There has been a recent resurgence of Section 125 “abusive tax arrangement” plans. Many times these programs are marketed to smaller employers, with several variations that all appear to be too good to be true – allow a larger portion of an employee’s income to be put through a Section 125 program as a pre-tax premium payment for a qualified employee benefit program (typically a self-insured program), then allow those same premium payments to be reimbursed to the employee as a tax-free “benefit”. Older programs simply reimbursed the employee their premium for the program (which the IRS responded to in Revenue Ruling 2002-3), while newer programs provide the funds back to the employee in the form of a “benefit” payment when they participate in (essentially) trivial required program actions.

The “reimbursement/benefit” paid to the employee usually corresponds with a specific portion of their wages (higher wage employees have a larger deduction, so they receive a larger “reimbursement/benefit”).

These programs are touted as providing a win-win to employers and employees to pocket tax savings, while employees see no reduction in their take-home pay.

An employee is certainly able to have a pre-tax salary reduction for a qualified health plan. The issue is the tax-free “reimbursement/benefit” – which is not permissible, as explained in the attached IRS memorandum. “Reimbursements/benefits” are considered taxable if they are received for events that do not result in medical expenses for the participant.

The general rule is, taxation applies to either the premium for the plan or the benefit received through the plan. For example, if an employee purchased a disability policy and paid the premiums pre-tax through a Section 125 plan, any disability benefit received by the employee would be taxed. Conversely, the employee could receive disability benefits tax free if the employee paid the premiums with after tax dollars and did not put them through the Section 125 plan. However, Section 105 provides an exception to this rule with tax-free reimbursements for allowable expenses incurred for medical care. The list of allowable medical care expenses is 213(d) – the same list of expenses an employee can receive reimbursement for through a Flex (FSA) plan. 213(d) does not apply to reimbursements/benefits received by the employee whether or not they incur an actual cost for care. Therefore, the reimbursements under these “abusive tax arrangements” are considered taxable.

Please contact your NEEBCo representative if you have been approached by or have any questions about these types of programs.

Chief Counsel Memorandum Tax Treatment Fixed Indemnity Health Plans