)

• Employers usually may deduct severance payments as ordinary and necessary business expenses

• Whether employers must withhold federal income and FICA taxes from severance payments depends on whether the severance payments are “wages” as defined under federal income tax and FICA withholding rules

• Severance payments made to employees in connection with “involuntary separations” are treated as supplementary wage payments and are subject to federal income tax and FICA withholding

Severance Benefits

Fringe Benefits

In general, all benefits and perquisites must be treated as taxable income to the recipient, unless they are specifically exempt from taxation under Code §61(a).

The amount that is required to be included in an individual's income is based on the fair market value of the benefit an employer provides.


Fringe Benefits

Code §132 contains the following five basic excludible fringe benefit categories:

• No-additional-cost services—Services provided free to employees for which the employer incurs no additional cost, such as free standby air travel for airline employees.

• Qualified employee discounts—Reduced prices provided to employees on employer merchandise (such as discounts on clothes offered to employees of a department store)or services (such as free auto maintenance offered to employees of a repair stop). For merchandise, the discount cannot exceed the gross profit percentage of the price of the property; for services, the discount cannot exceed 20 percent.

• Working condition fringes—Property or services provided to employees, such as company cars and mobile telephones, which are excluded from employee income so long as the cost of the perk would have been deductible by the employee as a business expense had the employee purchased the perk directly.

• De minimis fringes—Property or services of such small value that accounting for such perks would be unreasonable or administratively impracticable.

• Qualified transportation fringes—Transportation subsidies provided to employee to defray the cost of commuting to and from work.


Fringe Benefits

Educational Reimbursement Plans

• Under Code §127, payments made to an employee under an educational reimbursement plan (“ERP”) are deductible if they qualify as an “ordinary and necessary” business expense of the employer.

• However, if payments made under the ERP are considered part of the gross income of the employee, an employer is required to withhold and pay federal employment taxes including Social Security, Medicare, and unemployment.

• ERP payments normally are included in the gross income of the employee in the year the payments are received and are subject to employment taxation, with two exceptions:

Working Condition Fringes—

Accountable Plans—Any type of expenses, including educational expenses, that are paid or reimbursed under an “accountable plan” also are excluded from the gross income of an employee


Educational Reimbursement Plans

• Under Code §127, amounts are excludible from gross income is limited to $5,250 per calendar year

• Amounts excluded from an employee's income if the benefits meet requirements

• If not, then expenses must meet requirements under a traditional educational reimbursement program


Educational Assistance Plan

• Regardless of the amount, any tuition reduction is excludible from an employee's gross income as long as the program meets IRS qualification requirements.

• Neither the employee nor the recipient has to include the tuition reduction in his or her gross income. As a result, employers are not required to withhold or pay federal employment taxes such as social security, Medicare, federal unemployment, or federal withholding on a qualified tuition reduction.

• Employers are able to deduct only the actual cost of the tuition reduction itself, not the total value of the reduction, (for instance, the actual cost to the university of adding one additional student to a class, not the value of the tuition reduction itself).

• An employer may deduct the cost of tuition if it has an arrangement with another institution to which it sends its employees to attend courses. However, if the employer and the other institution have a reciprocal tuition-free arrangement, then both institutions can deduct only the actual cost of adding additional students to their classes.


Tuition Reduction Program

• Code §21 - Dependent Care Credit

• Code §23 - Adoption Credit

• Code §120 - Legal Assistance

• Code §129 - Dependent Care Assistance

• Code §137 - Adoption Assistance

• Code §223 - Health Savings Accounts


Other Benefits

Deductions for Funded Plans

• There are limits on the amount an employer may deduct for contributions to a statutory “welfare benefit fund”

• Amounts contributed are deductible to the extent of the “qualified cost” of the fund - Code §419(a)(2)

• “Qualified costs” is the sum of the qualified direct cost for a year and the amount that may be added to the qualified asset account” for such year

• “Qualified direct cost” is the amount (including administrative expenses) that an employer using the cash method of accounting could have deducted for benefits provided during the taxable year if the employer had provided the benefits directly on a current basis -Code §419(c)(3)(B)



• Qualified asset account - consists of two elements:

Amounts to fund claims that have incurred but yet paid as of the close year and

Amount necessary to fund the administrative costs for the incurred but unpaid claims - Code §419A(c)(1)(B)

• The account must be established for the payment of disability, medical, supplemental unemployment, severance pay or life insurance benefits

• Additions to the Qualified Asset Account

It is only allowed if employer self -insures a reserve set aside for the payment of permissible benefits

No additions are deductible to the extent that such addition results in the amount in the “qualified asset account” exceeding the so-called “account limit” (reserve) - Code §419A(a)



• Reserves that can be justified by experience are permitted up to the specified safe harbor limits. Higher reserves may be maintained in certain instances, provided the employer does not exceed the statutory limits and obtains actuarial certification.

• Post-retirement medical and life insurance benefits account

Funded over working lives of covered employees and must be actuarially determined on a level basis

Life insurance benefits must not exceed $50,000 - Code §419A(c)(2)

• SUB or Severance Pay Benefits

Account limit is 75% of the average annual qualified direct costs of such benefits of any 2 of the immediately preceding 7 years Benefits are limited to 150% of the defined contribution limit - Code §419A(c)(3)


Additions to the Qualified Asset Account

• Disability Benefits

May not take into account benefits that exceeds the lesser of 75% of the individual’s average compensation of his high three years or the defined benefit plan dollar limit – Code §419A(c)(4)(A)

• Separate Accounts for Key Employees

Amounts to fund post-retirement medical and life insurance benefits for key employees must provided in a separate account – Code §419A(d)

• Collectively Bargained and Employee Pay-All Plans:

No reserve limit applies to accounts under a separate fund for either:

• Under a collectively bargaining agreement

• For an employee pay-all plan VEBA if such plan has at least 50 employees and employee is entitled to a refund, other than experience refunds


Additions to the Qualified Asset Account

Safe harbor reserve limits

• Unless there is an actuarial certification of the account limit for the year, the limit may not exceed the sum of the various limits:

Short term disability – 17.5% of the qualified direct costs for the immediate preceding year

Medical benefits – 35% of the qualified direct costs for the immediate preceding year

SUB or severance pay benefit – 75% of the average annual qualified direct costs or any 2 of immediate preceding 7 years – Code § 419A(c)(5)

Safe harbor amounts are not a safety net. The employer must show the reserves are reasonable - 1984 TRA Conference Report


Additions to Qualified Asset Account

Questions?

Larry GrudzienAttorney at Law

(708) [email protected]

Copyright 2017 – Not to be reproduced without express permission of Benefit Express Services, LLC

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covert taxes: spying issues in health & welfare benefits

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