Proposed Regs Clarify Taxability of Insurance Not Paid for Actual Medical Expenses

(Parker Tax Publishing August 2023)

The IRS issued proposed regulations that modify the definition of short-term, limited duration insurance in Reg. Sec. 54-9801-2 to reduce the maximum length of such coverage from 12 months to 3 months. The proposed regulations also clarify that the exclusion from gross income under Code Sec. 105(b) does not apply to amounts received from certain employer-provided accident or health insurance, such as fixed indemnity excepted benefits coverage or specified disease excepted benefits coverage, if the benefit is paid without regard to the actual amount of Code Sec. 213(d) medical expenses incurred by the employee. REG-120730-21.

Background

Short-term, limited-duration insurance (STLDI) is a type of health insurance that is primarily designed to fill temporary gaps in coverage that may occur when an individual is transitioning from one plan or coverage to another, such as transitioning between employment-based coverages. STLDI is excluded from the definition of "individual health insurance coverage" in the Public Health Service Act, and therefore is generally exempt from the applicable federal individual market consumer protections and requirements for comprehensive coverage. Under Reg. Sec. 54.9801-2, STLDI is currently defined as coverage with an initial term specified in the contract that is less than 12 months after the original effective date of the contract, and taking into account renewals or extensions, has a duration of no longer than 36 months in total.

Another type of health insurance that does not provide comprehensive coverage is fixed indemnity excepted benefits coverage. Benefits are paid in a flat ("fixed") cash amount following the occurrence of a health-related event, such as a period of hospitalization or illness. Benefits are typically provided at a pre-determined level regardless of any actual health care costs incurred by a covered individual with respect to the qualifying event. Although a benefit payment may equal all or a portion of the cost of care related to an event, it is not necessarily designed to do so, and the benefit payment is made without regard to the amount of medical expense incurred.

The taxation of amounts received by an employee from accident or health insurance where the premiums or contributions are paid on a pre-tax basis is determined under Code Sec. 105. Code Sec. 105(a) provides that amounts received by an employee through accident or health insurance for personal injuries or sickness are included in gross income, except as otherwise provided in Code Sec. 105. Code Sec. 105(b) excludes from gross income amounts paid by the employer to reimburse an employee's expenses for medical care (as defined in Code Sec. 213(d)). Under Reg. Sec. 1.105-2, the Code Sec. 105(b) excludes only to amounts paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care. Thus, Code Sec. 105(b) does not apply to amounts which the taxpayer would be entitled to receive irrespective of whether or not expenses are incurred for medical care, and Code Sec. 105(b) is not applicable to the extent that such amounts exceed the amount of the actual expenses for such medical care. Further, under longstanding regulations and IRS guidance, including Notice 2017-47, Prop. Reg. Sec. 1.125-6, and Notice 2002-45, amounts for medical expenses within the meaning of Code Sec. 213(d) must be substantiated if reimbursed by employment-based accident or health insurance that would not be excluded from a taxpayer's gross income but for the application of Code Sec. 105(b).

Proposed Regulations

On July 12, the IRS issued proposed regulations that (1) modify the definition of short-term, limited duration insurance and (2) clarify the tax treatment of amounts received by a taxpayer through employment-based accident or health insurance that are paid without regard to the amount of incurred medical expenses under Code Sec. 213(d) and where the premiums or contributions for the coverage are paid on a pre-tax basis. According to the IRS, these revisions are intended to more clearly distinguish STLDI and fixed indemnity excepted benefits coverage from comprehensive coverage.

The proposed regulations amend the definition of STLDI in Reg. Sec. 54.9801-2 to reflect a new interpretation of the phrase "short-term." Under the proposed regulations, STLDI is defined as a policy, certificate, or contract of insurance with an issuer that has an expiration date specified in the policy, certificate, or contract of insurance that is no more than 3 months after the original effective date of the policy, certificate, or contract of insurance.

The proposed regulations also modify Reg. Sec. 1.105-2 to clarify that the exclusion from gross income under Code Sec. 105(b) does not apply to amounts received from accident or health insurance that pays an amount or distributes a benefit if the benefit is paid without regard to the actual amount of Code Sec. 213(d) medical expenses incurred by the employee. In addition, the proposed regulations provide that accident and health insurance payments that are not excluded from employees' gross income under Code Sec. 105(b), because the amounts were paid without regard to the actual amount of incurred or otherwise unreimbursed Code Sec. 213(d) medical care expenses, are wages subject to Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and income tax withholding.

According to the IRS, although a benefit payment at the pre-determined level under fixed indemnity excepted benefits coverage may incidentally cover all or a portion of the cost of medical care stemming from the precipitating health-related event, it is typically not designed to do so and is paid without regard to the amount of the medical care expense incurred. The IRS noted that some specified disease excepted benefits coverage operates in a similar manner. For example, coverage only for a specified disease or illness might offer lump sum payments upon a specific diagnosis or on the basis of treatment received, or it might offer fixed payments per day or other time period of hospitalization or illness. Further, the IRS observed that taxpayers covered by these arrangements will, in many cases, receive benefits upon the occurrence of a health-related event under these arrangements even if any incurred expenses associated with that event are already reimbursed through other coverage.

The IRS further explained that, while these arrangements are sold under a variety of names, they are commonly sold as fixed indemnity excepted benefits coverage or specified disease excepted benefits coverage. However, the IRS said that the changes in the proposed regulations would not be limited to these types of coverage. The IRS noted that it is important to look past the label on any given accident or health insurance product to determine whether amounts received by an employee are, in fact, for reimbursement of medical expenses or whether the amounts could be used for any purpose. For example, even if a benefit payment under the arrangement is used to reimburse an employee's medical expenses, if the amount of the payment is not tied to the amount of the expense incurred and the employee is entitled to keep any amounts by which the benefit payment exceeds the incurred expenses, that would indicate that the benefit is not actually a reimbursement for medical expenses.

The proposed regulations also clarify that, for amounts to be excluded from income under Code Sec. 105(b), the payment or reimbursement must be substantiated. The IRS said it understands that, in most circumstances, substantiation of medical expenses typically occurs prior to reimbursement. However, the IRS is the view that substantiation must occur at least within a reasonable period thereafter, and the IRS requested comments on whether any final rules should specifically address timing requirements for substantiation.

Applicability Dates

For new STLDI sold or issued on or after the effective date of the final rules, the amendments to the definition of STLDI would apply for coverage periods beginning on or after such date. However, for STLDI sold or issued before the effective date of the final rules (including any subsequent renewal or extension), the current definition of such coverage would continue to apply with respect to the maximum allowable duration. Therefore, existing STLDI could continue to have an initial contract term of less than 12 months and a maximum duration of up to 36 months (taking into account any renewals or extensions).

The proposed changes to Reg. Sec. 1.105-2 would apply as of the later of the date of publication of the final regulations or January 1, 2024.

For a discussion of amounts received through accident or health insurance, see Parker Tax ¶75,915. For a discussion of the exclusion for medical care expense reimbursements, see Parker Tax ¶120,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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