New Treatment and Penalties for Medical Reimbursement Plans

Recent IRS guidance stemming from the Affordable Care Act could catch clients and their advisors off guard

By Dennis Walsh, CPA

Key Takeaways:

  • Recent IRS guidance stemming from the Affordable Care Act (ACA) is eliminating the tax-preferred status of employer payment plans in 2014.
  • Benefits paid through a medical reimbursement plan (MRP) are being reclassified from a pretax employee benefit to a taxable fringe benefit.
  • Execs who are among the five highest-paid officers of a nonprofit organization are considered “highly compensated” regardless of their actual salary.
  • Benefits that highly compensated employees receive may be taxable to the extent that those benefits are not available to the organization’s other employees.

For many years, employers have been permitted to reimburse employees for the cost of individual health insurance policy premiums and for out-of-pocket medical expenses. They’ve also been permitted to exclude such amounts from the employee’s gross income. However, recent IRS guidance, stemming from the Affordable Care Act (ACA), eliminates the tax-preferred status of these employer payment plans beginning in 2014.

The effect of this change is to reclassify benefits paid through a medical reimbursement plan (MRP) from a pretax employee benefit to a taxable fringe benefit. Noncompliant employers risk severe penalties.

Many small nonprofit organizations are not able to provide group health insurance coverage to their employees. Like small-business employers, these organizations have often relied on individually structured health insurance arrangements for select employees—arrangements that received the same favorable tax treatment as group health insurance plans. Beginning in 2014, however, such “stand alone” plans violate ACA market reforms relating to unlimited essential benefits and no-cost preventive services.

This change, announced in IRS Notice 2013-54, has gone beneath the radar of many small employers. It applies to employers of all sizes, even those with fewer than 50 employees not otherwise affected by ACA provisions.

Employers maintaining such arrangements after 2013 are liable for a penalty of $100 per day, per employee participant. They may also be accruing penalties for late deposit of employment taxes attributable to benefits paid. And employees receiving benefits under these arrangements may be facing an unwelcome cut in net take-home pay.

Whom does this affect?

This change applies to employers that pay premiums—either directly to an insurer, through a third-party administrator or through direct reimbursement to an employee—for the cost of health insurance coverage acquired individually by the employee or for the reimbursement of out-of-pocket medical expenses incurred by a covered employee and his or her dependents. These types of arrangements are typically described as a medical reimbursement plan (MRP), Section 105 plan or health reimbursement arrangement (HRA).

The IRS is not saying that these types of plans are now illegal but, rather, that with limited exceptions, they no longer receive tax-favored treatment. Thus, benefits paid through such arrangements are now treated as cash wages subject to income and employment taxes.

When do these changes take effect?

This change is effective for plan years beginning in 2014. For a calendar-year benefit plan, this is January 1, 2014. If an organization uses a benefit plan year other than the calendar year, then it will be effective on the first day of its plan year beginning in 2014.

Are there any exceptions?

The ACA market reforms do not apply to:

  • A group health plan that has no more than one participant who is an employee on the first day of the plan year
  • Excepted benefits, including accident-only coverage, disability income, certain limited-scope dental and vision benefits, certain long-term care benefits, and certain health flexible spending accounts (FSAs)
  • A stand-alone HRA that is limited to retirees
  • An HRA that is integrated with ACA-compliant group health insurance coverage, provided that all participants are enrolled in the health insurance plan
What does this mean for an employer?

As with cash wages, benefits that must now be treated as wages are subject to matching FICA taxes. This is an added cost to the employer.

In addition, benefits paid may need to be included in covered wages in determining the employer’s workers’ compensation insurance premiums. And, if subject to state unemployment compensation coverage, such benefits may add to required contributions to the employer’s UC account.

What should be done next?

Employers need to determine if any existing payment plan is exempted from the market reform requirements, and if it isn’t, they need to determine if it is feasible to modify the plan to bring it into ACA compliance. If neither case applies, then the employer will need to decide if it makes sense to discontinue the plan or maintain it on an after-tax basis.

In making this assessment, be sure you or your clients:

  • Consider the effect on employees from reduced net wages/take-home pay resulting from increased tax withholding
  • Review the impact of additional employment taxes on the organization budget
  • Consider the resulting effect on cash flow and program activities
  • Consider the costs of reporting and paying the new PCORI trust fund fees and reinsurance program contributions, also applicable to self-insured plans

Note that a one-participant plan excepted from the ACA market reforms must nevertheless satisfy the long-standing nondiscrimination requirements of Section 105 of the Internal Revenue Code, pertaining to self-insured benefits provided to so-called highly compensated employees, in order for plan benefits to be excludable from the participant’s wages.

For example, an executive who is among the five highest-paid officers of a nonprofit organization is considered “highly compensated” regardless of the amount paid. Thus, the benefits provided to such a person may be taxable to the extent that those benefits are not available to non-highly compensated employees. Certain classes of employees are disregarded for discrimination testing purposes. However, future ACA regulations will likely have a profound effect on current nondiscrimination rules.

What if taxable benefits have already been paid?
  • Decide if the organization will pay the employee’s share of FICA taxes on prior payments or if it will recover such an amount from the employee.
  • Adjust payroll records as needed.
  • Promptly catch up on any undeposited IRS Form 941 taxes attributable to such adjustment, in order to reduce the risk of penalty for late deposit.
  • Include applicable benefits as taxable wages on Form 941 for the calendar quarter in which the benefits are paid.
Additional resources

For additional information and planning opportunities pertaining to the aforementioned law changes, consider a recent webinar from Clifton Larson Allen LLP, available for replay. This 60-minute presentation also highlights key changes from the Regulations released on February 10, 2014. Allow several minutes for the audio stream to start. The accompanying outline can be obtained from the Financial Management Updates page of the Guilford Nonprofit Consortium (GNPC) web site.


Consult your accountant and other employee benefit professionals as needed for advice on these issues.

About the Author

Through The Micah Project, Dennis Walsh, CPA, serves as a volunteer consultant to religious workers and exempt organizations, focusing on financial management, legal compliance and organizational development. A graduate of the University of Wisconsin, he completed the Duke University certificate program in nonprofit management and is a member of the North Carolina Association of CPAs and the American Institute of CPAs. He can be reached at nonprofitcpa365@gmail.com.