Guest Article

(From the March 5, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS PLR Provides Guidance on Tax Treatment of Group Health Benefits for Partners

A recent IRS ruling clarifies that partners can deduct premium payments to their partnership's group health plan, and exclude the plan's benefit payments from their gross incomes, so long as the plan has "the effect of accident or health insurance." IRS Private Letter Ruling (PLR) 200704017 (January 26, 2007). The ruling is significant because partners are not "employees," and thus they are not eligible for the IRC § 105(b) gross income exclusion for medical expense reimbursements or the IRC § 106(a) gross income exclusion for employer-provided health coverage. Also unlike employees, partners may not pay group health insurance premiums on a pre-tax basis through IRC § 125 cafeteria plans.

Of course, PLRs do not have any precedential value, and reliance on PLRs is limited to the party that initiated the request with the IRS. Nonetheless, PLRs do provide valuable insights into the IRS's position on the issues addressed.

Overview

At issue is IRC §§ 104(a)(3) and 162(l). The former provides a gross income exclusion for "amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer)". The latter permits self-employed individuals -- including partners -- a deduction "equal to the applicable percentage of the amount paid during the taxable year for insurance which constitutes medical care for the taxpayer, his spouse, and dependents." The "applicable percentage" is as follows:

The IRS issued the PLR at the request of a partnership that sponsors a self-insured group health plan ("Plan") for eligible partners and non-partner employees. The Plan pays eligible medical expenses for covered partners and non-partner employees (and their covered spouses and dependents) from a general account funded by participant premiums and partnership contributions. The partnership sets the participant premium rate each year -- with help from the Plan's independent third-party administrator -- according to the following formula:

Premiums for the various benefit options and types of coverage are the same for partners and non-partner employees. However, the partnership subsidizes a portion of the premium for non-partner employees. All premiums are paid to the partnership's general account. If total premium payments for a year are less than the Plan's benefit claims and expenses for that year, the partnership makes an additional contribution to the general account to cover the deficiency. If total premium payments exceed benefit claims and expenses, the surplus is used to pay claims and expenses in subsequent years.

The question is whether the partnership's self-insured Plan is "an arrangement having the effect of accident or health insurance" for purposes of IRC § 104(a)(3), as opposed to simply being a reimbursement arrangement. The distinction is significant for the partners because they cannot claim the IRC § 162(l) deduction for their premiums or exclude the Plan's benefit payments from their gross incomes under IRC § 104(a)(3) if the Plan is just a reimbursement arrangement.

IRS's Analysis

According to the PLR, "An essential indicia of accident or health insurance is the shifting of risk." Specifically, a health insurance plan or program shifts the risk of economic loss from the insured and his or her family to the plan, and distributes this risk among all of the plan's participants. The PLR continues, "In the context of this type of insurance, risk shifting will occur when an insurer agrees to protect the insured (or a third-party beneficiary) against a direct or indirect economic loss arising from a defined contingency involving an accident or health risk."

Without significant explanation or elaboration, the IRS ruled "the Plan is 'an arrangement having the effect of accident or health insurance'." Based on the specific "facts presented," the PLR concludes, "in return for the payment of a premium, the risk of economic loss in the event of personal injury or sickness is shifted from the partner and partner's family to the Plan and distributed among the Plan's participants." As a result, the partners can deduct their premium payments to the Plan under IRC § 162(l), and benefit payments from the Plan to or for the benefit of the partners (and their spouses and dependents) are excluded from their gross incomes under IRC § 104(a)(3).

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.