Beware of “Zero-Cost” Payroll Tax Savings Plans
When wellness benefits, Section 125 deductions and tax savings leave the employer holding all the risk
By Restaurant Accounting Services
A salesperson approaches your company with what sounds like an extraordinary opportunity.
Your employees will receive new health and wellness benefits. Their take-home pay may increase. Your company may save hundreds of dollars per employee in payroll taxes. The program will supposedly have little or no net cost to either the employer or the employees.
The arrangement is described as compliant with the Affordable Care Act and Sections 105 and 125 of the Internal Revenue Code.
What could possibly go wrong?
Potentially, quite a lot.
The problem is not that Section 125 cafeteria plans are inherently improper. They are legitimate and widely used. The problem begins when a complicated arrangement involving payroll deductions, self-funded medical reimbursements, insurance products, wellness services and recurring employee payments is marketed as a simple, risk-free source of tax savings.
Before signing anything, employers should stop listening to the presentation and start reading the contract.
The Sales Pitch
These programs are often marketed using some combination of the following claims:
- The employer will save payroll taxes.
- Employees will receive higher take-home pay.
- Employees will receive telehealth, prescription, wellness or supplemental insurance benefits.
- The program will not interfere with the company’s existing health insurance.
- The program will create no meaningful cost for the employer.
- The program will create no reduction in employee pay.
- Administration will be handled by the provider.
The presentation may refer to the arrangement as a tax-efficiency program, preventive-care program, wellness program, self-insured medical reimbursement plan, Section 125 plan or payroll-tax savings program.
Whatever name is used, the underlying concept is often similar.
Employee compensation is reduced on a pretax basis. Health, wellness or insurance-related benefits are provided. Employees may receive reimbursements or benefit payments through payroll. The employer saves payroll taxes on the pretax amounts, and part of those savings helps support the cost of the program.
On a sales slide, this can look like free money.
In the contract, it may look very different.
The Question Every Employer Should Ask
When everyone appears to receive more and nobody appears to pay, the employer should ask:
Where does the money come from, and who carries the risk if the tax treatment is challenged?
The answer may be: the employer.
In one actual set of agreements we reviewed, the employer was not merely purchasing a supplemental benefit. The employer was adopting a self-insured medical reimbursement plan and assuming significant responsibility for its operation.
The contract stated that the employer retained final authority and responsibility for the plan, determined eligibility for claim reimbursements, funded those reimbursements and remained responsible for legal reporting and disclosure obligations.
That is a very different proposition from simply purchasing a no-cost wellness benefit.
The Employer May Become the Plan Sponsor, Administrator and Self-Insurer
Employers may assume that the company selling the program will manage the legal and administrative obligations.
The contract may say otherwise.
The agreements RAS has reviewed provided that the employer would be considered the plan administrator and plan sponsor for ERISA purposes. The employer retained final responsibility for benefit decisions, denied claims, plan expenses and the payment of benefits.
The employer was also required to establish a bank account for the plan, deposit sufficient funds to pay benefits and remain liable for benefit checks issued by the third-party administrator.
The agreement stated plainly that the third-party administrator had no responsibility, risk or obligation to fund the plan. Funding was solely the employer’s responsibility.
In other words, the employer was not simply receiving a payroll-tax benefit.
The employer was becoming the financial backstop for a self-funded medical reimbursement arrangement.
The Tax Savings May Not Be Guaranteed
The financial appeal of these programs often depends heavily on favorable tax treatment.
That makes the tax-disclaimer language especially important.
In the plan we reviewed, the documents stated that the employer did not guarantee that the benefits would be tax-free to employees under federal or state law.
A separate Section 125 document also included a disclaimer that there were no guarantees regarding tax treatment.
That should give every employer pause.
If the core economic benefit is payroll-tax savings, but the contract does not guarantee the intended tax result, the employer must determine who bears the cost if the treatment is later challenged.
Possible consequences could include:
- additional payroll taxes;
- amended payroll-tax returns;
- interest and penalties;
- employee W-2 corrections;
- accounting and legal fees;
- Department of Labor or IRS inquiries;
- employee complaints or benefit disputes.
A salesperson’s assurance is not the same as a written legal opinion addressing the exact program and its exact payroll mechanics.
Automatic Reimbursements Deserve Careful Review
Another area requiring close scrutiny is the way employee reimbursements are generated.
The employee materials we reviewed stated that claims could be processed automatically, that documentation would not ordinarily be required unless requested, and that reimbursements would be paid in line with the employee’s normal payroll schedule.
The formal plan document similarly linked automatic claim processing to an employee remaining current and compliant with the digital wellness program.
At the same time, the plan described the payments as reimbursements for eligible medical expenses under Section 213(d) of the Internal Revenue Code.
That creates an important question:
Are the payments genuinely reimbursing substantiated medical expenses, or are they effectively recurring cash benefits tied to program participation?
That distinction can be critical to the tax treatment.
An employer should not assume that a recurring payment is tax-free merely because it is described as a medical reimbursement.
Compliance Work May Remain With the Employer
These programs can also create substantial ongoing responsibilities.
Someone must manage:
- employee eligibility;
- enrollment and termination dates;
- payroll deductions;
- reimbursement payments;
- plan funding;
- employee communications;
- annual notices;
- ERISA disclosures;
- claims and appeals;
- record retention;
- HIPAA obligations;
- nondiscrimination testing;
- payroll-tax reporting;
- benefit reconciliation;
- year-end reporting.
In the agreements RAS has reviewed, the employer was responsible for providing monthly eligibility changes, satisfying legal reporting and disclosure requirements, maintaining adequate funding and approving compliant communications.
The third-party administrator also expressly stated that it would not determine whether the plan violated the nondiscrimination requirements of Section 105(h), would not perform that testing and would not be responsible for penalties arising from a violation.
That is not a small administrative detail.
Nondiscrimination compliance can be an important condition of favorable tax treatment. If the vendor will not perform the testing, the employer must determine who will.
“Zero Cost” May Not Mean Zero Cost
A program may be described as having no net cost because payroll-tax savings are expected to offset the vendor fees.
But the actual cost should include much more than the monthly invoice.
Employers should consider:
- internal payroll time;
- human-resources administration;
- employee communication;
- accounting reconciliation;
- outside tax review;
- ERISA counsel;
- nondiscrimination testing;
- claims funding;
- audit support;
- amended-return risk;
- termination costs.
The agreements we have reviewed allowed the administrator to pass through certain taxes, governmental assessments, regulatory costs and vendor charges. It also allowed future administrative-fee increases.
The termination provisions were even more concerning.
The employer could receive remaining prefunded claim money at year-end only after a 10% final audit fee. If the employer terminated before the end of the plan year, the agreement provided that the claim fund could be forfeited and no refund would be issued. Unpaid claims would remain the employer’s responsibility.
That is not the type of language most employers expect to find in a supposedly simple, zero-cost benefit program.
The Indemnification May Protect the Vendor More Than the Employer
Employers should also review who protects whom if something goes wrong.
In the agreements RAS has reviewed, the employer agreed to defend, indemnify and hold the administrator harmless from claims, settlements, judgments, penalties, damages and attorneys’ fees relating to benefit claims and denials, so long as the administrator acted according to the plan or the employer’s instructions.
The administrator’s protection of the employer was more limited and generally depended on proving negligence, fraud or criminal conduct.
That allocation of risk matters.
A company should not be attracted by projected annual savings of a few hundred dollars per employee while overlooking the possibility that it is agreeing to absorb a much larger legal, regulatory and administrative exposure.
The Benefits May Be More Limited Than the Presentation Suggests
The benefit package itself may also deserve closer inspection.
In the materials RAS has reviewed, some of the telehealth and prescription-related services were expressly described as noninsurance products. The disclosure stated that they were not a replacement for health insurance, would not reimburse medical expenses and did not guarantee that a prescription would be written.
The administrative agreement also required certain services to be obtained through a specified provider network and stated that benefits would not be payable for services received outside that network.
Employers should therefore determine the real value of the employee benefits, not merely rely on broad descriptions such as “telehealth coverage,” “prescription benefits” or “supplemental health plan.”
Questions Every Employer Should Ask Before Signing
Before implementing one of these programs, employers should obtain clear answers to the following questions:
- Who guarantees the tax treatment in writing?
- Has independent employee-benefits tax counsel reviewed this exact program?
- Does the legal opinion address the exact payroll deductions, reimbursements and insurance products being used?
- Who is responsible for amended payroll returns if the tax treatment is challenged?
- Who pays the related taxes, penalties, interest and professional fees?
- Who performs Section 105 and Section 125 nondiscrimination testing?
- Who is legally designated as the plan administrator and fiduciary?
- Who makes final decisions on claims and appeals?
- Who funds the employee reimbursements?
- Are reimbursements tied to actual, substantiated medical expenses?
- What administrative work must be performed by payroll, accounting and human resources?
- What happens to prefunded money if the company terminates the agreement?
- Can funds be forfeited?
- Does the vendor indemnify the employer for tax and ERISA failures?
- What is the employer’s true net savings after all internal and professional costs?
If the salesperson cannot provide clear, written answers, the employer should not proceed.
Our View
A legitimate Section 125 plan can provide meaningful tax benefits. A legitimate wellness program can also provide real value to employees.
But the existence of legitimate Section 125 and wellness programs does not make every payroll-tax savings arrangement safe, practical or worthwhile.
Employers should be especially skeptical when a sales presentation promises all of the following at once:
- higher employee take-home pay;
- lower employer payroll taxes;
- additional health benefits;
- no cost to the company;
- no cost to employees;
- little administrative work;
- and no meaningful compliance risk.
There is no practical way for most employers to independently determine with 100% certainty that a complicated arrangement of this type is fully compliant without involving experienced tax, ERISA, payroll and benefits professionals.
That review may cost more than the projected savings.
The sensible question is not merely whether the program might be supportable.
The better question is:
Does the potential economic benefit justify the administrative burden, legal uncertainty and financial risk being placed on the employer?
In many cases, the answer may be no.
When a salesperson promises that a program costs nothing, saves taxes, increases employee pay and requires almost no work, do not ask how quickly the company can enroll.
Ask where the risk is being placed.
If the answer is buried in dozens of pages of contracts—and the answer turns out to be “on the employer”—it may be time to walk.
If not run.
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This article is intended for general informational purposes only and does not constitute legal, tax, insurance or employee-benefits advice. Employers should consult qualified tax and ERISA counsel before adopting any payroll-tax savings, wellness, reimbursement or employee-benefit arrangement.