Taxation rules surrounding employer-sponsored welfare benefit plans can be complex and ever-evolving. From cafeteria plans to disability coverage and wellness incentives, employers must navigate the Internal Revenue Code (IRC), IRS regulations, and nondiscrimination requirements to ensure compliance.

With increased IRS scrutiny on tax-preferred benefits, failure to follow these regulations could result in unexpected tax liabilities, penalties, or plan disqualification. This guide highlights key taxation considerations for employer welfare benefits in 2024 and beyond.

1. Section 125 Cafeteria Plans & Pre-Tax Contributions

Employers can allow employees to pay for health and welfare benefits on a pre-tax basis through Section 125 cafeteria plans, reducing taxable income for both employees and employers. However, these plans must meet specific IRS requirements:

• Written Plan Document Required – Employers must establish a formal written cafeteria plan to enable pre-tax salary reductions. If no written plan exists, the IRS may require employees to pay taxes on previously untaxed benefits.
• Election Changes are Generally Irrevocable – Employees must make benefit elections before the plan year starts. Mid-year election changes are only allowed in limited cases, such as birth, adoption, or changes in employment status.
• Compliance with Nondiscrimination Rules – Cafeteria plans cannot favor highly compensated employees (HCEs) or key employees, or they risk losing their tax-advantaged status.

2. Nondiscrimination Testing for Welfare Benefit Plans

To prevent unfair tax benefits for executives or high-earning employees, many employer-sponsored benefit plans must pass nondiscrimination tests under the IRS code. Plans subject to these rules include:

• Self-Funded Health Plans (IRC §105) – These plans must not disproportionately benefit executives or highly compensated employees (HCIs). If a plan fails testing, HCIs may face taxation on employer contributions.
• Group Term Life Insurance (IRC §79) – Up to $50,000 of employer-provided group life insurance is tax-free—unless the plan discriminates in favor of key employees, in which case key employees must pay taxes on the full benefit amount.
• Dependent Care Assistance Programs (DCAPs) (IRC §129) – Employer-provided dependent care benefits are tax-free only if the plan does not disproportionately benefit HCEs. Failure to comply results in HCEs paying taxes on the benefit received.

Real-World Impact:
🔹 In 2023, an employer was penalized for failing to apply nondiscrimination testing to its self-funded health plan. The IRS determined that disproportionate reimbursements to executives violated IRC §105(h), resulting in taxation of benefits for high earners. Employers must proactively test their plans to avoid similar issues. (Read more at IRS.gov)

3. Taxation of Wellness Program Incentives

Wellness programs are increasingly popular, but certain incentives can trigger taxable events for employees.

• Cash & Gift Cards – Subject to federal income tax, FICA, and withholding taxes.
• Employer-Paid Health Premium Discounts – Generally excluded from taxable income.
• Health Reimbursement Incentives (e.g., HRA deposits, gym memberships) – Typically tax-free, unless the benefit is considered compensation rather than a health-related expense.

IRS Scrutiny: The IRS has cracked down on so-called “fixed indemnity wellness programs”—where employees contribute pre-tax dollars and receive non-taxable reimbursements. The IRS ruled that these payments are taxable income, increasing audit risks for employers. (Read more in IRS Memo 2017-30)

4. Disability Benefits & Taxation

Short-term and long-term disability benefits can be taxable or tax-free depending on how premiums are paid:

• Employer-Paid, Pre-Tax Premiums → Disability benefits are taxable when received.
• Employee-Paid, Post-Tax Premiums → Disability benefits are tax-free when received.
• Split Payment (Employer & Employee Contributions) → Taxation is proportional to pre-tax vs. post-tax contributions.

Employer Consideration: Employers should communicate taxation implications of disability benefits clearly, as employees may be surprised when receiving taxed disability payments after a medical event.

5. Domestic Partner Benefits & Taxation

Employers increasingly offer benefits for domestic partners, but federal tax law does not recognize them as dependents unless they meet strict IRS criteria.

• Taxable “Imputed Income” – The fair market value of employer-paid benefits for domestic partners must be included in the employee’s taxable wages unless the partner qualifies as a tax-dependent.
• State Variations – Some states exempt domestic partner benefits from state income tax, but federal taxation still applies.

Example:
🔹 A company in California provided health benefits to domestic partners, assuming they were tax-free. However, the IRS later determined that the benefits were subject to federal tax, resulting in penalties for incorrect payroll reporting. Employers must accurately apply imputed income rules to avoid compliance issues. (Read more in IRS Publication 15-B)

Employer Action Steps for 2024 Compliance

✔ Review Plan Documents for Compliance
Ensure cafeteria plans, self-funded health plans, and life insurance policies meet IRS requirements.

✔ Conduct Nondiscrimination Testing Annually
Run tests for cafeteria plans, DCAPs, life insurance, and health plans to confirm compliance.

✔ Evaluate Wellness Program Incentives
Identify taxable vs. non-taxable incentives to prevent payroll errors and audit risks.

✔ Communicate Disability Benefit Tax Implications
Educate employees on how disability benefits will be taxed based on premium payment methods.

✔ Properly Handle Domestic Partner Benefits
Ensure imputed income for non-tax-dependent domestic partners is correctly reflected in payroll.

Final Thoughts

Employer welfare benefit taxation is highly regulated, and the IRS is actively auditing plans for noncompliance with Section 125, Section 105, and nondiscrimination rules. Employers that take a proactive approach—by conducting annual compliance reviews, training HR teams, and staying informed about federal regulations—will reduce risks and ensure employees maximize tax benefits legally.

By aligning benefits taxation with IRS guidance, employers can avoid costly penalties while maintaining a competitive and compliant benefits program.