Other Rulings Relevant to Defined Contributions Plans
In 1989, the U.S. Court of Appeals in the Sixth Circuit discussed the possible implications and restrictions of defined contributions health care plans. In this case, Adkins v. United States, lumpsum payments to employees (taxpayers) made in settlement of lawsuits against a former employer concerning the employer’s proposed termination of contributions to a hospital-medical benefits plan did not fall within provisions of section 106, which excludes contributions by employer to accident or health plans from gross income. The statute did not provide exemption for payments made by the employer directly to employees.
The petitioners in this case were the employees, both current and former, of a corporation that proposed in 1984 to terminate its contributions to a health benefits program for eligible pensioners and surviving spouses. A temporary settlement to the employees’ suit implemented a temporary modified contributory health insurance program. The employer offered employees who did not want to wait for the outcome of the negotiations or the litigation in the case the choice of a lump sum payment or continuing monthly case payments, which would be in full settlement of any claim against the corporation. The lump sum payments ranged from $6,000 to $20,000 and were dependent on each recipient’s age and marital status.
The decision to accept the lump sum payments was entirely voluntary. The pensioners choosing the lump sum payments had to fill out an election and release form and return both to the corporation. The election form advised the pensioners that there could be tax consequences subject to either election. The pensioners who chose the election were not required to use the lump sum or monthly cash payments for the purchase of medical insurance. Several pensioners, including petitioners in this case, made the lump sum payments election and sued to exclude it from taxable income under section 106 of the Internal Revenue Code.
The conclusion reached by the tax court in this case was predictable. What is more telling for the purposes of a defined contribution plan, however, is both the reasoning and the language used by the court:
The pensioners who made the election were not required to use the lump sum or monthly cash payments for the purchase of medical insurance. Some pensioners . . . who elected lump sum payments did not use the payments for the purpose of medical insurance. . . .
Section 106 clearly applies to contributions made by the employer to hospital, medical and accident benefit insurance programs, trusts, or funds. Section 106 does not contemplate, or infer, direct payments to the employee. . . .
It is undisputed that in this case the corporation paid the lumpsum payments in question directly to taxpayers without any use restrictions. The payments are accessions to wealth which must, therefore, be included in income the year of receipt, unless the taxpayers can show that Congress has unequivocally provided an exemption for the payments. See, e.g., United States v. Wells Fargo Bank, 485 U.S. 351, [citations omitted] (1988) (“exemptions from taxation are not to be implied; they must be unambiguously proved”). . . .
The exclusion from income provided in section 106, by its plain terms, applies only to an employer’s “contributions” to “accident or health plans.” There is nothing in the language of the statute that provides an exemption for payments made by an employer directly to employees. As the Tax Court held in Laverty v. Commissioner, 61 T.C. 160, 165 (1973), aff’d, 523 F.2d 479 (9th Cir. 1975). . . .
Section 106 has no application to payments an employer makes directly to his employee. . . . It deals only with the treatment of contributions by an employer to an accident or health plan for the benefit of his employees, either in the form of contributions to a separate fund or trust or by the payment of premiums on a policy of accident or health insurance. . . .
Taxpayers assert that the lumpsum payments were “earmarked specifically for hospital and medical care.”. . . This argument fails because it ignores the fact that the statute also requires that the funds be part of a plan. . . .
Finally, it is worth noting that Congress amended section 106 by section 1151(j)(2) of the Tax Reform Act of 1986 (Public Law 99-514, 100 Stat. 2085). Section 106(a) now provides that “gross income of an employee does not include employer-provided coverage under an accident or health plan.”9 [emphasis added]
In Cernik v. Commissioner, a former municipal employee sued to have his disability payments excluded from taxable income. The tax court ruled against Cernik. Disability payments are not exclusions from income under section 106. The outcome in Cernik, as it was in Adkins, was predictable. However, once again the language is informative. The court stated:
A former municipal employee could not exclude from gross income either the short-term or the long-term disability benefits that he received under employer- sponsored disability plans because the benefifits were either paid directly by the employer or were attributable to employer contributions that were not includible in the employee’s income. Pursuant to Code Secs. 104(a)(3) and 105(a), premiums paid by the taxpayer to a prior disability plan outside the relevant three-year look-back period were not taken into account for purposes of determining whether the benefits at issue were “attributable to contributions by the employer.”. . .
The taxpayer’s alternative argument that his disability payments were excludable under Code Sec. 105(c) as amounts received through accident or health insurance for personal injuries or sickness was rejected because the benefits were not computed with reference to the nature of his injury. Instead, the record established that the benefits were calculated with reference to the taxpayer’s salary and his years of service and did not vary depending on the injury or illness suffered.
The plain language of section 106 of the U.S. Code, the revenue rulings, and the tax court rulings discussed here suggest that a defined contribution health plan is a viable alternative to current defined benefits plans. The big questions arise in the administration of and transition to a DC approach.
The rulings make it clear that a trust or voucher system is necessary— wherein both proof of purchase and system accountability are in place. Merely earmarking funds for employee use is not enough. 11 The employer must maintain a separate trust account that uses either a voucher program or a joint payee program.
Any program adopted by the employer should include a mechanism of proof of health insurance purchase by the employee to avoid employer contributions from being subject to taxation as wages to the employee. In a voucher program, employees would submit vouchers to the trust administrator to pay the employer’s contribution to the carrier for the employee-selected plan. Payment for employee plans that exceeded the employer’s contribution limit would have to be supplemented by the employee.
Alternatively, employers could set up a system that allowed employees to submit premium notices to the administrator of the trust or a paymaster, who would in turn cut checks made payable jointly to the employee and the carrier.
It is certain that a defined contribution health care plan is a viable alternative to the current defined benefits health care plans. Section 106 of Title 26 of the U.S. Code makes it clear that a defined contribution by an employer to an employee health care plan would be excludable from the employee’s taxable income. Thus the first hurdle in a defined contributions plan is crossed. The other areas that need to be more fully examined are the administration, implementation, and application of a defined contribution plan, as well as the possible application of ERISA, COBRA, and other applicable federal and state labor laws and regulations.
But from a tax perspective, the good news remains that a defined contribution model is an avenue for possible reform.
The latest revenue ruling directly affecting DC plans was issued June 26, 2002, by the IRS and the U.S. Treasury Department regarding the tax consequences of HRAs12 (health reimbursement arrangements), which are in the defined contribution (DC) health plan family. To the extent that an HRA is an employer-provided accident or health plan, coverage and reimbursements for medical care expenses of an employee and the employee’s spouse and dependents are generally excludable from the employee’s gross income under sections 106 and 105. The revenue ruling and notice contain some much-needed guidance as well as some good news. First, HRAs that are funded solely by the employer (and not by salary reductions) can permit carryovers of unused amounts from year to year (that is, the use-it-or- lose-it rule does not apply). Second, HRAs are not subject to the onerous rules15 that apply to health FSAs (flexible spending arrangements).
Several other points of note regarding HRAs include the following: 17 (1) HRAs can reimburse only substantiated medical expenses, as defined in U.S. Code section 213(d); (2) HRAs may reimburse employees for the purchase of health insurance (beware of potential HIPAA as well as other issues); (3) for employers with both an HRA and a salary reduction–funded health FSA, the HRA may specify that coverage under the HRA is available only after expenses exceeding the dollar amount of the health FSA have been paid (that is, the health FSA pays first and the HRA pays second); (4) HRAs may provide for continued access to unused HRA amounts by former employees (including retirees), but cash-outs are not permitted; and (5) HRAs are subject to COBRA’S continuation requirements.