Section 105 Taxes The Reimbursement Only When A Self-Insured Plan Favors The Highly Paid
Section 105(b) makes reimbursements for medical care tax-free, and section 105(h) takes that away from highly compensated individuals when a self-insured plan favors them. This guide walks through both.
Three Things To Know About Section 105.
General information, not legal or tax advice. Check the current statute, the regulations and your plan document.
All Six Code Sections
Return to the overview of the six Internal Revenue Code sections this series explains.
Self-Insured Plan Nondiscrimination
Our practical guide to testing a self-insured plan for favoritism toward highly compensated employees.
Spouse As Employee
How the spouse-as-employee arrangement relies on section 105 for small business owners.
Subsection (b) And Medical Care Expenses.
Section 105 is where the Code addresses money that an employee receives through an employer-funded accident or health plan. Subsection (a) states the starting position: amounts received through employer-funded coverage for personal injuries or sickness are taxable to the extent they come from employer contributions that were not previously taxed to the employee. Subsection (b) then carves out the part that matters most to benefit plans. Amounts paid to reimburse the taxpayer for expenses incurred for medical care, as defined in section 213(d), are excluded from gross income.
The covered people are the taxpayer, the taxpayer’s spouse and dependents, and a child who has not reached age 27 by the end of the taxable year. The statute adds a coordination rule: the exclusion does not apply to amounts that are attributable to deductions the taxpayer already took under section 213 in an earlier year. A separate subsection, (c), excludes certain payments for permanent loss of a body part or function, or permanent disfigurement, when they are computed by the nature of the injury and not by the time the employee is away from work.
This is the section that sits behind health reimbursement arrangements, insured medical plans that pay claims, and the spouse-as-employee structures small owners use. It works hand in hand with section 106: section 106 handles the employer-provided coverage, and section 105 handles the benefits the employee collects. Subsection (g) clarifies that a self-employed individual is not an employee for these purposes, which is why sole proprietors and partners need different tools.
What Subsection (h) Requires.
Subsection (h) applies only to a self-insured medical reimbursement plan, meaning an employer plan that reimburses employees for medical expenses not paid under an accident or health insurance policy. Such a plan must not discriminate in favor of highly compensated individuals, and the statute names two tests: one on who is eligible to participate and one on the benefits provided.
Under the eligibility test, the plan must benefit at least 70 percent of all employees, or at least 80 percent of the employees who are eligible if at least 70 percent of all employees are eligible. A classification that the Secretary of the Treasury finds not discriminatory also satisfies the test. The statute allows some employees to be left out of the count, including those who have not completed three years of service, those under age 25, part-time or seasonal employees, certain employees covered by a collective bargaining agreement, and certain nonresident aliens. Under the benefits test, every benefit available to a highly compensated individual must be available to all other participants.
A highly compensated individual is one of the five highest paid officers, a shareholder who owns more than 10 percent of the employer’s stock by value, or an employee among the highest paid 25 percent. Employers treated as a single employer under the controlled group rules of section 414 are combined for this purpose. Treasury Regulation 1.105-11 supplies the detailed mechanics.
Excess Reimbursements, Not Plan Disqualification.
The penalty for failing subsection (h) falls on the highly compensated individual, not on the entire plan. If the plan fails for a plan year, the section 105(b) exclusion does not apply to a highly compensated individual’s excess reimbursements. For a benefit offered only to highly compensated individuals, or one that fails the benefits test, the excess is the full amount reimbursed. For other benefits, the excess is the individual’s total reimbursements multiplied by a fraction: reimbursements to all highly compensated participants over reimbursements to all employees.
Insured plans are outside subsection (h), because it speaks only to self-insured reimbursement plans. Whether a given arrangement is truly self-insured, and whether a stop-loss policy changes that answer, are questions to put to the plan’s adviser. Our guide on self-insured plan nondiscrimination rules lays out the testing steps in practice.
Laws And Sources
26 U.S.C. 105, Amounts Received Under Accident and Health Plans — Statutory text for subsections (a), (b), (c), (g) and (h), including the 70 percent and 80 percent tests and the excess reimbursement formula.
26 CFR 1.105-11, Self-Insured Medical Reimbursement Plan — The regulation that implements the nondiscrimination rule of section 105(h).
26 U.S.C. 106, Contributions by Employer to Accident and Health Plans — The companion exclusion for employer-provided coverage.
IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits — The IRS reference to section 105(h) and the treatment of accident and health benefits for employment tax.
General information, not legal or tax advice.
Quick Answers.
Short replies to what employers ask first on this section. Each leads to a fuller guide.
What is the difference between 105(b) and 105(h)?
Subsection 105(b) is the tax-free treatment for reimbursed medical care. Subsection 105(h) removes it for excess reimbursements to highly compensated individuals when a self-insured plan fails its eligibility or benefits test.
Does the nondiscrimination rule apply to insured group health plans?
Section 105(h) applies by its terms to self-insured medical reimbursement plans, meaning plans that reimburse expenses not paid under an insurance policy. It does not describe fully insured plans.
Can the plan cover a child under age 27?
Section 105(b) extends the exclusion to a child of the employee who has not reached age 27 by the end of the taxable year, in addition to the employee, spouse and dependents.
The Other Code Sections.
Section 106: Coverage Excluded From Income
Why employer-paid premiums stay out of taxable wages, plus the Archer MSA and HSA add-ons.
Section 125: Cafeteria Plans
The written plan, the cash-or-benefit choice and the tests that apply to key employees.
Section 132: Fringe Benefit Exclusions
Eight kinds of excluded fringe benefit, with the working condition and commuter rules up close.
Section 6039D: Dormant Reporting
What the statute asks of employers, what Notice 2002-24 suspended and what remains unconfirmed.
Section 223: Health Savings Accounts
Eligible individuals, annual limits, the HDHP definition and what happens to withdrawals.
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