A tax break is just another way of saying “government subsidy.” Most folks do not even think about that when they get a medical bill. They are generally just upset about the size of the co-pay! But Congress subsidizes medical care by allowing taxpayers to exclude from income everything the health insurance plans pay the medical providers above the co-pay.
The scope of that subsidy, however, depends on who pays for the insurance in the first place. If the taxpayer pays for the insurance, the exclusion is governed by §104(a)(3). That provision does not just exclude payments for actual medical services. It excludes any and all amounts paid on account of physical injury or sickness. In contrast, if the taxpayer’s employer pays for the insurance, then the exclusion is governed by §105(b) and that is a more restrictive exclusion. The §105 exclusion is limited to actual reimbursements (or payments) for identified medical care.
The differences between the §104(a)(3) exclusion and the §105(b) exclusion are most apparent when a taxpayer receives disability payments, as we learn in Cynthia L. Hailstone and John Linford v. Commissioner, T.C. Summ. Op. 2023-17 (Apr. 24, 2023) (Judge Leyden). There, the taxpayer received disability payments and attempted to exclude those from income. That might have worked under §104(a)(3) if the taxpayers had paid for the insurance, but since the payments at issue came from an employer-paid plan, the exclusion was not permitted, per §105(b). Details below the fold.
Law: The Difference Between 104 and 105 Exclusions for Medical Care Payments
Congress has created two different exclusion pathways for payments from health insurance plans: the §104(a)(3) exclusion and the §105(b) exclusion. Remember, §61(a)(1) tells us that, basically, everything is income “except as otherwise provided in subtitle A.” So, generally, when a taxpayer receives something of value—like a payment from an insurance company (either directly or indirectly to a medical provider), that something constitutes gross income, unless you can find a statutory basis to exclude it.
The 104(c)(3) Exclusion Pathway: You find one such statutory exclusion in §104(a)(3). It provides that gross income does not include “amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness.”
Notice the broadness of the exclusion. The phrasing: “amounts received....” puts no restrictions on what the amounts received are actually used for. However, notice also that taxpayers cannot use §104(a)(3) to exclude payments from insurance plans if the premiums for those plans were paid for by their employer. That is, the 104(c)(3) exclusion does not apply when “such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer).” Id. For those payments, taxpayers need a different exclusion provision. They need §105(b).
The 105(b) Exclusion Pathway: You find the exclusion pathway for payments from employer-paid insurance plans in §105. Section 105 has a squirrelly structure. While it is in that part of Subchapter B titled “Items Specifically Excluded From Gross Income” it starts out with a broad inclusion rule in §105(a): “amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.” Notice how this section uses the exact same language used in §104(a)(3) to describe amounts that could not be excluded under §104(a)(3).
Only after subsection (a) makes all “amounts received” from employer-paid plans income does §105(b) kick in to exclude some of those payments. It says that “gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in section 213(d))....”
So the §105(b) exclusion only works for payments that a taxpayer can link to identifiable medical care expenses.
Mixing It Up: Sometimes a taxpayer might receive payments from more than one insurance plan. Some of those payments might be eligible for exclusion under §104(a)(3) and other payments may be restricted to the exclusion rules in §105(b). That’s not our lesson today, but for those interested, Rev. Rule 69-154v gives the rules for calculating the proper exclusion in such situations.
The §106(a) Reason Why. I am not totally sure, but I think the reason for these two different exclusion pathways is because of the huge tax subsidy given in §106(a). Section 106(a) allows employees to exclude from gross income the amounts their employer pays for their health insurance plans. This §106(a) exclusion is as long-standing as it is debatable, as explained in this excellent Congressional Research Service report from 2011. What is not debatable, however, is that this is the single largest subsidy—a/k/a “tax break”—that Congress gives to anyone, period. This March 2023 Treasury Report estimates that exclusion represents some $237 billion in foregone revenue in FY23 alone. It projects lost revenue of over $3.4 trillion over 10 years. See Id. at Table 3.
One quickly sees how this really generous exclusion in §106(a) could well be why §105 is structured the weird way it is and why Congress limits the §105(b) exclusion to just those amounts paid to cover actual medical care costs that would qualify for deduction under §213.
Finally, note that §105(f) provides that for purposes of both §104 and §105, the payments excluded (or not!) under these provisions include disability payments. There used to be a separate deduction under §105(e) for disability payments but Congress nuked that when it created the tax credit for certain disability payments now found in §22. See Social Security Amendments of 1983, Pub. L. 98–21, 97 Stat. 85, 87. I welcome comments on anyone who wants to give war stories about the good old days when §105(e) was the rule to exclude disability payments and not §105(b).
Meanwhile, let’s look at what happened here and what we can learn.
The tax year at issue is 2017. In that year Mr. Linford received $105,000 from the Principal Life Insurance Co. as disability payments owed to him for an unspecified disability. He had filed his claim in 2014 and the insurance company did not approve it until 2017.
The insurance policy that paid his benefits had been purchased by Mr. Linford’s employer. The employer had paid 100% of the premiums for each covered employee. Mr. Linford did not have to report those premiums as income because of the generous exclusion in §106.
Mr. Linford and Ms. Hailstone also decided they did not have to report the $105,000 in disability payments Mr. Linford received when they filed their 2017 return. However, since the Insurance Company filed an information return showing the payments, the IRS computers picked up the discrepancy and sent them a CP2000 love letter, proposing to assess a deficiency of $21,910 and an accuracy-related penalty of $4,382.
The couple timely petitioned the Tax Court, During those proceedings, Ms. Hailstone requested and received spousal relief under §6015(c). Not our lesson for today. Rather, our lesson is why the disability payments cannot be excluded from income.
Lesson: The Restrictive Nature of the §105(b) Exclusion
If the §105(b) exclusion pathway applied here, Mr. Linford needed to report the disability payments because he could not link them to actual medical care. They were payments made independently of the medical care he needed for his disability. However, if §104(a)(3) exclusion pathway applied to any payments, those would be excluded because that exclusion is not limited to reimbursements for medical care.
It appears Mr. Linford tried to argue that 25% of the payments were eligible for the §104(a)(3) exclusion because the insurance plan gave his employer the option of having each employee chip in 25% of the premiums. Since the employer only "had" to pay 75% of the premiums it seems Mr. Linford was angling to come under the mixing rules in Rev. Rul. 69-154.
Judge Leyden had no difficulty rejecting that “woulda-coulda-shoulda” argument, writing that “the record is clear that the company did not choose that option and did not allow employees to pay any amount of the premiums. Rather, the record shows that the policy premiums were paid by the company.” Op. at 5. That fact made all payments fall under the §105(b) exclusion pathway.
It appears that Mr. Linford also tried to argue for an exclusion under §105(c). That section permits an exclusion if the disability payment is for the “permanent loss or loss of use of a member or function of the body, or...permanent disfigurement.” However, Mr. Linford never explained to the Court the nature of the disability for which he received payments.
Bottom Line: Whether disability payments can be excluded from income under §104(a)(3) depends on whether the insurance was paid for by the taxpayer with after-tax dollars or was instead paid for by the taxpayer's employer.
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Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.