Summary: The Internal Revenue Service (IRS) issued a Chief Counsel Memorandum on May 9, 2023 (“Memo”) clarifying that wellness benefit payments under a fixed-indemnity insurance policy and funded as employee salary reduction under an Internal Revenue Code (IRC) Section 125 cafeteria plan will be included in an employee’s gross income and subject to employment taxes if the employee has no unreimbursed medical expenses related to the payment.
Read on for more information.
The example provided in the Memo involves an employer offering a fixed-indemnity health insurance plan (fixed-indemnity plan) structured under an IRC Section 125 cafeteria plan, in which all employees may voluntarily enroll in and pay a monthly premium of $1,200 on a pre-tax basis. This voluntary fixed-indemnity plan is offered to employees in addition to the employer-sponsored group health plan that provides preventive care benefits at no participant cost-sharing in compliance with Affordable Care Act (ACA) regulations.
The fixed-indemnity plan is meant to supplement other health coverage through the provision of wellness benefits, including a monthly payment of $1,000 if an employee participates in certain health or wellness activities. Examples of these health or wellness activities that qualify for the payment include the following, all at no additional cost to the employee:
Additionally, the fixed-indemnity plan pays out a daily benefit for hospitalization. These wellness benefit payments are paid from the fixed-indemnity plan vendor to the employer, who then pays out the wellness benefit payment back to the employee through the employer’s payroll process.
The IRS concluded that these wellness benefit payments under a fixed-indemnity plan where employees pay for coverage on a tax-free basis under IRC Section 125[1], should be treated as taxable income and included in the gross income of the employee because the employee has no unreimbursed medical expenses related to the payments. The health or wellness activities listed above are not considered unreimbursed medical expenses because these activities either do not cost the employee anything or, the cost of the activity is reimbursed by other coverage (applicable in the case of vaccinations, covered as preventive under other health coverage).
Additionally, the fixed-indemnity plan pays $1,000 per month without regard to whether the employee has any unreimbursed medical insurance expenses. As a result, this payment under the fixed indemnity plan is included in the employee’s gross income and treated as taxable income under applicable IRC regulations[2].
Further, since these taxable wellness indemnity payments are connected to an individual’s employment as remuneration for employment under employer-funded benefit plans, they are treated as wages and subject to applicable employment taxes, including Federal Insurance Contributions Act (FICA) taxes, Federal Unemployment Tax Act (FUTA) taxes, and federal income tax withholding (FITW). Note that any applicable IRC exclusions[3] from “wages” do not apply to these fixed-indemnity plan wellness benefit payments since these payments are not provided for medical expenses under IRC Section 105(b) and not paid under a worker’s compensation or a disability/sick pay policy.
IRS Chief Counsel Memoranda are internal advice generally issued to attorneys and revenue agents within the IRS and frequently used as training materials for these IRS staff members. Although these memos explicitly state they may not be used or cited as precedent, they provide valuable insight into the IRS’s stance on certain taxation issues. This Memo serves as instructive guidance on the IRS’s position regarding wellness indemnity payments under fixed-indemnity plans funded by employee salary reductions under an IRC Section 125 cafeteria plan.
As these fixed-indemnity insurance products have proliferated throughout insurance markets in recent years touting tax benefits and savings for both employees and employers, this Memo reinforces related IRS tax guidance from prior IRS Chief Counsel Memoranda (click here and here) in connection with the taxability of fixed-indemnity plan payments when funded under an IRC Section 125 cafeteria plan. In these prior memoranda, the IRS consistently determined that benefit payments, including wellness-related payments, provided under pre-tax funded fixed-indemnity plans in excess of otherwise unreimbursed medical expenses are treated as taxable income.
This recent Memo signals that taxation of wellness benefit fixed-indemnity plans might become a ripe area for IRS scrutiny and audit activity in the near future. While increased IRS scrutiny might initially focus on the vendors promoting these fixed-indemnity plans, eventually employers who offer these plans for employees will likely get caught in the crosshairs and become subject to an IRS audit and/or investigation. As the old adage goes – if something sounds too good to be true, it likely is.
Employers are advised to consult with experienced benefits counsel before implementing these types of fixed-indemnity plans (funded under an IRC Section 125 cafeteria plan) for their employees lest they expose themselves and their employees to potential tax consequences and penalties.
Also, to the extent an employer has implemented fixed-indemnity programs similar to the one discussed in the Memo, the employer may face IRS penalties for unpaid employment taxes. These employers should also consult with their tax advisers to determine if corrected IRS Form W-2s need to be issued for employees required to report additional income, in accordance with the Memo guidance.
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[1] Generally, an employer may establish an IRC Section 125 cafeteria plan when employees are permitted to choose between two or more benefits consisting of taxable benefits, such as cash (generally, salary), and nontaxable, qualified benefits, such as employer-provided health coverage. If an employee elects salary reduction under IRC Section 125 to pay for health coverage, the coverage is excludable from gross income under IRC Section 106 as employer-provided accident or health coverage.
[2] Including IRC Sections 105(b), 104(a), 106(a), and 125.
[3] Applicable IRC exclusions including under IRC Sections 3121(a), 3306(b), and 3401(a).