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Tax update for consumer driven health plans
by Tony Novak, CPA, MBA, MT
This article was originally published 6/15/2004 and last updated 1/29/2011.
Tax treatment of health benefits provided through the new breed of health plans described as “consumer-driven health plans” can be a confusing issue for people switching from traditional health plans. Potential tax issues arise primarily when health benefit payments are not made through a group health insurance plan. The IRS listed this topic as an administrative priority for clarification and then issued a series of publications, revenue rulings and announcements over the past few years. These recent clarifications help in many cases but some lingering uncertainties remain that will likely lead to reporting errors and future IRA enforcement actions for some taxpayers.
The good news is that there are more ways to provide employees with tax-free health benefits than ever before. The new generation of consumer-driven health plans is more efficient and can provide benefits at a significantly lower cost than would be possible through an insured health plan. But these changes bring additional questions and the risk of tax abuse. The IRS fears that risk of abuse is highest in health plans that use special debit cards to pay for out-of-pocket medical expenses. These plans are very popular with employees, but are also the most problematic from an accounting perspective. Public accountants who observe or audit health plans indicate privately that the IRS is probably correct in this assumption of abuse but no publicly available audit information from IRS or other source is available yet to support this position.
Several problem items were addressed and resolved in recent months. Revenue Ruling 2002-80 stated that advance reimbursement payments made by an employer are taxable income to employees. Revenue Ruling 2003-43 addressed taxation of benefits paid through employer funded debit cards. This ruling also clarified the requirement for “independent third party claim substantiation” applies equally to FSAs, HRAs and Section 125 plans. Payments without substantiation would be treated as advance payments beginning January 1, 2004. Revenue Ruling 2003-102 explains that the deductions allowed for reimbursement of employee health expenses under IRC 105(b) are more liberal than itemized deductions allowed for individual taxpayers under IRC 213 and clarified earlier in the year in Revenue Ruling 2003-58. Specifically, the IRS clarified that most non-prescription drugs may be covered under an employer health plan and that there is no requirement that a covered expense be qualified under IRC 213. IRS News Release 2003-108 clarified that this allowance also extended to Flexible Spending Accounts that are funded with employee voluntary salary deductions. IRS Notice 2004-2 provided administrative and procedural detail for health savings accounts but did not address the reporting requirements for health insurance plans.
Potential tax problems
The tax issues that pose potential problems include:
- Owners of sole proprietorships, S-corporations and partners are not eligible employees for HRA plans that provide uninsured benefits.
- Eligibility for HSA deductions is not electronically verified by health insurance companies.
- The procedural requirements for “independent third party” claim verification is vague, especially with regard to small closely held companies.
- Benefits paid through an HRA or FSA plan prior to the date of verification creates a possibility of under-reporting of wage withholding taxes.
- Interactions when various plans used in combination: Flexible Spending Accounts, Medical Reimbursement Plans, Health Savings Accounts, Healthcare Reimbursement Arrangements as well as health insurance plans. (Many of these interaction issues were addressed in the revised IRS Publication 969 after the original date of publication of this article).
Many of the accounting and consulting requests received by Freedom Benefits Association this year centered on the handling of employee payments under a Healthcare Reimbursement Plan (HRA). This is an economically sensitive issue since a number of larger HRA administration firms charge significant fees for ongoing claim verification service that may or may not be necessary expense for small business employers. Smaller firms, especially family businesses, are interested in administering the health plans themselves to save costs. It seems possible that future legislation will ease the burden to require only an annual audit of health plans rather than requiring ongoing claims substantiation. Future clarification by IRS could liberalize the timeline for verifying health benefit payments to eliminate the risk of wage tax underpayment penalties.
In the meanwhile, an employer should follow these basic provisions to avoid problems with an uninsured health plan:
- The benefit plan should be in writing and communicated to all employees.
- Amounts paid to employee accounts are taxable wages until verified as non-taxable under one of the procedures listed below.
- If the firm has employees covered by an uninsured health plans who are not family members, verification of health claims should be done be an independent third party on at least a quarterly basis to avoid wage tax problems. The small business owner or internal benefits managers should not review employee health claims because this could be used to document violations of HIPAA law and be used in a legal claim against the employer in an employment discrimination issue. Keep a copy of this verification with the company’s permanent tax records.
- For health savings accounts, retain a copy of the title page of the qualifying health insurance policy or policies and evidence showing the dates of coverage for each participant. If the title page of the policy does not state “Health Savings Account Qualified” or some similar wording, then obtain a separate statement on the insurance company’s letterhead to clarify this eligibility. (IRS will not accept a third party statement for this purpose). These records should be kept with the companies permanent tax records.
- When combining two or more health plans, the company’s accountant should complete a checklist of tax compliance to assure that no benefits will be taxable. It is not possible to rely solely on either the health insurance company or the benefit plan administrator when two or more separate health plans are used in combination.
An employer who follows these five simple compliance procedures will avoid almost all of the current tax problems facing consumer-driven health plans.
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