Fixed-Indemnity Wellness Plans: The IRS Clarifies Taxation of Wellness Payments 

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On June 9, 2023, the IRS Office of Chief Counsel issued Memorandum No. 202323006 (the “Memorandum”) and addressed whether payments made under an employer-funded, fixed-indemnity wellness plan are includible in gross income of an employee if the employee has no reimbursed medical expenses related to the payments. This Memorandum was issued in response to a request for guidance about a particular employer’s wellness benefits.

Background

Many employers offer employer-sponsored programs to reward and encourage employees to participate. As a general matter, wellness incentives are subject to the same federal income tax treatment as typical employee rewards, which calls for inclusion of the amount of the reward (alternatively, its fair market value) in the employee’s gross income unless a specific tax exemption applies. As detailed herein, no such specific exemption has been expressly provided for fixed-indemnity wellness plans. Although coverage provided through an employer-funded wellness program is generally excluded from employees’ gross income, wellness payments to the employees are not.

These plans have been offered since 1970s; however, IRS guidance has been few and far between and only sparsely addressed particular iterations. For example, the IRS Office of Chief Counsel has previously addressed similar questions in Memorandums No. 201703013 and No. 201719025. Nevertheless, some consultants in the industry contend that this wellness arrangement should not result in taxable income to the employees as it is a “win-win” plan for both the employer and employees—when the employees reduce their pay, the employer saves on employment taxes, which similarly results in the employees saving on both employment and income taxes. In the Memorandum, the IRS Office of Chief Counsel generally disagreed and further reinforced its prior position regarding the taxability of fixed-indemnity wellness plan payments when funded under a Section 125 cafeteria plan.

Employer Plan Design

The Memorandum addressed circumstances in which a certain employer provided employees comprehensive medical coverage through a group health insurance policy that included preventative care benefits without any cost-sharing. The employer also offered its employees an opportunity to enroll in a fixed-indemnity health insurance policy to supplement the employees’ comprehensive health coverage with wellness benefits; however, enrollment in other health coverage was not required for participation in the fixed-indemnity coverage. The employees could enroll in such coverage by payment of monthly premiums of $1,200 by salary reduction on a pre-tax basis through a Section 125 cafeteria plan.

Among other things, the wellness plan provided wellness and nutrition counseling and telehealth visits at no additional cost. One of the wellness benefits under such policy was a payment of a specified amount ($1,000) once per month if the employee participated in certain health or wellness activities (i.e., preventative care, such as vaccinations under the comprehensive health coverage). The insurance company would make these payments to the employer who, in turn, paid the wellness benefit to the employee through payroll.

As discussed in the April issue of Benefitting You (and in more detail below), the U.S. District Court for the Northern District of Texas (the “District Court”) recently issued a ruling in the case Braidwood Management Inc. v. Becerra, wherein it vacated the implementation and enforcement of certain preventive service mandates under the Affordable Care Act (“ACA”). Following an appeal by the Department of Justice (“DOJ”), the U.S. Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) issued a temporary stay of the District Court’s ruling on May 15, 2023. As a result, implementation and enforcement of the ACA’s preventive services mandate will continue as normal while the Fifth Circuit considers the DOJ’s appeal.

Taxability to Employees

Pursuant to the Internal Revenue Code (the “Code”), all employee compensation, including fees and fringe benefits, are taxable to the employees unless a specific exemption applies.  In the Memorandum, the IRS Office of Chief Counsel concluded that no such exception applied in this case and stated that wellness payments under a fixed indemnity health insurance policy are includible in the gross income of the employee if the employee has no unreimbursed medical expenses related to the wellness payments.

The Memorandum explained that the Section 105(b) exclusion for medical expenses under the Code is meant to apply only to amounts limited to reimbursement of expenses incurred for medical care. This exclusion does not apply to amounts payable to the employee irrespective of whether expenses for medical care are incurred. The exclusion does not apply in such circumstances either because: (1) the activity that triggers the payment does not cost employee anything; or (2) the cost of the activity is reimbursed by other coverage. For instance, vaccinations may be covered as preventative care under the employee’s comprehensive health coverage. Accordingly, the Memorandum confirms that wellness payments under a fixed-indemnity insurance policy are not related to the amount of any medical expenses incurred or coordinated with other health coverage and thus cannot be excluded from employees’ gross income. The Memorandum also discussed whether wellness payments that are includible in gross income are due to be considered wages for purposes of the Federal Insurance Contributions Act (“FICA”), the Federal Unemployment Tax Act (“FUTA”), and federal income tax withholding (collectively referred to in this article as “employment taxes”). The IRS Office of Chief Counsel clarified that the taxable wellness payments are considered wages for purposes of employment taxes because such payments are provided in connection with the employee’s employment.

Employer Impact

Although the Memorandum cannot be relied upon and is applicable only to the specific employer requesting this guidance, employers may nevertheless find it significant in navigating these types of plans as the Memorandum offers valuable insight into the IRS’s stance on this taxation issue.  Notably, the Memorandum did not discredit all fixed-indemnity wellness plans across the board. However, any employer who currently sponsors a fixed-indemnity wellness plan or intends to implement one needs to consider both sides of the coin regarding various design options and the maintenance of these plans moving forward. Most importantly, employers need to be wary of the IRS knocking on their doors to assess penalties based on the employers’ alleged failure to remit taxes when due. Accordingly, some stakeholders suggested terminating such plans altogether to avoid IRS scrutiny and the possibility of audit activity. At a minimum, employers are advised to consult their benefits counsel to evaluate the risk of IRS penalties associated with unpaid employment taxes.