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HOME > ARTICLES > BENEFITS > HEALTH INSURANCE

Payroll Articles
Health Insurance

Most mid-size and large employers provide some type of health or medical insurance for their Employees, who consider it one of the most important benefits of their employment (although they are generally required to help pay for it). This section covers contributions to and benefits from health insurance plans that pay or reimburse Employees for their medical expenses. Insurance plans designed to replace an employe's salary while he or she is ill or injured are discussed later.

Types of Health Insurance Plans

There are several types of health care plans offered by employers to their Employees. They can generally be categorized as one of the following:

Traditional health insurance plans. Under a traditional health insurance plan, the employer either purchases an insurance policy from a third-party insurance carrier or self-insures and pays claims to Employees

or health care providers from its own insurance fund. Where the employer buys insurance coverage from

a third-party insurance carrier, the employer (or the employer and the Employee) pays premiums to the insurer, which then reimburses the Employee for medical expenses incurred or makes payments directly to the health care provider (doctor or hospital). This is a traditional fee-for-service arrangement.

Many mid-size and large employers choose self-insurance rather than purchasing a policy from an insurance company because such plans are less regulated than third-party plans and give the employers more direct control over plan reserves and health care cost containment. In doing so, they pay benefits out of their own insurance funds and either administer the plan themselves or contract with a third-party administrator to do it. Self-insured employers may also purchase iustop-losslc insurance from an insurance carrier to pay claims once the employer has paid out a certain amount in benefits during the year, thus limiting the employer's liability in the event of catastrophic medical expenses. Employers may also limit their liability through participation in "minimum premium plans," which combine third-party insurance and self-insurance. The employer pays a portion of a calculated premium to the insurer to cover administrative costs and the insurer's profit, while placing other funds in an account to cover benefit claims. If the benefit claims exceed the calculated premium, the employer's liability is limited to the amount of the premium. If not, the employer gets to keep the difference.

Health maintenance organizations (HMOs). An HMO is a health care system that provides health care but does not directly pay for it, as does a health insurance carrier. The HMO provides these health care services on a prepaid basis with employers contributing to the plan on behalf of Employees choosing the HMO option. (Employees also may be required to contribute if contributions are required from Employees for non HMO plans.) While HMOs may be attractive to Employees because they generally do not involve deductibles or complex claim forms, they limit members to using HMO doctors and hospitals. There are two types of health maintenance organizations. Under the traditional scheme, the HMO has its own health care facility or facilities, and patients (e.g., Employees and their families) have to go there to receive medical services. The other type of HMO is the Individual Practice Association, under which physicians sign up with a health care group and patients have the option of choosing their own physicians among those in the group, rather than being required to go to the HMO facility and seeing the first available physician.

A product now being offered by many HMOs is the Point-of-Service (POS) plan. The POS option allows covered Employees and their dependents to use non-HMO health care providers, with the inclusion ofdeductibles and insurance copayments. Employees and their dependents must select a primary care physi- cian from the POS network, who acts as a gatekeeper and oversees the delivery of all health care services. But the Employee can choose a physician contrary to the primary care physician's recommendation or go initially to a physician outside the network subject to deductibles and reduced levels of reimbursement. Some HMOs are now also offering ifopen accesslg POS plans, which do not require an Employee to choose a primary care physician from the POS network. Preferred provider organizations (PPOs). A PPO is a health care delivery system that gives participants a choice of a higher level of benefits and lower out-of-pocket costs if they use doctors who are part of the PPO's network. le If they use nonnetwork providers, the Employees' costs, in terms of deductibles and copayments, are significantly higher. Participants may or may not have to choose a ihprimary care physician,ls who must approve or authorize all of their health care before the higher level of benefits is provided.

Tax Treatment of Contributions and Benefits

Employer-paid premiums excludable from income. Generally, contributions made by an employer to an accident or health insurance plan providing insurance for its Employees and their spouses and dependents are not wages and are not subject to federal income tax withholding or Social Security, Medicare, and federal unemployment (FUTA) taxes. 1 On the other hand, contributions madeby Employees from their wages for health insurance must be included in their income for income tax withholding and employment tax purposes unless the contributions are made through a valid salary reduction plan under IRC §125 (see the discussion of Cafeteria Plans at Section 4.5).

The rules are not so clear when an employer (without a §125 plan) gives its Employees a choice whether to receive a portion of their compensation as wages or have the amount paid by the employer to a health insurance carrier to cover premiums. The IRS's position is that such amounts must be included in the Employees' income and are subject to federal income tax withholding and Social Security, Medicare and FUTA taxes no matter what choice is made. A federal district court, however, said such salary reduction amounts are not included in income because there is no basis for distinguishing between amounts paid by an employer above and beyond an Employee's salary for health insurance and amounts paid pursuant to a salary reduction plan.

The IRS has also ruled that, where an employer reduces its Employees' salaries, uses those amounts to pay for health insurance premiums, and then reimburses the Employees for the amount of the salary reduction, the reimbursements are not excluded from income.

Where an employer's plan would allow the employer to convert a retired Employee's unused sick time into a cash equivalent that the employer would then use to purchase additional medical insurance coverage for the retiree, the amount converted would not be income to the retired Employee, according to the IRS. Insurance benefits excludable from income. Benefits received by an Employee under an accident or health insurance plan that directly or indirectly reimburses the Employee for medical expenses incurred by the Employee and his or her spouse and dependents (by paying the Employee or the medical care provider) are also not included in the Employee's income. To qualify for this exclusion, the Employee's expenses must be for medical care, defined by the Internal Revenue Code as ihe diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.

The IRS said that the definition of "medical care" for purposes of determining whether a reimbursement for Employee medical expenses is excludable from income is somewhat broader than the definition for purposes of calculating the itemized Deduction for medical expenses on an individual's personal tax return.

Therefore, the IRS ruled that employer reimbursements of Employee expenses for nonprescription drugs, either directly through a health insurance plan or indirectly through a health flexible spending account (FSA, see Section 4.5-7) or health reimbursement arrangement (HRA, see Section 4.1-6), are excludable from the Employee's income. The IRS distinguished an earlier ruling in which it had concluded that expenses incurred for nonprescription drugs did not qualify as deductible medical expenses. In other rulings in 2002 and 2003, the IRS ruled that the following procedures and equipment qualify as medical care under IRC §213(d)(1):

The following procedures and items do not qualify as medical care, according to the IRS:

PLASTIC SURGERY IS NOT MEDICAL CARE The exclusion for medical care expenses does not apply to plastic or ircosmeticl, surgery that is designed to improve a person's appearance with out promoting the proper function of the body or preventing or treating an illness or disease. There are exceptions where the surgery is needed to correct a deformity, treat a disfiguring disease, or heal a personal injury suffered during an accident or other trauma. The exclusion for reimbursed medical care expenses applies only up to the amount actually spent or incurred by the Employee. Any reimbursements in excess of that amount are taxable income to the Employee.

Any amounts reimbursed for an Employee's expenses incurred before the plan initially takes effect must be included in the Employee's income.

Social Security, Medicare, and FUTA requirements. To exclude employer contributions from employment taxes (Social Security, Medicare, and FUTA), the payments must be made under a plan. A plan can be shown by one of the following:

  1. the plan is written or is otherwise made known to Employees;
  2. the plan is referred to in an employment contract (e.g., collective bargaining agreement) involving the Employees;
  3. Employees contribute to the plan;
  4. employer contributions are made to a fund that is separate from the employer's salary account;
    5. or
  5. 5. the employer is required to make the contributions.

Once the existence of a plan is established, the Social Security, Medicare, and FUTA tax exclusion for employer contributions will apply if the plan is set up to benefit Employees and their dependents. Payments to the plan by an employer will not be excluded if the plan benefits dependents only.

Living together is not enough. Health insurance plan contributions and benefits are not excluded from income if made or received on behalf of an Employee's "life partner", "nonspouse cohabitant" or domestic partner unless that person is recognized as a spouse under state law. If the Employee's domestic partner is of the same sex as the Employee, the partner does not qualify as the Employee's spouse for tax purposes, regardless of state law. The partner may qualify as a dependent of the Employee if the partner receives more than half of his or her support from the Employee, lives with the Employee, and the relationship does not violate local law.

WHAT ABOUT VERMONT AND CALIFORNIA In 2000, Vermont enacted a state law allowing same-sex couples to enter into a "civil unionl" that provides all the same state benefits that are provided to a married couple. Health insurance premiums paid by an employer to cover an Employee's civil union partner are not taxable to the Employee for state purposes in Vermont, but remain subject to federal income, Social Security, and Medicare taxes. A California law providing certain legal benefits to domestic partners in 2002 leads to the same result in that state.

Employer-paid physical exams. The fair market value of a physical examination that is paid for by the employer is not excluded from income as a working condition fringe benefit (see Section 3.2-1), but it is excluded as an employer-paid medical care expense.

Nondiscrimination requirements. Where an employer provides health insurance for its Employees through a third-party insurance company, there are no nondiscrimination requirements. The plan may be tailored to favor highly compensated Employees or to benefit only them without losing the exclusion for employer contributions and reimbursements. However, an employer that is self-insured and reimburses its Employees' medical expenses from its own funds may not discriminate in favor of highly compensated Employees, in terms of either benefits or eligibility. This is true whether the employer administers the plan itself or pays a third party to administer it, since the insurance risk is not shifted to the administrator. If the plan is discriminatory, amounts paid to highly compensated Employees must be included in their income.

For purposes of this nondiscrimination test, highly compensated Employees include:

In terms of benefits, a self-insured plan is nondiscriminatory if all the benefits provided to highly compensated Employees are provided for all other participating Employees. Plans may have limits on benefits, but they must be uniform for all participants when based on employer contributions and must not be proportionately based on Employee compensation.

If the plan is discriminatory, only those reimbursements and benefits that discriminate in favor of highly compensated Employees are taxable, and only to the highly compensated Employees receiving them. Other participants receive their benefits tax-free. The determination of the taxable amount depends on where the discrimination occurred. If a highly compensated Employee receives a reimbursement or benefit other participants are not entitled to or that otherwise discriminates in favor of the highly compensated Employee, the full value is taxable to the Employee. If the plan is discriminatory in terms of eligibility, the taxable amount of reimbursements received by a highly compensated Employee is determined by the following formula: taxable amount = amount paid to HCE x all amounts paid to HCEs all amounts paid to Employees Benefits that are included in highly compensated Employees' income because they are not provided to nonhighly compensated Employees are not taken into account when using this formula.

Example: Green Food, Inc. (GFI) has a self-insured medical plan. Only the 5 highest paid officers are eligible for dental benefits, and the plan otherwise fails the eligibility test for nondiscrimination regarding its other benefits. During 2004, Employee Anne is one of the 5 highest paid officers and she receives $300 in dental benefits. The other 4 receive a total of $700 in dental benefits. In addition, Anne was reimbursed for $4,500 of medical expenses, a benefit that was available to all participants in the discriminatory plan. GFICAs medical plan paid out a total of $51,000 in medical and dental benefits to all Employees in 2004, including $31,000 to the 5 highest paid officers. For 2004, because dental benefits are available only to the 5 highest paid officers, Anne received a taxable dental benefit of $300. In computing the amount of Anne's medical benefit that is tax able, the dental benefits paid by the plan are excluded since they are not available to nonhighly compensated Employees. Therefore, her taxable income is calculated as follows:

medical taxable amount = $4,500 x $31,000 - ($300 + $700)
$51,000 - ($300 + $700)
medical taxable amount = $4,500 x .6
medical taxable amount = $2,700
medical and dental taxable amount = $2,700 + $300 = $3,000.

Although these discriminatory reimbursements are taxable income to the highly compensated Employees receiving them, they are not subject to federal income tax withholding or Social Security, Medicare, and FUTA taxes.

Reimbursements that exceed expenses. For health insurance plans involving a third-party insurer, as well as for nondiscriminatory self-insured plans, reimbursements for Employees' medical expenses are not included in income up to the amount of those expenses. Any amounts reimbursed in excess of expenses are considered income to the extent they can be linked to employer-paid premiums. If the Employee pays the premiums with after-tax dollars, payments from the plan are tax-free.

Payments for loss of a limb or disfigurement. Payments received by Employees or their dependents under an employer-financed accidental death and dismemberment plan (usually part of a life insurance plan) for the permanent loss or loss of use of a body part or function or for permanent disfigurement are not included in the EmployeesT income. The payments must not be related to time lost from work, only to the permanent loss or disfigurement.