Revenue Ruling 96-79 confirms that when an employer pays for employee health coverage, those payments are not “wages” for Federal Insurance Contributions Act purposes, so long as they meet the conditions of Internal Revenue Code Section 3121(a)(2). The exclusion keeps the combined 7.65% FICA tax off every qualifying dollar of coverage on both the employer and employee sides. For a worker whose employer pays $8,000 a year toward a health plan, that is $612 the employee never pays in Social Security and Medicare tax and another $612 the employer does not owe in matching tax.
How the Exclusion Reduces FICA Wages
FICA funds Social Security and Medicare. Each side pays 6.2% for Social Security up to the annual wage base, which is $184,500 for 2026, and 1.45% for Medicare with no cap.1Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates2Social Security Administration. Contribution and Benefit Base Section 3121(a)(2) removes qualifying employer contributions for health coverage from the wage base before those percentages are calculated.3Office of the Law Revision Counsel. 26 USC 3121 – Definitions Revenue Ruling 96-79 sets out the IRS interpretation that gives payroll departments a clear rule to follow.
Conditions the Payments Must Meet
Two requirements do the real work. Miss either one and the money you thought was tax-free becomes taxable compensation.
Payments Must Be Made Under a Plan or System
The employer has to maintain a plan or system that covers employees generally or a defined class of employees, and it can extend to their dependents.3Office of the Law Revision Counsel. 26 USC 3121 – Definitions IRS Publication 15-B allows the plan to be insured or self-funded and does not require it to be in writing, though a written document is the cleanest way to prove the plan existed during an audit.4Internal Revenue Service. 2026 Publication 15-B – Employer’s Tax Guide to Fringe Benefits Handing one employee extra cash to buy coverage on their own, with no formal arrangement, is taxable wages. Consistent application to an identifiable group is what makes it a plan.
Payments Must Fund Sickness, Accident, or Medical Benefits
The money has to go toward covering sickness, accident disability, or medical and hospitalization expenses.5GovInfo. 26 CFR 31.3121(a)(2)-1 – Payments on Account of Sickness or Accident Disability, Medical or Hospitalization Expenses, or Death That covers group health insurance premiums, contributions to a trust or fund providing health benefits, and payments into Archer MSAs or Health Savings Accounts.4Internal Revenue Service. 2026 Publication 15-B – Employer’s Tax Guide to Fringe Benefits The exclusion also reaches payments for specific permanent injuries such as loss of use of a limb, as long as the amount is calculated without regard to time away from work. A bonus labeled “for health expenses” with no plan structure behind it does not qualify.
Salary Reductions Through Cafeteria Plans
Section 125 lets employees choose between taxable cash and qualified benefits like health coverage.6Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans When an employee elects a salary reduction before earning the compensation, the redirected amounts are treated as if the employee never received them. Under Section 3121(a)(5)(G), those salary reduction contributions under a qualifying cafeteria plan are generally not subject to FICA or federal unemployment tax.7Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans The election has to come before the wages are earned; a retroactive election does not work.
HSA contributions get the same treatment when funded through the cafeteria plan’s payroll deduction. Every pre-tax dollar routed into an HSA that way escapes Social Security, Medicare, and federal income tax, and the employer saves on matching FICA. An employee who funds an HSA outside payroll can still take an income tax deduction but loses the FICA savings, which is worth understanding before choosing how to contribute.
Coverage for Spouses and Dependents
Section 3121(a)(2) covers payments made on behalf of an employee’s dependents, and Publication 15-B extends the reach to spouses, dependents, and children under age 27 at the end of the tax year.4Internal Revenue Service. 2026 Publication 15-B – Employer’s Tax Guide to Fringe Benefits Premiums that cover a worker’s spouse or children stay out of Social Security and Medicare wages. The plan terms have to include those family members, and employers should keep enrollment records so they can show during an audit that everyone covered actually qualifies. An adult child who turned 27 before year-end no longer fits, and the value of that coverage becomes taxable wages.
Where the Exclusion Does Not Apply
The most common trap involves domestic partners who do not qualify as tax dependents under Section 152. When an employer covers a partner who is not a federal tax dependent, the fair market value of that partner’s coverage is imputed income for the employee. That imputed amount is subject to federal income tax and FICA. The employer has to calculate the value, withhold the employee’s share, and pay the employer match.
The exclusion also does not carry over to certain long-term care insurance benefits provided through a flexible spending arrangement. The premiums stay out of Social Security, Medicare, and federal unemployment tax, but they cannot be excluded from federal income tax withholding when delivered that way.4Internal Revenue Service. 2026 Publication 15-B – Employer’s Tax Guide to Fringe Benefits The split treatment catches employers off guard.
More-Than-2% S Corporation Shareholders
Any shareholder who owns more than 2% of an S corporation cannot be treated as a regular employee for purposes of the health coverage income tax exclusion. Health and accident premiums paid on behalf of these shareholder-employees have to be included in taxable wages and reported in Box 1 of Form W-2. The premiums do stay exempt from FICA and federal unemployment tax, however, as long as the plan covers employees generally or a defined class of employees. The result is that the amounts appear in Box 1 but not in Boxes 3 or 5.8Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues The shareholder can then claim an above-the-line deduction for the premiums on their personal return, provided they were not eligible for subsidized coverage through a spouse’s employer.
What Shows Up on the W-2
Excluding health coverage from FICA wages does not remove it from the W-2 entirely. Under the Affordable Care Act, employers report the total cost of employer-sponsored health coverage in Box 12 using Code DD, and that figure includes both the employer-paid and employee-paid portions.9Internal Revenue Service. Form W-2 Reporting of Employer-Sponsored Health Coverage The IRS has said this reporting is informational only and does not make the coverage taxable.10Internal Revenue Service. Reporting Employer-Provided Health Coverage on Form W-2 The excluded premiums stay out of Box 1, Box 3, and Box 5, but appear in Box 12 so the employee can see the total value of the benefit. A large Code DD amount is not a tax bill.
What Happens When Employers Get It Wrong
If the IRS decides that payments treated as exempt health benefits were actually taxable wages, the employer owes its half of the unpaid FICA plus the employee’s share that should have been withheld. Interest runs from the original due date, and accuracy-related penalties can stack on top.
The heavier exposure falls on individuals through the trust fund recovery penalty under Section 6672. Any person responsible for collecting and paying employment taxes who willfully fails to do so faces a personal penalty equal to the full unpaid trust fund portion, meaning the employee’s withheld income tax and FICA share.11Office of the Law Revision Counsel. 26 U.S. Code 6672 – Failure to Collect and Pay Over Tax, or Attempt to Evade or Defeat Tax The penalty reaches business owners, CFOs, and payroll managers personally. When the underlying error is treating taxable compensation as excluded health benefits, the numbers add up quickly for companies with many employees.
The way to stay out of trouble is straightforward. Keep a written plan document, apply eligibility rules consistently across the covered class, and make sure every dollar claimed as a FICA-exempt health contribution actually funds qualifying coverage for sickness, disability, or medical expenses under a plan that reaches a broad group of employees.3Office of the Law Revision Counsel. 26 USC 3121 – Definitions