IRS Cautions Employers Again on Wellness Plans Purporting to Avoid Payroll Taxes Absent Medical Expenses

The IRS recently issued IR-2024-65 alerting employers to beware of companies misrepresenting nutrition, wellness, and general health personal expenses as medical care expenses for health flexible spending arrangements (FSAs), health savings accounts (HSAs), health reimbursement arrangements (HRAs), or medical savings accounts (MSAs), collectively health spending plans. 

The news release addresses a concern that people are being misled by promoters of health spending plans as to which general health and wellness expenses will be reimbursed to employees and points out that personal expenses are not considered medical expenses under IRC Section 213(d) and therefore are not deductible or reimbursable under FSAs and other health spending plans.

The promoters, some of which are former employee retention credit promoters, typically provide seemingly credible materials that often include a reliable legal opinion on the validity of the tax savings generated when employees make elective deferrals to health care arrangements under IRC Section 125. However, the legal opinion usually does not opine on the type of expenses discussed by the promoter or address how the payment of “wellness” expenses impacts the intended tax benefits.  

The news release reiterates the items covered in Chief Counsel Advice Memorandum (CCA) 202323006, issued on June 9, 2023, and emphasizes that only plans that pay or reimburse bona fide medical expenses as defined by IRC Section 213(d) qualify an employee to make pretax contributions to a health benefit account and that distributions not used for IRC Section 213(d) medical expenses are taxable. Thus, contributions to plans that provide for the payment of non-medical wellness expenses are not deductible and payments under the plans are not tax free under FSA, HSA, HRA, and MSA rules. If the plan does not satisfy the IRC requirements, all payments made to taxpayers under the plan, even reimbursements for actual medical expenses, are includible in income.

Not surprisingly, the IRS stated in CCA 202323006 that wellness benefits are taxable wages for purposes of federal income and employment tax withholding (and employers would need to pay their share of FICA and FUTA taxes) if the benefits do not qualify as IRC Section 213(d) medical expenses that are eligible for tax-free reimbursement under an IRC Section 125 plan. 

What are Medical Expenses?

For decades, IRS rulings and court cases have consistently taken a very narrow view of what is a Section 213(d) medical expense. Based on these rulings and court decisions, the costs associated with many things commonly considered to be “good for your health” are not recognized as medical expenses by the IRS. For example, promoter materials typically advertise tax-free reimbursements for things that sound very positive for employees’ physical and mental health, including gym memberships, personal training, relationship counseling (including marital counseling, parental advice, interpersonal relationship goal-setting, and work-life balance coaching), general nutrition and exercise advice. However, none of these are Section 213(d) medical expenses and therefore wellness plan reimbursements for these types of costs are, in fact, taxable wages. See IRS Pub. 502 for a discussion of what is and is not a Section 213(d) medical expense. Also, the IRS has provided frequently asked questions on medical expenses related to nutrition, wellness, and general health to determine whether a food or wellness expense is a medical expense to help distinguish medical from personal expenses.  

Chief Counsel Advice 202323006

CCA 202323006 makes it clear that unless participants have qualifying Section 213(d) medical expenses, the cash benefits paid to them from these wellness plans will be taxable wage income, subject to both income and employment taxes. 

CCA 202323006 involves an employer-funded, fixed-indemnity insurance policy whereby employees pay a $1,200 tax-free monthly premium through a Section 125 plan. The employer has no liability for any costs incurred by the insurance company that exceed the premiums paid by the employees. The primary wellness benefit provided by the plan is a monthly payment of $1,000 in tax-free cash if the employee participates in certain health or wellness activities. Use of preventive care, such as getting vaccinations under the employer’s comprehensive health plan (which is independent of the wellness plan), qualifies the employee for the $1,000 cash payment (styled as a “preventive care reimbursement”) from the wellness plan. The wellness plan provides counseling on nutrition, general wellness, personal relationships, life coaching, and telehealth benefits at no additional cost. The employee must pay any costs associated with receiving any health-related activity, although in many cases the cost of the health-related activity will be provided at no cost or is covered by the employer’s other comprehensive health insurance. The wellness benefits are paid from the insurance company to the employer, which then pays the monthly $1,000 to employees through payroll, which would include appropriate Form W-2 reporting for the wellness plan contributions and benefit payments. 

The IRS concluded that the $1,000 cash payment to the employee was taxable wages, since there were no unreimbursed bona fide Section 213(d) medical expenses associated with that payment.

Conclusion

As noted in CCA 202323006 and IR-2024-65, wellness plans often do not provide the tax benefits represented by promoters. Moreover, once an employer begins operating a defective wellness plan that allows reimbursements that are not eligible for tax-free treatment, it may be years before this fact comes to light, creating significant problems for employers who must correct past Forms W-2, Forms 941, etc. for open tax years. Typically, the statute of limitations is three years, but it could be six years for substantial understatements. Employee morale issues can also arise, because employees may be required to amend their past years’ Forms 1040 individual income tax returns.