Defined Contribution Health Insurance

Policy Backgrounders | Health

No. 154
Thursday, October 26, 2000
by Greg Scandlen

Tax Law

One big question in evaluating a Defined Contribution approach is the tax code. Few if any companies would choose the Defined Contribution approach if it meant that employees would have to pay taxes on the employer's contribution. According to Lewin and Associates,30 the current tax exclusion for employer-provided benefits equals about 40% of total outlay - total spending for employer-sponsored coverage in the year 2000 is estimated at $356 billion, and the federal and state revenue loss is $141 billion. Making these contributions suddenly taxable would eliminate an enormous benefit for workers and would effectively prohibit a change.

"One big question in evaluating a Defined Contribution approach is the tax code."

Until recently, most observers thought that current tax law would need to be changed to allow for Defined Contributions. Much of the discussion, both for and against, assumed that workers would receive the funds, pay taxes on the money, and be free to spend it on things other than health insurance. Those opposed to the idea warned of a substantial increase in the numbers of uninsured under such a scenario. Those who supported Defined Contributions were prepared to seek a change in the tax code to treat employee-chosen health plans the same way employer-chosen plans are treated.

Now it is apparent that these concerns were misplaced. Defined Contributions can take place under current tax law. Section 106 of the Internal Revenue Code says simply, "Gross income of an employee does not include employer-provided coverage under an accident or health plan."31

The IRS issued a ruling in 1961,32 clarifying Section 106. It said in part:

The employer may contribute to an accident or health plan either by paying the premium...or by contributing to a separate trust or fund...which provides accident or health benefits directly or through insurance to one or more of his employees. For those employees who are covered by a group policy through their employment, the employer pays his share of the premium directly to the insurance company. For those employees who are not covered by the employer's group policy but have other types of hospital and medical insurance for which they pay the premiums directly to the insurers, the employer pays a part of such premiums upon proof that the insurance is in force and is being paid for by the employees.

1961 was a long time ago; does RR 61-106 still apply? In a 1988 decision in Adkins v. United States, the U.S. District Court for Northern Ohio33 confirmed that ruling in deciding that a lump sum payment from an employer that was not restricted to health coverage was taxable income, even if the money was intended to help employees pay for coverage. The government argued that the employees had "unfettered discretion to do what they please with the monies," so the payment did not fall within the Section 106 exclusion. The Court agreed saying:

Section 106 clearly applies to contributions made by the employer to hospital, medical and accident benefit insurance programs, trusts or funds. Section 106 does not contemplate, nor infer, direct payments to the employee.

This decision was later upheld on appeal.

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