IRS reminds employers: Certain wellness program incentive payments are taxable

Wellness incentive program payments will not receive favorable tax treatment if they are not related to health-care expenses, the IRS announced in a guidance memorandum issued on Wednesday. This is the fourth chief counsel advice, or CCA, that the IRS has released on this topic. Although a CCA is not formal guidance that may be used or cited as precedent, it provides an indication of the agency’s views on an issue.

The term “wellness program” generally refers to a health promotion and disease prevention program or activity, which include diabetes management programs and weight loss plans, offered by an employer to employees – and sometimes their spouses – either as part of the employer’s group health plan or separately as a benefit of employment, according to the agency. Employers may give certain incentives for participation in wellness programs, including a reduction in employee costs for group health-care coverage and certain other programs.

Some employers have paired their wellness programs with an Internal Revenue Code Section 125 cafeteria plan in an attempt to reduce income, FICA and unemployment taxes by reducing employees’ taxable income through salary reduction contributions that result in supposedly tax-exempt incentive payments to the employee. The IRS guidance includes this example:

“In addition to its regular group health coverage, the employer allows all employees, regardless of enrollment in other health coverage, to enroll in coverage under what is called a fixed-indemnity health insurance policy. The employees pay monthly $1,200 premiums by salary reduction through a cafeteria plan. The cafeteria plan pays a wellness benefit incentive of $1,000 per month if an employee participates in certain health or wellness activities. The wellness benefit incentives are paid by an insurance company to the employer, which then pays out the incentive to employees on a tax-free basis via the employer’s payroll system.”

Wellness benefit incentive payments can be included in the gross income of the employee if the employee has no unreimbursed medical expenses related to the payment. The exclusion under Code Section 105 is limited to amounts paid solely to reimburse expenses incurred for medical care and does not apply to amounts that the taxpayer is entitled to receive regardless of whether expenses for medical care are incurred. Therefore, the exclusion from income in Code Section 105 does not apply to wellness incentive payments when the employee has no unreimbursed medical expense, either because the activity that triggers the payment does not cost the employee anything or the cost of the activity is reimbursed by other coverage.

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“Under the facts described above, when the cafeteria plan pays $1,000 merely because the employee has participated in a wellness benefit program, the payment is included in the employee’s income and constitutes wages for purposes of FICA, FUTA and federal income tax withholding,” the IRS said.

The takeaway message for employers, according to The Wagner Law Group, is that “the IRS may seek to collect taxes, penalties and interest from employers based on their failure to properly withhold income and employment taxes from wellness program incentive payments that are impermissibly made on a tax-free basis. Therefore, employers should avoid sponsoring the type of wellness incentive program discussed in the memorandum.“