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► How Cafeteria Plans Intersect With Wellness Programs

Wellness programs are subject to a variety of rules and regulations familiar to most benefit professionals, like the Affordable Care Act (ACA), the Health Insurance Portability and Accountability Act (HIPAA), the Americans with Disabilities Act (ADA), and the Genetic Information Non-discrimination Act (GINA). What may be less obvious are the tax implications of these programs, particularly as they relate to a cafeteria plan.

Five major tax-related issues affect wellness programs:

• The taxation of certain incentives

• Health flexible spending account (FSA) prohibition related to surcharges

• Wellness tax-fraud schemes

• Cafeteria plan election changes and wellness credits

• Employer contributions to health FSAs and health savings accounts (HSAs)

1. Taxation of Incentives

Most wellness programs offer some level of financial reward when employees (and spouses, in some cases) engage in activities reasonably designed to promote health or prevent disease. When the reward affects the group health plan, it can be offered on a nontaxable basis. The classic example is a reduction in employee medical plan contributions, a waiver of a copayment or coinsurance, or a reduction in the deductible for completing certain wellness activities.

However, sometimes an employer wants to provide a reward in the form of cash or a cash equivalent (for example, a gift card). Or maybe, it’s a wearable health device (for example, a Fitbit) or other items with tangible value. In those cases, the fair market value of the reward will be taxable to the employee and reportable as W-2 wages in the year that the reward is given.

That’s because the employee is receiving something of value based on the employment relationship. Any cash or cash equivalent related to the spouse’s wellness activities will also be reportable as W-2 wages for the employee. This is the case even if the rewards are not directly issued by the employer but instead by a third-party vendor. An employer cannot avoid the tax consequences of these incentives through outsourcing.

2. Health FSAs and Surcharges

One common wellness target is reducing tobacco use. The typical method is to impose a surcharge on those who use tobacco. Because this method is considered an outcome-based, health contingent incentive under the ACA/HIPAA rules, an employer must provide a reasonable alternative standard that tobacco users can satisfy and still avoid the surcharge.

An example is tobacco cessation education. Still, some employees will neither quit tobacco use nor complete the education program and will be subject to the surcharge in employee medical plan contributions when the plan year starts.

Can employees receive reimbursement from the health FSA for the amount of the surcharge? After all, it is related to the medical plan, which is a pretax benefit under the cafeteria plan. The answer is no.

Health FSAs cannot reimburse employee contributions for other health plan coverage. That includes both fully insured and self-funded coverage, as well as other types of accident and health coverage (for example, dental, vision, long- and short-term disability, or accidental death and dismemberment).

3. Wellness Fraud Schemes

Over the years, the Internal Revenue Service (IRS) has issued guidance that specifically addresses tax fraud schemes that can generally be described as “double dipping.” That concept occurs where employees essentially receive a double tax-free benefit on the same amount.

An example is where employers reimburse employees for their tax-free health plan coverage on an equally tax-free basis. Another example is where a health reimbursement arrangement (HRA) reimburses insurance premiums on a tax-free basis (which HRAs are allowed to do in many cases) that were paid on a tax-free basis (for example, through a spouse’s employer’s cafeteria plan).

Wellness programs have received some attention in this area in the recent past, resulting in the publication of three Chief Counsel Memoranda from the IRS. These are typically couched as self-funded medical plans.

In the first piece of guidance, Chief Counsel Advice (CCA) 201622031, the IRS shot down a wellness program approach intended to give tax-free payments to employees. Employees made pretax payments to participate in the program and received tax-free rewards for easily achieved wellness activities. Because the reimbursements were not specifically for medical care, the IRS concluded there was no rationale for excluding them from taxation.

Thereafter, in CCA 201703013, the IRS addressed two variations on the same wellness theme. The first situation saw the employer offering a wellness plan that qualified as an accident and health plan. Employees paid for the coverage with pretax dollars through the cafeteria plan. The plan paid out fixed, tax-free cash payments for achieving certain wellness thresholds like completing a health risk assessment or participating in a health screening.

These indemnity payments were not related to the amount of any medical expense and were therefore taxable. The second situation was different only in the fact that the payments occurred on a pay period basis. The IRS treated the two situations the same.

Finally, in CCA 201719025, the IRS looked at two more approaches. In the first one, the self-funded wellness plan was funded by a small amount of post-tax employee contributions but resulted in a large amount of nontaxable cash payments for participating in wellness activities like attending a general health-related seminar or a counseling session. The IRS saw the absence of risk shifting, which is an inherent requirement for reimbursements to be tax-free.

In the second approach, employees made significant pretax payments (as well as the post-tax contributions) to participate in the wellness plan and received assurance that if their net take-home pay increased because of plan participation, the excess amounts would be treated as cafeteria plan flex credits. The IRS stated that any payments received greater than the post-tax payments would also be taxable, although the flex credits would be taxable only if used on taxable benefits.

Sometimes, the way these schemes are advertised is that the employer’s Federal Insurance Contributions Act (FICA) savings (amounting to 7.65% of the employee contributions) is split between the employer and the wellness vendor, enabling the employer to actually make money from the wellness program while employees receive a tax-free wellness benefit. That sounds too good to be true (and it is). An employer’s review with legal counsel is highly recommended.

4. Wellness Credits and Midyear Election Change Rules

Let’s say an employee earns a wellness credit that reduces the medical plan contribution midyear. Is this a viable election change? Arguably, yes. It can simply be viewed as an automatic cost change under the rules. Those changes can be initiated by either the employer or the employee. Recall that this cost change is not available for health FSAs.

5. Health FSA and HSA Wellness Contributions

As a reward for wellness program participation, an employer might want to help employees by putting extra money in either their health FSA or their HSA. Would this be permissible?

Regarding the health FSA, this would not count toward the salary reduction contribution limit (currently at $2,650 for 2018) because this would be an employer contribution. And as long as the contribution did not exceed $500 per plan year, there would be no risk in the health FSA losing its excepted benefit status (unless this program was extended to individuals who were not eligible for the medical plan, for example, part-time employees).

However, to the extent that this contribution occurs midyear, the IRS might view this as an election change—because employees are voluntarily participating in the wellness program—and this is not a permitted event that would warrant such a change. On the other hand, a reasonable argument exists that this is not really an election change because it is the employer—not the employee—making the contribution. We don’t have any regulation, notice, revenue ruling, or other guidance that addresses this situation.

Here is a further wrinkle for employer health FSA wellness contributions. What if some of those earning the extra money are highly compensated and some who do not earn the incentive are not highly compensated? Doesn’t that raise a nondiscrimination test (NDT) issue under Code Section 105(h), given that health FSAs are self-insured reimbursement plans? Perhaps, but no official guidance exists currently.

As well, a reasonable argument exists that this could be viewed as an “optional benefit” under the NDT rules. These types of benefits are permissible if all participants are eligible, and there is no required employee contribution, which would be the case here. Keep in mind also that an NDT under §105(h) allows for a certain amount of plan restructuring such that an employer could test the wellness health FSA contribution as a separate plan from the regular health FSA.

Regarding the HSA, the employer HSA contribution could be made through the cafeteria plan on a tax-free basis (assuming employees can make pretax HSA contributions through the cafeteria plan). Of course, the employer’s HSA contributions would need to be included in nondiscrimination testing, but §125 testing generally focuses on all qualified benefits (not testing each benefit separately), and most employers would likely run little NDT failure risk.

However, if an employer continues the HSA wellness contribution program for retirees, such an approach likely violates stricter HSA comparability rules (where contributions must be the same amount or percentage of the deductible for all participants); retirees do not make pretax HSA contributions through a cafeteria plan, after all. A 35 percent excise tax awaits those employers that violate the comparability rules.

In conclusion, wellness programs can play a key role in improving the health of an employer’s workforce, decreasing absenteeism, and reducing the costs of an employer’s medical plan. While most are familiar with the wellness-specific rules, it is important to be mindful of the tax considerations as well.

By Rich Glass. Mr. Glass is a health and welfare attorney for Mercer Health & Benefits LLC. He is a licensed attorney and brings more than 25 years of legal expertise, specializing in benefits and Human Resources, and is a contributing editor of BLR’s Flex Plan Handbook. 

[12/2018]

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