Predictable wellness payments are taxable income and wages

Plain-English summary

Chief Counsel analyzed arrangements marketed as self-funded health plans that paid employees large fixed amounts for completing routine health-related activities after employees made much smaller after-tax contributions. The payments were taxable because the arrangements did not shift or distribute insurance risk and therefore were not insurance or the equivalent of insurance under IRC § 104(a)(3). The predictable excess of benefits over employee contributions also showed that the excess was attributable to the employer. That excess was gross income and wages subject to income tax withholding, FICA, and FUTA. In a related wellness arrangement, flex credits remained excluded unless employees used them to buy taxable benefits through the cafeteria plan.

Ruling snapshot

• Question: Are fixed payments from an employer's self-funded health plan excluded when expected benefits greatly exceed employees' after-tax contributions?
• Outcome: Advice given. The payments are included in income and wages because the plan lacks insurance risk and the excess benefits are employer-funded.
• Key authorities: IRC §§ 61, 104(a)(3), 105, 106, 125, 3121, 3306, 3401; Treas. Reg. §§ 1.104-1, 1.105-1, 31.3401(a)-1; Rev. Rul. 69-154

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201719025
Release Date: 5/12/2017
CC:TEGE:EB
PRESP-104172-17

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

date: April 24, 2017

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

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

subject: Tax Treatment of Benefits Paid by Self-Funded Health Plans

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

ISSUE

Is a benefit paid under an employer-provided self-funded health plan included in income
and wages if the average amounts received by the employees for participating in a
health-related activity predictably exceed the after-tax contributions by the employees?

CONCLUSION

Yes, the amounts are included in income and wages for reasons including, but not
limited to, one or both of the reasons listed below. As a result, the exclusion from gross
income under section 104(a)(3) does not apply to the amounts received by the
employees.

(1) The employer-provided self-funded health plan does not involve insurance risk,
and accordingly, is not insurance (nor does it have the effect of insurance) for
federal income tax purposes (including section 104(a)(3)).

(2) The ratio of the average amounts received by the employees for participating in
health-related activities to the after-tax contributions by the employees

PRESP-104172-17 2

   demonstrates that the amounts received by the employees are attributable to
   contributions by the employer (and not employee after-tax contributions) so that
   the exclusion under section 104(a)(3) does not apply.

FACTS

In General

We understand that promoters (typically product developers or insurance brokers, but
sometimes other persons) are selling self-funded health plans (often referred to by
promoters as fixed indemnity health plans) and wellness plans to employers. The plans
are promoted as a way to provide certain benefits to employees at no or little cost to the
employer and no or little cost to the employees on a net of withholding take-home pay
basis. The promoters claim the benefits do not constitute income or wages and thereby
reduce the employer and employee share of employment taxes with respect to
employee remuneration. Under such plans:

• Employees who voluntarily participate in the plans make pre-tax contributions to
the wellness plans and relatively small after-tax contributions to the self-funded
health plans. A large portion of the pre-tax contributions are returned to the
employees as cash payments from the self-funded health plans or rewards
through the wellness plans that are purportedly not includible in income or
wages.

• The pre-tax contributions to the wellness plans lower the amount of Federal
Insurance Contributions Act (FICA) taxes that are owed by the employees and
the employers under sections 3101 and 3111. The cash payments that are made
to the employees from the plans are treated as not includible in income or wages
with the result that the participating employees’ net take-home pay (on either a
per-pay-period or an annual basis) generally remains unchanged.

• The employer pays a fee to the promoter for administering the plans, the amount
of which is less than (or at most insignificantly more than) the FICA taxes that
would have been paid by the employer had the plans not been adopted. As a
purported result, the employer is able to provide a health plan and a wellness
plan to its employees at “no or little cost” to the employer.

Examples

Situation 1. An employer provides all employees, regardless of enrollment in other
comprehensive health coverage, with the ability to enroll in coverage under a self-
funded health plan. Employees electing to participate in the self-funded health plan pay
a small after-tax employee contribution (the amounts deducted to pay the premium for
the self-funded health plan are included in the gross income of employees and are
subject to FICA, Federal Unemployment Tax Act (FUTA) taxes, and federal income tax
withholding). The self-funded health plan pays employees a fixed cash payment benefit
for participating in certain activities that are related to health (for example, calling a toll-

PRESP-104172-17 3

free telephone number that provides general health-related information, attending a
seminar that provides general health-related information, participating in a biometric
screening, or attending a counseling session). The employees are not charged for
participating in any of the activities. The fixed-dollar amount employees receive under
the self-funded health plan for each covered activity (for example, $1,425 per activity) is
much greater than the amount of the after-tax premium the employees pay to participate
in the self-funded health plan (for example, $60 per month). Each employee may
receive benefits under the self-funded health plan based on participation in no more
than one covered activity each month (a maximum of 12 covered events per year).
Under an actuarial analysis, all employees are expected to receive benefit payments
under the self-funded health plan that markedly exceed their after-tax premium
payments and, in practice, all employees (or nearly all employees) do receive payments
from the self-funded health plan that are in excess of their after-tax contributions.

Situation 2. The facts are the same as Situation 1, except the employer also provides
employees with the ability to enroll in coverage under a wellness plan, which would
independently qualify as an accident and health plan under section 106, together with
the self-funded health plan described in Situation 1. Employees electing to participate in
the wellness plan pay a pre-tax employee contribution (for example, $1,500 per month)
through a section 125 cafeteria plan (and, therefore, the amount of the salary reduction
is not included in compensation income or wages at the time the salary would otherwise
have been paid). These pre-tax contributions for participation in the wellness plan are in
addition to the small after-tax contributions for participation in the employer-provided
self-funded health plan. The wellness plan provides the employees with health-related
wellness activities at no charge to the employees. Typically, if the employee’s net take-
home pay (on either a per-pay-period or an annual basis) after receiving the fixed cash
payment from the self-funded health plan exceeds the amount of the employee’s net
take-home pay (on either a per-pay-period or an annual basis) prior to implementing the
plans, the wellness plan provides that the excess is paid in the form of flex credits that
can be used for benefits under the section 125 cafeteria plan. Consequently, the net
take-home pay (on either a per-pay-period or an annual basis) of each employee who
participates in the plans generally remains unchanged.

The following chart reflects how promoters may present the net benefits provided by
plans described in Situation 2 to employers (assuming a 15 percent income tax rate). In
addition, the promoter’s description of the plans may emphasize that the amount of
FICA taxes paid by the employer and employees is reduced.

Prior to Adopting the Plans Each Employee After Adopting the Plans
$4,000 Monthly Wage $4,000
$0 Wellness Plan Contribution <$1,500>
$4,000 Taxable Income $2,500
<$600> Income Taxes <$375>
$3,400 Post-tax Income $2,125
$0 Self-funded Health Plan <$60>
Contribution

PRESP-104172-17 4

         $0                    Fixed Cash Payment                    $1,425
       $3,400                        Net Pay                         $3,490
         $0                        Flex Credits                      <$90>
       $3,400                  Net Take-home Pay                     $3,400

LAW AND ANALYSIS

Income and Statutory Exclusions from Income

Section 61(a)(1) and § 1.61-21(a) 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, section 106(a) provides that gross income of an employee does not include
employer-provided coverage under an accident or health plan. Under section 105(b), an
employee generally may exclude from income 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.

Section 104(a)(3) provides that gross income does not include amounts received
through accident or health insurance (or through an arrangement having the effect of
accident or health insurance) for personal injuries or sickness. This exclusion does not
apply, however, if the amounts are either (1) attributable to contributions by the
employer that were not includable in the gross income of the employee, or (2) paid by
the employer. Id.

The legislative history to section 104(a)(3) provides that “payments for personal injury or
sickness through an arrangements [sic] having the effect of accident or health insurance
(and that are not merely reimbursement arrangements) are excludable from income. In
order for this exclusion to apply, the arrangement must be insurance (e.g., there must
be adequate risk shifting.)” H.R. Rep. No. 104-736, at 294 (1996) (Conf. Rep.).

Section 1.104-1(d) provides, in relevant part, that if an individual purchases a policy of
accident or health insurance out of the individual’s own funds, amounts received
thereunder for personal injuries or sickness are excludable from gross income under
section 104(a)(3). Section 104(a)(3) also applies to amounts received by an employee
for personal injuries or sickness from a fund which is maintained exclusively by
employee contributions. § 1.104-1(d). However, if an employer is either the sole
contributor to such a fund, or is the sole purchaser of a policy of accident or health
insurance for its employees (on either a group or individual basis), the exclusion
provided under section 104(a)(3) does not apply to any amounts received by the
employees through such fund or insurance. Id.

PRESP-104172-17 5

Rev. Rul. 69-154, 1969-1 C.B. 46, clarifies that excess indemnification received under a
medical insurance policy or plan that is attributable to an employer’s contribution is
includable in the employee’s gross income. Under the ruling, if the employer paid the
entire premium on a policy, section 104(a)(3) does not apply and thus to the extent an
employee received indemnification in excess of the medical expenses incurred by the
employee, the excess is included in the employee’s gross income because the
exclusion under section 105(b) only applies to the reimbursement of the amount of the
medical expense.1

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 section 125.
Under section 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 section 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 section 125, the coverage is excludable from gross income under
section 106 as employer-provided accident or health coverage.

APPLICATION OF EMPLOYMENT TAXES

Sections 3101 and 3111 impose FICA taxes on “wages” as that term is defined in
section 3121(a), with respect to “employment,” as that term is defined in
section 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 sections 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 section 3401(a) for federal income tax withholding purposes as all
remuneration for services performed by an employee for an employer, with certain
specific exceptions.

To the extent amounts are excluded from gross income under sections 105(b) or
106(a), they are also excluded from wages subject to income tax withholding under
section 3401. In addition, amounts paid to reimburse expenses incurred by the

1 Situations 2 and 3 in 2016 IRS CCA Lexis 131 were intended to address situations in which no medical
expenses were incurred or reimbursed, and should not be read to modify the analysis or result in Rev.
Rul. 69-154.

PRESP-104172-17 6

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 sections 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 section 125) if such
payment would not be treated as wages without regard to such plan and it is reasonable
to believe that (if section 125 applied for purposes of section 3121) section 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.

Section 3121(a)(2) provides an exception from FICA wages for:

    the amount of any payment (including any amount paid by an employer for
    insurance or annuities, or into a fund, to provide for any such payment) made to,
    or on behalf of, an employee or any of …[the employee’s] dependents under a
    plan or system established by an employer which makes provision for …[its]
    employees generally (or for …[its] employees generally and their dependents) or
    for a class or classes of …[its] employees (or for a class or classes of …[its]
    employees and their dependents) on account of

    (A)     sickness or accident disability (but, in the case of payments made to an
            employee or any of his dependents, this subparagraph shall exclude from
            the term “wages” only payments which are received under a [workers’]…
            compensation law);

    (B)     medical or hospitalization expenses in connection with sickness or
            accident disability…

Section 32.1 of the Temporary Employment Tax Regulations under the Act of
December 29, 1981 (Pub. L. 97-123)2 provides rules related to the FICA taxation of
payments on account of sickness or accident disability under section 3121(a)(2)(A).
Section 32.1(a) in effect provides that payments to or on behalf of an employee on
account of sickness or accident disability are not excluded from the term wages unless
they are received under a workers’ compensation law or qualify for the exception from
wages provided under section 3121(a)(4), which provides an exception for any payment

2 Although section 7805(e)(2) provides that any temporary regulation shall expire within 3 years after the
date of issuance of such regulation, that paragraph is effective only for temporary regulations issued after
November 20, 1988, and thus does not apply to this temporary regulation issued in 1982. Section 32.1
was amended in 2005 by T.D. 9233, 70 F.R. 74198, 2006-1 C.B. 303, confirming its continuing authority.
The temporary regulations also provide the guidance needed to satisfy the last sentence of
section 3121(a) which references regulations to provide an exception to the treatment of a third party as
the employer with respect to making a payment on account of sickness or accident disability that is
included in FICA wages solely by reason of the parenthetical matter contained in section 3121(a)(2)(A).

PRESP-104172-17 7

on account of sickness or accident disability made after the expiration of 6 calendar
months following the last calendar month in which the employee worked.

Section 32.1(d) provides that for purposes of § 32.1(a), a payment made on account of
sickness or accident disability includes any payment for personal injuries or sickness
includible in gross income under section 105(a) and the regulations thereunder and thus
does not include—

   (1)    any amount which is expended for medical care as described in section
          105(b) and § 1.105-2,

   (2)    any payment which is unrelated to absence from work as described in
          section 105(c) and § 1.105-3, or

   (3)    any payment or portion thereof which is attributable to a contribution by
          the employee as determined in paragraphs (d) and (e) of § 1.105-1.

Section 32.1(d) also provides that a payment made on account of sickness or accident
disability does not include any payment which is excludable from gross income under
section 104(a)(2), (4) or (5).

The last sentence of section 3121(a) and § 32.1(e) generally provide that any third party
which makes a payment included in wages solely by reason of the parenthetical matter
contained in section 3121(a)(2)(A) is treated as the employer with respect to such
payment. The temporary regulations distinguish between employers and agents for
purposes of this provision. If the third party is acting as an agent of the employer, the
employer for whom services are normally rendered is the employer for purposes of the
FICA liability with respect to the payments on account of sickness or accident disability.
If the third party is not an agent of the employer, the third party is responsible for the
payment of FICA taxes although, under certain conditions, it can transfer liability for the
employer share of FICA taxes to the employer for whom services are normally
rendered.

Section 31.3401(a)-1(b)(8)(i)(a) provides that income tax withholding is required on all
payments by an employer of amounts includible in gross income under section 105(a)
and § 1.105-1 to an employee under an accident or health plan for a period of absence
from work on account of personal injuries or sickness. Payments on which withholding
is required are wages under section 3401(a) for purposes of the income tax withholding
requirements.

Payments are considered made by the employer and subject to income tax withholding
under this provision if a third party makes the payment as an agent of the employer. The
determining factor as to whether a third party is an agent of the employer is whether the
third party bears any insurance risk. If the third party bears no insurance risk and is
reimbursed on a cost plus fee basis, the third party is an agent of the employer even if
the third party is responsible for making determinations of the eligibility of individual
employees of the employer for sick pay payments. If the third party is paid an insurance

PRESP-104172-17 8

premium and not reimbursed on a cost plus fee basis, the third party is not an agent of
the employer, but the third party is a payor of third party sick pay for purposes of
voluntary withholding from sick pay under section 3402(o) and the regulations
thereunder. Third party payments of sick pay, as defined in section 3402(o), are not
wages under section 3401 or § 31.3401(a)-1.

Application to Fixed Indemnity Health Plans

A fixed indemnity health plan generally refers to a plan that pays covered individuals a
specified amount of cash for the occurrence of certain health-related events, such as
medical office visits or days in the hospital. Similarly, a critical disease or specific
disease policy pays a specified amount for the diagnosis of a disease. The amount paid
is not related to the amount of any medical expense incurred or coordinated with other
health coverage.

The exclusion from gross income under section 104(a)(3) applies to amounts received
through accident or health insurance, or through an arrangement having the effect of
accident or health insurance, for personal injuries or sickness. 3 Amounts received from
a self-funded fixed indemnity health plan may qualify for this exclusion in certain
circumstances.

As a general rule, employees who elect to participate in a self-funded fixed indemnity
health plan, which constitutes insurance or has the effect of insurance, offered by their
employer and who pay 100 percent of the premiums on an after-tax basis may exclude
from their gross income and wages for income tax withholding purposes reasonable
amounts received through the self-funded fixed indemnity health plan as a result of the
employees experiencing certain health-related events (for example, a medical office
visit or a hospital stay). See sections 104(a)(3), 105(b), and 106(a), and the
accompanying regulations. For the income tax withholding authority, see section
3401(a) and § 31.3401(a)-1(b)(8).

For example, assume a traditional fixed indemnity health plan that pays fixed amounts
on unpredictable health events such as a medical office visit or a hospital stay and
receives premium payments on an after-tax basis, and that, unlike the arrangements
presented in the situations described above, the fixed indemnity health plan provides
insurance or has the effect of insurance. If that plan pays an individual $200 for a
medical 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. The exclusion
under section 104(a)(3), however, does not apply to the extent that amounts paid are
attributable to contributions by the employer which were not includable in the gross
income of the employee, or paid by the employer. Thus, if a fixed indemnity health plan
with premiums paid on a pre-tax basis through a section 125 cafeteria plan paid $200
for a medical office visit and the covered individual’s unreimbursed medical costs as the

3 For analysis of other situations regarding the taxation of payments to employees in relation to employer-
provided health plans, see Revenue Ruling 2002-3, 2002-3 I.R.B. 316; 2016 IRS CCA Lexis 50; and 2016
IRS CCA Lexis 131.

PRESP-104172-17 9

result of the visit were $30, $30 would be excluded from gross income under section
105(b) and the excess amount of $170 would be included in gross income.

DISCUSSION

Situation 1

The exclusion under Section 104(a)(3) applies to amounts received through accident or
health insurance (or through an arrangement having the effect of accident or health
insurance). Neither the Code nor the regulations define the term “insurance.” The
Supreme Court has explained, however, that in order for an arrangement to constitute
insurance for federal income tax purposes both risk shifting and risk distribution must be
involved. Helvering v. Le Gierse, 312 U.S. 531, 61 S. Ct. 646, 85 L. Ed. 996 (1941). The
risk transferred must be the risk of economic loss. Allied Fidelity Corp. v. Commissioner,
572 F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the fortuitous
occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290-
91 (2d Cir. 1950), and must not be merely an investment or business risk. Le Gierse,
312 U.S. at 542; Rev. Rul. 2007-47, 2007-2 C. B. 127.

In Situation 1, the participants receive a payment for engaging in certain activities
related to health, but the arrangement does not involve a risk of economic loss or
fortuitous event. Accordingly, there is no insurance for federal income tax purposes.
Similarly, because there is no insurance risk, there can be no “risk shifting,” which is
required for an arrangement to “have the effect of insurance.” See H.R. Rep. No. 104-
736, at 294 (1996) (Conf. Rep.).

Thus, because the self-funded health plan is neither insurance nor does it “have the
effect of insurance”, amounts received through the plan are not excluded from income
under section 104(a)(3) or from wages under section 3401(a).

Moreover, because the average benefits paid or predicted to be paid through the self-
funded health plan markedly exceed the after-tax contributions paid by a participating
employee (for example, $17,100 ($1,425 x 12) in annual benefit payments versus $720
($60 x 12) in annual premiums), the benefits in excess of the premiums (for example,
$16,380 ($17,100 - $720)) are either (1) attributable to contributions by the employer
that were not includable in the gross income of the employee, or (2) paid by the
employer. As a result, the exclusion under section 104(a)(3) would not apply to such
excess and the excess ($16,380) would be includible in the gross income of the
participating employee. In addition, the excess would be included as wages of the
participating employee under section 3401(a). Because the plan is not insurance, a third
party making the payments of benefits under the plan would have no insurance risk and
would be treated as an agent of the employer under the income tax withholding
regulations relating to payments on account of sickness or accident disability. Thus, the
excess payments would be subject to income tax withholding on the same basis as if
the employer were making the payments. § 31.3401(a)-1(b)(8)(i)(a). The excess would
also be subject to FICA and FUTA taxes because no exception from wages applies to
the excess, the excess payments are not made on account of sickness or accident

PRESP-104172-17 10

disability, and are not paid for medical or hospitalization expenses in connection with
sickness or accident disability. Even if the excess payments could be considered to be
paid on account of sickness or accident disability, section 3121(a)(2)(A) and § 32.1
would in effect provide that such excess payments would be subject to FICA and FUTA
taxation.

Situation 2

The outcome regarding benefits received under the self-funded health plan would be
the same in Situation 2 as it is in Situation 1. However, the flex credits awarded under
the wellness plan would be excluded from the income and wages of a participating
employee unless the flex credits were used to purchase taxable benefits under the
section 125 cafeteria plan, such as whole life insurance coverage (in contrast to group
term life insurance) or a gym membership. In that instance, the flex credits used to
purchase the taxable benefits under the section 125 cafeteria plan would be included in
the gross income and wages of the participating employee.

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