Ernst & Young LLP insights

ACA-covered employers should consider how they will approach their benefits and compensation policies as they relate to employees who incur out-of-pocket expenses to purchase individual health insurance policies. It is important to keep in mind that the potential cost of the IRC §4980D penalty far outweighs any employment tax advantage of claiming a health plan deduction under IRC §105.

Vol. 15, 126July 1, 2014

EY Payroll NewsFlash™

Watch out for this new wrinkle on employee health policy purchase reimbursements

For various reasons, employees may not be able to take advantage of health insurance benefits offered through their employer’s group plan. Employers may accommodate such employees by agreeing to reimburse them for all or a portion of the cost incurred in purchasing their own individual health insurance policies. Provided reimbursed employees submit receipts substantiating their out-of-pocket expenses for their health insurance purchases, these reimbursement retain their tax-favored status as a health and welfare benefit.

Although the income tax withholding and employment tax rules have not changed, new rules effective January 1, 2014, will cause large employers to think differently about how they offer health insurance benefits to employees who are not participating in the company’s group plan.

The Affordable Care Act

The IRS recently posted a frequently asked question (FAQ) to its website reminding employers subject to the health market reforms of the Affordable Care Act (ACA) that effective January 1, 2014, reimbursing employees for their purchase of an individual health insurance policy could result in penalties under IRC §4980D of up to $100 per day/$36,500 per year for each employee participating in the employer’s group health plan.

For instance, assume that an employer has 1,000 participants in it group health plan and one of its employees is reimbursed for health insurance that he or she individually purchases. The potential penalty in this case is $100,000 per day.

Income tax withholding and employment tax rules have not directly changed

The federal employment and income tax withholding rules have not changed. It is still the case that if employees substantiate the cost of their individually purchased health insurance, such reimbursement receives tax-favored treatment under IRC §105 as follows:

Vol. 15, 126July 1, 2014

EY Payroll NewsFlash™

Nondiscriminatory health plans. If the health policy reimbursement is made pursuant to an employer’s nondiscriminatory health plan, it is excluded from wages subject to federal income tax, federal income tax withholding, Social Security/Medicare and federal unemployment insurance.

Discriminatory plan. Reimbursements for individually purchased health insurance made to non-highly compensated employees follow the rules applicable to nondiscriminatory plans (see above). However, reimbursements made to highly compensated employees are subject to federal income tax but are exempt from federal income tax withholding, Social Security, Medicare and federal unemployment insurance tax. [IRC §3401(a)(20); Reg. §31.3401(a)(19)-1; IRC §3121(a)(2)(B); Reg. §31.3121(a)(2)-1(a)(3); IRC §3306(b)(2)(B), (b)(4) and Reg. §31.3306(b)(2)-1(a)(3)]

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