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October 28, 2019

All that glitters not gold

Chris Beinecke

A Cautionary Tale about Certain Claimed Tax Savings Arrangements Disguised as Wellness Programs

Promoters have long pitched some variation of the following wellness program to employers:

  • Employees pay pre-tax contributions to participate in a self-insured group health plan;
  • During the course of the plan year, the plan returns most or all of the employee contributions to the employees for the completion of wellness-related activities[1]; and
  • The reimbursements are tax free to the participants.

This proposal obviously sounds amazing to prospective employers due to the potential payroll tax savings to the employer and the payroll and income tax savings to employees. Many promoters will even provide some sort of memorandum from the promoter’s legal counsel and/or other written articles supporting the arrangement’s compliance with applicable laws, such as the Internal Revenue Code (IRC).  

As the old saying goes, “If it sounds too good to be true, it usually is.”   

Buyer Beware

At least three of these types of arrangements have been either rejected outright or limited by the IRS for impermissible tax avoidance. 

  1. The Double Dip
    This arrangement is the oldest of the three and generally works as described above. Participants typically receive large reimbursements greatly exceeding any actual out-of-pocket medical expense and/or for completing pretty nominal wellness-related activities. These may include watching a webinar, attending a presentation providing general health information,  or attending general health counseling sessions. It may also include participating in more robust wellness activities such as biometric screening.

    The IRS has explicitly stated on several occasions that programs whose primary purpose is to refund pre-tax contributions as tax free reimbursements do not qualify for an income tax exclusion for the employee under IRC Sections 105 or 106 when the reimbursements are disproportionately larger than any actual out-of-pocket medical expense (please see Revenue Ruling 2002-3). Despite this clear position, the Double Dip continues to pop up. The U.S. Department of Justice recently convicted the promoters of a Double Dip known as the Classic 105.

  2. The Sleight of Hand
    Under the Sleight of Hand arrangement, employees pay a small contribution toward the self-insured group health plan on an after-tax basis. The arrangement may or may not also involve the employees paying significantly larger pre-tax contributions toward coverage. Similar to the Double Dip, participants typically receive large reimbursements greatly exceeding any actual out-of-pocket medical expense and/or for completing wellness-related activities.

    The Sleight of Hand is an attempt to move the tax exclusion away from IRC Sections 105 and 106 to IRC Section 104(a)(3) and avoid the IRS’ unfavorable Double Dip guidance on disproportionately large reimbursements. Under IRC Section 104(a)(3), benefits are not taxable to the recipient if the health insurance coverage (or an arrangement that operates like health insurance) is not paid for on a tax free basis. 

    In IRS Chief Counsel Memorandum 201719025 (released May 12, 2017), the IRS indicated that IRC Section 104(a)(3) does not apply to these arrangements, because the plan cannot qualify as health insurance (or an arrangement that operates like health insurance). This is because there is no actual insurance risk for the participants, all or nearly all of whom are virtually guaranteed to receive benefits far in excess of their after-tax contributions. In addition, the IRS believes this demonstrates a significant portion of the coverage is really being provided on a tax free basis. As a result, the excess of the benefits received over the amount of any after-tax contribution should be treated as taxable income to the employee.

  3. The Flex Credit Switch
    This arrangement is similar to the Double Dip or Sleight of Hand, but with a twist. Under the Flex Credit Switch, some or all of the benefits received from the self-insured group health plan are provided as flex credits that can be used to purchase other benefits on a pre-tax basis through the client’s IRC Section 125 cafeteria plan instead of being provided as direct reimbursements.   

    If the flex credits are used to purchase non-taxable benefits under the cafeteria plan, the flex credits are excluded from the employee’s taxable income. A “non-taxable benefit” is a benefit that can both be paid for on a pre-tax basis and provide tax free benefits to participants. In other words, the Flex Credit Switch works when the flex credits are used for non-taxable benefits.

    This makes sense, because the entire exercise amounts to the employee deferring otherwise taxable income to make pre-tax cafeteria plan elections. But…there’s a catch.

    Under many Flex Credit Switch arrangements, the benefits that can be purchased with the flex credits are actually taxable benefits. This means the benefits cannot both be paid for on a pre-tax basis and provide tax free benefits. When this is the case, the flex credits are included in the employee’s taxable income (please see IRS Chief Counsel Memorandum 201719025, Situation #2).

Examples of problematic taxable benefits include:

  • Most accident and disability benefit products;
  • Whole and variable life insurance products;
  • Supplemental term life insurance products in excess of $50,000;[1]
  • Most fixed indemnity products;[2] and
  • Gym memberships.[3]


We believe permitting employees to pay pre-tax for many fixed indemnity products will also cause them to be considered ERISA plans sponsored by the employer if this wasn’t already the case.

Our Recommendation

We strongly recommend against relying on an opinion letter, memorandum, or articles provided by a promoter selling the claimed tax saving arrangement. We strongly recommend reviewing any claimed tax savings arrangement with your own legal counsel and/or tax advisor before signing up and offering the program to your employees.

[1] The difference, if any, tends to be used to compensate the promoter unless the promoter is paid through other means.

[2] The IRC and related rules only permit the first $50,000 of coverage to be paid for on a tax free basis.

[3] Most indemnity products can provide benefits in excess of unreimbursed medical expenses and are considered at least partially taxable benefits.

[4] We addressed the tax consequences for employer-provided gym memberships in an earlier article.