A tax break is just another way of saying “government subsidy.” Most people don’t even think about it when they get a medical bill. Usually they are just upset about the size of the copay! But Congress subsidizes health care by allowing taxpayers to exclude from income anything that health insurance plans pay medical providers above the copay.
However, the extent of that subsidy depends on who pays for the insurance in the first place. If the insurance is paid by the taxpayer, the exclusion is governed by §104(a)(3). That provision doesn’t just exclude payments for actual medical services. Excludes any and all amounts paid due to bodily injury or illness. Conversely, if the taxpayer’s employer pays for the insurance, then the exclusion is governed by §105(b) and that is a more restrictive exclusion. The §105 exclusion is limited to actual reimbursement (or payment) for identified health care.
The differences between the §104(a)(3) exclusion and the §105(b) exclusion are most apparent when a taxpayer receives disability payments, as we learn in Cynthia L. Hailstone and John Linford v. commissioner, TC Sum. Op. 2023-17 (April 24, 2023) (judge leyden). There, the taxpayer received disability payments and tried to exclude them from income. That could have worked under §104(a)(3) if taxpayers had paid for the insurance, but since the payments in question came from an employer-paid plan, the exclusion was not allowed under §105(b). . Details below the fold.
Law: The Difference Between 104 and 105 Exclusions for Health Care Payments
Congress has created two different exclusion pathways for health insurance plan payments: the §104(a)(3) exclusion and the §105(b) exclusion. Remember, §61(a)(1) tells us that basically everything is income “except as otherwise provided in subtitle A”. So, in general, when a taxpayer receives something of value, such as a payment from an insurance company (either directly or indirectly to a medical provider), that something constitutes gross income, unless you can find a legal basis to exclude it. .
He 104(c)(3) track of exclusion: You will find such a legal exclusion in §104(a)(3). Provides that gross income does not include “amounts received through accident or health insurance (or through an agreement having the effect of accident or health insurance) for personal injury or sickness”.
Note the breadth of the exclusion. The wording: “amounts received…” does not impose restrictions on the actual destination of the amounts received. Note also, however, that taxpayers cannot use §104(a)(3) to exclude payments from insurance plans if the premiums for those plans were paid by your employer. That is, the 104(c)(3) exclusion does not apply when “such amounts (A) are attributable to employer contributions that were not included in the employee’s gross earnings, or (B) are paid by the employer).” ID. For those payments, taxpayers need a different exclusion provision. They need §105(b).
He 105(b) track of exclusion: You will find the way of exclusion for payments from employer-paid insurance plans in §105. Section 105 has a squirrel structure. Although it is found in the portion of Subchapter B titled “Items Specifically Excluded from Gross Income,” it begins with a broad inexclusionary rule in §105(a): “amounts received by an employee through accident or health insurance for personal injury or illness shall be included in gross income to the extent such amounts (1) are attributable to employer contributions that were not included in income employee gross, or (2) are paid by the employer.” Notice how this section uses the exact same language that is used in §104(a)(3) to describe amounts that could No be excluded under §104(a)(3).
Only after subsection (a) makes all “received amounts” of income from employer-paid plans trigger §105(b) to exclude some of those payments. He says that “gross income does not No include the amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for medical care expenses incurred by the taxpayer (as defined in section 213(d)). ..”
Therefore, the §105(b) exclusion only works for payments that a taxpayer can link to identifiable physicians. careful bills.
mixing it up: Sometimes a taxpayer may receive payments from more than one insurance plan. Some of those payments may be eligible for exclusion under §104(a)(3) and other payments may be restricted by the exclusion rules in §105(b). That’s not our lesson today, but for those interested, Rule Rev. 69-154v gives the rules for calculating the appropriate exclusion in such situations.
He §106(a) reason why. I’m not entirely sure, but I think the reason for these two different exclusion paths is the huge tax subsidy given in §106(a). Section 106(a) allows employees to exclude from gross income the amounts their employer pays for their health insurance plans. This §106(a) exclusion is as old as it is debatable, as explained in this excellent Congressional Research Service Report as of 2011. What is not in dispute, however, is that this is the largest single subsidy, aka “tax break,” that Congress gives to anyone, period. This Treasury Report March 2023 estimates the exclusion represents some $237 billion in lost revenue in FY 23 alone. It projects a revenue loss of more than $3.4 trillion over 10 years. See identification. in Table 3.
One quickly sees how this really generous exclusion in §106(a) could well be the reason §105 is structured in the weird way and why Congress limits the §105(b) exclusion to only amounts paid to cover actual health care costs that would qualify for the deduction under §213.
Finally, note that §105(f) states that for the purposes of §104 and §105, the payments excluded (or not!) under these provisions include disability payments. There used to be a separate deduction under §105(e) for disability payments, but Congress removed it when it created the tax credit for certain disability payments now found in §22. See Social Security Amendments of 1983, Pub. L. 98–21, 97 Stat. 85, 87. I welcome comments on anyone wanting to give war stories about the good old days when §105(e) was the rule to exclude disability payments and not §105(b).
In the meantime, let’s see what happened here and what we can learn.
The tax year in question is 2017. In that year, Mr. Linford received $105,000 from Principal Life Insurance Co. as disability payments owed to him for an unspecified disability. He had filed his claim in 2014 and the insurance company didn’t approve it until 2017.
The insurance policy that paid his benefits had been purchased by Mr. Linford’s employer. The employer had paid 100% of the premiums for each covered employee. Mr. Linford did not have to report those premiums as income due to the generous exclusion in §106.
Mr. Linford and Ms. Hailstone also decided that they did not have to report the $105,000 in disability payments Mr. Linford received when they filed their 2017 return. However, since the Insurance Company filed an informational return showing payments, IRS computers detected the discrepancy and sent them a CP2000 love letter, proposing to assess a deficiency of $21,910 and an accuracy-related penalty of $4,382.
The couple timely petitioned the Tax Court. During those proceedings, Ms. Hailstone filed for and received spousal relief under §6015(c). It is not our lesson today. Rather, our lesson is why disability payments cannot be excluded from income.
Lesson: The Restrictive Nature of the §105(b) Exclusion
If the §105(b) exclusion path applied here, Mr. Linford needed to report disability payments because he could not link them to actual medical care. They were payments made independently of the medical care he needed because of his disability. However, if the §104(a)(3) exclusion path applied to any payments, they would be excluded because that exclusion is not limited to reimbursements for medical care.
It appears that Mr. Linford tried to argue that 25% of the payments were eligible for the §104(a)(3) exclusion because the insurance plan gave his employer the option of having each employee contribute 25% of the cousins. Since the employer only “had” to pay 75% of the premiums, it appears that Mr. Linford was seeking to submit to the blending rules in Rev. Rul. 69-154.
Justice Leyden had no difficulty in rejecting that “could-could-should” argument, writing that “It is clear from the record that the company did not opt for that option and did not allow employees to pay any amount of the premiums. Rather, the record shows that the premiums for the policy were paid by the company.” Op. at 5. That fact brought all payments under the §105(b) exclusion pathway.
It appears that Mr. Linford also tried to argue for an exclusion under §105(c). That section allows an exclusion if the disability payment is for the “permanent loss or loss of use of a bodily member or function, or…permanent disfigurement.” However, Mr. Linford never explained to the Court the nature of the disability for which he received payments.
Bottom line: Whether disability payments can be excluded from income under §104(a)(3) depends on whether the taxpayer paid for the insurance with after-tax dollars or was paid by the taxpayer’s employer instead.
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camp bryan is the George H. Mahon Professor of Law at the Texas Tech University School of Law. Invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to the TaxProf Blog for another Tax Court Lesson.