IRS limits tax break for HRA transfers
WASHINGTON-August 28, 2006 Employees with health reimbursement arrangements will lose HRA tax breaks if their employers allow enrollees to transfer unused balances to anyone other than a spouse or dependent, the Internal Revenue Service says.
If employers give employees the ability to designate that anyone can receive and use their HRA account balances to pay for medical expenses, the HRA will lose its tax-favored status and all HRA participants will be taxed on funds they receive from the HRA to reimburse them for medical expenses, the IRS said.
``Amounts paid to an employee under a reimbursement plan are not excludable from gross income...if the plan permits amounts to be paid as...medical benefits to a designated beneficiary other than the employee's spouse or dependents of the employee,'' the IRS said in Revenue Ruling 2006-36, which was released last week.
``Because the benefit is provided in connection with the performance of services by the employee, the benefit is considered provided to the employee and must be included in the employee's gross income,'' the ruling states.
Benefit experts aren't surprised at the IRS ruling, noting that it draws upon rules the IRS laid down three years ago, in which the IRS explicitly recognized the legitimacy of HRAs as a health care reimbursement vehicle.
``The ruling confirms that the IRS meant what they said in 2002: HRA funds can only flow to employees, spouses and dependents,'' said Andy Anderson, of counsel to the law firm Morgan, Lewis & Bockius L.L.P. in Chicago.
While HRAs haven't received the level of publicity of a somewhat similar arrangement-health savings accounts-they are, in fact, much more common among large employers. For example, among employers with at least 20,000 employees that offered a consumer-driven health care plan in 2005, 89% provided an HRA, while only 11% provided an HSA, according to a survey by Mercer Health & Benefits.
Like HSAs, HRAs are linked to high-deductible health insurance plans, with the arrangements used to reimburse enrollees for a portion of uncovered health care expenses, such as those that fall under the deductible.
Also like an HSA, unused HRA balances are automatically rolled over to pay for expenses incurred in succeeding years.
But there are important differences including:
* Employers can require that HRA balances be used only for reimbursement of medical expenses. By contrast, employees can use HSA balances for any reason, though they are taxed on the distribution if used to cover nonhealth care expenses.
* Only employers can fund HRAs. Federal law allows both employers and employees to fund HSAs.
* Federal law lays down specific rules on how much money can be contributed each year to employee HSAs, as well as the design of the high-deductible health insurance plans that are linked to HSAs. No such restrictions are imposed on HRAs.
* Unless set up to pay for health care expenses after retirement, employees typically forfeit HRA balances when they terminate employment. By contrast, HSA balances belong to the employee.
In the ruling, the IRS described an arrangement in which the HRA is used to reimburse the medical care expenses of employees and retirees, their spouses and dependents. Additionally, the HRA reimburses the medical care expenses of a surviving spouse and dependents of a deceased employee.
Upon the death of the deceased employee's surviving spouse and last dependent, or upon the death of the employee if there is no surviving spouse or dependent, an unused HRA account balance could be used to pay for any medical beneficiary designated by the employee. It's that last feature that causes the arrangement to lose its tax-favored status, according to the IRS ruling.
Benefit experts don't know how widespread such arrangements might be, though typically the IRS issues such rulings when it becomes aware of such a practice and wants to stop it.
``The IRS must have learned of the arrangement and wants to end it before it becomes widespread,'' said Sharon Cohen, an attorney with Watson Wyatt Worldwide in Arlington, Va.
Such arrangements would appeal, for example, to single employees who would want to give account balances to a close relative, such as a nephew or niece that faced significant medical care expenses.
Business Insurance via NewsEdge Corporation