Tax Treatment of Employee MLR Rebates Is Clarified

The IRS updated a set of Frequently Asked Questions to address the tax treatment of Medical Loss Ratio (MLR) rebates that are distributed to employees participating in employer group health plans. Essentially, rebates provided to employees who are making pre-tax premium contributions in the year the rebate is paid (either in cash or a premium reduction) are subject to Federal income and employment taxes. Rebates provided to employees who pay premium contributions on an after-tax basis are not subject to Federal income or employment taxes—although a rebate that is a purchase price adjustment for a prior year would be subject to Federal income tax to the extent the employee received a tax benefit from deducting those premium payments in that year.

The FAQs address the Federal income and employment tax treatment of MLR rebates under varying circumstances. The underlying analysis is specific to the facts, but general rules emerge.

Employee Premium Contribution
Cash Rebate
Premium Reduction
Comments
Pre-Tax
The rebate is a return of untaxed compensation for the year the rebate is paid.
The rebate is subject to Federal income and employment taxes. Q&A-11 and Q&A-13.
The premium reduction causes the employee’s salary reduction contributions to be reduced by that amount in the year the rebate is paid, which results in a corresponding increase in the employee’s taxable salary.
The increased compensation is subject to Federal income and employment taxes. Q&A- 10 and Q&A-12.
The analysis is the same regardless of whether the rebate is provided to:
  • All employees who participated in the plan during the year the rebate is paid, or
  • Only those employees who participated in the plan both in the year the premiums were paid and the year the rebate is paid.
After-Tax
The rebate is a return of a portion of the employee premiums paid for a prior year (i.e., a purchase price adjustment). The premiums were originally paid on an after-tax basis.
The rebate is not subject to Federal income or employment taxes. Q&A-6.
The rebate is a purchase price adjustment for a prior year. See column, left. The premiums were originally paid on an after-tax basis.
The rebate is not subject to Federal income or employment taxes. Q&A- 5.
The analysis applies when the rebate is provided only to those employees who participated in the plan both in the year the premiums were paid and the year the rebate is paid.
Caveat: If the employee deducted the prior year’s premium payments on Form 1040, the rebate (whether in cash or a premium reduction) would be taxable to the extent the employee received a tax benefit from the deduction. Q&A-7.
After-Tax
The rebate is due to participation in the plan in the year the rebate is paid, so it is a purchase price adjustment for the current year. The premiums were originally paid on an after-tax basis.
The rebate is not subject to Federal income or employment taxes. Q&A-7.
The rebate is a purchase price adjustment for the current year. See column, left. The premiums were originally paid on an after-tax basis.
The rebate is not subject to Federal income or employment taxes. Q&A- 8.
The analysis applies when the rebate is provided to all employees who participated in the plan during the year the rebate is paid, regardless of whether they participated in the year the premiums were paid.
Caveat: Since the rebate (whether in cash or a premium reduction) is a purchase price adjustment for the current year, it would not be taxable even if the employee had deducted the prior year’s premium payments (to which the rebate relates) on Form 1040. Q&A-8.

Plan sponsors are subject to restrictions in handling the MLR rebates. The Department of Labor issued a Technical Release explaining the analysis and procedures required by ERISA group health plan sponsors. The Department of Health and Human Services issued similar but distinct requirements for non-Federal governmental group health plans. The first round of rebates, based on financial data for 2011, is due from the issuers by August 1, 2012.

Source: Deloitte’s Washington Bulletin

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