The Internal Revenue Service (IRS) is seeking to discourage arrangements in which employees can obtain large wellness incentive payments in exchange for a relatively minor after-tax contribution. Contrary to their promoters’ claims, these setups cannot enable employers to finance wellness incentives solely by reducing their employment tax liability, the IRS warned.

A benefit paid under a self-funded health plan must be included in income and wages “if the average amounts received by the employees for participating in a health-related activity predictably exceed the after-tax contributions by the employees,” according to Memorandum 201719025 from the IRS Office of Chief Counsel (OCC). This is for one or both of the following reasons:

• The self-funded plan is not “insurance” for tax purposes because it does not involve shifting risk; and
• The ratio of employees’ average wellness rewards to their after-tax contributions indicates that these rewards are attributable to the employer’s contributions, not their own.

The OCC memo, released May 12, is the latest in a series that alert plan sponsors to arrangements purporting to reduce tax burden through wellness programs or fixed-indemnity health plans.

As promoters have tweaked these schemes in response to each IRS pronouncement, the service has had to play “whack-a-mole,” said IRS attorney Stephen Tackney at a recent conference. If employees can get a $1,200 fixed indemnity payment by calling into a wellness hotline, the IRS does not consider that insurance, added Tackney, IRS deputy associate chief counsel for employee benefits. Tackney spoke May 12 at a meeting of the American Bar Association’s Section of Taxation in Washington, D.C.

These promoters “are selling self-funded health plans (often referred to by promoters as fixed indemnity health plans) and wellness plans to employers,” according to the memo. “The plans are promoted as a way to provide certain benefits to employees at no or little cost to the employer,” and with little or no effect on employees’ take-home pay. “The promoters claim the benefits do not constitute income or wages and thereby reduce the employer and employee share of employment taxes.”

According to the IRS, these plans have three main components:

• Employees make pretax contributions to the wellness plans and relatively small after-tax contributions to the self-funded health pans. Much of the amount contributed pretax is then returned to the employees as cash payments from the self-funded health plan, or rewards from the wellness plan, that purportedly do not count as taxable income or wages.
• The pretax contributions to the wellness plans lower the amount of Federal Insurance Contributions Act (FICA) taxes owed by both the employer and employees. Because the cash payments the employees receive are not included in their income, their net take-home pay generally remains unchanged.
• The employer pays the promoter a fee to administer the plans that is usually less than the FICA taxes it otherwise would have paid, with the supposed result that the employer can offer its employees the health and wellness plan at “little or no cost.”

Underlying Law

In general, Section 106(a) of the Internal Revenue Code allows employees to exclude employer-provided health coverage from income, and Section 105(b) lets them exclude any payouts by such insurance to reimburse medical costs. Code Section 104(a)(3) excludes amounts received through accident or health insurance for “personal injuries or sickness,” unless these amounts were either paid by the employer, or attributable to pretax employer contributions.

The IRS memo cites the legislative history of Section 104(a)(3), in which the congressional committee indicated that “in order for this exclusion to apply, the arrangement must be insurance (e.g., there must be adequate risk shifting).”

Scenarios Examined

The IRS applied these principles to a specific scenario in which a self-funded health plan pays employees a fixed cash amount for participating in certain health-related activities—such as calling a toll-free number or attending a seminar for health-related information, undergoing biometric screening, or attending a counseling session.

Although the participants are being paid to engage in health-related activities, the arrangement is not insurance because it “does not involve a risk of economic loss or fortuitous event,” the IRS opined. Therefore, amounts received through the plan are not excluded from income or from wages subject to FICA taxes. The IRS memo contrasted this setup with a traditional fixed-indemnity plan that pays out a fixed amount in the case of an unpredictable medical event like a hospital stay.

Because the plan is not insurance, a third party making the payments is bearing no insurance risk and is treated simply as an agent of the employer. So, to the extent the payments exceed the employees’ premiums, they are subject to income tax withholding and to FICA and Federal Unemployment Tax Act taxes.

In a second scenario, employees also can enroll in a wellness plan by making a pretax contribution through a cafeteria plan. The wellness plan provides health-related wellness activities at no charge. If this makes an employee’s take-home pay higher than it was before the program was implemented, the excess is paid in the form of flex credits that can be used for benefits under the cafeteria plan.

In this situation, the payments made by the self-funded health plan still would be taxable, but the flex credits could be excludable, unless they were used to purchase taxable benefits like a gym membership or whole life insurance, the IRS concluded.

Additional Resources

• Flexible Benefits/Cafeteria Plans (Topic Analysis)
• Withholding (Topic Analysis)