Yet, the drive for tax savings and competitive compensation packages tempts many employers to go further than these conventional arrangements. For decades, benefit designers have responded by crafting innovative payment arrangements aimed at boosting take-home pay while reducing employment taxes. Many of these arrangements enjoy fleeting popularity until the IRS cracks down.
Perhaps the most enduring—and scrutinized—are variants of “double dip” health plans, particularly fixed indemnity plans. The double dip refers to a plan in which both premiums and benefit payments are purportedly exempt from taxation. Such a proposition is naturally enticing to employers and employees. Unfortunately, the line between legal tax minimization and illegitimate schemes is not always clear, leaving some businesses at risk for significant civil and, in some cases, criminal penalties. Employers considering double dip fixed indemnity plans should therefore consult with tax professionals and legal counsel to carefully consider the potential compliance risks.
Traditional Fixed-Indemnity Plans
Unlike comprehensive insurance, fixed indemnity plans are not meant to cover medical expenses directly. Their main purpose, at least traditionally, is to provide replacement income for a worker dealing with illness or injury. Subscribers pay a premium and, in the case of a qualifying health-related event, receive a fixed payment that does not depend upon actual medical costs. For example, a typical benefit might include a $100 payment for each day spent in the hospital, with a cap on the total amount. This benefit payment can be used at the subscriber’s (i.e., worker’s) discretion. As supplemental coverage, fixed indemnity plans are classified as “excepted benefits,” exempting them from numerous federal regulations governing comprehensive insurance [see 45 CFR section 148.220(b)(4)].
Tax-Minimization Fixed Indemnity Plans
Double dip fixed indemnity plans employ the same basic structure, but are designed to reduce employment taxes. Certain benefit providers have devised arrangements with plans that purportedly provide tax-free income to employees while reducing employers’ tax burdens. This is achieved by paying for the program with tax-free salary reductions pursuant to a cafeteria plan, before extending reimbursements to employees for completing simple health or wellness activities.
Imagine a hypothetical “Plan.” An employee takes an $800 pretax salary reduction under an IRC section 125 cafeteria plan. The Plan then reimburses $720 if the employee completes a simple health-related activity, like a medical survey. This $720, now considered a nontaxable reimbursed medical expense, is added back to the paycheck. At the end of the transaction, employees are left with more in their paycheck, while employers benefit from reduced tax obligations, making it seem as though one dollar invested in the Plan returns more than its initial value. A brief survey of the statutory framework governing health insurance benefits sheds light on possible IRS challenges to the Plan.
The Statutory Framework
Health and accident plans.
The treatment of health insurance plans is addressed in IRC sections 104 through 106. Section 106(a) states that the “gross income of an employee does not include employer-provided coverage under an accident or health plan.” However, this addresses the plan itself (i.e., the premium). The treatment of benefits received from a plan is detailed in sections 104 and 105.
Section 104(a)(3) excludes certain amounts received through health insurance for personal injury or sickness, but does not apply to amounts received from plans funded by employer contributions. Accordingly, arrangements whose premiums are paid with pretax salary reductions are not excluded under Section104(a)(3). [See Rev. Rul. 2002-3 (premiums funded with salary reductions through a cafeteria plan are employer contributions); Tuka v. Comm’r, 120 T.C. 1, 5 (2003), aff’d, 85 Fed. Appx. 875 (3d Cir. 2003); (Section 104(a)(3)’s exemption “depends on whether contributions [to the plan] involve after-tax dollars.”).]
Thus, any relief for amounts received from plans funded with pretax dollars must come from Section 105, which excludes amounts received under an employer-provided health plan “for personal injury or sickness” [IRC section 105(a)], if such amounts are paid to “reimburse the taxpayer for expenses incurred … [for] medical care” [IRC section 105(b)]. Among other things, medical care consists of amounts paid for the “diagnosis, cure, mitigation, treatment, or prevention of disease” [IRC section 213(d)].
Under Treasury Regulations section 1.105-2, IRC section 105(b)’s exclusion applies only to amounts that are paid specifically to reimburse “expenses incurred by [the employee] for the prescribed medical care.” Given that fixed indemnity plans pay without regard to medical expenses, attempts to exempt indemnity benefits under Section 105(b) have proven controversial.
Cafeteria plans, FICA, and FUTA.
Amounts excluded under IRC sections 105(b) or 106(a) are also excluded from wages subject to withholding under section 3401. Additionally, amounts paid to reimburse employee expenses for medical expenses for personal injury are not considered wages for FICA or Federal Unemployment Tax Act (FUTA) tax purposes [see IRC sections 3121(a)(2), 3306(b)(2)]. Finally, section 125 allows employers to establish a cafeteria plan funded with pretax salary reductions, from which employees may choose between two or more qualified benefits [IRC section 125(d)(1)]. Employer-sponsored health plans are among a cafeteria plan’s qualified benefits [IRC section 125(f)(1); see also IRC sections 3121 (a)(5)(G), 3306(b) (5)(G) (treatment of cafeteria plan payments for FICA and FUTA purposes, respectively.)]. The value received from such benefits is generally excludable from income [IRC section 125(a)(1)].
IRS Efforts to Curb Double Dip Arrangements
Over the past two decades, the IRS has repeatedly issued revenue rulings, legal memoranda, and other guidance aimed at curbing double dip health arrangements, including fixed indemnity plans. A 2002 ruling addressed a double dip variant whereby employers reimbursed employee salary reductions that funded an insurance plan, avoiding FICA and FUTA taxes [Rev. Rul. 2002-3]. The IRS ruled that sections 105 and 106 did not exclude the reimbursements, which were therefore subject to employment taxes.
After a period of relative quiet, double dip arrangements reemerged once again following passage of the Affordable Care Act. The IRS responded with several legal memoranda in 2016 and 2017 that targeted wellness and fixed indemnity–based plans that functioned as double dip arrangements (see CCA 201622031, CCA 201703013, CCA 201719025). Notably, a 2017 memorandum declared that payments from pretax-funded plans can only be excluded up to the amount of the employee’s unreimbursed medical expenses [IRS CCA 201719025, pp. 8-9].
Despite these efforts, double dip arrangements continued, prompting the IRS to continue its efforts in 2023. There was another memorandum declaring that benefits from plans funded with pretax contributions are fully taxable if employees receive a refund for performing easily completed health or wellness activities. In the IRS’s view, section 105(b) does not apply because the employee has no out-of-pocket costs, meaning there are no unreimbursed medical expenses (CCA 202323006, p. 11). Failing section 105(b), FICA and FUTA tax were imposed on the benefit payments.
The Proposed Rule, and its Subsequent Demise
A few months after issuing the 2023 memorandum, the Treasury Department announced plans to amend regulations to “clarify” the treatment of fixed-indemnity plans (IRB 2022-33). After a preamble decrying “certain arrangements that purport to avoid income and employment taxes” by recharacterizing income as medical care reimbursements, the proposed regulations provided that indemnity plan benefits are taxable if 1) the plan is funded with pretax contributions, or 2) benefits are paid without regard to the actual amount charged for medical care [Proposed Regulations 120730-21, 88 F.R. 44596-44658 (April 3, 2024)].
If recent history is any guide, the withdrawal of the proposed regulations will likely embolden promoters of fixed indemnity double dip plans.
In response to the proposed regulations, the Treasury Department received numerous comments arguing that only amounts exceeding the cost of medical expenses associated with a health-related event should be included in income. In April 2024, it withdrew the proposal, indicating a need to further develop guidance concerning the treatment of amounts not excluded from income [89 FR 23338, 23345-46 (June 17, 2024)].
The Current Landscape
If recent history is any guide, the withdrawal of the proposed regulations will likely embolden promoters of fixed indemnity double dip plans. Although the proposed regulations have been withdrawn, the IRS’s posture toward such plans likely remains unchanged. Indeed, at the same time it withdrew the proposed regulations, the Treasury Department declared that its concerns over double dip indemnity plans “have recently escalated” and pledged that “IRS compliance efforts regarding exclusions from gross income under section 105(b) … will continue” (89 FR 23338, 23345-46). Accordingly, companies considering such plans are wise to tread cautiously, and seek expert legal advice to navigate potential pitfalls. Legal counsel can also help businesses already facing IRS scrutiny mitigate the consequences of an examination.
