A recently released internal IRS memorandum has clarified how the tax code will treat cash benefits paid from voluntary hospital indemnity plans.

Issued from the office of the IRS General Counsel, the memo addresses the tax exposure of employer payments to indemnity plans and in cases where the employee premiums are deducted from the employee’s income through a 125 cafeteria plan.

In each of those cases, the benefits are taxable and employers must report them as paid income, according to the memo.

“This is a significant clarification,” says Andy Anderson, a partner at Morgan Lewis and head of the law firm’s employee benefits practice health and welfare task force. “It will be good news for employers that offer indemnity plans and have the employees pay for the benefits with after-tax dollars. But for those employers that pay the premiums on the plans or allow employees to purchase the policies through cafeteria plans with pre-tax compensation, this will require some changes.”

According to Anderson, there has been longstanding confusion over the tax implications of indemnity policies offered through the workplace.

Indemnity plans, as defined by the IRS memo, pay cash benefits upon the occurrence of certain health-related events — like hospital admission — without regard to the cost of medical treatment received.

A growing number of insurers have entered the voluntary indemnity market since the ACA was passed as a way to market gap coverage alongside high-deductible major medical plans.

“Whether or not the cash from polices is taxable has been difficult to pin down for employers, benefits brokers and even the IRS,” Anderson says. “It’s the million dollar question with respect to indemnity policies.”

Adding to the confusion is the fact that carriers have marketed the policies without clear language on their tax implications, says Anderson.

The good news is that benefits from policies purchased with employees’ own after-tax dollars are not taxed, which means that brokers would be advised to recommend that employers only offer the policies as a purely voluntary benefit.

“I don’t see a scenario where employers will continue to offer these plans for free,” Anderson says.

The IRS memo is not legally binding in the same way as a law or regulation, but it does articulate how the agency interprets the taxability of indemnity benefits.

Under the IRS code, health care benefits offered under major medical plans do not qualify as taxable compensation.

But indemnity plans don’t cover medical treatment. Rather, they pay a cash benefit to cover any expenses incurred in the event of hospitalization.

That has always been the rub with the IRS, says Anderson.

“Indemnity policies pay a fixed dollar amount regardless of the size or scope of medical expenses,” he says. “That has always troubled the IRS. These are cash benefits, not health care benefits, and the cash payments have no relationship to out-of-pocket medical expenses.”

Indemnity market still alive and well, but questions remain for group policies

Benefits brokers should not interpret the IRS memo as a threat to the voluntary hospital indemnity market.

“These products are alive and kicking,” says Anderson. “But brokers need to help employers understand that if they are not offering the products on a pure voluntary basis, there are downstream tax issues.”

The basic rule of thumb going forward? The less direct involvement employers have in hospital indemnity plans, the more likely they are to offer the policies in compliance with tax law.

Employers that do continue to pay for indemnity premiums will have considerable accounting and communication requirements to fulfill to remain in compliance. Collecting information on benefits payments from participants with indemnity plans in order to report payroll taxes would require a level of effort in which few employers can be expected to invest, says Anderson.

But less clear, and what the IRS memo does not address, is the question of voluntary indemnity policies offered through the workplace at a group discount.

In the group voluntary market, participants have the advantage of more competitive policy pricing than the retail market. Those group policy discounts raise the question of whether some portion of the benefits payments under the contracts are taxable, given the relationship of the policies to the employer.

“When insurers reduce rates through the group market, one thought is that the IRS would conclude that the benefit payments are an outgrowth of the work relationship, meaning some portion of the benefit is employer provided,” explains Anderson.

And that could mean that employers would have to report some portion of the benefits paid from group voluntary indemnity policies and participants would have to pay taxes on some portion of the benefits.

But the tax implications of group voluntary indemnity policies remain unaddressed for the time being, and will likely require guidance from the Labor Department’s Employee Benefits Security Administration, says Anderson.

“The IRS memo goes nowhere near addressing the tax implications of group voluntary indemnity policies,” says Anderson.