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Health Reimbursement Arrangement Deductions and Funding


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Has anyone reviewed the deduction and funding issues with respect to the new HRAs? Specifically, I am looking into setting up an HRA for current employees to fund their future premiums that will be used for individual policies following retirement. It does not appear that the Employer may receive a current deduction for the contributions to the HRA until after retirement when the employees begin tapping into the HRAs for their health insurance premiums. However, the contributiosn to the HRA and the later use of the HRA money to pay premiums on retiree health insurance would not be includable in the former employee's income pursuant to 105 and 106. I would like to find a way where the employer can take a current deduction for contributions to the HRA that will not be used to pay medical premiums until later. I don't want to use a VEBA because nondiscrimination rules will apply.

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The HRA rules are not concerned with contributions...only expenses. There is nothing in the guidance discussing putting any money aside for future liabilities. It is only guidance on what liabilities may be carried forward without triggering taxation to the participants.

Although not addressed in the guidance, the benefits community assumes that an HRA could be used in conjunction with a VEBA. There is no other funding vehicle available where deductions could be taken (other than a 401(h) account in a defined benefit pension plan - and I doubt they would be appropriate for an HRA).

Given your aversion to a VEBA, there isn't anything else available.

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MGB is correct that Notice 2002-45 and RR 2002-41 were not related to deductions. However, tax deductions are granted under 162 and 105 subject to limitations under Code Sections 419 and 419A.

As provided in Code Section 419, contributions to a "funded welfare benefit plan" are deductible in the year made to the extent that they represent the current year's "qualified" cost. Under Code Section 419A©, additional contributions for post-retirement medical benefits (without projection) may be deducted over the employee's working lifetime.

Note that under Code Section 419(e)(3) welfare benefit fund includes VEBAs as well as a taxable trusts. Therefore I must take issue with MGB on that issue. In fact, use of a VEBA is of limited value (although I believe in them and favor them) because trust earnings attributable to post-retirement medical funds are subject to UBIT. Tax-favored investments are therefore appropriate for funding vehicles for such accounts.

In other words if the employer uses a model of HRA that is funded, current deductions are available. If the employer does the HRA through "phantom" (unfunded) accounts or accounts under the employer's ownership and control, deductions will be allowed only to the extent of the current expenses (qualified costs) plus a 25% additional amount for unpaid claims.

PS Those "non-discrimination" rules you are concerned with (Code Section 505) will likely apply to any arrangement that seeks to avoid the 100% excise tax under Code Section 4976. Besides, the non-discrimination rules under Code Section 105(h) apply in any event. Also note that Code Section 419(t) applies the controlled-group and affiliated service group rules to such arrangements.

My recommendation: accept the inevitability of non-discrimination rules (bite the bullet!) and run with it using a VEBA.

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Thanks MGB and vebaguru. Because discrimination issues are the main concern, I guess I will need to fund the HRA through a rabbi trust. PLR 9107031 indicated that a rabbi trust type of arrangement was not a "welfare benefit fund" for purposes of 419 and therefore not subject to any excise tax under 4976. Therefore, in my case, the Employer will not be able to take deductions until premiums are reimbursed, which will be after retirement.

With respect to 105(h), I was planning on setting up the reimbursement arrangement as a premium only reimbursement arrangement instead of an HRA to avoid the application of 105(h). Treas. Reg. 1.105-11(a)(2) indicates that "a plan which reimburses employees for premiums paid under an insured plan is not subject to this section." The premium reimbursement arrangement would only reimburse retirees for premiums for individual insurance policies that they purchase. I have a number of employers in the same control group, but I guess that would not concern the employers if the PRAs are unfunded even if I set up a different PRA (with different reimbursement levels) with each employer.

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While the model you're selecting will avoid the Code Section 4976 tax, it will not result in a tax deduction for all contributions, only for the actual expenses, as you acknowledge.

My copy of the Regulations does not contain a 1.105-11(a)(2). The sentence you quote is in 1.105-11(B)(2).

It sounds as though your approach will work. However, by the way you keep trying to wiggle out of non-discrimination rules, it sounds as though you are trying to "carve out" a select group of employees for coverage. Be aware that a carve out will not work due to Code Section 414(t). All employees of the controlled group or affiliated service group must be included in determining whether or not the plan discriminates in operation.

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I agree. I meant 1.105-11(B)(2). The employer only wants to cover highly compensated individuals. I know 414(t) requires aggregation for 106 purposes, but I fail to see the prohibition against discrimination in operation. Wasn't that something that was repealed--the old 162(k)?

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You pose an intriguing premise: although under Code Section 414(t), accident and health plans require inclusion of all entities in determining whether or not they discriminate, nothing under Code Sections 106 (listed under 414(t)) or 105 (incorporated because it defines the terms used in Code Section 106), requires nondiscrimination with respect to insured health benefits unless those benefits are:

1. Funded through a VEBA or other welfare benefit fund needing to comply with Code Section 505 so as to avoid Code Section 4976; or

2. Self-insured as a medical expense reimbursement plan under Code Section 105(h); or

3. Are intended to be deducted in the year the amounts are contributed to the arrangement rather than the year in which the premiums are actually reimbursed.

This sounds like pretty good stuff. However, I'm afraid you didn't read far enough in Regs. Section 1.105-11(B)(2). In context, the quotation is: "However, a plan which reimburses employees for premiums paid under an insured plan is not subject to this section. In addition, medical expense reimbursements not described in the plan are not paid pursuant to a plan for the benefit of employees, and therefore are not excludable from gross income under section 105(B). Such reimbursements will not affect the determination of whether or not a plan is discriminatory."

In other words, such reimbursements of premiums are not subject to nondiscrimination requirements and are taxable to the (retired) employee. The employer gets a deduction later and the employee pays tax on it when it is received. Not such a good deal after all.

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vebaguru, thanks. However, the premium reimbursement arrangements I propose will describe the medical expenses (i.e., premiums allowed under 213) and accordingly, premiums will be paid pursuant to a plan for the benefit of employees. I believe the sentence you cite is meant to apply to expenses that are reimbursed but are not provided for in the reimbursement plan. In such case, the reimbursements would not be treated as part of the plan and would be taxed and not subject to nondiscrimination testing. Regardless, I am now trying to figure out a way to use a funding arrangement to get current deductions for future premium payments--because the deduction loss causes the arrangement to not be that advantageous. Obviously, it will be subject to some discrimination requirements, but maybe I can peg the reimursements to a % of compensation--I know 105(h) disallows this, but some provisions of IRC allow this. Do VEBAs allow this?

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OHH-

You state that the "premium reimbursement arrangements I propose * * * will be paid pursuant to a plan for the benefit of employees." You seek treatment as a plan that provides premium reimbursements for employees, but by your own admission your plan will be used to provide premium reimbursements for former employees.

The sentence is to be read in the context of the paragraph in which it occurs. The paragraph begins, "The rules of this section apply to a self-insured portion of an employer's medical plan or arrangement even if the plan is in part underwritten by insurance." This is clearly referring to an employer's medical plan. The mention in the third sentence of "premiums paid under an insured plan" refers back to the same "employer's medical plan" mentioned in the theme sentence. That explains why the next sentence states that "medical expense reimbursements not described in the [employer's medical] plan are not paid pursuant to a plan for the benefit of employees, and therefore are not excludable from gross income under section 105(B).

So there are 2 reasons why your model will not work: (1) Benefits are provided to former, not current, employees, and (2) you intend to reimburse individual premium expenses rather than the retirees' share of premiums under the employer's health plan.

The way to get a current deduction for future premium payments was referred to earlier: the employer can deposit the funds (within the limitations of 419A©) into either a VEBA or a taxable trust. IRC Section 505 provides that "In the case of any benefit for which a provision of this chapter other than this subsection provides nondiscrimination rules, paragraph (1) shall not apply but the requirements of this subsection shall be met only if the nondiscrimination rules so provided are satisfied with respect to such benefit.

That means that you can get out of the nondiscrimination rules of 505 by complying with the much easier nondiscrimination rules of 105(h). Much easier because it is possible to aggregate all health and/or welfare benefit plans together in doing the testing and nondiscrimination is determined as a percentage of compensation. Here's a revelation: non-HCEs generally cost as much as HCEs to provide health insurance for. Therefore it is theoretically possible to make additional retiree health contributions for HCEs only without discriminating in favor of HCEs, because the plans are aggregated.

The Regs under 105(h) provide that a percentage of salary allocation will not be acceptable, but it is certainly possible to accomplish the same result by means that are x dollars for each class of employee. This is what my VEBAs do (and why I call myself VEBAGURU)! I have been establishing such arrangements for several months now.

So yes, VEBAs can be used to accomplish this. However, VEBA or not, investment earnings inside the VEBA on retiree medical funds are subject to UBIT. Also watch out for 419A(d) that counts contributions to such an arrangement on behalf of key employees as annual additions toward the IRC Section 415© limit (the dollar limit, $40,000 for this year).

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Vebaguru, You've lost me. The analysis doesn't make sense to me. Notice 2002-45 specifically states that "medical care expense reimbursements under an HRA are excludable under 105(B) to the extent that reimbursements are provided to the following individuals: current and former employees (including retired employees) . . . " So, former/retired employees are treated the same as active employees under 105(B).

Section 105(B) of the Code reads "gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for medical care (as defined in section 213(d)) of the taxpayer. Section 213 of the Code includes amounts paid for insurance in the definition of "medical care." The Premium Reimbursement Arrangement I propose would only reimbursement insurance as defined by section 213 of the Code.

As I understand you, if the Employer allows retirees to continue in their current insured medical plan only if they pay the premiums under the insured medical plan (by using the accumulated account balances in their Premium Reimbursement Arrangement), then the premium reimbursements would be excludable under section 105(B) of the Code because they are being used to pay for Employer sponsored health insurance. But, if the Employer pays out reimbursements for premiums paid by retirees for their own individual policies, then 105(B) would tax them.

The way I read Treas. Reg. 1.105-11 is as follows "The rules of this section apply to the self-insured portion of an employer's [Premium Reimbursement Arrangement] even if the arrangement is in part underwritten by insurance. . . However, [a PRA] which reimburses employees for premiums paid under [any insured medical plan] is not subject to this section. In addition, medical expense reimbursements (such as medical expenses other than premiums in the case of the PRA I propose) not described in the [PRA] are not paid pursuant to a plan for the benefit of employees . . ." If your reading is correct, however, the solution would be simple, just have the Employer sponsor a medical plan for retirees, and have retirees use the build-up in their PRA to pay the full premiums under the Employer adopted retiree medical plan.

Thanks for your comments regarding a VEBA, however the employer has no other self-insured medical plans with which to aggregate with the PRA I propose. Now, I want to try and avoid the 105(h) rules so that I can base levels of benefits on years of service. In talking with the IRS, as long as the years of service calculation of benefits does not disproportionately favor HCEs, which in my case it would not (equal percentage of HCEs and NHCEs at each level of years of service), the IRS will likely approve an application for a VEBA. If I create the PRA as a 105(h) plan, then years of service are not allowed to be used to calculate benefits.

I should be fine on the 415© limits because the employer is bumping against the 25% deduction limit on the DB and DC plan and so only 18,000 or so is used up in the DC Plan for each HCE. I guess to avoid UBIT I should invest in tax free money market funds or something.

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I'm glad to see you have considered the issues. We're not far apart. Notice 2002-45 permits reimbursement of employees and former employees under an HRA. But an HRA is inherently a MERP under IRC section 105. You were attempting to avoid the nondiscrimination test under section 105.

Your proposal is to reimburse medical premiums which would indeed fit under 213(d). The participants in such an arrangement would pay tax on the payments from the plan but would be entitled to claim an itemized medical deduction for those premiums.

The difference is in our understanding of MERPs under Treas. Reg. 1.105-11. Your simple solution to my interpretation is not so simple. Yes, the Employer can sponsor a post-retirement medical plan. (Many do.) Yes, the retirees can use the balance in their PRA to pay the premiums. However, and employer-sponsored PRA that is funded is still subject to the nondiscrimination testing requirements of 105(h) IMHO.

Regs section 1.105-11©(3)(iii) provides that "To the extent that an employer provides benefits under a self-insured medical reimbursement plan to a retired employee that would otherwise be excludible from gross income under section 105(B), determined without regard to section 105(h), such benefits shall not be considered a discriminatory benefit under this paragraph ©. The preceding sentence shall not apply to a retired employee who was a highly compensated individual unless the type, and the dollar limitations, of benefits provided retired employees who were highly compensated individuals are the same for all other retired participants.

The next paragraph of the Regs. provides that An employer may designate two or more plans as constituting a single plan that is intended to satisfy the requirements of section 105(h)(2) and paragraph © of this section, in which case all plans so designated shall be considered as a single plan in determining whether the requirements of such section are satisfied by each of the separate plans. My reading of that provisions is that it is not limited to 2 or more self-funded plans but 2 or more plans when one of them is subject to this test.

It sounds to me as though the IRS did not understand that you meant to exclude HCEs from the VEBA. With whom were you speaking? Try Jim Holland, or even Harry Beker.

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Thanks.

I guess I am again confused. In your post on 8/29/02, you stated that "such reimbursements of premiums are not subject to nondiscrimination requirements . . ." Now you state that "an employer-sponsored PRA that is funded is still subject to the nondiscrimination testing requirements of 105(h) IMHO." This seems to be inconsistent.

I'm not sure what relevance Treas. Reg. 1.105-11©(3)(iii) has to this issue because it limits its application to self-insured plans. To determine if a plan is self-insured, the applicable provision is 1.105-11(B). Treas. Reg. 1.105-11©(3)(iii) merely provides an exception to the discrimination rules as they apply to retirees under a self-insured plan if certain conditions are met.

I did a search for commentary on self-insured medical plans (and PRAs) and found a few articles addressing the issue on which we disagree. I found two articles written by Mercer Consultants:

First, "Legal Communique: Health and group benefit plan nondiscrimination testing rules: An overview" written by Mark Hamelburg and Susan Kornetsky in February 2002. In it, the authors write that "The [105] regulations specify that a simple premium reimbursement arrangement--one that reimburses employees for premiums paid under an insured arrangement--is not subject to the nondiscrimination rules."

Second, "GRIST Report: Designing a health reimbursement arrangement to meet recent IRS guidance" written by Mark Hamelburg and Judy Bauserman states that the "105(h) rules for self-insured health plans" do not apply to premium reimbursement arrangements but they do apply to health reimbursement arrangements.

The employer adopted retiree medical plan I propose would be insured by a third party insurer, so it would not be a self-insured plan according to Treas Reg. 1.105-11(B). Further, the PRA does not appear to be a self-insured plan according to the articles above. Accordingly, I see no reason why code section 105(h) would apply and thus the default VEBA discrimination rules would be applicable. However, 105(B) should still exclude reimbursements of the premiums if the retiree medical plan only provided for 105(B) eligible medical care, which it should.

With respect to the two or more plans language, I agree that the regulations on their face do not specify that the two plans must both be self-insured medical reimbursement plans. However, the preamble in T.D. 7754, reads "The final regulations add clarifying provisions that allow an employer with two or more self-insured medical reimbursement plans to aggregate two or more plans into a single plan for purposes of satisfying the nondiscrimination requirements." It seems that "two or more plans" is referring back to the self-insured medical reimbursement plans addressed immediately before. Accordingly, it does appear that the provision in the regs is limited to "2 or more self-funded plans."

I spoke to Robert Fontenrose, who was listed as the 505 contact in the IRS directory. I've spoked to Harry before and as I recall, he generally deals with 125 plans, not VEBAs? Robert was pretty clear that I wanted to include HCEs and NHCEs at each level of benefits. The example I gave him was that contributions to the PRA/VEBA would be made at 3k for 3 yos, 4k for 4 yos, and so on up to 16 yos. He said that as long as HCEs were not disproportionately represented at any level, then the IRS would likely uphold the VEBA as satisfying the discrimination rules under 505 and 501©(9).

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It's nice to engage with someone who does his homework.

The post on 8/29 referred to a premium reimbursement arrangement. That type of arrangement reimburses current medical expenses for current employees or retirees. Tax deductions are taken as amounts are paid out. In the more recent post I was referring to a tax-deductible set aside for reimbursement of future premium expenses. Such an arrangement is a self-funded medical plan currently (in the year of set aside) and needs tested. The premium reimbursements do not need to be tested.

I believe that any fund created for future reimbursements is a "self-insured plan", and therefore Treas. Reg. 1.105-11©(3)(iii) is relevant.

Your commentaries from Mark Hamelburg are not inconsistent with my position.

You claim that "The employer adopted retiree medical plan I propose would be insured by a third party insurer, so it would not be a self-insured plan according to Treas Reg. 1.105-11(B). " However, that would only be true if you were not pre-funding the reimbursement accounts.

I acknowledge your interpretation of the language relative to the two or more plans language. However, I do not believe that IRS intended to say that combined testing on two or more groups cannot be done simply because one group is insured or partially insured rather than self-funded. Incidentally, I know of very few self-funded plans that contain no insurance. If we were to follow your interpretation, we would deduct the stop-loss premiums from the contributions or claims before testing. I doubt that you can find anyone who does the testing that way.

Bob Fontenrose is a very good source at IRS. He did the update of the VEBA Manual for IRS a couple of years ago and is up to date on relevant issues. He obviously agreed with me that you needed to include NHCEs at each level of benefits, thereby acknowledging the nondiscrimination test.

It sounds like were getting closer.

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  • 2 weeks later...

Vebaguru,

I still haven't found anywhere in the Code or the regulations that distinguishes a set aside reimbursement of future premium expenses with a current premium reimbursement arrangement. Treas. Reg. 1.105-11(B)(2) does not make any distinction between the two. Is there any reason you are making this distinction?

I spoke with Ms. Masano and Mr. Zech at the IRS and they both agreed that a prefunded VEBA Premium Reimbursement Arrangement for retiree medical benefits would not be subject to 105(h) nondiscrimination rules but would be subject to the general VEBA nondiscrimination rules. This was based on 1.105-11(B)(2). Ms. Masano said that if I filed a Form 1024 and they kicked it to her and Mr. Zech, that they'd rule 105(h) does not apply. Further, she stated that the only concern I should have is with the deduction of contributions under 419, which she said should not cause a problem based on the contribution scenario I gave her--i.e., 3k for 3 yos, 4k for 4 yos, up to 16.

In addition, I asked Ms. Masano about the section in 105-11(B)(2) following the sentence discussing premiums. "In addition, medical expense reimbursements not described in the plan are not paid pursuant to a plan for the benefit of employees and therefore are not excludable from gross income under section 105(B)." She stated that this sentence would not cause premiums to be taxable to the retired employee. What that sentence was meant to do was prevent an employer from reimbursing medical expenses when a plan was a premium only reimbursement arrangement. Therefore, if an employer sets up a premium reimbursement arrangement and then reimburses a participant for a doctor co-payment, that payment would be includable in the participant's income.

Ms. Masano did not see any issues with respect to whether the retiree medical insured plan was sponsored by the employer or not--just as long as risk was shifted (i.e., the plan (either individual or group) was insured by a third party).

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That's incredibly good news. Unfortunately, IRS is not bound by what they tell you orally. If I were you I would file for a PLR with respect to such an arrangement just to be safe.

Incidentally, I do (still) believe that there is a difference between a current PRA and a plan that accumulates contributions for future premium reimbursements (and that the latter requires non-discrimination testing). But if they are willing to give you a ruling that says otherwise, go for it!

In fact I am adding this issue to the issues that the ABA committee I serve on will be making official comments to the IRS/Treasury relative to Notice 2002-45 and additional guidance needed.

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Under Rev Rul 61-146 employer reimbursements of individual health insurance premiums paid by employees are excludible under IRC 105 and 106 if the employee is obligated to purchase the Insurance in order to receive the reimbursement or alternatively if the employer pays the insurance company directly for the policy owned by the employee. Also arent retirees considered employees for health insurance coverage under Rev. rul 82-196?

mjb

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Vebaguru,

Thanks. What would make you file a plr if you get them to sign off on a Form 1024?

Also, you state that "Incidentally, I do (still) believe that there is a difference between a current PRA and a plan that accumulates contributions for future premium reimbursements (and that the latter requires non-discrimination testing)." Do you have any basis for this? Neither the IRS nor any article I have read has suggested any difference between the two for purposes of 105(h). Nor do the regulations speak to a distinction.

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When is a health reimbursement arrangement a premium reimbursement arrangement and when is it not?

The wording of Notice 2002-45 and RR 2002-41 clearly can be applied to all premium reimbursement arrangements that have carryover balances. The Notice specifically requires all such arrangements to meet the nondiscrimination requirements of 105(h).

I believe that the correct answer to the foregoing question is that a PRA is an HRA when it has balances that carry over from one year to the next (whether or not the arrangement is funded). A PRA is not an HRA when it is done on a current year basis only.

A determination letter for a VEBA allows tax-free inside buildup for funded welfare benefit plans that meet certain requirements. However, under your proposed post-retirement PRA a VEBA will not provide tax-free inside buildup. Under Code Section 512 UBIT applies to accumulations for post-retirement medical benefits. The use of a VEBA therefore is irrelevant to your suggested arrangement.

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Vebaguru,

So, are you saying that setting up a VEBA and using tax free investments wouldn't be any more helpful than using a taxable trust with tax free investments? Any reason for the recommendation in the beginning of these posts--on Aug. 28, 2002, to use a VEBA? If no VEBA is needed, and a company can take a deduction currently for future retiree medical benefits and the only tax to worry about is the UBIT, which can be minimized by using tax free investments, then it would seem easier administratively, to use a non VEBA taxable trust.

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If benefits provided are limited to post-retirement medical benefits, there is no tax advantage to using a VEBA. It certainly is easier to use a non-VEBA trust. However, to avoid problems under 4976 it may still be desirable to comply with IRC Section 505 (VEBA non-discrimination rules) because it provides safe-passage out of the 100% excise tax under that Section.

I like VEBAs because:

1. They are approved by IRS.

2. They protect employees' accounts better than a grantor trust or even a Rabbi trust.

3. They are uniform from state to state since they exist under federal law rather than state law.

But despite those reasons, they are not particularly better unless there is a "business" reason for using it. A VEBA permits multiple types of benefits to be provided within the same trust. It permits tax-free income within the trust for all current (including the 25% medical carryover amount) benefits and anticipated future benefits other than retiree medical benefits.

One more note: You speak of using tax-free investments. Those potentially consist of municipal bonds, life insurance contracts and investments that lose money. None of those is particularly attractive. And if my argument is correct (that a post-retirement PRA is also an HRA), you are precluded from using life insurance contracts under Notice 2002-45. Annuities are not tax-exempt when used for funding a welfare benefit, since they cannot be distributed from the plan to the participant.

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Maybe I need an education but why cant the employer can reimburse employees/retirees for health insurance premiums under one of the following programs:

1. If the employer reimburses the employees without setting up a fund which will carry over from year to year just follow Rev. Rule 61-146 and reimburse employees for the purchase of health insurance or pay the insurer directly. The employer can pay the funds from its general account.

2. Where the employer wants to permit a carry over from year to year use the procedures in Notice 2002-45 which requires that the program conforms to non discrimination rules of 105(h). Since reimbursement of health insurance premiums is not subject to non discrimination under Reg 1.105-11(B)(2), there is no requirement to test the program for nondiscrimination on the carry over amount. The last time I checked, Tax regulations trump any provisions in an IRS notice or Revenue Ruling. The notice is devoid of examples of how nondiscrimination would apply to HRAs.

mjb

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You have pretty much summarized our conclusions. There is no evidence that a post-retirement PRA is subject to nondiscrimination testing under 105(h). Notice 2002-45 requires testing under 105(h) only to the extent that the HRA is a "self-insured medical expense reimbursement plan". If a PRA is not an SIMERP, no discrimination testing is required.

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  • 1 month later...

A few weeks ago we had the foregoing lively interchange with respect to currently funding future medical premium reimbursement expenses for executives only. Somewhere along the way I suggested that I had a hard time believing that it was possible to set aside funds for future benefits without being subject to nondiscrimination requirements. I have finally run across the reason why.

In order to be tax deductible under IRC Section 419A(e)(1), reserves (amounts not spent for current year benefits) must be nondiscriminatory in accordance with the requirements of IRC Section 505(B).

This will amend my prior post(s) in which I had reluctantly agreed with OHH that it was possible to avoid testing by limiting benefits to a PRA.

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