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.

Average small group health insurance premiums – before ACA

The purpose of this post of historical information is to compare the rates with post-ACA implementation figures as soon as they are available.  This may be the most direct and practical way to evaluate the market impact of ACA on small businesses.

The IRS released a list of the average small group market premiums in each of the 50 States and the District of Columbia for the 2010 tax year, as determined by the Department of Health and Human Services.

State Single Coverage Family Coverage
Alaska $6,204 $13,723
Alabama $4,441 $11,275
Arkansas $4,329 $9,677
Arizona $4,495 $10,239
California $4,628 $10,957
Colorado $4,972 $11,437
Connecticut $5,419 $13,484
District of Columbia $5,355 $12,823
Delaware $5,602 $12,513
Florida $5,161 $12,453
Georgia $4,612 $10,598
Hawaii $4,228 $10,508
Iowa $4,652 $10,503
Idaho $4,215 $9,365
Illinois $5,198 $12,309
Indiana $4,475 $11,222
Kansas $4,603 $11,462
Kentucky $4,278 $10,434
Louisiana $4,829 $11,074
Massachusetts $5,700 $14,138
Maryland $4,837 $11,939
Maine $5,215 $11,887
Michigan $5,098 $12,364
Minnesota $4,704 $11,938
Missouri $4,663 $10,681
Mississippi $4,533 $10,501
Montana $4,772 $10,212
North Carolina $4,920 $11,583
North Dakota $4,469 $10,506
Nebraska $4,715 $11,169
New Hampshire $5,519 $13,624
New Jersey $5,607 $13,521
New Mexico $4,754 $11,404
Nevada $4,553 $10,297
New York $5,442 $12,867
Ohio $4,667 $11,293
Oklahoma $4,838 $11,002
Oregon $4,681 $10,890
Pennsylvania $5,039 $12,471
Rhode Island $5,887 $13,786
South Carolina $4,899 $11,780
South Dakota $4,497 $11,483
Tennessee $4,611 $10,369
Texas $5,140 $11,972
Utah $4,238 $10,935
Virginia $4,890 $11,338
Vermont $5,244 $11,748
Washington $4,543 $10,725
Wisconsin $5,222 $12,819
West Virginia $4,986 $11,611
Wyoming $5,266 $12,163

401(k) fees checklist

Many 401(k) plan participants are concerned about the fees in the plan as a result of increased media and governmental focus on this issue. How do you get the best value for your money and is your 401(k) on target to deliver the benefits you expect?

401(k) plan participants began paying more attention to the fees and performance of their retirement accounts after August 2012 when new federal regulations required additional disclosures to all 401(k) plan participants. We believe that the only logical approach to improve 401(k) plan results is through independent advice – separate from the firms that provide retirement plan and investment services. A simple three step analysis, review and planning exercise will address these concerns and put your retirement plan back on the right track.

Ask questions

The Department of Labor prepared this ten point checklist to help 401(k) plan participants gain an understanding of these fees and potential areas for improvement:

  1. What investment options are offered under your company’s 401(k) plan?
  2. Do you have all available documentation about the investment choices under your plan and the fees charged to your plan?
  3. What types of investment education are available under your plan?
  4. What arrangement is used to provide services under your plan (i.e., are any or all of the services or investment alternatives provided by a single provider)?
  5. Do you and other participants use most or all of the optional services offered under your 401(k) plan, such as a participant loan program and insurance coverage?
  6. If administrative services are paid separately from investment management fees, are they paid for by the plan, your employer or are they shared?
  7. Are the investment options tracking an established market index or is there a higher level of investment management services being provided?
  8. Do any of the investment options under your plan include sales charges (such as loads or commissions)?
  9. Do any of the investment options under your plan include any fees related to specific investments, such as 12b-1 fees, insurance charges, or surrender fees, and what do they cover?
  10. Does your plan offer any special funds or special classes of stock (generally sold to larger group investors)?

Get independent advice

Plan participants should have access to independent 401(k) plan advice (an adviser not affiliated with the company that provides services to the 401(k) plan or its investments). An independent adviser typically compares the fees and services of your plan in comparison to similar fees and services on comparable plans in order to arrive at any  recommendations designed to lower fees and boost performance for the participants. More importantly, an independent adviser helps plan participants focus on a “big picture” assessment of whether the current accounts are on target to meet the participant’s overall expectations of a secure retirement.

Measure your progress

It is important to periodically re-evaluate your retirement planning in light of overall life changes. Freedom Benefits offers individual consultations to delve into these issues in more detail. A simple but highly effective interactive software program called “Taking the mystery out of retirement planning” is incorporated into our one-on-one discussions and group workshops for 401(k) plan participants. This “mini-planning” process takes only about an hour but delivers big results.

By taking these three simple steps –

  1. question 401(k) fees and performance
  2. access an independent advisor
  3. participate in a retirement planning evaluation

– it is possible to significantly improve performance and satisfaction with you 401(k) plan.

What is a simple cafeteria plan?

Simple cafeteria plans were created as part of the Affordable Care Act of 2010 to make it easier for small businesses to meet the applicable tax requirements for this type of employee benefit plan.

To qualify for a simple cafeteria plan, the plan must meet all of the following criteria:

  1. Eligible Employer. To be an employer eligible to sponsor a simple cafeteria plan the employer must have employed an average of 100 or fewer employees on business days during either of the 2 preceding years.

Growing Employers. Special rules apply to a ‘growing employer’, in the event that its employee population exceeds 100 employees. The employer can continue to sponsor a simple cafeteria plan; however, in the year following a year in which the employer employs on average 200 or more employees on business days, the plan must be converted to a classic cafeteria plan.

Aggregation Rules. Related employers, as defined in IRC Section 52(a), Controlled Group of Corporations, or Section 52(b), Employees of Partnerships, Proprietorships, Etc., Which Are Under Common Control, must be combined in determining employer size. In addition, leased employees, as defined in IRC §§414(n) or (o), are counted in determining employer eligibility.

  1. Minimum eligibility and participation requirements. Simple cafeteria plans must meet minimum eligibility and participation requirements. Specifically, all employees who had at least 1,000 hours of service for the preceding plan year are eligible to participate. Each employee eligible to participate in the plan may, subject to terms and conditions applicable to all participants, elect any benefit available under the plan.

Excludable Employees. Certain employees may be excluded from the minimum eligibility and participation requirements; these include:

  • Employees who are under age 21;
  • Employees who have been employed for less than one year;
  • Employees covered by a collective bargaining agreement where health benefits have been the subject of good faith bargaining; and
  • Nonresident aliens with no U.S. source of income.
  1. Contribution requirement. The employer is required, without regard to whether a qualified employee makes any salary reduction contribution, to make a contribution to provide qualified benefits under the plan, on behalf of each qualified employee. Qualified employees are those employees who are neither highly compensated individuals or key employees, as defined by the cafeteria plan rules, and who are eligible to participate in the cafeteria plan.

There are two types of employer contributions, as follows:

  • The non-elective contribution is a uniform percent of compensation, but not less than 2% of the employee’s compensation for the plan year.
  • The matching contribution is an amount that equals or exceeds the lesser of:
  • Six percent of the employee’s compensation for the plan year; or
  • Twice the employee’s salary reduction contribution.

The contribution method selected must be the same for all qualified employees, and must be a true employer contribution, i.e., it cannot include a salary reduction contribution at all.

When a plan meets these criteria then it meets the non-discrimination requirements for a cafeteria plan. These requirements are less complex than the requirements imposed on other cafeteria benefit plans.

Other resources:

article: Taxation of small business health plans

How does Medicare interact with a small business health plan?   

For small businesses with less than 20 employees, Medicare is always primary and the employer provided plan is always secondary.

Small businesses that reimburse the cost of Medicare to more than one employee need to consider the impact of market reform laws under the Affordable Care Act. Unless the reimbursements are made to employees who are also covered by group health insurance (in addition to Medicare) then this would create a group health plan (the reimbursement plan) that does not meet the requirements, thereby triggering excise tax penalties under IRC 4980D that can be severe. Since few small businesses wish to have Medicare-eligible employees also on the employer-sponsored group health insurance, this strategy is often impractical.

Since the Medicare-eligible person(s) are often the business owner(s). there may be business planning work-arounds available to avoid excise tax problems.

See the slide presentation at http://www.medicarerights.org/PartB-Enrollment-Toolkit/Medicare-and-Employer-Based-Insurance-The-Basics.pdf for a full explanation of this complicated topic.

Other resources:

Medicare Guide: Who pays first?

Medicare and You 2012

Medicare Interactive: Filling the gaps in Medicare: employer insurance

Is a Form 5500 required? 

The Internal Revenue Service no longer requires the filing of a Form 5500 for small business benefit plans if the plan had fewer than 100 participants in the plan year. This change became effective in 2002.

Other resources:

IRS Notice 2002-24

article: “Taxation of small business health plans

What is the difference between a “health reimbursement arrangement” and a “health reimbursement account”?

This is a common question that may signal an underlying misconception of the nature of the employee benefit plan under consideration. It makes sense to expand on the distinction between a “health reimbursement arrangement” and a “health reimbursement account” because of the potential to confuse the concepts or the tendency to use the terms interchangeably.

In the past – perhaps ten years ago – it was customary, even among employee benefits professionals, to hear the the terms used interchangeably. More recently employee benefit professionals use only the term “health reimbursement arrangement” and might have considered the term “health reimbursement account” to be just an improper usage or an error. Now the terminology has resurfaced in a new context.

We draw attention to the distinction between the two phrases because of recent surge in popularity of health reimbursement accounts that are part of executive compensation packages not associated in any manner with health reimbursement arrangements.

The former, a Health Reimbursement Arrangement (also known as an HRA) is a tax-qualified employee benefit plan that is not discussed in this Q&A. Please see other pages on this Web site devoted to HRAs. The latter term, a “health reimbursement account” is the subject of the remainder of this Q&A.

A health reimbursement account is a bank account or other accounting entry whose function is to distinguish funds earmarked by an employer for employee health expenses from other general operating expenses of the employer. The separation of funds is an accounting notion only since there is no legal distinction between the health reimbursement account and the employer’s general operating funds.

Funds placed into a health reimbursement account are not tax deductible and are treated in the same manner as funds in any other regular employer-owned account. The funds are subject to attachment by general business creditors, the same as any other general business funds. Interest, if any, is taxable to the employer. If the funds are paid to employees then this amount is taxable compensation (just like wages) unless a specific tax law (like IRC code section 105 or 125) allows them to be paid to employees tax-free. In other words, a health reimbursement account has no tax status or effect.

An employer may wish to eventually use the funds in the health reimbursement account to pay for employee health expenses in a manner that would make the expenses deductible to the business and tax-free to the employee. Any of the qualified health plans discussed elsewhere in this Web page can be used, including the HRA that was mentioned earlier in this article.

In some other cases employers use health reimbursement accounts to fund executive health benefits that are not tax-qualified benefits under any available option. The funds may be earmarked for owners, highly compensated employees or key employees whose health benefits are subject to additional tax restrictions. In this sense, the health reimbursement account serves the same purpose and function as funding a deferred compensation account for executive employees. In these cases it may be appropriate to refer to the health reimbursement account as a non-qualified account, indicating their lack of tax advantages.

Additionally, some employers ask whether it is possible to establish a health reimbursement account for each employee. This is possible and is becoming increasingly popular; but again this serves no legal purpose or function other than to earmark a specific sum of the employer’s funds that are intended for a specific employee’s future health expenses.

Finally, please be aware that “health reimbursement arrangement” is a term recognized in official tax publications and laws and therefore has a specific legal definition. In contrast, the term “health reimbursement account” is not a legally recognized term so some people may choose to take liberties in the usage of the phrase and define it as they wish. Our interpretation, we believe, represents the consensus of the employee benefit profession. Yet we are aware that some benefits salespeople deliberately interchange the use of these two terms to facilitate sales-related discussions. (It makes sense to have two phrases describe what you are selling rather than take the time that to say that you can not sell one of the two and then describe the difference).

Other resources:

article: “How to establish separate employee bank accounts in a small business HRA plan