Alert / Retirement
Medical reimbursement scheme epic fail

Medical reimbursement scheme epic fail: Federal agencies shut down bogus program promising tax savings

Federal prosecutors recently obtained a criminal conviction against the purveyors of the “Classic 105” tax-avoidance scheme that was peddled to hundreds of employers over several years. The case serves as a reminder to employers to be wary of promoters of schemes promising too-good-to-be-true tax savings.

The operators of the Classic 105 scheme had promised employers large tax savings under the guise of a medical reimbursement arrangement. The operators pleaded guilty to money laundering, conspiracy to defraud the IRS and improperly marketing a multiple-employer welfare arrangement (MEWA).

Background

Programs such as the Classic 105 often result in what’s known as the impermissible “double dip.” They commonly operate as follows: First, employees agree to have a large pretax payroll deduction made through the employer’s Section 125 cafeteria plan, thereby reducing their wages subject to federal income tax and Federal Insurance Contributions Act (FICA) tax. This, in turn, creates significant tax savings to both employees and to the employer.

Second, the employer – or a third-party on behalf of the employer – “reimburses” the amount of the pretax deduction, ostensibly as a nontaxable medical expense reimbursement, so employees’ net take-home pay is restored, but with no tax on the restorative payment. In short, employees first reduce taxable wages and then receive the same amount in the form of a “nontaxable” benefit, hence, the double-dip on tax savings.

Lockton comment: FICA taxes are made up of both Social Security and Medicare taxes. Both employers and employees pay FICA taxes. Generally, both the employee and employer pay 6.2% of the employee’s wages (subject to a limit) in Social Security taxes and 1.45% of wages (not subject to a limit) in Medicare taxes.

For these kinds of pretax deductions, followed by nontaxable healthcare expense reimbursements, to comply with federal tax law, however, the employee must incur an out-of-pocket healthcare expense equal to the nontaxable reimbursement coming back to the employee.

Under the Classic 105 program, employee reimbursement took the form of a loan. Similar programs use wellness credits or advance payments of out-of-pocket medical expenses. Commonly, payments are made before any out-of-pocket medical expenses are incurred (if they’re ever incurred at all).

When an employer takes a pretax deduction from an employee’s paycheck, the IRS views that deduction as employer rather than employee money. This is why employees are not taxed on the deduction. The payments made to employees to reimburse the premium deductions commonly fail to qualify as legitimately nontaxable payments.

In short, under programs like the Classic 105, the employee has not incurred an “expense,” so there is nothing to be “reimbursed” in a tax-favored way at the time they receive a payout. Similarly, offering an employee an excessively large reward for performing a simple “wellness” task is, on its face, inconsistent. Where the employer – or a third party on its behalf – appears simply to return the pretax wages to the employee (for example, as a loan), the IRS considers that payment to be additional taxable compensation to the employee.

Fallout

The promoters of the Classic 105 plan obtained opinion letters from two national law firms touting the legitimacy of the program, which, according to the indictment, were based on false information provided by the promoters and further contained modifications made directly by the promoters. At its peak, over 350 employers and approximately 4,400 employees were enrolled in the Classic 105 program.

In August 2018, a grand jury indicted the principals of the Classic 105 program, alleging a conspiracy to defraud the IRS and accusing them of making false representations in marketing a MEWA. In addition to charging employers exorbitant administrative fees, the Classic 105 plan did not allow reimbursement for prescription drug claims, vision and dental expenses or expenses related to a preexisting pregnancy. Consequently, 80% of employee participants never submitted claims under the program.

Lockton comment: Although marketed as a single-employer plan, the contributions from the participating employers and their employees were pooled in a business operating checking account. The Department of Labor viewed this pooling of money as creating a MEWA. In addition, the principals used these funds to purchase luxury vehicles and real estate, clearly expenses that were not a valid use of such funds.

The Classic 105 scheme resulted in participating employers falling to pay more than $20 million in FICA taxes, in addition to causing individuals to underpay federal taxes. The IRS can pursue collection of these unpaid taxes from the affected businesses, and it can impose personal liability for the unlucky individuals who, on the employers’ end, were required to orchestrate withholding the taxes but failed to do so. In this case, the principals behind the scheme were prosecuted. However, the IRS might circle back to the participating employers and their employees and seek back taxes and perhaps penalties as well.

Conclusion

We have long cautioned employers to be cynical about wellness or other medical reimbursement programs that promise unrealistic tax benefits, even in instances when a law firm’s opinion letter is produced by the program’s promoter. Typically, promoters of these programs won’t pursue a ruling or opinion letter from the IRS or DOL because they know the agencies won’t issue favorable rulings. Even worse, they refuse to offer indemnification to their customers if the program doesn’t provide the desired tax benefits.

The IRS has issued several rulings over the past decade that repeatedly refute the tax benefits of the double-dip. This recent enforcement activity may be the tip of the iceberg in seeking to stop disreputable programs being marketed to and used by employers as impermissible tax savings vehicles.

Not legal advice: Nothing in this Alert should be construed as legal advice. Lockton may not be considered your legal counsel, and communications with Lockton's Compliance Services group are not privileged under the attorney-client privilege.

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