White Paper · Audit & Governance

Executive summary

Audit defensibility is built, not hoped for. A benefit arrangement survives examination because it was designed around the statute and documented with discipline, and it fails when its design depends on a result the law does not support. That distinction is the subject of this paper.

The framework rests on settled ground. Employer contributions to an accident or health plan are excluded from income under Section 106, a Section 125 election funds them pre-tax, and benefits paid back are excluded under Section 105(b) to the extent they reimburse Section 213(d) medical care. Any amount above the employee's medical expenses is reconciled and reported by the employee. Each link is decades old; Revenue Ruling 69-154 has governed the excess benefit since the 1960s.¹

What an examiner tests is whether the arrangement actually follows that chain or only appears to. A design that pays only on a documented Section 213(d) medical event, reconciles any excess at the employee level, and keeps the insurance risk with the carrier sits on the defensible side of the line. This paper sets out the examiner's tests, the exclusion chain and the documentary hinge that holds it, the division of risk and records, the recordkeeping a sponsor must keep and is barred from holding, the current posture of the Service, and where the audit risk finally lands.

The examiner's view

What an examiner actually tests

An examination is a test of substance against form. The examiner is not asking whether the plan has attractive features. The narrower question is whether the payments qualify for the tax treatment the sponsor claimed, and whether the sponsor can show it.

For a fixed indemnity benefit funded through a cafeteria plan, that resolves into three tests. The trigger is where examiners look first, because the trigger reveals what the payment is for. A payment made because an employee completed an activity that cost nothing is not a reimbursement of a medical expense. A payment made because a provider documented a Section 213(d) medical event is a different instrument. Defensibility is decided at the design stage, long before any examiner arrives.²

The exclusion chain

Where the tax treatment holds

The favorable treatment of a fixed indemnity benefit is not a single rule. It is a sequence of exclusions, each governed by its own Code section, and the arrangement is defensible only where every link holds.

The first link is settled and not meaningfully disputed: Section 106 excludes employer-provided coverage, and a Section 125 election funds it pre-tax, reducing taxable income and the payroll-tax wage base.⁴ The second link, Section 105(b), excludes amounts that reimburse Section 213(d) medical care, but it does not reach an amount the employee would receive whether or not any expense was incurred.⁵

The hinge that holds it

Documentation of the medical event

A fixed indemnity benefit is defensible under Section 105(b) only if each payment corresponds to a Section 213(d) medical expense, and the arrangement must be able to show that correspondence.

A design that conditions payment on a provider's Current Procedural Terminology code, so that a claim pays only when the code indicates a Section 213(d) service was furnished, builds the documentary hinge into the claim itself. The code is the evidence that the trigger was a medical event and not an activity that carried no expense. This single feature is what allows the second link to hold under examination, and it is the feature most often absent from the arrangements the Service has questioned.⁷

Risk and records

Who bears the risk, and who holds the records

Whether an arrangement is insurance, and who stands behind it, is not a labeling question. It determines the tax analysis and it determines what the employer can know.

For federal tax purposes, an arrangement is insurance only if it shifts and distributes risk. A fully insured benefit satisfies both elements: the employer pays a premium and has no further exposure, while the carrier bears the risk, pools it across many insureds, and pays claims from the pool. That allocation of risk produces an allocation of knowledge. The Optiv arrangement is always administered by a licensed third-party administrator, so the claim and the supporting bill go to the carrier and its licensed administrator, not the employer. The employer holds no medical records, and one that never receives the claim cannot be charged with knowing the benefit's character.⁸

The record

What the sponsor must keep, and cannot hold

A sponsor's recordkeeping obligation is real and specific, and so is the limit on what the sponsor is permitted to hold. Defensibility requires getting both right.

Section 6001 requires records sufficient to establish liability, and employment tax records are retained at least four years. The licensed third-party administrator that Optiv provides generates and maintains the claims and benefit-payment records that underlie much of this file and supplies them to the sponsor, so the sponsor holds and produces a record the administered structure already creates rather than assembling it alone. The employer cannot maintain records of an employee's actual medical expenses, and it should not try to: it holds no medical records under this arrangement, because the claim and the medical information are received and held by the carrier and its licensed administrator, away from the employer. The limited record is a designed result, not a gap.¹⁰

The Service's posture

Reading the IRS position in 2026

A sponsor evaluating an arrangement in 2026 needs an accurate read of where the Service stands, including what it has done and what it has not.

The Service has issued chief counsel advice memoranda on fixed indemnity and wellness-triggered arrangements, most recently CCA 202323006: an employee made a large pre-tax election and received a fixed monthly payment for completing wellness activities that carried no out-of-pocket cost. Because the payment was made without regard to any incurred medical expense, the Service concluded the Section 105(b) exclusion did not reach it.¹² A defensible design is distinguishable on the grounds the Service itself identified: it is fully insured, pays only on a documented Section 213(d) event, is freestanding rather than layered on a group health plan, and pays nothing for completing an activity that carries no medical expense.¹³

The law here is open and not resolved. The question is whether the Service's reasoning in a non-precedential memorandum, directed at activity-triggered arrangements, could be extended to reach a benefit triggered by a documented Section 213(d) medical event with employee-level reconciliation of any excess. The stronger reading is that it cannot, grounded in the statutory text: Section 105(b) excludes reimbursement of Section 213(d) care, Revenue Ruling 69-154 governs the excess, and a chief counsel advice is not law and may not be cited as precedent.

For the contrary result to control, a specific chain of events would have to occur, and each link would have to hold against the taxpayer in turn:

Each of those conditions is independent, and a break in any one of them stops the adverse result. Two facts cut the other way and belong in the record. When the Service finalized a related rule in April 2024, addressing short-term limited-duration insurance and a consumer notice for fixed indemnity coverage, it did not finalize the Section 105(b) tax-treatment changes, and Treasury stated that the decision not to finalize them should not be read as approval of the arrangements it had questioned.¹⁴ And the Service has returned to this subject across several memoranda over several years, which signals sustained attention rather than a closed file.

The liability

Who bears the audit risk

For a finance leader, the decisive question is not whether the arrangement is attractive but who is exposed if the Service disagrees. The answer is specific, and it cannot be shifted by contract.

The duty to withhold runs to the employer. Section 3402(a) requires every employer that pays wages to withhold the tax due, and wages are all remuneration for services performed. The analysis turns on whether the indemnity benefit is remuneration for services. It is not: the benefit is funded by the carrier and triggered by a covered medical event, it bears no relation to services rendered, and the obligation continues even after employment ends, when there are no services at all.¹⁵

The Code reinforces the point through its carve-outs, which address payments the employer makes that might otherwise look like compensation. The indemnity benefit does not need them, because it is the carrier's payment and was never remuneration for services to begin with.¹⁶