Aggressive Plan Designs

Employers contemplating adoption of an HRA should be aware that several plan design options offered by some plan sponsors are very aggressive with respect to proper tax treatment of an HRA. Following is a list of the most common aggressive plan design options:

4Individual employee elective pre-tax contributions

On January 26, 2007, the IRS released Private Letter Ruling (PLR) 200704005, which confirms that individual, irrevocable elections to an HRA are taxable. Such contributions are not excludable from employees' gross income under Section 106 of the Internal Revenue Code.

This new ruling is consistent with previous guidance from the IRS. If a plan allows individual elections, irrevocable or otherwise, it does not meet the qualifications of an HRA and cannot enjoy the tax-favored treatment of a properly designed HRA. Such contributions are implemented primarily due to a lack of understanding of the IRS position on this feature, and in most cases, the misplaced motivations of highly compensated employer decision makers.

4Cash payments at death of participant

The IRS made it clear in their 2002 and 2005 IRS guidance regarding HRAs that any payments from an HRA may only be made for IRC Section 213(d) qualified expenses. Any payments which are not for IRC Section 213(d) qualified expenses would cause the HRA to lose its tax-favored status. The result of a violation of this provision is bad news. Providing such cash payments would result in all of the good benefit payments for medical expenses to become immediately taxable - including all of those paid for qualified medical expenses - while such a provision has been available in the plan, even if it has never been exercised by a single participant.

4Transfers of HRA balances to qualified retirement plans

Some HRA plans provide that amounts held in an HRA account may be transferred to a type of retirement qualified plan such as a 401(a), 403(b), or 457 plan. The IRS has ruled that such payments result in the HRA plan losing its tax-favored status.

4Heir death benefit

On August 14, 2006, the IRS issued Revenue Ruling 2006-36, which confirms that an HRA may provide benefits to a deceased participants surviving spouse and/or dependents. However, if no spouse or dependents remain, benefits cannot be paid to any other heir or beneficiary.

Many plan sponsors provide that if a participant dies and there is no spouse or tax-qualified dependents remaining which are eligible for reimbursements from such a plan, that a beneficiary or an heir may be provided with medical reimbursements as defined by IRC Section 213(d).

The IRS has provided for a transitional period for plans currently offering an heir death benefit. The Revenue Ruling will be effective for plan years beginning after December 31, 2008.

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