A summary of tax issues related to employer-provided health benefits

Taxation of employer-provided health benefits is often a misunderstood topic especially in the years after implementation of the Affordable Care Act market reform provisions. Yet the fundamental tax treatment of health plans and health benefits has not changed in decades.

Four key factual issues now control the tax treatment of employer-provided health benefits under U.S. law:

  1. Whether the health benefit was provided through insurance or outside of insurance,
  2. If provided through insurance, whether the insurance was ACA compliant, exempted, or non-compliant,
  3. Whether the employer’s health plan meets legal requirements. (I used to write “whether an employer plan exists” but now presume that all employer-provided health benefits are part of a “plan” for tax purposes,
  4. Whether the benefit involved employee contributions as a salary reduction.

There are different components of tax law to consider that affect employer-provided health benefits including:

  1. Deductibility of the expense by the employer under IRC Section 162 (ordinary business expenses). Almost all employee health plan expenses do qualify as an ordinary tax-deductible business expense for the employer.
  2. Taxability of benefits to the employee, as determined by IRC Section 3121 (definition of wages). In the past almost all employer-provided health benefits were received tax-free by the employee but this is no longer presumed to be the case following implementation of the Affordable Care Act.
  3. Excise taxes imposed on non-compliant employer health plans under IRC Section 4980D. This is the new ‘hot issue’ for employers in 2014 following implementation of the Affordable Care Act. Many employer health plans are subject to a new 10% excise penalty, a few will be subject to much higher penalty amounts.
  4. Taxation for FICA and FUTA and state income taxes. This tax treatment may be different than the tax treatment for federal income taxes.

There are many resources available for tax advisers and business owners. A few are listed here:

IRS – Publication 15-B

IRS – Employer Health Care Arrangements

Freedom Benefits – Small business health plan compliance checklist 

Novak, Tony – Taxation of health insurance

Novak. Tony – 18 Things Small Businesses Must Know About Health Reimbursement Arrangements (HRAs)

 

Why health care spending has declined at small companies

The Urban Institute Health Policy Center released a study in October 2012 during early implementation of the Affordable Care Act (ACA) that shows that spending on employer-sponsored coverage by small businesses declined since passage of ACA. The study titled “Implications of the Affordable Care Act for American Business” is quick to point out that the reduction is not attributable to cost-cutting measures in the law – these mostly affect Medicare – but rather to the accelerate cost shifting of financial burdens to employees. Cost shifting from employers and government to individual health care consumers is widely recognized as a core strategy of health care reform. In the years after 2012 we continued to see more evidence of the same strategy.

Perhaps the largest driver in the cost reduction, not covered in the report, is the massive effort by insurance agents to convert small businesses from defined benefit to defined contribution plans. This strategy preserves the agent’s relationship and insulates the employer from future cost increases. Usually this involves adoption of a Health Reimbursement Arrangement (HRA) or Health Savings Account (HSA) combined with high deductible insurance.

The Urban Institute study also indicated that the proposed online insurance exchanges have not yet had any significant effect on the small business health market. The report does not comment on speculation that many small business employers who currently offer health coverage will cancel those plans and send employees to individual health insurance exchanges in 2014. The individual health insurance exchanges will offer premium subsidies for most individuals who apply through an exchange. Since small companies are not required to provide health coverage to employees, there is little risk and now a financial incentive to disband employer-provided health insurance in favor of an uninsured medical expense reimbursement plan or supplemental medical insurance.

The study also shows costs have not decreased for larger employers (over 1,000 employees). This is probably because these employers are less likely to be able to implement cost-shifting strategies used by smaller firms. Employers with 100 to 1,000 employees are predicted to see healthcare costs increase 4.3% this year.

Some industry reviews and public media coverage of the Urban Institute (I conclude) incorrectly attribute the cost reduction to the effects of PPACA. These comments may be politically motivated opinions not based on observed evidence.

 

Planning a small business 401(k)

The majority of content on this Web page was originally produced by IRS and the U.S. Department of Labor in December 2011 and is edited and adapted here as part of Freedom Benefits financial education and consulting programs. 

Contents:

  1. Why 401(k) plans?
  2. Establishing a 401(k)
  3. Automatic enrollment
  4. Arrange a trust fund
  5. Develop a recordkeeping system
  6. Provide plan information to employees
  7. Operating a 401(k)
  8. Participation
  9. Contributions
  10. Vesting
  11. Nondiscrimination
  12. Investing
  13. Fiduciary responsibilities
  14. Disclosing plan information to employees
  15. Reporting to government agencies
  16. Terminating a 401(k) plan
  17. Compliance
  18. 401(k) plan checklist
  19. Resources

WHY 401(k) PLANS?

401(k) plans can be a powerful tool in promoting financial security in retirement. They are a valuable option for businesses considering a retirement plan, providing benefits to employees and their employers.

Employers start a 401(k) plan for a host of reasons:

  • A well-designed 401(k) plan can help attract and keep talented employees.
  • It allows participants to decide how much to contribute to their accounts.
  • Employers are entitled to a tax deduction for contributions to employees’ accounts.
  • A 401(k) plan benefits a mix of rank-and file employees and owners/managers.
  • The money contributed may grow through investments in stocks, bonds, mutual funds, money market funds, savings accounts, and other investment vehicles.
  • Contributions and earnings generally are not taxed by the Federal Government or by most State governments until they are distributed.
  • A 401(k) plan may allow participants to take their benefits with them when they leave the company, easing administrative responsibilities.

This booklet highlights some of a 401(k) plan’s advantages, some of your options and responsibilities as an employer operating a 401(k) plan, and the differences among the types of 401(k) plans. For more information, a list of resources for you and for 401(k) plan participants is included at the end of this booklet.

ESTABLISHING A 401(k) PLAN

When you establish a 401(k) plan, you must take certain basic actions. One of your first decisions will be whether to set up the plan yourself or to consult a professional or financial institution — such as a bank, mutual fund provider, or insurance company — to help with establishing and maintaining the plan. In addition, there are four initial steps for setting up a 401(k) plan:

  • Adopt a written plan document,
  • Arrange a trust fund for the plan’s assets,
  • Develop a recordkeeping system, and
  • Provide plan information to employees eligible to participate.

Adopt a written plan document — Plans begin with a written document that serves as the foundation for day-to-day plan operations. If you have hired someone to help with your plan, that person likely will provide the document. If not, consider obtaining assistance from a financial institution or retirement plan professional. In either case, you will be bound by the terms of the plan document.

Once you have decided on a 401(k) plan, you will need to choose the type of 401(k) plan that is best for you — a traditional 401(k) plan, a safe harbor 401(k) plan, or an automatic enrollment 401(k) plan. In all of these plans, participants can make contributions through salary deductions.

A traditional 401(k) plan offers the maximum flexibility among the three types of plans. Employers have discretion over whether to make contributions for all participants, to match employees’ deferrals, to do both, or to do neither. These contributions can be subject to a vesting schedule (which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time). Annual testing ensures that benefits for rank-and-file employees are proportional to benefits for owners/managers.

There are several kinds of 401(k) plans that aren’t subject to the annual contributions testing required with traditional 401(k) plans. These are known as safe harbor 401(k) plans and, in exchange for avoiding the annual testing, employees in these plans must receive a certain level of employer contributions. Under the most popular safe harbor 401(k) plan (discussed in this publication), mandatory employer contributions must be fully vested when made.

An automatic enrollment 401(k) plan allows you to automatically enroll employees and place deductions from their salaries in certain default investments, unless the employee elects otherwise. This is an effective way for many employers to increase participation in their 401(k) plans.

The traditional, safe harbor, and automatic enrollment plans are for employers of any size.

This booklet addresses traditional and safe harbor 401(k) plans. For more information on automatic enrollment 401(k) plans, see

Automatic Enrollment 401(k) Plans for Small Businesses

Once you have decided on the type of plan for your company, you will have flexibility in choosing some of the plan’s features — such as which employees can contribute to the plan and how much. Other features written into the plan are required by law. For instance, the plan document must describe how certain key functions are carried out, such as how contributions are deposited in the plan. See IRS Publication 4674 for more information.

Arrange a trust fund for the plan’s assets

A plan’s assets must be held in trust to assure that assets are used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments, and distributions. Since the financial integrity of the plan depends on the trustee, selecting a trustee is one of the most important decisions you will make in establishing a 401(k) plan. If you set up your plan through insurance contracts, the contracts do not need to be held in trust.

Develop a recordkeeping system

An accurate recordkeeping system will track and properly attribute contributions, earnings and losses, plan investments, expenses, and benefit distributions. If a contract administrator or financial institution assists in managing the plan, that entity typically will help keep the required records. In addition, a recordkeeping system will help you, your plan administrator, or financial provider prepare the plan’s annual return/report that must be filed with the Federal Government.

Provide plan information to employees eligible to participate

You must notify employees who are eligible to participate in the plan about certain benefits, rights, and features. In addition, a summary plan description (SPD) must be provided to all participants. The SPD is the primary vehicle to inform participants and beneficiaries about the plan and how it operates. The SPD typically is created with the plan document. (For more information on the required contents of the SPD, see Disclosing Plan Information to Participants.)

You also may want to provide your employees with information that discusses the advantages of your 401(k) plan. The benefits to employees — such as pretax contributions to a 401(k) plan (or tax-free distributions in the case of Roth contributions), employer contributions (if you choose to make them), and compounded tax-deferred earnings — help highlight the advantages of participating in the plan.

OPERATING A 401(k) PLAN

Once you have established a 401(k) plan, you assume certain responsibilities in operating the plan. If you hired someone to help in setting up your plan, that arrangement also may have included help in operating the plan. If not, another important decision will be whether to manage the plan yourself or to hire a professional or financial institution — such as a bank, mutual fund provider, or insurance company — to take care of some or most aspects of operating the plan.

Elements of operating 401(k) plans include the following:

  • Participation
  • Contributions
  • Vesting
  • Nondiscrimination
  • Investing 401(k) plan monies
  • Fiduciary responsibilities
  • Disclosing plan information to participants
  • Reporting to government agencies
  • Distributing plan benefits

Participation

Typically, a plan includes a mix of rank and-file employees and owners/managers. However, some employees may be excluded from a 401(k) plan if they:

  • Have not attained age 21;
  • Have not completed a year of service; or
  • Are covered by a collective bargaining agreement that does not provide for participation in the plan, if retirement benefits were the subject of good faith bargaining.

Employees cannot be excluded from a plan merely because they are older workers.

Contributions

In all 401(k) plans, participants can make contributions through salary deductions. You can decide on your business’s contribution to participants’ accounts in the plan.

Contributions in a traditional 401(k) Plan

If you decide to contribute to your 401(k) plan, you have further options. You can contribute a percentage of each employee’s compensation for allocation to the employee’s account (called a nonelective contribution), or you can match the amount your employees decide to contribute, or you can do both (within the limits of the tax law).

For example, you may decide to add a percentage — say, 50 percent — to an employee’s contribution, which results in a 50-cent increase for every dollar the employee sets aside. Using a matching contribution formula will provide employer contributions only to employees who make deferrals to the 401(k) plan. If you choose to make nonelective contributions, the employer contribution goes to each eligible participant, whether or not the participant decides to make a salary deferral to his or her 401(k) plan account.

Under a traditional 401(k) plan, you have the flexibility of changing the amount of employer contributions each year, according to business conditions.

Contributions in a Safe Harbor 401(k) Plan

Under a safe harbor plan, you can match each eligible employee’s contribution, dollar for dollar, up to 3 percent of the employee’s compensation, and 50 cents on the dollar for the employee’s contribution that exceeds 3 percent, but not 5 percent, of the employee’s compensation. Alternatively, you can make a nonelective contribution equal to 3 percent of compensation to each eligible employee’s account. Each year you must make either the matching contributions or the nonelective contributions. The plan document will specify which contributions will be made and this information must be provided to employees before the beginning of each year.

Contributions in a Roth 401(k)

401(k) plans may permit employees to make after-tax contributions through salary deduction. These designated Roth contributions, as well as gains and losses, are accounted for separately from pretax contributions. However, designated Roth contributions are treated the same as pretax contributions for most aspects of plan operations, such as contribution limits.

A 401(k) plan may allow participants to transfer certain amounts in the plan to their designated Roth account in the plan.

Contribution Limits

Employer and employee contributions and forfeitures (nonvested employer contributions of terminated participants) are subject to a per-employee overall annual limitation. This limit is the lesser of:

  • 100 percent of the employee’s compensation, or
  • $49,000 for 2011 and $50,000 for 2012.

In addition, the amount employees can contribute under any 401(k) plan is limited to $16,500 for 2011 and $17,000 for 2012.

All 401(k) plans may allow catch-up contributions of $5,500 for 2011 and 2012 for employees age 50 and over.

Vesting

Employee salary deferrals are immediately 100 percent vested — that is, the money that an employee has contributed to the plan cannot be forfeited. When an employee leaves employment, he or she is entitled to those deferrals, plus any investment gains (or minus losses) on his or her deferrals.

In safe harbor 401(k) plans, all required employer contributions are always 100 percent vested. In traditional 401(k) plans, you can design your plan so that employer contributions become vested over time, according to a vesting schedule.

Nondiscrimination

To preserve the tax benefits of a 401(k) plan, the plan must provide substantive benefits for rank-and-file employees, not just business owners and managers. These requirements are called nondiscrimination rules and compare both plan participation and contributions of rank-and-file employees to those of owners/ managers.

Traditional 401(k) plans are subject to annual testing to assure that the amount of contributions made for rank-and-file employees is proportional to contributions made for owners and managers. In most cases, safe harbor 401(k) plans are not subject to annual nondiscrimination testing.

Investing 401(k) Plan Monies

After you decide on the type of 401(k) plan, you can consider the variety of investment options. One decision you will need to make in designing a plan is whether to permit your employees to direct the investment of their accounts or to manage the monies on their behalf. If you choose the former, you also need to decide what investment options to make available to the participants. Depending on the plan design you choose, you may want to hire someone either to determine the investment options to make available or to manage the plan’s investments. Continually monitoring the investment options ensures that your selections remain in the best interests of your plan and its participants.

Fiduciary Responsibilities

Many of the actions needed to operate a 401(k) plan involve fiduciary decisions. This is true whether or not you hire someone to manage the plan for you or do some or all of the plan management yourself. Controlling the assets of the plan or using discretion in administering and managing the plan makes you and the entity you hire a plan fiduciary to the extent of that discretion or control. Hiring someone to perform fiduciary functions is itself a fiduciary act. Thus, fiduciary status is based on the functions performed for the plan, not a title.

Some decisions with respect to a plan are business decisions, rather than fiduciary decisions. For instance, the decisions to establish a plan, to include certain features in a plan, to amend a plan, and to terminate a plan are business decisions. When making these decisions, you are acting on behalf of your business, not the plan, and therefore, you would not be a fiduciary. However, when you take steps to implement these decisions, you (or those you hire) are acting on behalf of the plan and thus, in making decisions, may be acting as fiduciaries.

Basic Responsibilities

Those persons or entities that are fiduciaries are in a position of trust with respect to the participants and beneficiaries in the plan. The fiduciary’s responsibilities include:

  • Acting solely in the interest of the participants and their beneficiaries;
  • Acting for the exclusive purpose of providing benefits to workers participating in the plan and their beneficiaries, and defraying reasonable expenses of the plan;
  • Carrying out duties with the care, skill, prudence, and diligence of a prudent person familiar with such matters;
  • Following the plan documents; and
  • Diversifying plan investments.

These are the responsibilities that fiduciaries need to keep in mind as they carry out their duties. The responsibility to be prudent covers a wide range of functions needed to operate a plan. And, since all these functions must be carried out in the same manner as a prudent person would, it may be in your best interest to consult experts in various fields, such as investments and accounting.

In addition, for some functions, there are specific rules that help guide the fiduciary. For example, the deductions from employees’ paychecks for contribution to the plan must be deposited with the plan as soon as reasonably possible, but no later than the 15th business day of the month following the payday. If you can reasonably make the deposits in a shorter time frame, you need to make the deposits at that time.

For plans with fewer than 100 participants, salary reduction contributions deposited with the plan no later than the 7th business day following withholding by the employer will be considered contributed in compliance with the law.

For all contributions, employee and employer (if any), the plan must designate a fiduciary, typically the trustee, to make sure that contributions due to the plan are transmitted. If the plan and other documents are silent or ambiguous, the trustee generally has this responsibility. As part of following the plan documents in operating your plan, the plan document will need to be updated from time to time for changes in the law.

Limiting Liability

With these responsibilities, there is also some potential liability. However, there are actions you can take to demonstrate that you carried out your responsibilities properly as well as ways to limit your liability.

The fiduciary responsibilities cover the process used to carry out the plan functions rather than simply the end results. For example, if you or someone you hire makes the investment decisions for the plan, an investment does not have to be a “winner” if it was part of a prudent overall diversified investment portfolio for the plan. Since a fiduciary needs to carry out activities through a prudent process, you should document the decision-making process to demonstrate the rationale behind the decision at the time it was made.

In addition to the steps above, there are other ways to limit potential liability. The plan can be set up to give participants control of the investments in their accounts. For participants to have control, they must have sufficient information on the specifics of their investment options. If properly executed, this type of plan limits your liability for the investment decisions made by participants. You can also hire a service provider or providers to handle some or most of the fiduciary functions, setting up the agreement so that the person or entity then assumes liability.

Hiring a Service Provider

Even if you do hire a financial institution or retirement plan professional to manage the whole plan, you retain some fiduciary responsibility for the decision to select and keep that person or entity as the plan’s service provider. Thus, you should document your selection process and monitor the services provided to determine if a change needs to be made.

For a service contract or arrangement to be reasonable, service providers must provide certain information to you about the services they will provide to your plan and all of the compensation they will receive. This information will assist you in understanding the services, assessing the reasonableness of the compensation (direct and indirect), and determining any conflicts of interest that may impact the service provider’s performance.

Some additional items to consider in selecting a plan service provider:

Information about the firm itself: affiliations, financial condition, experience with 401(k) plans, and assets under their control;

  • A description of business practices: how plan assets will be invested if the firm will manage plan investments or how participant investment directions will be handled; and
  • Information about the quality of prospective providers: the identity, experience, and qualifications of the professionals who will be handling the plan’s account; any recent litigation or enforcement action that has been taken against the firm; the firm’s experience or performance record; if the firm plans to work with any of its affiliates in handling the plan’s account; and whether the firm has fiduciary liability insurance.
  • Once hired, these are additional actions to take when monitoring a service provider:
  • Evaluate any notices received from the service provider about possible changes to their compensation and the other information they provided when hired (or when the contract or arrangement was renewed);
  • Review the service provider’s performance;
  • Read any reports they provide;
  • Check actual fees charged;
  • Ask about policies and practices (such as trading, investment turnover, and proxy voting); and
  • Follow up on participant complaints.

(For more information, see Understanding Retirement Plan Fees and Expenses at www. dol.gov/ebsa. Click on “Fiduciary Education” under “Compliance Assistance” to access the publication.)

Providing Information in Participant-Directed Plans

When plans allow participants to direct their investments, fiduciaries need to take steps to regularly make participants aware of their rights and responsibilities under the plan related to directing their investments. This includes providing plan and investment-related information, including information about fees and expenses, that participants need to make informed decisions about the management of their individual accounts. Participants must receive the information before they can first direct their investment in the plan and annually thereafter. The investment-related information needs to be presented in a format, such as a chart, that allows for a comparison among the plan’s investment options. A model chart is available on www.dol.gov/ ebsa. If you use information provided by a service provider that you rely on reasonably and in good faith, you will be protected from liability for the completeness and accuracy of the information.

Prohibited Transactions and Exemptions

There are certain transactions that are prohibited under the law to prevent dealings with parties that have certain connections to the plan, self-dealing, or conflicts of interest that could harm the plan. However, there are a number of exceptions under the law, and additional exemptions may be granted by the U.S. Department of Labor, where protections for the plan are in place in conducting the transactions.

One exemption allows the provision of investment advice to participants who direct the investments in their accounts. This applies to the buying, selling, or holding of an investment related to the advice as well as to the receipt of related fees and other compensation by a fiduciary adviser.

Another exemption in the law permits you to offer loans to participants through your plan. If you do, the loan program must be carried out in such a way that the plan and all other participants are protected. Thus, the decision with respect to each loan request is treated as a plan investment and considered accordingly.

Bonding

Persons handling plan funds or other plan property generally must be covered by a fidelity bond to protect the plan against loss resulting from fraud and dishonesty by those covered by the bond.

Disclosing Plan Information to Participants

Plan disclosure documents keep participants informed about the basics of plan operation, alert them to changes in the plan’s structure and operations, and provide them a chance to make decisions and take timely action with respect to their accounts.

The summary plan description (SPD) — the basic descriptive document — is a plain-language explanation of the plan and must be comprehensive enough to apprise participants of their rights and responsibilities under the plan. It also informs participants about the plan features and what to expect of the plan.

Among other things, the SPD must include information about:

  • When and how employees become eligible to participate in the 401(k) plan;
  • The contributions to the plan;
  • How long it takes to become vested;
  • When employees are eligible to receive their benefits;
  • How to file a claim for those benefits; and
  • Basic rights and responsibilities participants have under the Federal retirement law, the Employee Retirement Income Security Act (ERISA).

The SPD should include an explanation about the administrative expenses that will be paid by the plan. This document must be given to participants when they join the plan and to beneficiaries when they first receive benefits. SPDs must also be redistributed periodically during the life of the plan.

A summary of material modification (SMM) apprises participants of changes made to the plan or to the information required to be in the SPD. The SMM or an updated SPD must be automatically furnished to participants within a specified number of days after the change.

An individual benefit statement (IBS) shows the total plan benefits earned by a participant, vested benefits, the value of each investment in the account, information describing the ability to direct investments, and (for plans with participant direction) an explanation of the importance of a diversified portfolio. Plans that provide for participant-directed accounts must furnish individual account statements on a quarterly basis. Plans that do not provide for participant direction must furnish statements annually.

As noted above, for plans that allow participants to direct the investments in their accounts, plan and investment information, including information about fees and expenses, must be provided to participants before they can first direct investments and periodically thereafter – primarily on an annual basis with information on the fees and expenses actually paid provided at least quarterly. The initial plan-related information may be distributed as part of the SPD provided when a participant joins the plan as long as it is provided before the participant can first direct investments. The information provided quarterly may be included with the IBS.

A summary annual report (SAR) is a narrative of the plan’s annual return/ report, the Form 5500, filed with the Federal Government (see Reporting to Government Agencies for more information). It must be furnished annually to participants.

A blackout period notice gives employees advance notice when a blackout period occurs, typically when plans change record-keepers or investment options, or when plans add participants due to corporate mergers or acquisitions. During a blackout period, participants’ rights to direct investments, take loans, or obtain distributions are suspended.

Reporting to Government Agencies

In addition to the disclosure documents that provide information to participants, plans must also report certain information to government entities.

Form 5500 Annual Return/Report of Employee Benefit Plans

Plans are required to file an annual return/ report with the Federal Government, in which information about the plan and its operation is disclosed to the IRS and the U.S. Department of Labor. Plans that must file the Form 5500 must do so electronically. These returns/reports are made available to the public.

Depending on the number and type of participants covered, most 401(k) plans must file one of the following forms:

  • Form 5500, Annual Return/Report of Employee Benefit Plan,
  • Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan, or
  • Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan.

Most one-participant plans (sole proprietor/ spouse and certain partnership plans) with total assets of $250,000 or less are exempt from the annual filing requirement. However, regardless of the value of the plan’s assets, a final return/report must be filed when a plan is terminated.

Form 1099-R

Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. is given to both the IRS and recipients of distributions from the plan during the year. It is used to report distributions (including rollovers) from a retirement plan.

Distributing Plan Benefits

Benefits in a 401(k) plan are dependent on a participant’s account balance at the time of distribution.

When participants are eligible to receive a distribution, they typically can elect to:

  • Take a lump sum distribution of their account,
  • Roll over their account to an IRA or another employer’s retirement plan, or
  • Purchase an annuity.

TERMINATING A 401(k) PLAN

401(k) plans must be established with the intention of being continued indefinitely. However, business needs may require that employers terminate their 401(k) plans. For example, you may want to establish another type of retirement plan in lieu of the 401(k) plan.

Typically, the process of terminating a 401(k) plan includes amending the plan document, distributing all assets, and filing a final Form 5500. You must also notify your employees that the 401(k) plan will be discontinued. Check with your plan’s financial institution or a retirement plan professional to see what further action is necessary to terminate your 401(k) plan.

COMPLIANCE

Even with the best intentions, mistakes in plan operation can still happen. The U.S. Department of Labor and IRS have correction programs to help 401(k) plan sponsors correct plan errors, protect participants, and keep the plan’s tax benefits. These programs are structured to encourage early correction of the errors. Having an ongoing review program makes it easier to spot and correct mistakes in plan operations. See the Resources section for further information.

401(k) PLAN CHECKLIST

1. Have you determined which type of 401(k) plan best suits your business?

2. Have you decided to hire a financial

institution or retirement plan professional to help with setting up and running the plan?

3. Have you decided whether to make contributions to the plan, and, if so, whether to make nonelective and/or matching contributions? (Remember, you may design your plan so that you may change your contributions if necessary due to business conditions.)

4. Have you adopted a written plan that includes the features you want to offer, such as whether participants will direct the investment of their accounts?

5. Have you notified eligible employees and provided them with information to help in their decision making?

6. Have you arranged a trust fund for the plan assets or will you set up the plan solely with insurance contracts?

7. Have you developed a recordkeeping system?

8. Are you familiar with the fiduciary responsibilities?

9. Are you prepared to monitor the plan’s service providers?

10. Are you familiar with the reporting and disclosure requirements of a 401(k) plan?

For help in establishing and operating a 401(k) plan, you may want to talk to a retirement plan professional or a representative of a financial institution offering retirement plans—and take advantage of the help available in the following Resources section. Freedom Benefits.org offers a free consultation to discuss small business 401(k) planning. Call Tony Novak at (800) 609-0683.

RESOURCES

The U.S. Department of Labor’s (DOL’s) Employee Benefits Security Administration and the IRS feature this booklet and additional information on retirement plans on their websites:

www.dol.gov/ebsa — Go to “Compliance Assistance for Small Employers” or “Publications and Reports” for additional information to help you understand and operate your 401(k) plan. This website also has information to help your employees understand the importance of saving for retirement through an employer-sponsored plan.

www.irs.gov/retirement — Go to “Plan Sponsor/Employer.” This website is filled with plain-language information that will help you maintain your 401(k) plan properly. All the IRS forms and publications mentioned in this booklet are available here.

In addition, the following jointly developed publications are available on the DOL and IRS websites and can be ordered through the toll-free numbers listed below:

Choosing a Retirement Solution for Your Small Business, Publication 3998, provides an overview of retirement plans available to small businesses.

Adding Automatic Enrollment to Your 401(k) Plan, Publication 4721, explains how to add automatic enrollment to your existing 401(k) plan.

Automatic Enrollment 401(k) Plans for Small Businesses, Publication 4674, explains a type of retirement plan that allows small businesses to increase plan participation.

Payroll Deduction IRAs for Small Businesses,

Publication 4587, describes an arrangement that is an easy way for businesses to give employees an opportunity to save for retirement.

Profit Sharing Plans for Small Businesses,

Publication 4806, describes a flexible way for businesses to help employees save for retirement.

SEP Retirement Plans for Small Businesses, Publication 4333, describes a low-cost retirement savings option for small businesses.

SIMPLE IRA Plans for Small Businesses, Publication 4334, describes a type of retirement plan designed especially for small businesses.

And for business owners with a plan:

Retirement Plan Correction Programs, Publication 4224, provides a brief description of the IRS and DOL voluntary correction programs.

Order From:

DOL: Electronically at www.askebsa.dol.gov or by calling 866-444-3272 IRS: 800-TAX-FORM (829-3676)

Related materials available from DOL:

For small businesses:

Understanding Retirement Plan Fees and Expenses

Meeting Your Fiduciary Responsibilities

Selecting an Auditor for Your Employee Benefit Plan

Reporting and Disclosure Guide for Employee Benefit Plans

To view these publications, go to www.dol.gov/ebsa and click on “Publications and Reports.”

In addition, DOL sponsors two interactive websites – the Small Business Retirement Savings Advisor, available at www.dol.gov/elaws/pwbaplan.htm , and, along with the American Institute of Certified Public Accountants (AICPA), www.choosingaretirementsolution.org . These encourage small business owners to choose the appropriate retirement plan for their business and provide resources on maintaining plans and correcting plan errors.

For employees:

A Look at 401(k) Plan Fees

What You Should Know about Your Retirement Plan (also in Spanish)

Savings Fitness…A Guide To Your Money and Your Financial Future (also in Spanish)

Taking the Mystery Out of Retirement Planning (also in Spanish)

Top 10 Ways to Prepare for Retirement (also in Spanish)

Women and Retirement Savings (also in Spanish)

To view these publications, go to www.dol.gov/ebsa and click on “Publications and Reports.”

Related materials available from the IRS:

The Retirement Plan Products Navigator, Publication 4460.

Lots of Benefits, Publication 4118, discusses the benefits of sponsoring a retirement plan and the stages involved in the life cycle of a retirement plan.

Have you had your Check-up this year? for Retirement Plans, Publication 3066, encourages employers to perform a periodic “check-up” of their retirement plans through the use of a checklist, and how to initiate corrective action if necessary.

401(k) Plan Checklist, Publication 4531, a tool to help you keep your plan in compliance with many of the important tax rules.

Designated Roth Accounts under a 401(k) or 403(b) Plan, Publication 4530, discusses this popular feature found in many 401(k) and 403(b) plans.

Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), Publication 560.

To view these related publications, go to the Retirement Plans Community Web page at www.irs.gov/retirement and click on “Forms/ Pubs/Products” in the left pane.

The IRS Retirement Plans Navigator, www.retirementplans.irs.gov , a Web guide for choosing a retirement plan, maintaining it and correcting plan errors.

401(k) Plans for Small Businesses is a joint project of the U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) and the Internal Revenue Service. Its publication does not constitute legal, accounting, or other professional advice.

To view this and other EBSA publications, visit the agency’s website at: www.dol.gov/ebsa. To order publications, contact us electronically at:

www.askebsa.dol.gov. Or call toll free: 866-444-3272.

For assistance from a benefits advisor, visit EBSA’s website at www.dol.gov/ebsa and click on “Request Assistance.” Or call toll free: 866-444-3272.

401(k) Plans for Small Businesses (IRS Publication 4222) is also available from the Internal Revenue Service at: 1-800-TAX-FORM (829-3676). (Please indicate publication number when ordering.) This publication will be made available in alternative format to persons with disabilities upon request: Voice phone: (202) 693-8664 TDD: (202) 501-3911. Publication 4222 (Rev. 12-2011) Catalog Number 37055P Department of the Treasury Internal Revenue Service www.irs.gov and U.S. Department of Labor

Health Reimbursement Arrangement (HRA) For Small Business – Sample Document

Freedom Benefits maintains a collection of sample documents for a wide range of small business employee benefit plans. While other content is published and available in its entirety here on this web site, sample documents are available only through personal request to this site’s author Tony Novak.

The sample documents should be reviewed by an attorney before recommendation or use in any application. While we are aware that some small businesses use our sample documents as templates, we can not endorse that approach.

Following is a sample outline for a Health Reimbursement Arrangement (HRA) plan specifically designed for a small business where the employer pays the entire amount of the contribution. This design would not be used in the more common situation when the employee pays part of the health cost and the goal is to avoid paying wage taxes on health plan contributions.

Table of Contents

ARTICLE I. PURPOSE AND ESTABLISHMENT
1.1 Purpose
1.2 Name
1.3 Plan Not Subject to Cafeteria Plan
1.4 Effective Date
1.5 Termination Date
ARTICLE II. DEFINITIONS
2.1 Board of Directors
2.2 Cafeteria Plan
2.3 Code
2.4 Committee
2.5 Employer
2.6 Compensation
2.7 Dependent
2.8 Employee
2.9 Participant
2.10 Plan
2.11 Plan Adviser
2.12 Plan Year
2.13 Qualifying Medical and Health Care Expenses
2.14 Reimbursement Account
2.15 Termination
ARTICLE III. ELIGIBILITY, ENROLLMENT AND TERMINATION
3.1 Eligibility
3.2 Enrollment
3.2 Acceptance of Elections
3.3 Termination
ARTICLE IV. REVOCATION AND MODIFICATION OF ELECTED COVERAGE
4.1 Revocation and Modification
4.2 Administrative Modification
4.3 Limitations on Elections of Highly Compensated Employees
ARTICLE V. BENEFITS
5.1 Generally
5.2 Carry-Forward
5.3 Forfeiture
5.4 Benefits Not Limited to Expenses Incurred During Plan Year
5.5 Qualifying Health and Medical Care Expenses
5.6 Refund of Duplicate Reimbursement
ARTICLE VI. ADMINISTRATION
6.1 Committee
6.2 Duties and Powers of the Committee
6.3 Delegation and Allocation of Responsibilities of the Committee
ARTICLE VII. CLAIMS PROCEDURE
7.1 Submission of Claims
7.2 Review of Denial of Claims
ARTICLE VIII. FUNDING
8.1 No Obligation to Fund
8.2 No Interest
ARTICLE IX. AMENDMENTS; TERMINATION
ARTICLE X. MISCELLANEOUS
10.1 No Employment Contract
10.2 No Assignment
10.3 Choice of Law
10.4 Severability
10.5 Gender, Singular and Plural References
ARTICLE XI. ADOPTION BY MULTIPLE EMPLOYERS
11.1 Method of Adoption
11.2 Delegation Upon Adoption
11.3 Employer Contributions
11.4 Withdrawal or Removal
Appendix A – Schedule of Benefits

In addition to the plan document, a sample corporate resolution to adapt the HRA (for the employer’s records) and sample Summary Plan Description (for electronic distribution to employees) are also provided. Sample plan documents are available free of charge to the attorney of Freedom Benefits’ business clients. Plan documents are typically modified to suit your specific business intent.

Other HRA resources at www.tonynovak.com:
25 reasons that small businesses choose health reimbursement arrangements
HRA plan design approved by IRS
HRA plan helps owner/employees
HRA plan overview
HRA plans for small businesses
HRA vs. HSA: Which is best for me?
IRS approves new HRA plan design
MSAs, HRAs and HSAs: which health plan is right for my small business

(If the links are broken due to an anticipated site update then do a search for a term or phrase).

Sample documents for a Consumer Driven Health Plan (CDHP)

Freedom Benefits maintains a collection of sample documents for all types of small business employee benefit plans. While other content is published and available in its entirety here on this web site, sample documents are available only through personal request to this site’s author Tony Novak.

The sample documents should be reviewed by an attorney before recommendation for use in any specific application. While we are aware that some small businesses use our sample documents as templates rather than samples, we can not endorse that approach.

Purpose

The purpose of this health plan is to furnish employees with health insurance and reimbursement for qualifying medical and health care expenses not reimbursed by any other plan or taken as a tax deduction.

Tax treatment

This is a “combination health plan” that takes advantage of the tax benefits of several different provisions of our tax laws. The plan is expected to qualify as a nondiscriminatory health reimbursement arrangement (HRA) under Notice 2002-45 of the Internal Revenue Code, a Flexible Spending Arrangement (FSA) plan under IRC Section 125 and as an accident and health care plan within the meaning of IRC Section 105(e) of the tax code. Additionally, the amount of the reimbursements paid to employees under this plan will be eligible for exclusion from their income under Section 105(b) of the Code.

Sample plan document table of contents

ARTICLE I. PURPOSE AND ESTABLISHMENT
1.1 Purpose
1.2 Name
1.3 Plan Not Subject to Cafeteria Plan
1.4 Effective Date
1.5 Termination Date
ARTICLE II. DEFINITIONS
2.1 Board of Directors
2.2 Cafeteria Plan
2.3 Code
2.4 Committee
2.5 Employer
2.6 Compensation
2.7 Dependent
2.8 Employee
2.9 Health Savings Account
2.10 High Deductible Health Plan
2.11 Participant
2.12 Plan
2.13 Plan Adviser
2.14 Plan Year
2.15 Qualifying Medical and Health Care Expenses
2.16 Reimbursement Account
2.17 Termination
ARTICLE III. ELIGIBILITY, ENROLLMENT AND TERMINATION
3.1 Eligibility and Enrollment
3.2 Acceptance of Elections
3.3 Termination
ARTICLE IV. REVOCATION AND MODIFICATION OF ELECTED COVERAGE
4.1 Revocation and Modification
4.2 Administrative Modification
4.3 Limitations on Elections of Highly Compensated Employees
ARTICLE V. BENEFITS
5.1 Generally
5.2 Carry-Forward Forfeiture Benefits Not Limited to Expenses Incurred During Plan Year
5.5 Qualifying Health and Medical Care Expenses
5.6 Refund of Duplicate Reimbursement
ARTICLE VI. ADMINISTRATION
6.1 Committee
6.2 Duties and Powers of the Committee
6.3 Delegation and Allocation of Responsibilities of the Committee
ARTICLE VII. CLAIMS PROCEDURE
7.1 Submission of Claims
7.2 Review of Denial of Claims
ARTICLE VIII. FUNDING
8.1 No Obligation to Fund
8.2 No Interest
ARTICLE IX. AMENDMENTS; TERMINATION ARTICLE X. MISCELLANEOUS
10.1 No Employment Contract
10.2 No Assignment
10.3 Choice of Law
10.4 Severability
10.5 Gender, Singular and Plural References
ARTICLE XI. ADOPTION BY MULTIPLE EMPLOYERS
11.1 Method of Adoption
11.2 Delegation Upon Adoption
11.3 Employer Contributions
11.4 Withdrawal or Removal
Appendix A – Schedule of Benefits

In addition to the plan document, a sample corporate resolution to adapt the plan (for the employer’s records) and sample Summary Plan Description (for electronic distribution to employees) are also provided. Sample plan documents are available free of charge to the attorney of Freedom Benefits’ business clients. Plan documents are typically modified to suit your specific business intent.

Other resources available at www.tonynovak.com:
25 reasons that small businesses choose health reimbursement arrangements
HRA plan design approved by IRS
HRA plan helps owner/employees
HRA plan overview
HRA plans for small businesses
HRA vs. HSA: Which is best for me?
IRS approves new HRA plan design
MSAs, HRAs and HSAs: which health plan is right for my small business

(If the links are broken due to an anticipated site update then do a search for a term or phrase).

Retirement planning software – free from the U.S. Department of Labor

The U.S. Department of Labor has an excellent retirement planning tool that can be used as a do-it-yourself tool or as the basis of a short retirement planning workshop.

The presentation is called “Taking The Mystery Out Of Retirement Planning” and is available online or as a small group workplace seminar.

zI’ve used this program in several situations and am impressed with the quality of content.

Carry-forward benefits in a Health Reimbursement Arrangement (HRA)

The most common use of a small business Health Reimbursement Arrangement (HRA) is to cover employee medical expenses that fall beneath the coverage limits of a high deductible insurance policy. Deductibles are usually set on an annual calendar year basis. Unless the HRA plan provides otherwise, the benefit expires each year and start again the following year with a new policy deductible. This is generally the preferable way to run a small business Health Reimbursement Arrangement.

Small businesses, however, often wish to allow their Health Reimbursement Arrangement (HRA) to carry forward unused benefits into future years. The logic may be that this rewards healthy employees, or alternately, may be based on the mistaken belief that HRA works like its cousin the Health Savings Account (HSA). For this reason, extra discussion is useful on the reasons that a business may wish to provide carry-forward benefits in a HRA.

While carry-forward of benefits in a HRA is possible, the details and concepts may be different than the business owner and employees imagine.

This article is an annotated excerpt of a regulation on the topic of Health Reimbursement Arrangements that expands upon Rev. Rul. 2002–41 related to allowable HRA carry-forward plan features and designs. Our comments added are in bold italics. All of the layout and formatting are for emphasis and readability for discussion purposes.

Section 105.—Amounts Received Under Accident and Health Plans (Also §§ 106, 125.) Health Reimbursement Arrangements (HRAs).

This ruling describes an employer-provided medical care expense reimbursement plan called a health reimbursement arrangement (HRA), in which reimbursements for medical care expenses made from the plan are excludable from employee gross income. Among other things, the HRA described retains favorable tax treatment because it only reimburses employees or former employees for medical care expenses of the employee or former employee and their spouses and dependents; is solely employer-funded and not paid for directly or indirectly from salary reduction; and although it allows participants to carry forward unused amounts for use in later coverage periods, these amounts may never be used for anything but reimbursements for qualified medical expenses.

ISSUE

Whether employer-provided coverage and medical care expense reimbursements made under a reimbursement arrangement that allows unused amounts to be carried forward (info future years of employment and even into retirement), as described in Situations 1 and 2 below, are excludable from gross income under §§ 106 and 105 of the Internal Revenue Code, respectively.

FACTS

Situation 1: An employer sponsors a major medical plan for all employees that provides coverage under a policy of accident and health insurance for certain medical care expenses described in § 213(d)(1)(A) and (B). The major medical plan has a $2,000 annual deductible for employee-only coverage and a $4,000 annual deductible for family coverage. However, certain preventive care benefits (e.g., annual physicals and well-baby visits) are covered without regard to the plan’s deductible. The major medical plan is paid for in part pursuant to salary reduction elections under the employer’s cafeteria plan. The election form provides that salary reduction elections are used only to pay for the major medical plan. To participate in the major medical plan, an employee must make a $1,000 annual salary reduction election for employee-only coverage or a $3,500 annual salary reduction election for family coverage. Notice that the features of the “major medical plan” are discussed separately from those of the insurance policy because the two are legally distinct. Most small employers consider them to one and the same.

The employee contributions are only for the insurance.

Participation in the employer’s insurance is required as a condition for the HRA.

The insurance is a “typical” high deductible insurance policy most commonly used within HSA-qualified plans.

There is no mention of separate accounting of employer funds for future benefits, separate employee accounts or segregation of employer funds for the amounts of possible benefit claims allocated to future years. These are all employer bookkeeping issues – not tax issues.

In addition to the major medical plan, the employer also sponsors a health reimbursement arrangement (HRA) that reimburses the medical care expenses of all participating employees and their spouses and dependents up to an annual maximum reimbursement amount that is fixed on January 1 of each year. The HRA is available only to employees who participate in the major medical plan. The HRA meets the nondiscrimination requirements of § 105(h). The HRA is paid for by the employer and employees do not make any salary reduction election to pay for the HRA. The HRA operates on a calendar year basis. Employees have no right to receive cash or any benefit other than reimbursement for medical care expenses under the HRA. The expenses reimbursable under the HRA are any medical care expenses that would be covered by the major medical plan but for the major medical plan’s deductible, (as a practical matter this makes claim administration easy for a small business since the insurance will effectively handle the insurance claim first and the amount listed as “applied to deductible” becomes the claim for the HRA plan) limitation to expenses that are “usual, customary and reasonable,” or any other similar dollar limitation imposed by the major medical plan. Only expenses that are substantiated are reimbursed. This section describes the “normal” features of an HRA; the example used is a very typical plan design.

The maximum reimbursement amount for the first year in which an employee participates in the HRA is $1,000 for an employee who has employee-only coverage under the major medical plan and $2,000 for an employee who has family coverage under the major medical plan. Unused reimbursement amounts from one year are carried forward for use in later years. Therefore, in each year after the first year, the maximum reimbursement amount under the HRA equals $1,000 for an employee who has employee-only coverage under the major medical plan and $2,000 for an employee who has family coverage under the major medical plan, increased by the unused amount from the previous year. If an employee retires or otherwise terminates employment, any unused reimbursement amount remaining in the HRA is unavailable thereafter. Under the terms of the plans, a qualified beneficiary who chooses to elect COBRA continuation coverage may only elect the HRA in conjunction with the major medical plan. However, a qualified beneficiary may choose to elect COBRA continuation coverage for only the major medical plan. The COBRA applicable premium for continuation of the major medical plan is $1,800 for employee-only coverage and $4,500 for family coverage. This section describes the more creative HRA plan design features under discussion.

Situation 2: The facts are the same as Situation 1, except that any portion of the maximum reimbursement amount under the HRA that is not applied to reimburse medical care expenses before an employee retires or otherwise terminates employment continues to be available after retirement or termination for any medical care expense under § 213(d)(1) (A), (B), and (D) incurred by the former employee or the former employee’s spouse and dependents. However, after the employee retires or otherwise terminates employment, the maximum reimbursement amount is not increased unless COBRA continuation coverage is elected. This second example describes a post-retirement benefit – not so common in small business HRA plans.

LAW AND ANALYSIS

Note that this discussion omits employer deductibility issues – a common area of concern for small business HRA plans. In short, employer contributions to an HRA are deductible when benefits are paid, not when benefits are allocated. An HRA plan that allows for carry-over means that the employer has financial liability for benefits promised in the future but not a tax deductible expense until the future year.

Section 61(a)(1) and § 1.61–21(a)(3) of the Income Tax Regulations provide that, except as otherwise provided in subtitle A, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.

Section 106 provides that “gross income of an employee does not include employer-provided coverage under an accident or health plan.”

Section 1.106–1 provides that the gross income of an employee does not include contributions which the employee’s employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by the employee or the employee’s spouse or dependents (as defined in § 152).

Section 105(a) provides that, except as otherwise provided in § 105, “amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.”

Section 105(e) states that amounts received under an accident or health plan for employees are treated as amounts received through accident or health insurance for purposes of § 105 (and § 104 relating to compensation for injuries and sickness).

Section 1.105–5(a) provides that an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness. Section 105(b) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under § 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in § 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as defined in § 152).

Section 1.105–2 provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Thus, § 105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care. This also relates to substantiation of claims for compliance purposes.

Section 105(h)(1) provides that, unless the plan satisfies the nondiscrimination requirements of § 105(h)(2), amounts paid under a self-insured medical expense reimbursement plan to a highly compensated individual will not be excludable from that individual’s gross income under § 105(b) to the extent they constitute excess reimbursements.

Coverage provided under an accident and health plan to former employees and their spouses and dependents are excludable from gross income under § 106. See, Rev. Rul. 82–196, 1982–2 C.B. 53; Rev. Rul. 85–121, 1985–2 C.B. 57. Under the facts described above, the HRA is an employer-provided accident and health plan used exclusively to reimburse expenses incurred for medical care as defined under § 213(d).

Under the HRA, no benefits other than reimbursements for medical care expenses are available either in the form of cash or other non-taxable or taxable benefits at any time. (Employees have no “right” to benefits other than through submission of a substantiated claim).

For purposes of determining whether any part of the salary reduction for the major medical plan is attributable to the HRA, under the facts and circumstances, the applicable premium for COBRA continuation coverage may be used as the actual cost of the major medical plan.

Under the facts described above, the actual cost of the major medical plan for one year is $1,800 for employee-only coverage and $4,500 for family coverage. The amount of salary reduction election for employee-only coverage ($1,000) is less than $1,800 and the amount of salary reduction election for family coverage ($3,500) is less than $4,500. Also, the cafeteria plan election form states that salary reduction elections are used only to pay for the major medical plan. Under these facts and circumstances, the HRA reimbursement amounts are not attributable to the salary reduction contributions made to pay for the major medical plan. This is important because employee contributions can not be used for the HRA.

In In Situation 2, the employer provides accident and health coverage under the HRA for former employees. This coverage is provided based on the former employee’s prior employment relationship with the employer. The HRA is used to reimburse the former employee only for medical care expenses of the former employee or the former employee’s spouse or dependents. Neither the former employee nor the former employee’s spouse or dependents receive any other benefits from the HRA at any time.

HOLDING

Employer-provided coverage and medical care expense reimbursements made under the reimbursement arrangement that allows unused amounts to be carried forward, as described in Situations 1 and 2, are excludable from gross income under §§ 106 and 105, respectively. See Notice 2002–45 published elsewhere in this Internal Revenue Bulletin for further information and guidance concerning HRAs. (end of excerpt)

 

The take home tips for small businesses setting up an HRA plan with carry-forward benefits:

1. Use only employer-paid money for the HRA. If employee contributions are required to the health plan, clearly specify this is for insurance only and outside of the HRA.

2. Have the HRA cover only expenses “applies to deductible” under the insurance policy. This makes claim administration easier.

3. Do not rely on this advice as a blanket approval for post-retirement benefits – it only pertains specifically to COBRA participants. Although technically allowed, post-retirement health benefits should probably not be covered under a typical small business HRA.

4. This tax publication does not address the practical accounting aspects, cash flow and asset management considerations of a small business HRA that provides benefits beyond the current year. These should be considered separately.

5.  HRAs are best suited to providing medical benefits in the current year that are not covered by insurance. In most cases there are better alternatives other than a HRA for providing health benefits in future years.

How to calculate small business excise taxes under IRC 4980D

The preparation of 2015 small business tax returns will require the self-assessment and calculation of a new tax triggered by the Patient Protection and Affordable Care Act (PPACA). Beginning with the filing of the 2015 federal income tax return in early 2016 taxpayers and professional tax preparers are required to recognize when this tax applies and the calculate the appropriate excise tax for their small business clients under Section 4980D of the Internal Revenue Code.

Background

This section of tax law was introduced under the PPACA in 2010. This provision of the law became effective January 2014 but IRS issued a delay in enforcement applicable to small business employers that expired June 30, 2015. After that date, the excise tax must be self-assessed and included in the tax liability for the firm’s 2015 tax return. Larger employers were already subject to the excise tax penalty for 2014.

While several authors have published legal commentary on this section of PPACA, there are no known sources of practical help for tax practitioners who need to recognize and calculate the tax liability under this new section of the tax code.

No official estimates are published on the number of small businesses affected by this new provision of tax law but I roughly estimated it to be in the tens of thousands nationwide based on anecdotal indications of the portion of small business firms engaging in one of the two trigger mechanisms discussed below. If we add the number of firms in violation of other tax provisions for health plans then the number of affected taxpayers would likely rise much higher.

Recognizing the tax liability

The first step for the tax practitioner is recognizing when this tax applies. This posed a significant potential stumbling block because the tax return preparer may not recognize a non-compliant small business health plan.

There are two situations that trigger this tax: 1) payment of individual health insurance and 2) reimbursing out-of-pocket medical expenses under an arrangement that is not integrated with an employer-provided group health insurance policy. The tax preparer must be able to recognize each of these  situations that triggers a tax.

Neither of these triggers should create a penalty against one employee business. Small businesses are particularly vulnerable when they hire their first employee so the tax preparer should review 4980D issues with a self-employed client before they make a hiring decision. One person C corporation owners with high out-of-pocket medical costs, in particular, may be well-advised to consider using a contractor like a virtual assistant rather than hiring an employee. This alternate strategy may make it possible to continue using individual health insurance and a Health Reimbursement Arrangement without adverse consequence.

No change to taxation of underlying transactions

There is nothing in this tax code section or any other part of the PPACA that changes the underlying tax treatment of health insurance or uninsured health benefits as discussed in my other article here. Instead, the new law adds an additional layer of tax on top of existing law without changing the underlying law.

This is important point to consider because some tax practitioners think that by changing the tax treatment of the underlying transactions then the 4980D excise tax can be avoided. For example, some small business accountants report that they changed a the reimbursement for individual health insurance from pre-tax to after-tax bonus in an attempt to avoid triggering the excise tax. The proverbial “two wrongs do not make a right” applies here. In this example, the insurance reimbursement is now being reported improperly and the business is still not in compliance with 4980D.

Method of Calculation

There are two primary methods of assessing the excise tax: 1) the statutory tax of $100 per employee per day and, for qualifying employers, 2) a reduced penalty of 10% of the employer’s health care costs.

The larger excise tax penalty – $100 per employee per day – appears straight forward at first consideration, there are unresolved issues that may impair accurate calculation. Assuming that we are preparing the 2015 full year tax return and the violation existed for the entire year then the tax is $36,500 per employee. Presumably employees who did not participate in the employer health plan or reimbursement are exempted from the penalty but we have no authoritative proof.

Qualifying for the reduced penalty

Considering the potential for greatly reduced taxes, we presume there will be great interest in qualifying for the tax for unintentional violations.

The lesser excise tax penalty for unintentional violations of 10% of health care expense may be substantially lower, we have no guidance on the availability or applicability of this reduced penalty. Specifically, a self-assessment of the reduced penalty raises serious preparer questions. How can the violation be unintentional if the preparer recognizes it? And what if the violation continues past the tax filing deadline where a 4980D excise tax is self-assessed, wouldn’t that be prima facia evidence that the violation is not unintentional? How can the preparer know about the violation and simultaneously claim that the violation was unintentional?

This discussion is incomplete due to a lack of information at the time of the article’s publication.

Minimum penalty on audit

IRC 4980D (3)(a)(ii) has a minimum penalty of $2,500 if a de minimis violation is uncovered during audit. This appears to be a way for the Service to settle cases without arguing that a small unintentional violation reduces liability to almost nothing. This provision of the law appears to suggest that small business employers are potentially liable for even the smallest violations.

Avoiding preparer penalties

It seems clear that this new tax opens the door for substantial underpayment tax penalties for the small business employer and their tax preparers.  Preparers should take these additional steps during the preparation of a 2015 small business tax return to avoid substantial underpayment penalties:

1) Review the businesses health plan documents. In some cases the preparer may discover that required plan documents do not exist. Lack of required plan documents is a separate tax violation completely outside of the scope of this article. See my article here for other common problems with HRA documents and plan design.

2) Examine the integrated insurance policy. Is it a group type insurance? Is it issued in the name of the employer? Does it meet minimum requirements of a qualified plan under ACA?

3) Review individual health insurance payment transactions. If the business has any interaction with individual health insurance payment transactions, be certain that the IRS would not classify the transactions as an employer payment arrangement. Review the employment contract, if applicable, or documentation of bonuses that might be used to pay for individual insurance. If an employer is making or facilitating the payment of individual health insurance then make sure that the employee has the right to receive cash instead of insurance.

4) Consider whether the business meets the one employee business exemption for individual insurance or the church plan exemption. IRS has clarified that a business will not be penalized simply because individual health insurance was the only available option. This exemption some but not all of the requirements of the provisions of 4980D. While issued regulations address the case of the single employee business, they do not address the case where there is more than one employee but only one is eligible for health insurance. In this latter case, the only insurance option is still individual health insurance but current regulations do not clarify an exemption from the excise tax. Church health plans are also exempt from the excise tax.

Tax preparers who are not familiar with health insurance and employee benefits documents are well advised to obtain a professional review and opinion before making a determination of whether excise taxes under 4980D should be included on the small business tax return for 2015.

This discussion of tax preparer liability is incomplete because additional information was not available at the time of the article’s publication. Ideally, some tax preparer checklist or action framework could be developed to minimize the possibility of tax preparer liability.

Finally, because this is a new area of tax compliance for small businesses we should recognize that additional information is likely to emerge.

Medical expenses includible in a small business employee health plan

The IRS lists the following eligible and ineligible expenses for a qualified Health Reimbursement Arrangement, Health Savings Account, Flexible Spending Account or other small business qualified employee health pan.  Each item in the list links to IRS discussion.

Individual businesses may modify the list of covered items under their employee health plan. For example, a religious business may wish to exclude abortion coverage. A health-oriented business may wish to include 100%  gym membership reimbursement (although the benefit would not be tax-free per these IRS rules). This list effectively serves as a starting point or a default in the design of employee health plan coverage.

Changes to 2014-2015 tax penalties for small business health plans

On February 18, 2015 the IRS released Notice 2015-17 that delays some of the tax penalties included in the Affordable Care Act related to businesses that pay for or reimburse certain types of employee medical costs under conditions not allowed by the Affordable Care Act. The notice is important to businesses that paid or reimbursed the cost of individual health insurance in 2014 or those who reimbursed employees for out-of-pocket medical expenses outside of an insurance plan over the past year.

Freedom Benefits previously estimated that more than 1 million small businesses were in violation of one of more provisions of the law and the size of potential excise tax penalties (up to $36,500 per employee for 2014 alone) was enough to bankrupt many small firms. Under the IRS guidance issued today the application of penalties for small businesses is delayed until June 30, 2015. It is important for small businesses to review and update their non-compliant health plans over the next four months. Freedom Benefits offers a do-it-yourself compliance checklist or a professional review with sample plan documents that are intended to meet the new requirements.

In summary, the tax penalty for past violations in small business employee health plans is gone. Businesses must bring their health plans into compliance by June 30, 2015 in order to avoid tax penalties for 2015 an beyond.