IRS draws a bead on fixed indemnity plans

Fixed indemnity plans pay employees a set amount of cash for, say, going to the doctor or participating in a health risk assessment. The IRS has now concluded that fixed indemnity plan benefits are fully taxable if the average amount employees receive predictably exceeds their after-tax contributions. (ILM 201719025)

Risky business. According to the IRS, the key to excluding fixed indemnity plan benefits from employees’ income is that there is an insurance risk—that is, there is adequate risk shifting from one party to another. In neither of the two following examples was there adequate risk shifting; the expenses were likely to be incurred and they weren’t subject to an actuarial evaluation.

Example. AlBee, Inc. has a major medical plan and a self-insured fixed indemnity plan. Employees who participate in the indemnity plan contribute $60 a month in after-tax dollars, but receive $1,425 per activity (e.g., calling a toll-free number that provides general health-related information). An actuarial analysis concludes that almost all employees will receive benefits under the plan that exceed their after-tax premiums.

IRS: This isn’t insurance because the arrangement doesn’t involve any risk of economic loss or fortuitous event. Conclusion: $1,365 ($1,425 – $60) is fully taxable as wages. If this happens every month, $16,380 is taxable.

Example. In addition to the major medical plan and the self-insured fixed indemnity plan, AlBee layers in a free wellness plan that’s available through its cafeteria plan. Employees who participate in the wellness plan contribute $1,500 a month on a pretax basis, in addition to paying for their major medical coverage and $60 a month for the fixed indemnity coverage.

How the plans mesh: If employees’ take-home pay after receiving their fixed cash payment from the indemnity plan exceeds what they would have taken home had they not participated in the indemnity plan, which is likely, the wellness plan converts that excess into flex credits that employees can use for other cafeteria plan benefits. Bottom line: Employees who participate in both plans take home the same amount of pay.

IRS: The result is the same. The excess amounts employees receive from the indemnity plan are fully taxable. The flex credits aren’t taxable, unless employees buy taxable benefits through the cafeteria plan.

GREAT RISK, LITTLE REWARD: Fixed indemnity plans took off after the Affordable Care Act was enacted, because benefits are considered excepted benefits—plans don’t have to comply with any market reforms. Promoters know this and are selling these plans by waiving around a long list of impressive clients.

Don’t be fooled. You won’t be able to recoup your losses from these promoters once the IRS levies penalties and interest against you.

Fixed indemnity plans have a place in your health insurance offerings, but only if they’re done the right way. Generally, employees must pay with after-tax dollars and the benefits must be commensurate with their expenses. If you’re not sure, ask your broker or tax pro.