(This inform is not updated to reflect 2019 proposed regulations so should be presumed to be partially obsolete).
Summary: Small businesses with middle-income employees may use a Health Reimbursement Arrangement (HRA) to help cover out-of-pocket medical costs or individual insurance premiums as one of the easiest ways to cut 2018 taxes at minimal administrative and setup cost.
The Tax Cuts and Jobs Act increases the incentive for middle-income workers to look for alternate ways to cover their health care expenses while reducing federal income taxes. Taxpayers in the $60,000 to $100,000 income range generally received the smallest tax cuts and some cases will see a tax increase in 2018. With health care costs rising, these middle income workers need more help than ever before. One way employers can help it to offer employees tax-free heath benefits instead of only taxable wages. This reduces payroll taxes for both the employer and the employee.
The tax strategy is to move expenses that are no longer tax-deductible to employees to tax-free employer reimbursements through a Health Reimbursement Arrangement (HRA). This completely avoids the payroll tax system, thereby reducing taxes for the employee and the employer. The effect is that compensation paid through a HRA avoids tax. A $5,000 after-tax medical expense would generate total wage taxes of about $1,500. This tax is avoided through this HRA strategy. This benefit works for employees only, sole proprietors and partners are excluded1.
While each small business benefit plan has its own rules and limitations, this blog post attempts to summarize the three basic steps required to run a successful small business Health Reimbursement Arrangement.
Step 1 Design and Document – Employers are free to design employee health benefit plans to their liking, and IRS gives much latitude with relatively few restrictions.2 There are three types of HRAs used by small businesses; the differences are not discussed here.3 General requirements for an HRA are listed here. Advisers like Freedom Benefits that offer small business employee benefit support generally keep a library of plan designs available for a range of employer needs. In almost all cases an employee benefit plan should be documented in writing both as an IRS requirement and a good business practice. Design and setup through Freedom Benefits can be handled as an inexpensive short term engagement typically involving a few emails and telephone calls.
Step 2 Account for the Expenses – As employees incur health care expenses that can be reimbursed on a tax-free basis, it is important to have an efficient accounting system to manage the required record keeping for what is called an “accountable plan” with maximum tax benefits and minimal risk of adjustment upon audit. I typically recommend a cell-phone based application that is integrated with the employer’s benefits adviser. The expense reimbursement reports are typically reviewed and approved by the health plan manager (an accountant outside of the employer firm of protect from HIPAA-related and other employer liability) omission for reimbursement.
Step 3 Reimburse through Payroll – The easiest way to make tax-free reimbursements is through the payroll system. This is easy to set up and requires minimal extra effort and usually no other cost.
The key to success in a small business health plan is to have one person who is familiar with the entire plan from the design through the payroll settlement function. This allows for fast and efficient resolution of any issue that might arise, whether with the employer or an individual employee.
HRAs are often added as a low-cost or free add-on to insurance or payroll services4. $5,000 of expenses run through an HRA will typically save $1,500 er year in wage taxes.
I am pleased to discuss the options that may work best from your business.
1This is not a strategy for self-employed sole proprietors or partners who should combine the small business HRA with supplemental insurance, HSAs or other health benefit plans. Freedom Benefits benefit plan designs typically include all of these options.
2Benefits must be paid by the employer however there is no restriction on renegotiating employee wages to a lower amount to offset all or part of the cost of the HRA.
3The newest type of HRA is the “QSEHRA” or “Qualified Small Employer Heath Reimbursement Arrangement” that was designed to support the goals of the Affordable Care Act (ACA) and help employees with individual coverage purchased through an exchange. Traditional HRAs and special purpose HRAs are also available. Other health benefit plans, like Flexible Spending Accounts are available where ACA plans are not used or simply to supplement the HRA.
4I am often asked to help set up a small business HRA as a stand-alone engagement. This is possible (and I do offer this service) but not recommended as the best practice. Employers and their employees get more value, lower overall cost and lower risk of service problems effort by combining the HRA services with related services like payroll and employee benefit insurance. The bulk of questions from employees, their spouses come later after the HRA setup is complete.