Tax Tip of the Day: Employer-Provided Wellness Plan is usually Excluded from Employee's Gross Income

Coverage under an employer-provided wellness plan that provides medical care is generally excluded from an employee's gross income and any medical care provided under the program is also excluded. However, a cash reward, cash incentive, or other payment that is not medical care would be taxable, unless it is a noncash or noncash equivalent payment that is excludable as a de minimis fringe benefit. A de minimis fringe benefit is any property or service the value of which (after taking into account the frequency with which similar fringes are provided by the employer to the employees) is so small as to make accounting for it unreasonable or administratively impractical.

A cash payment (other than overtime meal money and local transportation fare) is never a de minimis fringe. Under these rules, a T-shirt or coffee mug would not be taxable, but a gym membership or cash payments for going to the gym or attending nutrition classes would be.

If the employee purchases accident and health insurance with after-tax dollars, benefits paid by the policy for personal injuries or sickness are nontaxable under Sec. 104(a)(3). This exclusion does not apply to benefits attributable to employer premium payments that are not included in the employee's income or amounts the employer paid under a self-insured plan. Employers, however, may provide incidental administrative support for individuals to purchase the insurance, such as allowing the premiums to be deducted from employees' pay and remitting them to the insurer or allowing company facilities to be used to market the insurance to employees. Key distinguishing features of these types of permissible plans are that they are voluntary, paid with post-tax dollars, and include a medical underwriting requirement because this is the sale of individual health insurance.

The Sec. 104(a)(3) exclusion does not apply to amounts attributable to cafeteria plan salary reduction contributions as those benefits are considered to be provided by the employer (Sec. 125). Also, as the legislative history for Sec. 125 notes, the exclusion only applies to reimbursements through insurance arrangements and arrangements having the effect of insurance (e.g., there must be adequate risk shifting) (see H.R. Conf. Rep't No. 104-736, at 294 (1996)).

While neither the statute nor the regulations define insurance, judicial decisions indicate that the risk transferred must be the risk of an economic loss, contemplating the fortuitous occurrence of a stated contingency and not merely an investment or business risk (see Helvering v. Le Gierse, 312 U.S. 531 (1941); Allied Fidelity Corp., 572 F.2d 1190 (7th Cir. 1978); Treganowan, 183 F.2d 288 (2d Cir. 1950); Rev. Rul. 2007-47). State law definitions or determinations of insurance and risk shifting do not apply to this area. At least one arrangement with which we are familiar has been determined, for state law purposes, to be insurance by at least one state, but that determination is irrelevant for federal tax purposes.

Thus, if an employee pays for a fixed indemnity or wellness plan with after-tax dollars and the arrangement exhibits risk-shifting features, then all benefits paid under the arrangement are nontaxable under Sec. 104(a)(3). However, if the premiums for those plans are paid by the employer or with pretax dollars through a cafeteria plan, benefits paid are not excludable under either Sec. 104(a)(3) or Sec. 105(b), except to the extent that the benefits pay actual medical expenses that would otherwise be deductible under Sec. 213.

In addition, if the average benefits paid or predicted to be paid through a self-insured health plan markedly exceed the after-tax contributions paid by the participating employee, the benefits in excess of the after-tax premiums paid by the employer are not excludable under Sec. 104(a)(3) as they are either attributable to contributions by the employer that were not includible in income by the employee or paid by the employer. The excess of any reimbursement from the self-insured plan over the amounts the employee paid on an after-tax basis would be taxable to the employee for income tax purposes and also subject to employment taxes and income tax withholding.

Correcting errors

Employers having entered into these arrangements in 2017 can correct this relatively easily by withholding income and employment taxes on these amounts; amending Form 941, Employer's Quarterly Federal Tax Return, filings; and properly reporting the amounts on the 2017 Form W-2, Wage and Tax Statement. Tax payments for prior months can be accomplished by having the employee provide funds to the employer or letting the employer lend amounts to employees to cover 2017 withholding with repayment coming from 2017 and 2018 compensation, or withholding from the remaining 2017 salary and bonus payments.

If the employer pays the employee income or FICA tax obligation, that payment will be taxable and subject to income and employment tax withholding, requiring a gross-up calculation. Many employers in this situation pay some or all of the taxes for the employees as they feel responsible for having created the problem by offering the program and don't want to significantly decrease employees' take-home pay.

Employers with these arrangements for 2016 or earlier years will not be able to adjust income tax withholding but will be able to amend 2016 Forms 941 for unpaid employment taxes to the extent that the statute of limitation for employment taxes has not expired. In addition, employers would need to file Forms W-2c to report in Box 1 the previously unrecognized income employees will need to recognize. In addition, if the employer pays the employee’s income or employment tax liability, those amounts will need to be reported as income on Form W-2 in the year in which the payment is made.

With significant numbers of employees involved, one could approach the IRS to see if the unpaid taxes could be settled with a closing agreement. No IRS program exists for those agreements, and, based on recent experience, the IRS is reluctant to enter into them if the number of employees or the dollar amounts are not large.

Employers that do not include amounts in income for these arrangements may find that the IRS assesses the taxes, penalties for failure to pay taxes, and penalties for failure to deposit taxes. It is possible that the IRS would also assess a penalty for substantial understatement of taxes or a disregard of rules and regulations.

If the employer corrects the errors before an IRS assessment, the IRS will likely waive some or all the penalties. It is in the best interest of tax administration that taxpayers recognizing errors correct them without IRS examination. To encourage taxpayers to come forward when mistakes are found, penalties are rarely assessed when taxpayers correct their own mistakes.

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