Overview
Three years ago, we warned that payments to employees under some "wellness" or "medical indemnity" plans do not satisfy applicable Internal Revenue Service (IRS) requirements to provide promised payroll tax savings for employers or their workers. Indeed, such schemes could result in significant tax penalties for the employer and the employee if they are effectuated as promoted.
Employers continue to receive pitches for these so-called wellness or medical indemnity programs that promise significant payroll tax savings. Since our initial publication, however, the IRS and the Department of Treasury have issued clear guidance outlining why those programs do not effectively convert taxable wages into tax-free health benefits and are thus best avoided if tax savings are your goal.
How These Schemes Work
The pattern is familiar: employees elect to reduce taxable wages through an Internal Revenue Code (IRC) Section 125 cafeteria plan; the employer uses those amounts to pay premiums for a fixed-indemnity healthcare policy; and the insurer pays a monthly "wellness benefit" regardless of actual medical expenses incurred by the employee to offset the reduced wages. Employees can claim benefits for a broad range of activities such as preventive care, telehealth, health risk assessments, or wellness coaching—often for services that cost nothing or are already covered elsewhere. Promoters selling these plans then advertise these "wellness payments" as tax-free reimbursements and highlight the Federal Insurance Contributions Act (FICA), Medicare, and income tax savings for employees, and reduced FICA, Medicare, unemployment taxes, and workers compensation premiums for employers, all of which are calculated on total taxable wages paid.
What the IRS and Treasury Say
In June 2023, the IRS issued Chief Counsel Memorandum 202323006 concluding that such fixed-indemnity "wellness" payments are taxable wages because they are not reimbursements of actual medical expenses within the meaning of IRC Section 105.
The following month, Treasury and the IRS proposed regulations stating that the exclusion from gross income for employer-provided health benefits does not apply to payments from fixed-indemnity arrangements and similar plans to the extent payments are made without regard to actual incurred medical expenses or premiums. Although these regulations were never finalized, Treasury later clarified that this should not be considered approval of these schemes or as suggesting that the "wellness" payments are non-taxable.
Why the Tax Exclusion Doesn’t Apply
Section 105 excludes from taxable income only amounts paid to reimburse substantiated medical expenses and only up to the amount incurred. In the abusive designs, fixed cash amounts are paid irrespective of expense, including for events with no cost to the employee. Because the payments are connected to employment—and untethered to actual medical costs—the IRS treats them as wages subject to income tax withholding, FICA, Medicare, and the Federal Unemployment Tax Act.
The June 2023 IRS memorandum analyzed what appears to be a typical scenario: an employer provided comprehensive health coverage through a group health policy along with the ability to enroll in a fixed-indemnity policy offering wellness benefits for participating in certain activities.
Under these facts, the IRS concluded that the wellness benefits payments under the fixed-indemnity plan should be included in the employee’s gross income and subject to the full range of tax withholding—FICA, Medicare, unemployment, and income tax. The wellness payments could only be excluded from these withholding requirements to the extent that the reimbursements meet the Section 105 requirements.
Promoter Tactics to Watch
In each of the fixed-indemnity wellness plan proposals we reviewed that analyzed tax savings, the promoter improperly recharacterized taxable wages—the plan reimbursement arrangement—as a tax-free benefit. Promotional materials frequently include rosy before-and-after paycheck illustrations and offer glowing testimonials from clients. In one set of marketing materials, an employee health benefits provider implied that the IRS had blessed its plan by providing a testimonial from a former "IRS Corporate Auditor" claiming he saw "many wellness plans come under scrutiny," but "there would be no potential exposure" under the company’s plan. We are unaware of the IRS blessing any of these arrangements, and any assertions to the contrary should be closely scrutinized.
Some promoters also provide legal opinions or memoranda prepared by their law firms to support the permissibility of the proposed arrangements. If you or a client are considering these plans, you should first seek guidance from your legal and tax advisors. The promoter-provided legal "opinions" we reviewed either are written for the promoter to attest to the legality of the indemnity plan itself (about which there is no dispute) or they simply analyze general fact patterns and generally disclaim any right of reliance by third parties (i.e., you or your clients).
Some promoters attempt to distinguish their plans from the fact scenario analyzed under the June 2023 IRS guidance. Its promoters claim that the health plan described above, for example, provides "CPT-code- and/or activity-based prescribed medical treatment programs" that are not a wellness plan and that the payments thus qualify for the Section 105 income exclusion. There is no legal support for this proposition. CPT codes are billing descriptors, not proof of incurred medical expenses, and use of a CPT code does not change the nature of the provided service itself.
Another promoter pointed to its partnership with a charitable organization through which expenses under its program would be reimbursed as supporting the tax-free treatment of those wellness payments. But, once again, this fails the sniff test for legal support, and the outcome of routing payments through a charity does not change the wage character of the provided benefit.
Penalty and Litigation Exposure
If challenged by the IRS, employers may face steep penalties up to 20% of the underpaid taxes, as well as unpaid FICA and Medicare taxes, accuracy-related penalties, and compounding interest on all amounts due.
Taxpayers may avoid tax penalties if they act in good faith and reasonably rely on an opinion issued by an independent advisor that addresses all relevant facts. Treasury regulations and related case law make clear that promoters’ promotional materials and legal "opinions" will not suffice as they generally contain only generic tax opinions that do not analyze the outcome based on the employer’s specific facts.
One promoter-provided legal opinion that we reviewed did not address the tax implications but asserted that these arrangements constitute an ERISA welfare benefit plan. If plan participants are found to owe significant income taxes and penalties from underpayment of taxes, the ERISA fiduciary duty rule applies to welfare benefit plans and enables a private right of action allowing plan participants to sue; fiduciaries, such as employers that sponsored the plan, can be personally liable. Any tax insurance offered by the promoters as part of entering into a fixed-indemnity plan—as we have also seen highlighted in the marketing materials—is unlikely to provide protection for such fiduciary liability.
Red Flags and Next Steps
If you or your client are confronted with these proposals, any of the following should be a red flag:
- Any plan touting substantial payroll tax savings from "wellness" cash benefits.
- Fixed monthly payments made without proof of actual medical expenses.
- Reliance on CPT codes or activity check-the-box attestations in lieu of substantiation.
- Testimonials or assurances implying IRS "blessing."
- Legal opinions not addressed to your organization and disclaiming reliance.
Before proceeding with any proposal, have your own counsel or tax advisor review the exact facts, and assume that payments untethered to incurred medical expenses will be treated as taxable wages.
The bottom line is, employers should avoid arrangements that purport to convert taxable wages into tax-free "wellness" cash payments. As the saying goes, if it sounds too good to be true, it probably is.
