Fixed-indemnity health payments are taxable when coverage was paid pre-tax

Plain-English summary

The advice addresses employer fixed-indemnity health and wellness plans that pay preset cash amounts without tying payments to actual medical expenses. When employees pay premiums with after-tax wages, plan payments for covered health events are excluded under section 104(a)(3), even if they exceed the employee's medical costs. When the employer pays for coverage or employees use pre-tax salary reductions through a section 125 cafeteria plan, the fixed cash payments are included in the employee's gross income and wages. Section 105(b) does not exclude them because they are not reimbursements for actual medical care expenses. The same rule makes fixed wellness-plan cash rewards taxable when participation was funded pre-tax. Taxable payments are also subject to the applicable income-tax withholding, FICA, and FUTA rules.

Ruling snapshot

• Question: Are fixed cash payments from employer health or wellness plans excluded when coverage is employer-paid, purchased pre-tax, or purchased after-tax?
• Outcome: advice given, after-tax funded benefits may be excluded, while employer-paid and pre-tax funded fixed payments are taxable
• Key authorities: IRC §§ 104(a)(3), 105(b), 106(a), and 125; Treas. Reg. §§ 1.104-1(d) and 1.105-2

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201703013
       Release Date: 1/20/2017
       CC:TEGE:EB
       PRESP-137084-16

UILC: 105.00-00, 106.00-00, 104.00-00

date: December 12, 2016

 to:   Jeremy Fetter, Area Counsel
       CC:TEGEDC:DAL

from: Stephen Tackney
Deputy Associate Chief Counsel (Employee Benefits)
CC:TEGE:EB

subject: Tax Treatment of Benefits Paid by Fixed-Indemnity Health Plans

       This Chief Counsel Advice responds to your request for assistance. This advice may not
       be used or cited as precedent.


       ISSUES

       Are payments received by an employee from an employer under a fixed indemnity
       health plan excludible from the employee’s income under § 105 of the Code?

       Are payments received by an employee from an employer under a fixed indemnity
       health plan excludible from the employee’s income under § 105 of the Code if the
       amounts paid by the employee (employee premiums) for coverage under the fixed
       indemnity health plan were made by salary reduction through a § 125 cafeteria plan
       (and thereby not included in the employee’s compensation income at the time the
       amounts were paid)?

       CONCLUSION

       An employer may not exclude from an employee’s gross income payments under an
       employer-provided fixed indemnity health plan if the value of the coverage was
       excluded from the employee’s gross income and wages.

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An employer may not exclude from an employee’s gross income payments under an
employer-provided fixed indemnity health plan if the premiums for the fixed indemnity
health plan were originally made by salary reduction through a § 125 cafeteria plan.

FACTS

Situation 1. An employer provides all employees, regardless of enrollment in other
comprehensive health coverage, with the ability to enroll in coverage under a fixed
indemnity health plan that would qualify as an accident and health plan under § 106 of
the Code. Employees pay premiums for the plan by deducting the amount of the
premium each pay period from the employee’s salary; the amount of the deducted
premium is included in gross income and wages for federal tax purposes,
notwithstanding that the plan would qualify as an accident and health plan under § 106.
The fixed indemnity health plan pays employees $100 for each medical office visit, and
$200 for each day in the hospital, without regard to the amount of medical expenses
otherwise incurred by the employee.

Situation 2. The same facts as Situation 1, except the employer provides the coverage
to the employees at no cost to the employee.

Situation 3. The same facts as Situation 1, except the employees electing to participate
in the fixed indemnity health plan pay premiums by salary reduction through a § 125
cafeteria plan (and therefore the amount of the salary reduction is not included in
compensation income at the time the salary would otherwise have been paid).

Situation 4. An employer provides all employees, regardless of enrollment in other
comprehensive health coverage, with the ability to enroll in coverage under a “wellness
plan” that qualifies as an accident and health plan under § 106. Employees electing to
participate in the wellness plan pay an employee contribution by salary reduction
through a § 125 cafeteria plan (and therefore the amount of the salary reduction is not
included in compensation income at the time the salary would otherwise have been
paid). The wellness plan pays employees a fixed indemnity cash payment benefit of
$100 for completing a health risk assessment, $100 for participating in certain
prescribed health screenings, and $100 for participating in other prescribed preventive
care activities, without regard to the amount of medical expenses otherwise incurred by
the employee.

Situation 5. An employer provides all employees, regardless of enrollment in other
comprehensive health coverage, with the ability to enroll in coverage under a wellness
plan that qualifies as an accident and health plan under § 106. Employees electing to
participate in the wellness plan make an employee contribution by salary reduction
through a § 125 cafeteria plan (and therefore the amount of the salary reduction is not
included in compensation income at the time the salary would otherwise have been
paid). The wellness plan pays employees a fixed indemnity cash payment benefit each
pay period (for example, equal to a percentage of the salary payable for the pay period)
PRESP-137084-16 3

for participating in the wellness plan, without regard to the amount of medical expenses
otherwise incurred.

LAW AND ANALYSIS

Income and Statutory Exclusions from Income

Section 61(a)(1) of the Code and § 1.61-21(a)(3) provide that, except as otherwise
provided in subtitle A, gross income includes compensation for services, including fees,
commissions, fringe benefits, and similar items.

In general, § 106(a) provides that gross income of an employee does not include
employer-provided coverage under an accident or health plan. Under § 106(a), an
employee may exclude from income premiums for accident or health insurance
coverage that are paid by an employer. Also, under § 105(b), an employee may
exclude amounts received through employer-provided accident or health insurance if
those amounts are paid to reimburse expenses incurred by the employee for medical
care (of the employee, the employee’s spouse, or the employee’s dependents, as well
as children of the employee who are not dependents but have not attained age 27 by
the end of the taxable year) for personal injuries and sickness. To the extent amounts
received through employer-provided accident or health insurance are paid without
regard to the amount of expenses incurred by the employee for medical care, the
amounts are not excluded from gross income because the amounts are not paid to
reimburse expenses incurred by the employee for personal injuries and sickness.

Generally, amounts received through accident or health insurance for personal injuries
or sickness are excluded from gross income under § 104(a)(3). This exclusion does not
apply, however, if the amounts are either (1) attributable to contributions by the
employer that were not includible in the gross income of the employee or (2) paid by the
employer. See § 1.104-1(d); for this purpose, salary reduction under a § 125 cafeteria
plan is treated as an employer contribution, and not an employee contribution.

Generally, an employee choice between two or more benefits consisting of taxable
benefits such as cash and nontaxable benefits such as employer-provided health
coverage results in a cafeteria plan the taxable benefits under which are included in
income unless the choice is provided in accordance with the rules under § 125. Under
§ 125, an employer may establish a cafeteria plan that permits an employee to choose
among two or more benefits, consisting of cash (generally, salary) and qualified
benefits, including accident or health coverage. Pursuant to § 125, the amount of an
employee’s salary reduction applied to purchase such coverage is not included in gross
income, even though it was available to the employee and the employee could have
chosen to receive cash instead. If an employee elects salary reduction pursuant to
§ 125, the coverage is excludible from gross income under § 106 as employer-provided
accident or health coverage.

Application of Employment Taxes
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Sections 3101 and 3111 impose FICA taxes on “wages” as that term is defined in
§ 3121(a), with respect to “employment,” as that term is defined in § 3121(b).
Section 3121(a) defines the term “wages” for FICA purposes as all remuneration for
employment, with certain specific exceptions.
Section 3301 imposes FUTA tax on wages paid with respect to employment. The
general definitions of the terms “wages” and “employment” for FUTA purposes are
similar to the definitions for FICA purposes. See § 3306(b) and (c).

Section 3402(a), relating to federal income tax withholding, generally requires every
employer making a payment of wages to deduct and withhold upon those wages a tax
determined in accordance with prescribed tables or computational procedures. The
term “wages” is defined in § 3401(a) for federal income tax withholding purposes as all
remuneration for services performed by an employee for his employer, with certain
specific exceptions.

To the extent amounts are excluded from gross income under §§ 105(b) or 106(a), they
are also excluded from wages subject to income tax withholding under § 3401. In
addition, amounts paid to reimburse expenses incurred by the employee for medical
care (of the employee, the employee’s spouse, or the employee’s dependents, as well
as children of the employee who are not dependents but have not attained age 27 by
the end of the taxable year) for personal injuries or sickness are excepted from wages
for FICA and FUTA tax purposes under §§ 3121(a)(2) and 3306(b)(2), respectively.

Section 3121(a)(5)(G) provides an exception from FICA wages for any payment to or on
behalf of an employee under a cafeteria plan (within the meaning of § 125) if such
payment would not be treated as wages without regard to such plan and it is reasonable
to believe that (if § 125 applied for purposes of § 3121) § 125 would not treat any wages
as constructively received. Section 3306(b)(5)(G) contains a similar exception from
wages for purposes of FUTA tax.

Application to Wellness Programs and Fixed Indemnity Health Plans

The value of coverage by an employer-provided wellness program that provides
medical care (as defined under § 213(d)) generally is excluded from an employee’s
gross income under § 106(a), and any reimbursements or payments for medical care
(as defined under § 213(d)) provided by the program is excluded from the employee’s
gross income under § 105(b). However, any reward, incentive or other benefit provided
by the medical program that is not a payment for or reimbursement of medical care (as
defined under § 213(d)) is included in an employee’s compensation income, unless
excludible as an employee fringe benefit under § 132. That is because under § 1.105-2,
the exclusion under § 105(b) does not apply to amounts which a taxpayer would be
entitled to receive irrespective of whether or not the taxpayer incurs expenses for
medical care, including amounts paid irrespective of the amount of expense incurred by
a taxpayer.
PRESP-137084-16 5

A fixed indemnity health plan is a plan that pays covered individuals a specified amount
of cash for the occurrence of certain health-related events, such as office visits or days
in the hospital. The amount paid is not related to the amount of any medical expense
incurred or coordinated with other health coverage. Consequently, while the payment by
the employer for coverage by a fixed indemnity health plan is excludible from gross
income under § 106, any payments by the plan are not excluded under § 105(b).
Moreover, to the extent the premiums are paid with pre-tax dollars through a § 125
cafeteria plan or otherwise excluded from income, any payments by the plan are not
excluded under § 105(b) or 104(a)(3). However, to the extent that premiums are paid
with after-tax dollars, payments by the plan are excluded under § 104(a)(3), without
regard to the amount of any medical expense incurred by the event upon which the
payment is conditioned. For example, if the fixed indemnity plan with premiums paid on
an after-tax basis paid $200 for an office visit and the covered individual’s unreimbursed
medical costs as the result of the visit were $30, the $200 would be excluded from
income.

DISCUSSION

In Situation 1, because the premiums for the fixed indemnity health plan are included in
the employee’s gross income and wages (and thus paid with after-tax dollars), amounts
paid by the plan are excluded from gross income and wages under § 104(a)(3).

In Situations 2, and 3, because the premiums for the fixed indemnity health plan are
paid with amounts that are not included in the employee’s gross income and wages, the
exclusions under §§ 105(b) and 104(a)(3) do not apply to the payments and any amount
paid by the plan are included in the employee’s gross income and wages, regardless of
the amount of any medical expenses incurred by the employee upon which the payment
is conditioned.

In Situations 4 and 5, because the premiums for the wellness plan are paid with
amounts that are not included in the employee’s gross income and wages, the
exclusions under §§ 105(b) and 104(a)(3) do not apply to the fixed indemnity cash
benefit payments and any payments are included in the employee’s gross income and
wages, regardless of the amount of any medical expenses incurred by the employee
upon which the payment is conditioned.

Please call me at (202) 317-6000 if you have any further questions.