I recently worked with a large employer to transition their voluntary benefits (VB) from a traditional payroll deduction model to a more efficient split direct deposit model.  Most employers that are choosing to shift to a split direct deposit model are doing so because it allows them to eliminate the monthly billing and reconciliation chores that frustrate most HR departments when it comes to voluntary benefits.  But, when I asked this large group why they were switching to a direct deposit model, the answer was not just billing issues; it was because their broker had recommended they cease pre-taxing VB because of the tax implications now imposed by the IRS.

IRS rulings about the taxability of voluntary benefits paid for with pre-tax dollars through a Section 125 plan have always been an issue.  But today, the move away from pre-taxing of VB is stronger than ever, led by the large broker houses, consultants, and the good old IRS.

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

“CONCLUSION:  An employer may not exclude from an employee's gross income payments under an employer-provided fixed indemnity health plan if the value of the coverage was excluded from the employee's gross income and wages.  An employer may not exclude from an employee's gross income payments under an employer-provided fixed indemnity health plan if the premiums for the fixed indemnity health plan were originally made by salary reduction through a Section 125 plan.”

If you're interested, here is the full memo.

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

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

“Last year, the IRS issued a memorandum that changed the way we look at the taxability of fixed indemnity plans such as critical illness, accident insurance, and hospital indemnity coverage, when these benefits are purchased with pre-tax dollars or purchased by an employer for its employees [i.e., defined contribution].  The IRS recently updated its position on the taxability of fixed indemnity benefits, by clarifying that the amount that would be taxed would be the amount that was not adequately 'substantiated,' rather than the entire benefit amount paid by the plan.  For example, if I buy one of the aforementioned policies (and pay for premium on a pre-tax basis, or my employer pays the premium on my behalf), and the plan pays a flat fee of $75 for an office visit, but my co-pay for a doctor's visit is $25, the amount to be taxed is the difference between the amount reimbursed by the plan and the actual out-of-pocket cost incurred, in this case, $50.” 

“Currently, most carriers do not send out a Form 1099 for benefits paid under a fixed indemnity benefit, or make benefit payment information available to employers to address the tax implications of these plans.  For this reason, we recommend that employers offer these plans on a post-tax basis, or if premiums are paid for by employers [defined contribution], that wages are grossed up accordingly, to eliminate the tax liability associated with offering these benefits.”

Like the example above, many of the large brokers are highlighting pre-taxing of VB as a liability for the employer based on current IRS guidelines — and not worth the risk and accounting process to adjudicate employees' gross incomes.  So, it is no surprise that as brokers hold a larger share of the voluntary benefits market, pre-taxing is being de-emphasized.  According to the latest Eastbridge study, brokers now place more than 75 percent of all VB premium in the market; so their opinions matter.

According to the memo, defined contribution falls into the same liability scenario, because it is treated as if the premiums were pre-taxed by the employee. And as defined contribution gains steam in the market, brokers who are pushing DC are also pushing the shift to post-tax only.

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

John Hickman, an attorney with Alston and Bird, and a leading authority on these issues, wrote a piece to address the memo as well.  Here is an excerpt from that piece. Again, thank you for doing so in plain English.

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

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

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

For that, you can thank PPACA.

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

Nowadays, most voluntary plans have annual wellness benefits.  This is a benefit paid to the insured — usually between $50–$75 per family member insured — for a procedure that provides for preventative care.  If you are an agent or broker, you know exactly what I am talking about.

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

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

And although most lump-sum plans (mostly CI) are implemented post-tax, there are still millions of insureds with first-occurrence riders (up to $5,000–$10,000) on their cancer plans that are paid pre-tax.  Those benefits might fall into the tax liability category as well.

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

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

Every day, more companies are electing to stop payroll deduction and move their voluntary benefits to a zero-bill, post-tax, direct deposit model.

Driven largely by the broker community, the future of the market certainly points to the decline of the pre-tax model as a sales incentive.  And as an agent or broker, you should consult with your clients (or their CPA or attorney) and make sure they fully understand the implications of offering a Section 125 plan for their voluntary benefit offerings.

Now that there is a better way to offer “payroll deduction without the deduction,” and pre-taxing is becoming less appealing from a tax liability perspective, maybe now is the time for businesses and government entities that offer voluntary benefits to move towards a direct deposit model where no tax liability or monthly bill exists.