Summary: Employer-paid health benefits included as W-2 taxable wages is an accounting error that appears to flourish this year due to misinterpretation of tax laws surrounding the Affordable Care Act by small business accountants. The error financially hurts employees by overstating tax liability and reducing eligibility for various tax credits. Fix the error by talking to your employer, your accountant or the IRS before filing your 2015 personal tax return.
Employees of small businesses may be surprised to see that their W-2 for 2015 includes amounts for employer-paid health benefits as taxable wages. This is an accounting error that should be corrected immediately before filing your personal income tax return.
Employer-paid health benefits – whether through insurance or other uninsured health benefits – are not taxable income to employees. The Affordable Care Act (ACA) changed many other aspects of our tax laws but this basic law under Internal Revenue Code 106 remains unchanged. The general rule as simply stated in the tax law is “Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan”. The rare exceptions to this general rule apply mostly to Medical Savings Accounts and Health Savings Account contributions that are otherwise above the allowable limits.
The confusion began when, effective July 1, 2015, some small business employers became subject to a new excise tax for providing certain types of employee health benefits. This new tax does not change the tax aspects for employees. Some employers and their tax advisers have suggested that by including employer-paid health benefits in an employees taxable wages the employer may avoid the new excise tax. The IRS specifically stated this is not true yet there seems to be some confusion even among tax experts.
What is an employer-paid health benefit?
According to IRS and Department of Labor, an employer paid health benefit is one where the employee did not have the option of choosing cash wages instead of the health benefit. Employer-paid health benefits do not include amounts paid solely through a voluntary payroll reduction practice where the employee has voluntarily elected to have the employer forward some amount of post-tax wages to a health insurance issuer with no contribution by the employer (IRS Notice 2013-57 and DOL 29 C.F.R. §2510.3-1(j)).
For example, assume an employee’s salary is $15 per hour. The employer also pays part of the cost of the employee’s health insurance. Normally this would be an employer-provided health benefit. But if the employee had the option to be paid a salary greater salary, say $17 per hour, but instead opted to have the payroll company send the difference ($2 minus the applicable wage taxes) to a health insurance company to pay premium expenses, then this is not an employer-sponsored plan. (Note that while these voluntary payroll arrangements are likely to grow in popularity in the future, the large majority of small businesses did not offer these in 2015 so this is not likely to apply to a W-2 for 2015).
What is the harm of improper wage reporting?
When health benefits are included in you taxable wages the result is that you are over-charged for several types of wage taxes. Your federal and state income taxes are improperly increased. Your charges for social security and other payroll-based social benefits are overstated.
Even worse, your benefits under other income-based tax programs might be reduced or eliminated. You could lose all or part of the Earned Income Tax Credit (EITC), individual health insurance premium credit, education credits, dependent care credits, savers tax credit and more.
For all of these reasons, it is important that your W-2 list the proper amount of wages without employer-paid health benefits.
How to correct the W-2 error
If the amount in Box 1 on your W-2 includes an amount that your employer paid for health insurance or other health benefits, you should first ask your employer for a corrected W-2 as quickly as possible1. If the employer is unfamiliar with the issue, you might consider showing them this article.
If the employer won’t issue the corrected W-2 then simply call the IRS at 800-829-1040 to to request that an IRS representative initiate a Form W-2 complaint. (It is important that you use the term “Form W-2 complaint” to save time and communicate effectively to the IRS representative).
The IRS will send your employer a letter requesting that they furnish you a corrected Form W-2 within ten days. The letter advises your employer of their responsibilities to provide a correct Form W-2 and of the penalties for failure to do so.
The IRS will send you a letter with instructions and Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. You can use the Form 4852 in the event that your employer does not provide you with the corrected Form W-2 in time to file your tax return.
What is the immediate impact?
You need a correct W-2 to file your 2015 personal income tax return. You should not file your 2015 income tax return until you ave the corrected W-2 or the Form 4852 as described above. If you did already file, an amendment is necessary.
What is the impact to the employer?
Employers who provide incorrect W-2 statements are subject to a penalty. That penalty increased for 2015. In some cases those W-2 penalties can be abated.
If the employer is still making payments toward employee health benefits targeted by ACA – mostly individual insurance and reimbursement arrangements – this procedure needs to be stopped or amended immediately to avoid further taxes. Again, those excise tax penalties for 2015 can be abated. I’ve written about a strategy (presented as a “toolkit“) to correct the problem by formally amending the employer health plan for 2016 and using this documentation of voluntary compliance correction to help argue the case for abatement of the 2015 penalty.
1 This article does not address amounts shown on Form W-2 in Box 12 with the code “DD” for informational purposes only that does not affect your individual income taxes and is a voluntary reporting for small businesses in 2015.