An overview of IRS section 105, and how it related to reimbursements made by company sponsored medical expense plans.
Section 105 describes some employee medical benefits that don’t have to be included in an employee’s gross income, and therefore will be tax-free. These are exceptions to the general rule that employee benefits should be included in gross income.
1. Amounts paid from a company-financed health plan to reimburse out-of-pocket medical expenses of an employee or the employee’s spouse or children are excluded from gross income. These reimbursements may have been paid either directly to the employee or indirectly to the medical service providers.
The types of medical expenses that are allowed under this section are broader than the types of medical expenses that are allowed as itemized deductions. For example, while only prescription drugs are deductible, reimbursements for both prescription AND over-the-counter drugs may be excluded from gross income under this section. The allowed expenses, however, are not unlimited. Expenses must be for medical care, not for items that are merely beneficial to general good health. Therefore, according to an IRS ruling, expenses for things such as vitamins are neither reimbursable nor excludable from gross income under section 105.
2. Payments for permanent physical injuries (permanent loss of part of the body, loss of use of part of the body, or disfigurement) of the employee, spouse, or children are also excluded from gross income, provided that the payments are based only on the nature of the injury and not on the amount of time the employee is absent from work.
Payments made from accident and health plans, such as company-sponsored health flexible spending arrangements (FSAs), are treated, for purposes of this section, the same as payments made from health insurance plans.
People who are self-employed are not covered by this section. However, there are many ads on the internet for “Section 105 Plans” which claim to have found a rather clever way to get around this. They advise that self-employed people hire their spouses and then, as their spouses’ employers, the self-employed people provide company-sponsored health insurance to the spouses, in the spouses’ names, that will cover the whole family (including themselves). At least one of the major popular tax guides endorses this idea, but if this is something that interests you, you should check with a tax professional to make sure that it really is kosher.
Section 105 also has some anti-discrimination provisions. If a self-insured medical reimbursement plan discriminates in favor of highly-compensated employees (defined as the highest-paid 25 percent of all eligible employees, the five highest paid officers, and employees who own more than ten percent of the company’s stock) either by granting the highly-compensated employees benefits not available to other plan participants, or by discriminating in favor of the highly-compensated employees in terms of eligibility for the plan, then part of the benefits received by the highly-compensated employees will be taxable.
This article is meant as a general overview of the subject, and does not constitute legal or other professional or expert advice. You should consult a tax attorney or other tax professional if you have any questions about this subject.