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Are Pre-Tax Wellness Indemnity Plans a Tax Scam?

Contributor: Jack Wang, Account Executive

November 2nd, 2023 | 4 min. read

By Tony Calavitta

When it comes to selecting your employee benefits program, you have a lot to consider.

You want to offer competitive benefits so you can attract and retain top talent, but you also have to think about cost, coverage quality, compliance, and the list goes on (and on).

Enter pre-tax wellness indemnity plans – supplemental benefits plans that seem to check all of your boxes and even promise tax advantages for both you and your employees.

Did these types of plans just make your decision easy? Or are they a scam?

Here at Combined, we understand the immediate allure of options like pre-tax wellness indemnity plans that seem to offer a total solution to benefits program offerings. And that is why we are committed to helping you navigate the complexities of them.

In this article, we'll discuss pre-tax wellness indemnity plans and offer insights into:

  • What these plans are
  • Why their tax status has caught the attention of the IRS
  • And best practices to evaluate if this type of plan will actually benefit your business

By the end of it, you'll be equipped with the knowledge you need to make an informed decision about whether a pre-tax wellness indemnity plan is a fit for you – or a risk not worth taking.

What are pre-tax wellness indemnity plans?

Pre-tax wellness indemnity plans have emerged as an innovative way for employers to offer a more competitive benefits package.

These plans are employer-sponsored benefit programs that incentivize employees to engage in wellness activities by offering tax-free reimbursements. Although not intended to replace traditional medical coverage, these plans focus on promoting healthy behaviors, which are marketed as a form of preventive care that can lead to reduced medical costs.

One of the key attractions of these plans is the tax advantages they facilitate. Not only do employees who participate receive a substantial amount of tax-free compensation, but employers who offer these plans also benefit from lower payroll taxes. As a result, both parties save money.

Here’s how they work:

Imagine that employees at a company pay $1,200 in pre-tax monthly premiums into a wellness program through a cafeteria plan via salary deduction. By engaging in wellness activities, they then receive $1,000 in tax-free claim payments for these expenses.

This arrangement allows employees to use pre-tax dollars to purchase wellness indemnity plans so that they will pay less in taxes and come out ahead financially after receiving their claim payments. Additionally, because premiums for these plans are pre-taxed, they reduce the gross income employees receive which lowers the amount of payroll tax employers are responsible for.

Pre-tax wellness indemnity plans - Right for you?

In this section, we will discuss the intricacies of pre-tax wellness indemnity plans, so you can figure out whether they are a viable option for your business.

The sales pitch vs. the reality:

It’s a really convincing sales pitch:

  • Tax-free payments promising more income to employees
  • Financial incentives to drive increased employee participation
  • Lower payroll taxes and reduced the overall cost of benefits for employers

But are these selling points substantiated?

Unfortunately, no.

The reality is that pre-tax wellness indemnity plans oversell and underdeliver on the promise of financial savings for wellness activities.

Here’s why these touted tax breaks, aren’t actually savings at all:

Remember those tax-free wellness reimbursements that act as the backbone for pre-tax wellness indemnity plan savings?

Well, according to the Internal Revenue Service (IRS), they are actually taxable.

On June 9, 2023, the IRS released OCC Memo 202323006 warning that, if participants have no unreimbursed medical expenses related to their premium payment, wellness indemnity payments under a fixed indemnity insurance policy are considered wages for purposes of the Federal Insurance Contributions Act (FICA) taxes, the Federal Unemployment Tax Act (FUTA) taxes, and the Federal Income Tax Withholding (FITW).

This means that not only have pre-tax wellness indemnity plans caught the attention of the IRS in an unfavorable light, but also that they come with a heightened risk of audits and penalties if they are not structured correctly.

In other words, employers need to approach these plans with caution.

The recent IRS memo underscores the importance of giving careful consideration to tax implications and compliance with tax laws when sponsoring a plan of this nature.

Here’s the takeaway:

While the sales pitch for pre-tax wellness indemnity plans is undoubtedly compelling, employers must carefully weigh the reality and potential risks of these plans before making a decision.

Pre-tax wellness indemnity plans – Worth the risk?

The IRS isn't known for its leniency when it comes to tax loopholes and has issued memos warning employers that these plans could potentially violate tax codes.

As a general rule, unless the IRS has explicitly stated that an exemption applies, employers and plan participants risk facing financial repercussions for noncompliance.

Employers found in violation may face back taxes, fines, and even legal action. Moreover, employees could be blindsided by unexpected tax bills. It's a potential lose-lose situation charged with both financial and relational risks.

Best practices for employers considering pre-tax wellness indemnity plans

As an employer, the last thing you want is to inadvertently get tangled up in a tax scandal. With the complexities and potential risks associated with pre-tax wellness indemnity plans, due diligence becomes your best ally.

Here’s how you can navigate these plan types with careful discretion:

1. Consult experts

Before even considering a pre-tax wellness indemnity plan, seek advice from tax and legal professionals. They can provide insights into compliance and help you understand the nuances of IRS guidelines.

2. Question providers

Don’t take a provider’s word at face value. Ask pointed questions about how their plan aligns with IRS regulations. Request clear documentation and evidence of compliance.

3. Educate your team

Ensure that your HR and finance teams are well informed about the potential risks and legal implications of these plans. Knowledge is power, and it’s crucial for making an informed decision.

4. Stay in the know

Tax laws and IRS guidelines can change. Stay abreast of any updates or memos that might affect the status of wellness indemnity plans.

5. Consider alternatives

Given the potential risks, it may be wise to explore alternative benefits options that offer similar advantages without the tax complexities.

By adopting these best practices, you position yourself as a responsible employer, prioritizing both compliance and the well-being of your company and employees. Remember, when it comes to tax-related decisions, it’s always better to err on the side of caution.

Take the next steps – Let’s find the best employee benefits for your business

In this article, we've discussed the intricacies of pre-tax wellness indemnity plans. While these plans promise tax benefits and financial incentives, a deeper analysis shows that they also come with IRS warnings and compliance challenges

By reading it, you’ve learned the realities of pre-tax wellness indemnity plans and understand their true value and potential drawbacks.

So, the critical question to ask yourself when considering a plan of this type:

Would a pre-tax wellness indemnity plan be a strategic asset for your business or, rather, a fiscal façade?

If you need help answering this question, our team of experts is ready to assist.

Here at Combined, we are dedicated to guiding you through the complexities of employee benefits and helping you find the right benefits for your business and your employees. Together, we can ensure that your benefits program is not only competitive but also compliant and built to last.

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This article is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice.