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Solving accounting problems with small business HRAs
by Tony Novak, CPA, MBA, MT
revised 11/16/11
Summary: Small businesses who administer their own Health Reimbursement Arrangement (HRA) plans should avoid making advance payments to employees if possible but when this practice is used then the employer should allow for an additional future expense related to wage taxes on HRA account balances. A transfer to a Health Savings Account (HSA) or conversion to Flexible Spending Account (FSA) may also provide some relief in some limited circumstances.
A basic principle of good accounting procedures is that the cost of executing the procedure should never exceed the value of its expected benefits. While the new type of health plans known as Health Reimbursement Arrangements are gaining acceptance among small businesses, too many are ignoring this basic accounting rule and will eventually face adverse tax consequences.
The basic difference between the health plans of small firms and those of larger employer is cost. Large firms spend, on average, twice the amount per employee on health benefits. Small businesses try to cost costs in many areas, including HRAs. Most small business HRAs are self-administered, while larger firms hire employee benefits firms with more resources for this service. While there is nothing wrong with self-administered HRA, employers must pay attention to the rules established by the Department of Labor and the IRS. Failing these requirements in a tax audit could mean paying a substantial tax penalty. Running afoul of other rules could be even more damaging.
Health Reimbursement Arrangements (HRAs) are unique in both an accounting and employee benefits perspective in that the responsibility for accounting stays with the employer. The basic premise of HRAs is that the funding is provided solely by the employer and the employer is responsible for all wage taxes until the point where the funds meet the requirements for tax-free distribution to employees. Unfortunately this also means that the potential liabilities for wages taxes and related liabilities also remain with the employer that are often more than half the amount of the HRA contribution1. Of course, the employer usually does not pay that amount, but generally accepted accounting procedures quire that some provision be made for that contingent liability.
Originally HRA plan accounting was intended to operate in the same way as other business expense reimbursements. For example, an employee health expense reimbursement would be handled by a business in the same manner as an employee travel expense reimbursement. That means that when an employee presents a request for reimbursement in the proper format (usually with a receipt and written explanation), the cash reimbursement is disbursed by the business.
Ideally, HRA administrators validate claims in “real time” and issue the payment to the medical provider at the same time that the claim is validated. While most large employers use these plans, most small businesses with HRAs do not. Part of the reason is cost (the proprietary software and technology used by these third party administrators is still expensive) and part of the reason is that these service providers typically have more restrictive procedures than small businesses prefer2.
Over the past few years a number of financial institutions have presented opportunities to “reimburse” employees in advance by making accounts with debit or credit cards available to employees. In fact, the marketers pushed a renaming of the term “Health Reimbursement Arrangements” to “Health Reimbursement Accounts“. While the term “accounts” is not recognized legally or in employee benefits field or in tax accounting, banks and lenders see this a great opportunity to expand business. The fees that banks earn on these accounts are higher than most types of regular individual bank and credit card accounts. (Some companies are even working on combining health insurance with credit cards so that bills not paid by insurance are automatically added to the credit card balance!). IRS reacted harshly to these plans that issue individual debit or credit cards to employees and issued a series of expanded rulings and restrictions that increased the recordkeeping requirements for HRAs and made it clear that the employer is responsible for all wage taxes on HRA benefits that do not met stated requirements.
To further complicate the issue, the implementation of procedures under the Health Insurance Portability and Protection Act has had far-reaching effects on the way that employees may interact with employee health information. Most employers have adapted a “hands-off” policy when it comes to private employee information in order to avoid the legal liability associated with HIPAA claims.
Recently Congress passed the Health Opportunity Patient Empowerment Act of 2006 that theoretically allows employers to shift some of the liability to the employees through one time transfer to Health Savings Accounts. But the law does not go far enough to really make a difference. There are many “catches” with Health Savings Accounts that are not addressed in the new law3. Perhaps the most significant issue is that the large majority of health insurance plans available today are incompatible with HSAs. It is statistically unlikely that an employer with problematic HRA could solve the issues by shifting to an HSA. At this point there are too many limiting issues with HSAs to make this viable option on a widespread basis.
There are three specific accounting issues that small businesses should be aware when using debit cards with HRAs:
Separate employee HRA accounts creates a separate contingent liability for the employer
For example, if an employer sets up a new asset account for an employee by establishing a bank account titled “Acme Business Products FBO John Smith, HRA”4, then a contra account should be established called “HRA contingent wage taxes in the amount of about $1000”. The liability would be smaller for a large employer with more experience operating an HRA, but the unfortunate reality is that the tax liability is actually higher for small businesses due to the nature of the employment and operating environment. Since the employees have access to the cash in the HRA accounts, these funds cannot be used to offset the employer liability. This may have an adverse effect on working capital and bank loan calculations.
HRA accounting should be done concurrently with wage tax reporting
Some small businesses pay wage taxes quarterly but prepare HRA reports on an annual basis. This would be a problem In the event of an interim audit of wage taxes.
Termination of an employee usually results in realization of wage tax liability.
It is fair to assume that a departing employee cashed in the balance of the HRA account about the same time that they decide to terminate employment. It would be unreasonable to assume that employees would use of turning in their HRA account card with balance untapped and provide a full accounting of any withdrawals in their final pay period. The employer should presume a liability for the balance in the account at this point. Even when employer’s withhold a final paycheck, it may not be legally entitled to reduce final pay to offset losses and additional wage tax expenses incurred in the HRA.
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Footnotes:
1For example, the total withholding and taxes related to a dollar of wages might be $.28 federal income taxes, $.05 state income taxes, $.01 local income taxes, $.15 FICA and FUTA, $.04 worker’s compensation and state unemployment tax for a total potential employer’s liability of $.52 of every dollar earmarked for health benefits.
2 State laws prohibit employers from requiring employees to provide private health information and federal HIPAA legislation increased the potential legal liability of employers who have even incidental access to health information of employees so most small employers with self-administered health plans use an independent third party to validate the uninsured health plan claims.
3The limitations of HSAs are discussed in other articles including“The Spin on Health Savings Account” and“Summary of HSA Reform Proposals for 2007”.
4HRA accounts are always established in the name of the business with the businesses tax ID number. It the account is established in the name of the employee, then it is not a tax-qualified HRA and should be accounted for as regular taxable wages.
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