IRS To Tax Certain Payments From Fixed Indemnity Health Plans

Nov
16

According to the IRS, payments made to participants under certain fixed indemnity insurance policies must be included in the employees’ gross wages, unless the premiums are paid on an after-tax basis. Fixed indemnity health plans are plans that pay covered individuals a specified amount of cash for the occurrence of certain health-related events such as hospital visits or the diagnosis of a particular condition or disease (e.g., cancer).  The benefit amounts paid to participants in the plan are not related to the amount of medical expenses actually incurred by the employee.

Earlier this year, the IRS released a Chief Council Advice Memorandum, CCA 201703013.  The IRS concluded that “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was excluded from the employee’s gross income and wages” or “if the premiums for the fixed indemnity health plan were originally made by salary reduction through a Section 125 cafeteria plan.”  If the premiums are paid with after-tax dollars, the plan benefit payments are excluded from the employee’s gross income.  Employer payments and employee premiums paid under a cafeteria plan towards fixed indemnity health plan coverage are not included in the employee’s compensation income at the time the amounts were paid since they are made through salary reduction under a cafeteria plan.  Therefore, according to this memorandum, benefit payments associated with that coverage constitute taxable income.

The problem with fixed indemnity health plans for the IRS is the fact that cash payments are made to employees without regard to the actual amount of expenses incurred by the employee for medical care.  Section 106(a) of the Internal Revenue Code (the “Code”) excludes from income premiums for accident or health insurance coverage that are paid by an employer.  Section 105(b) of the Code allows employees to exclude amounts received through employer-provided accident or health insurance, if those payments are made as reimbursement for medical care related to personal injuries or sickness.  However, the IRS reasons that since amounts received under employer-sponsored fixed indemnity health plans do not take into account the actual medical costs incurred, the reimbursements are not reimbursements for personal injury or sickness, and therefore must be included in gross income.

The IRS guidance also specifically discusses cafeteria plans.  The IRS notes that under Section 125 of the Code, the employee has the option to receive cash instead of a salary reduction applied to purchase accident or health coverage. If the employee elects a pre-tax salary reduction for accident coverage instead of cash, that amount is excluded from gross income as employer-provided accident or health coverage under Section 106.  However, if the employee elects a salary reduction for premiums toward a fixed indemnity health plan, the amounts payable as benefits to the employee under the plan will be includible in gross income since the cash reimbursement amount is provided to the employee without regard to the amount of medical expenses otherwise incurred.

In light of this guidance, employers offering fixed indemnity plans should carefully evaluate how premiums for that coverage is paid and the impact of that decision on future benefit payments. According to the IRS, when employees pay premiums for a fixed indemnity health plan through a pre-tax salary reduction under a Section 125 cafeteria plan, benefit payments under the policy will be treated as taxable income. If you are uncertain about the tax implications of your fixed indemnity benefits or have questions about this IRS guidance, please contact a member of the McGrath North employee benefits practice group.

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