Wellness and Medical Indemnity Tax Schemes on the Rise Again

Despite clear warnings by the IRS, employers continue to receive pitches for so-called “wellness” or “medical indemnity” programs that promise significant payroll tax savings for employers and employees. We’ve even seen some proposals that go so far as to estimate that employees could take home additional pay under these schemes.

In June 2023, the IRS issued Chief Counsel Memorandum 202323006 concluding that these “wellness” payments were not eligible for tax-free treatment and should instead be taxed as wages. Promoters of these arrangements grew quiet in light of the clear guidance in 2023, but we’ve recently seen an increase in promotions of these types of arrangements again.

These arrangements generally use a Section 125 cafeteria plan and a fixed indemnity insurance policy to replace a portion of employees’ taxable wages with cash payments characterized as tax-free health benefits.

A Section 125 cafeteria plan allows employees to pay for certain qualified benefits (including eligible accident or health coverage) on a pre-tax basis through salary reduction contributions. Fixed indemnity insurance provides predetermined benefits for certain medical services or events rather than reimbursing actual medical expenses.

Under these tax schemes, employees reduce their taxable wages through a Section 125 cafeteria plan, and the employer uses the redirected funds to purchase fixed indemnity coverage. In return, employees become eligible to receive cash payments for participating in certain wellness activities. Examples include preventive care, telehealth visits, wellness counseling, nutrition counseling, health risk assessments, and vaccinations. Employees often receive these cash payments without incurring any unreimbursed medical expenses because another health plan already covered the “wellness” services.

The IRS rejects these arrangements. In its 2023 Chief Counsel Memorandum, the IRS concluded that wellness indemnity payments generally constitute taxable wages when not tied to actual medical expenses incurred by the employee. According to the IRS, payments made merely because an employee participates in wellness activities do not qualify for the medical expense reimbursement exclusion under Internal Revenue Code § 105(b). Instead, the payments are treated as wages subject to FICA, FUTA, and federal income tax withholding.

The critical question is whether a payment qualifies for a tax exclusion, not whether a promoter labels it a “wellness” or “medical” benefit. Employers that treat taxable benefits as tax-free may face interest and penalties for unpaid employment taxes of up to 20% of the underpaid tax.

Employers considering these arrangements should evaluate whether the plans promise substantial payroll tax savings from wellness cash benefits, provide fixed monthly payments without proof of actual medical expenses, or rely on testimonials implying IRS approval.

Morgan L. Kreiser
Sydney M. Mack, Summer Associate