With increasing regularity we receive some variation of this question, "What is this 'employer exclusion' that some lawmakers are considering for inclusion in they various proposed Obamacare replacement efforts?"
Short Answer
Private employer-sponsored health insurance covers approximately 177 million Americans. Currently, employer-sponsored health insurance premiums paid for by the employer, or paid by employees through a cafeteria plan, are completely excluded from income taxation. This is sometimes referred to as the "employer exclusion," but it is really a tax exclusion for employees on the cost of employer-provided health care. This tax-favored status helps create stability in the largest of marketplaces: the employer group coverage market.
In the Affordable Care Act (ACA), the complicated "Cadillac tax" was developed to impose a 40 percent excise tax on high-cost employer-sponsored health plans. The tax, however, would have been imposed on employers and insurers, not employees.The tax was delayed until 2020. Under the recently introduced (but not passed) American Health Care Act (AHCA), and a subsequent "Manager's Amendment" to the AHCA, there would be a further delay until 2026.
Prior to introducing the AHCA, in order to collect revenues to pay for the replacement bill, Republicans hinted they want to tax employees for health insurance coverage exceeding a set statutory cap. In a very simple example, if the first $20,000 of employer-sponsored family coverage is determined to be tax free and $13,000 is the aggregate premiums paid, then the employee owes no tax. Under the same example, if $22,000 is the cost of premiums, then the $2,000 excess above $20,000 is taxed to the employee as ordinary income - and presumably subject to payroll taxes (FICA and FUTA), as well. To be clear, this is an example only. No cap has been set yet. While the draft version of a bill leaked in February 2017 included such a tax, the AHCA did not.
The AHCA would have, however, retained the Cadillac tax for 2026 and later, while the earlier draft completely eliminated the Cadillac tax. It remains to be seen whether there will be some "horse trading" and the tax on employer-provided coverage reappears in the AHCA in return for a full repeal of the Cadillac tax. This tax might also enter into comprehensive tax reform discussions, which will likely take place later this year or next.
Click on the link below to read the American Benefits Council white paper, "Taxing Employer-Sponsored Health Benefits: Myths and Realities." This is an area of real concern for employers and, even though not included in the AHCA, will likely still be relevant to the ACA replace/repair debate, as well as tax reform discussions.
Analysis
Section 61(a) of the Internal Revenue Code (IRC) provides that all forms of income, from whatever source, are taxable unless there is an express exception. With respect to employer-provided health care coverage, there are two exceptions that are relevant:
- An exclusion for the cost of coverage (e.g., the amount of premiums paid for the coverage) under IRC Section 106
- An exclusion for the benefits received under IRC Section 105
Several of the earlier versions of the Republican replace/repeal proposals for the ACA limited the exclusion (from income under IRC Section 106) on the cost of employer-provided health care coverage. Some reasons for these proposals are ideological - the belief that employer-provided coverage does not afford employees with enough "skin in the game" to be wise users of health care dollars, which results in them obtaining more coverage than they otherwise would or should have. Others note the effect on tax revenue mentioned above. The more pressing reason in the earlier versions of these proposals, however, is the need for replacement of budget dollars that would be lost by repeal of the Cadillac and other taxes.
Of course, with the AHCA, Republican leaders have, at least for now, backed off the notion of taxing employer-provided health care coverage, but they have retained the Cadillac tax for years 2026 and later. We must see if the concept of taxing employer-provided health care coverage reappears in return for a complete repeal of the Cadillac tax or in subsequent comprehensive tax reform negotiations.
None of the earlier proposals eliminated the exclusion entirely. These proposals all kept the exclusion for employer-provided health care coverage up to a certain level. One proposal, for example, kept the exclusion for employer-provided health care coverage up to $12,000 for individual coverage and $30,000 for family coverage. The draft Republican bill leaked in February set the cap at the nationwide 90th percentile of average premiums for group health care coverage. As mentioned above, however, this taxation is currently not part of the most recent version of the AHCA.
In reviewing any proposal to tax employer-provided health care coverage, it is not only important to focus on any cap, but also on how the cap will be indexed in the future. Some earlier proposals are similar to the Cadillac tax, where the cap is indexed to the consumer price index. Others use the consumer price index plus a certain percentage. Significantly, these proposals do not set the index to the rise in the cost of health care. Therefore, if health care costs escalate faster than the selected index, as years go by, more and more employees could be subject to taxation for employer-provided coverage.
Also of critical importance is what will be included in the cost of employer-provided coverage. For example, some proposals did not include Health Savings Accounts (HSAs) in that cost. The likely result, if such a proposal became law, would be employers providing lower-cost high-deductible plans with increasingly higher deductibles, so their employees will not be taxed, but "making up the difference" with an employer contribution to an HSA.
But, again, we stress these are merely proposals and, while included in the leaked bill, were not included in the most recent version of the AHCA. The failure to include these provisions in the AHCA is likely the result of push-back on limiting this income tax exclusion, which has been in existence for more than 50 years. In the summary above, you will find the link to the American Benefits Council's white paper, "Taxing Employer-Sponsored Health Benefits: Myths and Realities," which provides some of the reasons for this pushback.
We will simply have to wait and see whether any type of tax on employer-provided health care coverage reappears in any future version of the AHCA or in any comprehensive tax reform package.
