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Medical Reimbursement - Section 105

The "Benefits" of Section 105 Plans

Instructions For Counsel  

Medical Reimbursement Plans in General

Medical reimbursement plans are designed to reimburse employees for medical expenses incurred. The plans may be insured or uninsured. The sample corporate resolution and announcement letter, which follows, are appropriate for an uninsured excess medical reimbursement plan established by a closely held corporation.

An excess medical reimbursement plan provides  reimbursement to employees for unreimbursed medical and dental expenses not covered by the employer’s group medical and dental program. Section 105(b) of the Internal Revenue Code provides that an employee’s gross income does not include amounts received under an “accident or health plan for employees.” Contributions by an employer to an accident and health plan to provide health or disability benefits (through insurance or otherwise) generally are deductible by the employer as an ordinary and necessary business expense under section 162(a) of the Code. These provisions result in one of the few instances where corporate funds can be used directly for the benefit of employees (including shareholder-employees of regular C corporations) totally tax-free, with the employer obtaining a full income tax deduction for the amount of the reimbursement.

An excess medical reimbursement plan is an attractive fringe benefit for employees because taxpayers are allowed a deduction for family medical expenses only to the extent such unreimbursed medical expenses exceed 7.5% of adjusted gross income.

Nondiscrimination Requirements for Excess Medical Reimbursement Plans

The Tax Reform Act of 1986 added new nondiscrimination requirements for business health insurance plans under section 89 of the Code. Complicated testing of plans was required to determine whether they discriminated against lower-paid employees. In response to pressure from business and labor groups, section 89 was repealed retroactively in 1989. Generally, the nondiscrimination rules applicable before enactment of section 89 have been reinstated. Health benefits provided by an employer under an insured plan are not subject to nondiscrimination tests. However, employer-provided health benefits under an uninsured medical reimbursement plan must satisfy the nondiscrimination requirements of section 105(h) of the Code. Medical reimbursements under such plans are excludible from the taxable income of “highly compensated” individuals only to the extent that the plan does not discriminate in their favor, either as to eligibility to participate or as to benefits. For this reason, such plans will primarily be attractive to smaller corporations in which the owners are willing to provide the benefit for nearly all of the corporation’s employees. Family owned businesses and professional corporations often provide medical reimbursement benefits. S corporations, partnerships and sole proprietorships generally do not establish such plans because the owners of the business are not eligible to participate.  

A plan discriminates as to eligibility to participate unless the plan benefits:

(1) Seventy percent or more of all employees, or 80% or more of all the employees who are eligible to benefit under the plan if 70% or more of all employees are eligible to benefit under the plan; or

(2) Such employees as qualified under a classification set up by the employer and found by the IRS not to be discriminatory in favor of highly compensated participants.

For the purpose of meeting either of the above eligibility requirements, the following employees may be excluded: (1) those who have not completed three years of service; (2) those under age 25; (3) part-time or seasonal employees; (4) those not included in the plan who are included in a unit of employees covered by a collective bargaining agreement, if accident and health benefits were the subject of good faith bargaining; and (5) nonresident aliens who receive no earned income from the employer within the United States. (IRC sec. 105(h)(3)(B)). Employees whose customary weekly employment is less than 35 hours or less than nine months a year will be considered part-time or seasonal if other employees in similar work with the same employer (or, if there are no employees of the employer in similar work, other employees in similar work in the same industry and location) have substantially more hours or months of employment. Notwithstanding the previous statement, a safe harbor rule to apply is: any employee whose customary weekly employment is less than 25 hours or whose customary annual employment is less than seven months may be considered as part-time or seasonal. (Reg. sec. 1.105-1 1(c)(2)(iii)(C)).

A plan discriminates as to benefits unless “all benefits provided for participants who are highly compensated individuals are provided for all other participants.” (IRC sec. 105(h)(4)).

The waiting period to become eligible for benefits must be identical for all participants. (Let. Ruls. 8411050 and 8336065). Benefits available to dependents of highly compensated employees must be equally available to dependents of all participants. Any maximum limit on reimbursement must be uniform for all participants and for all dependents. A plan is discriminatory if the type or amount of benefits subject to reimbursement is offered in proportion to compensation and highly compensated employees are eligible for benefits. The tests are applied to benefits subject to reimbursement, not to the actual benefit payments or claims. (Reg. sec. 1.105-11(c)(3)).

A “highly compensated individual” is one who (1) is one of the five highest paid officers; (2) is a shareholder who owns (either actually or constructively with the application of Section 318) more than 10% in value of the company’s stock; or (3) is among the highest paid 25% of all employees (other than those who may be excluded for the purpose of meeting eligibility requirements and who are not participants).

An amount paid under a discriminatory self-insured medical expense reimbursement plan to a highly compensated individual which is includible in gross income is called an “excess reimbursement.” If the benefit paid is not available to a broad cross-section of employees, the entire benefit paid is an “excess reimbursement.” If the benefit is available to a broad cross-section of employees but the plan fails to meet other nondiscriminatory provisions, a proportion of the benefit, based on the ratio of reimbursements paid to highly compensated individuals for the plan year to all reimbursements paid, will be considered to be an “excess reimbursement.”

Amounts reimbursed to employees (not dependents) for medical diagnostic procedures performed at a facility which provides only medical services are not considered a part of the medical reimbursement plan and do not need to meet the above nondiscrimination requirements. (Reg. sec. 1.105-1 1(g)).

Contributory Plans

Reimbursements that are attributable to employee contributions are income tax-free to the employee, unless the expense was previously deducted. Amounts attributable to employer contributions are determined in the ratio that the employer contributions bear to total contributions for the calendar years preceding the year of receipt, up to three years. (Reg. sec. 1.105-1 1(i)).

Withholding

Income tax need not be withheld by the employer from any amounts reimbursed under a self-insured plan as defined in section 105(h)(6) of the Code. (IRC sec. 3401 (a)(20)).

The Importance of a Written Plan

Although the Treasury Regulations do not specifically require that accident or health plans be in writing, a number of court decisions have made it clear that it is imperative that a corporation, by a resolution adopted by its Board of Directors, formally establish certain rules and regulations governing payment of benefits and that these rules be communicated to the employees involved as a definite policy of the corporation. Without such a written plan, deductions can be lost, premiums may become taxable income, and benefits can lose their tax shelter.

Presumably, all medical reimbursement plans will need to be in writing in order to satisfy the IRS that nondiscrimination requirements have been met. Also, Title I of the Employee Retirement Income Security Act (ERISA) requires that a written instrument establish Employee Welfare Plans. Any plan providing medical, surgical or hospital care, sickness or accident benefits, or disability benefits is an Employee Welfare Plan and is subject to ERISA requirements. Provisions have been included in our sample resolution and plan document package, which are designed to meet ERISA requirements in regard to a named fiduciary, allocation of responsibilities for the operation and administration of the plan, claims procedures and amendment procedures. Such provisions may not be necessary if the corporation has adopted a resolution applicable to all of the corporation’s Employee Welfare Plans, which incorporates the provisions required by Title I of ERISA.

Please contact us at 1-800-622-2411 or via e-mail: info@benefitplans.com for a sample resolution and plan document template package.

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For IRS clarification on Section 105 self-funded medical reimbursement plans see Rev. Ruling 2002-58 and Rev. Bulletin 2003-38

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Monday, October 21, 2013 09:58 AM

 

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