HRAs: What’s permitted and what’s prohibited (an update for 2016)

There continues to be an incredible amount of deception about standalone health reimbursement arrangements, and some misunderstanding of what, if anything, is now permitted in terms of premium reimbursement. A couple of posts I wrote last year helped provide some clarity on these issues and I’ve been asked by a number of folks to update the post for 2016.

A history lesson:  Back in 1961, the Internal Revenue Service issued Revenue Ruling 61-146, which recognized “employee payment plans” as ways that employers could pay for certain expenses for their employees. Prior to that ruling, any reimbursement by an employer for its employees’ medical expenses was considered taxable income to that employee. Many of these rules were clarifications about two sections of the Internal Revenue Code: Section 105 which permitted the creation of medical expense reimbursement arrangements (MERP) and Section 106 concerning payments by employers for group health plans.

In 2002, the IRS and Treasury issued IRS Notices 2002-41 and 2002-45, which modified (by Executive Action and without legislative authority) Sections 105 and 106 to create a modified form of MERPs that we all know today as a Health Reimbursement Arrangement (HRA). The main difference between MERP and HRA was that rollover amounts were permitted under an HRA but the employer would have to be solely responsible for paying the costs associated with the HRA’s benefits.

With the new attention splashed on HRAs, they suddenly became the latest “hot” thing in terms of benefits, and were used in many different ways — to buy less insurance benefits and close the gap with an HRA to lower deductibles or other cost-sharing expenses; or to reimburse an employee for their individual health insurance premiums. (The Internal Revenue Code also permitted this practice through Section 125 Premium Reimbursement Arrangement, but it was hardly ever used due to that section’s nondiscrimination rules. Congress dramatically modified PRAs as a part of the adoption of the Affordable Care Act in 2010) In retrospect, HRAs really did nothing more take an old car, add some fancy lights and new paint, install a catalytic converter so it would run on unleaded fuel and sell it like it was a brand new car.

And we sold our clients on this “innovative” solution, ignorant of the history of how we’d gotten here, and that we could have done it before this new ruling.

ACA changes everything

When the ACA became law in March 2010, it included a number of market reforms for group health plans such as eliminating annual and lifetime limits and requiring preventive benefits be paid at 100% without any cost sharing. These reforms were additional requirements to laws Congress passed previously such as COBRA, Women’s Health and Cancer Rights Act, Newborn and Mother’s Protection Act, and the Mental Health Parity Act.

Almost immediately, the IRS and Department of Labor was made aware that employer reimbursement of individual health insurance premiums would have an adverse impact on the group market and the employer mandate. The first couple of pieces of guidance provided a heads-up that they were going to take pretty dramatic action on the issue, which ultimately came in IRS Notice 2013-54.

This notice began with making changes to the original legal basis for employer premium reimbursements (Rev. Ruling 61-146) and modified what would be considered an employee payment plan going into the future. This first act was completely legal because the IRS had dreamt up the original EPP rules, and they adjusted them to fit into a post-ACA world. This critical point has been ignored by those trying to justify premium reimbursements while selling their software services since 2013-54 was issued.

The second part of that notice was to split HRA/MERP into two types: integrated and standalone. Integrated HRAs are required to be paired with a group health plan (either insured or self-funded) that would alone comply with the preventive services requirements and other market reforms required by the ACA and ERISA. There are some rules too that go along with Integrated HRAs:

• Employer offers, in addition to the integrated HRA, a group health plan to its employees that does not consist solely of excepted benefits;
• Employee who participates in the HRA is also enrolled in the employer’s group health plan;
• HRA is limited to reimbursement of copayments, coinsurance and deductibles from the group health plans, as well as medical care that is not essential health benefits; and
• The HRA permits an employee to permanently opt out and waive future reimbursements from the HRA at least annually.

These integrated HRAs remain a critical way that many small- and mid-sized employers can better manage the cost of healthcare between premiums and “gap” expenses to find the right mix based on their financial capabilities and risk tolerance. But abuse of this model has already sparked some carriers to require disclosure and even integrated administration, and will result in more scrutiny and regulation if agents aren’t careful.
Standalone HRAs were largely prohibited in the aftermath of IRS Notice 2013-54. The gaps and holes that some rats tried to run into were addressed in DOL’s ACA FAQ XXII and IRS Notice 2015-17. But there was also some clearly allowed standalone HRAs permitted from this bevy of additional guidance. I’ll start by highlighting what is permitted:

Spousal Coverage Reimbursement HRAsallow for an employee to be reimbursed by their employer when the employee is covered on their spouse’s group health plan as long as the spouse’s group health plan meets the ACA’s requirements. (Note that reimbursing an employee for coverage on their spouse’s individual health insurance plan is not permitted under this approach.) With so much discussion over spousal participation, contribution and eligibility rules, the use of this type of reimbursement HRA may have limited use, but we’ve already seen instances where it can assist an employer and the employee in many positive ways. But there are landmines for the employee if not properly informed about the tax consequences of this type of HRA — which is best illustrated by an example:

Bob’s Fresh Fruit reimburses one of its employees, John, for the cost of health coverage that he has through his wife’s (Sally) employer using the Spousal Coverage Reimbursement HRA. The amount that Bob’s Fresh Fruit reimburses is based on the information received from Sally’s employer on the cost between covering the employee only and covering herself and her spouse.

For the purpose of this example, let’s say that the cost for employee only coverage for Sally and other employees is $20 per month, but to cover John, Sally would have to pay an additional $240 per month. So Bob’s Fresh Fruit reimburses John $240 each month for the cost of spousal coverage, which is not considered taxable income to John.

But when Sally pays $240 each month to cover John, she’s probably doing so using a Premium Conversion Plan which allows her to pay the $240 on a pre-tax basis. So there may be a tax issue for John and Sally when they pay their income taxes annually since they’ve been reimbursed for an amount paid on a pre-tax basis – creating a “double” pre-tax event that could result in an audit issue in the future.

So when reimbursing an employee for spousal group coverage, it is very important that the employer also inform the employee of the need to see tax advice about the proper way to treat the reimbursement in light of these pre-tax issues.

Retiree-Only Reimbursement Plansare also explicitly permitted, but obviously their use is very limited to former employees who have satisfied a clearly defined retiree category of eligibility. Therefore, retirees covered in a retiree-only HRA satisfy the ACA’s individual mandate (requiring most Americans to have health insurance) and are not subject to the individual mandate penalty.

The Retiree-Only Reimbursement Plan can reimburse retirees who are not yet eligible for Medicare and purchase coverage either on or off the federally-facilitated Marketplace or a state-based Exchange. One key point: anyone reimbursed for coverage through a retiree-only HRA is not eligible for premium tax credits (federal assistance for lower-income individuals) or cost-sharing assistance for coverage they might select through the Marketplace.

Many employers — particularly governmental entities — have permitted Pre-65 Retirees to remain on their group health plans until they become eligible for Medicare. But the long-term cost of covering these individuals has been very high and also unpredictable, and governmental accounting standards are requiring these employers to account for this liability as an ongoing obligation to avoid these folks being left without coverage in the future.

The Retiree-Only Reimbursement Plan allows the employer to predict the actual cost annually for covering their employees and to eliminate the uncertainty of these older individuals impacting the cost of their health plan directly (if self-funded) or indirectly (through higher risk rating for health insurance if more than 50 employees).

One of the two new permitted standalone HRAs after 2015-17 was issued is for Active Employees who are Medicare or Tricare Eligible. These HRAs would allow an employer to reimburse their active employees and/or retirees with the cost of Medicare Part B, Medicare Supplemental (or Medigap), Prescription Drug Plan (Part D), Medicare Advantage premiums, or Tricare premiums. But their availability for active employees is very limited.

Under federal law, an employer with 20 or more employees is prohibited from paying for or providing any incentive for an eligible employee to have Medicare or Tricare be primary versus being enrolled on the group health plan. (It’s important to note under both Medicare and Tricare Secondary Payer rules, the small employer exception is for those with 19 or more employees — meaning full-time or part-time employees. An employer cannot count employees working less than full-time hours as a fraction or use any other mathematical approach around the 20 or more employee count for these laws.)

Under these laws, an employer will be responsible for reimbursing either CMS or Tricare for the costs paid as primary when they should have been considered secondary after the employer’s group health plan.

Finally, Shareholders of an S-Corporationmay be reimbursed by an employer for the cost of their individual health insurance premiums through at least 2015. This exception recognized that technically S-Corp Shareholders owning 2% of more of a business are not considered employees and therefore reimbursing their individual health insurance premiums is treated as imputed income to that person.

This exception highlights something many business owners and their tax advisers fail to realize: the 100% deductibility of health insurance premiums for partners in a partnership, members of an LLC, 2% or more shareholders of an S-Corp and sole proprietors is still alive and well (with its own set of arcane rules). The IRS has published on their website a reminder of this fact, and is something that is a helpful reminder to share as tax time comes next year.

One final point: a good friend who is also a co-worker of mine asked recently about how PCORI impacts these permitted standalone HRAs. Loving a good question, I ran off and discovered that the IRS says that HRAs which are reimbursing premiums are required to pay PCORI fees based on the average number of employees or retirees who receive benefits during a plan year. So don’t forget that obligation as well.

What is prohibited?

Pretty much any other reimbursement of an employee’s individual health insurance premiums is prohibited. Over the last 12 months, I’ve seen a handful of imaginative approaches that all fail to satisfy the IRS’s prohibition on standalone HRAs. The list of misguided collection of rogues include:

• Healthcare Reimbursement Plans (HRP), which argue that individual health insurance premiums are not essential health benefits and therefore are not subject to the mandate that group health plans cannot have annual or lifetime limits on their benefits. The vendor pushing this idea assures employers that it has passed muster with tax attorneys, but has so far failed to provide any proof of that legal conclusion to their clients or prospects.

• Classic 105 Plans (also known as Bene$mart) creatively argue that an employer can withhold a significant portion of an employee’s gross pay on a pre-tax basis, which is then used to purchase some form of credit life or similar product and finally loan the entire amount that had been withheld pre-tax back to the employee “tax-free.” This loan-back approach winds up reducing both the employee’s income tax obligation as well as FICA costs for employee and dependent. The IRS has ruled that this approach is a prohibited tax-avoidance scheme and has resulted in significant tax issues for employees and employers once terminated — we had an employer whose new CFO immediately ended this arrangement and almost immediately their employees began receiving 1099’s for the entire amount loaned back to them over the course of the year.

• Recently, we came across a vendor pushing the Participatory Wellness Plan, purporting to satisfy both Section 125 and the ACA’s wellness regulations and then making the impossible leap of being a way to allow for reimbursement of individual health insurance premiums. By combining different terms that have nothing to do with each other, the vendor created something that sounds possible but is not allowed under any reading of the law. It’s Frankenstein (or Frankenstein’s monster for the literary perfectionists out there) and will be a menace to the towns where allowed to roam freely.

One way to find out if the vendor selling any approach that says it is allowed, and to protect both you and your client: Ask for a clear warranty that will hold the employer harmless from any and all penalties that may be assessed by the IRS, Department of Labor or other regulatory agency, and also reimburses the employee for the cost of representation on this matter. This kind of written protection may be hard to come by, but if someone selling this wants to stand by their product, then this would seem to be something they will readily and confidently provide to any employer who follows their advice or purchases their product.
As you can see, this is a topic that is not easily understood and is subject to accidental or intentional confusion. But there are serious consequences for failure to abide by these rules. The IRS has clearly stated that they will charge an employer who is reimbursing their employees for individual health insurance premiums $100 per day per employee as an excise tax. That means that the penalties must be paid with after-tax dollars, which raises the real cost of compliance by as much as 40%.

At the end of the day, the agencies responsible for implementing the Affordable Care Act have tried to strike a balance between the premium subsidy programs available for many lower-income individuals and employer reimbursement of health premiums. The permitted types of HRAs will not violate the rules against standalone HRAs and still allow employers to provide options to offer coverage and manage costs for their employees and retirees in the future.

Smith is vice president, health & welfare benefits, at Ebenconcepts in Fayetteville, N.C. Reach him at dcsmith@ebenconcepts.com.