Medical Loss Ratio Rebates – The Tax Consequences
Beginning in August 2012 many of our clients and friends have begun (maybe to their surprise) to receive checks from their health insurance carriers under the title Medical Loss Ratio rebate. As a result, there have been many questions regarding what should or can be done with the rebate and the income tax consequences, if any. This Alert addesses the tax consequences of receiving the rebate after the employer has decided how the rebate should be used. For guidance in determining your ERISA fiduciary obligations related to the utilization of the rebate, please see our recent article “Will You Benefit from a Medical Loss Rebate?” by clicking here
In April of this year, the Internal Revenue Service (IRS) issued a set of Frequently Asked Questions explaining the tax treatment of these premium rebates under the Medical Loss Ratio (MLR) requirements imposed by the Patient Protection and Affordable Care Act (the Act).
The Act requires health insurance issuers in the individual and group markets to report plan costs for the purpose of calculating the insurer’s medical loss ratio (the percentage of insurance premium dollars spent on reimbursement for clinical services and activities to improve health care quality). Absent an express waiver, large group insurers must spend at least 85% of premium dollars on claims and activities to improve health care quality, and individual and small group insurers must spend at least 80% of premium dollars on claims and activities to improve health care quality.
Beginning in August 2012, health insurance issuers must provide rebates to policy holders if the plan’s medical loss ratio did not meet the minimum standards under the Act for 2011. The IRS issued its guidance for the purpose of providing information on the federal tax consequences to a health insurance issuer that pays a MLR rebate and a policyholder or plan participant who receives an MLR rebate.
Below is a general summary of the tax treatment of the MLR rebate under a number of potential scenarios based on the IRS guidance.
Policies Purchased on the Individual Market
If the policyholder purchased coverage with after-tax dollars (i.e., s/he did not deduct the premium payments on IRS Form 1040 Schedule A), the rebate is not taxable, irrespective of whether received as a cash payment or applied as a reduction in the amount of the subsequent year’s premiums.
If the policyholder deducted the premium payments on her/his IRS Form 1040 Schedule A, then the MLR rebate is subject to federal income tax.
Group Policies—Employee After-Tax Premium Payments
The MLR rebate is a rebate of part of the policyholder’s prior year premiums (what the IRS refers to as a “purchase price adjustment”). If the taxpayer paid taxes on her/his compensation in the prior year and used part of the after-tax income to pay her/his portion of the current premiums, because s/he did not deduct the premiums, the rebate is not taxable. The result is the same if the policyholder receives a cash distribution of the MLR rebate. The cash in this instance is a reduction in the cost of future premiums. However, if the policyholder previously deducted her/his premium payments, the MLR rebate is subject to federal tax on her/his Form 1040.
Group Policies—Employee Pre-Tax Payments, Scenario 1
In the case where the MLR rebate is limited to employees participating in a group health plan both in the year the employee paid the premiums being rebated and the year the MLR rebates are paid and where the employer applies the rebate to reduce current premiums, the rebate is taxable. Because the MLR rebate is distributed as a premium reduction, the amount the employee pays for premiums through a salary reduction contribution in the subsequent year is decreased by her/his portion of the rebate received. As a consequence, there is a corresponding increase in her/his taxable salary equivalent to the reduction in premium for the current year.
The result is similar if the MLR rebate is paid in cash. The employee has an increase in taxable income for her/his portion of the rebate received for the year in which the rebate is paid to her/him.
Group Policies—Employee Pre-Tax Payments, Scenario 2
In the case where the MLR rebate is paid regardless of whether the employee who receives the MLR rebate participated in the health plan during the plan year covered by the MLR rebate, then:
- For employees who were covered by the health plan in the year to which the rebate applies, the result is the same as in Scenario 1 above.
- For employees who were not covered by the health plan for the year to which the rebate applies, if the MLR rebate is distributed as a premium reduction, the amount the employee pays for premiums through a salary reduction contribution is decreased by her/his portion of the rebate received. As a result, there is a corresponding increase in her/his salary equivalent to the amount of the reduction in premiums paid for the year, which is taxable income. If the employee instead receives the MLR rebate as a cash payment, s/he will have taxable income in the year the rebate is paid to her/him.
The IRS reasoning for the taxation of the cash payments under the two preceding scenarios is that the amount the employee pays for premiums for health insurance is deducted from her/his salary on a pre-tax basis under her/his employer’s cafeteria plan. The MLR rebate is a return to the employee of part of that untaxed compensation that is no longer being used to pay for health insurance. Therefore, the MLR rebate is an increase in taxable income.
With the advent of the MLR rebates, it is critical for employers to first determine how they will utilize the rebate in light of their fiduciary responsibilities under ERISA and then determine the appropriate tax treatment and reporting based on how the rebate is utilized.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.