Employee Tax Payments and Consumer-Driven Health Care
In a defined contribution plan, an employer allocates to each employee a set dollar amount for the purchase of health care services—that is, for the purchase of the health care policy or for an allocation into a health care account or for both. The allocation can be used for the premium only, for the employer-sponsored health insurance account only, or for a percentage of each. Defined contribution allows employees to fine-tune coverage to their individual needs. This contrasts with the present typical defined benefits plan wherein the employer does all the legwork, employees’ options are limited, and satisfaction is often limited.
Of course there are income tax considerations when an employer changes from a defined benefit to a defined contribution plan. I review the major considerations here.
The first question the employer will need to ask is, Are defined contributions tax deductible—like defined benefits? The answer is yes. The answer to the next important question—What is the impact of the transition from defined benefits to defined contribution plans on the income tax situation of the employee?—is less clear.
Application of The Tax Law to Defined Contributions Plans
Section 106 of Title 26 of the U.S. Code governs the application of federal and state income tax to a defined contribution health care plan:
Sec. 106. Contributions by employer to accident and health plans. (a) General rule Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan.
Although the plain language of the statute is broad, fortunately federal regulation 1.106-1 makes it clear that a defined contribution is both viable and excludable from taxable income: Sec. 1.106-1. Contributions by employer to accident and health plans. The gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by him, his spouse, or his dependents, as defined in section 152. The employer may contribute to an accident or health plan either by paying the premium (or a portion of the premium) on a policy of accident or health insurance covering one or more of his employees, or by contributing to a separate trust or fund (including a fund referred to in section 105(e)) which provides accident or health benefits directly or through insurance to one or more of his employees. However, if such insurance policy, trust, or fund provides other benefits in addition to accident or health benefits, section 106 applies only to the portion of the employer’s contribution which is allocable to accident or health benefits. (See paragraph (d) Sec. 1.104-1 and Secs. 1.105-1 through 1.105-5, inclusive, for regulations relating to exclusion from an employee’s gross income of amounts received through accident or health care insurance and through accident or health plans.)
Implication of The Law
The method of implementation of a defined contributions program affects the tax status. Several revenue rulings and U.S. Tax Court cases address the issue.
A revenue ruling3 released in 1961 concluded that reimbursements by an employer to his employees for the employer’s share of the premiums for hospital and medical insurance provided or purchased by his employees may be considered as contributions by the employer to accident or health plans for his employees. A designation of the reimbursements by the employer would result in the exclusion of such payments from the gross income of the employees under section 106 of the Internal Revenue Code of 1954. (The current code includes section 106.)
The application of section 106 and the exclusion of taxable income to the employees were distinguished by the administration of the reimbursement. In this case an employer had a group plan in which some of his employees participated. The employer also reimbursed employees who did not participate in the group plan for individual insurance expenses. The ruling turned on the following points:
To facilitate payment of his share of the premiums paid directly by the employees to the insurers, the employer used the following methods:
(1) reimburses each employee directly once or twice a year for the employer’s share of the insurance upon proof of prior payment of the premiums by the employee; or
(2) issues to each employee a check payable to the particular employment based insurance company, the employee being obligated to turn over the check to the insurance company; or
(3) issues a check as in method (2) except the check is made payable jointly to the insurance company and the employee.
The Internal Revenue Service (IRS) concluded that each of these methods constituted employer payments of accident or health insurance premiums for employees because all met the necessary proof requirements. Both methods 2 and 3 included proof via checks from the employer made directly or jointly to the carrier and method 1 required proof of prior payment of premiums. Accordingly, the IRS concluded the amounts paid were excludable from the gross income of the employees under section 106 of the Internal Revenue Code.
In contrast, a previous revenue ruling5 addressed the allotment of a defined contribution as a part of wages in the context of a negotiated agreement between an employer and an employee union. The conclusion reached by the IRS confirms that certain payments made to employees pursuant to a union contract constitute “wages” for federal employment tax purposes.
In the case on which the ruling was made, an employers’ association negotiated an agreement between the association on behalf of its members and the employees’ union, obligating the member employers to pay a stipulated weekly sum to each employee covered by the agreement for the purchase of individual hospitalization and surgical insurance coverage. The parties specifically agreed that the sum paid was to be used for the “express purpose” of purchasing the hospitalization and surgical insurance for covered employees. The union made direct arrangements with a hospital service for the stated purpose, and payments made under the contract were used exclusively for the contracted purpose.
Under the U.S. Code, “wages” consist of all remuneration for services performed by an employee for his employer, including the cash value of all remuneration paid in any medium other than cash, with certain immaterial exceptions. The IRS concluded that the payments in questions were required under the terms of a labor agreement governing employee relations of the employers involved, the payments were directly related to the services performed by the employees, and the payments were made directly to each employee. “Thus,” according to the ruling, “they constitute a basic part of the compensation of each employee involved. Accordingly, it was held that such payments which are made by the employers directly to the employee constitute ‘wages’ for ‘employment’ for purposes of the Federal employment taxes and are includible in the gross income of the employees under section 61 of the 1954 Code.” The fact that the union assumed the responsibility for the disposition of such payments by the employees was deemed immaterial.
Administrative Implications of Consumer Driven Health Care
The ruling against the union muddies the 106 waters for employers of “union member” employees, who have submitted to employer-provided “mandated” health care benefits determined by a collective bargaining agreement. (The tax court can, and probably will, rule that by definition, wages and remuneration dictated by collective bargaining—regardless of form: for example, benefits, health, retirement, and so forth—are all included in the collectively bargained “wage package.”)
However, exceptions to the ruling can occur for nonunion employers, particularly small employers (less than one hundred employees), or for union employees whose health care packages are tailored to them and not tied to the collective bargaining agreement. (How to accomplish this is another question.) Thus whether a defined contribution plan can be excluded under section 106 seems to depend on the existence of an “open” health care plan, that is, one that is not a mandatory employer-provided (collective) benefit, as part of wages or salary. The way benefits packages are structured and presented to employees may well determine the application of 106.
The revenue rulings addressed here in the text and the notes are the only rulings that relate directly to defined contributions. (Most of the tax court rulings have been modeled on Revenue Ruling 61-146.)
Although the case law is limited, it is probable that some direction can be drawn from pension fund litigation, particularly that involving 401(k) plans. A 401(k) plan is somewhat analogous to a defined contribution health care plan in its administration, implementation, and application.