Medical Insurance Premiums as Taxable Compensation

The IRS recently ruled on this issue.

The IRS ruled that workers receive taxable compensation if they can choose to have their employer pay their medical insurance premiums or receive an equivalent amount in cash.

An employer adopted a group health program for its employees and paid employee medical insurance premiums directly to the insurance company. Employees who chose not to participate in the program were given cash in the amount of the premiums that the employer would have paid.

The IRS noted that section 106 of the Internal Revenue Code permits employees to exclude from their income taxes the amount of health insurance premiums paid by their employer. The IRS further acknowledged that it ruled in 1961 that employees who pay their own health insurance premiums directly to an insurance company and are reimbursed by their employer for the amount of the premiums do not have to report this amount as income for tax purposes so long as the employer requires proof that the insurance coverage exists and that the employee in fact paid the premium.

However, the IRS ruled in 1975 that monies paid by an employer to an employee to purchase health insurance were includable in the employee's taxable income since the employer did not verify that the employee in fact used the monies to pay health insurance premiums.

The 1975 ruling was based on the "constructive receipt" doctrine, under which a taxpayer will be taxed on income that is "constructively" received. The income tax regulations specify that "income, although not actually reduced to the taxpayer's possession, is constructively received in the taxable year during which it is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time, or so that the taxpayer could have drawn upon it during the taxable year if notice of intention to withdraw had been given."

The IRS concluded that the constructive receipt principle requires an employee to report as taxable income amounts paid by an employer that the employee can receive as a cash benefit or as a medical insurance premium reimbursement, at the employee's option.

It does not matter that employees in fact use the money to pay health insurance premiums, since they have the right to treat it as a cash benefit. This is all that is required to create taxable income under the constructive receipt rule.

The IRS further noted that "if health insurance is purchased [with the employer payments], the premium amount is considered an employee contribution out of salary rather than a contribution by the employer within the scope of section 106." Private Letter Ruling 9022060.

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