Health Reform Questions-Taxation of MLR Rebate Cash Payments

By Larry Grudzien, JD

April 12, 2012

My employer has just indicated that it will receive a Medical Loss Ratio (MLR) rebate from the insurer for group health coverage provided in 2011.  It will distribute the rebate to employees in the form of a cash payment for any amounts contributed by them.  Will these cash payments be taxable to employees when they receive them?

It will depend if employees made pre-tax or after-tax contributions for their share of premium.  See the discussion below:

Pre-tax Contributions: In frequently asked questions (FAQs), IRS clarified the tax treatment of rebates for group health plan enrollees. Employees who paid for health coverage with pretax contributions will be taxed on any cash MLR rebate they receive. Rebates used to reduce employee pretax contributions will lower employees’ salary reduction amounts, resulting in higher wages subject to income and employment taxes.

If an employer uses the MLR rebate received this year to make cash payments to employees who made pretax contributions, the rebate payment will be taxable income to those employees and subject to employment taxes. If the employer instead uses the MLR rebate to reduce employees’ 2012 health plan premiums, each employee’s pretax plan contribution will shrink, causing wages subject to income and employment taxes to increase by the same amount.

Example. For 2011 and 2012, Betty participated in her employer’s insured group health plan, making pretax contributions for coverage. In 2012, her employer sends Betty a check for her share of the MLR rebate after income and employment tax withholding.

Example. John participates in his employer’s group health plan, electing under its cafeteria plan to make $6,500 in pretax contributions for coverage in 2012. John’s employer receives an MLR rebate in July 2012 and applies it to reduce each group health plan participant’s 2012 premiums by $1,000. This requires adjusting the payroll system to lower pretax deductions for the rest of the year. As a result, John’s total pretax cafeteria plan contributions will decrease to $5,500, and his taxable income will increase by $1,000 for 2012. Both John and his employer will have to pay employment taxes on that additional taxable amount.

After-tax Contributions: When employees pay group health plan premiums with after-tax contributions, MLR rebates typically won’t be taxable. Whether used to reduce 2012 premiums or paid in cash, any MLR rebates for these employees simply refund their after-tax premium payments. The rebate will be taxable, however, if employees – such as partners in a partnership -deducted the after-tax premiums on their 2011 federal income tax returns.

The FAQs don’t address the tax treatment of MLR rebates for former employees participating in an employer’s plan, such as COBRA beneficiaries or retirees. Although the tax treatment of rebates presumably would be the same for former and current employees paying with after-tax contributions, any guidance would be helpful.

For a copy of the Frequently Asked Questions released by the IRS, please click on the link below:

http://www.irs.gov/newsroom/article/0,,id=256167,00.html 

If you have any comments or questions regarding any of above information, please do not hesitate to call (708) 717-9638 or e-mail larry@larrygrudzien.com

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