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Cash in lieu of group health plan benefit

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I have a client that offers group health insurance to its employees.  The employer contributes up to $500 per month toward the cost of the benefit for each eligible employee.    One employee does not enroll in the group health plan because he is covered by his wife's group health plan through her employer.

The employer has decided they want to pay this employee the $500 benefit that he is "missing out on."  The employee and employer insist that this should be considered a non-taxable health insurance reimbursement.   Their argument is that all the other employees receive the $500 employer paid benefit non-taxable.  From everything I have read, that is wrong and it is considered  cash in lieu and is taxable to the employee on his W-2.     

Can anyone provide me with an authoritative source (IRS Notice, etc.) that addresses this and states that is should be taxable income to the employee (assuming I am correct)?

Thanks in advance!

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@KdGal That's arguably more of an cashable flex credit than an opt-out credit, but it doesn't really matter.  Either way, the cash option is always standard taxable income.

That's the whole reason we have Section 125 in the first place--as a safe harbor from the doctrine of constructive receipt of the taxable cash option for those who elect the non-taxable qualified benefits.

I've got a summary of those rules on slides 5-6 here: ABD Office Hours Webinar: Section 125 Cafeteria Plans

Summary of the opt-out credit and flex credit affordability concerns here: https://www.theabdteam.com/blog/how-the-aca-affordability-increase-to-9-83-affects-employers/

If you want to go direct to the source, I recommend the IRS "Potluck Guidance" in Notice 2015-87: https://www.irs.gov/pub/irs-drop/n-15-87.pdf

Lots of discussion there about the opt-out credits and cashable flex credits as taxable income (and more significantly, how they affect ACA affordability).

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Another point worth mentioning regarding Section 125 is that, among other requirements, it is necessary for the employer in such situation to timely adopt a Section 125 plan. Otherwise, the constructive receipt exception is not there, This may mean that even those employees opting for group health coverage would have to be taxed on the $500 opt-out amount.

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You will probably want to run this through the cafeteria plan so that you don't end up with a constructive receipt issue.  And, generally speaking, remember that cafeteria plans also have non-discrimination rules - including a benefits test that generally requires you to provide the same benefits to highly paid and not so highly paid.  So, this is probably an option you will want to make available to all employees.  As a result, you may want to wait to add this to your cafeteria plan until the beginning of the next plan year when all employees are making coverage decisions.     



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