by Tony Novak, CPA, MBA, MT
,last updated on 11/29/2011
Editor's note: This article was originally one of a three-part series: "HRA Plans Help Owner/Employees", "HRA Plans Help Small Business Employers", and "HRA Plans Help Small Business Employees". The three groups are addressed separately because the significant issues, objectives and tax treatment of each are completely different. Since the date of first publication the other two articles were sold and are no longer available here for reproduction.
Note for 2014: I recommend a flexible benefit plan design that accommodates a combination of tax-free and after tax health benefits as allowed under the Affordable Care Act and prior law without the need to revise the benefit plan documents as tax regulations continue to evolve.
Healthcare Reimbursement Arrangements (HRAs) have emerged as the best way for a small business to provide health benefits to employees. An HRA plan, in technical terms, is an employer-funded defined contribution fringe benefit plan design recently approved by the IRS. The most important point HRAs enjoy more favorable tax and legal treatment than other types of group health plans. As a result, HRAs provide significantly greater benefits as compared with other types of health plans to the employer, the individual employees and to the owner/employees. HRA plans reduce overall costs, limit employer liability, cut waste, offer more choice to employees, and generally improve the efficiency and satisfaction with employer-provided health plans. These plans are now available commercially to all small businesses as an all-inclusive package that comes complete with professional support.
Switching from a traditional "defined benefit" type small business health plan to a modern "defined contribution" HRA plan is easy once there is a clear understanding of the objectives and mechanical procedures. This article focuses only on the advantages to owner/employees of a small business. Other articles in this series address the issues applicable to the business itself (as the employer) and the other non-owner individual employees.
To better understand this benefit plan, it helps to review the basics of health plan taxation. Tax treatment is handled in one of two ways, depending on the type of benefit plan: insured and uninsured health benefits. Health insurance benefits are always deductible by a business and provided tax-free to employees, regardless of the type of business or ownership interest in the business. (S-corporation owners and unincorporated business owners report health insurance expenses differently than C corporations but the net tax effect is the same). Health insurance is not subject to any formal benefit plan requirements or non-discrimination rules. Uninsured health benefits provided under a formal benefit plan are deductible to the business for employees but not owners of s-corporations or unincorporated businesses. Owner/employees of c corporations can received tax-free uninsured health benefits if the benefits do not discriminate in favor of the owners or higher paid employees. Self-employed persons working in a L.L.C., partnership, sole-proprietorship or S corporation are not considered "employees" for purposes of tax issues related to coverage under any employer-sponsored health plan, including HRA plans. By combining a health insurance plan with an HRA, business owners can effectively enjoy a higher level of health benefits legally with total compliance with tax rules. This is how:
Suppose that an employer establishes a HRA plan with $2000 benefit per employee. Each employee may use that money as they wish. Presumably most of this money will be used by the employees to cover the cost of group or individual health insurance. In addition, the business pays the full cost of health insurance for the owner/employees and their dependents. No documentation or formal benefit plan is needed. Remember, health insurance is always tax-favored and may be discriminatory.
The net effect is that the business has capped its healthcare expense liability at $2000 for each employee but provided the owner/employee with full health insurance benefits plus another $2000 available for out-of-pocket expenses like dental, eye care, over-the-counter medicines, routine and preventative care. If the full $2000 is not needed, the extra allowance can be rolled over and accumulated year after year into the future.
There are a few peripheral issues to consider when implementing this strategy: HRA plans effectively sidestep the participation restrictions placed on group health insurance plans, keep in mind that some health insurance companies will not issue coverage to a single owner without the employees. An owner/employee might find that an insurer declines to issue the specific coverage that she wants unless a majority of the employees also enroll in a plan. In most states, the owner/employee can buy a higher quality individual health insurance plan at a lower price than is available to the whole group. This adds to the attractiveness of small business HRA plans, but in New York state this effect is not as likely to be realized due to more uniform pricing of individual health insurance plans.
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Opinions expressed are the solely those of the author and do not represent the position of any other person, company or entity mentioned in the article. Information is from sources believed to be reliable but cannot be guaranteed. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Tony Novak operates as an independent adviser under the trademarks "Freedom Benefits", "OnlineAdviser" and "OnlineNavigator" but is not a representative, agent, broker, producer or navigator for any securities broker dealer firm, federal or state health insurance marketplace or qualified health plan carrier. He has no financial position in any stocks mentioned. Novak does work as an accountant, agent, adviser, writer, consultant, marketer, reviewer, endorser, producer, lead generator or referrer to other companies including the companies listed in the articles on this web site.