When people talk about compliance for self-funded health plans, the conversation usually starts and ends with ERISA. And that’s for good reason: ERISA sets the stage for most of the visible aspects of a plan’s core functionality, such as fiduciary duties, claims procedures, and plan documents. If there’s a lawsuit over benefits, odds are you’ll find ERISA at the center of it.
But ERISA is only part of the story. Behind this visible scaffolding sits a quieter authority that shapes whether any of these plans actually make financial sense: the Internal Revenue Code. While ERISA asks core underlying questions such as whether a plan validly exists to begin with, the IRC decides whether the dollars that flow through it get to do so tax-free. The moment that tax shelter crumbles, the plan’s entire value proposition can collapse alongside it, for the employer and participants alike.
That’s the power of the IRS: it’s the gatekeeper to the tax savings that make self-funded plans worth the effort in the first place. ERISA may run the more visible day-to-day aspects such as claims, appeals, and fiduciary procedure, but the tax code sets the conditions for the whole arrangement to qualify as a tax shelter to begin with. Miss a rule, even a very technical one, and the IRS can strip the plan of its favored status for everyone, not just the person who made the mistake. In the tax world, there are very few situations where good faith and reasonable decisions are compliant even when they don’t strictly comply with the law; the IRS has historically disavowed any type of “close enough” mentality, because a little latitude can turn into an unfair advantage, or an outright abuse. The strictness may seem like red tape for red tape’s sake, but the official justification is that it keeps the playing field level and the system administratively manageable for all employers without needing a complex system of exceptions and special enforcement.
We see this tension play out the moment an employee enrolls. For most, that enrollment happens through a cafeteria plan under Section 125 (i.e., the tax mechanism that allows employee contributions to be withheld from payroll on a pre-tax basis). On paper, it’s a simple promise: the employee can make an election, pay for it pre-tax, and once an election is made, it’s locked for the year, unless the IRS’s narrow list of life events says otherwise.
But reality isn’t always quite so neat and simple. Employees are humans, and so are HR reps. Maybe an employee’s spouse takes a new job with better coverage mid-year; maybe someone moves a couple of towns over and the plan’s network is still usable, but not quite as helpful as it once was; maybe an employee didn’t realize that his spouse became eligible for better and more affordable coverage in the midst of the plan year. HR, wanting to help, approves a mid-year change. Payroll adjusts the deduction accordingly. Everyone is happy!
Everyone except for the IRS, that is. Payroll and plan audits happen, at both the personal level and at the employer or TPA level. Under the regulations, an impermissible election change converts that entire year’s worth of pre-tax contributions into taxable wages, with the potential for penalties and interest as well. Benefits consulting firms see this type of thing all too often – all because HR wanted to do right by their valued employees. In fact, even a single impermissible election change can threaten the tax-favored status of the entire cafeteria plan, potentially resulting in all participants’ pre-tax contributions being reclassified as taxable income. This is what the IRS calls “constructive receipt” – a principle that taxes an individual on income they have a right to receive, even if they don’t actually take possession of it.
Even if elections are handled flawlessly, though, risks to tax-favored status can arise from the plan’s very structure, and one prime example is when leadership perks come into play. The Section 105(h) rule prohibiting discrimination in favor of highly-compensated individuals is generally well-known yet still is not quite simple. But rather than being a benefit rule or something the plan has to comply with, let’s frame it correctly: it’s a tax law.
In competitive industries, it’s tempting to sweeten benefits for key executives: waive the waiting period, lower the deductible, and add a few special benefits that don’t apply to the rest of the employees. ERISA won’t stand in the way if the plan language supports it. In many ways, ERISA is just a big softie – like a loving aunt who lets her nephew get away with anything. But the IRC isn’t quite so forgiving. The tax code sees this favoritism as a threat to fairness across plan participants, and hits right where it hurts: not by faulting or penalizing the plan, but by reclassifying those extra benefits as taxable income. This is the IRS’ way of saying that if an employer wants to recruit top talent with incentives, it has to be taxable.
This tension between well-meaning flexibility and strict tax rules extends beyond plan design and into day-to-day administration. Take COBRA, for instance. Just like ERISA, COBRA is very much its own independent law, and yet the intersection with the IRS’ rules happens without warning. Employers often offer to pay some or all of an employee’s COBRA premium as a part of a severance package. But what feels like it should be a simple plan perk (after all, the employer can simply offer coverage; it doesn’t need to actually pay itself) is generally taxable income like most other personal obligations that an employer satisfies on an individual’s behalf. If the employer lumps the COBRA premium in as a pre-tax benefit through a cafeteria plan for someone who’s no longer eligible (whether for simplicity, by mistake, or as a way to intentionally reap tax benefits from the money), the employer has effectively paid out untaxed compensation.
Sometimes, too, a provider will pay the individual’s COBRA premium to keep those group health plan payments coming in the door instead of switching to, for instance, Medicare (dialysis providers are a prime example). Given the complexity of the tax and health insurance systems in this country, it isn’t surprising that many employees (or even plans, employers, or providers) don’t realize that payment of an individual’s COBRA premiums isn’t just a generous no-strings-attached gift – but the fact is, it’s not. Like so many aspects of the IRS’ regulation, it doesn’t quite control the who, the what, or the why, but it does control the how: after taxes, that’s how.
The same “extra dollars” trap shows up when a plan caps its payment, then blows past its own ceiling to settle a balance-bill dispute in good faith. Many self-funded plans set a hard payment limit, such as RBP plans that cap payments at a percentage of Medicare, or even at the “lesser of” a contracted rate or 150% of Medicare, etc. Many such plans are willing to negotiate balance billing settlements, often out of sheer operational necessity. On paper, the cap protects the plan from violating its duty under ERISA to abide by the terms of the plan document; in practice, however, a desperate plan with an aggrieved member may bump up its payment offer to make the balance bill disappear, and that can have tax consequences.
Intuitively, and per ERISA, the plan’s written limit is the plan’s stated obligation. When a plan sets a hard limit without accounting for negotiated rates, the plan is effectively disavowing any payment responsibility for any amounts above that hard limit, so anything above it amounts to cash that the employer pays to settle the plan member’s medical debt. There’s that “constructive receipt” doctrine again: even though the plan may physically pay the additional money, if the plan isn’t permitted to pay it as a benefit, it’s not a benefit, and it’s instead taxable income paid to the member. Few sponsors realize this, and even fewer payroll systems are set up to issue a W-2 for a midyear settlement check.
Despite the rigidity, legislative twists can nonetheless change the rules mid-game, and the One Big Beautiful Bill Act (OBBBA) is the freshest example. Passed after years of patchwork pandemic safe harbors that kept employers guessing whether offering virtual visits or DPC memberships would unexpectedly disqualify their employees’ HSAs for the coming year, the OBBBA directly addresses this uncertainty. With remote care here to stay – and a significant lobbying push from employers and DPC supporters – Congress finally gave HDHPs a reliable way to conform to modern care models. The OBBBA permanently allows first-dollar telehealth coverage for HDHPs, preserving HSA eligibility even for non-preventive services. It also clarifies that certain DPC arrangements and wellness benefits are inherently HSA-compatible. These changes resolve years of regulatory uncertainty and give plan sponsors and TPAs a clearer compliance roadmap.
The twist is that Congress didn’t rewrite the definition of a medical expense or change anything inherent in the DPC or telehealth models; it simply made a new rule for the IRS and changed the tax boundary line. Once again, the story is the same, even though it exerts influence from the rings rather than from center stage: whether a plan stays compliant often doesn’t have anything to do with ERISA; it hinges on how the IRS treats each dollar, and where the line is between wage and benefit.
Across all these moments, from initial enrollment to COBRA, the theme is the same. The plan sponsor is trying to be flexible, supportive, and competitive. But the tax code doesn’t put much stock into what might seem reasonable, fair, or important from a business perspective; it cares whether each taxable dollar given to an individual is appropriately taxed.
Managing a self-funded health plan isn’t just about reading ERISA in black and white, or even the many shades of grey inherent in the framework. In addition to the common question of whether ERISA permits a certain plan change, procedure, or payment, each decision should also entail the question of whether the IRS would as well. Losing the tax-advantaged protection makes dollars and processes that once looked so efficient unravel into back taxes, penalties, interest, frustrated employees, and a great deal more risk than just medical claims.
In the end, the real compliance work happens in the small, boring moments: documenting life event changes, double-checking executive perks, verifying wellness claims, auditing COBRA deductions. Even a small, seemingly innocuous change, error, or overlooked dollar can have ballooning tax implications. Plan sponsors and their TPAs should ensure that the IRS and its governing Code doesn’t go overlooked for what seem like minor decisions, especially since ignoring the IRC in the margins can rewrite an entire balance sheet overnight.
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