Retiree coverage under medical reimbursement plan.

Established a plan (P) that reimburses eligible employees for medical care expenses (as defined in Sec. 213) incurred by the employee and his or her spouse and dependents (as defined in Sec. 152). P reimburses only substantiated and otherwise unreimbursed medical expenses; employees have no right to receive cash or other benefits under P. E also sponsors a group health plan, under which eligible employees can elect from various options.

Eligible employees may elect among three coverage options under P E accrues a notional annual contribution on each participant's behalf based on the enrollee's option and whether the participant is enrolled in employee--only or family coverage under E's group health plan. The annual contribution not used during the plan year is carried over for use in subsequent plan years if the employee continues to participate in P.

Under P, covered expenses are those that would otherwise be covered by the group health plan, but for which no benefits are paid due to the group health plan's deductible, co-payment and coinsurance provisions. Such covered expenses are first subject to a deductible; additional covered expenses are reimbursed. The deductible and maximum reimbursement amount available to a participant each P year vary, based on the enrollee's option and whether an expense is incurred in or out of network. Although a maximum annual contribution is designated at the beginning of the P year, only an additional pro-rata portion of such amount is available for reimbursement of medical expenses for each pay period.

Retiree Coverage

E proposes to add a "spend down option" to P, available to all participants who retire and meet certain criteria of E's retirement plan. Under this option, P would continue to reimburse all eligible retired employees for medical care, until all unused accumulated amounts are exhausted. E also proposes to contribute to P an amount equal to all or a portion of the value of a retired employee's unused sick days at retirement. Retired employees make no election as to the contribution of sick days and have no right to receive their value in cash or other benefits. Prior to the beginning of each P year, E will determine whether it will contribute all or a portion of the unused sick days to P on behalf of employees who retire during that year.

In Rev. Rul. 2002-41, 2002-2 CB 75, an employer sponsored a health reimbursement arrangement (HRA) paid for solely by the employer and not through salary reduction contributions. The HRA reimburses substantiated medical care expenses 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 under the HRA, which is not applied to reimburse medical care expenses before an employee retires or otherwise terminates employment, continues to be available for such costs after retirement. That ruling concludes that HRA coverage and reimbursements are excludible from the gross income of employees and retired employees under Secs. 106 and 105; see also Notice 2002-45, 2002-2 CB 93.

Similarly, in Situation 1 of Rev. Rul. 2005-24, IRB 2005-16, 892, an employer sponsored a reimbursement plan for the substantiated medical expenses of both current and former employees (including retired employees), their spouses and dependents. When an employee retires, the employer automatically (and on a mandatory basis) contributes an amount equal to all or a portion of the retired employee's accumulated unused vacation and sick leave. The ruling concluded that such coverage and reimbursements are excludible from gross income under Secs. 106 and 105.

Conclusion

P meets the requirements as set forth in Rev. Rul. 2002-41, Notice 2002-45 and Rev. Rul. 2005-24. Thus, (1) contributions, including nonelective contributions equal to the value of a retiring employee's unused sick leave, and coverage under P, are excludible from employees' and retired employees' gross income under Sec. 106; and (2) P's payment or reimbursement of their medical expenses is excludible from gross income under Sec. 105(b).

IRS LETTER RULING 200535015 (9/2/05)

REFLECTIONS: In IRS Letter Ruling 200452013, an employer contributed to an HRA that reimbursed medical care expenses of former employees and their families. As above, the IRS determined that the contributions, coverage and reimbursements were excludible from gross income; see Tax Trends, "HRAs for Former Employees," 36 The Tax Adviser 121 (February 2005).

David O'Driscoll, J.D., LL.M.