This article does not include updates triggered by the 21st Century Cures Act in late 2016 so some information is out-of-date. For more recent information and postings, see http://tonynovak.com/novaks-2015-small-business-health-plan-bibliography/.
Introduction: This article is written in response to IRS Notice 2015-17 that details the threat of excise tax penalties against possibly tens of thousands of small business employers after June 30, 2015.
Prior to implementation of the Affordable Care Act (ACA), Health Reimbursement Arrangements (HRAs) were the most efficient way for an employer to provide payments for routine health care to employees. While insurance was and still remains as the best way to cover catastrophic and unexpected medical expenses, insurance is inherently expensive and inefficient method of paying for ordinary, routine and expected medical costs. Direct reimbursement methods, especially on a tax-free basis, have obvious advantages for these types of expenses.
HRAs were among the most popular methods of providing this type of benefit1. All of that changed with the implementation of ACA rules in 2014.Tough new tax regulations2 built into ACA are designed to ensure that employers provide employees with employer-sponsored health insurance before getting involved in any tax-favored reimbursements. These regulations are largely intended to deter employers from dumping employees onto the individual health insurance exchanges where many workers would receive government-paid subsidies for their health insurance. In the aftermath of these new regulations, the use of traditional HRAs is greatly reduced and some suggest these plans are all but worthless. Many of the remaining small business HRA plans are simply not in legal compliance with current tax law and the employers may still be unaware that they face stiff excise tax fines under IRS code section 4980D for continuing to reimburse medical expenses without integrating the HRA with employer-sponsored group medical insurance.
To be clear, HRAs are still allowed under current law and they provide the same tax benefits as before ACA implementation3. The difference is only in the strict insurance prerequisite to providing HRA benefits. My anecdotal observation is that most small business HRAs are not in compliance with current law. The reality is that few small businesses have the desire to provide the required (expensive) employer-sponsored group health insurance and then pay additional amounts to those same employees for reimbursement of medical expenses not paid by insurance.
To put some numbers to this discussion: a typical small business firm might find that the cost of providing bronze level employee health insurance is $6,000 per year and the cost to provide full medical benefits, including reimbursement of deductible and out-of-pocket expense would double the cost to $12,000 per employee per year4. We might make an argument that if an employer wished to increase overall health benefits it would be more efficient to purchase an HSA-compliant insurance and pay for the full HSA contribution.
There are exceptions, however, that keep HRAs alive in the small business employee benefit toolbox. Current law endorses the use of limited purpose HRAs that do not otherwise interfere with employer-sponsored group medical insurance5. A term “special purpose HRAs”6 has been introduced more recently to describe HRAs that are designed to not interfere with ACA health insurance requirements. Perhaps the brightest of these are limited dental and vision HRAs.
Exempted benefits as a solution
Dental and vision HRAs can be established as a special purpose HRA without running afoul of tax regulations.7 Limited dental and vision benefits plans are better-suited to reimbursement arrangements than insurance plans as described in the opening paragraph of this article. These HRAs can be inexpensive and easy for a small employer to set up and administer8. HRAs are down but not out of the game. The remaining older non-compliant small business HRA plans will likely disappear as IRS steps up tax penalty enforcement after June 30, 2015. We may see then more interest in the new types of HRAs from small businesses over the coming months to provide exempted benefits.
Corrective action steps
It appears that a small business employer that modifies its health reimbursement plan before June 30, 2015 to provide excepted benefits and then makes appropriate adjustments to prior period payroll taxes would escape the potentially huge penalties threatened under Code section 4980. Otherwise, it appears that additional taxes, possibly retroactive to January 1, 2014, would be unavoidable. There is still some professional uncertainty about this topic and we do not know how IRS will approach enforcement in the absence of an understanding by tax professionals.
(1) Other popular methods are Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs) that are not addressed in this article.
(4) One of the side-effects of ACA is the shifting of a greater portion of recurring medical expenses from insurance to the individual. While reliable data on this may not be available yet, it is generally understood that out-of-pocket employee medical risks not paid by insurance have risen sharply and could be as high as $6,550 for individuals and $13,100 per family per year in many common health plans for 2016.
(5) IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits
(6) The term “special purpose HRA” used in this article is not to be confused with a “limited purpose HRA” where the latter term is used by the Department of Treasury to refer to HRAs that are paired with HSAs. The term “special purpose HRA” has no widely accepted definition.
(8) My practice Freedom Benefits offers assistance with a small business HRA plan setup for a flat fee.