The Internal Revenue Service (IRS) Office of Chief Counsel (OCC) recently released Memorandum 201719025 which provides guidance concerning the tax treatment of certain “wellness” or other programs that certain marketers offer to employers with an assurance that the arrangements could provide positive tax effects for both employees and employers. This guidance reiterates the IRS’s position that such arrangements cannot provide the alleged tax advantages and could actually subject employers who implement them to hefty fines.

Background

For several years various promoters have enticed employers with benefit program designs that purportedly give employees additional health and welfare benefits with no change to their net paychecks. These programs have been called by many different names, such as wellness plans, defined contribution health plans, Section 105 plans, and limited medical benefit plans. All of these types of programs share a common claim that employees can make pre-tax salary reduction elections to reduce their taxable income and save the employer thousands of dollars in employment taxes. These programs also claim that an employer can return salary reduction contributions to employees (minus a fee to the plan promoter) through a wellness plan or benefit bank from which employees can buy various supplemental health insurance benefits.

The marketing materials explaining the financial benefit of these programs often contain assurances regarding compliance – some even accompanied by a letter from legal counsel explaining how such plans comply with applicable laws and regulations. But, the IRS has repeatedly explained that these designs cannot work as advertised because the return of funds to an employee’s wellness plan account or benefits bank must be taxable to the employee. This is because the Internal Revenue Code (IRC) does not provide a specific exclusion for these types of payments.

The IRS first denounced these types of programs in 2002 in Revenue Ruling 2002-3. In this ruling, the IRS stated that when an employer pays for employee health coverage through a group health insurance policy and then reimburses employee salary reduction payments, it actually results in taxable income to the employees.

Last year, the OCC published Memorandum 201622031, which concludes that an employer may not exclude from an employee’s gross income payments of cash rewards for participating in a wellness program or reimbursements of premiums for participating in a wellness program even if the premiums were originally made by salary reduction through a cafeteria plan.

In its memorandum, the OCC reviewed a wellness program that provided health screening and other health benefits that allowed employees to earn cash rewards or benefits that are not qualified medical expenses, such as gym membership fees. The OCC considered an arrangement with no required employee contributions as well as with required employee salary reduction contributions through a cafeteria plan. It also considered a design whereby an employer reimbursed required salary reduction contributions to employees.

The OCC reasoned that the income exclusion under Code section 105(b) does not apply to amounts which an employee would be entitled to receive that are neither medical care nor a de minimis fringe benefit. Thus, cash rewards such as gym membership fees received from a wellness program are not excludible from an employee’s income. The IRS further cited Revenue Ruling 2002-3 to conclude that an employer must include the wellness plan “premium” reimbursements in employees’ gross income.

The OCC again last year considered a unique wellness program design and concluded that it could not deliver on its beneficial tax promises. In the newest case, an employer offered a wellness program with salary reductions through a cafeteria plan. The wellness plan paid employees $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 the employee incurred. Alternatively, the wellness plan paid a fixed amount each pay period for participating in the wellness plan, without regard to actual incurred medical expenses. The IRS used the same analysis from its prior guidance to conclude that no income exclusion in the Code could apply to the payments made under this design.

Latest guidance from IRS

Finally, the OCC last month issued Memorandum 201719025 in which it acknowledged that certain promoters continue to market self-funded health plans (aka fixed indemnity health plans) and wellness plans to employers as a way to provide certain employee benefits at little or no cost to the employer and little or no impact on the employees’ take-home pay. The promoters claim the benefits do not constitute income or wages and thereby reduce the employer and employee share of employment taxes.

The OCC reviewed designs under which employees make voluntary pre-tax contributions to a wellness plan and a relatively small after-tax contribution to a self-funded health plan, and later receive a reimbursement of a large portion of the pre-tax contribution as cash payments from the self-funded health plan or a reward through the wellness plan. The OCC noted specific marketing materials that demonstrate how pre-tax contributions to the wellness plans lower the amount of taxes owed by employees and the employers, as well as how cash payments to employees from the plans are not includible in income -- resulting in employees’ net take-home pay remaining unchanged. This example shows that the fees an employer pays to the plan marketer balance out the pledged tax savings and allow employers to provide significant benefits at little or no cost to them. The OCC specifically examined two situations and reached the same conclusion.

Situation One

In Situation One, an employer provides all employees coverage under a self-funded health plan for which they pay a small after-tax contribution. The self-funded health plan then pays employees a fixed cash payment benefit for participating in certain activities that are related to health (e.g., calling a toll-free 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, and the amounts the employees receive under the self-funded health plan for each covered activity is much greater than the amount of the after-tax premium the employees pay to participate in the self-funded health plan.

Situation Two

In Situation Two, the employer also offers employees coverage under a wellness plan with the self-funded health plan described in Situation One. Employees electing to participate in the wellness plan pay a pre-tax employee contribution through a cafeteria plan in addition to the small after-tax contribution for the self-funded health plan. The wellness plan provides health-related wellness activities at no charge to the employees. Typically, if an employee’s net take-home pay after receiving the fixed cash payment from the self-funded health plan exceeds the amount of the employee’s net take-home pay prior to implementing the plans, the wellness plan pays the excess as flex credits that an employee may use for benefits under the cafeteria plan. Therefore, promoters say that the net take-home pay of each employee who participates in the plans generally remains unchanged.

The OCC found that the plan in Situation One does not meet the definition of insurance for federal income tax purposes, and involves no risk shifting to give the arrangement the effect of insurance. Thus, any amounts received through the plan are not excludible from income or from wages. Moreover, the OCC stated that because the average benefits paid or predicted to be paid through the self-funded health plan exceeded an employee’s after-tax contributions for the plan, the benefits in excess of premiums are either attributable to contributions by the employer that were not includable in the gross income of the employee, or paid by the employer. Consequently, the excess must be included in a participating employee’s gross income as regular wages.

The only exception to the OCC’s most recent conclusions is that in Situation Two, the flex credits awarded under the wellness plan would be excluded from the income and wages of a participating employee unless he used them to purchase taxable benefits under the cafeteria plan, such as whole life insurance coverage or a gym membership.

Key takeaways

There are plenty of viable wellness plan designs available, but employers should be wary of any marketing efforts that claim that cash payments, gym membership fees or salary reduction reimbursements can be tax-free to employees. Employers also should be skeptical of materials that show an example of an employee’s take home pay being identical despite having made payroll deductions for wellness or other benefits that an employer reimburses.

Employers that operate plans that run afoul of relevant IRS guidance can be liable for the tax withholding amounts not properly withheld, a potential 100% fine for willful disregard of payroll tax obligations, late payment fees of up to 25% of any amounts not properly withheld and paid, understatement penalties of up to 20% of the amount not properly withheld and interest on these amounts. The facts and circumstances surrounding each incident will determine an employer’s liability, if any.

If you have any questions regarding questionable benefit plan designs you might encounter, please reach out to your EPIC account team to help you analyze marketing information and provide you with viable compliant alternatives.

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For further information on this or any other topics, please contact your EPIC benefits consulting team.

EPIC offers this material for general information only. EPIC does not intend this material to be, nor may any person receiving this information construe or rely on this material as, tax or legal advice. The matters addressed in this document and any related discussions or correspondence should be reviewed and discussed with legal counsel prior to acting or relying on these materials.