Background. Many employers provide health insurance for their employees. This is a nontaxable fringe benefit under section 106 of the tax code. But what if an employer pays for this insurance by reducing the salaries of its employees? Must the employer report the salary reductions as taxable income, or are the reductions nontaxable? The IRS addressed this question in a recent ruling. An employer provided health coverage for its employees through a group health insurance policy. The employer reduced its employees’ salaries and applied the salary reduction amounts to the payment of the health insurance premiums for the employees. In other words, employees received lower salaries in exchange for employer-provided health coverage.
The IRS concluded that the amount by which an employee’s wages were reduced to cover the employer’s payment of health insurance premiums was nontaxable. It based this conclusion on section 106 of the tax code, which states that “gross income of an employee does not include employer-provided coverage under an accident or health plan.” The IRS noted that when the employer “applies the amount of employees’ salary reduction to pay health insurance premiums, the premium payments are paid by the employer, not the employees, and are excludable from the employees’ gross income under section 106 because they are paid by the employer.”
But the IRS ruled that “reimbursements” made by the employer to its employees in the amount of their salary reductions (so their after-tax pay was the same as if there were no salary reductions) had to be reported as taxable income to the employees. The IRS observed that section 106 “allows an employee to exclude employer reimbursements for health insurance premiums, but only if those premiums are actually paid by the employee.” Here, however, “there is no employee-paid premium for the employer to reimburse, and therefore the reimbursement payments that the employer makes to employees are not excluded from gross income under section 106.”
Relevance to church treasurers. Churches often provide ministers and lay employees with accident or health insurance coverage, and pay some or all of the premiums for such coverage. Here are some helpful rules for church treasurers to keep in mind:
- Church employees’ health insurance premiums paid directly to the insurer by the church are excludable from the employees’ gross income for federal tax reporting purposes.
- Church employees’ health insurance premiums paid directly to employees are excludable from the employees’ gross income for federal tax reporting purposes if the church requires proof that the employees in fact paid the premiums themselves. In other words, the church treats this arrangement like an “accountable” business expense reimbursement arrangement, and only reimburses those expenses for which it receives adequate substantiation.
- If a church provides employees with cash in lieu of paying their health insurance premiums, the exclusion does not apply and the amount of cash distributed to employees is fully taxable. However, the cash provided to the employees can be tax free if the church adopts a type of “cafeteria plan” called a “health flexible spending arrangement” or “flex plan.” Such an arrangement gives employees the right to receive cash or certain fringe benefits including employer paid premiums under an accident and health plan. This important fringe benefit is explained in chapter 5 of Richard Hammar’s 2002 Church & Clergy Tax Guide. IRS Revenue Ruling 2002-3.
This article first appeared in Church Treasurer Alert, February 2002.