IRP ¶ 80,600 (1999)
Background. It is common for churches to pay some or all of the medical expenses of their ministers or lay employees. This can include direct payment of expenses, reimbursing employees for expenses they have incurred, and paying a "deductible" amount on an employee's medical insurance. The tax consequences of such payments and reimbursements are not well understood.
Section 105 of the tax code permits employees to exclude from gross income amounts received under an employer financed "accident and health plan" as payments for permanent injury or loss of bodily function, or as reimbursements of medical expenses. The payments can be made on behalf of a spouse or dependent of the employee. This exclusion assumes that the employer has established an "accident or health plan." Unfortunately, the requirements for such a plan are not specified in the tax code. The regulations simply state that "an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness." The regulations further specify that "an accident or health plan may be either insured or uninsured, and it is not necessary that the plan be in writing or that the employee's rights to benefits under the plan be enforceable." Of course, a written plan is preferable, since it generally will eliminate any doubt regarding the existence or date of a plan. The regulations do require that notice of a plan be "reasonably available" to employees (if employees' rights under the plan are not enforceable).
Employers may reimburse employee medical expenses under either a self insured plan (e.g., reimbursements are paid out of the employer's own funds rather than through an insurance policy), or an insured plan. However, if reimbursements are made under a self insured plan, then nondiscrimination rules apply. Generally, these rules require that the plan not discriminate in favor of highly compensated individuals with regard to either amount of benefits or eligibility to participate. If a self-insured plan is discriminatory, then highly compensated individuals ordinarily must report some or all of the amount of the employer's reimbursements as taxable income. If a reimbursement arrangement discriminates in favor of highly compensated individuals on the basis of the amount of benefits (e.g., highly compensated individuals receive a greater benefit than other participants in the plan), then such individuals must report the entire amount of the reimbursements as income. More complicated rules determine how to compute the taxable portion of an employer's reimbursements if the plan discriminates on the basis of participation (rather than the amount of benefits). In general, a plan discriminates in favor of highly compensated individuals on the basis of eligibility to participate unless the plan benefits 70 percent or more of all employees. Some employees can be disregarded in applying this test, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees, if they are not participants in the employer's plan.
Key point. Who are highly compensated individuals? For churches, they include (1) one of the 5 highest paid officers, or (2) those employees among the highest paid 25 percent of all employees (some employees are not considered, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees—and who are not participants in the employer's plan).
The regulations specify that "benefits paid to participants who are not highly compensated individuals may be excluded from gross income … even if the plan is discriminatory." The fact that highly compensated employees must report some or all of their reimbursements as income does not affect the ability of non highly compensated employees to fully exclude employer reimbursements.
A recently published internal IRS policy provides church treasurers with some helpful guidance on these rules.
The IRS ruling. The IRS policy addresses this question: "Are employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan excludable from gross income by the employee under section 105(b) of the Internal Revenue Code?" The IRS policy concludes that "employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan are not excludable from gross income by the employee."
The IRS noted that employers often adopt self-insured accident and health plans to cover medical expenses incurred prior to the date of the adoption of the plan but within the same taxable year. This is done in an attempt to allow employees to exclude these medical expense reimbursements from income.
Example 1. A church employee experiences a severe illness. The church board agrees to pay the $2,500 "deductible" on the employee's health insurance policy. The board assumes that this amount is nontaxable because it was motivated by charity. Several weeks later, the board learns that the payment is nontaxable only if the church had a formal accident and health "plan" in place. The board hastily drafts a few paragraphs describing its "plan," and inserts the text in the minutes of a board meeting.
The IRS noted that
The basic tenet of income taxation is that unless wages, benefits or other income fall within an explicit exclusion to the Internal Revenue Code's definition of gross income, they are included within that term. Exclusions and exemptions from income are matters of legislative grace and are construed narrowly …. [Code section] 105(b) states that gross income does not include amounts paid, directly or indirectly, to the employee to reimburse the employee for expenses incurred by him, his spouse or dependents for medical care …. However, section 105(b) does not apply unless the medical expense reimbursements are received under an accident or health plan.
The IRS pointed out that the income tax regulations define a "plan" as "an arrangement for the payment of amounts to employees in the event of personal injuries or sickness." The IRS conceded that a plan "need not be enforceable and need not be in writing." However, in order for there to be a plan, the employer "must be committed to certain rules and regulations governing payment. These rules must be made known to employees as a definite policy and must be determinable before the employee's medical expenses are incurred."
The IRS concluded that "payments for reimbursement of medical expenses incurred prior to the adoption of a plan are not paid or received under an accident or health plan for employees. Thus, these amounts are includible in the employee's gross income … and are not excludable under section 105(b) of the Code."
Relevance to church treasurers. The relevance of the IRS policy to church treasurers is clear. church leaders often distribute funds to ministers and lay employees to cover medical expenses without any serious consideration of the tax consequences. In most cases, they simply assume that these payments are nontaxable. The IRS policy addressed in this article suggests that such an assumption may be erroneous and lead to needless tax complications. In many cases a church not only is required to report the payments or reimbursements as taxable income and add them to the employee's W-2, but the employee will need to report them on his or her tax return and pay taxes on them. All of this can be avoided, the IRS concluded, if the church simply adopted an adequate "plan" in advance of making the medical payments.
Key point. The tax code and regulations do not define a "plan." The IRS policy simply states that an employer "must be committed to certain rules and regulations governing payment," and that these rules "must be made known to employees as a definite policy and must be determinable before the employee's medical expenses are incurred." While a plan need not be in writing, it certainly will be desirable for a church to set forth a plan in writing to eliminate any question regarding when it when it was adopted.
Key point. A plan may not operate retroactively. A church cannot reimburse an employee's medical expenses, and later attempt to insulate these payments from tax by belatedly adopting a medical payment plan.
Let's illustrate these important rules with some practical examples.
Example 2. Rev. M is a minister at First Church. He undergoes major surgery and incurs $10,000 of expenses that are not covered under any insurance policy. The church board decides to reimburse Rev. M for the full amount of $10,000. The church has no formal plan of reimbursing any employee's medical expenses. Several weeks after making the $10,000 reimbursement, the church treasurer learns that the reimbursement will represent taxable income to Rev. M unless it was made pursuant to an "accident and health plan." The church board quickly adopts a written plan. The board's action is too late to avoid reporting the $10,000 reimbursement as taxable income to Rev. M under section 105 of the tax code.
Example 3. Same facts as example 2, except that the church board decides that their previous decision to reimburse the pastor's medical expenses constituted an accident and health "plan." They rely on the fact that such a plan need not be in writing. It is likely that the board's argument will fail. According to the IRS internal policy, an employer "must be committed to certain rules and regulations governing payment," and these rules "must be made known to employees as a definite policy and must be determinable before the employee's medical expenses are incurred." It is very unlikely that the IRS would consider the mere act of reimbursing the pastor's medical expenses to constitute a "plan." If the church's argument were accepted, it would render the plan requirement meaningless, since any employer's payment or reimbursement of medical expenses would automatically constitute a plan.
Example 4. Same facts as example 2, except that the church treasurer learned of the "plan" requirement a few weeks before the reimbursement was made. Prior to making the reimbursement, the church board adopted a "plan" that stated: "Resolved, that the church will pay the unreimbursed medical expenses of the pastor." It is possible that this action will not constitute a valid plan. According to the IRS internal policy, an employer "must be committed to certain rules and regulations governing payment," and these rules "must be made known to employees as a definite policy and must be determinable before the employee's medical expenses are incurred." Does the one-sentence resolution by the church board satisfy this test? Unfortunately, the answer is not clear. The church could have eliminated any doubt by providing more detail in the resolution.
Example 5. Same facts as example 2. The church treasurer realizes by now that the $10,000 reimbursement cannot be excluded from the pastor's income as a payment under an accident and health plan under section 105 of the tax code. The church treasurer is wondering if the amount can be excluded from the pastor's income as a charitable or benevolent distribution from the church. This is a possibility, depending on the circumstances. Churches certainly are free to make distributions to the poor and needy, since such distributions further a church's religious and charitable purposes. However, when churches make distributions to one of their own employees (such as the pastor in this example), it is less likely that the distribution will be viewed by the IRS or the courts as serving the church's religious and charitable purposes. This is so for the following two reasons: (1) Whenever an employee is the recipient of a church distribution, the immediate assumption is that the distribution represents additional taxable compensation for services rendered. (2) The income tax regulations define "charitable" quite narrowly. The term includes the "relief of the poor and distressed or of the underprivileged." The regulations define "needy" as "being a person who lacks the necessities of life, involving physical, mental, or emotional well being, as a result of poverty or temporary distress. Examples of needy persons include a person who is financially impoverished as a result of low income and lack of financial resources, a person who temporarily lacks food or shelter (and the means to provide for it), a person who is the victim of a natural disaster (such as fire or flood), a person who is the victim of a civil disaster (such as civil disturbance), a person who is temporarily not self sufficient as a result of a sudden and severe personal or family crisis (such as a person who is the victim of a crime of violence or who has been physically abused)." It is unlikely, though not impossible, that the church's reimbursement of the pastor's medical bills would be deemed a "charitable" distribution under this definition.
Example 6. Same facts as example 2, except that the church board adopted a plan several months before reimbursing the pastor's medical bills that spelled out the church's commitment to paying the senior pastor's medical bills not covered under any available insurance coverage. The plan did not provide for the payment of any other employee's medical bills. Assuming that the board's action qualifies as an accident and health "plan," it will not prevent the $10,000 reimbursement from being treated as taxable income to Rev. M. Why? Since the church's plan is self-insured (the pastor's medical expenses will be paid out of the church's general fund), the $10,000 is excludable from Rev. M's income only to the extent that the church's plan is not discriminatory. If Rev. M is one of the 5 highest paid officers, or is among the highest paid 25 percent of all employees, he may not exclude any of the $10,000 from his income for tax purposes if the same benefit is not available to non highly compensated individuals.
Example 7. First Church provides health insurance for Rev. G, who reports his income taxes as an employee. In order to reduce the cost of the insurance, the church elects a $1,000 deductible (e.g., the insurance pays for any expense only to the extent that it exceeds $1,000). The church established a "medical fund" for Rev. G in order to reimburse all of his medical expenses that are less than $1,000 (and not covered by insurance). The church does not provide health insurance, or a "medical fund," for any other employee. The church's "medical plan" is self insured and discriminatory (in favor of Rev. G, a highly compensated individual), and accordingly all of Rev. G's medical expenses reimbursed by the church represent taxable income and must be included on his W 2 and Form 1040 (as wages). However, the health insurance premiums paid by the church are not taxable to Rev. G.
Payment of Employee Medical Expenses
Here are some important points to consider before paying some or all of an employee's medical expenses:
- Do you want the payments to be nontaxable? There are only two ways for this to occur: (1) The payments satisfy the IRS definition of "charitable." This definition is quoted in the article. Note that this is a narrow definition, especially in the context of employees. (2) The payments are made pursuant to an accident and health plan.
- If you are considering the adoption of an accident and health plan, note the payments made under the plan will be nontaxable only if they meet the following conditions: (1) an adequate plan is established prior to the payment or reimbursement of medical expenses, and (2) the plan does not discriminate in favor of "highly compensated individuals" as defined in this article.