Compliance Questions – Cash Out Option

Provided by Larry Grudzien

Q. Each year, my client gives its employees a choice of health coverage or a cash payment of $3,000. If my client does not adopt a cafeteria plan, will any portion of the health coverage elected by the employee be taxable?


A. Yes. An employee will be taxed up to the amount of cash that he or she could have received. In Private Letter Ruling 9406002, IRS indicates that a cafeteria plan must be in place in order to be a qualified cash-out option. If the cash-out option plan is not set up under cafeteria plans, employees who elect coverage under the health plan will be taxed on an amount equal to the amount of cash they could have received for waiving coverage. IRS provided that when an option is available to either elect the health plan, or to receive a cash-out incentive, then the premium payment becomes wages. Employees who elected health insurance received less compensation than employees who declined health insurance. The amount of compensation to be paid was determined before services were rendered by the employees; the difference in compensation did not necessarily correspond to the actual cost of the health insurance elected. The IRS concluded that the difference between the compensation paid to an employee who elected health insurance and the greater amount that the employee would have received if he or she had not elected health insurance was includible in the employee’s gross income and was wages for employment tax purposes. It is important to note that, although the cafeteria plan protects the employees electing coverage from taxation, the cash-out incentive is an after-tax benefit. Another thing to consider when setting up a cash-out incentive plan is proper documentation. An employee should only be allowed to waive coverage when there is another plan available and proof of enrollment is provided. If there is a subsequent loss of that coverage, HIPAA Special Enrollment Rights will allow entry onto the plan, and the cash-out incentive will cease.

For a copy of Private Letter Ruling 9406002, click on the link below:

PLR 9406002