Employer Provided Health Insurance – Tax Deductions & Exclusions
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Are you considering whether to incorporate your sole-proprietorship and provide health insurance to your employees and you have questions concerning the deductibility of health benefits?
In general, amounts received by an employee for personal injuries or sickness through accident and health insurance are taxable if those amounts are paid by the employer or are attributable to employer contributions not included in the employee’s gross income. If the plan is financed partially by the employer and partially by the employee, then the benefits received are partially taxable and partially tax-free. Benefits received under an accident or health plan for employees are treated as amounts received through accident and health insurance. A separate formal plan document is required only if benefits are not provided through insurance.
A self-employed individual may deduct 100% the amount paid for health insurance for the individual and his or her spouse, dependents, and children who will still be under the age of 27 at the end of the individual’s tax year.
Amounts paid by an employer to an employee to reimburse for the cost of medical care for the employee, his spouse, his dependents and children under age 27 are excluded from gross income. Such reimbursements are not subject to federal income tax withholding or to FICA or FUTA taxes, provided it is reasonable to believe that the payments are of the type that are excludible. This exclusion applies whether the payments are made through insurance or under a noninsured (i.e., “self-insured”) medical reimbursement plan. Self-insured employer-sponsored health plans are subject to rules that prohibit discrimination in terms of eligibility or benefits to certain “highly compensated individuals.”
If a self-insured plan discriminates, any “discriminatory amounts” will be includible in the gross income of highly compensated individuals.
To be excludible, a payment must be a reimbursement for one of the types of expenses that, had the employee paid it personally, would be deductible as a medical expense (determined without regard to the percentage limits on such deductions). These include expenditures not only for the diagnosis, treatment, or prevention of disease or for the purpose of affecting a structure or function of the body, but also for transportation primarily for and essential to the foregoing, and for insurance covering such medical care and transportation. Expenses paid for cosmetic surgery are not deductible expenses unless necessary to correct a congenital deformity, personal injury from accident or trauma, or disfiguring disease.
Payments that are designed to compensate for the permanent loss or loss of use of a member or function of the body, or for permanent disfigurement, of the employee, spouse, or dependent are not taxable if the payments are based on the nature of the injury and not upon the length of absence from work. A payment for an injury that permanently renders an individual unable to continue his principal or chosen vocation is not necessarily excludible from income under this test. A limited tax credit, however, is available to an individual who is permanently and totally disabled and retires on disability.
In general, coverage under an accident or health plan that is financed by an employer is not taxable to the employee. The exclusion applies whether the contributions are made in the form of insurance premiums or to a trust or fund. Also, the exclusion applies to coverage of employees’ spouses, dependents and children under age 27, and retired former employees, and to employees on layoff.
From the employer’s perspective, amounts paid to finance sickness and injury benefits for its employees generally are deductible as ordinary and necessary business expenses provided they are used to pay accident and health insurance premiums or are otherwise actuarially determined. Unlike the individual income tax deduction for medical expenses, the employer’s deduction is not subject to a percentage limitation, other than the applicable limit with respect to self-employed individuals. The timing of deductions is governed by the usual rules depending on whether the employer pays taxes on a cash or accrual basis.
Certain exceptions and details have been omitted in the interest of brevity and I hope this information will prove useful to you in determining whether or not to provide accident and health benefits to your employees. Please call me at your convenience if you would like to discuss this option in more detail.