In many respects, the federal tax treatment of group medical (including group dental) expense premiums and benefits parallels that of other group coverage if they are provided through an insurance company, a Blue Cross—Blue Shield plan, an HMO, or a PPO. Contributions by the employer for an employee's coverage or the coverage of the employee's dependents are tax deductible to the employer, as long as the employee's overall compensation is reasonable. Employer contributions do not create any income tax liability for an employee. Moreover, benefits are not taxable to an employee except when they exceed any medical expenses incurred. The value of any employer-provided coverage for an employee's domestic partner, minus any employee contributions, represents taxable income to the employee unless the partner qualifies under IRS rules as the employee's dependent.
One major difference between group medical expense coverage and other forms of group insurance is that a portion of an employee's contribution for coverage may be tax deductible as a medical expense if that individual itemizes his or her income tax deductions. Under the Internal Revenue Code, individuals are allowed to deduct certain medical care expenses (including dental expenses) for which no reimbursement was received. This deduction is limited to expenses (including amounts paid for insurance) that exceed 7.5 percent of the person's adjusted gross income.
If a sole proprietorship or partnership pays the cost of medical expense coverage for a proprietor or partner (including dependent coverage), this amount constitutes taxable income to the proprietor or partner. However, the proprietor or partner may be entitled to an income tax deduction for a percentage of this amount. As a result of recent legislation, this deduction is 60 percent through 2001, 70 percent in 2002, and 100 percent thereafter. The deduction cannot exceed the individual's earned income from the proprietorship or partnership that provides the medical expense plan, and the deduction is available only if the proprietor or partner is not eligible to participate in any subsidized medical expense plan of another employer of the proprietor, the partner, or the proprietor's or partner's spouse. It is important to recognize that this is not an itemized deduction; rather, it is a deduction in arriving at adjusted gross income. The remainder of the cost of the medical expense coverage can be deducted as an itemized expense to the extent that it and other medical expenses exceed the 7.5 percent threshold previously described.
As of 1999, there is one circumstance under which a self-employed person, other than a more-than-2 percent owner-employee of an S corporation, can receive a 100 percent deduction for his or her medical expense coverage. This occurs only if the spouse is a bona fide employee of the self-employed person. The medical coverage is then provided to the spouse, who elects dependent coverage for the self-employed person. The self-employed person then pays the entire premium and takes a business deduction for the medical expense coverage provided to an employee. However, the IRS has indicated that such an arrangement will be challenged if the spouse's involvement in the business consists of nominal or insignificant services that have no economic substance or independent significance. Note that if there is a significant investment of the spouse's separate assets in the business, the spouse is employed in the business as a joint owner and treated as self-employed person rather than an employee for purposes of the medical expense insurance.
The tax situation may be different if an employer provides medical expense benefits through a self-funded plan (referred to in the Internal Revenue Code as a self-insured medical reimbursement plan), under which employers either (1) pay the providers of medical care directly or (2) reimburse employees for their medical expenses. If a self-funded plan meets certain nondiscrimination requirements for highly compensated employees, the employer can deduct benefit payments as they are made, and the employee has no taxable income. If a plan is discriminatory, the employer still receives an income tax deduction. However, all or a portion of the benefits received by "highly compensated individuals," but not by other employees, are treated as taxable income. A highly compensated individual is defined as (1) one of the five highest-paid officers of the firm, (2) a shareholder who owns more than 10 percent of the firm's stock, or (3) one of the highest-paid 25 percent of all the firm's employees. There are no nondiscrimination rules if a plan is not self-funded and provides benefits through an insurance contract, a Blue Cross—Blue Shield plan, an HMO, or a PPO.
To be considered nondiscriminatory, a self-funded plan must meet certain requirements regarding eligibility and benefits. The plan must provide benefits (1) for 70 percent or more of "all employees" or (2) for 80 percent or more of all eligible employees if 70 percent or more of all employees are eligible. The following can be excluded from the all-employees category without affecting the plan's nondiscriminatory status:
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Employees who have not completed three years of service.
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Employees who have not attained age 25.
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Part-time employees. Anyone who works fewer than 25 hours per week is automatically considered a part-time employee. Persons who work 25 or more but fewer than 35 hours per week, may also be counted as part-time, as long as other employees in similar work for the employer have substantially more hours.
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Seasonal employees. Anyone who works fewer than seven months of the year is automatically considered a seasonal employee. Persons who work between seven and nine months of the year may also be considered seasonal, as long as other employees have substantially more months of employment.
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Employees who are covered by a collective-bargaining agreement if accident-and-health benefits were a subject of collective bargaining.
Even if a plan fails to meet the percentage requirements regarding eligibility, it can still qualify as nondiscriminatory, as long as the IRS is satisfied that the plan benefits a classification of employees in a manner that does not discriminate in favor of highly compensated employees. This determination is made on a case-by-case basis.
To satisfy the nondiscrimination requirements for benefits, the same type and amount of benefits must be provided for all employees covered under the plan, regardless of their compensation. In addition, the dependents of other employees cannot be treated less favorably than the dependents of highly compensated employees. However, because diagnostic procedures are not considered part of a self-funded plan for purposes of the nondiscrimination rule, a higher level of this type of benefit is permissible for highly compensated employees.
If a plan is discriminatory in either benefits or eligibility, highly compensated employees must include the amount of any "excess reimbursement" in their gross income for income tax purposes. If highly compensated employees receive any benefits that are not available to all employees covered under the plan, these benefits are considered an excess reimbursement. For example, if a plan pays 80 percent of covered expenses for employees in general but 100 percent for highly compensated employees, the extra 20 percent of benefits constitutes taxable income.
If a self-funded plan discriminates in the way it determines eligibility, highly compensated employees have excess reimbursements for any amounts they receive. The amount of this excess reimbursement is determined by a percentage that is calculated by dividing the total amount of benefits highly compensated employees receive (exclusive of any other excess reimbursements) by the total amount of benefits paid to all employees (exclusive of any other excess reimbursements). Using the previous example, assume a highly compensated employee receives $2,000 in benefits during a certain year. If other employees receive only 80 percent of this amount (or $1,600), the highly compensated employee has received an excess reimbursement of $400. If the plan also discriminates in the area of eligibility, the highly compensated employee incurs additional excess reimbursement. For example, if 60 percent of the benefits (ignoring any benefits already considered excess reimbursement) are given to highly compensated employees, 60 percent of the remaining $1,600 ($2,000 - $400), or $960, is added to the $400, for a total excess reimbursement of $1,360.
If a plan provides benefits only for highly compensated employees, all benefits received are considered an excess reimbursement, because the percentage is 100 percent.
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