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Ever on the lookout for a way to save money, many employers are getting snagged by a double-dipping scheme. Promoters of the scheme tell employers that they can reduce an employee’s pay on a pretax basis for health insurance premiums and then reimburse the employee with untaxed dollars for those same premiums — thus the expression "double dipping."

The question is: How can the employee be reimbursed with untaxed dollars for an expense that was paid for with untaxed dollars? To justify the plan, promoters point to two different IRS exclusions from income for health insurance premiums and one IRS Revenue Ruling.

Here's how the scheme typically works, broken into two parts:

1. The employer begins by deducting $300, the entire amount of the insurance premium, from the employee's paycheck on a pretax basis. This is perfectly legal under IRC Section 125.
2. Citing IRC Section 106 and Revenue Ruling 61-146 as its authority, the employer then reimburses the employee for part of the premium expenses deducted from the employee's paycheck. The employer is instructed to reimburse only enough of the premium to increase the employee's paycheck back to the original take-home pay amount.

Too Good To Be True?

If looked at separately, parts one and two are perfectly legal. But when the parts are combined, issues arise. For an employee to be reimbursed on a nontaxable basis for the insurance premiums, the employee must incur the expense. But, because the premium is being paid with pretax dollars, the expense is deemed to have been paid by the employer.

Who Loses?

The employee is the loser here – big time. This plan is often implemented without the employee's knowledge or full understanding. So, without prior consent, the employer pockets all of the employee's tax savings. And, because an employee's take-home pay has not changed, he is clueless about the drop in'funds going toward Social Security.

IRS Revenue Ruling 2002-03 clearly acknowledges this type of arrangement and declares the reimbursement to be taxable as wages.

"The exclusions from gross income under Sections 106(a) and 105(b) do not apply to amounts that an employer pays to employees to reimburse the employees for amounts paid by an employer for health insurance coverage that are excluded from gross income under Section 106(a) (including salary reduction amounts pursuant to a cafeteria plan under Section 125 that are applied to pay for such coverage). Accordingly, the reimbursement amounts that the employer pays to the employees are included in the employees' gross income under Section 61 and are subject to employment taxes under Sections 3401, 3121(a) and 3306(b)."

The employment taxes referred to include federal withholding, federal unemployment, and FICA.

Variations on a Theme

Shortly after IRS Revenue Ruling 2002-03 melted down this double-dipping scheme, a couple of other reimbursement programs popped up. One was a so-called advance reimbursement and the other involved a "loan" to employees.

These arrangements have been dubbed "Son of Double Dip." The employee is given a nontaxable, advance reimbursement for healthcare expenses at the same time pretax salary redirections are taken to pay for healthcare premiums. Again, because the employee's take-home pay remains the same, the employee may be totally unaware of the deal or the loss of Social Security benefits.

As the year advances, participants are told to turn in expenses for healthcare that will not be reimbursed through any other health plan. These expenses offset the "advance reimbursement" account. If the employee doesn't accumulate enough expenses to equal the advance reimbursement, the excess is then treated as taxable income to the employee.

The IRS is also focusing on a second double-dipping arrangement. The "loan" scheme is a program in which the employee again pays the entire healthcare premium amount with pretax redirections. A loan is set up for each employee to make up the difference in their paychecks and to pay for out-of-pocket medical expenses.

A legitimate loan isn't taxed at the time of occurrence, because it's assumed that the loan will be repaid. However, this loan never needs to be paid back. If the employee turns in eligible, unreimbursed medical expenses throughout the year, those receipts reduce the loan amount.

What if the employee doesn't incur any qualified healthcare expenses? The employer forgives the loan and adds the outstanding amount to the employee's taxable income.

What Makes These Arrangements Illegal?

The money was afforded the employee before the employer knew whether the individual would have medical expenses, and that's taxable income as far as the IRS is concerned. Even if the money is eventually used for qualified medical expenses, these types of arrangements make all payments taxable.

The employer must have a true healthcare reimbursement account set up in a way that ensures only medical expenses will be paid from the fund. If the funds are ever available as cash, then even legitimate medical expenses become taxable. That's because the arrangement is not an accident or health plan.

In both scenarios, the answer is the same. "Advance reimbursements" or "loans" are included in the employee's gross income. Check out Revenue Ruling 2002-80 for all the details.

The IRS proves once again – if it sounds too good to be true, it probably is.

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The information contained in this article is not intended to be legal, accounting or other professional advice. We assume no liability whatsoever in connection with its use, nor are these comments directed to specific situations.