Disagreements about taxation of individual health insurance in 2014

It seems that the most confusing tax topic this year in the wake of the Affordable Care Act implementation is the taxation of individual health insurance when an employer is involved in the payment of the cost. No doubt other confusing issues are still on the horizon, but this one is here and now. Small business clients seeking an answer now are sometimes met with conflicting opinions on the issue.

The legal community has been equivocal on its position against the use of individual insurance as an employer paid expense in 2014. Meanwhile, CPAs have been noticeably quiet on the topic after issuance of Internal Revenue Bulletin 2013-40. My take is that accountants are still trying to take it all in, and certainly there are many nuances to consider before forming an opinion. This blog post is meant to break that silence among accountants and perhaps stir some more discussion.

What others are saying

Here is a summary of some of the better-written commentary:

Angela Bohmann, an attorney with Stinson Leonard Street writes in her blog post “Employers were hoping that by providing funds to employees to purchase coverage on the individual market, the employer could avoid the penalty for failure to offer coverage while limiting the employer’s cost. In recently issued guidance, the IRS and the Department of Labor have essentially said no to this alternative.” (emphasis added) Note that Ms. Bohmann hedges her statement, much like I did in my article on the same topic, based on independent research. Her article also reaches the same conclusions on some other points: “The IRS did not revoke the 1961 Revenue Ruling permitting pre-tax payment of employee premiums for individual market policies.  Some employers are hoping that they can continue to allow employees to pay for individual market health insurance policies on a pre-tax basis through a cafeteria plan even if the employer provides no subsidy for the coverage.  The recent guidance is not clear on that point.” (emphasis added)

Law firm Alston and Bird LLP publishes a well-written opinion on the impact of ACA on individual health insurance. The author is not identified. Their conclusion is stated: “Thus, the Agency Guidance (referring to IRS Notice 2013-54 and Technical Release 2013-03) indicates that any arrangement that provides for the purchase of IM Coverage on a pre-tax basis will fail PHSA Sections 2711 and/or 2713.” (emphasis added) I am not convinced by Alston’s summary conclusion. The author takes a giant leap from the guidance’s lengthy discussion of disallowed reimbursement plans to saying “any plan” without a discussion of other possible arrangements that might fall into the category of “employer payment plan” and not fall into the category of reimbursement plan. An example is presented below in the one employee corporation situation.

The insurance brokerage firm Parker Smith Feek states “The DOL recently issued Technical Release 2013-03 which answers a question that has been unclear since the Affordable Care Act (ACA) was passed. Can employers pay for the purchase of individual health insurance plans for employees on a tax-free basis? The DOL’s answer to this question is no.  emphasis added. We should be generally skeptical of posts be the employee benefits industry because of their financial addiction to group health insurance commissions.

Likewise, firms that sell software and individual health insurance exchange support services like Zane Benefits have the opposite financial interests and are among the strongest proponents of the use of individual health insurance in employer-paid situations. I avoid specific citations of Zane Benefits statements.

Getting to the heart of the issue

The IRS logic in the 2013 guidance is based on the assumption that employer payments are part of a qualified employee benefit plan and all of the published guidance focuses on various types of qualified employee health benefit plans. We might borrow concepts learned from the estate tax planning field where it is common to deliberately fail to meet a code section laid out in the tax code in order to default into different and more desirable tax treatment.

The one person corporation example

Theorems may be best tested by consideration of an example that defies the principle. For that purpose, consider the case of a one employee “C” corporation. This employer is bared from the group health insurance market (in most states) by virtue of the single employee. Most states consider a one person business to be a candidate for individual insurance, with two employees the minimum for a group health insurance plan. The employee is not eligible to claim a self-employment health insurance deduction. None of these fact patterns changed with the implementation of the Affordable Care Act; one person “C” corporations are well-accustomed to reporting health benefits as a non-taxable benefit to the employee. Was this meant to change with implementation of the Affordable Care Act? There is no indication whatsoever in the new guidance that this business cannot continue to deduct the cost of insurance for this employee. Of greater interest, there is no guidance stating that insurance purchased by this business outside of an employee benefit plan is taxable to the employee. Should we now conclude that every payment of health insurance by corporations with one employee are now taxable to the employee? I suspect that a CPA is warranted and has reasonable basis to not change the tax treatment of this transaction for 2014 in the absence of further guidance from the Service.

Audit consideration approach

Accountants sometimes consider a tax position in terms of the audit procedures and legal procedures that might be used to challenge a specific tax position. While audit procedures do not determine the law, and I’m not suggesting “do it if you think you’ll get away with it”, the consideration of audit procedures does help clarify the step-by-step application of the law and testing logic that might be used to interpret the law in questionable situations.

In this case, the validity of the business deduction for an insurance payment for individual health insurance might be questioned in a full audit of the company. I am not aware of any basis upon which the deduction might be challenged if paid on behalf of a legitimate employee. The second step would be to consider the tax withholding and treatment. The basis for which IRS might assert taxes would be to claim that the payment was part of an “employer-sponsored employee health benefit plan”. It seems less likely that the Service would assert this to be a “group health plan”. By the services’ own requirements an employer-sponsored health benefit plan must be in writing. In the example proposed we presume that there is no written employee benefit plan. From a technical perspective, we could argue that any attempt to form a qualified employee benefit plan was defeated by failure to meet documentation requirements. What we are left with in this theoretical audit example is a check written by an employer that is or is not taxable compensation to the employee. Given the current language of the law and recent guidance, it is my opinion that any tax court would find it difficult to conclude that the payment amount is taxable to the employee.

Conclusion

My conclusion is that we are likely to receive more guidance from Treasury Department on this issue. Common sense and experience tells me that guidance is more likely to be influenced by the political climate in the future rather than technical explanation of prior positions.

 

A closer look at the self-employed health insurance tax deduction

The self-employed health insurance deduction seems simple at first glance but can trigger tricky questions when dealing with the details. Unlike other business expenses and itemized deductions, this is a separate deduction taken on the first page of the Form 1040 tax return. Because of its “above the line” status this deduction can be more valuable in reducing overall taxes than other deductions. Additionally, and perhaps more important, the deduction directly affects the amount of health insurance subsidy for modest income self-employed taxpayers.

These are some notes I made for myself in a recent review of the subject:

  • Self-employed health insurance deduction can be taken for medical, dental and long-term insurance
  • Self-employed health insurance deduction is described IRS Pub 535 “Business Expenses”
  • There are several ways to deduct health insurance on a tax return
  • Pay attention to what portion of the payment made is qualified as a deductible health insurance premium – some of the payment to an insurer may not be
  • Self-employed health insurance deduction includes the amount paid for children under age 26 even if they are not a dependent
  • Self-employed health insurance deduction is an “above the line” deduction but cannot be duplicated by a deduction on Schedule A (itemized deductions).
  • Self-employed health insurance is generally better than Schedule A deduction but is limited to the amount of your health insurance deduction. Additional amounts are reported in Schedule A.
  • Self-employed health insurance deduction can actually be a tricky item when preparing tax returns and manual adjustments are sometimes necessary to override the computer-generated tax returns.

How to handle shock health insurance increases

Today’s Wall Street Journal brought the confirmation that most health insurance advisers already suspected. Medical care utilization under the new Obamacare policies is at record levels. The coming rate increases of high health insurance renewal rates for 2015 and 2016 will pose a financial shock to policyholders. But if you believe as I do that “We have to skate toward where the puck is going to be, not to where it has been” then today’s confirmation should be a call to action.

How will policyholders react when presented with unprecedented premium increases? The nation’s financial advisers and health insurance enrollment firms must adjust strategies to be ready for the market response. We have to be ready to answer consumers when the shock of their premium renewal notice arrives in their mailbox.

The likely response from government will be to simply delay rather than cancel various components of health care reform. (This is the consensus opinion at this time despite increased attention over the past few days to bipartisan political efforts for repeal of some provisions). For affected individuals, this means the health insurance mandate and its related penalties. I predict that penalties will be rolled back for those affected by shock increases. The administrative actions intended to eliminate non-compliant but less expensive health plans will likely also be postponed.

Consumer response is also predictable. We know that rate increased greater than 15% (for example) result in dramatically higher turnover of insurance policies. I expect non-renewal rates of existing Obamacare policies to be about 30% or higher for 2015 and 2016. That means 2 to 3 million people will be desperate for an answer and millions more under significant financial stress due to increasing health care costs.

What can we do to prepare for unprecedented health insurance premium rate increases?

1) Have alternative insurance and non-insurance health plans available. While the coverage is not as good, at least this is an affordable and therefore “doable” solution for those priced out of the health care market. This is especially important to working class people who live in states like Pennsylvania that have not expanded Medicaid enrollment.

2) Talk to families about isolating and managing financial risks. In states with “doctrine of necessities” laws, relatives are financially responsible for uncovered medical care. Health care providers are increasingly adept at locating and enforcing payment for care of a parent, estranged spouse or even an adult child.

3) Propose bold solutions. For some who will be caught in unenviable position of chronic high health care expenses without the ability to afford insurance, the best option may be to relocate to an area where they would have access to care. State control of health insurance is not going to change anytime soon, so the dramatic differences between state coverage and affordability will continue to exist for the foreseeable future.

4) Remain politically active for the long term but do so in a positive manner that is more likely to effect change. There is far too much “Obamamcare bashing” that achieves nothing. Only positive forward-moving influences will be effective.