By David Slaughter, JD, Senior Legal Editor

Payments that an employer makes to an employee under a fixed indemnity health plan must be included in the employee’s taxable income, the Internal Revenue Service (IRS) recently indicated, if the plan premiums were paid by the employer or by salary reduction under a cafeteria plan.

“An employer may not exclude from an employee’s gross income payments under an employer-provided fixed indemnity health plan if the value of the coverage was excluded from the employee’s gross income and wages,” according to the memorandum released January 20 by the IRS Office of Chief Counsel (No. 201703013). The same applies “if the premiums for the fixed indemnity health plan were originally made by salary reduction through a §125 cafeteria plan.”

In explaining this conclusion, the IRS first noted that Section 106(a) of the Internal Revenue Code allows employees to exclude from income “accident or health insurance” premiums paid by the employer, and Section 105(b) makes excludable any payouts by such insurance to reimburse “medical care.”

However, if these insurance payments are not directly related to the employee’s medical expenses, “the amounts are not excluded from gross income because the amounts are not paid to reimburse expenses incurred by the employee for personal injuries and sickness,” the IRS determined.

Fixed indemnity coverage typically pays out a set dollar amount per day of hospitalization, for example, rather than reimbursing actual medical costs that the individual incurs. Some fixed indemnity insurance is an “excepted benefit” exempt from many Affordable Care Act requirements, although the precise scope of that exemption has been hotly contested.

Payouts by these policies are generally excluded from the employee’s gross income under Code Section 104(a)(3), but not if they are attributable to contributions made by the employer or excluded from gross income—such as through a cafeteria plan.

Example 1. An employer offers a fixed indemnity health plan to all employees, whether or not they have other health coverage. Employees pay the premiums with salary deductions, and these amounts are included in their taxable income.

Amounts paid out by this plan would be excluded from gross income and wages, the IRS stated. This would not be the case, however, if the employer provided the coverage at no cost to the employee, or the salary deductions were part of a cafeteria plan—and therefore not included in compensation at the time the salary would have been paid.

Wellness Programs

The IRS also discussed a related issue regarding fixed indemnity benefits and wellness programs.

Example 2. An employer gives all employees the chance to enroll in a “wellness plan” by salary deduction under a cafeteria plan. The wellness plan pays employees a fixed cash benefit, unrelated to any medical expenses, of $100 for completing a health risk assessment, $100 for undergoing health screenings, and $100 for participating in other prescribed preventive care activities.

Because the wellness plan’s premiums were paid from funds not included in the employee’s income, the exclusions in sections 104(a)(3) and 105(b) do not apply to the fixed indemnity payments, so the payments are included in gross income and wages, according to the IRS. The same would be true if the wellness plan simply paid out a fixed cash benefit every pay period.

In a previous memorandum, the IRS cautioned that if employees paid a wellness program “premium” by salary reduction under a cafeteria plan, the program could not then pay cash and other nonmedical wellness “rewards” on a tax-free basis.

Employer Takeaway

This latest IRS memorandum does not really break new ground, according to Rich Glass, a benefits attorney with Mercer LLC. It does clarify the general IRS position that if these types of programs are paid for on a pretax or nontaxable basis, then the benefit payouts must be taxable, said Glass, contributing editor to BLR’s Flex Plan Handbook.