DOL Issues Fixed Indemnity Taxation Memorandum
According to this guidance, if an employee is not taxed on the premiums for fixed indemnity health coverage (the premiums are paid by the employer or by employees on a pre-tax basis through a cafeteria plan), any payments from the coverage must be included in the employee’s gross income and wages. These same rules also apply to wellness programs that provide fixed indemnity benefits for engaging in wellness activities.
The IRS’ memorandum does not address how employers should administer fixed indemnity payments that are taxable to employees. When employees are not taxed on the premiums for fixed indemnity coverage, employers should work with their carriers to implement a process for tax withholding and reporting.
To avoid these tax issues, employers should consider requiring that employees pay for their fixed indemnity coverage on an after-tax basis outside of their cafeteria plans.
Fixed Indemnity Health Coverage
Fixed indemnity health coverage pays a fixed dollar amount for certain health-related events (for example, $100 for each medical office visit and $200 for each day in the hospital), policies pay regardless of the amount of medical expenses that the individual actually incurs. Employers sometimes offer fixed indemnity health coverage to their employees in addition to their group medical plan.
Section 105(b) of the Internal Revenue Code (Code) states that the amounts that an employee receives through employer-provided accident or health insurance are not taxable if the amounts are paid to reimburse medical care expenses that were actually incurred. Because benefits under a fixed indemnity plan are not related to medical expenses that were actually incurred, there has been some confusion regarding the tax treatment of these payments.
According to the IRS’ memorandum, the tax status of the payments under fixed indemnity health coverage depends on how the premiums are paid.
- The payments are not taxable if the coverage is paid by employees on an after-tax basis. For example, if a 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 for the visit were $30, the $200 would be excluded from income.
- However, if the coverage is paid by the employer tax-free or if employees pay for the coverage on a pre-tax basis through a cafeteria plan, any payments from the plan are taxable and must be included in employees’ gross income and wages (regardless of the amount of medical expenses actually incurred).
|Employee paid, after tax (or employer paid and imputed as taxable income to employees)
|Employee paid, pre-tax (through a Section 125 plan)
|Employer paid (without imputing payment as taxable income to employees)
When payments from fixed indemnity health coverage are taxable, they are subject to income tax and employment tax withholding. This may raise administrative issues for employers because the payments under fixed indemnity coverage are usually controlled by the insurance carrier, not the employer.
Thus, when fixed indemnity payments are taxable, employers may need to work with the carriers to determine a process for tax withholding.
The IRS’ memorandum also addresses wellness programs where employees pay a pre-tax premium to participate. Because this type of wellness program design is uncommon, the IRS’ guidance appears to be targeted at fixed indemnity plans that label themselves as wellness programs. These wellness programs pay fixed indemnity benefits for participating in the program (for example, $100 for completing a health risk assessment), without regard to the amount of medical expenses incurred by the employee. The IRS concluded that these fixed indemnity benefits are taxable and should be included in employees’ gross income and wages.
Guidance: Five Scenarios
To provide guidance on this issue, the Office of Chief Counsel (OCC) considered five different scenarios in which an employee receives cash payout benefits from a fixed-indemnity plan. The Memorandum makes clear that its conclusion in each of the five scenarios derives from the fact that a fixed-indemnity plan, unlike traditional insurance, pays a benefit that bears no relationship to the amount of health care expenditures incurred by the employee. Whether the benefits are taxable ultimately depends on whether or not the premiums were paid from an amount included in the employee’s compensation. If not, then the benefits are taxable.
Scenario One – 1
Under the first scenario proposed by the OCC, an employer gives all employees the opportunity to participate in a fixed-indemnity plan. Employees pay premiums for the plan with after-tax dollars: the employer withholds the premiums from the employee’s salary, but the amount of the premiums are included in the employee’s compensation. The plan pays employees $100 per medical office visit and $200 for each day in the hospital. The OCC concludes that these payments from the plan are excludible from income because the premiums had been included in the employee’s compensation.
Scenario Two – 2
Scenario two is the same as scenario one, except that the employee’s premiums are paid by the employer at no cost to the employee. This factor changes the analysis. Under this scenario, the OCC concludes that any payments from the plan are included in the employee’s gross income.
Scenario Three – 3
Scenario three is also identical to scenario one, except that the premiums are paid through a salary reduction arrangement under a section 125 cafeteria plan (and, as a result, the premiums are excludible from the employee’s income). The OCC concludes that, as is the case with scenario two, any payments from the plan are includible in the employee’s income.
Scenarios Four and Five
Scenarios four and five address employee wellness plans. In both scenarios, as is the case with scenario three, employees who elect to participate in the plans do so by paying premiums through a salary reduction arrangement under a section 125 cafeteria plan. Under scenario four, the employee receives a cash payment of $100 for completing a health risk assessment; $100 for participating in prescribed health screenings; and $100 for participating in prescribed preventative activities. Under scenario five, the employee simply receives a cash payment each pay period for participating in the wellness plan. In both scenarios, the OCC concludes that the payment from the plans is taxable income.
The Memorandum also addresses the treatment of the payments from the indemnity plans for purposes of employment taxes: Social Security (FICA), unemployment and withholding taxes. The IRS concludes that, in scenarios two, three, four, and five, the benefits paid are subject to FICA and unemployment taxes, and are also subject to withholding.
While this guidance coheres with previous analysis on the status of fixed-benefit health plans and does not disturb the larger question of the exclusions from income under sections 104, 105 and 106 of the Internal Revenue Code regarding employer contributions, it is notable because for the first time, the IRS has addressed the tax treatment of payments under an indemnity plan. Employers should review the Memorandum closely as they design their benefit plans for 2018.
Information contained in this Important Updates—Health-Benefits – Fixed Indemnity Benefits is not intended to render tax or legal advice. Employers should consult with qualified legal and/or tax counsel for guidance with respect to matters of law, tax and related regulations. Creative Benefits & Insurance Solutions provides comprehensive benefits advice and administrative services with respect to all forms of employee benefits, risk management, property & casualty, workers’ compensation, staffing insurance and human resources services. For additional information about our services, please contact us at (586) 992-0404 or email us at firstname.lastname@example.org.