Taxing employer-sponsored health insurance? A cap is part of GOP budget proposal
There’s a proposal to cap the tax-free amount available for health care expenditures, including amounts paid by both an employer and an employee, according to the Republican Study Committee’s budget proposal.
For decades, the value of health coverage provided by an employer for an employee and the employee’s dependents has generally been excludable from an employee’s gross income. In addition, amounts paid by an employee for health coverage may be paid on a pre-tax basis through a cafeteria plan or Section 125 plan sponsored by an employer or other tax-favored vehicles such as health savings accounts (HSAs). On March 20, 2024, the Republican Study Committee’s Budget and Spending Task Force released the RSC’s Fiscal Year 2025 Budget proposal, which includes a proposal to cap the tax-free amount available for health care expenditures, including amounts paid by both an employer and an employee.
Proposed shift to tax treatment. Under Sections 105 and 106 of the Internal Revenue Code (“Code”), the value of employer provided group health plan benefits are generally excludable from an employee’s gross income. Therefore, an employee does not pay Federal income tax (and in most cases state income taxes) on the value of the health coverage provided through employment. In addition, these amounts are not subject to employment taxes, including FICA and Medicare taxes. The RSC’s proposal would not subject the full amount paid towards health coverage to these taxes. Instead, the proposal indicates that the amount paid over a cap would lose favorable tax treatment. The proposal does not indicate what the RSC proposes as an appropriate cap.
Example: While additional details are needed to fully analyze the tax impact to an employee of the introduction of a cap on the amount of employer-provided health coverage that may be provided on a tax-free basis, here is an example that provides some context. Let’s assume that the full cost of family health coverage – employee, spouse and dependent children – offered by an employer is $1,500 a month or $18,000 a year. The employer pays 80% of the cost of the coverage, and the employee pays 20%. The employee’s Federal income tax withholding rate is 15%. Let’s also assume that the cap on health expenditures that are not taxable is $1,000 a month. Therefore, the employee has additional taxable income each month of $500.
| Employee | Employer | |
| Total Monthly Cost | $1,500 | $1,500 |
| Amount over the $1,000 Cap | $500 | $500 |
| Income Tax Withholding – 15% | $75 | – |
| Employment Tax Withholding/Payment – 7.65% | $38.25 | $38.25 |
| Total Additional Monthly Withholding Taxes | $113.25 | $38.25 |
| Total Additional Annual Tax Withholding/Payment | $1,359 | $459 |
Therefore, under these facts, an employee’s take-home pay would be reduced by $1,359 a year, and the employer would pay additional employment taxes of $459 a year.
Cadillac Tax 2.0. As part of the Affordable Care Act (ACA) as originally enacted, an excise tax, commonly referred to as the Cadillac Tax, applied to the value of employer-provided health care over a certain threshold. The Cadillac Tax was repealed in 2019; however, prior to repeal, the Internal Revenue Service (IRS) rules provided that, in addition to the premiums paid by an employer and employee toward the cost of the coverage, contributions to an HSA counted towards determining whether the Cadillac Tax threshold was achieved. In addition, amounts made available by an employer under a health reimbursement arrangement (HRA), which typically works to reduce the portion of the deductible for which an employee is responsible, and amounts contributed or made available under a health flexible spending account (FSA) counted towards the calculation of the threshold for purposes of the Cadillac Tax. Under the RSC’s proposal, it is not clear if these types of expenditures by an employer or employee would count towards the established cap for purposes of determining whether the employer-provided health coverage is taxable. The proposal frames the discussion around “employer sponsored insurance” (ESI) premiums and does not specifically mention payments towards health care in addition to premiums. If the tax exclusion for these additional items, such as HRA funds, HSA contributions and health FSA accounts, is eliminated or included for purposes of applying the cap, the increase in the taxable income of employees who receive employer provided health care benefits may be larger.
The RSC’s proposal to introduce a cap on ESI is included under a section entitled “Modernizing the Tax Treatment of Health Insurance.” Also included in this section of the RSC’s proposal is a discussion of the support for codifying current rules which create individual coverage HRAs (ICHRAs). Under an ICHRA, an employer makes an HRA available to groups of employees, and the HRA may be used solely to purchase individual health insurance coverage. As long as the annual contribution to the ICHRA is made at a certain level, the ICHRA may be considered an offer of “affordable coverage” for purposes of determining an employer’s compliance with the ACA’s employer shared responsibility requirements.
Related: Think tank with Republican ties proposes employer health tax exclusion limit
While the RSC’s proposal does not expressly state that the cap may be established at the threshold that determines whether the ICHRA is considered an offer of “affordable coverage”, the inclusion of the ICHRA discussion in the “Modernizing the Tax Treatment of Health Insurance” section suggests that the RSC may be considering an alignment of these amounts in some way.
Legislative considerations. Due to the effect of the RSC’s proposal on both employees and employers, this topic should generate more discussion if proposed legislation includes this change. If the proposed cap is set sufficiently high, so that its impact is not immediately felt by employees and employers but comes into play in future years as the cost of health care increases, the concept may have a better chance of ultimately being enacted.
Sarah Sise is an employee benefits and executive compensation partner at the Quarles & Brady St. Louis office. Sarah advises private and public companies and tax-exempt organizations on how to navigate the employee benefits and executive compensation regulatory environment. She is particularly experienced in assisting clients with the design and administration of qualified retirement plans, nonqualified arrangements, welfare and fringe benefit plans, employee stock ownership plans (ESOPs), and executive compensation programs.
Lauren Schuster