Employer Beware: Promoted Wellness Benefit Programs Create Tax Headaches, Not Benefits
In the wake of the COVID-19 pandemic, we saw all-too-clearly the tactics bad actors and so-called "promoters" used to convince well-meaning employers to file questionable—or outright false—employee retention credit (ERC) claims. Years later, many employers are dealing with the fallout. These tactics are by no means limited to the ERC arena. Employer-provided wellness and medical indemnity programs are another frequently targeted area that's ripe for exploitation by promoters of abusive schemes. Often, promoters pitch these programs with the promise of significant tax savings and tax-free benefits for employees—by converting taxable wages into tax-free benefits. Years ago, the IRS warned that these schemes fail to qualify for the promised tax benefits—and, in fact, can result in significant penalties on both the employer and employee side.
Medical and Wellness Indemnity Schemes: Section 125
One common pattern has emerged over the years with respect to fixed indemnity plans. Promoters target employers, offering an opportunity for employees to elect to reduce taxable income via a Section 125 cafeteria plan (i.e., via salary deferral). The employer then uses the employee deferrals to purchase a fixed indemnity health insurance policy. The insurer, in turn, pays a fixed wellness benefit to the employee—a benefit that is promised to be tax-free.
That wellness benefit can cover many different activities, such as wellness planning, preventative care or even obtaining health risk assessments. The key fact is that the benefits paid to the employees are not dependent on the employee incurring any type of qualifying medical expense. The wellness benefit is entirely separate from the coverage provided under the employer's group health insurance plan.
Promoters of these plans claim that the insurer-paid wellness benefits are tax-free to the employee and reduce taxes for the employer (in terms of FICA, Medicare, workers' compensation insurance premiums and unemployment taxes). The promoter's claim is that both employer and employee benefit by reducing the employee's taxable wages—the employee, through reduced taxable income, and the employer, because their liability is tied to the employee's taxable wages.
The IRS Disagrees
The IRS has clearly stated that these fixed indemnity programs do not qualify for tax-free treatment. In 2023, the IRS released a Chief Counsel Memorandum clarifying that the wellness benefits constitute taxable wages because they are in no way tied to medical expense reimbursement.
Medical expense reimbursements can qualify for tax-free treatment under IRC Section 105. The tax-free treatment is limited to the amount of medical expenses incurred (subject to substantiation requirements). Only amounts paid for qualifying medical expenses are eligible for tax-free reimbursement.
The IRS has also proposed regulations on the matter—clearly stating that wellness payments are not excluded from gross income because they are not correlated to medical expenses or health insurance premium payments. Instead, they are based on the employment arrangement (meaning that they are subject to FICA/FUTA employment taxes).
Steep Penalties May Apply
Significant penalties can apply for employers who implement an abusive wellness program scheme. In addition to paying all relevant taxes associated with the employee deferrals, employers can also face a 20% underpayment penalty if they fall for one of these abusive schemes. Interest and accuracy penalties may also apply. Plan participants who are found to owe taxes and underpayment penalties are also able to sue for ERISA fiduciary violations.
It's also important to remember that taxpayers should never rely on opinions provided by the promoter themselves. Tax penalties may not apply in situations where a taxpayer, in good faith, relies on an opinion prepared by an independent advisor on the facts.
Many promoters offer legal opinions themselves—and even attempt to differentiate their schemes from those described as abusive by the IRS. IRS regulations are clear that promotional materials and opinions provided by promoters cannot provide the reasonable basis for the taxpayer's decision.
Conclusion
The bottom line is that if it seems like it's too good to be true, it probably is. Promoters of abusive schemes will go to great lengths to sell their programs—some even offer tax-related insurance that almost certainly will not cover the associated penalties and losses incurred on the employer side. Ultimately, employers should consult trusted tax and legal advisors before implementing any type of employment benefit program. Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.