A program that promises to increase employee take-home pay without increasing compensation should make any employer pause. Yet that is exactly the pitch behind a growing number of Section 125 “wellness” arrangements now being marketed to businesses.
The setup sounds appealing: employees redirect a portion of their wages into a health and wellness program, complete a minimal wellness activity, and receive most of the money back as a tax-free reimbursement. The employer lowers payroll taxes. The employee takes home more pay. The promoter collects its fee. On paper, everyone wins.
In practice, these arrangements may be doing something far riskier: taking ordinary wages, routing them through an insurance product, and calling the result a tax-free medical reimbursement, when in reality, it’s nothing of the sort.
*
Legitimate Section 125 cafeteria plans have been around for decades. They allow employees to choose between taxable cash compensation and qualified non-taxable benefits. In a standard plan, an employee may reduce taxable wages on a pre-tax basis to pay for eligible medical or dependent care expenses. This lowers the employee’s income and FICA taxes while also reducing the employer’s payroll tax liability. It is a well-established, IRS-approved structure.
The version now being marketed to employers works very differently:
Consider an employee earning $100,000 annually. Under a wellness arrangement, the employee elects to divert $15,000 of compensation into the wellness program on a pre-tax basis, lowering reported taxable wages to $85,000.
Of that $15,000, roughly $2,000 covers the cost of the wellness program, insurance coverage, administrative fees, or the stated value of the wellness services themselves. The remaining $13,000 is paid back to the employee as a supposed tax-free medical reimbursement.
To trigger that payment, the employee completes a “wellness activity” — often something minimal, such as a monthly online therapy session or a call with a nurse. A claim is submitted, and the employee receives the cash reimbursement directly.
The legal theory is that these reimbursed payments are not wages, so they are not subject to income tax withholding, employee FICA, or employer FICA. The employee nets roughly $98,000 — $85,000 in reported wages plus $13,000 in tax-free reimbursements.
These arrangements rely on fixed-indemnity insurance tied to the wellness activity. In a traditional setting, that kind of policy might pay a set dollar amount when a defined medical event occurs, such as a hospitalization or injury, regardless of the actual bill. Here, the same concept is applied to low-friction wellness activities, and the resulting payments are presented as fully non-taxable benefits.
The problem is that the employee has a responsibility to report the difference between the reimbursement received and the actual value of the benefit received on their income tax return. This is explained in the Explanation of Benefits employees will receive monthly from the wellness provider; but these letters often go unnoticed—despite the red “Important Tax Information Enclosed” emblazoned on the envelope.
In the example above, the employee receives $13,000 in reimbursement but receives only $2,000 in actual benefit. The $13,000 gap is taxable income.
Both the law and the IRS Office of Chief Counsel (in Memorandum Number 202323006) state this clearly. These reimbursements constitute taxable income unless tied to actual unreimbursed medical expenses.
The legal opinion obtained by these programs shields the employer from treating the payments as wages for tax withholding and FICA purposes, allowing the employer to remain compliant. What it does not do is address the employee’s tax obligation when the value of the medical benefit received is lower than the reimbursement.
Wellness program providers bury that nuance in dense legal language, while their marketing focuses entirely on the payroll tax savings. But burying the obligation does not make it disappear.
What this really amounts to is a transfer of complexity — and risk — from the employer to the employees. Most programs try to hand-wave this by saying employees should use the reimbursement for other qualified medical expenses. That is a weak argument, given that most employees will never understand what they have signed up for in the first place.
The IRS scrutiny Section 125 “wellness” arrangements invite is just the beginning.
Lower reported wages create unintended consequences for employees who are completely unaware that’s what they signed up for. Applying for a mortgage, leasing a vehicle, seeking credit, or verifying income for any other financial purpose becomes problematic when the employee tells the lender they earn $100,000 but wage records show $85,000. Questions are inevitable.
These programs also place a significant administrative burden on the employer. Employee enrollment, signed acknowledgements, participation tracking, insurance documentation, and ongoing compliance procedures all add up. And then there is the challenge of explaining any of this to people who simply want the maximum take-home paycheck they can get. In one audit we oversaw, most employees did not even attend the wellness session but still received reimbursement payments.
*
Every tax professional has a version of this story to tell. Arrangements are marketed as innovative ways to generate substantial tax savings through overly aggressive interpretations of existing rules. History suggests they rarely hold up once regulators begin paying closer attention.
This specific use of Section 125 benefits has been on the IRS radar since 2016. Memorandum 202323006 is not the first guidance issued to address wellness indemnity arrangements and their tax treatment.
Consider the parallel to micro-captive insurance arrangements. That strategy began with a legitimate concept — businesses creating captive insurance companies to insure legitimate risks. It was marketed aggressively as a tax shelter and eventually drew heavy IRS scrutiny. As Barron’s reported, the IRS has been cracking down on micro-captives used by small businesses and partnerships to deduct large insurance premiums while facing few real claims. This Section 125 wellness version has a similar smell: a real benefit structure stretched into a payroll tax strategy, with employers and employees left to manage the consequences after the promoter has moved on.
When it all goes wrong, it is the participants — not the third-party provider of these “wellness programs” — who are left untangling years of complexity they never fully understood.
*
A wellness program should not be confused with a legitimate tax strategy. If the provider talks more about tax benefits than actual wellness, caution is warranted.
The best employee benefit programs are easy to explain and administer, and they deliver genuine value. If the main selling point is that somehow everyone pays less tax without any change in the underlying economics, it is time to ask a critical question:
Is this really an employee benefit? Or is it a questionable arrangement with nothing but IRS scrutiny in its future?
No professional company operates with these risks. Neither should yours.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
