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IRS Penalizing Employers Before Checking Household Income – Making the IRS Enforcement Position More Stringent than the Actual Law

October 6, 2022

Many employers have received Letters 226J from the IRS since it began enforcing the employer mandate penalties associated with the Affordable Care Act (ACA). While the IRS was very lenient with employers during the initial years of reporting, the IRS has more stringently enforced the law with each successive year. Beginning with the 2017 calendar year the IRS began checking if an employer was eligible for the affordability safe harbors the employer was inserting in line 16 for its workforce. When the IRS determined the employer was not eligible for the affordability safe harbor based on information submitted by the employer or established benchmarks (such as the line 15 amount, box 1 of the Form W2, or the federal poverty line), the IRS penalized employers who had employees receive a premium tax credit or cost sharing subsidy. This is an egregious position by the IRS and goes against the clear, unambiguous language of the ACA. The remainder of the article explores the actual affordability standard set forth by the ACA and discusses the consequences employers have faced as a result of the IRS’ flagrant position.

IRC section 36B(c)(2)(C) states the affordability standard for an employer’s offer of coverage. That provision states:

(C)Special rule for employer-sponsored minimum essential coverage. For purposes of subparagraph (B)—

(i)Coverage must be affordable Except as provided in clause (iii), an employee shall not be treated as eligible for minimum essential coverage if such coverage—

(I) consists of an eligible employer-sponsored plan (as defined in section 5000A(f)(2)), and

(II) the employee’s required contribution (within the meaning of section 5000A(e)(1)(B)) with respect to the plan exceeds 9.5 percent of the applicable taxpayer’s household income.

This clause shall also apply to an individual who is eligible to enroll in the plan by reason of a relationship the individual bears to the employee.

Similarly, the applicable regulation at section 1.36B-2(c)(3)(v)(A)(1) states:

(v) Affordable coverage - (A) In general - (1) Affordability for employee. Except as provided in paragraph (c)(3)(v)(A)(3) of this section, an eligible employer-sponsored plan is affordable for an employee if the portion of the annual premium the employee must pay, whether by salary reduction or otherwise (required contribution), for self-only coverage does not exceed the required contribution percentage (as defined in paragraph (c)(3)(v)(C)of this section) of the applicable taxpayer's household income for the taxable year. See paragraph (c)(5) of this section for rules for when an HRA or other account-based group health plan described in paragraph (c)(3)(i)(B) of this section is affordable for an employee for a month.

Both the statute and the regulation make it clear that an employee’s household income is what is used to measure if an employer’s offer of coverage was affordable. Unfortunately, most employers will not have access to the data necessary to accurately determine an employee’s household income. Consequently, the IRS created three affordability safe harbors for employers. The preamble to the final regulations for the Shared Responsibility for Employers Regarding Health Coverage states “Because an employer generally will not know the taxpayer employee’s household income, the proposed regulations under section 4980H set forth three separate safe harbors under which an employer could determine affordability based on information that is readily available to the employer.” The three safe harbors offer employers the opportunity to have their offer of coverage deemed affordable so long as the requirements of the affordability safe harbor are satisfied.

However, just because an individual does not qualify for an affordability safe harbor or has a Form 1095-C with a blank line 16 does not necessarily mean that the employer did not offer affordable coverage under the ACA. Affordability under Internal Revenue Code (IRC) section 36B is determined by reference to the taxpayer’s household income. It was only in light of the employer generally not knowing the employee’s household income that the IRS created the three affordability safe harbors. There are myriad ways an individual could have a higher income than the wages paid by an employer such as income from another job, a spouse’s income, or a dependent child’s income to list just a few. However, an employer has no way of determining an employee’s household income accurately so the IRS relieved an employer of these burdens by creating the affordability safe harbors.

According to IRC section 36B(c)(3)(v)(A)(1) an employer-sponsored plan is affordable for an employee if the portion of the annual premium the employee must pay, whether by salary reduction or otherwise (required contribution) for self-only coverage does not exceed the required contribution percentage (9.61 percent for 2022 and 9.12 percent in 2023) of the applicable taxpayer’s household income for the taxable year.

What is shocking and disturbing is the IRS is not even looking at an employee’s household income before proposing penalties to employers through the Letter 226J. In private practice we have seen countless employers fall short of the Form W2 affordability safe harbor. As a result, these employers have received a Letter 226J with an accompanying Form 14765 with an “XF” for certain individuals. The IRS placing the “XF” code on the Form 14765 means the employer fell short of the Form W2 affordability safe harbor in the IRS’ view. In most cases we have reviewed in private practice, the employer did fall short of the Form W2 affordability safe harbor, but only by a few hundred dollars. This calculation is very easy for the IRS to make using the line 15 data along with the amount entered in box 1 of the Form W2. However, as IRC section 36B states, this is not the ACA’s standard for affordability. In these situations, the employer has to state to the IRS that is would like it to review the household income of the individuals listed on the Form 14765. It is only at that time that the IRS calculates the household income, which, again, is the clear and unambiguous standard for affordability under the ACA.

There are several things that are problematic about this approach by the IRS. First, the IRS is penalizing employers who do not owe a penalty to the IRS. If the IRS wants to penalize employers for filing incorrect returns in these circumstances, it would be in-line with the text of the Code to do so under IRC section 6721. However, by electing to propose penalties under IRC section 4980H, it is holding employers to a higher standard than the ACA allows. In the worst-case scenario, the employer who receives the proposed penalty actually pays the penalty when the employer owed no penalty. In the best-case scenario, the employer appeals the decision (most likely using an attorney), and receives a revised, accurate proposed penalty through a new Letter 226J or if the employer is fortunate, it has its penalty reduced to $0. However, in the best-case scenario, the employer has wasted valuable company resources defending itself against a standard that is higher than allowed by the language of the ACA.

While we don’t recommend this strategy, an employer should be able to leave line 16 blank on every Form 1095-C it completes and still not receive a Letter 226J penalty even if certain employees erroneously receive a premium tax credit so long as the employer’s offer of self-only coverage meets the requirements of IRC section 36B. Unfortunately, this is not the case. It appears the IRS is proposing a penalty to any employer who has a full-time employee who receives a premium tax credit in addition to the employer not qualifying for any of the three affordability safe harbors or who leaves line 16 blank.

The IRS has created an unnecessary, wasteful game employers have to play. The game starts with the IRS sending the employer a Letter 226J with an accompanying Form 14765. Frequently, as discussed above, the employers Form 14765 will have several months for which the IRS disallowed the Form W2 affordability safe harbor which is designated with an “XF”. However, an employee may be listed on the Form 14765 for other reasons such as line 16 being left blank by the employer because it knew it did not meet any of the affordability safe harbors.

In this wasteful game the IRS has created, the onus is then shifted to employers to respond to the IRS and ask the IRS to review the affordability of the employer’s offer of self-only coverage in light of the employee’s household income. It is only at this time that the IRS checks the household income of the employees listed on the Form 14765. Again, this goes against the standard set forth by the ACA at IRC section 36B.

The IRS should be reviewing the household income of each individual listed on the Form 14765 before any Letter 226J is sent out. By not doing so the IRS is not only wasting the valuable resources of employers, but is proposing penalties to employers who do not owe a penalty.

The IRS must immediately stop sending out letters 226J to employers before it makes the appropriate affordability calculation using the amount listed on line 15 and the employee’s household income. Additionally, the IRS should go back and review each penalty that has been collected to date to determine if the employer actually owed a penalty in light of the employee’s household income. If the IRS determines that an employer who previously paid a penalty did not owe a penalty based on the employee’s household income, the IRS should refund the employer the amount it erroneously paid along with the appropriate amount of interest.

The IRS ignoring the clear language set out in the statute is infuriating and a waste of valuable company resources. However, it is in line with other highly questionable positions the IRS has taken with its enforcement of the ACA as our previous publication discussed. We have certainly benefitted from these aggressive IRS positions, but we would strongly prefer to have our practice focused on proactively protecting clients from the IRS. In our view, the IRS needs to be more forward thinking with the perception it is creating with the trustworthiness of the Service through its positions. Regardless, with the IRS taking these aggressive positions, accurate, meticulous ACA reporting is imperative. As always, if you have any questions regarding ACA reporting or would like to learn how Accord Systems can assist you with your ACA reporting needs, please don’t hesitate to contact us.

About the author – Ryan Moulder serves as General Counsel at Accord Systems, LLC and is a Partner at Health Care Attorneys P.C. Ryan received his LL.M. from Georgetown University Law Center and his J.D. from Saint Louis University School of Law. He has distinguished himself as a leader in the Affordable Care Act arena and has written and spoken on a variety of ACA topics as it relates to compliance for companies.

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