Medical reimbursements are excluded and disability payments avoid payroll tax

Plain-English summary

A bankruptcy settlement funded a tax-exempt employee benefit association that established a health reimbursement arrangement and a disability plan for former employees with long-term disabilities. The HRA was funded without participant contributions, reimbursed only substantiated medical expenses, offered no cash alternative, and carried unused balances forward. The IRS ruled that the HRA coverage and reimbursements were excluded from participants' gross income under sections 106 and 105(b). It also ruled that the disability payments were not wages for FICA or FUTA purposes because the former employees had performed no services during the six-month periods specified by sections 3121(a)(4) and 3306(b)(4).

Ruling snapshot

• Question: Are the HRA contributions and medical reimbursements excluded from income, and are the separate disability payments exempt from FICA and FUTA taxes?
• Outcome: Approved on both questions.
• Key authorities: IRC §§ 105(b), 106, 213(d), 3121(a)(4), 3301, and 3306(b)(4); Treas. Reg. §§ 1.105-2 and 1.106-1.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201527040 Third Party Communication: None
Release Date: 7/2/2015 Date of Communication: Not Applicable
Person To Contact:
Index Number: 105.00-00, 106.00-00 ------------------, ID No. ------------------
3121.00-00, 3301.00-00 Telephone Number:
----------------------------------------------------------- ----------------------
------------------------- Refer Reply To:
------------------------------------------- CC:TEGE:EB:HW
------------------------------- PLR-146896-14
Date: March 25, 2015

Legend:

Taxpayer = ----------------------------------------------------------------------------------------
------------------------

Debtors = ---------------------------------------------

HRA Plan = ----------------------------------------------------------------------------------------
----------------------------------------------------------

Disability Plan = ----------------------------------------------------------------------------------------
-----------------------------

Dear ---------------------------------:

This is in reply to your letter dated October 7, 2014, and subsequent correspondence
concerning whether contribution to, and payments from the HRA Plan are excludable
from gross income under sections 106 and 105 of the Internal Revenue Code (the
Code) and whether payments made by the Disability Plan are wages subject to Federal
Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes.

Debtors filed voluntary petitions for relief under chapter 11 of title 11 of the Bankruptcy
Code. The United States Bankruptcy Court issued an order directing the United States
Trustee to appoint a committee to represent the Debtors’ long term disabled employees
who were participants in the Debtors’ long term disability plans. The Debtors had
historically provided a number of benefits to disabled employees, including disability
coverage and medical benefits. The Bankruptcy Court subsequently issued an order
approving the settlement agreement between the Debtors and the committee. The
committee received Court authority to create the Taxpayer. The Taxpayer was created
to establish and administer the HRA Plan and the Disability Plan.

PLR-146896-14 2

The committee established an LLC on behalf of the long term disabled employees. In
accordance with the terms of the settlement agreement, the settlement proceeds were
placed into the LLC and subsequently transferred to the Taxpayer. The Taxpayer,
which is exempt under section 501(c)(9) of the Code, funds the HRA Plan and the
Disability Plan from the settlement proceeds.

HRA Plan

Only eligible long term disabled former employees of the Debtors who are eligible to
receive benefits under the Disability Plan may become participants and receive benefits
under the HRA Plan. These include former employees of one or more of the Debtors,
as well as surviving spouses and eligible dependents.

The allocation made on behalf of each eligible participant in the HRA Plan from the
settlement proceeds will, in general, constitute the maximum reimbursement amount
available for the participant under the HRA Plan, subject to reduction for administrative
costs and fees. No benefits provided under the HRA Plan are funded directly or
indirectly with any participant contributions.

A participant will be able to use the full amount allocated to his or her account under the
HRA Plan (subject to reduction for costs and fees). The HRA Plan will only reimburse
expenses for medical care as defined in section 213(d) of the Code, including out–of-
pocket medical expenses and premiums for medical insurance. Only those medical
expenses incurred by a participant, or such person’s spouse, dependents and children
who have not attained age 27 as of the end of the taxable year, will be reimbursed. The
HRA Plan will reimburse premiums for insurance covering medical care expenses. Any
unused portion in an account under the HRA Plan at the end of a calendar year will be
carried forward and may be used in a subsequent year until the account is fully spent.
No benefits other than reimbursements of medical expenses will be available under the
HRA Plan either as cash or other nontaxable or taxable benefits. The HRA Plan will
reimburse medical expenses only to the extent such expenses have not been
reimbursed from any other source. Each medical expense submitted for reimbursement
under the HRA Plan will be substantiated.

Following the death of a participant, unused amounts will continue to be available for
any remaining beneficiaries of the participant until the account is fully spent. If any
amount remains in the account following the death of the participant and eligible
beneficiaries, such amount will be forfeited.

Disability Plan

The Disability Plan is effective as of a certain date and provides benefits for participants.
A participant is defined in the Disability Plan as a long term disabled employee of

PLR-146896-14 3

Debtors in active pay status who is disabled and continues to be disabled at all times for
which the applicable benefit payment relates. Disabled or disability is defined under the
Disability Plan as a participant’s inability to perform substantial and material duties of
any reasonable occupation as of the date the Disability Plan was effective. A
reasonable occupation is any job that a participant is or could become qualified to do
with the participant’s education, training, or experience. Continued disability must be
the result of the accident or sickness causing the participant’s disability that existed as
of the date the Disability Plan was effective and for which the participant is under the
direct and continuous care of a licensed physician, other than a member of the
participant’s family or household. Under the terms of the Disability Plan, the
participant’s physician must provide updated medical information on a regular basis and
document the functional restrictions and limitations caused by the participant’s medical
condition prohibiting a return to a reasonable occupation.

Benefits payments under the Disability Plan are distributed under different schedules
based on the age of the participant immediately prior to the effective date of the
Disability Plan, with payments distributed on or about and after the effective date of the
Disability Plan.

Taxpayer represents that the Debtors ceased all operations six months before the
effective date of the Disability Plan, which means that none of the participants
performed services during the month in which the first payment was made and the six-
month calendar period preceding the month of the first payment under the Disability
Plan, or in the six-month calendar periods preceding the dates of other payments under
the Disability Plan.

Analysis

Section 61(a)(1) of the Code and section 1.61-21(a)(3) of the Income Tax Regulations
provide that, except as otherwise provided in Subtitle A, gross income includes
compensation for services, including fees, commissions, fringe benefits, and similar
items.

Section 106 provides that gross income of an employee does not include employer
provided coverage under an accident or health plan. Section 1.106-1 of the regulations
provides that the gross income of an employee does not include contributions which the
employee’s employer makes to an accident or HRA Plan for compensation (through
insurance or otherwise) to the employee for personal injuries or sickness incurred by the
employee or the employee’s spouse or dependents (as defined in section 152). The
employer may contribute to an accident or health plan either by paying the premium on
a policy of accident or health insurance covering one or more of the employees, or by
contributing to a separate trust or fund which provides accident or health benefits
directly or through insurance to one or more of the employees. However, if the
insurance policy, trust or fund provides other benefits in addition to accident or health,

PLR-146896-14 4

section 106 applies only to the portion of the contributions allocable to accident or
health benefits.

Section 105(b) states that except in the case of amounts attributable to (and not in
excess of) deductions allowed under section 213 (relating to medical expenses) for any
prior taxable year, gross income does not include amounts that are paid, directly or
indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the
taxpayer for the medical care (as defined in section 213(d)) of the taxpayer or the
taxpayer's spouse or dependents (as defined in section 152, determined without regard
to subsections (b)(1), (b)(2), and (d)(1)(B)) and any child (as defined in section
152(f)(1)) who has not attained age 27 as of the end of the taxable year. Section 1.105-
2 of the regulations provides that only amounts that are paid specifically to reimburse
the taxpayer for expenses incurred by the taxpayer for the prescribed
medical care are excludable from gross income. Thus, section 105(b) does not apply to
amounts that the taxpayer would be entitled to receive irrespective of whether or not the
taxpayer incurs expenses for medical care.

In Rev. Rul. 2002-41, 2002-2 C.B. 75, an employer sponsors a health reimbursement
arrangement (HRA) that is paid for solely by the employer and not through salary
reduction contributions. The HRA reimburses substantiated medical care expenses (as
defined in section 213(d)) of participating employees and their spouses and
dependents (as defined in section 152) up to a maximum annual reimbursement
amount. Unused amounts from one coverage period are carried forward to subsequent
coverage periods. Participating employees have no right to receive cash or any other
benefit in lieu of medical expense reimbursements. In Situation 2 of Rev. Rul. 2002-41,
the maximum reimbursement amount under the HRA that is not applied to reimburse
medical care expenses before an employee retires or otherwise terminates employment
continues to be available after retirement or termination for any medical care expense
incurred by the former employee or the former employee's spouse and dependents. The
ruling concludes that coverage and reimbursements made under the HRA are
excludable from the gross income of participating employees under sections 106 and
105.

Notice 2002-45, 2002-2 C.B. 93, provides that an HRA is an arrangement that: (1) is
paid for solely by the employer and not pursuant to salary reduction; (2) reimburses the
employee for medical care expenses (as defined in section 213(d)) incurred by the
employee and the employee’s spouse and dependents (as defined in section 152); and
(3) provides that any unused portion of the maximum dollar amount available during the
coverage period is carried forward to subsequent periods. Notice 2002-45 also provides
that benefits under an HRA must be limited to reimbursements of section 213(d)
expenses and that all such expense reimbursements must be substantiated to be
excludable under section 105. Notice 2002-45 further provides that medical care
expense reimbursements under an HRA are excludable under section 105(b) if the
reimbursements are provided to the following individuals: current and former employees

PLR-146896-14 5

(including retired employees), their spouses and dependents (as defined in section 152
as modified by the last sentence of section 105(b)), and the spouses and dependents of
deceased employees.

Federal Insurance Contribution Act (FICA) taxes are imposed on wages, which are
defined in section 3121(a) as all remuneration from employment, unless specifically
excepted. FICA taxes consist of Old-Age, Survivors, and Disability Insurance taxes
(“Social Security taxes”) and the Hospital Insurance taxes (“Medicare taxes”).
Section 3301 imposes Federal Unemployment Tax Act (FUTA) tax with respect to
wages. Section 3306(b) defines wages for FUTA purposes as all remuneration for
employment with certain specific exceptions.

Generally, payments on account of sickness or accident disability with respect to
employment made by employers and third parties to employees are wages for purposes
of FICA and FUTA taxes, but there are exceptions to this general rule. The relevant
exceptions here are section 3121(a)(4), relating to the FICA, and section 3306(b)(4),
relating to the FUTA, which provide exceptions from the definition of wages for
payments made on account of sickness or accident disability by an employer to or on
behalf of an employee after the expiration of 6 calendar months following the last
calendar month in which the employee worked for such employer.

Accordingly, based on the information submitted, representations made and authorities
cited above, we conclude as follows:

(1) Contributions and coverage under the HRA Plan, and payments and
reimbursements of medical expenses made by the HRA Plan will be excludible
under sections 106 and 105(b) of the Code from the gross income of the
participants, their current and surviving spouses, eligible dependents and
children who have not attained age 27 as of the end of the taxable year.

(2) Disability payments made by the Disability Plan are not wages subject to FICA
taxes (social security and Medicare taxes) imposed under section 3121 of the
Code and FUTA taxes imposed under section 3301 of the Code.

No opinion is expressed concerning the Federal tax consequences of the HRA and
Disability Plans under any other section of the Code other than those specifically stated
herein.

PLR-146896-14 6

This ruling is directed only to the Taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

                                     Sincerely,

                                     /S/

                                     Harry Beker
                                     Chief, Health and Welfare Branch
                                     Office of Associate Chief Counsel
                                     (Tax Exempt & Government Entities)