IRS AUTHORIZES A NEW TYPE OF PLAN FOR TAX-FREE

REIMBURSEMENT OF MEDICAL EXPENSES

Prepared by: Jeffrey R. Capwell

McGuireWoods LLP

Charlotte, North Carolina

One of the hottest topics in health care in recent years has been so-called “defined contribution” health reimbursement arrangements. The basic concept is to provide employees with a specified amount of dollars to allocate among the health benefit options most important to them. Defined contribution health plans have been touted by many as a more flexible, consumer-driven method for reimbursing health care expenses, and as a means of controlling the recent escalation of health care costs.

Interest in such arrangements is sure to significantly increase as a result of some very favorable guidance issued by the Internal Revenue Service (“IRS”) last week. In a surprisingly comprehensive release, the IRS specifically sanctioned a new type of plan for reimbursing employee and dependent medical expenses called a “Health Reimbursement Arrangement” (“HRA”). HRAs are similar, but at the same time are significantly different from, the well-known health care Flexible Spending Account (“FSA”). Like FSAs, they allow for reimbursement of medical expenses for employees, former employees, and their spouses and legally recognized dependents. However, there are many important distinctions between FSAs and HRAs. A summary of these distinctions is contained in the attached chart.

The following is an outline of the significant characteristics of HRAs:

• Favorable Tax Treatment. Coverage under an HRA and expenses reimbursed through the HRA are excludable from the covered individual’s gross income. As with FSAs, however, the individual may not claim an income tax deduction for an expense that has been reimbursed under an HRA.

• Solely an Employer-Paid Benefit. An HRA must be paid solely with employer dollars. It cannot be paid for, directly or indirectly, through employee salary reduction elections, and it cannot be provided through the employer’s cafeteria plan.

• Reimbursement for Medical Expenses Only. An HRA may be used only to reimburse employees for medical expenses (as defined in the tax law), provided that the employee provides proper substantiation. Reimbursable expenses include amounts paid for premiums for other accident or health coverage, but do not include premiums for long-term care insurance. An arrangement cannot qualify as an HRA if it permits participants to receive cash or any taxable or non-taxable benefit.

· Carry-Over of Unused Coverage. One of the most significant features of HRAs is that they can allow the unused portion of plan coverage to be carried over to subsequent coverage periods. For example, any amounts left over at the end of a yearly coverage period may be carried forward to the next year’s coverage period. There are no limits on the amount that may be carried forward or the number of years for which an amount may be carried forward. However, at no time may the participant receive cash, directly or indirectly, for any unused amounts in the HRA.

• Retirees May Be Covered. An HRA may cover both current and former employees (including retirees) and their spouses and tax dependents. The surviving spouse and dependents of a deceased employee may also be covered. Many employers have been interested in establishing defined contribution health plans as an alternative to or in conjunction with traditional retiree health care.

• Coordination with Major Medical Plan. An HRA may be provided in conjunction with the employer’s primary group health plan. For example, the employer may offer a high-deductible major medical plan along with coverage under the HRA. Employees may use the HRA to receive reimbursement for deductibles, co-pays, and other expenses not covered under the primary group health plan.

• Coordination with Flexible Spending Accounts. As mentioned above, HRAs differ in many respects from FSAs. As a result, the IRS has specifically exempted HRAs from several of the requirements that would otherwise apply to FSAs. The attached chart compares some key features of an HRA to those of an FSA. An employer may offer both an FSA and an HRA. The same expense cannot, however, be reimbursed under both the HRA and the FSA. Special ordering rules require that if an employee has coverage under both an FSA and an HRA, reimbursements must first be made from the HRA before they can be made from the FSA. Alternatively, FSAs and HRAs can be structured to provide for reimbursement of mutually exclusive types of medical expenses (such as permitting the FSA to cover only vision expenses and permitting the HRA to cover all other forms of medical expense). Further, if the HRA and FSA cover the same expenses, the HRA plan document may, prior to the plan year for the FSA, specifically provide that coverage under the HRA is available only after the FSA funds have been used.

• COBRA. An HRA is considered a “group health plan” for purposes of the health care continuation coverage requirements under COBRA. A participant electing COBRA coverage must be eligible to receive the maximum amount of reimbursement that was otherwise available at the time of the COBRA qualifying event. The amount available must be increased at the same time and in the amount as any increase for similarly situated non-COBRA beneficiaries. In addition, the COBRA premium may not differ for similarly situated COBRA beneficiaries, regardless of the dollar amount available to each individual.

· Nondiscrimination Rules Apply. An HRA must comply with tax rules that prohibit discrimination in favor of highly compensated individuals with respect to eligibility, contributions or benefits. As a result, HRAs could not be offered to only to high-paid executives.

Although the IRS guidance provides welcome news for employers seeking more flexible and creative approaches to funding employee health care coverage, the initial guidance has left several questions unanswered, including the following:

• ERISA. The IRS did not comment upon the extent to which ERISA may apply to an HRA. However, an HRA appears to meet the definition of an ERISA “employee welfare benefit plan” and would therefore be subject to ERISA’s reporting and disclosure requirements, fiduciary standards, claims procedures and other requirements otherwise applicable to ERISA welfare benefit plans.

• HIPAA. The IRS does not address the extent to which the various requirements of the Health Insurance Portability and Accountability Act (“HIPAA”) apply to HRAs. Among the HIPAA requirements that may apply to an HRA are the rules that prohibit discrimination on account of health status, medical privacy rules, preexisting condition limitations, special enrollment rights, and the requirement to issue certificates of creditable coverage.

• COBRA. Although it is clear from the guidance that COBRA generally applies to HRAs, the IRS did not provide many details on the application of COBRA to an HRA. For instance, it is not clear how to calculate COBRA premiums for an HRA. Further, as with FSAs, a spouse’s continuation rights are unclear if the qualifying event is a divorce.

The IRS release is sure to generate much discussion and interest in coming months. Employers who wish to adopt HRA plans should carefully consider the requirements described above, particularly if they wish to offer an HRA in addition to a cafeteria plan that offers FSAs. HRA plan documents will need to be carefully drafted to meet some of these requirements, such as the prohibition on salary reduction contributions and the ordering rules for when both HRA and FSA coverage is made available.

A Comparison of Flexible Spending Accounts (FSAs)

With

Health Reimbursement Arrangements (HRAs)

Key Feature	FSAs	HRAs
May employees make pre-tax salary reduction contributions?	Yes. Employee salary reduction contributions are permitted.	No. Coverage must be paid for solely by the employer. Salary reduction contributions (either directly to the HRA or indirectly to another arrangement) are strictly prohibited.
May unused coverage be carried over to subsequent tax years?	No. Unused coverage must be forfeited at the end of the coverage period (which is typically a calendar year).	Yes. Unused coverage can be carried over to subsequent coverage periods, even if the coverage period is in a subsequent tax year. Coverage carried over may increase the coverage limit available in subsequent periods.
Must the arrangement have a specified period of coverage?	Yes. Coverage generally must be available for a period of no less than 12 months.	No. There is no required period of coverage. Employers are free to fashion their own coverage periods. For example, separate coverage periods could be offered each calendar quarter.
What types of expenses may be reimbursed?	Any type of expense for medical care, as that term is defined under applicable tax laws. No reimbursement is permitted for premium payments for other health coverage.	Same types of medical expenses that are reimbursable under FSAs are reimbursable under HRAs. Unlike FSAs, however, premium payments for other health coverage also are reimbursable. For example, an HRA could be used to pay premiums under a spouse’s health plan or pay premiums for coverage under the employer’s retiree medical plan
May premiums for long-term care insurance be reimbursed under the arrangement?	No.	No.

Key Feature	FSAs	HRAs
Who is entitled to receive reimbursement?	Current and former employees, their spouses and dependents (as defined under applicable tax laws), and the spouses and dependents of deceased employees. Self-employed persons cannot be covered.	Same.
Must the maximum amount of reimbursement permitted under the arrangement be available at all times?	Yes. The FSA must have a risk-shifting element that makes the full amount of coverage available even if the reimbursement exceeds the participant’s actual contributions to the plan at the time of reimbursement.	No.
Can medical expenses incurred outside of the period of coverage be reimbursed?	Generally, no.	Yes, (1) if the claim was incurred after the HRA was put into effect, and (2) the individual was covered under the HRA at the time the claim was incurred.
Do the tax rules prohibiting discrimination in favor of highly compensated employees apply?	Yes. The arrangement cannot discriminate (either in form or in operation) with respect to eligibility for coverage or for the reimbursement benefits provided.	Same as for FSAs.
Must COBRA continuation coverage be offered upon the occurrence of a qualifying event?	Generally, yes. However, if certain conditions are met, COBRA obligations are limited.	Yes, but rules are unclear at this time.
Key Feature	FSAs	HRAs
Is the arrangement subject to HIPAA?	If certain conditions are met, an FSA is exempt from HIPAA’s creditable coverage requirements, health status nondiscrimination rules, preexisting condition limitations, and special enrollment periods.	Unclear at this time. For example, the IRS has raised the question as to whether individually underwritten health insurance policies reimbursed through an HRA are offered under a group health plan and are therefore subject to HIPAA’s nondiscrimination rules (which do not otherwise apply to individually underwritten policies).
Is the arrangement subject to ERISA?	Yes.	Unclear at this time. However, it is possible that an HRA will satisfy the definition of an “employee welfare benefit plan” under ERISA.

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