If an employer wishes to offer compensation in lieu of group health plan coverage (oftentimes referred to as an “opt out payment” or a “waiver payment”), there are two important compliance issues that must be considered. First, in order to preserve the tax-free nature of the group health plan coverage, the offer must be made through a so called “cafeteria plan” or “section 125 plan” (noting that it is Section 125 of the Internal Revenue Code that allows the tax benefit). Second, in many cases, an opt out payment must be taken into account as part of the employee cost of coverage for purposes of the affordability requirement of the Affordable Care Act (ACA) “employer mandate” (more on this below).
Reimbursing individual insurance coverage in the ACA era
Prior to the ACA, another popular benefit was simply reimbursing employees for individual insurance coverage that they purchased on their own. In most cases, these types of reimbursements could be made on a non-taxable basis. However, as part of the implementation of the ACA, these types of so called “employer payment plans” became largely prohibited, regardless of whether the reimbursements are taxable or non-taxable.
For the time being, the only ways for an employer to “pay for” individual insurance coverage obtained by an employee is to establish a “Qualified Small Employer Health Reimbursement Arrangement” (QSEHRA) or provide additional taxable compensation, whether though a simple salary increase or a monthly “bonus” or “stipend.” Regarding the additional compensation approach, the key is that the payment not be a “reimbursement”—i.e., not conditioned on proof that the employee indeed obtained his or her own individual insurance coverage. Rather, the increased compensation (regardless of the form) must be unconditional and taxable.
The other approach - establishing a QSEHRA - is limited to smaller employers who are not subject to the ACA employer mandate (i.e., because they average fewer than 50 full-time employees and full-time equivalents) and who do not offer an employer-sponsored group health plan to any of their employees.
A QSEHRA may reimburse employees for individual insurance coverage that they purchase on their own and the reimbursements may be made on a non-taxable basis. However, QSEHRA reimbursements must be made available to all eligible employees on the same terms and conditions (i.e., no discrimination) and are subject to inflation-indexed annual limits.
Last, but not least, just like with any other employer-based group health plan, establishing a QSEHRA will subject an employer to various regulatory compliance requirements, including plan documentation requirements and notice requirements. Small businesses are advised to work with a 3rd party QSEHRA administrator to make sure all plan requirements are met. There are costs involved, but the end result of being able to reimburse employees for individual coverage without subjecting that reimbursement to taxation might be worth it.
Affordability Test for Employers Subject to the ACA Employer Mandate
If an employer is subject to the ACA employer mandate (i.e., because the employer averages 50 or more full-time employees and full-time equivalents), then offering an opt out payment through a cafeteria plan may impact the affordability test that must be satisfied in order to avoid ACA penalties. Since 2023, employer coverage has been considered affordable if the employee’s required contribution for employee-only coverage does not exceed 9.12% of the employee’s household income (the affordability requirement for 2022 was 9.61%). For example, if employee-only coverage under employer Medical Plan A will cost an employee $100 per month, then the employer will have satisfied the ACA affordability requirement so long as $100 per month does not exceed 9.12% of the employee’s household income. However, if the employee is offered an unconditional opt out payment of $50 per month if the employee waives the employer coverage, then generally the deemed cost of coverage will be $150 per month (i.e., the $100 out of pocket cost plus the “opportunity cost” of losing the $50 opt out payment) and the coverage will only satisfy the ACA affordability requirement if $150 per month does not exceed 9.12% of the employee’s household income.
In many cases, the difference between a monthly cost of $100 and a deemed monthly cost of $150 could be the difference between affordable coverage vs. unaffordable coverage, which can lead to ACA penalties. Generally, the only way to avoid this affordability issue is to make sure the opt out payment qualifies as a so called “eligible opt out arrangement.” Eligible opt‐out arrangements are arrangements under which opt out payments are available only to employees who provide “reasonable evidence” (which may include an employee attestation) that they and their “expected tax family” (i.e., all individuals for whom the employee reasonably expects to claim a personal exemption deduction for the taxable year) have or will have coverage other than individual insurance coverage (such as coverage under a spouse’s employer’s plan) during the period covered by the opt out arrangement. This is generally the only way to avoid having an opt out payment impact ACA affordability.
Compensation in lieu of benefits is still possible in the ACA era. However, in addition to the pre-ACA requirement to implement opt out payments through a cafeteria plan in order to preserve the tax-free nature of the group health plan coverage, new post-ACA requirements must also be addressed in order to prevent exposure to ACA penalties.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.