How a Compliant SIMRP Works (and the IRS 2023 Wellness Plan Warning)

The short version

A SIMRP (self-insured medical reimbursement plan) lets employees set aside part of their pay before taxes and receive health and wellness benefits in return. Done correctly, it is built on long-standing parts of the tax code. Done incorrectly, the IRS treats the payments as ordinary taxable wages. The difference comes down to one question: is each payment tied to real medical care or coverage?

Two plans working together: Section 125 and Section 105

A compliant SIMRP pairs two kinds of plans:

• A Section 125 cafeteria plan. This is the part that lets employees choose to have a portion of their pay redirected before taxes. Pre-tax salary reductions lower the wages subject to income and payroll taxes.
• A Section 105 self-insured medical reimbursement plan. This is the part that pays benefits. Under Section 105, amounts an employer plan pays to reimburse employees for medical care can be excluded from their income, as long as the plan follows the rules.

Put simply, Section 125 handles how the money goes in, and Section 105 governs how benefits come out. Both sides have to be set up and run properly, including correct payroll and W-2 coding, for the tax treatment to hold.

The rules for self-insured plans: 26 CFR § 1.105-11

The Treasury regulation that governs self-insured medical reimbursement plans is 26 CFR § 1.105-11, "Self-insured medical reimbursement plan". It covers what counts as a self-insured plan and, importantly, the nondiscrimination rules.

In plain English, the nondiscrimination rules say a plan can't be designed to favor the people at the top. The regulation looks at two things:

• Eligibility. Enough of the workforce has to be eligible to participate, not just a select group. The regulation sets out percentage tests and allows certain employees to be excluded (for example, those with very short service, those under 25, part-time or seasonal workers, and some union-covered employees).
• Benefits. The benefits offered to highly compensated individuals must also be offered to everyone else who participates. A plan can't give richer benefits to owners or top earners.

If a plan fails these tests, highly compensated individuals can lose the tax exclusion on some or all of their reimbursements. That is why plan design and testing matter from day one.

What the IRS warned about in 2023

In 2023 the IRS Office of Chief Counsel released Chief Counsel Advice memorandum 202323006 (released June 9, 2023). It looked at an arrangement where employees paid premiums through a cafeteria plan for a fixed-indemnity "wellness" policy, then received a set cash payment simply for doing a wellness activity, such as a health screening or counseling session, whether or not they had any medical bills.

The IRS concluded that when the employee has no unreimbursed medical expenses related to the payment, the payment is included in the employee's income and counts as wages for federal income tax withholding, Social Security and Medicare (FICA), and federal unemployment (FUTA) taxes. In other words, a flat payout that isn't tied to an actual medical cost doesn't get the medical-reimbursement tax treatment. The memo notes it can't be cited as precedent, but it shows clearly how the IRS views these arrangements.

How a compliant plan avoids that problem

The IRS's concern was payments with no connection to real medical expenses. A compliant SIMRP is built to avoid exactly that:

• Payments are tied to qualified medical care or coverage. Reimbursements go toward actual medical expenses or health coverage, not flat cash for completing an activity.
• Eligibility is checked. Employees need compliant health coverage from any source (it doesn't have to come through the employer). Employees on federal subsidies or with no coverage don't qualify for the pre-tax arrangement. If some employees are in that situation, a SIMRP Advisor may be able to provide guidance so they can take part.
• The plan passes the nondiscrimination tests in 26 CFR § 1.105-11, so the tax treatment applies across the workforce.
• Payroll and W-2 reporting are handled correctly for both the Section 125 and Section 105 pieces.
• Documentation is kept, so the plan can show how each payment connects to medical care or coverage.

Questions to ask any SIMRP provider

• How are reimbursements tied to qualified medical expenses or coverage?
• How does the plan meet the nondiscrimination rules in 26 CFR § 1.105-11?
• How are employees without compliant coverage, or on federal subsidies, handled?
• How is the plan coded in payroll and on W-2s?
• What plan documents and records will we receive?

Sources

• 26 CFR § 1.105-11, Self-insured medical reimbursement plan (Legal Information Institute, Cornell Law School)
• IRS Chief Counsel Advice memorandum 202323006: Tax Treatment of Employer-Funded, Insured, Fixed-Indemnity Wellness Policy (IRS.gov, PDF)