ACLI Update: Update on Noncoordinated Benefits
By Sarah Lashley, Mandana Parsazad, and Regina Rose
TAXING TIMES, October 2023
In our October “ACLI Update Column” in TAXING TIMES, we discussed a proposal in the General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (Greenbook) purporting to clarify the tax treatment of noncoordinated benefits (NCBs). Since our update was published, the same proposal was included again in the 2024 Greenbook. Shortly thereafter in June, the Internal Revenue Service (IRS) issued a Chief Counsel Advice Memorandum (CCA)[1] relating to NCBs, and in July, the Department of the Treasury (Treasury); the Department of Labor (DOL), and the Department of Health and Human Services (HHS) issued a proposed rulemaking (Proposed Rulemaking) that would alter the tax treatment of NCBs and similar health policies that pay a fixed benefit regardless of the amount of medical expenses a policyholder incurs (fixed benefits). As of the time of the writing of this article, ACLI is reviewing the Proposed Rulemakings and will respond with comments.
NCBs are supplemental health insurance policies that are excepted benefits under the Health Insurance Portability and Accountability Act of 1996.[2] Typical NCBs include cancer-only, critical illness, and hospital indemnity insurance, which are designed to pay for extraordinary medical expenses not covered by major medical insurance, like copays, deductibles, and travel for medical care. The policies pay a fixed dollar amount on the occurrence of a medical event, regardless of the amount of medical expenses the insured incurs.
Background
CCA 202323006 (2023 CCA) was recently published by the IRS indicating that wellness benefits paid under an employer funded, fixed-indemnity insurance policy were includible in the employee’s gross income (subject to FICA, FUTA and Federal income taxes) because the benefits were not paid for medical expenses. The facts of the 2023 CCA are similar to previously issued CCA 201719025 and CCA 201703013 in which employees purchased a fixed-indemnity wellness policy through a pre-tax salary reduction. Benefits under the policy were paid when the employee participated in a health-related activity. The health-related activity may have also been free or covered by the employer’s comprehensive health coverage.
The 2023 CCA states that benefits paid to employees through insurance policies purchased through an employer on a pre-tax basis are only exempt from tax if the benefits are paid to reimburse the employee for medical expenses.[3] It explains that because the benefits under the wellness plan are paid even if the cost of the health-related activity is reimbursed by the employer’s comprehensive health coverage or the activity is free, the benefits are not paid to reimburse the employee for medical expenses. As a result, the benefits are not exempt from tax. Though unclear when the 2023 CCA was issued, this conclusion appears to foreshadow the divergence in the Proposed Rulemaking from CCA 201719025 from which it can be logically concluded that NCB benefits are reimbursements for medical expenses and are only taxable to the extent they exceeded medical expenses.
The 2023 CCA then concludes that because the payments are provided in connection with the employee’s employment,[4] the payments are wages for income tax purposes, and further states that the payments are not sick pay because they do not relate to an absence from work. It explains that because the benefits are taxable as amounts received through health insurance for income tax purposes, they are also subject to FICA or FUTA taxes.[5]
Proposed Rulemaking
On July 12, Treasury, DOL, and HHS published the Proposed Rulemaking, which was intended to make changes to regulations impacting NCBs and short-term limited-duration insurance (STLDI). These changes would significantly impact, if not eliminate NCBs from the market. Several of the changes are to portions of the U.S. Code of Regulations other than regulations promulgated under the Internal Revenue Code.[6] With respect to changes applicable to only regulations promulgated under the Tax Code, the Proposed Rulemaking:
- Would modify section 1.105-2 so that any NCB or other health benefit for which the amount paid is fixed regardless of the medical expenses the policyholder incurs, is fully taxable, even if the policyholder, in fact, has unreimbursed medical expenses. Currently section 1.105-2 provides that amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer, taxpayer’s spouse or dependents for the prescribed medical care are excludable from gross income.
- Does not make changes to payroll tax regulations but concludes nonetheless that amounts that are taxable under section 105(a)[7] and are not exempt from tax under section 105(b) are wages.
- Would create a requirement that policyholders substantiate medical expenses for insurance benefits reimbursing those medical expenses to be exempt from tax under section 105(b).
- Requests comments as to whether clarification is needed regarding how the proposed rules would apply to types of accident or health insurance other than NCBs that pay a fixed benefit amount that is not tied to the amount of any medical expenses incurred.
The rules would apply as of the later of the date of publication of the final regulations or Jan. 1, 2024.
Proposed Taxation of NCB Benefits
The proposed rule states that the exclusion from income for amounts expended for medical care under accident and health plans (section 105(b)) does not apply to NCB benefits because those benefits are paid without regard to the “actual amount of incurred and otherwise unreimbursed section 213(d) medical expenses”[8] noting that section 105(b) only applies to amounts that are paid specifically to reimburse the taxpayer for medical care and does not apply to amounts to which the taxpayer would be entitled even if they do not incur medical expenses.[9] The Proposed Rulemaking then concludes that because the entire amount of any NCB benefit is paid without regard to the amount of medical expenses a policyholder incurs, the entire benefit is included in gross income to the extent such amounts are attributable to contributions by the employer or are paid by the employer under section 105(a).[10]
Treasury and the IRS also state that the Proposed Rulemaking is clarifying the application of section 105(b) to assist taxpayers who have misinterpreted section 1.105-2 as exempting from taxation benefits that are paid without regard to the amount of medical expenses a policyholder incurs on the occurrence of a medical event. They further indicate that some taxpayers have also misinterpreted Rev. Rul. 69-154 as stating that benefit payments that are not tied to the amount of medical expenses a policyholder incurs are only taxable to the extent they exceed the associated medical expenses.[11]
Finally, a footnote in the Proposed Rulemaking explains that Rev. Rul. 69-154, which the IRS itself cited in CCA 201719025, does not apply to NCBs. The footnote distinguishes NCBs from the facts in Rev. Rul. 69-154 stating that the revenue ruling addressed payments from two separate medical reimbursement policies resulting in an excess reimbursement, whereas NCBs pay benefits regardless of the amount of medical expenses incurred. It is not entirely clear, however, how the situation in Rev. Rul. 69-154 differs from NCBs under Treasury and the IRS’s interpretation of section 1.105-2. Treasury and the IRS’s interpretation of section 1.105-2 applies not only to benefits paid without regard to the actual amount of expenses incurred but also to benefits paid without regard to the amount of a policyholder’s medical expenses that are otherwise unreimbursed. As with NCBs, the insurers in Rev. Rul. 69-154 paid benefits without regard to the otherwise unreimbursed medical expenses.[12]
Payroll Tax Regulations Are Not Changed in the Proposed Rulemaking
The proposed rule does not make changes to the payroll tax regulations. It applies the same analysis used in the 2023 CCA, concluding that because NCB benefits are subject to tax under section 105(a), they are wages for income, FICA, and FUTA tax purposes.
The Proposed Changes to Section 1.105-2 Likely Apply to More Than NCB benefits
The Proposed Rulemaking also requested comments as to how the proposed rule would apply to arrangements other than NCBs. The proposed change to section 1.105-2 appears to encompass much more than NCBs even though the Proposed Rulemaking indicates it applies only to NCBs and STLDI. For example, an accident-only insurance policy may not be an NCB, but still provides benefits without regard to the amount of medical expenses the policyholder incurs. Additionally, as described in Rev. Rul. 69-154, it is possible that payments by two policies that do not pay fixed benefits and for which the amount of benefits paid is tied to the policyholder’s medical expenses could result in an excess reimbursement that would be taxable under section 105(a). It is not clear from the Proposed Rulemaking whether excess reimbursements such as those described in Rev. Rule 69-154 would also be considered wages.
The Proposed Rulemaking Creates a Substantiation Requirement
The Proposed Rulemaking also incorporates a requirement in section 1.105-2 that a policyholder substantiate medical expenses for those reimbursements to be excluded from taxable income under section 105(b). The Proposed Rulemaking explains that current regulations under section 1.105-2 provide that section 105(b) is applicable to amounts paid to reimburse a policyholder for medical expenses “even though such amounts are paid without proof of the amount of the actual expenses incurred by the taxpayer.”
The proposed changes to section 1.105-2 and imposition of wage treatment on NCBs would substantially diminish the assurance NCB policies can provide to policyholders to offset medical expenses. Further, the combined impact of the regulatory changes in the Proposed Rulemaking have the potential to significantly impact, if not eliminate, NCBs from the marketplace. ACLI is actively educating policymakers and addressing the potential consequences of these rules that in many cases may take away or impose additional taxes on benefits that individuals rely on to supplement out of pocket expenses they are not otherwise equipped to pay when an unexpected medical event arises.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Sarah Lashley is assistant vice president, Taxes and Retirement Security, for the American Council of Life Insurers and may be reached at sarahlashley@acli.com.
Mandana Parsazad is vice president, Taxes and Retirement Security, for the American Council of Life Insurers and may be reached at mandanaparsazad@acli.com.
Regina Rose is senior vice president, Taxes and Retirement Security, for the American Council of Life Insurers and may be reached at reginarose@acli.com.