On June 26, 2002, the IRS issued guidance, in the form of Notice 2002-45 and Revenue Ruling 2002-41, which approves a new type of health plan design called a Health Reimbursement Arrangement (HRA). While many employers have established similar types of reimbursement arrangements, which are sometimes referred to as a defined contribution accounts or consumer-driven health plans, the tax treatment of HRAs was previously uncertain. Although the IRS guidance approved certain HRA plan designs, employers must take care when adopting an HRA to ensure that it satisfies the requirements for tax-favored treatment.
HRAs are employer-provided arrangements, which can be funded or unfunded, that reimburse employees, former employees and their tax-qualified dependents for qualified medical expenses up to a maximum dollar amount. Any amounts in an HRA that are not used in one year may be carried over and used to reimburse qualified medical expenses in subsequent years. Amounts in an HRA may also be used to reimburse an individual for qualified medical expenses of the account holder, and his or her spouse or dependents, during the individual’s retirement or after termination of employment or death. Self-employed individuals may not participate in an HRA.
If designed according to the IRS guidance, an HRA will be treated as an accident or health plan under the Internal Revenue Code and afforded special tax treatment. Accordingly, an employer may deduct amounts contributed to an HRA when it is actually used to pay for or reimburse qualified medical expenses or if it is contributed to certain types of welfare benefit trusts. Amounts in an HRA that are used to reimburse an individual for the payment of qualified medical expenses are not taxable to the individual.
Design Features of HRAs
In order to qualify for special tax treatment under the Internal Revenue Code, an employee may not make contributions to an HRA through pre-tax salary reduction or otherwise. The HRA must be funded solely through employer contributions. In addition, the HRA may only provide reimbursement for qualified medical expenses, as defined by the code.
An employee may not take a deduction for amounts paid for qualified medical expenses and receive a reimbursement from an HRA for the same expenses. Also, amounts in an HRA may only be used to reimburse expenses incurred after the date the HRA was established or the employee first became enrolled.
An HRA can make reimbursements for the after-tax cost of group accident and sickness coverage paid by current employees, retirees and COBRA qualified beneficiaries. Code Section 125 cafeteria plan pre-tax salary reductions may still be elected by the employee to pay the cost of group health coverage, including the cost of tandem high-deductible, catastrophic coverage offered in conjunction with the HRA. However, special restrictions apply to avoid any direct or indirect funding of the HRA through the cafeteria plan. In addition, no individual may receive cash or any reimbursement, other than for qualified medical expenses, from an HRA. Failure to comply with these rules will result in disqualification of the HRA and full taxation of HRA reimbursements (including all amounts previously paid for qualifying medical expenses) to all individuals covered under the HRA.
Where an employer maintains both a cafeteria plan with or without a health care flexible spending account (FSA) feature and an HRA, plan design and plan documentation require careful attention so pre-tax salary reductions under the cafeteria plan are not linked to the HRA.
Because HRAs cannot be part of a cafeteria plan, certain rules applicable to health FSAs offered through a cafeteria plan do not apply to HRAs. Accordingly, unused amounts in an HRA may carry over from one plan year to subsequent plan years. Also, unlike health FSAs, the maximum amount of reimbursement (excluding amounts carried forward from previous years) need not be available to participants at all times during the plan year. An HRA does not have a mandatory 12-month period of coverage and may reimburse a qualified medical expense if the individual was covered under the HRA at the time the expense was incurred. If an HRA is offered in addition to a cafeteria plan health FSA, employees must exhaust amounts in their HRA before reimbursements may be made under the health FSA unless the health FSA reimburses amounts that are not reimbursable under the HRA, or the HRA provides that it will only reimburse expenses after amounts under the health FSA have been exhausted. If the HRA is self-insured, certain nondiscrimination rules apply that preclude an employer from providing greater benefits to high-paid employees.
HRAs are also subject to COBRA. If an individual elects to continue his or her HRA pursuant to COBRA, any contributions made by the employer in subsequent years to other plan participants must also be made to the HRAs of COBRA qualified beneficiaries. COBRA premiums are calculated based on the amount of the annual addition to the HRA and not on the maximum reimbursable amount under an individual’s HRA.
Other Applicable Laws
The guidance makes it clear that HRAs are subject to other federal statutes and rules, though the IRS notice and the revenue ruling do not contain specific information on the application of the other statutes. Other applicable Internal Revenue Code sections include the funding limitation rules under IRC Sections 419 and 419A for funded HRAs; and the Code Section 404(b)(2) timing rules for employer deductions where the HRA is unfunded. The Health Insurance Portability and Accountability and the Employee Retirement Income Security Acts also apply to HRAs, since the accounts qualify as employer group health plans.
Members of McDermott, Will & Emery’s Employee Benefits Department are uniquely qualified to assist you in establishing HRAs for your employees and identifying the legal compliance issues that must be addressed.