Conversion of Taxable Income to Non-taxable “Wellness Benefits” – IRS says – “No, that won’t work.”
July 3, 2023Jay Kirschbaum
A recent Memorandum published by the IRS Office of the Chief Counsel has reiterated that employers cannot adopt “plans” that reduce taxable compensation and return it to employees as non-taxable compensation. The promoters of these plans claim that employees can reduce taxable compensation and use those funds to buy into a “wellness” plan that reimburses the employees for wellness activities on a non-taxable basis. Similar plans have been promoted over the years, but none have ever been approved by the IRS.
We hear of plans that seek to utilize some aspect of the Internal Revenue Code to avoid paying income and employment taxes. A recent favorite is the so-called “classic 105 plan,” which purports to take advantage of the tax benefits for employer-provided medical plans. This situation is different, but it still tries to convert taxable income into non-taxable income.
Medical Plans And Benefits Are Generally Not Taxable Under The IRC
The type of plan in this instance is tied to Sections 104, 105 & 106 of the Internal Revenue Code (IRC), which are the general exclusions for employer-provided accident and health coverage. In addition, it layers in Section 125, the cafeteria plan exclusion. All of these provisions work to provide tax benefits under their terms, and they can be tied to reductions of income by the employees. That results in tax benefits to the employees and employers who save their portions of the FICA and FUTA taxes on the reduced salaries.
The IRC states that under Section 106, the premiums for employer-provided medical plans are excludable from the employees’ taxable income. Section 105 provides that any benefits paid under an employer plan are not taxable to the employees. Section 104 provides for an exclusion for amounts received on account of personal injury or sickness. These types of plans are “fixed indemnity” plans. For example, if an individual with such a plan is injured, the plan will pay a fixed amount based on the injury, irrespective of the actual cost of treating the injury. The plan might pay a fixed amount for a visit to an emergency room, again, irrespective of the actual cost of the emergency room treatment. Finally, Section 125 permits employees to reduce their taxable income to purchase non-taxable benefits. Each of these plans works individually and can often be joined together to offer multiple benefits. However, the design of this plan does not comply with the IRS rules for tax exclusions. The IRS went into detail regarding the employment tax issues and noted that the payments were all considered wages for FICA and FUTA.
IRS – This Plan Has No Substance
In this case, the employer has a major medical plan, and the employees are covered under that plan. Presumably, there is no tax or compliance issue with that plan. However, the employer now wants those employees to reduce their incomes by $1200 per month to participate in a wellness plan. That participation will permit them to earn up to $1000 per month for doing certain wellness activities, such as getting vaccinations. It also provides additional health benefits, such as nutritional counseling, wellness counseling, and some telehealth. The plan pays the amounts to employees irrespective of whether the employee had any unreimbursed medical expenses. The IRS notes that for the exclusions to be applicable, there must be unreimbursed medical expenses being reimbursed or due to the employee incurring a personal injury or sickness. None of that is occurring with this program. The promoters seem to be trying to buttress their argument because the payments are also tied to the completion of wellness activities. However, payments for participating in wellness activities are not excludable from taxable income. So, taken together, these programs are outside the tax benefits the employer is hoping for.
Employers should be wary of plans that purport to reduce their employment taxes (and the corresponding employee employment and income taxes) in a way that may seem too good to be true. They need to seek the insight of their tax and legal advisors before adopting these “novel” plans.