Pre-Tax Premiums May Have Employees Singing the Post-Tax Blues
by Matt Gerard, J.D.Mr. Gerard is affiliated with National Benefit Services, LLC, which provides retirement and flexible benefit administration to over 20,000 employers nationwide and has grown to become a national name in third-party benefit administration. Reprinted with permission. Visit here.
May 24, 2017 — Employers who offer fixed indemnity health coverage or wellness programs to their employees may consider reassessing how that coverage is administered in view of a recent Internal Revenue Service (IRS) internal memorandum that examines the tax treatment of benefits paid by fixed indemnity health plans.
The Office of Chief Counsel Memorandum states that payments made to participants under certain fixed indemnity health plans (and certain wellness programs) must be included in employees’ gross income, unless the premiums for such plans are paid on an after-tax basis. However, the Memorandum does not address how employers should administer these taxable fixed indemnity payments.
Employers primarily offer fixed indemnity health coverage as a supplement to their group health plan, and numerous insurers offer such plans. A common example of fixed indemnity health coverage is hospital indemnity insurance. Fixed indemnity health coverage pays a fixed dollar amount to the policyholder after the occurrence of specific insured events. For example, the policyholder receives $50 for each visit to a doctor’s office or $200 for each day in a hospital. Such payments do not cover specific medical expenses but rather provide a preset amount regardless of the actual cost of a medical expense to the policyholder. Consequently, payments from fixed indemnity health coverage are not directly related to an individual’s incurred medical expense and, therefore, can create tax liability for the individual. Hence, many insurers have been reluctant or unwilling to address the tax effects of their fixed indemnity health plans with employers.
The Memorandum considered the taxability of payments received from fixed indemnity health plans and wellness programs in the five following situations:
- Employees pay the fixed indemnity health plan premiums through post-tax deductions, and the amount of the deducted premium is included the employees’ gross income.
- The employer pays the fixed indemnity health plan premiums.
- Employees pay the fixed indemnity health plan premiums with pretax salary reductions through a section 125 cafeteria plan.
- The employer offers to all its employees a wellness program that pays participants a fixed indemnity payment for completing specified wellness activities, such as a health risk assessment or health screening. Employees pay for the wellness program with pretax salary reductions through a section 125 cafeteria plan.
- The employer offers to all its employees a wellness program that pays participants a fixed indemnity cash payment each pay period. Employees pay for the wellness program with pretax salary reductions through a section 125 cafeteria plan.
In the Memorandum, the Office of Chief Counsel determined that tax exclusions under Code sections 105(b) and 104(a)(3) were inapplicable to payments from fixed indemnity health plans and wellness programs when the premiums for such plans were not taxed. Essentially, if a fixed indemnity health plan’s premiums were excluded from an employee’s gross income either because the employer paid them or an employee paid them on a pretax basis through a cafeteria plan, then plan payouts to the employee must be included in that employee’s gross income. Conversely, if a fixed indemnity health plan’s premiums were paid on a post-tax basis or otherwise included in an employee’s gross income, then plan payouts to the employee would be excluded the from that employee’s gross income. Thus, from the situations listed above, only payments from the plan in Situation 1 would be excluded from an employee’s gross income.
The Memorandum’s stated conclusions have caused further confusion on how benefits from a fixed indemnity health plan should be taxed since the analysis discussed in the Memorandum may be inconsistent with previous IRS guidance. Some commentators claim the Memorandum fails to fully apply tax principles set forth in Treasury Regulation section 1.105-2 and Revenue Ruling 69-154.
In the nearly fifty-year-old ruling, the IRS specifically addressed the taxability of “excess indemnification” received through medical insurance when the taxpayer had more than one health insurance policy. Ruling 69-154 set forth three situations in which an employee received indemnity from multiple health insurance policies that exceeded the actual cost of the employee’s incurred medical expenses. In that ruling, the IRS cited the portion of Treasury Regulation section 1.105-2 which provides that the section 105(b) exclusion for medical care reimbursements is inapplicable when the amounts a taxpayer receives for reimbursement exceed the actual incurred expenses for such medical care. Consequently, in situations where the employer paid for one or more of the health insurance premiums, the IRS determined that only the amount of excess indemnity was taxable. Thus, some reviewers of the Memorandum conclude that benefits paid to an employee under a pre-tax funded (or employer paid) fixed indemnity health policy should be tax-free up to the incurred cost medical care.
So, if an employee receives $50 for each doctor visit under an employer-paid fixed indemnity health policy but pays a $35 copay to see the doctor, then the employee should only be taxed on $15. Commentators claim that if fixed indemnity payments are never considered a reimbursement for medical expenses, (even when generated by a health-related event likely to result in medical expenses) then Revenue Ruling 69-154 is unnecessary.
Conversely, the Memorandum’s position parallels the IRS’s more recent position on taxation of short-term and long-term disability benefits. In Revenue Ruling 2004-55, the IRS held that disability benefits received by an employee are includable in the employee’s gross income under section 105(a) when the disability coverage is paid by the employer on a pretax basis for the plan year in which the employee becomes disabled. Revenue Ruling 2004-55 also states that such disability benefits are not included in an employee’s gross income when the disability coverage is paid on a post-tax basis. The rationale for these conclusions is that disability benefits compensate an employee for lost wages, not for medical expenses, and therefore, the section 105(b) exclusion does not apply to disability benefits. Thus, the tax treatment of disability benefits parallels the tax treatment of benefits from fixed indemnity health plans as set forth in the Memorandum.
Additionally, the Memorandum’s position conforms to Treasury Regulation section 1.105-2. That regulation states, “Section 105(b) applies only to amounts which are paid specifically to reimburse the taxpayer for expenses incurred by him for the prescribed medical care.” Treasury Regulation section 1.105-2 also provides that section 105(b) does not apply to any amounts to which a taxpayer is entitled to receive irrespective of whether the taxpayer incurred expenses for medical care. Most fixed indemnity health coverage benefits pay out upon the occurrence of specified events, not when a policyholder incurs medical expenses. Consequently, the section 105(b) exception should not apply to those fixed indemnity health plan benefits when the fixed indemnity health plan’s premiums were excluded from an employee’s gross income. While the Memorandum may not have fully explained the analysis behind its conclusions, readers can deduce that the Memorandum does conform to Treasury Regulation section 1.105-2.
Multiple reviewers state that IRS officials have informally commented that the Memorandum may have overstated the taxability of fixed indemnity benefits and that the IRS will be reviewing the Memorandum and issuing clarifying guidance; however, IRS officials have not provided a time frame in which the IRS will issue such clarifying guidance.
First, the Memorandum is neither law nor definitive IRS guidance. Chief Counsel Advice memorandums are internal IRS documents drafted by the IRS Office of the Chief Counsel to respond to legal questions posed by IRS area offices. Chief Counsel Advice memorandums may not officially be used or cited as IRS precedent. Nevertheless, such memorandums demonstrate the IRS’s position and reasoning on specific legal issues. Thus, the Memorandum is an indicator as to how the IRS may act in the future regarding fixed indemnity health plan benefits and wellness program rewards that operate like fixed indemnity health plan benefits.
Second, employers should discuss whether the Memorandum affects their offered benefits and wellness programs with their trusted tax and legal advisors. Employers who pay, or allow their employees to pay on a pretax basis, the premiums for fixed indemnity health coverage may want to reevaluate their current methodology. Employers may contemplate providing such health coverage outside of their cafeteria plans, requiring employees to purchase such coverage on a post-tax basis, or including employer-paid premiums in their employees’ gross income. Nevertheless, post-tax premiums may lessen the appeal of fixed indemnity coverage to employers and employees.
Finally, employers should review administration of benefit payments.
Employers may not know whether or when their employees receive taxable payments from fixed indemnity coverage. Upon review, employers may consider working with their tax advisors and insurance carriers to implement a process for withholding and submitting the required employment taxes from fixed indemnity coverage payments on the employer’s behalf. Employers should clearly establish who has the liability to report any benefit payments or and associated taxes that should be included in an employee’s gross income and wages.