If you currently allow employees to pay pre-tax for supplemental insurance benefits (often called “voluntary benefits”) such as fixed-indemnity health or hospitalization insurance, you might want to consider only allowing employees to pay post-tax, or confirm with the insurer that it will take certain steps to ensure that either you or they withhold any federal taxes due on the benefits paid under these policies.
The reason: Recent IRS guidance reiterates that such payments should be included as “wages” and that an employer who is obligated to withhold taxes and fails to do so may be liable for the taxes that should have been withheld. (Code § 3403)
IRS Chief Counsel Memorandum 201703013 (https://www.irs.gov/pub/irs-wd/201703013.pdf ) describes five different fact situations and explains when such benefits will be taxable. These are summarized below. If your benefit offerings meet any of these fact situations, you might want to read the Tax Memo.
In addition to three situations involving voluntary fixed-indemnity policies, the other two describe wellness programs that require employees to pay pre-tax in order to obtain payments for participating in or completing specified wellness activities. These are different from “traditional” wellness programs, which are much more prevalent and do not require employee pre-tax payments, and so are not affected by this Tax Memorandum. The Memorandum addresses fixed-indemnity insurance and hospital benefits and wellness programs that qualify as accident and health plans under Tax Code § 106 and for which employees pay on a pre-tax basis.
The Bottom Line
The bottom line under Tax Memo 201703013 is that:
- If the employer pays, or employees pay by salary reduction through a Code § 125 cafeteria plan, the premiums for a fixed-indemnity health insurance policy or a “wellness program” that pays a fixed-indemnity cash payment benefit (such as $100 for completing a health risk assessment or participating in certain health screenings),
- Then any benefits paid under such policy or wellness program must be included in the employee’s gross income.
- Also, employers are obligated to withhold federal income and employment taxes on amounts that should be included in employees’ gross incomes; and employers who fail to do so may be liable for the taxes they should have withheld. (Code § 3402 and § 3403)
Two exceptions or differences not noted in the Tax Memo:
- In the application of these Code sections, benefits paid under pre-tax insurance have only been taxable to the extent the benefits exceed the amount of unreimbursed medical expenses.
- Wellness payments would not be taxable if they are only paid as contributions to the employees’ H.S.A. accounts.
How Would the IRS Determine Taxable Amounts?
Several people have asked how the IRS would know that an employee received benefits under one of the pre-tax arrangements described above. The primary way the IRS would become aware of such pre-tax arrangement is by asking on audit if the employer offers voluntary benefits and allows employees to pay pre-tax. In order to determine if taxes were due, the IRS also would have to know which employees received benefit payments, the amount of those payments, and the amount of unreimbursed medical expenses each employee had.
While all this might be unlikely, if the IRS determines on audit that an employer offered pre-tax voluntary benefits and these benefits were not included in taxable income, the employer could be liable for unpaid income and employment taxes on those benefits amounts. The Tax Memo explains why these benefits amounts are included in taxable wages.
The fact that the IRS has issued this Tax Memo (as well as 201622031, see earlier article on this site) MIGHT be an indication that in future audits the IRS will ask if an employer offers voluntary benefits and (if so) how the premiums are paid. Or it might just be the IRS is putting employers on notice that they have this obligation, in the hopes this will increase compliance.
Example of a Fixed-Indemnity Health Insurance Plan
Situations 1, 2 & 3 in Tax Memo 20170313: A fixed indemnity health plan that pays employees $100 for each medical office visit, and $200 for each day in the hospital, without regard to the amount of medical expenses actually incurred by the employee or the amount that is paid or reimbursed by other insurance.
Examples of a Wellness Program that Pays a Fixed Indemnity Cash Payment
Situation 4 in Tax Memo 20170313: A 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 in Tax Memo 20170313: 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) for participating in the wellness plan, without regard to the amount of medical expenses otherwise incurred.”
Employer Obligation to Withhold Taxes & Consequences of Noncompliance
An employer who is obligated to withhold taxes and fails to do so will be liable for the taxes that should have been withheld. This is why employers who offer the types of plans described above and allow employees to pay pre-tax for them should reconsider this or confirm with the insurer or wellness provider that any taxes due on benefits will be paid. Specifically:
Code § 3402(a) provides that every employer making a payment of wages is required 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. Some of those exceptions are that amounts excluded from gross income under §§ 105(b) or 106(a) are also excluded from wages subject to income tax withholding under § 3401.
Employers are also required to deduct and withhold FICA taxes (Sections 3101 and 3111) and FUTA taxes (Section 3301) from wages they pay to employees.
Code § 3403 provides that every employer who is required to deduct and withhold the tax under section 3402 is liable for the payment of such tax whether or not it is collected from the employee. The regulations (§ 31.3403-1) specifically provide: “If, for example, the employer deducts less than the correct amount of tax, or if he fails to deduct any part of the tax, he is nevertheless liable for the correct amount of the tax.” There is an exception, however: the employer will not be liable if the employer can show (the IRS) that the tax has been paid (presumably by the employee or another entity). (Regulations §31.3402(d)-1.) (Tax Memo 20170313 does not discuss Code § 3403 and employer liability; it only notes §§ 3402, 3101, 3301 and 3111.)
The Tax Code Reasons these Benefits are Taxable
The general rule (Code § 61) is that an employee’s gross income includes all compensation received for services provided, including wages, fees, commissions and fringe benefits. Other sections of the Code provide specific exceptions, however, so certain amounts are not included in gross income. Relevant Code sections and excluded amounts are:
- § 106(a): If the employer pays the premiums or cost for coverage under an employer-provided accident or health plan, these amounts are not included in gross income.
- § 105(b): Amounts received through employer-provided accident or health insurance are not included in gross income if those amounts are paid to reimburse expenses incurred by the employee for medical care (of the employee, spouse, dependents, or children under age 27 who are not tax dependents). However, if an accident or health plan pays amounts without regard to the amount of expenses the employee incurred for medical care, these amounts are not excluded from gross income.
- § 104(a)(3): Amounts received through accident or health insurance for personal injuries or sickness generally are not included in gross income. However, this exception does not apply (and these amounts are included in gross income) if the amounts are either: 1) attributable to contributions by the employer that were not included in gross income of the employee, or 2) paid by the employer. For this purpose, employee salary reduction amounts under a § 125 cafeteria plan are treated as employer contributions, not employee contributions.
How these Tax Rules Apply to the Situations in Tax Memo 20170313
Employers should review the fact situations below and ensure that applicable taxes (if any) are being withheld and paid to the IRS.
Situations 1, 2 and 3: A fixed-indemnity health plan that pays employees $100 for each medical office visit, and $200 for each day in the hospital, without regard to the amount of medical expenses actually incurred by the employee or the amount that is paid or reimbursed by other insurance.
- If an employee pays on an after-tax basis for premiums for this coverage, amounts paid by the plan are excluded from gross income under §104(a)(3).
- If the employer pays the premiums for this coverage, or the employee pays on a pre-tax basis through a §125 cafeteria plan, any amount paid by the plan is included in the employee’s gross income, regardless of the amount of medical expenses incurred by the employee. The exclusions noted above under §105(b) and §104(a)(3) do not apply.
Situations 4 and 5: Employer wellness program that pays employees a fixed indemnity cash payment for participating in the wellness program or for completing specific wellness activities. The amount paid may be a specific dollar mount or a percentage of compensation, but the fixed amount is paid without regard to the amount of medical expenses incurred by the employee.
- If the employee pays for this coverage on a pre-tax basis through a §125 cafeteria plan, any amount paid by the plan is included in the employee’s gross income, regardless of the amount of medical expenses incurred by the employee. The exclusions noted above under §105(b) and §104(a)(3) do not apply.