Section 105 HRA Plans
October 13, 2010
This article on Medical Reimbursement and Health Rearrangement Plans comes from Timothy Wolfe, a Chicago based tax and business specialist who shares his expertise online at Chicago Business Advice. A while back I looked at flexible spending accounts vs health savings accounts and Timothy left a comment about Section 105 HRA plans. Since I wasn’t familiar with how those worked, I asked Timothy if he could write up some information on Section 105, hopefully you’ll find it useful.
Section 105 Overview
There are really only a few key definitions under code section 105, which covers two plans. Both require written plans and are not discriminatory. However, both plans may have some eligibility requirements that may be included in the written plan that allow certain employees to be excluded:
- Employees who have not completed 3 years of service
- Employees who have not attained aged 25
- Part-time (<25 hours /week) or seasonal (<7 months of service)
Medical reimbursement plan (code section 105) – a medical reimbursement is a tax free payment from the employer to the employee to reimburse the employee for medical expenses, not insurance. Also, employees who leave the company do not get reimbursed.
Health reimbursement arrangement (105(b)) This plan has options the medical reimbursement plan doesn’t, including the option to include health insurance premiums. Maximum reimbursements must be established and carryovers of unused reimbursements from year to year may be included in the plan.
Note that the major difference from the 125 plan (discussed in other blogs) and the 105 plan is the entity/person who funds (pays for) the plan. The employee funds a 125 plan through having money withheld from his paycheck and then reimbursed while the employer funds the 105 plan as a true reimbursement.
Section 105 Benefits
The key to understanding who should utilize this benefit is key because the employer is not only providing a tax free benefit plan to the employee but is paying the cost. Because the employer is paying for 100% of the funding, the employer probably only wants to utilize this plan when he is one of the few or only beneficiaries of the plan.
I will use myself as an example. Because of pre-existing conditions our (family) insurance is very expensive. And of course there are prescriptions, eye care, including glasses, dental, etc. So our average medical expenses, including health insurance premiums, are over $20,000/year.
Because I am a corporation and have no other employees I can offer this tremendous benefit of over $20,000 of tax free income. I wouldn’t want to offer this to an employee who wasn’t a relative or key employee but I might have to if I had employees who were not eliminated from coverage. If I had several employees I would want to opt for a different plan such as a 125 plan.
To finish my example let’s say I have an average federal tax rate of 20%, FICA of 7.65% and the (IL) state rate of 3% then my total individual tax rate is 30.65%. So I am saving $6,130/year in taxes (30.65%*$20,000). In addition my corporation will save $1,530 which is the employers matching FICA of 7.65% times $20,000. So a total tax savings of $7,630. Not bad.
Section 105 Eligibility
Any business entity, including the employees of someone who is self employed can utilize a 105 plan. However, there are limitations. If you are a partnership this benefit cannot be offered to a partner or spouse of a partner, unless they themselves are a partner. A 2% or greater shareholder is limited to only having the FICA portion of their taxes being tax free. And the self employed individual himself cannot participate in a 105 plan. However, the if self employed’s spouse is a bona fide employee, that spouse can fully participate. With an employed spouse you must consider the type of work the spouse is doing and the number of hours worked to determine if the benefit paid to the spouse is reasonable.
Section 105 Plan vs. Other Plans
The three plans offering the maximum medical deductions are the section 105 plan discussed above, the section 125 (flexible spending arrangement) and the Health Savings Account. (HSA) The section 105 plan and 125 plans were discussed above while an HSA differs in that expenses are reimbursed though a medical savings type vehicle, which the employee or employer can fund.
One main point is that the HSA requires a specific type of health insurance plan called a High Deductible Health Plan (HDHP), which means a higher deductible, federally mandated policy. Additionally, the premium for the HDHP cannot be deducted from the HSA account but can be deducted as an employer expense under code sections 105, 106 or 125 or as a reimbursement to the employees under either code sections 105 or 106.
The bottom line is that there a number of ways to deduct medical expenses, although all have to be established by the employer. In my mind these are the greatest employee benefit plans an employer can offer. The employer only has to be careful so that they do not unknowingly provide a larger benefit to his employee than they intended. Additionally, I want to stress that if you are a S Corporation you really need to evaluate not only the type of plan you have but whether the other tax benefits of being an S Corp offset what you lose as an S Corporation.
For additional information Section 105 HRA Plans you can visit Timothy’s site, Chicago Business Advice.
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