Freedom Benefits University
Can an employer deduct the cost of individual health
by Tony Novak, CPA, MBA, MT
last updated August 16, 2014
Can a small business employer deduct the cost of individual health insurance paid on behalf of an employee?
Yes, generally and in limited circumstances 1
, but the
application of this principle may not be useful in most
circumstances. The complete response must be broken down into three distinct parts. It may be necessary to consider all three components to arrive at the correct conclusion on the tax treatment of individual health insurance when an employer is involved in payment of the premium expense:
a. Allowable business expense deductions for individual health insurance
- The original basis for allowing deduction of individual health insurance premium is based on a Revenue Ruling issued more than 50 years ago. Revenue Ruling 61-145 is clearly written and directly addressed the most common accounting
and management practices we see in the handling of individual health insurance costs within
the very smallest businesses today. This ruling does not
contemplate the accounting and human resource management practices commonly
used today within businesses with a larger number of employees.
Last year the IRS cited and reaffirmed the
distinctions in the 1961 ruling in Internal Revenue Bulletin 2013-40. It is important to notice that IRS is making a distinction between an "employer payment plan" (allowing deduction and tax-free benefit to the employee) and an employer-sponsored plan (that does not allow the same tax benefit).
The Notice says "An employer payment plan, as the term is
used in this notice, does not include an employer-sponsored
arrangement under which an employee may choose either cash
or an after-tax amount to be applied toward health
coverage." The subtle distinction is whether the employee would have been entitled to cash compensation if not for the employer's payment of the health insurance cost.
This is not the same issue as we are considering regarding
the fundamental ability of the business to take the tax
deduction as an expense other than taxable employee
Specifically, the IRS does not address the question
"Can an employer payment for insurance exist outside of an
employer-sponsored employee benefit plan?" Other writers
have said "no". I say "yes, maybe and more likely in small
business situations than in larger firms". A discussion of
dissenting opinion on this issue from various law firms and
employee benefit brokers is published on
my blog site.
It may also be important to consider that this Revenue Ruling was issued before the flood of regulations of employee benefits including those commonly referred to as ERISA, COBRA, and HIPAA.
A discussion of the implication of employer employee
benefit practices and electronic banking practices on employer-sponsored employee benefit plans is outside the scope of this article, but it is fair to say that very small employers may have an easier time compiling with the Rev. Rule 61-145 allowance than mid-sized and larger employers.
As a practical matter employers with more than 10 employees
(as an arbitrary example) would have a difficult time
operating in an environment where individual health
insurance costs were selectively reimbursed for some
employees without consideration of its overall impact on the
company's employee compensation policies. Employers should be aware that the procedures they establish to enable the payment of individual health insurance for employees will have a direct impact on the tax treatment of those payments. Currently marketed software purporting to help employers manage employee health insurance costs might actually have the unintended effect of disqualifying an employer for the general allowance cited here.
Finally, we note that there is no other support for this tax position in other IRS publications. Conversely, there is no publication or tax case specifically prohibiting the practice. Specifically, IRS Publication 535 title "Business Expenses", Chapter 6 specifically says that group health insurance is deductible but does not mention individual insurance either as an allowed or disallowed expense. The complete lack of mention of individual health insurance premium deduction in more recent IRS publications about allowable might be explained by the complexity that would be required in making the distinction between the two scenarios described in this article.
b. Disallowance of employer payments by individual health insurance plans
- It is important to consider this important market limitation that impacts the question even though it is completely outside of tax law. Individual health insurance plans do not accept a premium payment from an insurer. While this practice may occasionally happen in error but virtually every individual health insurance plan, to our knowledge, has restrictions against the practice. This is because employer-sponsored health insurance is subject to different federal requirements than individual health insurance plans. Specifically, Individual health insurance policies do not meet ERISA or HIPAA requirements for employer-sponsored health insurance. Health plans are focused on avoiding legal liability under these feral laws and no so much concerned with helping small business customers get an additional tax break. If the health plan administrator will not legally accept a payment from an employer then the question about tax treatment may be mute.
c. Taxation of employer reimbursements of individual health insurance
- Current regulations are clear that an employer may reimburse (as opposed to pay directly) the cost of individual health insurance but that this amount must be included in the employee's taxable income. The common mechanisms for this type of arrangement are Health Reimbursement Arrangements (HRA)2
and Flexible Spending Accounts (FSA). See Internal Revenue Bulletin 2013-40, Notice 2013-54, issued September 30, 2014 for the latest as of the date of publication.
IRS contemplates that, as a result of ACA implementation, we will see more employers making after-tax health insurance premium payments on behalf of employees covered by individual health insurance. We concur with this position that in most cases a business with more than a few employees will have an easier time complying with the law if they adopt a health benefit plan that utilized after-tax reimbursement of individual health insurance.
We also recognize the strong motivation of small business owners to enjoy the greatest tax benefit possible so, going forward, CPAs and other advisers are likely to focus on providing support to distinguish between the various forms of tax treatment of health insurance premiums (both individual and group) and the impact and tax treatment expanding of uninsured medical expenses.
This expanded support may include accounting practices for
verification and payment of pre-tax individual insurance,
establishment of HSAs and special purpose HRAs for uninsured
health care expenses, expansion of the use of supplemental
insurance plans (both employer-paid and voluntary
salary-deducted), and modification of payroll tax accounting
systems to allow for after-tax payment of some individual
health insurance premiums.Footnotes1
This response is based on 2014 tax law as published on the date of this article. There is a reasonable possibility of clarification before the due date of 2014 federal income tax returns that would change this response.
A new type of Health Reimbursement Arrangement referred to as a "limited purpose HRA" was introduced in IRS and DOL publications following implementation of the Affordable Care Act that would not create the adverse effect indicate here. As a result, most of the HRA plans established
by Freedom Benefits (and presumably by others) for small businesses in 2014 are limited purpose HRAs.
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