November, 2006 Tax Newsletter

Medical Reimbursement Plans

A Medical Reimbursement Plan (“MRP”) is any plan where an employer reimburses an employee for uninsured health or accident expenses incurred by the employee or his dependents.  It, and its first cousin, the Health Reimbursement Arrangement (“HRA”), are authorized under tax law (Section 105 of the Internal Revenue Code) and allow reimbursements of qualifying out-of-pocket medical expenses to be received tax-free by the employee and are tax deductible to the employer.  Any employer, including a sole proprietor with employees, can adopt an MRP.

The most common type of plan is a self-funded health plan where the employer has chosen not to insure health care benefits and to self-fund the benefits, rather than pay premiums to an insurer.  Often these plans supplement a conventional health insurance plan to reimburse amounts that are not covered by the insurance.  The plan can also be under the umbrella of a Section 125 Cafeteria Plan as a medical flexible spending account (“FSA”).  The difference between a stand-alone MRP and one under a Cafeteria Plan is that in the stand-alone plan the employer pays the cost of the reimbursements, while under a Cafeteria Plan, the employee pays the cost through salary reductions.

There must be a bona fide employer-employee relationship and the plan must conform to IRS guidelines.  Covered employees must have notice of the plan.  It is always recommended that the plan be well documented and in writing.

To comply with the law the plan must satisfy two important tests before it is considered non-discriminatory and able to provide a tax-free fringe benefit to its covered employees.  The plan must not discriminate in favor of highly compensated with respect to (1) eligibility to participate or (2) benefits provided under the plan.

With regard to eligibility, the plan must pass at least one of three requirements:  (1) at least 70% of all non-excludable employees must actually participate, or (2) at least 70% of all non-excludable employees are eligible to participate, and at least 80% of all employees who are eligible to participate actually do so, or (3) the plan must be offered to a “fair cross-section” of employees that is found by the IRS not to discriminate in favor of Highly Compensated Employees (“HCE’s”).  If the plan fails the eligibility test at least a portion of the benefit that is provided to HCE’s will be treated as taxable income.  An HCE is one who is either one of the five highest-paid officer of the employer, is a shareholder who owns directly or indirectly more than 10% in value of the employer’s stock, or is in the top 25% of highest paid employees.

With regard to benefits, a plan will not discriminate if the type and amount of benefits available to highly compensated participants and their dependents are also available on the same basis for all other participants and their dependents.  This test is applied by reference to available benefits, rather than actual benefit payments under the plan.