Reimbursements of pre-tax health insurance contributions are taxable.

• Author: Packard, Pamela

In January 2002, the IRS ruled in Rev. Rul. 2002-3 that a company's reimbursement of an employee's pre-tax salary reduction used to pay for health insurance was not excludible from gross income under Sec. 106(a) or 105(b) and was subject to withholding and employment taxes.

In the ruling, an employer designed its health plans so that an employee paid all or a portion of the health insurance premium through pre-tax salary-reduction contributions. That would reduce the employee's FICA and FUTA wage base on which Federal payroll taxes are assessed. The employer then reimbursed the employee for a portion of the contributions.

Example: Employer Z provides health coverage for its employees through a group health insurance policy that qualifies for exclusion coverage under Sec. 106(a). Z has a payroll arrangement under which it reduces its employees' salaries and applies the salary-reduction amounts to health insurance premium payments for the employees. Thus, the employee receives a lower salary in exchange for employer-provided health coverage. In addition, Z makes "reimbursement" payments to its employees for the health insurance premiums in amounts that adjust the employee's after-tax pay from Z to be the same as it would have been if there were no salary-reduction and no reimbursement payments. Z takes the position that both the salary reduction and the reimbursement payments are excludible from its employees' gross income and not subject to FICA or FUTA taxes.

If Z's position were correct, the tax planning advantages would be significant. For example, if a health plan costs $100 a month, an employee would pay 25% of the premiums, or $25 a month on a pre-tax basis. If the employer then restructured the plan so that the employee would pay the entire $100 monthly premium on a pre-tax basis, it would end up reimbursing the employee $75 a month. Thus, each party's share of the premium remains identical. After the plan restructuring, the employee's FICA income is reduced by $100 a month under the assumption that the employee does not pay tax on the $75 reimbursement. As a result, the employer saves over $45 in FICA taxes because of the employee's reduced FICA wage base. The employee would receive similar tax savings. Under this plan structure, a large employer reaps considerable payroll tax savings.

IRS Analysis

The IRS noted that under Sec. 106(a), an employee's gross income does not include employer-paid health plan coverage. Under Sec...