Setting Up a MERP Through Your C-Corp: Tax-Free Medical Reimbursement

Most business owners get almost no tax benefit from their medical expenses. The itemized medical deduction under IRC Sec. 213 only applies to amounts exceeding 7.5% of adjusted gross income, and only if you itemize. A family earning $600,000 would need more than $45,000 of medical costs before the first dollar became deductible.

A Medical Expense Reimbursement Plan in a C-Corporation removes that problem completely. Every dollar is deductible to the corporation and tax-free to you.

How a MERP Works

IRC Sec. 105(b) excludes from an employee's gross income amounts received through employer-provided coverage as reimbursement for medical care expenses of the employee, spouse, and dependents. IRC Sec. 162 gives the employer the deduction.

Put those together in a corporation where you are the owner and an employee, and the mechanics are simple. You incur a medical expense. You submit it to the plan. The corporation reimburses you. The corporation deducts the payment. You report nothing.

No 7.5% floor. No itemizing requirement. No dollar cap imposed by statute, though the plan itself may set one.

Why an S-Corp Cannot Do This

This is the reason the strategy is specifically a C-Corp strategy.

IRC Sec. 1372 provides that for fringe benefit purposes, an S corporation is treated as a partnership and a more-than-2% shareholder is treated as a partner. Partners are not employees, and the Sec. 105(b) exclusion is an employee benefit.

The result is that reimbursements to a more-than-2% S-Corp shareholder must be included in W-2 wages rather than excluded. For health insurance premiums, the shareholder recovers this through the above-the-line self-employed health insurance deduction under IRC Sec. 162(l), which makes premiums roughly neutral. Out-of-pocket medical reimbursements get no equivalent relief, so they end up as taxable compensation.

A MERP in an S-Corp is therefore a benefit for non-owner employees, not for the owner. See MERPs and S-Corps and S-Corp health insurance treatment.

In a C-Corporation the owner is an actual employee. Sec. 1372 does not apply. The exclusion works as written.

What Can Be Reimbursed

Anything qualifying as medical care under IRC Sec. 213(d), which is broad:

• Health insurance premiums, including coverage purchased individually
• Deductibles, copays, and coinsurance
• Dental care, including orthodontia
• Vision care, glasses, contacts, and corrective surgery
• Prescription drugs and insulin
• Mental health treatment and therapy
• Chiropractic, physical therapy, and acupuncture
• Fertility treatment
• Medical equipment and supplies
• Qualified long-term care services and, within statutory limits, long-term care insurance premiums
• Mileage to and from medical appointments at the medical rate

Expenses for your spouse and dependents are included, which is what makes the numbers meaningful for a family.

What It Is Worth

A family with $38,000 of annual out-of-pocket medical costs, at a combined marginal rate around 45% on the income that would otherwise have funded them, saves roughly $17,000 per year. If the alternative was the Sec. 213 itemized deduction, which they almost certainly could not use, the entire $38,000 was being paid with after-tax dollars.

Over a decade with orthodontia, fertility treatment, or a chronic condition in the family, this single plan document is worth six figures.

Setting It Up

1. The plan document. A MERP must be in writing. It specifies eligible employees, covered expenses, any annual limits, the substantiation procedure, and the reimbursement process. This is not a formality; without a written plan adopted before expenses are incurred, the exclusion is not available.

2. Corporate adoption. Board resolution adopting the plan, with an effective date. Expenses incurred before the effective date are not covered.

3. Eligibility design and Sec. 105(h) testing. This is where plans fail. IRC Sec. 105(h) prohibits a self-insured medical reimbursement plan from discriminating in favor of highly compensated individuals, in either eligibility or benefits. If the plan discriminates, the highly compensated individual, meaning you, includes the excess reimbursement in income. The plan is not disqualified; the benefit is simply taxed to the person it was designed for.

The eligibility test can be satisfied several ways, and the rules permit excluding employees who have not completed three years of service, who are under age 25, who are part-time or seasonal, and who are covered by a collective bargaining agreement. A one-employee corporation passes automatically. A corporation with fifteen employees needs the design done properly.

4. ACA integration. A plan that reimburses general medical expenses is a group health plan for Affordable Care Act purposes. A standalone arrangement covering two or more employees can run into the ACA market reform requirements, including the prohibition on annual limits. The common solutions are to integrate the MERP with a group health plan, to run it as a one-participant plan, or to structure it as a qualified small employer HRA or individual coverage HRA where those fit. This is the part that most needs professional design.

5. Substantiation. Every reimbursement needs documentation: date, provider, service, amount, and evidence it was not reimbursed by insurance. Reimburse from the corporate account, not personally, and keep the file.

Common Mistakes

No written plan. The most frequent failure. Reimbursing medical bills through the business without a plan document is just taxable compensation with extra steps.

Ignoring Sec. 105(h) with employees. Adopting an owner-only plan when the corporation has ten employees produces a discriminatory plan and taxable reimbursements.

Reimbursing expenses already covered by insurance. Double reimbursement is not excludable.

Retroactive reimbursement. Expenses incurred before the plan's effective date are not covered. Adopt the plan first.

Doing it in the wrong entity. Adopting a MERP in an S-Corp and expecting owner-level tax-free treatment. It does not work.

Where It Fits

A MERP is rarely the sole reason to operate a C-Corporation, but it is frequently the item that tips a marginal decision. For an owner already considering a C-Corp for the flat 21% rate on retained earnings, for income shifting, or to access the closely held passive loss rule, the MERP is a substantial additional benefit that costs almost nothing to add.

It also works in a hybrid structure. An owner with an S-Corp operating business and a separate C-Corp handling management services can employ themselves through the C-Corp and adopt the MERP there, subject to the controlled group rules under IRC Sec. 414(b) and (c), which aggregate related employers for benefit testing purposes. That aggregation is exactly the kind of detail that needs to be checked rather than assumed.

See the C-Corp tax strategy guide, C-Corp income shifting, and the S-Corp optimization guide.

Frequently Asked Questions

What is a MERP?

A Medical Expense Reimbursement Plan is an employer-funded arrangement that reimburses employees for medical care expenses. Under IRC Sec. 105(b) the reimbursement is excluded from the employee's income, and under IRC Sec. 162 the employer deducts it. In a C-Corporation where the owner is an employee, this converts family medical costs into a full business deduction received tax-free.

Why can a C-Corp do this when an S-Corp cannot?

IRC Sec. 1372 treats an S corporation as a partnership and a more-than-2% shareholder as a partner for fringe benefit purposes. Partners are not employees, so the Sec. 105(b) employee exclusion does not apply and reimbursements must be included in W-2 wages. In a C-Corporation the owner is a genuine employee and the exclusion applies as written.

Is there a limit on how much a MERP can reimburse?

The statute does not impose a dollar cap, though the plan document may set one and often should for budgeting purposes. The real constraints are that expenses must qualify as medical care under IRC Sec. 213(d), the plan must not discriminate in favor of highly compensated individuals under Sec. 105(h), and the arrangement must satisfy the applicable Affordable Care Act market reform requirements.

What happens if my plan discriminates in favor of me as the owner?

Under IRC Sec. 105(h), the plan is not disqualified, but the highly compensated individual must include the excess reimbursement in gross income. In practice that means the owner loses the tax-free treatment the plan existed to provide. Eligibility design matters, and the rules permit excluding employees with less than three years of service, those under 25, and part-time or seasonal workers.

Can I set up a MERP if I have employees?

Yes, but it requires proper design. The plan must satisfy the Sec. 105(h) eligibility and benefits tests, and because a general medical reimbursement arrangement is a group health plan, it must be integrated with a group health plan or structured as a qualifying HRA to satisfy Affordable Care Act requirements. A one-participant corporation is far simpler than one with a workforce.

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