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I recently worked with a large employer to transition theirvoluntary benefits (VB) from a traditionalpayroll deduction model to a more efficient split direct depositmodel.  Most employers that are choosing to shift to asplit direct deposit model are doing so because it allows them toeliminate the monthly billing and reconciliation chores thatfrustrate most HR departments when it comes to voluntarybenefits.  But, when I asked this large group why theywere switching to a direct deposit model, the answer was not justbilling issues; it was because their broker had recommended theycease pre-taxing VB because of the tax implications now imposed bythe IRS.

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IRS rulings about the taxability of voluntary benefits paid forwith pre-tax dollars through a Section 125 plan have always been anissue.  But today, the move away from pre-taxing of VB isstronger than ever, led by the large broker houses, consultants, and the goodold IRS.

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A recent IRS memorandum from the Office of Chief Counsel statesthe following as it pertains to the taxability of payments fromfixed indemnity health plans (i.e., voluntary benefits). Here is an excerpt from the memorandum:

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“CONCLUSION:  An employer may not exclude from anemployee's gross income payments under an employer-provided fixedindemnity health plan if the value of the coverage was excludedfrom the employee's gross income and wages.  An employermay not exclude from an employee's gross income payments under anemployer-provided fixed indemnity health plan if the premiums forthe fixed indemnity health plan were originally made by salaryreduction through a Section 125 plan.”

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If you're interested, here is the fullmemo.

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As always, the IRS memorandums are about as clear as mud to theaverage person.  Thankfully, there are professionals whoare paid to interpret them for the rest of us.  So let'sreview a couple of those interpretations.

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HUB International, the nation's seventh largest insurancebroker, is now recommending that their clients offer voluntaryplans only on a post-tax basis.  Hats off to HUB forwriting a synopsis that the average insurance agent and broker canunderstand.  Here is an excerpt from their letter toclients, titled “Should we recommend pre- or post-tax?”

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“Last year, the IRS issued a memorandum that changed the waywe look at the taxability of fixed indemnity plans such as criticalillness, accident insurance, and hospital indemnity coverage, whenthese benefits are purchased with pre-tax dollars or purchased byan employer for its employees [i.e., definedcontribution].  The IRS recently updated its position onthe taxability of fixed indemnity benefits, by clarifying that theamount that would be taxed would be the amount that was notadequately 'substantiated,' rather than the entire benefit amountpaid by the plan.  For example, if I buy one of theaforementioned policies (and pay for premium on a pre-tax basis, ormy employer pays the premium on my behalf), and the plan pays aflat fee of $75 for an office visit, but my co-pay for a doctor'svisit is $25, the amount to be taxed is the difference between theamount reimbursed by the plan and the actual out-of-pocket costincurred, in this case, $50.” 

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“Currently, most carriers do not send out a Form 1099 forbenefits paid under a fixed indemnity benefit, or make benefitpayment information available to employers to address the taximplications of these plans.  For this reason, werecommend that employers offer these plans on a post-tax basis, orif premiums are paid for by employers [defined contribution], thatwages are grossed up accordingly, to eliminate the tax liabilityassociated with offering these benefits.”

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Like the example above, many of the large brokers arehighlighting pre-taxing of VB as a liability for the employer basedon current IRS guidelines — and not worth the risk and accountingprocess to adjudicate employees' gross incomes.  So, it isno surprise that as brokers hold a larger share of the voluntarybenefits market, pre-taxing is being de-emphasized. According to the latest Eastbridge study, brokers now place morethan 75 percent of all VB premium in the market; so their opinionsmatter.

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According to the memo, defined contribution falls into the sameliability scenario, because it is treated as if the premiums werepre-taxed by the employee. And as defined contribution gains steamin the market, brokers who are pushing DC are also pushing theshift to post-tax only.

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So as brokers push further downstream into the market (smalleremployers) and defined contribution becomes more commonplace, therecommendation to cease pre-taxing VB grows stronger every day.

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John Hickman, an attorney with Alston and Bird, and a leadingauthority on these issues, wrote a piece to address the memo aswell.  Here is an excerpt from that piece. Again, thankyou for doing so in plain English.

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“If the premiums are paid on a pre-tax basis throughemployer contributions or employee pretax salary reduction througha cafeteria plan, then whether the benefits are taxable depends onthe individual's unreimbursed medical expenses.  If theamount paid under the policy does not exceed the individual'sunreimbursed medical expenses, then the amount received is notincludable in the employee's income.  However, if theamount received under the fixed indemnity policy is more than theindividual's unreimbursed medical expenses, then the excess istaxable.”

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He goes on to say, “The recent memo also includes a helpfulexample of a traditional fixed indemnity health plan that paysfixed amounts on the occurrence of health events such as a medicaloffice visit or hospital stay where the premiums for the policy arepaid on a pre-tax basis through a cafeteria plan.  Theplan pays $200 for a medical office visit.  If the coveredindividual's unreimbursed medical costs as a result of the visitwere $30, then $30 would be excluded from the employee's income,and the excess amount of $170 would be taxable”.

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You may be asking yourself, “Yeah, I get it, but when does a VBpayment actually exceed the unreimbursed medical costs to trigger this taxissue?  Paying $100 a day for a hospital room surelydoesn't exceed the actual cost?  It's supplemental,right?  So where's the danger of the tax liability comeinto play?”

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For that, you can thank PPACA.

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With ACA/Obamacare, these rulings now actually have meaning forthe VB market.  Currently, the law provides for 66 no-costpreventative care services; from mammograms to coloscopies toimmunization vaccines.

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Nowadays, most voluntary plans have annual wellnessbenefits.  This is a benefit paid to the insured — usuallybetween $50–$75 per family member insured — for a procedure thatprovides for preventative care.  If you are an agent orbroker, you know exactly what I am talking about.

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But if you submit a wellness benefit claim for a preventativeservice for which you had no unreimbursed medical costs (such asACA preventative services) and you pay the premium pre-tax, youremployer is required to include that wellness benefit payment inyour gross income — and to pay matching FICA on it!  Butcurrently, carriers do not share that information with the employerto make them compliant with the IRS guidelines.  And thisis why HUB and many others are recommending their clients ceasepre-tax to eliminate the accounting process and tax liability untila process is put in place to ensure compliance.

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Remember, wellness benefits are estimated to be approximately 70percent of the claims — in terms of number of claims paid — by VBcarriers.  So in that sense, 70 percent of claims paymentsmay very well be triggering a tax liability on behalf of theemployee and a burden on the employer to pass that liability on tothe employee's gross income.

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And although most lump-sum plans (mostly CI) are implementedpost-tax, there are still millions of insureds withfirst-occurrence riders (up to $5,000–$10,000) on their cancerplans that are paid pre-tax.  Those benefits might fallinto the tax liability category as well.

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Also read: My wife's story: Anatomy of an insane health carebilling system

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Without the tax savings incentive, many clients lose theappetite to continue payroll deduction — and the laborious billingand reconciliation process that goes along with it. Remember, over half of clients that drop VB offerings cite “billingissues” as the primary reason.  Why continue to be thebanker and accountant for the carrier if there is no tax savings inthe offering?  Why would the client not shift the premiumprocess to a premium direct deposit model, which eliminates theemployer's burden of collecting the premium from its employees,receiving a monthly carrier bill, reconciling it, and remitting themoney in a timely manner, every 30 days?

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Every day, more companies are electing to stop payroll deductionand move their voluntary benefits to a zero-bill, post-tax, directdeposit model.

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Driven largely by the broker community, the future of the marketcertainly points to the decline of the pre-tax model as a salesincentive.  And as an agent or broker, you should consultwith your clients (or their CPA or attorney) and make sure theyfully understand the implications of offering a Section 125 planfor their voluntary benefit offerings.

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Now that there is a better way to offer “payroll deductionwithout the deduction,” and pre-taxing is becoming less appealingfrom a tax liability perspective, maybe now is the time forbusinesses and government entities that offer voluntary benefits tomove towards a direct deposit model where no tax liability ormonthly bill exists.

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