An HRA is based on several sections of the Internal Revenue Code, including Sections 105, 106, and 213; however, it was Notice 2002-45 that gave the Section 105 plan a formal name and the guidelines for administering an HRA.
Internal Revenue Service Notice 2002-45 defines an HRA as an arrangement that:
- is paid solely by the employer and not provided pursuant to salary reduction election or otherwise under a Section 125 cafeteria plan;
- reimburses the employee for medical care expenses (as defined by Section 213(d) of the Internal Revenue Code) incurred by the employee and the employee's spouse and dependents (as defined in Section 152); and
- provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount for a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods. To the extent that an HRA is an employer-provided accident or health plan, coverage and reimbursements of medical care expenses of an employee and the employee's spouse and dependents are generally excludable from the employee's gross income under §§ 106 and 105. Assuming that the maximum amount of reimbursement which is reasonably available to a participant under an HRA is not substantially in excess of the value of coverage under the HRA, an HRA is a flexible spending arrangement (FSA) as defined in § 106(c)(2).
Note: goHRA recommends that employer HRA Plans include a NO CARRY OVER provision, so that unused balances DO NOT carry over to subsequent plan years. This ensures that the maximum amount available for reimbursement in a plan year equals the total HRA account balance, which qualifies the HRA as a “flexible spending arrangement” HRA as defined in § 106(c)(2).
An HRA is a tax-exempt plan established by an employer for an employee, which is funded solely by employer contributions, and not through a salary reduction. Employer contributions are excludable from the employee's gross income under §§ 106 and 105, and are not subject to FICA or FUTA taxes. Reimbursements from the plan can only be used to pay for medical expenses incurred by a current and former employee (including a retired employee) and his or her spouse and dependents. If amounts remain in the HRA after an employee dies, the plan can be used for the medical expenses of the deceased employee’s spouse and dependents.
“Business Owners” are not eligible to participate in an HRA Plan. A “Business Owner” is anyone who holds more than 2 percent ownership in an S-corporation, LLC or LLP, is not considered to be a W-2 common law employee, but rather a self-employed individual for tax purposes.
However, under IRS Code section 162 (l) “Business Owners” are permitted to deduct the cost of healthcare insurance as a normal business expense. In addition, under IRS Code section 213(a), “Business Owners” may deduct medical expenses not covered by insurance, to the extent that the expenses exceed 7.5% of their adjusted gross income.
To qualify for the exclusion under §§ 106 and 105, an HRA may only provide reimbursement for medical expenses as defined in § 213(d). All medical care expense under an HRA must be substantiated. An HRA cannot reimburse a medical expense that was deducted for tax purposes in any prior taxable year, and it cannot reimburse an expense that is incurred before the date the HRA goes into existence, nor can it reimburse for medical expenses incurred before the date an employee first becomes enrolled in the HRA.
Internal Revenue Service (IRS) Code Section 213(d) and IRS Publication 502 provide the guidelines for reimbursable and non-reimbursable medical expenses.
Internal Revenue Service (IRS) Code Section 213(d) defines the term “medical care” as amounts paid:
- For the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,
- For transportation primarily for and essential to medical care referred to in subparagraph (A),
- For qualified long-term care services (as defined in section 7702B (c)), or
- For insurance (including amounts paid as premiums under part B of title XVIII of the Social Security Act, relating to supplementary medical insurance for the aged) covering medical care referred to in subparagraphs (A) and (B) or for any qualified long-term care insurance contract (as defined in section 7702B (b)).
HRA reimbursements are excludable from the employee's gross income. However, each class within the HRA is subject to the non-discrimination rules under § 105. Those rules prohibit discrimination in favor of highly compensated individuals (HCI) as to eligibility to participate and the benefits provided by the HRA. HCIs include:
- one of the 5 highest paid officers
- shareholders who own more than 10% of the company
- the highest paid 25% of all employees
“Business Owners” not eligible to participate in the HRA are excluded from the test.
Non-discriminatory eligibility classification requires that the HRA benefit at least 70% of all non-excludable employees or 80% of all eligible employees. Excludable employees may include:
- employees with less than 3 years of service
- employees who are under age 25
- employees who are part-time or seasonal
- employees covered by a collective bargaining agreement
- employees who are non-resident aliens with no U.S. source income
If, upon audit, an HRA class is found to violate these rules, the HCIs must pay income taxes on the additional amounts received. However, it does not mean other employees are entitled to the higher level of reimbursement received by HCIs, nor does it jeopardize the company's ability to deduct all HRA reimbursements. As long as the employer establishes the classes as allowed under § 105, nondiscrimination rules will apply to each class independently.
Federal regulation 29 CFR §2590.702 states that a plan or issuer may treat participants as two or more distinct groups of similarly situated individuals if the distinction between or among the groups of participants is based on a bona fide employment-based classification consistent with the employer's usual business practice.
To comply with these regulations, employee classes within the HRA must:
- be based on bona fide business differences including full-time versus part-time status, different geographic location, membership in a collective bargaining unit, date of hire, length of service, current employee versus former employee status, and different occupations.
- not be based on any health factor, unless it is favorable treatment of individuals with adverse health factors.
- be clearly defined; the eligibility requirements, benefits and rules must be included in the plan documents.
An HRA also needs to avoid employer endorsement of individual health insurance plans. The Department of Labor (DOL) does provide a “safe harbor” for some “voluntary” plans. How much an employer “endorses” a plan, or is involved in the planning and administration will help determine whether or not the plan must comply with ERISA. To avoid employer endorsement of employees’ individual health insurance plans, the employer may not directly pay premiums to the insurance carrier or receive any form of compensation in connection with the employee's individual health insurance policy (see C.F.R. § 2510.3-1(j)). The employer must also avoid becoming involved in:
- an employee’s decision to purchase individual health insurance or their decision of which insurer or plan to use.
- any negotiations with the insurance carrier over price or benefits.
- any claim dispute between an employee and an insurance carrier. This includes not furnishing employees with insurance claim forms or any other materials related to their individual health insurance policies.
Note: With goHRA, an employer contributes to the HRA Plan, not to the purchase of individual health insurance. The employee “voluntarily” chooses what qualified medical expenses (e.g. doctor visits, insurance premiums, etc) to submit to goHRA for reimbursement. goHRA notifies employers of the amount of reimbursement, not type of medical expense.
Ordinarily, an HRA is an employee welfare benefit plan under ERISA. Therefore, an HRA must be in writing, and ERISA claim procedure rules will apply. Code Section 404(a)(5) and (b) employer deduction rules apply to an HRA that is unfunded(paid from the general assets of the employer), and generally make the deduction available at the time amounts are actually reimbursed to employees. If an HRA is funded, VEBA rules and Code Section 419 and 419A apply.
An HRA is subject to COBRA continuation coverage requirements. Internal Revenue Notice 2002-45 states, if an individual elects COBRA continuation coverage, an HRA complies with these COBRA requirements by providing for the continuation of the maximum reimbursement amount for an individual at the time of the COBRA qualifying event and by increasing that maximum amount at the same time and by the same increment that it is increased for similarly situated non-COBRA beneficiaries (and by decreasing it for claims reimbursed).
An HRA complies with continuation requirements if the COBRA premium is the same for qualified beneficiaries with different total reimbursement amounts available from the HRA at the time of the qualifying event. In other words, COBRA premium must be the same for all qualified beneficiaries regardless of their HRA account balance.
The Health Insurance Portability and Accountability Act of 1996 (HIPAA) treats an HRA as a group health plan. To the extent that an HRA is a group health plan, it must comply with HIPAA privacy and non-discrimination requirements.
Medicare Secondary Payer Reporting Requirement
Under MMSEA Section 111, an HRA is treated as a group health plan and subject to the Medicare Secondary Payment (MSP) provisions (See: 42 CFR §411.101.) HRAs are subject to the MSP provisions regardless of whether or not they have an end-of-year carry-over feature.