A tax break is simply one other method of claiming “authorities subsidy.”  Most folk don’t even take into consideration that after they get a medical invoice.  They’re typically simply upset in regards to the dimension of the co-pay!  However Congress subsidizes medical care by permitting taxpayers to exclude from revenue every part the medical insurance plans pay the medical suppliers above the co-pay.

The scope of that subsidy, nonetheless, is determined by who pays for the insurance coverage within the first place.  If the taxpayer pays for the insurance coverage, the exclusion is ruled by §104(a)(3).  That provision doesn’t simply exclude funds for precise medical companies.  It excludes any and all quantities paid on account of bodily damage or illness.  In distinction, if the taxpayer’s employer pays for the insurance coverage, then the exclusion is ruled by §105(b) and that may be a extra restrictive exclusion.  The §105 exclusion is restricted to precise reimbursements (or funds) for recognized medical care.

The variations between the §104(a)(3) exclusion and the §105(b) exclusion are most obvious when a taxpayer receives incapacity funds, as we be taught in Cynthia L. Hailstone and John Linford v. Commissioner, T.C. Summ. Op. 2023-17 (Apr. 24, 2023) (Decide Leyden).  There, the taxpayer acquired incapacity funds and tried to exclude these from revenue.  Which may have labored below §104(a)(3) if the taxpayers had paid for the insurance coverage, however because the funds at problem got here from an employer-paid plan, the exclusion was not permitted, per §105(b).  Particulars under the fold.

The 104(c)(3) Exclusion Pathway:  You discover one such statutory exclusion in §104(a)(3).  It offers that gross revenue doesn’t embrace “quantities acquired by means of accident or medical insurance (or by means of an association having the impact of accident or medical insurance) for private accidents or illness.”

Discover the broadness of the exclusion.  The phrasing: “quantities acquired….” places no restrictions on what the quantities acquired are literally used for.  Nevertheless, discover additionally that taxpayers can not use §104(a)(3) to exclude funds from insurance policy if the premiums for these plans have been paid for by their employer.  That’s, the 104(c)(3) exclusion doesn’t apply when “such quantities (A) are attributable to contributions by the employer which weren’t includible within the gross revenue of the worker, or (B) are paid by the employer).”  Id.  For these funds, taxpayers want a distinct exclusion provision.  They want §105(b).

The 105(b) Exclusion Pathway: You discover the exclusion pathway for funds from employer-paid insurance policy in §105.  Part 105 has a squirrelly construction.  Whereas it’s in that a part of Subchapter B titled “Objects Particularly Excluded From Gross Earnings” it begins out with a broad inclusion rule in §105(a): “quantities acquired by an worker by means of accident or medical insurance for private accidents or illness shall be included in gross revenue to the extent such quantities (1) are attributable to contributions by the employer which weren’t includible within the gross revenue of the worker, or (2) are paid by the employer.” Discover how this part makes use of the very same language utilized in §104(a)(3) to explain quantities that would not be excluded below §104(a)(3).

Solely after subsection (a) makes all “quantities acquired” from employer-paid plans revenue does §105(b) kick in to exclude some of these funds.  It says that “gross revenue does not embrace quantities referred to in subsection (a) if such quantities are paid, instantly or not directly, to the taxpayer to reimburse the taxpayer for bills incurred by him for the medical care (as outlined in part 213(d))….”

So the §105(b) exclusion solely works for funds {that a} taxpayer can hyperlink to identifiable medical care bills.

Mixing It Up:  Typically a taxpayer would possibly obtain funds from a couple of insurance coverage plan.  A few of these funds is likely to be eligible for exclusion below §104(a)(3) and different funds could also be restricted to the exclusion guidelines in §105(b).  That’s not our lesson right this moment, however for these , Rev. Rule 69-154v provides the principles for calculating the right exclusion in such conditions.

The §106(a) Purpose Why.  I’m not completely positive, however I believe the rationale for these two totally different exclusion pathways is due to the large tax subsidy given in §106(a).  Part 106(a) permits staff to exclude from gross revenue the quantities their employer pays for his or her medical insurance plans.  This §106(a) exclusion is as long-standing as it’s debatable, as defined on this wonderful Congressional Analysis Service report from 2011.  What isn’t debatable, nonetheless, is that that is the one largest subsidy—a/okay/a “tax break”—that Congress provides to anybody, interval. This March 2023 Treasury Report estimates that exclusion represents some $237 billion in foregone income in FY23 alone.  It initiatives misplaced income of over $3.4 trillion over 10 years.  See Id. at Desk 3.

One rapidly sees how this actually beneficiant exclusion in §106(a) may properly be why §105 is structured the bizarre method it’s and why Congress limits the §105(b) exclusion to simply these quantities paid to cowl precise medical care prices that will qualify for deduction below §213.

Lastly, word that §105(f) offers that for functions of each §104 and §105, the funds excluded (or not!) below these provisions embrace incapacity funds.  There was once a separate deduction below §105(e) for incapacity funds however Congress nuked that when it created the tax credit score for sure incapacity funds now present in §22.  See Social Safety Amendments of 1983, Pub. L. 98–21, 97 Stat. 85, 87.  I welcome feedback on anybody who desires to offer conflict tales in regards to the good outdated days when §105(e) was the rule to exclude incapacity funds and never §105(b).

In the meantime, let’s take a look at what occurred right here and what we will be taught.

Details
The tax yr at problem is 2017.  In that yr Mr. Linford acquired $105,000 from the Principal Life Insurance coverage Co. as incapacity funds owed to him for an unspecified incapacity.  He had filed his declare in 2014 and the insurance coverage firm didn’t approve it till 2017.

The insurance coverage coverage that paid his advantages had been bought by Mr. Linford’s employer.  The employer had paid 100% of the premiums for every coated worker.  Mr. Linford didn’t should report these premiums as revenue due to the beneficiant exclusion in §106.

Mr. Linford and Ms. Hailstone additionally determined they didn’t should report the $105,000 in incapacity funds Mr. Linford acquired after they filed their 2017 return.  Nevertheless, because the Insurance coverage Firm filed an data return displaying the funds, the IRS computer systems picked up the discrepancy and despatched them a CP2000 love letter, proposing to evaluate a deficiency of $21,910 and an accuracy-related penalty of $4,382.

The couple well timed petitioned the Tax Courtroom,  Throughout these proceedings, Ms. Hailstone requested and acquired spousal aid below §6015(c).  Not our lesson for right this moment.  Relatively, our lesson is why the incapacity funds can’t be excluded from revenue.

Lesson: The Restrictive Nature of the §105(b) Exclusion
If the §105(b) exclusion pathway utilized right here, Mr. Linford wanted to report the incapacity funds as a result of he couldn’t hyperlink them to precise medical care.  They have been funds made independently of the medical care he wanted for his incapacity.  Nevertheless, if §104(a)(3) exclusion pathway utilized to any funds, these could be excluded as a result of that exclusion isn’t restricted to reimbursements for medical care.

It seems Mr. Linford tried to argue that 25% of the funds have been eligible for the §104(a)(3) exclusion as a result of the insurance coverage plan gave his employer the choice of getting every worker chip in 25% of the premiums.  Because the employer solely “had” to pay 75% of the premiums it appears Mr. Linford was angling to return below the blending guidelines in Rev. Rul. 69-154.

Decide Leyden had no issue rejecting that “woulda-coulda-shoulda” argument, writing that “the file is obvious that the corporate didn’t select that possibility and didn’t enable staff to pay any quantity of the premiums. Relatively, the file exhibits that the coverage premiums have been paid by the corporate.”  Op. at 5. That truth made all funds fall below the §105(b) exclusion pathway.

It seems that Mr. Linford additionally tried to argue for an exclusion below §105(c).  That part permits an exclusion if the incapacity cost is for the “everlasting loss or lack of use of a member or perform of the physique, or…everlasting disfigurement.”  Nevertheless, Mr. Linford by no means defined to the Courtroom the character of the incapacity for which he acquired funds.

Backside Line: Whether or not incapacity funds will be excluded from revenue below §104(a)(3) is determined by whether or not the insurance coverage was paid for by the taxpayer with after-tax {dollars} or was as an alternative paid for by the taxpayer’s employer. 

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Bryan Camp is the George H. Mahon Professor of Regulation at Texas Tech College College of Regulation.  He invitations readers to return every Monday (or Tuesday if Monday is a federal vacation) to TaxProf Weblog for one more Lesson From The Tax Courtroom.

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