By now you are probably aware of how great Section 105 plans can be. In the right situation, they are a home run.
But how much do you know about the plan document? What about the rules, requirements and qualified expenses? If you are a business owner looking for tax-preferred ways to fund medical expenses, a Section 105 plan could be a great option.
In this post, we will help you understand the advantages and disadvantages, tax benefits, and how to set up a plan for your company. Let’s jump in.
Table of contents
- What is a Section 105 Plan?
- Tax Advantages of Section 105
- List of Qualified Section 105 Plan Expenses
- Plan Example
- Document Rules & Requirements
- Annual Compliance Requirements
- Where Are Section 105 Expenses Included on My Tax Return?
- Bottom line
What is a Section 105 Plan?
A Section 105 plan is also called a Health Reimbursement Arrangement (or “HRA”). It is a company-sponsored plan that reimburses employees for medical care expenses incurred.
The employer reimburses the employees for allowable expenses incurred. It is not structured as a salary reduction. The company can establish the maximum or reimbursement limit for a specified period. Additionally, this plan reimburses expenses that another plan has not reimbursed.
A popular option allows the plan to have a “rollover” provision. This provision allows any unused portion of the employee’s reimbursement amount to be rolled over to the following plan year. Without this provision, the excess or unused portion will be forfeited.
The IRS requires that a company maintains a written plan document. The plan document must define eligible expenses, the maximum amount of employer reimbursement, and other eligibility requirements.
The IRS requires that employees submit documentation in support of their reimbursement claim. This documentation must be retained for ten years.
Section 105 plans are required to comply with IRS nondiscrimination rules. These rules state the plan cannot discriminate in favor of highly compensated employees (HCEs). This relates to participant eligibility or benefits provided under the plan.
|Can Include Insurance Premiums||Easy Self Administration|
|Tax-Free Reimbursements||Can Cover F/T or P/T Employees|
|Low Administration Fees||Flexible Reimbursement Policy|
|Solo or Owner-Only Option||Many Qualified Expenses|
Tax Advantages of Section 105
A Section 105 plan offers tax advantages to both companies and employees. The main advantage is that C-corporations, limited liability companies (LLCs), and partnerships usually qualify for a full tax deduction.
Companies can deduct the plan costs and medical reimbursements as a qualified business expense. In addition, the reimbursements are tax-free to the recipient employees. The deductible reimbursements under the plan include:
- Medical insurance premiums for eligible employees and their dependents
- Dental insurance premiums
- Premiums paid for long-term care insurance
- Qualified expenses for medical, dental, and vision, paid out of pocket by employees and their dependents
List of Qualified Section 105 Plan Expenses
Qualified medical expenses under a Section 105 plan include amounts paid for the diagnosis, cure, treatment, or prevention of disease or affecting any structure or function of the body. Qualified expenses also include any relevant transportation to receive medical care.
There are a variety of expenses that are allowable for reimbursement under a plan.
|Lab fees||Dental surgery||OBGYN costs||Speech therapy|
|Sleep aids||Vaccinations||Infertility treatment||Medical operations|
|Physical therapy||Orthodontic fees||Contacts & Glasses||Eye drops|
|X-rays||Prescriptions||Flu shots||Certain Supplements|
|Prescriptions||Psychiatrist fees||Allergy Pills||Chiropractic|
A Section 105 plan can also include qualified long-term care services. Specific yearly premium amounts that are fully deductible using Section 105 plans include the below:
- 40 years old or less: $200 per year
- Between 40 and 50 years old: $375 per year
- Between 50 and 60 years old: $750 per year
- Between 60 and 70 years old: $2,000 per year
- More than 70 years old: $2,500 per year
Lodging expenses up to fifty dollars per day to receive specialized care in a specific location are reimbursable, so long as there is no vacation element to receiving the medical care in that location.
Let’s look at an example of Jane, who spent $10,000 on medical-related fees, indicated below:
|$250||Co-pays for physician visits|
|$1,000||X-ray to diagnose a back injury|
Jane may be reimbursed for $8,500 of these expenses. Teeth whitening, hair removal, and gym fees are non-qualified medical expenses under Section 105 plans and cannot be reimbursed tax-free.
Carry Over Provision
The IRS issued Revenue Ruling 2002-41 to clarify issues relating to section 105 plans. It includes a provision for a plan to manage and capitalize on future deductibility of unused medical expense reimbursements. Employees can carry the excess over to future years if they do not use their maximum allowable amount. This ensures a deduction for significant medical expenses incurred in the coming years.
The carry-over provision applies to all qualified employees. The maximum amount available under this provision will accumulate over successive plan years, and the company must track the carry-over for each employee. If desired, the company can select a maximum carry-over amount.
Document Rules & Requirements
One of the critical concepts surrounding Section 105 plans is legitimate employment between spouses or any other employee. The IRS closely scrutinizes this issue, and the employment relationship must exist. As such, the following items should be in place to ensure the plan operates correctly:
- A written and documented employment agreement
- A log of hours worked
- An established and reasonable wage for work performed
In addition, you should consider the following:
- The employee is the insured (any insurance policy should be in the employee’s name).
- Separate checking accounts should be maintained (one for business and one for personal).
- Payment for medical expenses should be made by the employee from their account and then reimbursed by the company.
There are also other types of healthcare arrangements that fall under the umbrella of Section 105 Plans. Other common terms or plan structures include:
- Health Reimbursement Arrangement (HRA)
- Medical Reimbursement Plan
- Qualified Small Employer HRA (QSEHRA)
- Health Reimbursement Plan
- Medical Expense Reimbursement Plan
- Individual Coverage HRA (ICHRA)
- Health Reimbursement Account
- Group Coverage HRA (GCHRA)
These all are different terms that generally mean the same thing and refer to health reimbursement arrangements (HRAs) as a whole.
Annual Compliance Requirements
Companies that offer Section 105 plans must submit Form M-1 by March 1 of the calendar year following the calendar year for which the report is required. Form M-1 provides specific information on the plan, including the following:
- What type of coverage is provided
- Insurance coverage information
- Number of participants covered in the plan
- Information about any enforcement actions
- Information regarding compliance with Part 7 of ERISA, including any litigation alleging non-compliance
The form must be filed electronically to the U.S. Department of Labor, Employee Benefits Security Administration.
At least thirty days before offering a Section 105 plan, the business must file Schedule M-1 to comply with regulations. Only companies that plan to provide medical coverage benefits (not just disability or life insurance benefits) must file Form M-1. If significant changes occur during a calendar year that affects the plan’s status, a Form M-1 must be filed.
Significant changes can include coverage for employees located in another state or an increase in the number of employees covered by the plan by more than 50% from the preceding calendar year. If the plan experiences a material change as defined in the plan documents, Form M-1 must also be filed.
Companies must ensure that they file Form M-1 completely and accurately. EINs and contacts for any other individuals or companies who have control or authority over the Section 105 plan or its assets should be given.
Information regarding every state in which the Section 105 plan operates must be listed. A confirmation number will be presented at the end of the filing process, which should be retained until the following year since it will be required for the new filing.
IRS Annual Filing Requirements
Companies must file either Form 5500, Form 5500-SF, or Form 5500-EZ with the IRS depending upon the number of participants in the plan. This form provides general information on the plan, including the plan’s name, plan administrator information, number of people covered under the plan, total assets available in the plan, contributions made towards the plan during the year, and specific compliance and funding questions.
Companies that offer the plan to more than 100 participants must file Form 5500, which is quite complicated and requires outside actuarial valuation done by an outside qualified party.
Smaller businesses can complete form 5500-SF with less than 100 participants. It must be filed electronically. Form 5500-EZ is available for one-person (or one-person plus spouse) plans. It must be filed on paper and submitted to the IRS. However, if the company would instead file electronically, the owner may submit Form 5500-SF instead.
Typical schedules in the Form 5500 filing include Schedule A, which details premium and agent commissions. This schedule does not apply to self-funded plans. Schedule C is sometimes required and lists the fees associated with the plan. Form 5500, Form 5500-SF, and Form 5500-EZ must be filed by the last day of the seventh month following the plan year’s end.
Where Are Section 105 Expenses Included on My Tax Return?
Section 105 expenses are classified on the tax return according to the type of legal structure the company falls under. Business owners should work with their CPAs to ensure correct classification.
Sole proprietorships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 14 of Schedule C (Profit or Loss from Business). Under labor and tax regulations, the reimbursement expense must be paid directly to the employee.
The employee must, in turn, cover the sole proprietor on the insurance policy for this to be deductible from the business’s taxable income. The reimbursement expense will appear on the employee’s W-2 as non-taxable fringe benefits, generally in box 12 FF. These amounts are excluded from the employees’ taxable income.
Owners of sole proprietorships with no employees do not qualify for the Section 105 tax-free treatment of medical expense deduction. Instead, they can include the cost of their medical plans in line 29 of Form 1040. However, they are still subject to the 15.3% self-employment tax on these expenses.
Partnerships who qualify for Section 105 plans by employing a spouse or family member may include the expense in line 19 of form 1065. This expense is directly deducted from the business’s taxable income divided into each partner’s K-1 tax form.
However, partners who do not qualify for Section 105 treatment must include any payments for health insurance premiums made by the business in the “Guaranteed Payments” section of form 1065. This amount is then included in taxable income to the partner but can be deducted in line 29 of Form 1040. It is still subject to the 15.3% self-employment tax like a sole proprietorship.
S-Corporations are eligible to set up Section 105 plans. Still, they cannot claim tax-free exemptions that sole proprietorships or partnerships can if they have family members who work for the company.
Instead, the payments for shareholder health insurance premiums and reimbursements made through the company appear on 1120-S under item 1b) Returns and allowances. These payments are taxable income to the business owner. However, payments made for group health employee benefits to employees who are not classified as shareholders can be deducted directly from taxable income in line 18.
Like sole proprietorships and partnerships, the premiums and medical reimbursements can be deducted on Form 1040, line 29. It is still subject to the 15.3% self-employment tax.
C-Corporations file Form 1120 and may deduct the total cost of health insurance premiums for both owners and employees on line 24, Employment benefit programs. C-corporations enjoy the tax-free benefits of Section 105 plans and are not subject to some of the limitations on individual reimbursements that sole proprietorships, partnerships, and S-Corps are.
Premiums and reimbursement payments flow through to the owner’s and employee’s W-2 forms as fringe benefits and are not subject to further taxation.
How to Set Up a Section 105 Plan Document
The 5 steps for setting up a Section 105 plan:
- Choose basic plan structure
Section 105 plans are technically employee welfare plans falling under the ERISA rules. These rules require every welfare plan to have a Summary Plan Description (SPD) and to furnish copies of the SPD to each participant.
The IRS has specific regulations that employers must comply with. The rules cover employee reimbursement for individual health insurance premiums that do not trigger ERISA plan status. For example, the company cannot endorse specific separate health insurance policies or pay directly for them.
- Determine eligible employees and dependents
Most planned documents will specify that employees must be qualified as full-time employees. This is typical for employees that work over 1,000 a year. Discrimination rules will not allow you to pick and choose different participants outside the annual hourly requirements. Dependence can be included or excluded.
- Select the eligible expenses
Fortunately, the rules allow for a variety of eligible expenses. Traditional, qualified expenses include co-pays, prescriptions, and other medical-related reimbursements. As a general rule, if a physician or medical professional prescribes or states that a procedure is necessary, it is deductible. But you do have the ability in the plan document to specify certain expenses that are or are not allowable.
- Determine proper exclusions
Virtually all business owners qualify to offer a plan. However, unique rules and exclusions can apply to your company. This depends on how the plan is structured and what you want to offer or exclude. Companies can decide the amount of the employee annual reimbursement and can even offer different reimbursements to different employee classes.
- Finalize plan document
Once all the provisions and exclusions are determined, you must finalize the plan document. These documents should not be completed on your own. Remember that they must meet IRS approval. As such, you should engage a third-party administrator who can draft a proper plan. Once prepared, ensure you sign the plan and deliver the summary plan document to employees to understand the rules and requirements.