This article was originally published on June 19, 2023 and was last updated September 13, 2024 to reflect additional guidance published by the IRS.
Executive summary: IRS says that certain wellness plans are subject to employment taxes
The IRS Office of Chief Counsel issued memorandum number 202323006 on May 9, 2023, and proposed regulation amendments on July 12, 2023, regarding certain wellness plans which are promoted as saving companies and their employees employment and income taxes. The IRS determined that the cash benefits paid by the plans are taxable income to the employees and treated as wages for employment tax purposes. In April of 2024, the IRS again expressed concerns about these types of plans and indicated it is continuing to study the matter and expects to issue additional guidance in the future.
Wellness plan schemes are addressed in IRS guidance
Wellness plan schemes
Across the country, companies are being approached by consultants selling wellness or indemnity plans which purport to add new health benefits for employees while saving the companies and employees taxes. The general concept is that employees will participate in these plans by making large pretax payroll deductions which reduce their taxable incomes, thus saving their companies employment taxes while the employees save on both employment and income taxes. The employees will then receive reimbursements for engaging in certain health-related activities so that their after-tax take-home pay remains the same or is increased. The consultants sell these plans as a win-win for the companies and their employees with potential tax savings in the thousands or millions of dollars.
If this sounds too good to be true, the IRS thinks so as well. These types of schemes have been around for decades and tend to re-emerge every so often. Every time they pop back up the IRS puts out a memo or other communication to specifically address the current iteration. The conclusion is always that the new scheme doesn’t work and the benefits provided are taxable income subject to employment taxes. The IRS reached that same conclusion in recent guidance.
May 2023 guidance
On May 9, 2023, the IRS Office of Chief Counsel issued memorandum number 202323006 about the tax treatment of a wellness plan using a fixed-indemnity insurance policy. In general, a fixed-indemnity health insurance policy pays covered individuals a specified amount of cash for the occurrence of certain health-related events, such as office visits or days in the hospital. The amount paid is not related to the amount of any medical expense incurred or coordinated with other health coverage.
The memo discusses whether wellness indemnity payments under an employer-funded, fixed-indemnity insurance policy (including those where the premium for coverage is paid pretax by the employee through a section 125 cafeteria plan) are includible in the gross income of the employee if the employee has no unreimbursed medical expenses related to the payment. The memo also discusses whether the wellness indemnity benefits that are includible in gross income are wages for purposes of the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and federal income tax withholding (FITW) (collectively, “employment taxes”).
The facts laid out by the IRS in this memo are as follows:
- The employer provides comprehensive health coverage for its employees through a group health insurance policy. The employer also provides all employees, regardless of enrollment in the health coverage, with the ability to enroll in coverage under a fixed-indemnity health insurance policy where employees pay monthly $1,200 premiums for the policy by pretax salary reduction through a section 125 cafeteria plan.
- One of the wellness benefits provided by the fixed-indemnity health insurance policy is a payment of $1,000 per month if the employee participates in certain health or wellness activities, like using preventive care under the comprehensive health plan. The policy also provides wellness counseling, nutrition counseling and telehealth benefits at no additional cost. Under the policy, the wellness benefits are paid from the insurance company to the employer who then pays out the wellness benefit to the employees via payroll.
The IRS concluded that wellness indemnity payments under an employer-funded, fixed-indemnity insurance policy (including when the premium for coverage is paid by employee pretax salary reduction through a section 125 cafeteria plan) are includible in the gross income of the employee if the employee has no unreimbursed medical expenses related to the payment. Because the fixed indemnity health insurance policy pays $1,000 per month without regard to whether the employee has any unreimbursed health insurance expenses, the IRS determined that the payment is included in the employee’s gross income and treated as wages for employment tax purposes. Therefore, taxable wellness indemnity benefits are wages for purposes of FICA, FUTA and FITW.
July 2023 guidance
On July 12, 2023, the IRS issued proposed amendments to Reg. section 1.105-2 to clarify the tax treatment of amounts received by employees through employment-based health insurance that are paid without regard to the amount of incurred medical expenses and where the premiums for the coverage are paid on a pretax basis. The IRS explained that these amendments are intended to address certain arrangements that purport to avoid income and employment taxes by characterizing cash benefits as reimbursements for medical care, even though the amounts are paid without regard to the actual amount of incurred medical expenses. The IRS noted that these arrangements are marketed as supplemental coverage that saves employers and employees money by avoiding employment taxes. The IRS further noted that in some arrangements employees are paid an amount every month, purportedly for medical expenses, even if they do not incur any medical expenses, or if they simply complete certain health-related activities.
According to the fact sheet accompanying the proposed amendments, the IRS wants to make clear that payments from employer-provided fixed-indemnity health insurance plans (and other similar plans) are not excluded from an employee’s gross income if the amounts are paid without regard to the actual amount of any incurred medical expenses. Additionally, the proposed amendments clarify that the employee must meet substantiation requirements for reimbursements of medical expenses from any employer-provided health plan to be excluded from the employee’s gross income.
The Reg. section 1.105-2 proposed amendments were one component of a broader set of proposed rules issued by the IRS on July 12, 2023. Other topics covered by these proposed rules were short-term, limited-duration insurance, excepted benefit requirements for hospital or fixed indemnity and specified disease policies, and level-funded plan arrangements.
April 2024 guidance
The IRS released final regulations dated April 3, 2024, and a related fact sheet, regarding short-term, limited-duration insurance and the consumer notice required for certain fixed indemnity coverage. This guidance finalized some, but not all, of the proposed rules from July 12, 2023.
Contrary to the claims of certain consultants, the IRS did not finalize rules regarding the tax treatment of payments from employer-provided fixed indemnity health insurance and other similar plans. The IRS indicated it was not ready to finalize the Reg. section 1.105-2 proposed amendments from July 12, 2023, because it needed more time to study the matter.
Instead, the IRS reiterated its concern regarding fixed indemnity policies and other arrangements where premiums for the coverage are paid pretax and cash payments are made even though no medical expenses are incurred (including when participants simply complete certain health-related activities) or the medical expenses are reimbursed through other coverage. It explained that these payments generally are taxable wages subject to FICA, FUTA and FITW. The IRS also stated that it intends to issue more guidance in the future.
Action needed
Companies should consult with their tax advisors regarding these wellness plan schemes. If a company has implemented one of these plans, it may want to consider terminating the plan and the possibility of an IRS payroll examination. The IRS typically seeks to collect taxes, penalties and interest related to the failure to withhold and remit taxes when due and would most likely assert penalties based on the employer’s incorrect filing and issuing of its Forms W-2.
