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Small Business Tax Strategies for Group Health Insurance

from TaxCoach™ Briefs
Volume 1, Number 19 — October 5, 2006

by Edward A. Lyon, JD

I work with many small business owners who buy their own health insurance or sponsor small group-health plans. And I'm hearing more and more complaints over rising health insurance costs. Group health insurance premiums have risen over 70% in the last five years, with no sign of slowing or stopping. In fact, the average family health insurance premium is now higher than the average family mortgage payment!

The tax code offers relief in the form of tax-deductible premiums, tax-free reimbursements, medical expense reimbursement plans, and the new Health Savings Accounts. But are there small business tax strategies for cutting the cost of group health insurance?

My colleague Tom Quigley operates an insurance consulting firm called Total Benefits here in Cincinnati. Tom takes the same proactive, planning-oriented approach to employee benefits as I do to taxes, and he's accomplished some amazing results. (In one case, he was able to secure private coverage for a client a month after being diagnosed with Parkinson's disease. In another, he secured coverage for a small business owner with a pregnant wife just one month before her due date.)

Together, Tom and I have created what we call the 'Total Benefits' small business tax strategy for employers with 2-100 employees. We present it as a way to 'refinance' employee benefits, while keeping the same benefit level, in much the same way as homeowner clients refinance their homes to enjoy the same space for less monthly payment. I'm going to briefly outline how it works so that you can evaluate how you might incorporate it into your practice.

1. Raise deductibles. Dramatically.

Raising deductibles is an easy step that most of us have already adopted for ourselves and our clients. But are we raising them enough to make a real difference? In our practice, Quigley and I find that most tax professionals aren't aware just how much raising deductibles can cut premiums. One local small-group provider offers a suite of products, including 'Option 7' (full coverage, with little or no deductibles or co-pays) and 'Option 34,' a $2,500 deductible policy focusing on catastrophic coverage. Both policies offered a $5 million lifetime limit. Last I looked, switching from Option 7 to Option 34 cut premiums by 48%. Bottom line: the insurer charges nearly as much for the first $2,500 of benefit as the next $5 million.

Raising deductibles is an easy concept to explain. You have homeowner's insurance, but you don't pay to insure a $50 plumber's bill. You have car insurance, but you don't pay to insure a $40 oil change. Why would you pay to insure the heath care equivalent?

2. Add a Section 105 plan to replace benefits.

The problem with raising deductibles is that it costs employees benefits. How do you replace them, economically? Our solution is to pay them directly, through a Section 105 medical expense reimbursement plan. The employer covers the difference between the old deductible and the new deductible, so that actual benefits remain unchanged. But the employer pays only if and when an employee incurs a covered expense.

Cutting out the insurance company middleman for those first few thousand dollars of claims can cut overall costs by 20-40%. The company engages a third-party administrator (TPA) to handle claims and avoid running afoul of federal medical privacy rules.

3. Add 'gap' insurance to protect savings.

Insurance premiums may be outrageous, but at least they're predictable. Raising employee deductibles and covering those expenses out-of-pocket can leave employers with uncertain costs. After all, who knows when a foreman's daughter is going to break her arm?

If clients are nervous that reimbursing employees will play havoc with their cash flow, they can buy 'gap' coverage for specific risks such as accidents, surgeries, or critical illnesses. The goal here is NOT to replace the coverage we eliminate when we raise deductibles. It's to protect the client's savings by avoiding unexpectedly large reimbursements. We generally reserve this step for the smallest employers, those who feel nervous taking the risk of covering new, higher deductibles.

4. Add a 'spousal 105.'

Employers will often 'bribe' their married employees to elect coverage on their spouse's plans. This obviously lowers their own costs, and shifts usage to the spouse's plan. But these sorts of incentives are taxable, and subject to employment taxes and even retirement plan contributions. And employees don't always take the bait.

Many of our clients will redefine eligibility for their plan to exclude those employees who are eligible for subsidized coverage through their spouses. Then, we use a 'spousal 105' plan to replace any difference between the client's plan and the spouse's plan. Now the incentive is mandatory and fully tax-free.

5. Consider individual insurance.

This final step, which Quigley and I call 'the individual piece,' is the most eye-opening and, in some states, controversial part of the strategy. Individual coverage is far less expensive than group coverage for those employees who qualify. That's because insurers can reject unhealthy applicants. But there may be several ways to take advantage of lower individual rates and cut employer contributions by up to 80%.

There are several ways that small employers can use individual policies to cut employee benefit costs. They can 'cherry-pick' healthy spouses and dependents off of the group plans and cover them with individual policies. (Leaving employees on the plan assures that employers meet minimum coverage requirements). They can even terminate group plans entirely and replace them with a tax-free 'allowance' employees can use to buy individual coverage.

The 'individual piece' isn't for everyone. We generally use it with smaller employers who would otherwise be forced to give up group insurance benefits entirely. But when it works, it solves problems that clients never thought they could solve, and makes us heroes.

Controlling employee benefit costs is crucial to keeping small business clients viable. In coming months, TaxCoach will add a new module on 'Small Business Tax Strategies for Group Health Insurance.' We've also partnered with Quigley and his TPA, ClaimLinx, to create BenefitsCoach, a software subscription service that will let you create and administer Section 105 plans for your clients. We'll let you know as soon as the new service is available.

Click here to learn more about small business tax strategies from TaxCoach™.

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