Were payments received under health insurance policy taxable? Yes, and here’s why

IRS told one employer that payments made to employees under its fixed-indemnity health insurance policy were subject to federal income, FICA and FUTA taxes.

The policy was optional, with comprehensive health coverage provided through its group health insurance policy.

Both policies qualified as accident and health plans under Sec. 106 of the Internal Revenue Code, IRS pointed out in Chief Counsel Advice 202323006.

As such, the company could offer the fringe benefits to employees as part of a Sec. 125 cafeteria plan.

The good news was contributions to the plans weren’t subject to taxes.

But when it came to payments made to employees, that’s where the plans differed. After all, to be an excluded benefit, among other things, payments or reimbursements have to be for medical expenses. While the group health insurance policy could pass that test, the fixed-indemnity health insurance policy couldn’t.

Here’s a closer look at the company’s arrangement and the insight provided by the IRS Office of Chief Counsel.

Health insurance payments

The premiums for the fixed-indemnity insurance policy cost enrolled employees $1,200 per month. They paid the premiums through salary reductions on a pre-tax basis.

Then, the insured plan paid $1,000 per month to employees who participated in certain health or wellness activities.

Such activities included using preventive care under the comprehensive health plan. That plan offered reimbursements for the cost of flu shots and other vaccinations – and there was no cost for covered individuals.

Meanwhile, the fixed-indemnity health insurance policy also provided benefits at no additional cost. They included wellness counseling, nutrition counseling and telehealth benefits. Furthermore, the policy provided hospitalization coverage.

As for the $1,000 wellness indemnity payments, they’d need to be included in an employee’s gross income if that person had no unreimbursed medical expenses related to the payment, IRS concluded.

That could occur if the:

• activity that triggered the payment didn’t cost the employee anything, or
• cost of the activity was reimbursed by other coverage.

What’s more, the payments were wages for employment tax purposes, as explained in the IRS guidance to the employer that requested it.

Action step: If your company makes payments to employees for wellness measures they take, consider the possible tax implications.

Are payments or reimbursements for medical expenses?

If not, Payroll may need to withhold federal income and FICA taxes from the wellness payments, and your company may have to pay its portion of FICA tax and also pay FUTA tax on the amounts.