A recent IRS Office of Chief Counsel Memorandum includes new guidance on the tax treatment of certain supplemental health benefits provided by employers. You may access the memo here.
Refresher point: IRS rules for pre-tax payroll deductions under Section 125 allow many different types of supplemental health or accident benefits (also known as “worksite benefits”) to be paid either (a) by employees with pre-tax deductions, or (b) by the employer in whole or part without tax consequence to the employee. Those rules have not changed.
Quick takeaway: New IRS guidance says that if certain supplemental or worksite benefits are paid with pre-tax dollars, or by employer and not taxed to the employee, then any future benefit paid by the plan would be taxable to the recipient. Programs subject to this analysis include “fixed indemnity health plans.” In order to protect the tax-free nature of future benefits paid, best practice for employers is to require that premiums be paid with post-tax dollars.
Analysis: The new IRS guidance focuses only on supplemental or worksite programs that operate as fixed-indemnity health plans. Specifically, the IRS memo states that if a plan pays a fixed benefit that is not tied to the cost of medical treatment, then the benefit is subject to a tax analysis similar to what we are familiar with for short-term and long-term disability plans. The ultimate benefit may be tax-free, but only if the premiums are paid with taxable income. Thus, while these plans have always been (and continue to be) eligible for pre-tax treatment under Section 125, the best practice going forward is for the premiums to be paid on a post-tax basis. Otherwise, as with STD and LTD benefits, any future benefit would be taxable to the employee.
As a result of this new guidance, employers and advisors should assess all supplemental or worksite benefits regarding status as “fixed indemnity” or non-fixed indemnity, and any fixed indemnity benefits should be reclassified by employers as post-tax premiums paid by employees by post-tax deduction. Alternatively, if premiums are paid in whole or part by the employer, including by defined contribution credit, then the amount of the employer payment be imputed as taxable income to the employee. That will protect the tax-free nature of future benefits paid.
Of course, as with LTD and STD benefits, employers have the option to do the opposite.
The memo focuses on “employer provided” plans, which of course would include worksite programs provided under an employer contract. The memo does not specifically reference the worksite benefits that are not employer-sponsored – the traditional individual voluntary programs. However, my assumption is that the same analysis applies.
On a broader scope, our team has always been of the opinion that employers should seek to exclude the individual, non-group supplemental plans from ERISA if possible. If the employer makes all individual supplemental plans post-tax, then that would remove any formal employer sponsorship and keep those benefits outside of ERISA for purposes of SPDs and Form 5500 filings. The supplemental plans provided under group contract are automatically subject to ERISA by virtue of the formal sponsorship by the employer, so making those benefits post-tax will not, unfortunately, change the ERISA analysis.