IRS Revenue Ruling
2002-3

 Code Secs. 106, 125

<<FULL TEXT>>

(Also Section 125 -- Cafeteria Plans and Section 105 -- Amounts Received
Under Accident and Health Plans).

Application of sections 106(a) and 105(b) to reimbursements of
employees for salary reduction amounts previously excluded from gross
income under section 106(a).



REV. RUL. 2002-3

ISSUE

Whether, under the facts described, the exclusions from gross income
under sections 106(a) or 105(b) of the Internal Revenue Code apply to
reimbursements by an employer to employees for salary reduction amounts
used to pay for health insurance premiums.


FACTS

Employer M provides health coverage for its employees through a group
health insurance policy. The coverage constitutes accident or health
coverage for purposes of the exclusion for employer-provided accident or
health coverage under section 106(a).

M has a payroll arrangement under which employees' salaries are
reduced, and M applies the salary reduction amounts to the payment of the
health insurance premiums for the employees. Thus, employees receive lower
salaries in exchange for employer-provided health coverage. In addition, M
makes "reimbursement" payments to employees with respect to the health
insurance premiums in amounts that cause employees' after-tax pay from M
to be the same as what it would have been if there were no salary
reduction and no "reimbursement" payments. M takes the position that both
the salary reduction and the "reimbursement" payments are excluded from
gross income of employees and are not subject to Federal Insurance
Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes.

The salary reduction used to pay for health insurance premiums under
M's payroll arrangement could be done with or without employee elections.
For example, M could make a unilateral decision to reduce employees'
salaries and use those amounts to provide health insurance to the
employees. Alternatively, M could offer employees the choice under a
section 125 cafeteria plan to reduce their salaries in order to receive
employer-provided health insurance.


LAW AND ANALYSIS

In general, section 106(a) provides that gross income of an employee
does not include employer-provided coverage under an accident or health
plan. Under section 106(a), an employee may exclude premiums for accident
or health insurance coverage that are paid by an employer. Also, under
section 105(b), an employee may exclude amounts received through
employer-provided accident or health insurance if those amounts are paid
to reimburse expenses incurred by the employee for medical care (of the
employee, the employee's spouse, or the employee's dependents) for
personal injuries or sickness. To the extent amounts are excluded from
gross income under section 105(b) or 106(a), they are also excluded from
income tax withholding under section 3401. In addition, amounts paid to
reimburse expenses incurred by the employee for medical care (of the
employee, the employee's spouse, or the employee's dependents) for
personal injuries or sickness are also excluded from FICA and FUTA taxes
under sections 3121(a) and 3306(b).

Under section 125, an employer may establish a cafeteria plan that
permits an employee to choose among two or more benefits, consisting of
cash (generally, salary) and qualified benefits, including accident or
health coverage. Pursuant to section 125, the amount of an employee's
salary reduction applied to purchase such coverage is not included in
gross income, even though it is available to the employee and the employee
could have chosen to receive cash instead. If an employee elects salary
reduction pursuant to section 125, the coverage is excludable from gross
income under section 106 as employer-provided accident or health coverage.

Rev. Rul. 61-146 (1961-2 C.B. 25) provides that the section 106
exclusion applies to an employer's reimbursement of an employee for
individual accident and health insurance premiums paid by the employee to
an insurer if (1) the employer has an accident and health plan under which
it permits such reimbursements and (2) any reimbursement is of premiums
actually paid by the employee.

Under the rationale of Rev. Rul. 61-146, section 106 allows an employee
to exclude employer reimbursements for health insurance premiums, but only
if those premiums are actually paid by the employee. Under both
alternative arrangements described above, when M applies the amount of
employees' salary reduction to pay health insurance premiums, the premium
payments are paid by M, not the employees, and are excludable from the
employees' gross income under section 106 because they are paid by M.
Although the section 106 exclusion applies to the health insurance
premiums paid by M, there is no employee-paid premium for M to
"reimburse", and therefore the reimbursement payments that M makes to
employees are not excluded from gross income under section 106. Similarly,
the reimbursement payments are not excluded from gross income under
section 105 because they do not reimburse employees for expenses incurred
for medical care. Accordingly, the reimbursement payments are not excluded
from income tax withholding under section 3401. In addition, because the
reimbursement payments are not reimbursements of expenses incurred for
medical care, they are not excluded from FICA taxes under section 3121(a)
or FUTA taxes under section 3306(b).

If the premium payments were instead actually paid by the employees out
of the employees' salaries, the salary amounts from which the payments
were made would not be excludable from the employees' gross income, but
any payments by M to reimburse the employees for the premium payments
would be excludable under section 106.


HOLDING

The exclusions from gross income under sections 106(a) and 105(b) do
not apply to amounts that an employer pays to employees to reimburse the
employees for amounts paid by an employer for health insurance coverage
that are excluded from gross income under section 106(a) (including salary
reduction amounts pursuant to a cafeteria plan under section 125 that are
applied to pay for such coverage). Accordingly, the reimbursement amounts
that the employer pays to the employees are included in the employees'
gross income under section 61 and are subject to employment taxes under
sections 3401, 3121(a), and 3306(b).


EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 61-146 is distinguished.


DRAFTING INFORMATION

The principal author of this Revenue Ruling is Janet A. Laufer of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities). For further information regarding this Revenue
Ruling, contact her at (202) 622-6080 (not a toll-free call).

<<END RULING>>

TO CONTACT
DON FITCH CPA

Phone Don Fitch CPA Toll Free at (877)CPA-Help or (877)272-4357 or on our Direct Line at (760)674-1722.