Employee wellness plans: Some benefits may be taxable

Editor: Mark G. Cook, CPA, CGMA

The correlation between health and employee engagement has been the subject of many studies in recent years. The overarching conclusion is that healthy employees are happier and show higher rates of job satisfaction. Employers can encourage health and wellness for their employees with many types of benefit options, including on-site fitness centers, healthy lunch and snack offerings, or employee assistance programs.

An additional option is a fixed-indemnity wellness plan. The unique qualities of fixed-indemnity wellness plans have led to some confusion concerning the taxability of benefit payments. The IRS issued Chief Counsel Advice (CCA) 202323006 on May 9, 2023, to address this topic. The CCA provides support for the conclusion that benefit payments are taxable wages to the insured employees.

Fixed-indemnity insurance is a type of plan that makes a predetermined cash payment to the insured on a per-period or per-incident basis. These payments are triggered by certain health-related events specified in the plan, such as a visit to the doctor, days in the hospital, or the diagnosis of a particular condition or disease. The wellness type of fixed-indemnity plan makes benefit payments triggered by wellness-specific activities, for example, wellness counseling, nutrition counseling, telehealth benefits, and preventive care such as vaccinations. The trigger for payment is health-related, but benefit amounts are predetermined, not related to medical costs. The payments are also not dependent upon or coordinated with any other health coverage.

The wellness plan evaluated in CCA 202323006 is a voluntary plan offered by an employer to its employees to supplement their comprehensive health coverage. In addition to the comprehensive health coverage, the employer offers enrollment in wellness fixed-indemnity coverage qualifying as an accident and health plan under Sec. 106. For this fixed indemnity coverage, employees pay monthly $1,200 premiums pretax via salary reduction structured as a Sec. 125 cafeteria plan. Employees pay all premiums, and the employer has no liability for costs incurred by the insurance company that exceed the monthly premiums.

This wellness plan offers two types of benefits. The first is a payment of $1,000 if the employee participates in certain specified health or wellness activities, limited to one payment per month. The second is a payment for each day the employee is hospitalized. Payment of benefits does not depend on costs the employee incurs and is not coordinated with any other health coverage. In many cases, the employee does not incur any out-of-pocket expenses. The activities qualifying for the benefit payment are often no-cost or covered by other health insurance held by the employee. The insurance company pays benefit payments to the employer, which then uses its payroll system to pay them to employees.

To determine the taxability of benefit payments, the IRS Office of Chief Counsel (OCC) evaluated and cited both income tax and employment tax provisions.

Sec. 105(a) provides the general rule that “amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.” The pretax treatment of premiums is addressed by Regs. Sec. 1.104-1(d) by clarifying that pretax salary reductions under a Sec. 125 cafeteria plan are treated as an employer contribution, not an employee contribution, because the premiums were not included in the employee’s gross income. Therefore, barring any exceptions, the benefit payments should be includible in the employee’s gross income when paid.

There is an exception to the general rule for gross income inclusion in Sec. 105(b) for amounts paid by an employer to reimburse the employee for medical expenses. However, Regs. Sec. 1.105-2 clarifies that Sec. 105(b) “does not apply to amounts which the taxpayer would be entitled to receive irrespective of whether or not he incurs expenses for medical care.” The plan provisions allow for payment of wellness benefits without consideration of medical expenses incurred or covered by other health insurance policies. Because of the pretax treatment of plan premiums and the payment of benefits without consideration of medical expenses incurred, the wellness benefits received should be includible in gross income of the employees, the OCC concluded.

The OCC next evaluated the Code’s employment tax provisions to determine if the wellness benefits are subject to withholding of taxes for FICA (Federal Insurance Contributions Act, consisting of Social Security and Medicare taxes) and FUTA (Federal Unemployment Tax Act). FICA and FUTA taxes are imposed on wages, which are defined in Sec. 3121(a) for FICA purposes and Sec. 3306(b) for FUTA purposes as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash” unless the payments meet an exception outlined in the Code.

There is a specific exception from FICA wages in Sec. 3121(a)(5)(G) and a similar exception from FUTA wages in Sec. 3306(b)(5)(G) for payments to employees under a Sec. 125 cafeteria plan if the payments would not be treated as wages without regard to such a plan and if it is reasonable to believe that Sec. 125 would not treat any such wages as constructively received. The wellness benefits are fixed amounts and not reimbursements for actual medical expenses incurred. Thus, the payments would be considered wages without regard to the Sec. 125 cafeteria plan and do not meet this exception from FICA or FUTA wages.

There is another exception from FICA wages in Sec. 3121(a)(2)(A) and a similar exception from FUTA wages in Sec. 3306(b)(2)(A) for payments received on account of sickness or accident disability. However, these same Code sections state that “this subparagraph shall exclude from the term ‘wages’ only payments which are received under a workmen’s compensation law.” The taxable wellness fixed-indemnity benefit plan payments are not paid under a worker’s compensation law and thus do not qualify for this exception.

There is also an exception under Sec. 3121(a)(2)(B) from FICA wages and a similar exception from FUTA wages under Sec. 3306(b)(2)(B) for medical or hospitalization expenses in connection with sickness or accident disability, but the taxable wellness indemnity benefits cannot qualify for this exception because the payments do not meet this description.

In short, then, the wellness benefit payments do not meet a specific exception outlined in the Code’s employment tax provisions. They fall under the general definition of “wages” and are subject to FICA and FUTA taxes, the OCC concluded.

Studies have shown the importance of employee health and its positive impact on job satisfaction. There are many kinds of programs or plans for employers that want to promote employee health. Fixed-indemnity wellness plans funded through pretax contributions can be a great option for employers to promote health and encourage participation in wellness activities. However, there is no tax break for benefit payments made through this sort of plan. The IRS’s issuance of CCA 202323006 clarified that wellness benefit payments paid to employees from a fixed-indemnity wellness plan structured as a Sec. 125 cafeteria plan are gross income and taxable wages to the employees when payment is made.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.