Among the many changes the Patient Protection and Affordable Care Act (PPACA) has triggered, amendments to the tax code rank high. Employers and those who advise them may have questions about what expenses qualify for deductions, which tax credits they can take advantage of, and what the new rules mean for grandfathered plans. Individuals may be wondering how HSA distributions are taxed, or whether benefits received under a personal health insurance policy are taxable. If these or other questions are coming your way, fear not, we have the well-researched answers you’re looking for.
1. Are premiums paid for personal health insurance deductible as medical expenses?
Premiums paid for medical care insurance, that is, hospital, surgical, and medical expense reimbursement coverage, is deductible as a medical expense to the extent that, when added to all other unreimbursed medical expenses, the total exceeds 10 percent of a taxpayer’s adjusted gross income (7.5 percent for tax years beginning before 2013). The threshold is also 10 percent for alternative minimum tax purposes.
The Patient Protection and Affordable Care Act increased the threshold to 10 percent of a taxpayer’s adjusted gross income for taxpayers who are under the age of sixty-five effective in tax years beginning January 1, 2013. Taxpayers over the age of sixty-five will be temporarily excluded from this provision and the threshold for deductibility for these taxpayers will remain at the 7.5 percent level from years 2013 to 2016.
No deduction may be taken for medical care premiums or any other medical expenses unless a taxpayer itemizes his or her deductions. The limit on itemized deductions for certain high-income individuals is not applicable to medical expenses deductible under IRC Section 213.
Premiums for only medical care insurance are deductible as a medical expense. Premiums for non-medical benefits, including disability income, accidental death and dismemberment, and waiver of premium under a life insurance policy, are not deductible.
Amounts paid for any qualified long-term care insurance contract or for qualified long-term care services generally are included in the definition of medical care and, thus, are eligible for income tax deduction, subject to certain limitations.
Compulsory contributions to a state disability benefits fund are not deductible as medical expenses but are deductible as taxes. Employee contributions to an alternative employer plan providing disability benefits required by state law are nondeductible personal expenses.
If a policy provides both medical and non-medical benefits, a deduction will be allowed for the medical portion of the premium only if the medical charge is reasonable in relation to the total premium and is stated separately in either the policy or in a statement furnished by the insurance company.
Similarly, because the deduction is limited to expenses of the taxpayer, his or her spouse and dependents, where a premium provides medical care for others as well (as in automobile insurance) without separately stating the portion applicable to the taxpayer, spouse and dependents, no deduction is allowed.
If a policy provides only indemnity for hospital and surgical expenses, premiums qualify as medical care premiums even though the benefits are stated amounts that will be paid without regard to the actual amount of expense incurred. Premiums paid for a hospital insurance policy that provides a stated payment for each week an insured is hospitalized, not to exceed a specified number of weeks, regardless of whether the insured receives other payments for reimbursement, do not qualify as medical care premiums and hence are not deductible.
Premiums paid for a stand-alone critical illness policy are considered capital outlays and are not deductible.
A deduction will also be denied for employees’ contributions to a plan that provides that employees absent from work because of sickness are to be paid a percentage of wages earned on that day by co-employees.
Premiums paid for a policy that provides reimbursement for the cost of prescription drugs are deductible as medical care insurance premiums.
Medicare premiums, paid by persons age sixty-five or older, under the supplementary medical insurance or prescription drug programs are deductible as medical care insurance premiums. Taxes paid by employees and self-employed persons for basic hospital insurance under Medicare are not deductible.
Premiums prepaid by a taxpayer before the taxpayer is sixty-five for insurance covering medical care for the taxpayer, his or her spouse, and his or her dependents after the taxpayer is sixty-five are deductible when paid provided they are payable on a level-premium basis for ten years or more or until age sixty-five, but in no case for fewer than five years.
Payments made to an institution for the provision of lifetime care are deductible under IRC Section 213(a) in the year paid to the extent that the payments are properly allocable to medical care, even if the care is to be provided in the future or possibly not provided at all. The IRS has stated that its rulings should not be interpreted to permit a current deduction of payments for future medical care including medical insurance provided beyond the current tax year in situations where future lifetime care is not of the type associated with these rulings.
2. May an employer deduct as a business expense the cost of premiums paid for accident and health insurance for employees?
An employer generally can deduct as a business expense all premiums paid for health insurance for one or more employees. This includes premiums for medical expense insurance. Dismemberment and sight loss coverage for the employee, his or her spouse and dependents, disability income for the employee, and accidental death coverage.
Premiums are deductible by an employer whether coverage is provided under a group policy or under individual policies. The deduction for health insurance is allowable only if benefits are payable to employees or their beneficiaries; it is not allowable if benefits are payable to the employer. Where a spouse of an employer is a bona fide employee and the employer is covered as a family member, the premium is deductible. A corporation can deduct premiums it pays on group hospitalization coverage for commission salespersons, regardless of whether they are employees. Premiums must qualify as additional reasonable compensation to the insured employees.
If a payment is considered made to a fund that is part of an employer plan to provide the benefit, the deduction for amounts paid or accrued may be limited.
An accrual basis employer that provides medical benefits to employees directly instead of through insurance or an intermediary fund may not deduct amounts estimated to be necessary to pay for medical care provided in the year but for which claims have not been filed with the employer by the end of the year if filing a claim is necessary to establish the employer’s liability for payment.
3. What credit is available for small employers for employee health insurance expenses?
A credit is available for employee health insurance expenses of an eligible small employer for taxable years beginning after December 31, 2009, provided the employer offers health insurance to its employees.
An eligible small employer is an employer that has no more than twenty-five full time employees, the average annual wages of whom do not exceed $50,000 (in 2010, 2011, 2012 and 2013; the amount is indexed thereafter).
An employer must have a contribution arrangement for each employee who enrolls in the health plan offered by the employer through an exchange that requires that the employer make a non-elective contribution in an amount equal to a uniform percentage, not less than 50 percent, of the premium cost.
Subject to phase-out based on the number of employees and average wages, the amount of the credit is equal to 50 percent, and 35 percent in the case of tax exempts, of the lesser of (1) the aggregate amount of non-elective contributions made by the employer on behalf of its employees for health insurance premiums for health plans offered by the employer to employees through an exchange, or (2) the aggregate amount of non-elective contributions the employer would have made if each employee had been enrolled in a health plan that had a premium equal to the average premium for the small group market in the ratings area.
For years 2010, 2011, 2012 and 2013, the following modifications apply in determining the amount of the credit:
(1) the credit percentage is reduced to 35 percent (25 percent in the case of tax exempts);
(2) the amount under (1) is determined by reference to non-elective contributions for premiums paid for health insurance, and there is no exchange requirement; and
(3) the amount under (2) is determined by the average premium for the state small group market.
The credit also is allowed against the alternative minimum tax.
In 2014 small employers will have exclusive access to an expanded Small Business Healthcare Tax Credit under the Patient Protection and Affordable Care Act (PPACA). This tax credit covers as much as 50 percent of the employer contribution toward premium costs for eligible employers who have low- to moderate-wage workers.
4. Are benefits received under a personal health insurance policy taxable income?
All kinds of benefits from personal health insurance generally are entirely exempt from income tax. This includes disability income; dismemberment and sight loss benefits; critical illness benefits; and hospital, surgical, or other medical expense reimbursement. There is no limit on the amount of benefits, including the amount of disability income, that can be received tax-free under personally paid health insurance or under an arrangement having the effect of accident or health insurance. At least one court has held, however, that the IRC Section 104(a)(3) exclusion is not available where a taxpayer’s claims for insurance benefits were not made in good faith and were not based on a true illness or injury.
The accidental death benefit under a health insurance policy may be tax-exempt to a beneficiary as death proceeds of life insurance. Disability benefits received for loss of income or earning capacity under no fault insurance are excludable from gross income. The exclusion also has been applied to an insured to whom policies were transferred by a professional service corporation in which the insured was the sole stockholder.
Health insurance benefits are tax-exempt if received by the insured and if received by a person having an insurable interest in an insured.
Medical expense reimbursement benefits must be taken into account in computing a taxpayer’s medical expense deduction. Because only unreimbursed expenses are deductible, the total amount of medical expenses paid during a taxable year must be reduced by the total amount of reimbursements received in that taxable year.
Likewise, if medical expenses are deducted in the year they are paid and then reimbursed in a later year, the taxpayer or the taxpayer’s estate, where the deduction is taken on the decedent’s final return but later reimbursed to the taxpayer’s estate, must include the reimbursement, to the extent of the prior year’s deduction, in gross income for the later year.
Where the value of a decedent’s right to reimbursement proceeds, which is income in respect of a decedent, is included in the decedent’s estate, an income tax deduction is available for the portion of estate tax attributable to such value.
Disability income is not treated as reimbursement for medical expenses and, therefore, does not offset such expenses.
Example. Mr. Jones, whose adjusted gross income for 2012 was $25,000, paid $3,000 in medical expenses during that year. On his 2012 return, he took a medical expense deduction of $1,125 [$3,000 - $1,875 (7.5 percent of his adjusted gross income)]. In 2013, Mr. Jones receives the following benefits from his health insurance: disability income, $1,200; reimbursement for 2012 doctor and hospital bills, $400. He must report $400 as taxable income on his 2013 return. Had Mr. Jones received the reimbursement in 2012, his medical expense deduction for that year would have been limited to $725 ($3,000 – $400 [reimbursement] – $1,875 [7.5 percent of adjusted gross income]). Otherwise, he would have received the entire amount of insurance benefits, including the medical expense reimbursement, tax-free.
5. How is employer-provided disability income coverage taxed?
An employer generally can deduct all premiums paid for disability income coverage, as with all premiums paid for health insurance, for one or more employees as a business expense.
Premiums are deductible by an employer whether coverage is provided under a group policy or under individual policies. The deduction is allowable only if benefits are payable to employees or their beneficiaries; it is not allowable if benefits are payable to an employer.
The deduction of premiums paid for a disability income policy insuring an employee-shareholder was prohibited where the corporation was the premium payor, owner, and beneficiary of the policy. The Tax Court held that IRC Section 265(a) prevented the deduction because the premiums were funds expended to produce tax-exempt income. The Tax Court stated that disability income policy benefits, had any been paid, would have been tax-exempt under IRC Section 104(a)(3).
Taxation of benefits
Sick pay, wage continuation payments, and disability income payments, both preretirement and postretirement, generally are fully includable in gross income and taxable to an employee. Specifically, long-term disability income payments received under a policy paid for by an employer are fully includable in income to a taxpayer.
A disabled former employee could not exclude from income a lump sum payment received from the insurance company that provided the employee’s employer-paid long-term disability coverage. The lump sum nature of the settlement did not change the nature of the payment into something other than a payment received under accident or health insurance.
If benefits are received under a plan to which an employee has contributed, the portion of the disability income attributable to the employee’s contributions is tax-free. Under an individual policy, an employee’s contributions for the current policy year are taken into consideration. With a group policy, an employee’s contributions for the last three years, if known, are considered.
In Revenue Ruling 2004-55, the IRS held that the three-year look back rule did not apply because the plan was amended so that, with respect to each employee, the amended plan was financed either solely by the employer or solely by the employee. The three-year look back rule does not apply if a plan is not considered a contributory plan.
An employer may allow employees to elect, on an annual basis, whether to have premiums for a group disability income policy included in employees’ income for that year. An employee who elects to have premiums included in his or her income will not be taxed on benefits received during a period of disability beginning in that tax year. An employee’s election will be effective for each tax year without regard to employer and employee contributions for prior years.
Where an employee-owner reimbursed his corporation for payment of premiums on a disability income policy, the benefit payments that he received while disabled were excludable from income under IRC Section 104(a)(3).
Where an employer initially paid disability income insurance premiums but, prior to a second period of benefit payments, an employee took responsibility for paying premiums personally, the benefits paid from the disability income policy during the second benefit-paying period were not includable in the employee’s income.
Premiums paid by a former employee under an earlier long-term disability plan were not considered paid toward a later plan from which the employee received benefit payments. Thus, disability benefits were includable in income. If an employer merely withholds employee contributions and makes none itself, the payments are excludable. A tax credit for disability retirement income is available to taxpayers receiving those payments after the minimum age at which they would have received a pension or annuity if not disabled. This credit is called the Disability and Earned Income Tax Credit (EITC).
6. How is personal disability income coverage taxed?
Premiums for non-medical care, such as personal disability income coverage, are not deductible. Only premiums for medical care insurance are deductible as a medical expense.
A deduction is allowed for medical care that is not otherwise compensated for by insurance. The deduction is allowed to the extent that the medical care expenses exceed 7.5 percent of the taxpayer’s adjusted gross income. For taxable years beginning in 2017, the deduction is allowed to the extent that the medical care expenses exceed 10 percent of the taxpayer’s adjusted gross income. The threshold is 10 percent for the alternative minimum tax and there is a transition rule for people over 65. The 10 percent threshold for regular tax does not apply until 2017.
Taxation of benefits
Benefits from personal disability income coverage typically are entirely exempt from income tax. There is no limit on the amount of benefits, including the amount of disability income, that can be received tax-free under personally paid disability income coverage.
If benefits are received under a plan to which both an employer and employee have contributed, the portion of the disability income attributable to the employee’s contributions is tax-free.
7. How are amounts distributed from a Health Savings Account (HSA) taxed?
A distribution from an HSA used exclusively to pay qualified medical expenses of an account holder is not includable in gross income. Any distribution from an HSA that is not used exclusively to pay qualified medical expenses of an account holder must be included in the account holder’s gross income.
Any distribution that is includable in income because it was not used to pay qualified medical expenses is also subject to a penalty tax. The penalty tax is 10 percent of includable income for a distribution from an HSA. For distributions made after December 31, 2010, the additional tax on nonqualified distributions from HSAs is increased to 20 percent of includable income.
Includable distributions received after an HSA holder becomes disabled within the meaning of IRC Section 72(m)(7), dies, or reaches the age of Medicare eligibility are not subject to the penalty tax.
Qualified medical expenses are amounts paid by the account holder for medical care for the individual, his or her spouse, and any dependent to the extent that expenses are not compensated by insurance or otherwise. For tax years beginning after December 31, 2010, medicines constituting qualified medical expenses will be limited to doctor-prescribed drugs and insulin. Consequently, over-the counter medicines will no longer be qualified expenses unless prescribed by a doctor after 2010.
With several exceptions, the payment of insurance premiums is not a qualified medical expense. The exceptions include any expense for coverage under a health plan during a period of COBRA continuation coverage, a qualified long-term care insurance contract, or a health plan paid for during a period in which the individual is receiving unemployment compensation.
An account holder may pay qualified long-term care insurance premiums with distributions from an HSA even if contributions to the HSA were made by salary reduction through an IRC Section 125 cafeteria plan. Amounts of qualified long-term care insurance premiums that constitute qualified medical expenses are limited to the age-based limits found in IRC Section 213(d)(10) as adjusted annually.
An HSA account holder may make tax-free distributions to reimburse qualified medical expenses from prior tax years as long as the expenses were incurred after the HSA was established. There is no time limit on when a distribution must occur.
HSA trustees, custodians, and employers need not determine whether a distribution is used for qualified medical expenses. This responsibility falls on individual account holders.
8. When may an account owner transfer or rollover funds into an HSA?
Funds may be transferred or rolled over from one HSA to another HSA or from an Archer MSA to an HSA provided that an account holder effects the transfer within sixty days of receiving the distribution.
An HSA rollover may take place only once a year. The year is not a calendar year, but a rolling twelve month period beginning on the day when an account holder receives a distribution to be rolled over. Transfers of HSA amounts directly from one HSA trustee to another HSA trustee, known as a trustee-to-trustee transfer, are not subject to the limits under IRC Section 223(f)(5). There is no limit on the number of trustee-to-trustee transfers allowed during a year.
A participant in a health reimbursement arrangement (“HRA”) or a health flexible spending arrangement (“Health FSA”) may make a qualified HSA distribution on a one time per arrangement basis. A qualified HSA distribution is a transfer directly from an employer to an HSA of an employee to the extent the distribution does not exceed the lesser of the balance in the arrangement on September 21, 2006, or the date of distribution. A qualified HSA distribution shall be treated as a rollover contribution under IRC Section 223(f)(5), that is, it does not count toward the annual HSA contribution limit.
If an employee fails to be an eligible individual at any time during a taxable year following a qualified HSA distribution, the employee must include in his or her gross income the aggregate amount of all qualified HSA distributions. The amount includable in gross income is also subject to a 10 percent penalty tax.
General purpose health FSA coverage during a grace period, after the end of a plan year, will be disregarded in determining an individual’s eligibility to contribute to an HSA if the individual makes a qualified HSA distribution of the entire balance. Health FSA coverage during a plan year is not disregarded, even if a health FSA balance is reduced to zero. An individual who begins HDHP coverage after the first day of the month is not an eligible individual until the first day of the following month.
The timing of qualified HSA distributions therefore is critical for employees covered by general-purpose, that is, non-high-deductible, health FSAs or HRAs:
(1) An employee only should make a qualified HSA distribution if he or she has been covered by an HDHP since the first day of the month;
(2) An employee must rollover general purpose health FSA balances during the grace period after the end of the plan year, not during the plan year, and, of course, he or she must not be covered by a general purpose health FSA during the new year; and
(3) An employee must rollover the entire balance in an HRA or a health FSA to an HSA. If a balance remains in an HRA at the end of a plan year or in a health FSA at the end of the grace period, the employee will not be an HSA-eligible individual.
Beginning in 2007, a taxpayer may, once in his or her lifetime, make a qualified HSA funding distribution. A qualified HSA funding distribution is a trustee-to-trustee transfer from an IRA to an HSA in an amount that does not exceed the annual HSA contribution limitation for the taxpayer. If a taxpayer has self-only coverage under an HDHP at the time of the transfer, but at a later date during the same taxable year obtains family coverage under an HDHP, the taxpayer may make an additional qualified HSA funding distribution in an amount not exceeding the additional annual contribution for which the taxpayer has become eligible.
If a taxpayer fails to be an eligible individual at any time during a taxable year following a qualified HSA funding distribution, the taxpayer must include in his or her gross income the aggregate amount of all qualified HSA funding distributions. The amount includable in gross income also is subject to a 10 percent penalty tax.
9. What employers are eligible for the new tax credit for health insurance, and how does it work?
The new health insurance tax credit is designed to help approximately four million small for-profit businesses and tax-exempt organizations that primarily employ low and moderate-income workers. The credit is available to employers that have twenty-four or fewer eligible full time equivalent (“FTE”) employees paying wages averaging under $50,000 per employee per year.
IRC Section 45R provides a tax credit beginning in 2010 for a business with twenty-four or fewer eligible FTEs. Eligible employees do not include seasonal workers who work for an employer 120 days a year or fewer, owners, and owners’ family members, where average compensation for the eligible employees is less than $50,000 and where the business pays 50 percent or more of employee-only (single person) health insurance costs. Thus, owners and family members’ compensation is not counted in determining average compensation, and the health insurance cost for these people is not eligible for the health insurance tax credit.
The credit is largest if there are ten or fewer employees and average wages do not exceed $25,000. The amount of the credit phases out for business with more than ten eligible employees or average compensation of more than $25,000 and under $50,000. The amount of an employer’s premium payments that counts for purposes of the credit is capped by the average premium for the small group market in the employer’s geographic location, as determined by the Department of Health and Human Services.
Example: In 2013, a qualified employer has nine FTEs (excluding owners, owners’ family members, and seasonal employees) with average annual wages of $24,000 per FTE. The employer pays $75,000 in health care premiums for these employees, which does not exceed the average premium for the small group market in the employer’s state, and otherwise meets the requirements for the credit. The credit for 2013 equals $26,250 (35 percent x $75,000).
Additional examples can be found here.
10. How do the rules for obtaining the tax credit change over the years?
To obtain the credit, an employer must pay at least 50 percent of the cost of health care coverage for each counted worker with insurance.
In 2010, an employer may qualify if it pays at least 50 percent of the cost of employee-only coverage, regardless of actual coverage elected by an employee. For example, if employee-only coverage costs $500 per month, family coverage costs $1,500 per month, and the employer pays at least $250 per month (50 percent of employee-only coverage) per covered employee, then even if an employee selected family coverage the employer would meet this contribution requirement to qualify for the tax credit in 2010.
Beginning in 2011, however, the percentage paid by an employer for each enrolled employee must be a uniform percentage for that coverage level. If an employee receives coverage that is more expensive than single coverage, such as family or self-plus-one coverage, an employer must pay at least 50 percent of the premium for each employee’s coverage in 2011 and thereafter.
Thus, grandfathered health insurance plans that provide, for instance, for 100 percent of family coverage for executives and employee-only coverage for staff will qualify for the tax credit in 2010 but not in 2011 or beyond.
11. Are grandfathered health insurance plans exempt from nondiscrimination and all health care reform requirements?
Yes and no.
Although grandfathered health insurance plans are exempt from many requirements, they are not exempt from all health care reform requirements. Instead, they are subject to the following:
(1) Prohibition of lifetime benefit limits;
(2) No rescission except for fraud or intentional misrepresentation;
(3) Children, who are not eligible for employer-sponsored coverage, covered up to age twenty-six on a family policy, if the dependent does not have coverage available from his or her employer;
(4) Pre-existing condition exclusions for covered individuals younger than nineteen are prohibited; and
(5) Restricted annual limits for essential benefits.
Grandfathered health plans are exempt from the following additional requirements that apply to new and non-grandfathered health plans:
(1) No cost-sharing for preventive services;
(2) Nondiscrimination based on compensation;
(3) Children covered up to age twenty-six on family policy regardless of whether a policy is available at work. Grandfathered status for the adult dependent coverage ends on January 1, 2014;
(4) Internal appeal and external review processes;
(5) Emergency services at in-network cost-sharing level with no prior authorization; and
(6) Parents must be allowed to select a pediatrician as a primary care physician for their children and women must be allowed to select an OB-GYN for their primary care physician.
For more tax planning coverage, visit www.LifeHealthPro.com/taxplanning