Benefits Paid Under Employer's Self-Funded Plan Are Includible In Employee's Income

News from RWHSG

Benefits Paid Under Employer’s Self-Funded Plan Are Includible In Employee’s Income

Posted by Kim Chen on May 27th, 2017

Chief Counsel Advice 201719025
In Chief Counsel Advice (CCA), IRS has determined that benefits paid under an employer-provided self-funded health plan for an employee’s participation in certain health-related activities didn’t qualify for exclusion under Code Sec. 104(a)(3) and were thus includible in the employee’s income. IRS reasoned that the plan neither involved insurance risk nor had the effect of insurance, and that the amounts received by employees for participating in health-related activities were mostly attributable to employer contributions.
Background. Employer-paid premiums for accident or health insurance coverage are excluded from an employee’s gross income under Code Sec. 106(a). Under Code Sec. 105(b), an employee excludes amounts received through employer-provided accident or health insurance if they are paid to reimburse expenses incurred by the employee for medical care (of the employee, the employee’s spouse, or the employee’s dependents, as well as children of the employee who are not dependents but have not attained age 27 by the end of the tax year) for personal injuries or sickness. To the extent amounts received through employer-provided accident or health insurance are paid without regard to the amount of expenses incurred by the employee for medical care, 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.
Amounts received through accident or health insurance for personal injuries or sickness are generally excluded from gross income under Code Sec. 104(a)(3). This exclusion does not apply, however, if the amounts are either
1. Attributable to contributions by the employer that were not includible in the gross income of the employee or
2. Paid by the employer.
The legislative history underlying Code Sec. 104(a)(3) provides that, for the exclusion to apply, the arrangement must be insurance (i.e., with adequate risk shifting) or must have the effect thereof.
Reg. § 1.104-1(d) provides that if an individual purchases a policy of accident or health insurance out of the individual’s own funds, amounts received thereunder for personal injuries or sickness are excludable from gross income under Code Sec. 104(a)(3). This exclusion also applies to amounts received by an employee for personal injuries or sickness from a fund which is maintained exclusively by employee contributions. (Reg. § 1.104-1(d)) However, if an employer is either the sole contributor to such a fund, or is the sole purchaser of a policy of accident or health insurance for its employees, the exclusion doesn’t apply to any amounts received by the employees through such fund or insurance. (Reg. § 1.104-1(d))
Under the Code Sec. 125 cafeteria plan rules, an employee’s salary reduction applied to buy health insurance coverage isn’t included in gross income, and the coverage is excluded under Code Sec. 106 as employer-provided accident or health coverage.
Facts. Promoters (typically product developers or insurance brokers) sell self-funded health plans (often referred to by promoters as “fixed indemnity health plans”, described by the CCA as plans that pay covered individuals a specified amount of cash for the occurrence of certain health-related events) and wellness plans to employers. The plans are promoted as a way to provide certain benefits to employees at no or little cost to either the employer or employees.
Specifically, the plans purport to provide the following benefits:

• Employees who voluntarily participate make pre-tax contributions to the wellness plans and relatively small after-tax contributions to the self-funded health plans. A large portion of the pre-tax contributions are returned to the employees as cash payments from the self-funded health plans or rewards through the wellness plans—which are purportedly not includible in income.
• The pre-tax contributions to the wellness plans lower the amount of Federal Insurance Contributions Act (FICA) taxes that are owed by the employees and the employers, and the cash payments that are made to the employees from the plans are treated as not includible in income or wages.
• The employer pays a fee to the promoter for administering the plans, the amount of which is generally less than the FICA taxes that otherwise would have been paid, purportedly allowing the employer to provide a health plan and a wellness plan to its employees at no (or little) cost.
The CCA provided two illustrative factual situations:

• Situation 1. An employer provided all employees, regardless of enrollment in other comprehensive health coverage, the option to enroll in coverage under a self-funded health plan. Participants paid a small after-tax employee contribution and were paid a significantly larger fixed cash payment benefit for participating in certain health-related activities. The participants didn’t pay for the activity, and the cash benefit could be received for up to 12 activities per year. Under an actuarial analysis, all employees were expected to receive benefit payments under the self-funded health plan that markedly exceeded their after-tax premium payments, and in practice, all (or nearly all) employees received payments from the plan that exceeded their after-tax contributions.
• Situation 2. The facts are the same as Situation 1, except the employer also provided employees with the ability to enroll in coverage under a wellness plan which would independently qualify as an accident and health plan under Code Sec. 106. Participants in the wellness plan paid a pre-tax employee contribution through a Code Sec. 125 cafeteria plan. The wellness plan provided participants with health-related wellness activities at no charge to the employees. Typically, if the employee’s net take-home pay after receiving the fixed cash payment from the self-funded health plan exceeded the amount of the employee’s net take-home pay prior to implementing the plans, the wellness plan provided that the excess was paid in the form of flex credits that could be used for benefits under the Code Sec. 125 cafeteria plan such that the net take-home pay of each employee who participated in the plans generally remained unchanged.
Exclusion doesn’t apply to self-funded plan. The CCA concluded that the employer-provided self-funded plan didn’t qualify for exclusion under Code Sec. 104(a)(3), which applies to amounts received through accident or health insurance (or an arrangement having that effect). While neither the Code nor the regs define the term “insurance”, the Supreme Court has explained that, in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be involved. (Helvering v. Le Gierse, (S Ct 1941) 25 AFTR 118125 AFTR 1181) The risk transferred must be the risk of economic loss. (Allied Fidelity Corp. v. Comm., (CA 7 1978) 41 AFTR 2d 78-104441 AFTR 2d 78-1044) The risk must contemplate the fortuitous occurrence of a stated contingency (Comm. v. Treganowan, (CA 2 1950) 39 AFTR 67239 AFTR 672), and must not be merely an investment or business risk. (Le Gierse)
As applied to Situation 1, the CCA observed that, while the participants received a payment for engaging in certain activities related to health, the arrangement did not involve a risk of economic loss or fortuitous event. Accordingly, there was no insurance for federal income tax purposes. Similarly, because there was no insurance risk, there was no “risk shifting”, so the arrangement did not “have the effect of insurance”. Accordingly, amounts received through the plan were not excluded from income under Code Sec. 104(a)(3).
In addition, the CCA found that, because the average benefits paid or predicted to be paid through the self-funded health plan significantly exceeded the after-tax contributions paid by a participating employee, the benefits in excess of the premiums were either attributable to contributions by the employer that were not includable in the gross income of the employee or paid by the employer—and thus ineligible for exclusion under Code Sec. 104(a)(3).
In Situation 2, the result was the same for the self-funded health plan. However, the flex credits awarded under the wellness plan were excluded from the income of a participating employee unless used to purchase taxable benefits under the Code Sec. 125 cafeteria plan, such as whole life insurance coverage or a gym membership. In that instance, the flex credits used to purchase the taxable benefits under the Code Sec. 125 cafeteria plan were included in the gross income and wages of the participating employee.