Fringe Benefits: Health And Accident Coverage
A fringe benefit is non-monetary compensation for employment that is usually taxed less than monetary compensation. Contributions or insurance premiums paid by an employer on behalf of an employee for a health, hospitalization, or accident plan is one of the best fringe benefits, because, not only is it expensive, but it is income for the employee that is exempt from income taxes, Social Security and Medicare (FICA) taxes, and federal unemployment (FUTA) taxes. Health insurance has been a tax-free fringe benefit since 1954. Generally, tax-free coverage is provided by making pre-tax salary reduction contributions under the employer's cafeteria plan. Moreover, a C corporation can have a discriminatory plan, where the owners can give themselves a much better plan than is offered to the employees.
Coverage can be provided for the employee and the employee's spouse and children under the age 27, even if they cannot be claimed as dependents, and any other dependents of the employee. Tax-free coverage by the employer can continue even if the employee is laid-off or is retired. The employer can also provide tax-free coverage to the family of an employee who has died. For employees 65 years of age or older, Medicare premiums paid by the employer are also tax-free.
Because of the 1996 Defense of Marriage Act, coverage provided for a gay or lesbian partner of the employee was taxable. However, DOMA was overturned by the Supreme Court on 6/26/2013. As a result, the IRS has published new guidelines, stating that if a same-sex couple got married in a state that allows it, then the IRS will recognize the couple as being married, even if they move to a state that does not recognize same-sex marriages.
Same-Sex Marriage Is Now Legal in All 50 States
On June 26, 2015, the U.S. Supreme Court has ruled that "same-sex couples have a constitutional right to marry", thereby legalizing same-sex marriage throughout the country. Henceforth, they will enjoy all the benefits (and drawbacks) of marriage.
Two other fringe benefits that can help defray the cost of out-of-pocket expenses or deductibles or other medical expenses are the flexible spending arrangement (FSA) and the health reimbursement arrangement.
Healthcare Reimbursement Plans
Flexible spending arrangements (aka FSAs, flexible spending accounts) are accounts funded through pretax salary reduction contributions from employees and can be used to reimburse employees for health or dependent care expenses for the tax year and a grace period of 2½ months into the next year. If the money is not used up during that time period, then most of it is forfeited by the employee, but up to $550 can be carried over into the new year. Although medicines can be purchased with FSA funds, only prescribed medicines or insulin will be eligible for reimbursement; over-the-counter medicines have not been eligible since 2009.
Because of the Covid-19 pandemic, the new Consolidated Appropriations Act for 2021 (H.R. 133), signed into law on December 27, 2020, and the CARES Act allows employers to amend their FSAs to allow the following:
- Employers may permit participants to use dependent care FSA funds for children up to age 13. The previous age was 12.
- Unused 2020 benefits may be carried to 2021 and unused 2021 benefits to 2022.
- Employees who stopped participating in the plan (e.g., because of employment termination or job change) in 2020 or 2021 may be allowed to continue using unused amounts up to the extent of their contributions through the end of the plan year, including any grace periods or extensions.
- Participants may also be allowed to change contribution amounts throughout the year. Previously, changes could only be made outside of the open enrollment period because of a life changing event, such as getting married or giving birth.
- FSA funds can now be used for more types of medical expenses, such as over-the-counter medications and menstrual products.
Except for the expanded list of eligible items, which has been made a permanent part of the tax code by the CARES Act, the tax changes apply only for tax years 2020 and 2021. Employers have until the end of 2021 to amend their 2020 plans and until the end of 2022 to amend their 2021 plans.
A disadvantage for employers is that if the employee takes out more than he paid in, but quits before paying the full amount, then the employer is out of the amount not paid, because the plan must pay for benefits up to the annual limit that the employee agreed to.
Example: The Employer May Not Be Able to Recoup Any Losses from an FSA If an Employee Quits
- An employee agrees to pay $200 per month to an FSA for the year, takes out $1000 in January to pay for medical treatment, then quits in February.
- The employer would not be able to recoup the $800 the employee has failed to pay.
To qualify for favorable tax treatment, a FSA must specify which expenses are eligible for reimbursement and the maximum amount that can be reimbursed and any other reasonable conditions. Starting in 2013, a healthcare FSA will not be a qualified benefit under a cafeteria plan unless the salary reduction contribution does not exceed the legal maximum (the legal maximum is double for a dependent care FSA), adjusted annually for inflation; otherwise, all distributions from the FSA will be taxable to the employee, thereby eliminating any benefit of the account.
|2020 - 2021||$2,750||$550|
|2015 - 2016||$2,550|
|2013 - 2014||$2,500|
The maximum elective deferral for a dependent care FSA, which is not adjusted for inflation, is $5000, but $2500 for married filing separately. This $5000 limit applies to both spouses filing jointly, even if each spouse has a separate dependent care FSA offered by their employer. By contrast, the health FSA limit applies to each spouse separately, so each spouse can contribute up to $2750 for 2021, if the employer's plan allows it.
Health Reimbursement Arrangements (HRAs, aka Section 105 plans) are much like FSAs, except that unused amounts can be rolled over to the next year and HRAs are totally funded by the employer, not through salary reduction contributions. If the employee leaves the company, then he forfeits any remaining balance in the HRA. The HRA is simpler to implement than the FSA, since it does not require separate funding. The HRA can be used to pay the employee's share of the premium for medical insurance and medical expenses not covered by the insurance plan. The reimbursements are limited to a specified maximum amount during the year. If the employer provides both an FSA and an HRA, then the FSA should be used up 1st, since otherwise the money in the account must be forfeited if not used within the required time. However, a sole proprietor cannot participate in an HRA, but if a spouse is employed by the business, then the spouse can participate. HRA requirements:
- the plan must be written;
- participants must be employees;
- the plan cannot favor highly compensated employees or owners as to eligibility or benefits;
- reimbursed expenses cannot have been eligible for reimbursement under any other health insurance policy.
Starting in 2017, small business owners can now offer standalone Health Reimbursement Arrangements that can be used to reimburse employees for health-related expenses, including insurance. The limits are $4,950 for individual employee's and $10,000 to cover the employees families. This provision of the 21st Century Cures Act will be adjusted for inflation annually. Previously, only businesses that also offer health insurance could use HRAs, and many employers with fewer than 50 employees were not required to provide health insurance, so those who didn’t provide health insurance could not offer HRAs.
The self-employed can hire their own spouse and buy family coverage for the employee-spouse, allowing the business to provide tax-free reimbursements of medical expenses incurred by either spouse or their dependents.
Health savings accounts (HSA) can also be used to pay for out-of-pocket medical expenses and deductibles, where the employee can make contributions every year, up to a maximum amount that can be used to pay qualified medical expenses. The contributions are deductible against income taxes only, not FICA taxes, and distributions from the account are tax-free if they are used to pay qualified medical expenses.
Disability coverage provided by an employer is tax-free if it is made by paying the premiums through pre-tax salary reduction contributions. However, any income received during a disability will then be taxable. Conversely, if the disability premiums are paid with after-tax income, then disability benefits will be tax-free to the employee when collected.
Payments for permanent physical injuries — permanent loss of a body part, use of a body part, or disfigurement, either of the employee, spouse, children younger than 27 as of the end of the year, and dependents — may also be tax-free. The payments must be paid according to the type of injury, not based on prior years of service or the amount of time that the employee is unable to work. If the payments do not depend specifically and only on the injury, then they will be taxable, even if the employee is permanently disabled. A profit-sharing plan can also provide tax-free disability payments if the plan provides tax-free benefits where the amount depends on the specific injury.
The payment of premiums for long term care coverage that covers employees if they become chronically ill is tax-free, but coverage cannot be provided through a cafeteria plan nor can reimbursements of expenses be made from a flexible spending arrangement.
Discriminatory Medical Reimbursements May Be Taxable to Highly Compensated Participants
Medical reimbursements for highly compensated employees and stockholders may be taxable if the business self-insures and the reimbursements discriminate in their favor. If the insurance is from a third party, then these rules do not apply. Highly compensated participants include the highest paid 25% of employees other than those who do not have to be included under the law, the 5 highest-paid officers, and employees who own more than 10% of the employer stock. If the reimbursements are not available to the rank-and-file employees, then all reimbursements are taxable; if there is a lower limit for the rank-and-file employees, then any reimbursements above that limit are taxable. So if a highly-compensated employee is entitled to a $3000 reimbursement, but rank-and-file employees are only entitled to a $1000 limit, then up to $2000 of excess reimbursement is taxable to the highly-compensated employee.
Another nondiscrimination test applies to plan eligibility. Under the eligibility test, the plan must benefit either at least 70% of the employees or at least 80% of the employees eligible to participate if at least 70% of all employees are eligible. Some employees are not considered under the test:
- those with less than 3 years of service
- younger than 25
- part-time or seasonal, or
- are covered by a union collective bargaining agreement.
If the reimbursement plan is discriminatory, then a fraction — equal to the total reimbursements paid to the highly compensated divided by the total reimbursements paid to all employees — of the reimbursements paid to the favored group is taxable.
|Taxable Fraction of Reimbursement||=||Total Reimbursements Paid |
to the Highly Compensated
Paid to All Employees
|×||Reimbursement Paid |
So if the total reimbursements paid to the highly-compensated = $30,000 and the total reimbursements = $60,000, then ½ of any reimbursement paid to a highly-compensated employee will be taxable.
The tax year for which the taxable reimbursements must be reported depends on the plan provisions, which may be for the tax year for which the expense was incurred, or, if the plan does not provide otherwise, the year when the expense was paid.
The Self-Employed Can Deduct Health Insurance Premiums
Sole proprietors, active partners, and at least 2% shareholder-employees of an S corporation can deduct health insurance premiums as an above-the-line deduction, meaning that it is not an itemized deduction, but this deduction only lowers income tax, not FICA taxes, so it is not as good of a deal as employees of a C corporation get. However, the following equation must be true to claim the full deduction:
Self-Employment Income − ½ × Self-Employment Tax − Retirement Plan Contributions ≥ Health Insurance Premiums
If self-employment income is not sufficient to claim the total amount of health insurance premiums, then the amount that reduces the income to 0 can be deducted. To claim the deduction, the taxpayer must not be eligible to participate in an employer-sponsored health insurance plan, either through the taxpayer's employer or through the spouse's employer. Any remaining amount can be deducted as an itemized deduction on Schedule A, subject to the 10% AGI floor (or 7.5% AGI floor, if the taxpayer or spouse is at least 65 by year-end). Since this part is an itemized deduction, there is no deduction at all if the taxpayer claims the standard deduction.
Partnerships and limited liability companies can deduct health insurance premiums paid for its partners or members as guaranteed payments, which is reported to the partners on Schedule K-1, or the premium payments can be considered as a reduction in distributions, in which case, the payments are not deductible by the partnership, since the partners are not paying any tax on the benefit.
Example: Deducting Health Insurance Premiums
- IRA Contribution = $6000
- Health Insurance Premiums = $5000
- Net Self-Employment Income = $50,000
- ½ × Self-Employment Tax = $50,000 × 92.35% × 15.3% × 50% = $3532.39
- Net Taxable Income = $50,000 − $3532 − $6000 − $5000 = $35,468
- Net Self-Employment Income = $10,000
- ½ × Self-Employment Tax = $10,000 × 92.35% × 15.3% × 50% = $706
- Net Taxable Income before Deducting Health Insurance Premiums = $10,000 − $706 − $6000 = $3294.00
- Since net taxable income, after subtracting ½ of the self-employment tax + IRA contribution leaves only $3294, only that amount of the health insurance premiums can be deducted. The remaining $1,706 can still be deducted on Schedule A as an itemized deduction subject to the applicable AGI floor.
Access Rules and COBRA Continuation Coverage
Federal law governs the accessibility of group health plans. A group health plan cannot discriminate among employees based on health status or medical history. Specific conditions or procedures can be excluded or coverage may be limited, but only if the limits apply to all similarly situated employees. Failure to comply with these rules will subject the employer with more than 50 employees to daily penalties. Smaller employers are not subject to the penalties unless it is for the hospital length-of-stay requirements for mothers and newborns. Generally, pre-existing conditions must be covered unless the condition was diagnosed and treated within 6 months before enrollment. Coverage must also be provided to women who are pregnant on the enrollment date and newborn children who were rolled within 30 days of birth. If the parent changes jobs and enrolls in the new plan within 62 days when the previous coverage ended, then the child cannot be excluded. Likewise, for adopted children under age 18, if they're enrolled within 30 days of the adoption.
In 1986, the Coverage Omnibus Budget Reconciliation Act (COBRA) was enacted that allows employees who left the company, either voluntarily or involuntarily, unless it was for gross misconduct, to continue their health coverage under the group health plan of the former employer. The federal COBRA laws apply to employers with 20 or more employees, although smaller businesses may have to provide continuing coverage under state mini-COBRA laws. The premium charged to the employee cannot be any greater than 102% of the premium charged to the company for each employee. However, the ex-employee must pay the full premium during the continuation coverage period, but he will still benefit from the group rates, and it may only be increased at the beginning of a 12-month premium cycle.
COBRA coverage must be provided for at least 18 months for employees who leave either voluntarily or involuntarily or because of a reduction in working hours. If a worker cannot obtain new coverage and renew under a new employer because of a pre-existing condition, then the old employer must continue coverage for the ex-employee. If an individual was disabled or becomes disabled within 60 days of the continuing coverage period, then the employee can notify the plan administrator within 60 days of a determination of disability as defined in the Social Security Act.
If an employee dies, then the surviving spouse and dependent children are eligible for continuing coverage for at least 36 months. Likewise, if the employee divorces or legally separates from his spouse. The 36 month rule applies even if the employee drops coverage because of his anticipation of a divorce or legal separation. However, coverage does not have to be provided between the time the employee drops coverage and the divorce or separation. The 36 month rule also applies if the covered employee becomes eligible for Medicare or if a dependent child becomes ineligible because she reaches a certain age.
Continuing coverage must also be provided to an employee, his spouse, and dependents, who takes unpaid leave under the Family and Medical Leave Act of 1993 (FMLA) because of a birth or the adoption of a child or because of a serious family illness, but does not return at the end of the leave.
Employers must provide written notice of the COBRA continuation coverage option, and eligible employees, spouses, and dependents have 60 days to elect the continuing coverage.
- The Affordable Care Act requires that the total value of the insurance premiums paid by the employer be listed in the Form W-2, Wage and Tax Statement for the employee, but it is still not taxed.