Back to Employer-Sponsored Accident And Health Insurance Benefits

Employer-Sponsored Accident and Health Insurance Benefits

  • 8787. May an employer deduct as a business expense the cost of premiums paid for group accident and health insurance for employees?

    • An employer generally can treat accident and health insurance as a business expense, and can therefore deduct the cost of premiums paid for employees’ coverage under a group health plan. This includes premiums for medical expense insurance, dismemberment and sight loss coverage for the employee, the employee’s spouse and dependents, disability income for the employee, and accidental death coverage.

      The employer is entitled to deduct these premiums if coverage is provided under a group policy, but is not permitted to reimburse employees for the cost of premiums for individual insurance purchased through the health insurance marketplace. The deduction will be disallowed if benefits are payable to the employer—the deduction for health insurance is allowable only if benefits are payable to employees or their beneficiaries.1 However, if the employer’s spouse is a bona fide employee and the employer is covered as a family member based on the spouse-employee’s coverage, the premium is deductible.2

      A corporation can deduct premiums it pays on group hospitalization coverage for commission salespersons, regardless of whether they are technically treated as employees or independent contractors.3 The premiums paid, however, must qualify as additional reasonable compensation to the insured employees.4

      A different rule applies for certain accrual basis employers that provide medical benefits to employees directly instead of through insurance or an intermediary fund. In this case, the employer may not deduct amounts estimated to be necessary to pay for medical care provided in the year, but for which no claims have been filed with the employer by the end of the year, if filing a claim is necessary to establish the employer’s liability for payment.5

      1 .Treas. Reg. §1.162-10(a); Rev. Rul. 58-90, 1958-1 CB 88; Rev. Rul. 56-632, 1956-2 CB 101.

      2 .Rev. Rul. 71-588, 1971-2 CB 91; TAM 9409006.

      3 .Rev. Rul. 56-400, 1956-2 CB 116.

      4 .Ernest Holdeman & Collet, Inc. v. Comm., TC Memo 1960-10. See Rev. Rul. 58-90, supra.

      5 .U.S. v. General Dynamics Corp., 481 U.S. 239 (1987).

  • 8788. What credit is available for small employers who contribute to employee health insurance costs?

    • Eligible small employers may take advantage of a tax credit for employee health insurance expenses for taxable years beginning after December 31, 2009, provided the employer offers health insurance to its employees and makes a non-elective contribution on behalf of each employee who participates in the plan.1

      Planning Point: The IRS has provided relief for small employers who wish to claim the small business health care tax credit, but do not have access to a small business health options program (SHOP) marketplace plan for 2017. Under IRC Section 45R, certain small employers may claim a tax credit for two consecutive years if they provide qualified health coverage to employees. However, employers who first claimed the credit in 2016 may find that they no longer have access to a SHOP plan in 2017. These employers will be permitted to claim the credit with respect to health insurance coverage provided outside of the SHOP marketplace for the remainder of the credit period if the coverage that is provided would have qualified for the credit under the rules that applied before January 1, 2014.2

      An eligible small employer is defined as an employer that has no more than twenty-five full time employees, the average annual wages of whom do not exceed $55,200 for 2020 (in 2019, the amount was $54,200; in 2018, the amount was $53,400; and in 2017, the amount was $52,400).3

      In order to qualify, the employer must have a contribution arrangement for each employee who enrolls in the health plan offered by the employer through an exchange that requires that the employer make a non-elective contribution in an amount equal to a uniform percentage, not less than 50 percent, of the premium cost.4

      Subject to phase-out5 based on the number of employees and average wages, the amount of the credit is equal to 50 percent, and 35 percent in the case of tax-exempt organizations, of the lesser of:

      (1)the aggregate amount of non-elective contributions made by the employer on behalf of its employees for health insurance premiums for health plans offered by the employer to employees through an exchange; or

      (2)the aggregate amount of non-elective contributions the employer would have made if each employee had been enrolled in a health plan that had a premium equal to the average premium for the small group market in the ratings area.6

      For years 2010 through 2013, the following modifications apply in determining the amount of the credit:

      (1)The credit percentage is reduced to 35 percent (25 percent in the case of tax-exempt entities).7

      (2)The amount under (1) is determined by reference to non-elective contributions for premiums paid for health insurance, and there is no exchange requirement.8

      (3)The amount under (2) is determined by the average premium for the state small group market.9

      The credit also is allowed against the alternative minimum tax.10

      Planning Point: Proposed regulations explain how to calculate employer tax credits after 2013.11 The regulations propose that the maximum credit for taxable years after 2014 (available for only two years) increase to 50 percent (35 percent for tax-exempt organizations), with some adjustments. There is a proposed phase out for small employers with more than ten employees or whose average annual wages exceed $25,000 (adjusted for inflation). In addition, the proposed regulations clarify that employer contributions to an HRA, FSA, or HSA are not considered premium payments12 (See Q 8840.)

      1 .IRC Sec. 45R, as added by PPACA 2010.

      2.Notice 2018-27.

      .IRC Sec. 45R(d), as added by PPACA 2010; IRC Sec. 45R(d)(3)(B), as amended by Section 10105(e)(1) of PPACA 2010.

      .IRC Sec. 45R(d)(4), as added by PPACA 2010.

      .IRC Sec. 45R(c), as added by PPACA 2010.

      .IRC Sec. 45R(b), as added by PPACA 2010.

      .IRC Sec. 45R(g)(2)(A), as added by PPACA 2010.

      .IRC Secs. 45R(g)(2)(B), 45R(g)(3), as added by PPACA 2010.

      .IRC Sec. 45R(g)(2)(C), as added by PPACA 2010.

      10 .IRC Sec. 38(c)(4)(B), as amended by PPACA 2010. The IRS has issued guidance; see Notice 2010-44, 2010-22 IRB 717; Notice 2010-82, 2010-51 IRB 1.

      11 .2013 IRB LEXIS, 2013-38 IRB 211 (modifying Notice 2010-44, 2010-22 IRB 717; Notice 2010-82, 2010-51 IRB 1).

      12 .Prop. Treas. Reg. §1.45R-3.

  • 8789. Is the value of employer-provided coverage under accident or health insurance taxable income to an employee?

    • Generally, no. This includes medical expense and dismemberment and sight loss coverage for the employee, the employee’s spouse and dependents, and coverage providing for disability income for the employee. Unlike the exclusion for group-term life insurance, there is no specific limit on the amount of employer-provided accident or health coverage that may be excluded from an employee’s gross income. Further, coverage is tax-exempt to an employee when it is provided under a group insurance policy.1 Similarly, the employee is not taxed on the value of critical illness coverage.

      Accidental death coverage apparently also is excludable from an employee’s gross income under IRC Section 106(a).2

      The IRS has ruled privately that the value of consumer medical cards purchased by a partnership for its employees was excludable from the employees’ income under IRC Section 106(a).3

      Where an employer applies salary reduction amounts to the payment of health insurance premiums for employees, the salary reduction amounts are excludable from gross income under IRC Section 106.4

      On the other hand, an employee must include in income payments received from an employer that may be used to pay the accident and health insurance premiums if those amounts are not required to be used for that purpose.5 Employers are generally no longer permitted to reimburse employees for the cost of premiums for individual insurance policies purchased by the employee without incurring a penalty. Beginning in 2017, certain small employers may use a qualified small employer health reimbursement arrangement (QSEHRA) to reimburse employees for the cost of health coverage without incurring a penalty (see Q 908). Beginning in 2020, individual coverage HRAs (ICHRAs) may be used to reimburse employees for the cost of individual health insurance without incurring a penalty. See Q 446 to Q 452 for details.

      Where a taxpayer’s contribution to a fund providing retiree health benefits is deducted from the taxpayer’s after-tax salary, it is considered an employee contribution and is includable in the taxpayer’s income under IRC Section 61. In contrast, where an employer increases or grosses up a taxpayer’s salary and then deducts the fund contribution from the taxpayer’s after-tax salary, the contribution is considered to be an employer contribution that is excludable from the gross income of the taxpayer under IRC Section 106.6

      The IRS has ruled privately that a return of a premium rider on a health insurance policy was a benefit in addition to accident and health benefits, so that the premium paid by the employer had to be included in the employee’s taxable income.7

      For purposes of determining the tax treatment of employer-provided accident and health insurance, full time life insurance salespersons are treated as employees if they are employees for Social Security purposes.8 Coverage for other commission salespersons is taxable income to the salespersons, unless an employer-employee relationship exists.9

      Discrimination generally does not affect exclusion of the value of coverage. Even if a self-insured medical expense reimbursement plan discriminates in favor of highly compensated employees, the value of coverage is not taxable; only reimbursements are affected.

      For a discussion of the considerations applicable to S corporations, see Q 8966 to Q 8976.

      1 .IRC Sec. 106(a). See also Treas. Reg. §1.106-1; Rev. Rul. 58-90, 1958-1 CB 88; Rev. Rul. 56-632, 1956-1 CB 101.

      2 .See Treas. Reg. §1.106-1; Treas. Reg. §1.79-1(f)(3); Let. Ruls. 8801015, 8922048.

      3 .Let. Rul. 9814023.

      4 .Rev. Rul. 2002-03, 2002-1 CB 316.

      5 .Rev. Rul. 75-241, 975-1 CB 316, Let. Rul. 9022060. See also Let. Rul. 9104050.

      6 .Let. Rul. 9625012.

      7 .Let. Rul. 8804010.

      8 .IRC Sec. 7701(a)(20).

      9 .Rev. Rul. 56-400, 1956-2 CB 116; see also IRC Sec. 3508.

  • 8790. Is the value of employer-provided coverage under accident or health insurance taxable income to an employee if the employee has a choice as to whether to receive coverage or a higher salary?

    • Outside of the context of cafeteria plans, if an employer offers an employee a choice between a lower salary and employer-paid health insurance or a higher salary and no health insurance, the employee must include the full amount of the higher salary in income regardless of the employee’s choice. If the employee selects the health insurance option, the IRS will deem the employee to have received the higher salary and, in turn, paid a portion of the salary equal to the health insurance premium to the insurance company.1

      However, a federal district court faced with a similar fact situation ruled that for employees who accept employer-paid health insurance coverage, the difference between the higher salary and the lower one is not subject to FICA and FUTA taxes or to income tax withholding.2

      1 .Let. Rul. 9406002. See also Let. Rul. 9513027.

      2 .Express Oil Change, Inc. v. U.S., 25 F. Supp. 2d 1313 (N.D. Ala. 1996), aff’d, 162 F.3d 1290 (11th Cir. 1998).

  • 8791. Is the value of employer-provided coverage under accident or health insurance taxable income to an employee when the coverage is provided for the employee’s spouse, children or dependents?

    • Employer-provided accident and health coverage for an employee and the employee’s spouse and dependents, both before and after retirement, and for the employee’s surviving spouse and dependents after the employee’s death, does not have to be included in gross income by the active or retired employee or, after the employee’s death, by the employee’s survivors.1

      In 2010, the Affordable Care Act (“ACA”), expanded the exclusion from gross income for amounts expended on medical care to include employer-provided health coverage for any adult child of the taxpayer if the adult child has not attained the age of twenty-seven as of the end of the taxable year. The IRS has released guidance indicating that the exclusion applies regardless of whether the adult child is eligible to be claimed as a dependent for tax purposes.2

      1 .Rev. Rul. 82-196, 1982-2 CB 53; GCM 38917 (11-17-82).

      2 .IRC Sec. 105(b), as amended by the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010. Notice 2010-38, 2010-20 IRB 682.

  • 8792. When will amounts received by an employee under employer-provided accident and health insurance be taxable income to the employee?

    • Amounts received by an employee under employer-provided accident or health insurance, group or individual, that reimburse the employee for hospital, surgical, and other medical expenses incurred for care of the employee or spouse and dependents are generally tax-exempt without limit.

      Despite this, if the employee deducted the expense in a prior year and is later reimbursed, the reimbursement must be included in gross income. Moreover, if reimbursements exceed actual expenses, the excess must be included in gross income to the extent that it is attributable to employer contributions.1

      Where an employer reimburses employees for salary reduction contributions applied to the payment of health insurance premiums, these amounts are not excludable under IRC Section 105(b) because there are no employee-paid premiums to reimburse.2 Employers should note that, under the ACA, the employer may be liable for penalties if it chooses to reimburse employees for the cost of individual health insurance premiums. However, beginning in 2017, certain small employers may use a qualified small employer health reimbursement arrangement (QSEHRA) to reimburse employees for the cost of health coverage without incurring a penalty (see Q 908). Beginning in 2020, individual coverage HRAs (ICHRAs) may be used to reimburse employees for the cost of individual health insurance without incurring a penalty.  See Q 446 to Q 452 for details.

      Similarly, where an employer applies salary reduction contributions to the payment of health insurance premiums and then pays the amount of the salary reduction to employees regardless of whether the employee incurs expenses for medical care, these so-called “advance” reimbursements or loans are not excludable from gross income under IRC Section 105(b) and are subject to FICA and FUTA taxes.3

      Critical Illness Benefits

      If the value of an employer-provided critical illness insurance policy was not includable in the employee’s gross income, amounts later received by the employee under the policy are includable in that employee’s gross income. The exclusion from gross income under IRC Section 105(b) applies only to amounts paid specifically to reimburse medical care expenses. Because critical illness insurance policies pay a benefit irrespective of whether medical expenses are incurred, these amounts are not excludable under IRC Section 105(b).4

      Wage Continuation and Disability Income

      Sick pay, wage continuation payments, and disability income payments, both preretirement and postretirement, generally are fully includable in gross income and taxable to an employee.5

      Sight Loss and Dismemberment

      An employee is only entitled to exclude payments not related to absence from work for the permanent loss, or loss of use, of a member or function of the body, or permanent disfigurement of the employee or spouse or a dependent, if the amounts paid are computed with reference to the nature of the injury.6

      An employee was entitled to exclude a lump-sum payment for incurable cancer under a group life-and-disability policy based upon this provision.7

      However, if the benefits are determined based upon length of service rather than type and severity of injury, the exemption will not apply.8 Similarly, if the benefits are determined as a percentage of the disabled employee’s salary, rather than by the nature of the employee’s injury, they are not excludable from income.9 An employee who has permanently lost a bodily member or function, but who continues to work and draw a salary, cannot exclude a portion of that salary as payment for loss of the member or function if that portion was not computed with reference to the loss.10

      1 .IRC Sec. 105(b); Treas. Reg. §1.105-2; Rev. Rul. 69-154, 1969-1 CB 46.

      2 .Rev. Rul. 2002-3, 2002-1 CB 316.

      3 .Rev. Rul. 2002-80, 2002-2 CB 925.

      4 .See Treas. Reg. §§1.105-2, 1.213-1(e).

      5 .See Let. Ruls. 9103043, 9036049.

      6 .IRC Sec. 105(c).

      7 .Rev. Rul. 63-181, 1963-2 CB 74.

      8 .Beisler v. Comm., 814 F.2d 1304 (9th Cir. 1987); West v. Comm., TC Memo 1992-617. See also Rosen v. U.S., 829 F.2d 506 (4th Cir. 1987).

      9 .Colton v. Comm., TC Memo 1995-275; Webster v. Comm.,870 F. Supp. 202, 94-2 USTC ¶50,586 (M.D. Tenn. 1994).

      10 .Laverty v. Comm., 61 TC 160 (1973) aff’d, 523 F.2d 479, 75-2 USTC ¶9712 (9th Cir. 1975).

  • 8793. Are benefits paid under an employer-sponsored plan by reason of the employee’s death received tax-free?

    • Accidental death benefits under an employer’s plan are received income tax-free by an employee’s beneficiary under IRC Section 101(a) as life insurance proceeds payable by reason of the insured’s death.1 Death benefits payable under life insurance contracts issued after December 31, 1984, are excludable if the contract meets the statutory definition of a life insurance contract in IRC Section 7702. See Q 8763 to Q 8785 for a detailed discussion of the tax treatment of life insurance death proceeds.

      Survivors’ Benefits

      Benefits paid to a surviving spouse and dependents under an employer accident and health plan that provided coverage for an employee and the employee’s spouse and dependents both before and after retirement, and to the employee’s surviving spouse and dependents after the employee’s death, are excludable to the extent that they would be if paid to the employee.2

      1 .Treas. Reg. §1.101-1(a).

      2 .Rev. Rul. 82-196, 1982-2 CB 53; GCM 38917 (11-17-82).

  • 8794. Are benefits provided under an employer’s noninsured accident and health plan excludable from an employee’s income?

    • Although there is no particular legal form of plan required, uninsured benefits must be received under some sort of accident and health plan established by the employer for its employees in order to be tax-exempt on the same basis as insured plans.1 An Ohio federal District Court described the “plan” requirement as follows: “there is no legal magic to a form; the essence of the arrangement must determine its legal character.”2

      A formal contract of insurance is not required if it is clear that, for an adequate consideration, the company has agreed and has become liable to pay and has paid sickness benefits based upon a reasonable plan of protection established for the benefit of its employees. For example, a provision for disability pay in an employment contract has been held to satisfy the condition.3

      For tax purposes, it is not necessary for the plan to be in writing or even that an employee’s rights to benefits under the plan be enforceable. For example, a plan has been found based on an employer’s custom or policy of continuing wages during disability, which was generally known to employees.4

      If an employee’s rights are not enforceable, the employee must have been covered by a plan or a program, policy, or custom having the effect of a plan when the employee became sick or injured, and notice or knowledge of the plan must have been readily available to the employee.5 Further, for a plan to exist an employer must commit to certain rules and regulations governing payment and these rules must be made known to employees as a definite policy before accident or sickness arises. Ad hoc payments that are made at the complete discretion of an employer do not qualify as a plan.6

      The plan must be for employees. A plan may cover one or more employees and there may be different plans for different employees or classes of employees.7 A plan that is found to cover individuals in a capacity other than their employee status, even though they are employees, is not a plan for employees. For purposes of determining the excludability of employer-provided accident and health benefits, self-employed individuals and certain shareholders owning more than 2 percent of the stock of an S corporation are not treated as employees.8

      Further, uninsured medical expense reimbursement plans for employees must meet nondiscrimination requirements for medical expense reimbursements to be tax-free to highly compensated employees. See Q 8795 for a discussion of the nondiscrimination requirements applicable to employer-provided health insurance plans.

      1 .IRC Sec. 105(e).

      2 .Epmeier v. U.S., 199 F.2d 508, 511 (7th Cir. 1959).

      3 .Andress v. U.S., 198 F. Supp. 371 (N.D. Ohio 1961).

      4 .Niekamp v. U.S., 240 F. Supp. 195 (E.D. Mo. 1965); Pickle v. Comm., TC Memo 1971-304.

      5 .Treas. Reg. §1.105-5(a).

      6 .Est. of Kaufman, 35 TC 663 (1961), aff’d, 300 F.2d 128 (6th Cir. 1962); Lang v. Comm., 41 TC 352 (1963); Levine v. Comm., 50 TC 422 (1968); Est. of Chism v. Comm., TC Memo 1962-6, aff’d, 322 F.2d 956 (9th Cir. 1963); Burr v. Comm., TC Memo 1966-112; Frazier v. Comm., TC Memo 1994-358; Harris v. U.S., 77-1 USTC ¶9414 (E.D. Va. 1977).

      7 .Treas. Reg. §1.105-5(a); Andress, 198 F. Supp. 371 (1961).

      8 .IRC Sec. 105(g); Treas. Reg. §1.105-5(b).

  • 8795. What nondiscrimination requirements apply to employer-provided health insurance plans?

    • Under current law, employer-provided health insurance plans are subject to nondiscrimination rules concerning discrimination based on health status under HIPAA ’96. Though the HIPAA rules generally apply to both insured and uninsured plans, a plan that provides health benefits through an accident or health insurance policy need not meet the nondiscrimination requirements of IRC Section 105(h), which applies to amounts paid to highly compensated employees for coverage under self-insured plans, for covered employees to enjoy the tax benefits described in Q 8798.

      For plan years beginning on or after September 23, 2010, which was six months after the date of enactment of the Affordable Care Act (ACA), insured plans that are not grandfathered were expected to become subject to the same nondiscrimination requirements as self-insured plans. On December 22, 2010, however, the IRS announced in Notice 2011-1 that compliance with nondiscrimination rules for health insurance plans will be delayed until regulations or other administrative guidance has been issued.1 The IRS indicated that the guidance will not apply until plan years beginning a specified period after guidance is issued.

      Affordable Care Act Rules

      The ACA requires that a group health plan that is not a self-insured plan satisfy the requirements of IRC Section 105(h)(2). More specifically, the ACA provides that rules similar to the rules in IRC Section 105(h)(3) (nondiscriminatory eligibility classifications), Section 105(h)(4) (nondiscriminatory benefits), and Section 105(h)(8) (certain controlled groups) apply to insured plans. The term “highly compensated individual” has the meaning given that term by IRC Section 105(h)(5).2 A detailed discussion of the applicable definition of highly compensated individual under Section 105 is provided in Q 8799.

      A plan that reimburses employees for premiums paid under an insured plan does not have to satisfy nondiscrimination requirements.

      1 .2011-1 CB 259.

      2 .Sec. 2716 of the Public Health Service Act, as added by Section 1001(5) of PPACA 2010, as amended by Section 10101(d) of PPACA 2010.

  • 8796. What is a self-insured health plan?

    • A self-insured plan is one in which reimbursement of medical expenses is not provided under a policy of accident and health insurance.1 According to regulations, a plan underwritten by a cost-plus policy or a policy that, in effect, merely provides administrative or bookkeeping services is considered self-insured.2

      An accident or health insurance policy may be an individual or a group policy issued by a licensed insurance company, or an arrangement in the nature of a prepaid health care plan regulated under federal or state law including an HMO. A plan will be found to be self-insured unless the policy involves shifting of risk to an unrelated third party.

      A plan is not considered self-insured merely because prior claims experience is one factor in determining the premium.3 Further, a policy of a captive insurance company is not considered self-insurance if, for the plan year, premiums paid to a captive insurer by unrelated companies are equal to at least one-half of the total premiums received and the policy is similar to those sold to unrelated companies.4


      An employer does not have to withhold income tax on an amount paid for any medical care reimbursement made to or for the benefit of an employee under a self-insured medical reimbursement plan within the meaning of IRC Section 105(h)(6).5

      1 .See IRC Sec. 105(h)(6).

      2 .Treas. Reg. §1.105-11(b).

      3 .See, for example, Let. Rul. 8235047.

      4 .Treas. Reg. §1.105-11(b).

      5 .IRC Sec. 3401(a)(20).

  • 8797. Are reimbursements attributable to employee contributions to a self-insured health plan taxable to the employee?

    • Generally, reimbursements attributable to employee contributions are received tax-free. However, an employee must include any reimbursed amount to the extent that the employee has taken a deduction for the expense.

      Amounts attributable to employer contributions are determined based on the ratio that employer contributions bear to total contributions for the calendar years immediately preceding the year of receipt (up to three years may be taken into account). If the plan has been in effect for less than a year, then the determination may be based upon the portion of the year, or such determination may be made periodically (such as monthly or quarterly) and used throughout the succeeding period.1

      For example, if an employee leaves employment on April 15, 2021, and 2021 is the first year the plan was in effect, the determination may be based upon the contributions of the employer and the employees during the period beginning with January 1 and ending with April 15, or during the month of March, or during the quarter consisting of January, February, and March.

      1 .Treas. Reg. §1.105-11(i).

  • 8798. What nondiscrimination requirements apply to self-insured health plans?

    • The nondiscrimination requirements set forth in IRC Section 105(h) apply to self-insured health benefits, although the IRS announced in Notice 2011-1 on December 22, 2010, that compliance with nondiscrimination rules for other health insurance plans will be delayed until regulations or other administrative guidance has been issued. The IRS indicated that the guidance will not apply until plan years beginning in a specified period after guidance is issued.

      Benefits received pursuant to a self-insured plan are generally excludable from an employee’s gross income. Despite this, if a self-insured medical expense reimbursement plan or the self-insured part of a partly-insured medical expense reimbursement plan discriminates in favor of highly compensated individuals, certain amounts paid to the highly compensated individuals will be taxable to those highly compensated individuals.

      A medical expense reimbursement plan cannot be implemented retroactively because, if this were permitted, the nondiscrimination requirements of IRC Section 105 would be ineffective.1

      A self-insured plan may not discriminate in favor of highly compensated individuals either with respect to eligibility to participate or benefits.


      A plan discriminates as to eligibility to participate unless the plan benefits:

      (1)70 percent or more of all employees, or 80 percent or more of all the employees who are eligible to benefit under the plan if 70 percent or more of all employees are eligible to benefit under the plan; or

      (2)employees who qualify under a classification set up by the employer and found by the IRS not to be discriminatory in favor of highly compensated individuals.2

      For purposes of these eligibility requirements, an employer is not required to consider those employees who:

      (1)have not completed three years of service at the beginning of the plan year; however, years of service during which an individual was ineligible under (2), (3), (4), or (5) below must be counted for this purpose;

      (2)have not attained age twenty-five at the beginning of the plan year;

      (3)are part-time or seasonal employees;

      (4)are covered by a collective bargaining agreement if health benefits were the subject of good faith bargaining; or

      (5)are nonresident aliens with no U.S.-source earned income.3

      Part-time and Seasonal Workers

      Part-time employees include those employees who are customarily employed for fewer than thirty-five hours per week. Seasonal employees are those who are customarily employed for fewer than nine months per year. In determining whether an employee is part-time or seasonal, the IRS will consider whether similarly situated employees of the employer (or employees in the same industry or location as the employer) are employed for substantially more hours or months, as applicable. A safe harbor rule provides that employees customarily employed for fewer than twenty-five hours per week or seven months per year may automatically be considered part-time or seasonal.4


      A plan discriminates as to benefits unless all benefits provided for participants who are highly compensated individuals are provided for all other participants.5 If some participants become eligible for benefits immediately and others only after a waiting period, benefits are not considered to be available to all participants.6 Benefits available to dependents of highly compensated employees must be equally available to dependents of all other participating employees. The test is applied to benefits subject to reimbursement, rather than to actual benefit payments or claims.

      Any maximum limit on the amount of reimbursement must be uniform for all participants and for all dependents, regardless of years of service or age. Further, if the type or amount of benefits subject to reimbursement is offered in proportion to compensation and highly compensated employees are covered by the plan, the plan will be found to discriminate with regard to benefits.

      A plan will not be considered discriminatory in operation merely because highly compensated participants use a broad range of plan benefits to a greater extent than other participants.7

      The nondiscrimination rules are not violated merely because benefits under the plan are offset by benefits paid under a self-insured or insured plan of the employer, of another employer, or by benefits paid under Medicare or other federal or state law. A self-insured plan may take into account benefits provided under another plan only to the extent that the benefit is the same under both plans.8 Benefits provided to a retired employee who was highly compensated must be the same as benefits provided to all other retired participants.

      For purposes of applying the nondiscrimination rules, all employees of a controlled group of corporations, or employers under common control, and of members of an affiliated service group are treated as employed by a single employer.9

      Highly Compensated Individual

      An employee is a highly compensated individual if the employee falls into any one of the following three classifications:

      (1)The employee is one of the five highest paid officers.

      (2)The employee is a shareholder who owns, either actually or constructively through application of the attribution rules, more than 10 percent in value of the employer’s stock.

      (3)The employee is among the highest paid 25 percent, rounded to the nearest higher whole number, of all employees other than excludable employees who are not participants and not including retired participants.10 Fiscal year plans may determine compensation on the basis of the calendar year ending in the plan year.

      A participant’s status as officer or stockholder with respect to a particular benefit is determined at the time when the benefit is provided.11 See Q 8799 for a discussion of the tax consequences to a self-insured plan that is found to be discriminatory under these rules.

      1 .Wollenburg v. U.S., 75 F. Supp. 2d 1032, 1035 n.2 (D. Neb. 1999) (noting that “an employer can choose to benefit or hurt certain employees with much greater precision, with the benefit of hindsight.”); American Family Mut. Ins. Co. v. U.S., 815 F. Supp. 1206 (W.D. Wisc. 1992). See also Rev. Rul. 2002-58, 2002-38 IRB 541.

      2 .IRC Sec. 105(h)(3)(A).

      3 .IRC Sec. 105(h)(3)(B).

      4 .Treas. Reg. §1.105-11(c).

      5 .IRC Sec. 105(h)(4).

      6 .Let. Ruls. 8411050, 8336065.

      7 .Treas. Reg. §1.105-11(c)(3).

      8 .Treas. Reg. §1.105-11(c)(1).

      9 .IRC Sec. 105(h).

      10 .IRC Sec. 105(h)(5).

      11 .Treas. Reg. §1.105-11(d).

  • 8799. What are the tax consequences for amounts paid by an employer to highly compensated employees under a discriminatory self-insured medical expense reimbursement plan?

    • If a self-insured medical reimbursement plan is found to be discriminatory in favor of highly compensated employees, those highly compensated employees may be taxed on reimbursed amounts provided under the plan. The taxable amount of payments is the “excess reimbursement.”1 The two situations discussed below will produce an excess reimbursement.

      The first situation occurs when a benefit is available to a highly compensated individual but not to all other participants, or if the benefit otherwise discriminates in favor of highly compensated individuals. In this case, the total amount reimbursed under the plan to the employee with respect to that benefit is an excess reimbursement.

      The second situation occurs when a plan discriminates as to participation, even though all benefits are available to all other participants and are not otherwise discriminatory. If this is the case, the excess reimbursement is determined by multiplying the total amount reimbursed to the highly compensated individual for the plan year by a fraction. The numerator of this fraction is the total amount reimbursed to all participants who are highly compensated individuals under the plan for the plan year and the denominator is the total amount reimbursed to all employees under the plan for such plan year. In determining the fraction, any reimbursement attributable to a benefit not available to all other participants is not taken into account.2

      Multiple plans may be designated as a single plan for purposes of satisfying nondiscrimination requirements. If an employee elects to participate in an optional HMO offered by the plan, that employee is considered benefited by the plan only if the employer’s contributions with respect to the employee are at least equal to what would have been made to the self-insured plan and the HMO is designated, with the self-insured plan, as a single plan.

      Unless a plan provides otherwise, reimbursements will be attributed to the plan year in which payment is made. Accordingly, they will be subject to tax in an individual’s tax year in which a plan year ends.

      Amounts reimbursed for medical diagnostic procedures for employees, but not dependents, performed at a facility that provides only medical services are not considered a part of a plan and do not come within these rules requiring nondiscriminatory treatment.3

      1 .IRC Sec. 105(h)(1).

      2 .IRC Sec. 105(h)(7).

      3 .Treas. Reg. §1.105-11(g).

  • 8800. Are premiums paid by a taxpayer for personal health insurance deductible?

    • A taxpayer may deduct premiums paid for medical care insurance (including hospital, surgical, and medical expense reimbursement coverage) as a medical expense to the extent that, when added to all other unreimbursed medical expenses, the total exceeds 10 percent of a taxpayer’s adjusted gross income (7.5 percent for tax years beginning before 2013 and for 2017-2020). The threshold is also 10 percent for alternative minimum tax purposes.

      The Affordable Care Act increased the threshold to 10 percent of a taxpayer’s adjusted gross income for taxpayers who are under the age of sixty-five effective in tax years beginning January 1, 2013. For taxpayers over the age of sixty-five, the threshold for deductibility remained at the 7.5 percent level from years 2013 to 2016. The 2017 tax reform legislation reduced the threshold to 7.5 percent for all taxpayers for 2017 and 2018. The 7.5 percent threshold has been extended through 2020 for all taxpayers.

      A taxpayer must itemize his or her deductions in order to take a deduction for medical care premiums or any other medical expenses.1 The reduction of itemized deductions for certain high-income individuals is not applicable to medical expenses deductible under IRC Section 213 (itemized deductions are not reduced for high income taxpayers for 2018-2025 under the 2017 tax reform legislation).2

      The only premiums deductible as a medical expense are for medical care insurance. Premiums for non-medical benefits, such as disability income, accidental death and dismemberment, and waiver of premium under a life insurance policy, are not deductible.

      The definition of “medical care” generally includes amounts paid for any qualified long-term care insurance contract or for qualified long-term care services and, thus, these expenses may be deducted, subject to certain limitations.3

      Mandatory contributions to a state disability benefits fund are not deductible under the provisions applicable to medical expense deductions, but are deductible as taxes.4 Employee contributions to an alternative employer plan providing disability benefits required by state law are nondeductible personal expenses.5

      If a policy provides both medical and non-medical benefits, a deduction will be allowed for the medical portion of the premium only if the medical charge is reasonable in relation to the total premium. In order to take advantage of this bifurcated approach, the medical portion must be stated separately in either the policy or in a statement furnished by the insurance company.6

      Similarly, where a premium provides for medical care for individuals other than the taxpayer, spouse and dependents (such as with automobile insurance), a deduction will not be allowed unless the policy separately states the portion that is applicable to the taxpayer, spouse and dependents.7

      If a policy provides only indemnity for hospital and surgical expenses, premiums qualify as medical care premiums even though the benefits are stated amounts that will be paid without regard to the actual amount of expense incurred by the taxpayer.8 Premiums paid for a hospital insurance policy that provides a specific payment for each week the insured is hospitalized, not to exceed a specified number of weeks, regardless of whether the insured receives other payments for reimbursement, do not qualify as medical care premiums and are not deductible.9

      Because the benefit under a critical illness insurance policy is payable regardless of any actual medical expenses incurred or reimbursement received, the premiums paid for this type of policy would appear not to be deductible.10

      A deduction also will be denied for employees’ contributions to a plan that provides that employees absent from work because of sickness are to be paid a percentage of wages earned on that day by co-employees.11

      A taxpayer may deduct premiums paid for a policy that reimburses the taxpayer for the cost of prescription drugs as medical care insurance premiums.12

      Medicare premiums, paid by persons age sixty-five or older, under the supplementary medical insurance or prescription drug programs are deductible as medical care insurance premiums. However, the taxes paid by employees and self-employed individuals for basic hospital insurance under Medicare are not deductible.13

      If a taxpayer prepays premiums before the taxpayer is sixty-five for insurance that will cover medical care for the taxpayer, spouse, and dependents after the taxpayer is sixty-five, these premiums are deductible when paid provided they are payable on a level-premium basis for ten years or more or until age sixty-five, but in no case for fewer than five years.14

      Payments made to an institution for the provision of lifetime care are deductible under IRC Section 213(a) in the year paid to the extent that the payments are properly allocable to medical care, even if the care is to be provided in the future or possibly not provided at all.15 The IRS has stated that its rulings should not be interpreted or expanded to permit a current deduction of payments for future medical care (including medical insurance provided beyond the current tax year) in situations where future lifetime care is not of the type associated with the ruling at issue.

      1 .IRC Sec. 213(a).

      2 .IRC Sec. 68(c).

      3 .IRC Sec. 213(d)(1).

      4 .McGowan v. Comm., 67 TC 599 (1976); Trujillo v. Comm., 68 TC 670 (1977).

      5 .Rev. Rul. 81-192, 1981-2 CB 50 (citing N.Y. law); Rev. Rul. 81-193, 1981-2 CB 52 (citing N.J. law); Rev. Rul. 81-194, 1981-2 CB 54 (citing Cal. law).

      6 .IRC Sec. 213(d)(6).

      7 .Rev. Rul. 73-483, 1973-2 CB 75.

      8 .Rev. Rul. 58-602, 1958-2 CB 109, modified by Rev. Rul. 68-212, 1968-1 CB 91.

      9 .Rev. Rul. 68-451, 1968-2 CB 111.

      10 .See Treas. Reg. §1.213-1(e)(4).

      11 .Rev. Rul. 73-347, 1973-2 CB 25.

      12 .Rev. Rul. 68-433, 1968-2 CB 104.

      13 .IRC Sec. 213(d)(1)(D); Rev. Rul. 66-216, 1966-2 CB 100.

      14 .IRC Sec. 213(d)(7).

      15 .Rev. Rul. 76-481, 1976-2 CB 82; Rev. Rul. 75-303, 1975-2 CB 87; Rev. Rul. 75-302, 1975-2 CB 86.

  • 8801. Are benefits received under a personal health insurance policy taxable income?

    • No. All kinds of benefits from personal health insurance generally are entirely exempt from income tax. This exemption applies to disability income, dismemberment and sight loss benefits, critical illness benefits,1 and hospital, surgical, and other medical expense reimbursement. The taxpayer is not limited as to the amount of benefits, including the amount of disability income that he or she can receive tax-free under personally paid health insurance or under an arrangement having the effect of accident or health insurance.2 However, courts have held that the IRC Section 104(a)(3) exclusion will be denied where a taxpayer’s claims for insurance benefits were not made in good faith and were not based on a true illness or injury.3

      If a health insurance policy provides for accidental death benefits, the proceeds of these death benefits may be tax-exempt to the policy beneficiary as death proceeds of life insurance.4 A taxpayer may exclude from gross income disability benefits received for loss of income or earning capacity under no fault insurance.5 The exclusion also has been applied where the policies were provided to the insured taxpayer by a professional service corporation in which the insured was the sole stockholder.6

      Health insurance benefits are also tax-exempt if received by a person who has an insurable interest in the individual insured by the policy, rather than by that individual himself.7

      Medical expense reimbursement benefits will impact the amount that a taxpayer is allowed to deduct for medical expenses. Because only unreimbursed expenses are deductible, the total amount of medical expenses paid during a taxable year must be reduced by the total amount of reimbursements received in that taxable year.8

      Similarly, if the taxpayer deducts medical expenses in the year they are paid and then receives reimbursement in a later year, the taxpayer (or the taxpayer’s estate, where the deduction is taken on the decedent’s final return but later reimbursed to the taxpayer’s estate) must include the reimbursement, to the extent of the prior year’s deduction, in gross income for the later year.9

      Where the value of a decedent’s right to reimbursement proceeds, which is income in respect of a decedent,10 is included in the decedent’s estate, an income tax deduction is available for the portion of estate tax attributable to such value.

      Disability income is not treated as reimbursement for medical expenses and, therefore, does not offset such expenses.11

      Example: Ryan, whose adjusted gross income for 2020 was $25,000, paid $4,000 in medical expenses during that year. On his 2020 return, he deducted medical expenses totaling $2,125 [$4,000 – $1,875 (7.5 percent of his adjusted gross income)]. In 2021, Ryan receives the following benefits from his health insurance: disability income of $1,200 and reimbursement for 2020 doctor and hospital bills of $400. He must report $400 as taxable income on his 2021 return. Had Ryan received the reimbursement in 2020, his medical expense deduction for that year would have been limited to $1,725 (4,000 – $400 [reimbursement] – $1,875 [7.5 percent of adjusted gross income]). Otherwise, he would have received the entire amount of insurance benefits, including the medical expense reimbursement, tax-free.

      1 .See, e.g., Let Rul. 200903001.

      2 .IRC Sec. 104(a)(3); Rev. Rul. 55-331, 1955-1 CB 271, modified by Rev. Rul. 68-212, 1968-1 CB 91; Rev. Rul. 70-394, 1970-2 CB 34.

      3 .Dodge v. Comm., 981 F.2d 350 (8th Cir. 1992).

      4 .IRC Sec. 101(a); Treas. Reg. §1.101-1(a).

      5 .Rev. Rul. 73-155, 1973-1 CB 50.

      6 .Let. Rul. 7751104.

      7 .See IRC Sec. 104; Castner Garage, Ltd. v. Comm., 43 BTA 1 (1940), acq. 1941-1 CB 11.

      8 .Rev. Rul. 56-18, 1956-1 CB 135.

      9 .Treas. Reg. §§1.104-1, 1.213-1(g); Rev. Rul. 78-292, 1978-2 CB 233.

      10 .See Rev. Rul. 78-292, above.

      11 .Deming v. Comm., 9 TC 383 (1947), acq. 1948-1 CB 1.

  • 8802. How are accident or health benefits taxed for stockholder-employees of a closely-held C corporation?

    • An employer’s accident or health plan must be established for employees in order to provide tax-free coverage and benefits.1 The same is true with respect to amounts received under a state’s sickness and disability fund under IRC Section 105(e)(2).

      If a plan covers only stockholder-employees, the IRS can challenge tax benefits claimed under the plan on the ground that the plan is not for employees. The challenge for the closely-held C corporation is in establishing that the stockholder-employees are covered as employees, rather than in their capacity as stockholders. If this cannot be established, then premiums or benefits are likely to be treated as dividends. The result is that the premiums will be nondeductible by the corporation and the premiums or benefits will be includable in the gross incomes of covered stockholder-employees.2

      Courts have found, however, that the tax benefits of employer-provided health insurance are available in a plan that covers only stockholder-employees. This is the case only if the plan covers a class of employees that can be segregated rationally from other employees, if any non-stockholder employees exist, on a criterion other than their being stockholders.3

      The Bogene, Smith, Seidel, and Epstein cases, which were decided in favor of the taxpayers, all involved plans that covered only active and compensated officers of the corporation who also were stockholders. In Smith and Seidel, the officer-shareholders also were the only employees, though in Bogene and Epstein the corporations also employed other employees who were not shareholders and who were not covered by the plans.

      The plan in American Foundry, where the plan was found to not be a plan for employees, covered only two of five active officers of a family corporation.4

      The plan in Sturgill covered four officer-stockholders of a family corporation. Two of the four were not active or compensated as officer-employees and the plan was held not to be one for employees.5

      The plan in Leidy covered only the president, who was the sole stockholder, and the vice president, who was no longer active in the company.

      In American Foundry and in Sturgill, courts allowed the corporations to deduct reimbursement payments to the active officers as reasonable compensation, even though the payments were not excludable by shareholder-employees under IRC Section 105.

      1 .IRC Sec. 105(e).

      2 .Larkin v. Comm., 48 TC 629 (1967), aff’d 394 F.2d 494 (1st Cir. 1968); Levine v. Comm., 50 TC 422 (1968); Smithback v. Comm., TC Memo 1969-136; Est. of Leidy v. Comm., 77-1 USTC ¶9144 (4th Cir. 1977).

      3 .Bogene, Inc. v. Comm., TC Memo 1968-147, acq. 1968 AOD LEXIS 272; Smith v. Comm., TC Memo 1970-243, acq. 1970 AOD LEXIS 245; Seidel v. Comm., TC Memo 1971-238, acq. 972 AOD LEXIS 15; Epstein v. Comm., TC Memo 1972-53, acq. 1972 AOD LEXIS 124; Oleander Co., Inc. v. United States, 82-1 USTC ¶9395 (E.D.N.C. 1981); Giberson v. Comm., TC Memo 1982-338; Est. of Leidy, above; Wigutow v. Comm., TC Memo 1983-620.

      4 .American Foundry v. Comm., 76-1 USTC ¶9401 (9th Cir. 1976), acq. 1974-2 CB 1.

      5 .Charlie Sturgill Motor Co. v. Comm., TC Memo 1973-281, acq. 1974 AOD LEXIS 151.

  • 8803. How is health insurance coverage for partners and sole proprietors taxed?

    • Partners and sole proprietors are self-employed individuals, not employees, and the rules for personal health insurance, rather than employer-provided health insurance, usually apply. Partners and sole proprietors, are, therefore, entitled to deduct 100 percent of amounts paid during a taxable year for insurance that provides medical care for the individual, spouse, and dependents during the tax year.

      The insurance can also cover a child who was under age twenty-seven at the end of the tax year, even if the child did not qualify as the taxpayer’s dependent. A “child” for this purpose is defined to include a taxpayer’s child, stepchild, adopted child, or foster child. A foster child is any child placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction.

      In additional, certain premiums paid for long-term care insurance are eligible for this deduction.1

      A partner or sole proprietor is not entitled to this deduction for any calendar month in which the partner or proprietor is eligible to participate in any subsidized health plan maintained by any employer of the self-employed individual or spouse. This rule is applied separately to plans that include coverage for qualified long-term care services or are qualified long-term care insurance contracts, and plans that do not include that coverage and are not those kinds of contracts.2

      The deduction is allowable in calculating adjusted gross income and is limited to the self-employed individual’s earned income for the tax year that is derived from the trade or business with respect to which the plan providing medical care coverage is established. Earned income means, in general, net earnings from self-employment with respect to a trade or business in which the personal services of the taxpayer are a material income-producing factor.

      Any amounts paid for this kind of insurance may not be taken into account in computing:

      (1)the amount of a medical expense deduction under IRC Section 213; and

      (2)net-earnings from self-employment for the purpose of determining the tax on self-employment income.3

      Additional considerations may apply in the case of a partnership. If a partnership pays accident and health insurance premiums for services rendered by partners in their capacity as partners and without regard to partnership income, premium payments are considered to be “guaranteed payments” under IRC Section 707(c). As such, the premiums are deductible by the partnership under IRC Section 162, subject to IRC Section 263, and must be included in partners’ income under IRC Section 61.

      A partner is not entitled to exclude premium payments from income under IRC Section 106 but may deduct payments to the extent allowable under IRC Section 162(l), as discussed above.4 For partners, a policy can be either in the name of the partnership or in the name of the partner. The partner can either self-pay the premiums, or the partnership can pay them and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in the partner’s gross income. However, if the policy is in the partner’s name and the partner self- pays the premiums, the partnership must reimburse the partner and report the premium amounts on Schedule K-1 (Form 1065) as guaranteed payments to be included in the partner’s gross income. Otherwise, the insurance plan will not be considered to be established under the business.

      The IRS has found that the cost of consumer medical cards purchased for partners is not deductible by the partners under either IRC Section 162(l) or IRC Section 213. This conclusion was based on the rationale that consumer medical cards that provide discounts on certain medical services and items are not actually insurance products.5

      The IRS has also concluded that payments from a self-funded medical reimbursement plan set up by a partnership, and made to partners and their dependents, are excludable from partners’ income. Premiums paid by partners for coverage under a self-funded plan are deductible, subject to the limits of IRC Section 162(l).6

      There is no limit on the amount of benefits a partner or sole proprietor can receive tax-free.7

      The IRS has also found that coverage purchased by a sole proprietor or partnership for non-owner-employees, including an owner’s spouse, generally are subject to the same rules that apply in any other employer-employee situation.8

      The IRS has issued settlement guidelines addressing whether a self-employed individual (“employer-spouse”) may hire his or her spouse as an employee (“employee-spouse”) and provide family health benefits to the employee-spouse, who then elects family coverage including the employer-spouse. The IRS position is that if an employee-spouse is a bona fide employee, the employer-spouse may deduct the cost of the coverage and the value of the coverage also is excludable from the employee-spouse’s gross income.

      However, the IRS will closely examine the situation to determine whether an employee-spouse qualifies as a bona fide employee. Part-time employment does not negate employee status, but nominal or insignificant services that have no economic substance or independent significance will be challenged.9

      1 .IRC Secs. 162(l); 213(d)(1).

      2 .IRC Sec. 162(l).

      3 .IRC Sec. 162(l).

      4 .Rev. Rul. 91-26, 1991-1 CB 184.

      5 .Let. Rul. 9814023.

      6 .Let. Rul. 200007025.

      7 .Rev. Rul. 56-326, 1956-2 CB 100; Rev. Rul. 58-90, 1958-1 CB 88.

      8 .Rev. Rul. 71-588, 1971-2 CB 91; TAM 9409006.

      9 .IRS Settlement Guidelines, 2001 TNT 222-25 (Nov. 16, 2001); see also Poyda v. Comm., TC Summary Opinion 2001-91.

  • 8804. How is health insurance coverage taxed for S corporation shareholders?

    • A shareholder-employee who owns more than 2 percent of the outstanding stock or voting power of an S corporation (based on direct ownership as well as attributed ownership) will be treated as a partner, not an employee (see Q 8803 for the rules applicable to partners).1 Therefore, accident and health insurance premium payments for more-than-2 percent shareholders paid in consideration for services rendered are treated as guaranteed payments made to partners. The result is that an S corporation can deduct premiums under IRC Section 162 and a shareholder-employee must include premium payments in income under IRC Section 61. The shareholder-employee cannot exclude them under IRC Section 106, but may deduct the cost of the premiums to the extent permitted by IRC Section 162(l), as discussed in Q 8803.The IRS released a CCM clarifying that this remains the case even if the 2-percent shareholder-employee is treated as a 2-percent shareholder via the family attribution rules.3

      Planning Point: The IRS has released a set of frequently asked questions based upon the regulations governing the new Section 199A deduction for pass-through entities, such as S corporations.  The FAQ provides that health insurance premiums paid by the S corporation for a greater-than-2-percent shareholder reduce qualified business income (QBI) at the entity level (by reducing the ordinary income used to calculate QBI).  Similarly, when a self-employed individual takes a deduction for health insurance attributable to the trade or business, this will be a deduction in determining QBI and can reduce QBI at the entity and individual levels.4

      With respect to coverage purchased by an S corporation for employees who do not own any stock and for shareholder-employees who own 2 percent or less of the outstanding stock or voting power, the same rules apply as in any other employer-employee situation.

      1 .IRC Sec. 1372.

      2 .Rev. Rul. 91-26, 1991-1 CB 184.

      3 .CCM 201912001.

      4 .FAQ is available at:

  • 8805. What is a health reimbursement arrangement (HRA) and how is it taxed?

    • The IRS defines an HRA as an arrangement that:

      (1) is solely employer-funded and not paid for directly or indirectly by salary reduction contributions under a cafeteria plan; and

      (2) reimburses employees for substantiated medical care expenses incurred by the employee and the employee’s spouse and dependents, as defined in IRC Section 152, up to a maximum dollar amount per coverage period. See Q for a discussion of the impact of the ACA on HRAs.

      A taxpayer is entitled to carry forward any unused amounts in the individual’s account to increase the maximum reimbursement amount in subsequent coverage periods.1 HRAs are not available for self-employed individuals.

      Employer-provided coverage and medical care reimbursement amounts under an HRA are excludable from an employee’s gross income under IRC Section 106 and IRC Section 105(b), assuming all requirements for HRAs are met.2

      Reimbursements for medicine are limited to doctor-prescribed drugs and insulin for tax years beginning after December 31, 2010. Beginning in 2020, the CARES Act permanently removed this restriction so that a prescription is no longer required.3

      An HRA is not permitted to offer cash-outs at any time, even on an employee’s termination of service or retirement. However, it may continue to reimburse former employees for medical care expenses after such events even if the employee does not elect COBRA continuation coverage.4 An HRA is a group health plan and, thus, is subject to COBRA continuation coverage requirements.

      HRAs once could, on a one-time basis per HRA, make a qualified HSA distribution. A qualified HSA distribution is a rollover made before January 1, 2012 to a health savings account (see Q 8825), of an amount not exceeding the balance in the HRA as it existed on September 21, 2006.5

      HRAs may not be used to reimburse expenses that were either incurred before the HRA was in existence or that are deductible under IRC Section 213 for a prior taxable year. An unreimbursed claim incurred in one coverage period may be reimbursed in a later coverage period, so long as the individual was covered under the HRA when the claim was incurred.6

      The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.7

      In 2020, the IRS proposed regulations on direct primary care arrangements and their treatment for HRA purposes.  Direct primary care arrangements are more commonly known as “concierge care”, where an individual and a medical professional enter a contract to cover the cost of medical care for a fee (without the involvement of a traditional third-party insurance company).  Under the regulations, a direct primary care arrangement could be used for medical care or medical insurance.  This would make these payments eligible expenses for purposes of the Section 213 medical expense deduction.  They could also be reimbursed from an HRA if the regulations are finalized.8

      1 .Notice 2002-45, 2002-2 CB 93; Rev. Rul. 2002-41, 2002-2 CB 75. See also IRS Publication 969 (2019) “Health Savings Accounts and Other Tax-Favored Health Plans.”

      2 .Notice 2002-45, 2002-2 CB 93; Rev. Rul. 2002-41, 2002-2 CB 75.

      3 .IRC Sec. 106(f), as added by PPACA 2010.

      4 .Notice 2002-45, above.

      5 .IRC Sec. 106(e).

      6 .Notice 2002-45, 2002-2 CB 93.

      7 .Notice 2006-69, 2006-31 IRB 107; Rev. Proc. 2003-43, 2003-21 IRB 935, supplemented by Rev. Proc. 2007-62; 2007-2 CB 786. See also Notice 2007-2, 2007-2 IRB 254.

      8.See Preamble to the proposed regulations, REG-109755-19.

  • 8806. What ordering rules for reimbursement apply if a taxpayer maintains both an HRA and a health FSA?

    • An employee may not be reimbursed for the same medical care expense by both an HRA and an IRC Section 125 health FSA (see Q 8834). Technically, ordering rules from the IRS specify that the HRA benefits must be exhausted before FSA reimbursements may be made. Despite this, HRAs can be drafted to specify that coverage under the HRA is available only after expenses exceeding the dollar amount of an IRC Section 125 FSA have been paid. Thus, an employee could exhaust FSA coverage, because FSA funds may only be carried over if the FSA specifically permits a carry over (and even then only up to $500 per year can be carried forward), before tapping into HRA coverage, which can be carried over.1

      1 .Notice 2002-45, 2002-2 CB 93.

  • 8807. Can HRA contributions be made via salary reduction or through a cafeteria plan?

    • Employer contributions to an HRA may not be attributable in any way to salary reductions. Thus, an HRA may not be offered under a cafeteria plan, but may be offered in connection with a cafeteria plan. Where an HRA is offered in connection with another accident or health plan funded by a salary reduction plan, a facts and circumstances test is used to determine if salary reductions are attributable to the HRA. If a salary reduction amount for a coverage period to fund a non-HRA accident or health plan exceeds the actual cost of the non-specified accident or health plan coverage, the salary reduction will be attributed to the HRA. An example of the application of this rule can be found in Revenue Ruling 2002-41.1

      Because an HRA may not be paid for through salary reduction, the following restrictions on health FSAs are not applicable to HRAs:

      (1)The ban against a benefit that defers compensation by permitting employees to carry over an unlimited amount of unused elective contributions or plan benefits from one plan year to another plan year.

      (2)The requirement that the maximum amount of reimbursement must be available at all times during the coverage period.

      (3)The mandatory twelve month period of coverage.

      (4)The limitation that reimbursed medical expenses must be incurred during the period of coverage.2

      1 .2002-2 CB 75.

      2 .Notice 2002-45, 2002-2 CB 93.