Fixed Indemnity Medical Plan Payments Are Taxable as Wages When Received If Premiums Were Not Paid from After-Tax Funds

Normally employees who have employer paid health insurance (or who pay for such insurance via §125 cafeteria plans) do not include either the premiums nor the medical costs paid by the policy as income.  But in Chief Counsel Advice 201703013 we are reminded that this treatment will not apply for payments from fixed indemnity health plans.

For traditional health plans the plan reimburses only amounts actually paid (or billed) for medical care incurred by the covered individual.  However, a fixed indemnity plan is different, as explained in the memorandum:

A fixed indemnity health plan is a plan that pays covered individuals a specified amount of cash for the occurrence of certain health-related events, such as office visits or days in the hospital. The amount paid is not related to the amount of any medical expense incurred or coordinated with other health coverage.

The fact that the amount is paid regardless of the amount of expense incurred changes the tax treatment of the payment.  As the memorandum notes:

In general, § 106(a) provides that gross income of an employee does not include employer-provided coverage under an accident or health plan. Under § 106(a), an employee may exclude from income premiums for accident or health insurance coverage that are paid by an employer. Also, under § 105(b), an employee may exclude amounts received through employer-provided accident or health insurance if those amounts 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 taxable year) for personal injuries and 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.

The memorandum seeks to answer two questions.  The first one is stated as follows:

Are payments received by an employee from an employer under a fixed indemnity health plan excludible from the employee's income under § 105 of the Code?

Based on the above analysis, the memorandum provides the following answer:

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.

The second question posed was:

Are payments received by an employee from an employer under a fixed indemnity health plan excludible from the employee's income under § 105 of the Code if the amounts paid by the employee (employee premiums) for coverage under the fixed indemnity health plan were made by salary reduction through a § 125 cafeteria plan (and thereby not included in the employee's compensation income at the time the amounts were paid)?

With the answer being:

An employer may not exclude from an employee's gross income payments under an employer-provided fixed indemnity health plan if the premiums for the fixed indemnity health plan were originally made by salary reduction through a § 125 cafeteria plan.

The following examples, adapted from the memorandum, illustrate the application of the law in the eyes of the author of the memorandum.

EXAMPLE 1

An employer provides all employees, regardless of enrollment in other comprehensive health coverage, with the ability to enroll in coverage under a fixed indemnity health plan that would qualify as an accident and health plan under § 106 of the Code. Employees pay premiums for the plan by deducting the amount of the premium each pay period from the employee's salary; the amount of the deducted premium is included in gross income and wages for federal tax purposes, notwithstanding that the plan would qualify as an accident and health plan under § 106. The fixed indemnity health plan pays employees $100 for each medical office visit, and $200 for each day in the hospital, without regard to the amount of medical expenses otherwise incurred by the employee.

Because the premiums for the fixed indemnity health plan are included in the employee's gross income and wages (and thus paid with after-tax dollars), amounts paid by the plan are excluded from gross income and wages under § 104(a)(3).

EXAMPLE 2

The facts are the same as Example 1 except that the employer provides the coverage to the employees at no cost to the employee. 

Because the premiums for the fixed indemnity health plan are paid with amounts that are not included in the employee's gross income and wages, the exclusions under §§ 105(b) and 104(a)(3) do not apply to the payments and any amount paid by the plan are included in the employee's gross income and wages, regardless of the amount of any medical expenses incurred by the employee upon which the payment is conditioned.

EXAMPLE 3

Instead of the employer providing the coverage at no cost as in Example 2, employees electing to participate in the fixed indemnity health plan pay premiums by salary reduction through a § 125 cafeteria plan (and therefore the amount of the salary reduction is not included in compensation income at the time the salary would otherwise have been paid).

For the same reasons as are provided for Example 2, the benefits received must be included in the employee’s gross income and wages regardless of any medical expenses actually incurred.

EXAMPLE 4

An employer provides all employees, regardless of enrollment in other comprehensive health coverage, with the ability to enroll in coverage under a "wellness plan" that qualifies as an accident and health plan under § 106. Employees electing to participate in the wellness plan pay an employee contribution by salary reduction through a § 125 cafeteria plan (and therefore the amount of the salary reduction is not included in compensation income at the time the salary would otherwise have been paid). The wellness plan pays employees a fixed indemnity cash payment benefit of $100 for completing a health risk assessment, $100 for participating in certain prescribed health screenings, and $100 for participating in other prescribed preventive care activities, without regard to the amount of medical expenses otherwise incurred by the employee.

Because the premiums for the wellness plan are paid with amounts that are not included in the employee's gross income and wages, the exclusions under §§ 105(b) and 104(a)(3) do not apply to the fixed indemnity cash benefit payments and any payments are included in the employee's gross income and wages, regardless of the amount of any medical expenses incurred by the employee upon which the payment is conditioned.

EXAMPLE 5

An employer provides all employees, regardless of enrollment in other comprehensive health coverage, with the ability to enroll in coverage under a wellness plan that qualifies as an accident and health plan under § 106. Employees electing to participate in the wellness plan make an employee contribution by salary reduction through a § 125 cafeteria plan (and therefore the amount of the salary reduction is not included in compensation income at the time the salary would otherwise have been paid). The wellness plan pays employees a fixed indemnity cash payment benefit each pay period (for example, equal to a percentage of the salary payable for the pay period) for participating in the wellness plan, without regard to the amount of medical expenses otherwise incurred.

As with Example 4, the benefits are going to be included in gross income and wages for the same reasons.  When the premiums are not included in income when paid, the benefits will be included in income when received.