How Do I Set Up a MERP (Medical Expense Reimbursement Plan) for My S-Corp?

A Medical Expense Reimbursement Plan -- commonly called a MERP -- allows an S-Corp to reimburse employees for medical expenses on a tax-free basis. For S-Corp owners with employees, a properly structured MERP can transform out-of-pocket health care costs into deductible business expenses under IRC Sections 105 and 106. However, the tax treatment differs significantly depending on whether the recipient is a rank-and-file employee or a greater-than-2% S-Corp shareholder, and understanding this distinction is critical to setting up the plan correctly.

How a MERP Works

Under IRC Section 105(b), amounts received by an employee through an employer-funded accident or health plan are excluded from gross income to the extent they reimburse medical expenses as defined under IRC Section 213(d). The employer deducts the reimbursements as an ordinary business expense under Section 162. For rank-and-file employees (those who are not greater-than-2% shareholders), the reimbursements are completely free of income tax, Social Security tax, Medicare tax, and federal unemployment tax.

The plan must be established in writing, adopted by the board of directors, and communicated to eligible employees. It should specify which medical expenses are eligible for reimbursement, any annual caps on reimbursement amounts, the claims submission process, and the substantiation requirements. Eligible expenses under Section 213(d) include insurance premiums, deductibles, copayments, prescription medications, dental care, vision care, mental health services, and a broad range of other medical costs.

Special Rules for Greater-Than-2% Shareholders

IRC Section 1372(a) provides that for purposes of employee fringe benefit rules, an S-Corp is treated as a partnership and any greater-than-2% shareholder is treated as a partner. This means that health insurance premiums and medical reimbursements paid on behalf of a greater-than-2% shareholder-employee are not excludable from income under Section 105(b). Instead, these amounts must be included in the shareholder's W-2 wages in Box 1 (but not in Boxes 3, 5, or the equivalent payroll tax boxes, per IRS Notice 2008-1).

The shareholder then claims the self-employed health insurance deduction on Line 17 of Schedule 1 (Form 1040) under IRC Section 162(l). This deduction is available for the cost of health insurance premiums paid by the S-Corp and included in the shareholder's W-2. It is an above-the-line deduction, meaning it reduces adjusted gross income regardless of whether the taxpayer itemizes deductions. However, this deduction is limited to the shareholder's earned income from the S-Corp and cannot create a loss.

Setting Up the Plan Document

The MERP plan document should be drafted and formally adopted before any reimbursements are made. The document must include the effective date, eligibility requirements (all employees, certain classes, or specific waiting periods), a list of covered medical expenses referencing Section 213(d), maximum reimbursement limits per employee per year, the claims submission procedure and required documentation, and a statement that the plan is funded solely by the employer. The board of directors should adopt the plan through a written resolution, and copies should be distributed to all eligible employees.

Compliance with ACA and Nondiscrimination Rules

The Affordable Care Act created significant restrictions on employer health reimbursement arrangements. Under ACA Section 2711 and IRS Notice 2013-54, a standalone MERP that reimburses individual health insurance premiums is treated as a group health plan and must comply with ACA market reforms, including the prohibition on annual dollar limits for essential health benefits. Violation can result in excise taxes of $100 per day per employee under IRC Section 4980D -- potentially $36,500 per employee per year.

There are two primary compliant approaches. First, a Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) under IRC Section 9831(d) allows small employers (fewer than 50 employees) to reimburse individual health insurance premiums and medical expenses up to annual limits set by the IRS. Second, an Individual Coverage HRA (ICHRA) under Treasury Regulation Section 54.9802-4 allows employers of any size to reimburse individual health insurance premiums with certain class-based offering requirements.

Tax Benefits in Practice

For an S-Corp with non-shareholder employees, a MERP provides significant tax savings. The S-Corp deducts the reimbursements, reducing its taxable income that flows through to shareholders on Schedule K-1. The employees receive the reimbursements tax-free, avoiding income tax and payroll taxes. For example, an S-Corp that reimburses $5,000 in medical expenses to an employee saves approximately $765 in employer-side payroll taxes (7.65% FICA), while the employee avoids approximately $1,500 to $2,500 in combined income and payroll taxes depending on their bracket.

A MERP is a valuable component of a comprehensive employee benefits package and can be particularly effective for small S-Corps looking to attract and retain talent while generating legitimate tax deductions. AE Tax Advisors helps S-Corp owners design compliant MERPs that maximize tax benefits while meeting all ACA and IRS requirements.

This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.