For companies with more than a de minimis amount in their workers’ compensation reserve, it may be worthwhile to review the details underlying the reserve amount. The reason? These days a significant portion of a workers’ compensation reserve likely results from amounts due to medical service providers for treatment already provided to injured employees. And while a payment or series of payments required under a workers’ compensation act is treated as a payment liability under the IRC § 461(h) economic performance rules, the liability for medical services provided to an injured employee is treated as a service liability.
This difference is significant for income tax purposes, since economic performance occurs with respect to liabilities arising out of the performance of services as those services are provided. Thus, a portion of a taxpayer’s workers’ compensation reserve may represent a liability that is properly deductible for tax purposes in the year the medical services are provided to the injured employee (instead of the year payment is made).
In the past, medical coverage for employees—whether medical benefits or workers’ compensation coverage—was generally provided through insurance, and taxpayers claimed a deduction for the insurance premiums when paid. Then the costs of medical insurance started skyrocketing, and more employers started self-insuring the majority of their covered-employee medical liability. This change transformed an employer’s insurance payment liability into a medical services liability.
As a consequence, in accordance with the economic performance rules, the timing for deducting the liability went from when the employer paid the premiums to when the services were performed. As a result, many taxpayers found themselves able to claim an income tax deduction for a significant portion of their liability for incurred but not reported medical services. It turns out that a similar transition has taken place in the workers’ compensation arena. While a portion of an organization’s workers’ compensation reserve usually results from a liability for lost wages and damages, in all likelihood a portion also results from a liability for medical services provided to injured employees.
According to IRC § 461(h) and Treas. Reg. § 1.461-1(a)(2), under an accrual method of accounting a liability is incurred in the tax year in which the following three elements are satisfied:
- All the events have occurred that establish the fact of liability;
- The amount of the liability can be determined with reasonable accuracy; and
- Economic performance has occurred with respect to the liability.
Traditionally, workers’ compensation has been viewed as a form of long-term disability coverage and accordingly has been treated as a payment liability, properly deductible when paid. Treas. Reg. § 1.461-4(g)(2) specifically provides that if the liability of a taxpayer requires payments to another person and arises under any workers’ compensation act, economic performance occurs as payment is made to the person to whom the liability is owed. Until recently, this was pretty much where the story ended.
But just as changes in funding employee medical benefits affected the tax treatment of the underlying employer liabilities, changes in workers’ compensation coverage have had a similarly significant impact on the tax treatment of such liabilities. Today, many workers’ compensation programs have migrated away from traditional insurance and toward self-insurance, including the employer’s liability for a large deductible under an insurance policy. Thus, today’s workers’ compensation payments are likely not solely premium payments. And, to the extent such payments are not (1) insurance or (2) a payment or series of payments to another person, treating such amounts as a payment liability under the economic performance rules may not be proper.
Workers’ compensation programs typically provide three primary types of coverage: (1) regular payments in place of wages, (2) compensation for economic loss, and (3) payment of medical expenses. While items (1) and (2) remain payments or a series of payments, item (3) likely involves directly paying medical service providers for the care given to injured employees. As such, the proper timing of the deduction for this liability differs from the timing for a payment made to an employee for lost wages or to compensate for economic loss.
In the case of a liability to provide medical services to an injured employee, all the events have occurred that establish the fact of liability when medical services are provided to that employee. Furthermore, when the services are provided, the exact amount of the liability for those services is generally known and, if not known, can almost always be determined with reasonable accuracy.
With regard to economic performance, where a taxpayer has an obligation to provide medical benefits to an injured employee, economic performance should be satisfied as medical services are provided to the employee, though this conclusion requires a two-part analysis. First, under Treas. Reg. § 1.461-4(d)(4)(i), if the liability of a taxpayer requires the taxpayer to provide service to another person, economic performance occurs as the taxpayer recognizes that liability under its method of accounting, that is, under the all-events test for an accrual-method taxpayer. Second, under Treas. Reg. § 1.461-4(d)(2)(i), if a taxpayer’s liability arises out of the provision of services to the taxpayer by another person, economic performance occurs as the service or property is provided.
In the workers’ compensation case, the taxpayer’s liability arises out of its requirement to provide medical services to its injured employees. A third-party medical professional generally provides the services. Thus, the same action (that is, the medical service professional’s caring for the injured employee) should satisfy the economic performance requirement for both Treas. Reg. § 1.461-4(d)(2)(i), the taxpayer’s liability arising out of its obligation to reimburse the medical professional for the services provided, and Treas. Reg. § 1.461-4(d)(4)(i), the taxpayer’s liability to provide medical services to its injured employee.
What is involved in making a change in accounting method for this item? First, a taxpayer must analyze and understand its underlying facts, which are likely included in the workers’ compensation reserve balance found on the balance sheet. To the extent a workers’ compensation liability to provide medical services to injured employees is identified, the amount of the liability outstanding at year-end generally can be identified through an incurred-but-not-reported lag report. These reports usually detail medical services provided to injured employees by year-end for which payment was not made until the following year. Frequently a program’s third-party administrator can readily provide such a report.
A Form 3115, Application for Change in Accounting Method, for this item may be filed under the automatic consent procedures of Revenue Procedure 2008-52 as modified by Revenue Procedure 2009-39. It should be noted that to the extent a taxpayer’s workers’ compensation costs are included in its IRC § 263A uniform capitalization adjustment, the section 481(a) adjustment included on the Form 3115 must take into account the portion of the adjustment that should itself be subject to capitalization under the taxpayer’s uniform capitalization methodology (this adjustment will usually be an unfavorable offset to the overall adjustment).
A tax adviser’s job is to apply the tax rules to a taxpayer’s facts. Sometimes revisiting an old and familiar item, such as a taxpayer’s workers’ compensation reserve, can identify a beneficial opportunity. In the case of workers’ compensation reserves, changes over the past decade or so have greatly affected how employers fund these programs. Based on a taxpayer’s particular situation, these changes may have created an opportunity for a taxpayer to deduct a portion of its workers’ compensation liability in the year when medical services were provided to an injured employee, rather than waiting until payment is actually made.
Scott Mackay is with Deloitte Tax LLP in Washington, D.C.
This article originally appeared in the March 2010 issue of The Tax Adviser , the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price. Call 800-513-3037 or e-mail firstname.lastname@example.org for a subscription to the magazine or to become a member of the Tax Section.