Employers - Be Careful With Medical Reimbursement Plans

I am reading a notice from the Department of Labor titled “FAQs about Affordable Care Act Implementation (Part XXII)."

This will never make it as summer reading while on a beach.

And the DOL pretty much says what many practitioners concluded last year when the IRS issued Notice 2013-54, addressing employer reimbursement arrangements and individual health insurance policies acquired on an exchange.

COMMENT: “Exchange” and “marketplace” are the same.

The government does NOT like them.

Let’s clarify what we are talking about. There used to be a very common arrangement whereby an employer would pay your health insurance, reimburse your medical expenses, or a combination of the two, with no tax to you. These plans had several names, including health reimbursement plans or Section 105 plans. The practice had been around since before I was born.

Introduce ObamaCare. Say that someone goes on the exchange and buys an individual policy. Let’s take one more step and say that someone qualifies for a government subsidy on that individual policy.

Step One: You have someone getting money (in the form of the subsidy) from the government.

Say that person’s employer has a health reimbursement plan. The plan reimburses medical expenses, including insurance, up to some dollar amount – say $2,500.

Step Two: That person submits his/her government-subsidized Obamacare policy to the employer for reimbursement, up to $2,500.

To the extent that person’s share of the policy cost was less than $2,500, that person has broken even on the deal. To the extent that his/her share was $2,500 or more, his/her share of the cost would be $2,500 less.

Step Three: The government did not like this, did not like this at all. They huffed and they puffed and they issued Notice 2013-54, which pretty much indicated that the government was not going to allow a mixture of Obamacare individual health policies and employer reimbursement plans. Many practitioners were shocked. Heck, I myself had a similar plan at one time.

But there were a select few companies who continued marketing these things. Introduce some painful and lawyerly reading of the rules, and the companies declared that “their” plan would somehow pass muster with Notice 2013-54.

If there was any legitimate question, there is none now.

Let’s review Q&A 3:

Q: A vendor markets a product to employers claiming that employers can cancel their group policies, set up a Code section 105 reimbursement plan that works with health insurance brokers or agents to help employees select individual insurance policies, and allow eligible employees to access the premium tax credits for marketplace coverage. Is this permissible?

A: No. … the arrangements described in this Q3 are themselves group health plans and, therefore, employees participating in such arrangements are ineligible for premium tax credits….

Second, as explained in …, such arrangements are subject to the market reform provisions of the Affordable Care Act …. Such employer health care arrangements cannot be integrated with individual market policies to satisfy the market reforms, and, therefore, will violate …., which can trigger penalties such as excise taxes under section 4980D of the Code.

There are extremely limited exceptions, such as a one-person employer, but the broad broom has swept. The government is not going to allow a tax-free employer reimbursement for an individual policy acquired on an exchange.

So what if the employer included the reimbursement on the employee’s W-2? It would not be tax-free then, by definition. My previous understanding was that an employer could reimburse the individual policy, as long as the reimbursement was included on the employee’s W-2.

COMMENT: Another way to say it is that the government doesn’t care, as long as it gets its tax.

Let’s take a look at Q&A 1:

Q: My employer offers cash to reimburse the purchase of an individual market policy. Does this arrangement comply with the market reforms?

A: No. If the employer uses an arrangement that provides cash reimbursement for the purchase of an individual market policy, the employer’s payment arrangement is part of a plan, fund, or other arrangement established or maintained for the purpose of providing medical care to employees, without regard to whether the employer treats the money as pre-tax or post-tax to the employee.

Huh? Wait a minute here.

I interpret this to mean that an employer cannot have employees submit their insurance bills for reimbursement in lieu of other compensation. To phrase it differently, the employer must give the employee a raise (or bonus) and the employee must decide whether he/she wants to use the raise (or bonus) toward the insurance. The employee may decide to take the money and go on vacation; the employer cannot decide this for the employee.

By the way, notice that we have been speaking about individual health policies. The above discussion does not apply to group health policies acquired through SHOP, which is the exchange for businesses with less than 50 full-time employees. Those polices are group policies, not individual policies, and do not qualify for the ObamaCare subsidy. No subsidy, different rules.

Is Income From Investing Tax-Exempt Income Also Tax-Exempt?

Our story starts in 2005. Taxpayer (Lundy) received a Form 1099-R reporting approximately $42,000 of “retirement” income. The Lundys left it off their tax return. The IRS noticed and demanded payment. Off to Tax Court they went. Before there could be any hearing, the IRS settled, agreeing there was no tax due.

This action is referred to as a “stipulated” decision, and they tend to be about as terse as Bill Belichick at a press conference. We won’t read much there.

That said, I am thinking personal injury. We know that damages for personal injuries (think car accident) are tax-free. My hunch is that Lundy got injured, received a $42,000 settlement and a Form 1099-R to boot. Somebody messed up by issuing the 1099 in the first place. The IRS made a second mistake by not adequately investigating the facts before taking the matter to court.

Fast forward 6 years.

The Lundys file their tax return for 2011. Mr. Lundy has a W-2 from driving a school bus, and Mrs. Lundy has approximately $20,000 from a small business. There is some income tax, throw in some self-employment tax, and the Lundys owed about $3,500.

They send in the return. They do not send in any money, nor was there any withholding on Mr. Lundy’s W-2.

The IRS – of course – wants to know why. And they want their money.

The Lundy’s have no intention of sending money. 

The Lundys file a request for a due process hearing.

Their argument?

The funds that you are attempting to collect from are indeed part of my total and permanently [sic] disability benefits which were subject of the UNITED STATES TAX COURT CASE # 2759-07S***. We filed a timely appeal to the U.S. TAX COURT and laid out all of our affirmative defenses to the Commissioner of the Internal Revenue Service claims at that time. The most important claim that we made at that time is that whatever we funded, financed, and paid for with my total and permanently [sic] disability funds which were determined by this order to be non-reportable, tax free, and tax exempt from the clutches of the IRS was also off limits from the IRS.”

Well then.

Let’s think about their argument for a moment. The Lundys were arguing that any income earned from a tax-free source would – in turn – also be tax-free. Does this make sense? Let me give you a few situations:

·        You sell your primary residence, excluding $500,000 of gain. You invest the $500,000 in the next hot IPO. It takes off, and next thing you know you are rubbing shoulders with Gates, Buffett and Zuckerberg.

·        You take the interest from your municipal bond fund to fund the next great mobile app. You are subsequently acquired by Apple and you buy Ecuador.

·        You work overseas for a number of years, always claiming the foreign earned income exclusion. You invest your tax savings in raw land. Two decades later you sell the land to someone developing an outdoor mall. You buy a county in Wyoming so you have somewhere to hunt.

Of course it doesn’t make sense. It is clear that we have to separate the cart from the groceries. The cart stays at the store while the groceries go home with you. They are two different things, and the fate of the cart is not the fate of the groceries. Income from a tax-free pile of money does not mean that the earnings are magically tax-free. If only it were so. Could you imagine the ads from Fidelity or Vanguard if it were that simple?

The Lundys lost, of course.

Of surprise to me, as a practitioner, was the IRS restraint on penalties. The IRS popped them for late payment penalties, of course, but not for the super-duper penalties, such as for substantial accuracy. Why?

Who knows, but I did notice the Tax Court case was “pro se,” meaning that the Lundys represented themselves. There is a way to have a tax practitioner involved in a “pro se,” but I do not think that is what happened here. I suspect they actually represented themselves, without an accountant or attorney.

Not that an accountant or attorney could have represented them in any event. A practitioner is prohibited from taking frivolous positions. The Lundy positon was as close to frivolous as I have heard in a while.

And the IRS gave them a break.

Not that the Lundys would see it that way, though.

Do You HAVE To Cash That Bonus Check (To Get A Tax Deduction)?

For (very) closely-held service companies, it is common to “bonus” enough profit to bring taxable income down to zero (or very close). There are two reasons for this:

(1)  The company is a personal services company (PSC), meaning that it will face a maximum corporate tax rate on whatever profit is left in the company. This is a tremendous impetus to not leave profit in the company.

(2)   There is one owner (or very few owners) and the majority of the money is going to him/her/them anyway.

In many cases the company is also cash-basis taxpayer, and the accountant normally pays very close attention to cash in-and-out during the last few days of the tax year. With electronic bank transfers becoming more commonplace, I have seen carefully-monitored tax planning destabilized by sizeable electronic customer transfers on the last day or two. It happens, as the customer may be doing cash-basis planning themselves, and payment to my client is a tax deduction to them.

There are limitations on how far this can be pushed, though. It is not acceptable to delay depositing customer checks, for example, in order to avoid income recognition. In addition, one has to be careful about writing so many checks that it creates a bank overdraft. A common way to plan around an overdraft is to have a line of credit available. The bank would then sweep funds from the line as necessary to cover any overdraft. One might also run an overdraft if he/she knows that a deposit will arrive early the following month, as that deposit would occur during the float period of any outstanding checks.  A business owner might “know” that check is coming because said check is already in the owner’s desk drawer, but we will not speak further of such absurd examples. It is not as though I have ever seen such a thing, of course.

Let’s talk about Vanney Associates, Inc. Robert Vanney is an architect with perilously close to 40 years experience. The firm has about 25 employees, and Robert is the sole shareholder. He is – without question – the key man. His wife, Karen, is a CPA with a retired license, and she takes care of the books and records.

In 2008 Mr. Vanney received $240,000 in monthly payroll. At the end of the year, he determined and paid employee bonuses, taking as a personal bonus whatever was left over. The leftover was $815,000. The withholdings on the leftover were approximately $350,000, leaving approximately $464,000 payable to Mr. Vanney.

Problem: there was only $389 thousand in the bank.

There was enough money to pay the withholding taxes, but there wasn’t enough to also pay Mr. Vanney. What to do? The Vanney’s did not need the money, so they decided not to borrow from the bank. Mr. Vanney instead endorsed the check back to the company, and that was the end of the matter.

But it wasn’t. The IRS looked at the business tax return and decided to disallow the $815,000 bonus and almost $12,000 in related employer payroll taxes.

Why? The government got their taxes, so why should they care? 

There is a legal concept when paying with a check. A check is referred to as a “conditional payment,” because writing the check is subject to a condition subsequent. That subsequent condition is the check clearing the bank. We take it for granted, of course, so we overlook that technically there are two steps. When the check clears, the two steps unify and become as one. This is why you can send a check to a charity on December 31 and claim the deduction in the same tax year. There is no chance that the charity is receiving that check and depositing it by December 31. Still, if it clears in the normal course of business, all parties – including the IRS – consider the check as having been written on December 31.

That is not what happened here. The check never cleared the bank.

Which is unfortunate, as the IRS now could argue that the check remained conditional. Being conditional there was never payment in 2008. This was fatal, as Vanney Associates was a cash-basis taxpayer.  

And the Court agreed.

Think about this for a moment. The corporation was disallowed a 2008 deduction for the $815,000. Whereas the Court did not address this point, that bonus was included on Mr. Vanney’s 2008 Form W-2. He would have reported that W-2 on his 2008 individual tax return.

There is something seriously wrong with this picture.

I suppose Vanney Associates could amend its 2008 payroll tax returns. It could reverse that bonus, as well as the related withholding taxes. It would get a refund, but it would be amending multiple federal and state (and possibly local) payroll returns.

Mr. Vanney would then amend his personal 2008 tax return.

But that is assuming we are within the statute of limitations to amend all those returns.

When then would Vanney Associates get its $815,000 bonus deduction?

Your first response might be the following year: in 2009. I believe you would be wrong. Why? Because Mr. Vanney did not cash his check in 2009. The check remained a conditional payment in 2009. Same answer for 2010, 2011, 2012 and 2013. This case was decided September, 2014. Seems to me the first time Mr. Vanney could “cash” his check is this year – 2014.

Let me ask you another question: why didn’t the Court allow the (approximately) $350,000 in withholdings as a tax deduction? That check cashed, right?

I think I know. If the company did not “pay” the $815,000 in 2008, then there is no “bonus” for that withholding to attach to. From a tax perspective, the company overpaid its withholding taxes in 2008. The tax problem is that the overpayment is not a "deduction," as no payroll taxes were actually due. Payroll taxes attach to payroll, and there was no payroll. It was a "prepayment," waiting on Vanney to request a refund.

What is our takeaway?

Over the years I have heard more than one practitioner declare a tax outcome as “making no sense.” An unfortunate consequence is that the practitioner may not pursue a line of reasoning to conclusion. There are reasons for this, of course. First, an accountant has probably been exposed somewhere to generally accepted accounting principles. GAAP is a financial statement concept (think auditors, not tax accountants) and GAAP generally has some symmetry to it. The practitioner forgets that the IRS not bound by GAAP. The purpose of the IRS is to collect and enforce, and it does not consider itself bound by any symmetry should GAAP get in its way. The second is human: we respond to an absurd result by assuming we must have made a mistake in our reasoning. Many times we are right. In Vanney’s case, we were not.

What could Vanney have done?

Simple.

He could have had a line of credit in place. He could have cashed that check.

BTW I almost invariably recommend my cash-basis clients have a line of credit, even if they have no intention of using it. This costs them money, as the bank may charge a flat fee (say $100 or $250) annually for keeping the line of credit available. In addition, many a bank will require at least one draw over a month-end annually in order to keep the line open. This means there will be some interest expense.

Why do I recommend it? It is cheap insurance against nightmares like this.

Has Maryland Been Caught Reaching Into The Tax Cookie Jar?

There are several states that impose a county tax in addition to a state income tax. Maryland is one of those states, and it has attracted attention to itself with the Maryland v Wynne. This case will soon go before the Supreme Court, which will decide whether Maryland has run afoul of the Commerce Clause of the Constitution.

That sounds esoteric.

It is not that bad, though, as long as we stay out of the weeds.

Let’s start this tax tale with an S corporation shareholder. His name shall be Clark. You may remember that “S” corporations do not pay tax (except in rare circumstances). Instead the corporation “passes through” its income to its shareholders, who in turn report their proportionate share of the corporate income on their individual tax returns.

Let’s say that Clark and his wife live in Maryland.

Let’s say that the S corporation does business both inside and outside Maryland. This means that Clark gets to pay income tax to all the states where the S corporation does business. This happens all the time, much to the chagrin of the tax professional who gets to prepare the paperwork.

Clark's corporation does business in North Carolina,. Clark pays tax to North Carolina (remember: the shareholder pays the income tax for an S corporation). Clark then takes a tax credit on his Maryland income tax for the taxes paid North Carolina. As long as North Carolina is not more expensive than Maryland, there is no-harm-no-foul, except for the professional fees to sort all this out.

And there we encounter the rub.

You see, Maryland divides its tax between a “state” tax and a “county” tax. And it makes a difference.

Enter Brian and Karen Wynne (the Wynnes). They are shareholders in Maxim Healthcare Services, Inc., an S corporation that files returns in 39 states. They themselves live in Howard County, Maryland. When they filed their 2006 Maryland tax return, they claimed taxes that they paid the other 38 states as a credit against their Maryland tax.

And the Maryland State Comptroller changed their numbers and sent them a bill. This lead to Appeals, then Maryland Tax Court, followed by the Circuit Court and – now - the Supreme Court.

The Comptroller’s argument? The Wynnes could not claim a credit for taxes paid other states against the county portion of the Maryland tax. Maryland changed its law in 1975, which was like … a really, really long time ago. Why are we even going there? How can one reasonably offset a state tax against a county tax?

I have to disagree.

Take two people living in Maryland. Have one invest in an S corporation that does all its business inside Maryland. Have the other invest in an S that does all its business in Maine. Unless the other state’s income tax rate is less that the Maryland state income tax rate, the first investor will pay less tax than the second investor. Tell me, how is that fair? Is the state not burdening interstate commerce by taxing the second investor (who invested outside Maryland) more than the first (who invested exclusively within Maryland)? And there you have the core of the challenge under the Commerce Clause.

Let’s use some numbers to make this concrete.

Say that the S corporation income allocable to Maine is $1,000,000. 

(1) The top Maine income tax is 7.95%, so let’s say the Maine income tax will be $79,500.

(2) The top Maryland state income tax rate is 5.75%, so the state income tax will be $57,500.

(3) The Maryland county tax rate is 3.2%, so the county income tax will be $32,000.

(4) This makes the total tax to Maryland $89,500. This exceeds the Maine tax by $10,000.

One offsets the $79,500 paid Maine against the $89,500 otherwise paid Maryland, and it all works out, right?

This is where you get hosed. According to Maryland, you cannot take the excess $22,000 (that is, $79,500 – 57,500) and claim it against the county tax. After all, it is a …. county tax. It does not make sense to offset Maine’s state tax against Maryland’s county tax.

Uhhh, yes it does.

Let us play games with this, shall we? I live in Kentucky, for example. Kentucky has 120 counties. Only Texas and Georgia have more counties, and I wonder why anybody would want more. I understand this goes back to rural times, when travel was more arduous. Nowadays it doesn't make much sense. How much money is wasted on duplication of facilities, county commissions, staff and services that accompanies all these counties?

Let’s say that Frankfort finds itself in a financial bind. Some hotshot realizes that disallowing a resident credit to Kentuckians with income outside the state would help to bridge that financial bind. Said hotshot proposes to carve the Kentucky state income tax into two parts: the state part and the county part. When the county part arrives, Frankfort will just pass it along to the appropriate county. Considering that Frankfort is shuttling monies to the counties already, all one has done is rearrange the furniture.

Except that Frankfort now keeps more money by disallowing a resident credit against all those county taxes. After all, it does not make sense to allow a state tax credit against county tax, right? Pay no attention that Frankfort itself would have created the distinction between state and county income tax. Why that was ... a really, really long time ago. Why are we even going there?

Could Maryland possibly, just possibly, be cynical enough to be playing out my scenario?

I’ll bet you a box of donuts that they are.

So Maryland v Wynne is before the Supreme Court, which will review whether Maryland has violated the “dormant” Commerce Clause. The Maryland Association of Counties has joined in (I will let you guess on which side), and the case has attracted considerable attention from tax practitioners and government policy wonks. There is, for example, some interesting tension in there between the Due Process and Commerce Clauses, for those who follow such things.

The case is scheduled for hearing the second week of November.