Unreimbursed medical expense plans provide little known alternative

Over the last several years, few practices have escaped the profit margin impact felt by the rising costs of employee health insurance coverage.

Practice owners and hospital administrators are increasingly challenged to find creative ways of retaining employees through competitive compensation and benefit plans. A little known, but merited, benefit plan for small business has long resided in the tax code.

Sometimes, the Internal Revenue Service uses plain old common sense. Unreimbursed medical expense plans are one of those instances where the logic of the tax system is inescapable.

Such qualified plans, on a non-discriminatory basis, provide medical expense benefits to employees that are excludable from the employee's gross income and fully deductible by the employer as a business expense. The plans are simple to administer. No special tax form reporting is required.

Under Section 105 of the Code, employers may establish a written plan that provides for employees, on a non-discriminatory basis, reimbursement of medical expenses not covered by another plan or program. Reimbursement may be for qualified medical expenses of the employee, the employee's spouse and dependents.

The reimbursement paid by a practice employer is excludable from the employee's W-2 and deductible by the employer.

Rules apply

As with all tax regulations and rules, specific exceptions and requirements must be followed.

The plan must not be discriminatory. The plan must be written. The plan must provide consistent reimbursement. The employer defines what medical expenses may be reimbursed in the plan. The identified reimbursed expenses can be limited by the employer, but must not be picked discriminatorily to favor the advantages of highly compensated individuals or shareholders.

An unreimbursed medical expense plan meeting the IRS requirements is basically a self-insured medical expense program. As such, it is treated as "accident and health insurance" under Section 105(e) of the Internal Revenue Code.

Medical expense reimbursements paid under such a plan are excludable from the employee's gross income under Section 105(b). Reimbursements paid to an employee are not subject to income taxation or Social Security and Medicare tax withholdings.

Similar to special rules for treatment of heath insurance plans in sole-proprietorships, partnerships and SubChapter S corporations, principals in these entities may be required to include reimbursements in gross income. However, spouses and dependents providing bona fide services to the practice as employees may be considered on the same basis as any other employee within plan guidelines. In such a situation, the qualifying medical expenses of an owner might be reimbursed through the spouse's or dependent's allowance without inclusion in income.

A recent ruling, Rev. Ruling 2002-58, 2002-38 I.R.B. (9/23/2003) made a common sense clarification that reimbursement of medical expenses that were incurred prior to the establishment of a plan are not excludable from the gross income of the employee if paid by the employer. Simply stated, you cannot reimburse expenses that were incurred prior to the time you established your unreimbursed medical expense plan without taxation to the employee. Reimbursement of expenses prior to the formal establishment of the plan is not permitted to be retroactive.

Typical plan

The typical plan document includes administrative guidelines, as well as definitions. Expenses that are qualified for reimbursement must generally fit within the definition of a deductible medical expense. Typical expenses that might be reimbursed include dental care, eye examinations, contact lenses and eyeglasses, medical insurance premiums, and the deductible portion of medical and hospital visits paid by the employee.

It is the employer's right to exclude reimbursement for certain procedures, if desired. These must be defined within the document.

Generally, the employer will establish limits of the total monetary amount that will reimbursed during the year. Amounts may accrue on a month-by-month basis and be reimbursed to the employee as hours of service are fulfilled. The administration may stipulate that unused, earned amounts for reimbursement be carried over to the next year or not. New employees may be eligible only after a certain number of months of service (and up to three years), as defined within the plan document. If part-time or seasonal employees are excluded, the definition of a full-time employee for inclusion in the plan may be stipulated by state statute, and clarified within the document through the assistance of an attorney well-versed in state employment law and guidelines for definition of full-time employment.

Practice plan

As an example, a practice's plan document might provide that full-time employees are eligible after three months of continual service. At that point, the maximum amount of earned benefit per month that may be reimbursed is $100.

Employees are responsible for timely submission of receipts to the practice administrator for authorization and payment. The practice writes a check to the employee to reimburse exactly for the amount of the receipt thus submitted.

If the employee has only been eligible for two months of inclusion in the plan, a maximum of $200 of reimbursement is available. A receipt for qualified medical expense care submitted in excess of that amount would be carried forward to subsequent months, when the employee has earned a right for reimbursement through additional hours of full-time service to the practice.

Under this plan example, an employee who had worked for a full year after meeting the initial eligibility requirement of three months in prior years would be eligible for up to $1,200 of reimbursement by the practice. If only $900 of receipts had been submitted during the course of the year, the employee can only be reimbursed for up to that amount, not anything more.

Any allowance not used might be lost at the end of the year, if the document so provides. If carryover is allowed, then the unused $300 of potential reimbursement would carry forward to the next year, and newly qualified medical invoices submitted to the practice by the employee could be reimbursed.

Uncomplicated alternative

Revenue Ruling 2002-58 is an excellent reminder of a relatively uncomplicated alternative to group health insurance or cafeteria plans. A reasonable option is to establish a sensible unreimbursed medical expense plan for your practice that will benefit employees by offering healthcare monetary support that is not includable in income or subject to Social Security taxes and an expenditure that is deductible by the employer.

A word of caution is appropriate. These plans must be written. They must be authored by a competent attorney licensed in the state of the practice's domicile. The plan must be signed on a contemporaneously current basis and must be ratified through the corporate minutes.

Do not do your own plumbing. Engage a competent attorney.

In fact, we strongly recommend that an attorney be consulted on a periodic basis to ensure not only that these requirements are met, but the corporate minute book is maintained consistently to document plan adaptation and all other issues of business administration and employee management

Mr. McCafferty owns Owen E. McCafferty (OEM), CPA, Inc., in North Olmsted, Ohio. The firm offers tax, accounting and management consulting services.

Dr. Heinke is a partner of Owen E. McCafferty (OEM), CPA, Inc., in North Olmsted, Ohio. The firm offers tax and accounting and management consulting services. E-mail can be directed to her at MLHeinke@aol.com; phone: (440) 779-1099.