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Beware of tax promoters purporting to save employment taxes on health plans

Recently, a number of wellness plans and health plan arrangements have been marketed to employers as a way to save employment and income taxes for employers and employees, but don't give the promised benefits. The arrangements usually involve an employee paying a nominal insurance premium to be reimbursed for expenses that are virtually certain to be incurred. As such, the amounts are not tax-free reimbursements under either Sec. 104(a)(3) or Sec. 105.

The problem

Similar arrangements were marketed years ago, resulting in the issuance of Rev. Rul. 2002-3. The IRS is aware of a recent resurgence of arrangements with a different twist and is explaining to taxpayers and their tax advisers that many do not have the promised tax benefits, which depend on the arrangement being health insurance. An arrangement is insurance for tax purposes only if the arrangement involves risk shifting: the transfer of risk to another party. In this case, there is no risk as the expenses are virtually certain to be incurred, some do not involve deductible health benefits, and determining the amount of premiums does not involve any actuarial underwriting.

The marketing of these arrangements is especially concerning because employers and employees can end up with unexpected employment and income tax liabilities, likely including penalties, and not much, if any, recourse to the individual who sold the arrangement. That person, likely under a contract that takes no responsibility for tax advice, has collected a commission for assisting with implementing the arrangement. The employer purchasing the arrangement has paid the commission and then will need to pay unexpected employment taxes, and employees will have unexpected income and employment taxes.

The arrangements

Recently, the IRS issued three pieces of Chief Counsel Advice (CCAs) on these arrangements, concluding that the benefits paid are taxable. With the release of each CCA, promoters tweak their offerings and purport to have a product that avoids application of the CCA because it is not specifically addressed.

CCA 201622031 involved income exclusions for cash rewards paid or premiums for participating in wellness programs. The CCA describes three situations, each provided to all employees regardless of whether the employee was covered by the employer's comprehensive health plan. First, employees are provided cash or other taxable rewards for participating in health screenings or other activities that generally qualify as an accident or health plan. A second situation involves payment for these plans by employees through a Sec. 125 cafeteria plan. The third situation is the same as the second except that one of the benefits under the arrangement includes reimbursement of all or a portion of the required employee contribution that the employee made through salary reduction.

CCA 201703013, issued approximately eight months later, expands the situations covered to include fixed-indemnity plans that would qualify as a health plan. In one situation, employees pay a premium to participate with after-tax dollars, notwithstanding that the premiums could be tax-free under Sec. 106. The plan pays employees a fixed dollar amount for each office visit or hospital stay, without regard to whether unreimbursed medical expenses are incurred. A variation involves the employer's paying the premium for this plan and the employee's participating in the arrangement through a Sec. 125 salary reduction arrangement.

Another situation gives employees the ability to enroll through a Sec. 125 cafeteria plan arrangement in coverage under a wellness plan that qualifies as an accident and health plan, regardless of enrollment in other comprehensive health coverage. The plan pays a fixed-indemnity cash payment benefit for completing a health risk assessment and participating in certain prescribed health screenings or preventive care activities, without regard to the amount of medical expenses the employee incurred.

The final situation similarly provides the employees the opportunity to participate in a Sec. 125 cafeteria plan paying wellness benefits, regardless of enrollment in comprehensive health coverage. The plan pays employees a fixed-indemnity cash payment each pay period (e.g., a specified percentage of salary) for participating in the plan, without regard to the amount of medical expenses incurred.

The most recently issued advice, CCA 201719025, highlights the fact that promoters are selling self-funded health plans, referred to as wellness plans or fixed-indemnity health plans, for little or no cost to the employer or employee taking into account the employee's after-tax net take-home pay. Employees who voluntarily participate make pretax contributions to a wellness plan and a nominal contribution to a self-funded health plan. The pretax contributions are returned as cash payments from the self-funded health plans or as purportedly nontaxable wellness plan rewards.

The advice provides an example of how an employee's income taxes are reduced by converting payments into purportedly nontaxable health benefits with the promoter's fee paid with employment tax savings enjoyed by the employer under these arrangements. In the first situation, the self-funded health plan pays employees cash for participating in activities related to health (e.g., calling a toll-free number for general health-related information, attending a seminar that provides general health-related information, participating in a biometric screening, or attending a counseling session). The amount employees receive for participating in these activities is much greater than the after-tax premium they pay to participate.

In all cases, the promoters highlight tax savings as a result of tax-free premiums, salary reduction through cafeteria plans, and/or tax-free benefits. The IRS details that the amounts paid to employees are taxable as reimbursement of nonmedical expenses or as payments made through an arrangement that does not have the required risk shifting of insurance.

In general, Sec. 104(a)(3) provides that health benefits paid or reimbursed through health insurance purchased by an individual are nontaxable. Sec. 106 excludes from gross income employer-provided coverage under an accident or health plan. As such, premiums for accident or health insurance coverage are not taxable. In addition, Sec. 105(b) excludes benefits received through employer-provided accident or health insurance if those amounts are paid to reimburse an employee for expenses incurred for medical care of the employee, the employee's spouse, the employee's dependents, and children of the employee who are age 26 or younger irrespective of whether they are dependents.

Regs. Sec. 1.105-2 provides that the exclusion does not apply if the taxpayer is entitled to receive reimbursement irrespective of whether medical expenses are incurred or whether reimbursement exceeds the actual medical expenses from an employer plan. Nontaxable amounts are not included in wages for income tax withholding or employment tax purposes, whereas amounts that are not excluded are.

The tax rules

Coverage under an employer-provided wellness plan that provides medical care is generally excluded from an employee's gross income and any medical care provided under the program is also excluded. However, a cash reward, cash incentive, or other payment that is not medical care would be taxable, unless it is a noncash or noncash equivalent payment that is excludable as a de minimis fringe benefit. A de minimis fringe benefit is any property or service the value of which (after taking into account the frequency with which similar fringes are provided by the employer to the employees) is so small as to make accounting for it unreasonable or administratively impractical.

A cash payment (other than overtime meal money and local transportation fare) is never a de minimis fringe. Under these rules, a T-shirt or coffee mug would not be taxable, but a gym membership or cash payments for going to the gym or attending nutrition classes would be.

If the employee purchases accident and health insurance with after-tax dollars, benefits paid by the policy for personal injuries or sickness are nontaxable under Sec. 104(a)(3). This exclusion does not apply to benefits attributable to employer premium payments that are not included in the employee's income or amounts the employer paid under a self-insured plan. Employers, however, may provide incidental administrative support for individuals to purchase the insurance, such as allowing the premiums to be deducted from employees' pay and remitting them to the insurer or allowing company facilities to be used to market the insurance to employees. Key distinguishing features of these types of permissible plans are that they are voluntary, paid with post-tax dollars, and include a medical underwriting requirement because this is the sale of individual health insurance.

The Sec. 104(a)(3) exclusion does not apply to amounts attributable to cafeteria plan salary reduction contributions as those benefits are considered to be provided by the employer (Sec. 125). Also, as the legislative history for Sec. 125 notes, the exclusion only applies to reimbursements through insurance arrangements and arrangements having the effect of insurance (e.g., there must be adequate risk shifting) (see H.R. Conf. Rep't No. 104-736, at 294 (1996)).

While neither the statute nor the regulations define insurance, judicial decisions indicate that the risk transferred must be the risk of an economic loss, contemplating the fortuitous occurrence of a stated contingency and not merely an investment or business risk (see Helvering v. Le Gierse, 312 U.S. 531 (1941); Allied Fidelity Corp., 572 F.2d 1190 (7th Cir. 1978); Treganowan, 183 F.2d 288 (2d Cir. 1950); Rev. Rul. 2007-47). State law definitions or determinations of insurance and risk shifting do not apply to this area. At least one arrangement with which we are familiar has been determined, for state law purposes, to be insurance by at least one state, but that determination is irrelevant for federal tax purposes.

Thus, if an employee pays for a fixed indemnity or wellness plan with after-tax dollars and the arrangement exhibits risk-shifting features, then all benefits paid under the arrangement are nontaxable under Sec. 104(a)(3). However, if the premiums for those plans are paid by the employer or with pretax dollars through a cafeteria plan, benefits paid are not excludable under either Sec. 104(a)(3) or Sec. 105(b), except to the extent that the benefits pay actual medical expenses that would otherwise be deductible under Sec. 213.

In addition, if the average benefits paid or predicted to be paid through a self-insured health plan markedly exceed the after-tax contributions paid by the participating employee, the benefits in excess of the after-tax premiums paid by the employer are not excludable under Sec. 104(a)(3) as they are either attributable to contributions by the employer that were not includible in income by the employee or paid by the employer. The excess of any reimbursement from the self-insured plan over the amounts the employee paid on an after-tax basis would be taxable to the employee for income tax purposes and also subject to employment taxes and income tax withholding.

Correcting errors

Employers having entered into these arrangements in 2017 can correct this relatively easily by withholding income and employment taxes on these amounts; amending Form 941, Employer's Quarterly Federal Tax Return, filings; and properly reporting the amounts on the 2017 Form W-2, Wage and Tax Statement. Tax payments for prior months can be accomplished by having the employee provide funds to the employer or letting the employer lend amounts to employees to cover 2017 withholding with repayment coming from 2017 and 2018 compensation, or withholding from the remaining 2017 salary and bonus payments.

If the employer pays the employee income or FICA tax obligation, that payment will be taxable and subject to income and employment tax withholding, requiring a gross-up calculation. Many employers in this situation pay some or all of the taxes for the employees as they feel responsible for having created the problem by offering the program and don't want to significantly decrease employees' take-home pay.

Employers with these arrangements for 2016 or earlier years will not be able to adjust income tax withholding but will be able to amend 2016 Forms 941 for unpaid employment taxes to the extent that the statute of limitation for employment taxes has not expired. In addition, employers would need to file Forms W-2c to report in Box 1 the previously unrecognized income employees will need to recognize. In addition, if the employer pays the employee’s income or employment tax liability, those amounts will need to be reported as income on Form W-2 in the year in which the payment is made.

With significant numbers of employees involved, one could approach the IRS to see if the unpaid taxes could be settled with a closing agreement. No IRS program exists for those agreements, and, based on recent experience, the IRS is reluctant to enter into them if the number of employees or the dollar amounts are not large.

Employers that do not include amounts in income for these arrangements may find that the IRS assesses the taxes, penalties for failure to pay taxes, and penalties for failure to deposit taxes. It is possible that the IRS would also assess a penalty for substantial understatement of taxes or a disregard of rules and regulations.

If the employer corrects the errors before an IRS assessment, the IRS will likely waive some or all the penalties. It is in the best interest of tax administration that taxpayers recognizing errors correct them without IRS examination. To encourage taxpayers to come forward when mistakes are found, penalties are rarely assessed when taxpayers correct their own mistakes.

Deborah Walker is National Director, Compensation and Benefits, at Cherry Bekaert LLP in Tysons Corner, Va., and Richard Barnes is a lecturer at North Carolina State University in Raleigh, N.C.