How to Avoid HSA and HRA Pitfalls and Traps: A Legal but Practical Perspective

How to Avoid HSA and HRA Pitfalls and Traps:

A Legal but Practical Perspective

Ashley Gillihan, Esq.Alston & Bird, LLP

[email protected]

mailto:[email protected]

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Overview of Traps

• Trap #1: ERISA Applicability• Trap #2: Nondiscrimination Rules• Trap #3: HRA Direct and Indirect Funding Rules• Trap #4: Disqualifying Coverage• Trap #5: New Contribution Rules under HR 6111• Trap #6: Distribution Traps• Trap #7: Cafeteria Plan Issues• Trap #8: Prohibited Transaction Issues• Trap #9: Employee Cash Flow Concerns• Trap #10: Monitoring contributions• Other compliance issues

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HSA/HRA Traps and Pitfalls

Trap #1: ERISA Applicability

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• ERISA Headaches—Why do we care?• DOL Guidance• Steps to avoid ERISA applicability

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• Headaches if ERISA applies . . . – Form 5500– SPD and Plan Document– COBRA

•Code’s COBRA provisions do not apply but ERISA may

– HIPAA Privacy issues – Fiduciary Requirements

•Code’s Prohibited Transaction Rules apply whether ERISA’s prohibited transaction rules apply or not

– Class Action Litigation

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• Original view was that HSAs would be treated like IRA’s

• IRAs that satisfy the following four “Safe Harbor” conditions are not subject to ERISA:– No contributions are made by the employer

•Pre-tax contributions are employee contributions for DOL purposes

– Participation is completely voluntary– The employer does not endorse the program– The employer receives no consideration other than

reasonable compensation for services actually rendered •Same requirements apply to voluntary group

insurance

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• DOL issued Field Assistance Bulletin (“FAB”) 2004-1:– Establishes “safe harbor”

– DOL found that employer contributions were less significant in determining whether ERISA applies to HSAs so they tweaked the safe harbor to allow for employer contributions without triggering ERISA

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Trap #1: ERISA Applicability• Special Safe Harbor for HSAs

– Employers may contribute to an HSA without triggering ERISA so long as the employer satisfies all of the following conditions:•Participation is completely voluntary•No restrictions on account holder’s ability to

move funds to another HSA trustee•No restrictions on use of funds other than those

permitted by code•Does not make or influence investment decisions•No “endorsement” by employer•Does not receive any payment or compensation

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• FAB 2006-02 clarifies aspects of FAB 2004-1 as well as other ERISA related issues– Employer may establish HSA on behalf of

employee and make “employer” contribution w/o violating “completely voluntary” requirement•Salary reductions from employees must be

voluntary in order to satisfy the safe harbor– ERISA is not triggered solely because

employer chooses a particular vendor to whom it makes contributions.

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• FAB 2006-06 (cont’)– The employer does not “make or influence”

investment decisions solely by choosing a vendor that offers same funds as employer’s 401(k)

– FICA savings generated through cafeteria plan are not “compensation” to the employer

– Employers can pay trustee/custodian fees directly without triggering ERISA

– Employer/trustees can offer HSAs to its own employees without triggering ERISA so long as same product offered in normal course of business.

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• FAB 2006-06 (cont’)– Employer does receive “compensation” if it

receives discount on services offered by vendor in conjunction with HSA

– Failing to promptly forward contributions to trust is a prohibited transaction (even if ERISA does not apply)

– IRA Class PT exemptions on free or reduced cost services not applicable to HSAs

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• Steps to avoid ERISA:– Include clear disclaimer regarding HSA status

as an individual financial account – NOT an employer sponsored benefit plan

– Review vendor materials– Review enrollment materials– Carefully draft HSA summaries– Review bundled arrangements

•Look for potential discounts– Proceed with caution if choosing substituting

401(k) funds

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Trap #2: Nondiscrimination Traps

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• Tests Applicable to HSAs– Comparability– IRS guidance on comparability rule– Statutory improvements made by HR 6111

• Tests Applicable to HRAs– General 105(h) concepts– HIPAA Nondiscrimination

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• What is the HSA “Comparability Rule”?– If an employer makes contributions to

an individual’s HSA, it must make “comparable contributions” for all “comparable participating employees”

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• What is the HSA “Comparability Rule”?– What are “comparable contributions”

•The same amount or •The same percentage of the HDHP

deductible covering the employee

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Trap #2: Nondiscrimination Traps• What is the HSA Comparability Rule? (cont’)

– Who are comparable participating employees?•Employees of employers who are eligible individuals

(as defined in Code Sec. 223) with the same level of coverage and fall into one of the following categories:– P/t employees– F/t employees– Former employees (other than those receiving

COBRA coverage)•Employer may restrict HSA contributions to those

who participate in the Employer’s HDHP•What about restrictions related to the HSA custodian

chosen by employer?

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• What is the HSA Comparability Rule? (cont’)– Permitted levels of coverage for purposes

of comparability only:•Single•Family +1•Family +2•Family +3 or more

– Amount for lower level cannot be more than next highest level of coverage

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• What is the HSA Comparability Rule? (cont’)– Who is NOT a comparable participating

employee?•Union employees•Partners/self-employed•Sole proprietors•Former employees receiving COBRA coverage

under employer’s HDHP•With respect to contributions to non-HCEs,

HCEs are not comparable participating employees (H.R. 6111)

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• What is the HSA Comparability Rule? (cont’)– Comparability Rule measures amounts actually

contributed during the calendar year (not just amounts “made available”)•HDHP plan year is irrelevant

– Allows variations based on service during the year so long as everyone received the same monthly pro-rata amount

– Employer agrees to contribute $100 per month to employees’ HSAs.

– Bob is employed 12 months and Jim is employed 11 months.

– Bob receives $1200 during the year and Jim only receives $1100. Is there a violation?

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• What is the HSA Comparability Rule? (cont’)– Timing of contributions under Comparability Rule

can be confusing.•Pay as you go

– Allows me to stop making contributions during the year

•Catch Up– Must track down former employees who were

eligible individuals during the year•Pre-pay

– May switch methods during the year but cannot stop making contributions

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• What is the HSA Comparability Rule? (cont’)– Comparability rule DOES NOT APPLY to HSA

contributions “made through the cafeteria plan”•When are contributions “made through the

cafeteria plan”?– Pre-tax salary reductions– Matching contributions– Non-elective contributions to HSAs of

those who were provided “opportunity” to make elective contributions through 125 plan

– 125 discrimination rules apply.

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• What is the HSA Comparability Rule? (cont’)– Recurring Issues and Concerns

• Part year employees• Last day of year vesting rule prohibited•What if HSA is never opened

– What if opened with “other” trustee•Disease management programs and

wellness program incentives

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• HRA nondiscrimination traps:– Self-insured benefits cannot discriminate in favor

of HCEs as to eligibility and benefits– Two tests:

•Eligibility Test– Could be an issue if HRA offered only to a

limited group consisting substantially of HCEs (top 25% in pay)

•Contributions and Benefits Test– Pass test if same HRA accrual is made

available to all participants for same contribution

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• HRA nondiscrimination traps (cont’)– Plan Design issues:

•Allowing only salaried to participate•Providing higher annual allocation to

salaried than to hourly•Providing a higher annual allocation to

those with more years of service or higher pay

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Trap #3: HRA Direct and Indirect Funding Rules

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• HRA cannot be funded by pre-tax salary reduction (including cashable Flex Credits) under a cafeteria plan

• An HRA may be offered “in conjunction” with major medical plan under a cafeteria plan provided it is not funded directly or indirectly with pre-tax salary reductions

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• Direct Funding:– Employees cannot elect to pay for HRA with

pre-tax contributions•Salary reduction agreement should

indicate that pre-tax contributions do NOT fund HRA

– Salary reduction (and otherwise cashable credits) attributable to medical coverage cannot exceed applicable premium for non-HRA medical coverage•Applicable premium is determined using

COBRA criteria (not including 2% admin charge)

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• Indirect Funding:– No positive correlation between salary

reduction for medical plan and HRA amount– Impermissible practices

• HRA and salary reduction amount cannot increase or decrease in tandem – Option 1: HRA=$500/Salary Reduction=$300– Option 2: HRA=$800/Salary Reduction=$500

• Cannot allow employees to elect to use HRA funds to pay for employer coverage in lieu of funding coverage via salary reduction

• Cannot allow FSA forfeitures to fund HRA

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• Indirect Funding (cont’)– Permissible practices

• Variation between individual/family coverage– Single coverage/HRA of $500/Salary Reduction $300– Family coverage/HRA of $700/Salary Reduction $500

• Threshold correlation (in/out HRA option)• Inverse Correlation

– HRA amount for multiple options decreases (or increases) as salary reduction amount for multiple options increases (or decreases)• Option 1: HRA=$500/Salary Reduction=$300• Option 2: HRA=$800/Salary Reduction=$200

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Trap #4: Disqualifying Coverage

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• What is a Qualifying HDHP coverage?

• Permissible benefits below HDHP deductible

– The “Three P’s”• Preventive Care• Permitted Insurance• Permitted Coverage

• Problem Area: State insurance mandates

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• General Rule– No coverage below deductible except for

“three p’s”

• Traps for the unwary participant– FSA/HRA general purpose coverage– Health FSA coverage with grace period– Executive medical (other than preventive)– Employer sponsored/on site clinics– Coverage under spouse’s plan

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• What is Preventive Care?– Code Section 223 does not specifically define

“preventive care”– Notice 2004-23 provides safe harbor definition

of “preventive care”•Preventive care includes, but is not limited

to,– Periodic health evaluations and routine

pre-natal and well-child care– Child and Adult immunizations– Obesity/Weight loss and Tobacco cessation

programs– Screening services (specific list of

permissible services provided)

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• What is preventive care? (cont’)– Preventive care DOES NOT include services

that treat an existing condition– Ancillary medical procedures that are

part of a preventive care service or program do not cause an otherwise preventive care service or treatment to fall outside of the safe harbor so long as it would be unreasonable or impractical to separate the medical procedure from the preventive care service or program•Removing polyps during a colon

cancer screening procedure

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Trap #4: Disqualifying Coverage• What is preventive care? (cont’)

– Drugs that constitute preventive care: A drug that satisfies any of the following 3 conditions is considered “preventive care”

•Condition #1:– They are taken by an individual with risk

factors for a condition that has not yet manifested itself or not yet become clinically apparent (the individual is asymptomatic)

•Statins to lower cholestorol

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• What is preventive care? (cont’)

– Drugs that are “preventive care” (cont’)

– Condition #2: •They are taken by an individual to

prevent the recurrence of a disease from which the person has recovered

– ACE inhibitors for heart attack and stroke victims

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• What is preventive care? (cont’)

– Drugs that are “preventive care” (cont’)

•Condition #3: – The drugs are taken as part of a preventive

care program

•Drugs taken as part of a smoking cessation program or weight loss program

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• “Permitted coverage” is coverage for any of the following:– Dental– Vision– Long term care– Accidents– Disability

• An example: school or sports accident/injury coverage

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• “Permitted Insurance” is:– Insurance where substantially all of the

coverage relates to:•Workers’ compensation liability•Tort liabilities•Property/landowner liabilities

– Insurance for a specified disease or illness– Insurance paying a fixed amount per day of

hospitalization•e.g., Hospital Indemnity

– Generally must be provided pursuant to a commercial insurance contract

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• PLR 200704010 regarding the 3 P’s:– coverage triggered solely by cancer (or another specified

disease), including first occurrence benefits, progressive benefits, ROP benefits, and specified treatment indemnities triggered by cancer are permissible

– preventive and screening benefits attached as riders to permissible benefits are permissible

– a fixed indemnity policy with initial benefits triggered by heart attack, heart disease, or stroke is permissible (but no benefits are paid for any sickness, disease, or incapacity resulting from heart attack, heart disease or stroke)

– fixed indemnities under HIP for treatment associated with a HIP such as surgery, ambulance, etc is not permissible

– accident or disability only indemnities are permissible

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• Health FSA and HRA coverage

– General Rule: Can’t be an Eligible Individual if you have general purpose Health FSA and/or HRA coverage (Rev. Rul. 2004-45).

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• Health FSA/HRA coverage (cont’)– Situations in which you can have Health FSA and still

be an Eligible Individual– Health FSA coverage is limited to:

•Expenses incurred after statutory minimum deductible is met (Post Deductible)– Pays after HDHP’s deductibles have been satisfied– Pays after own high deductible has been satisfied– Difficult Administration Issues

•Certain permitted coverage expenses (i.e., vision/dental)

•Preventive care– Difficult administration issues

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• Health FSA/HRA coverage (cont’)– Situations in which you can have HRA and still be an

Eligible Individual•HRA coverage is limited to:

– Expenses incurred after statutory minimum deductible is met (Post deductible)

– Permitted coverage expenses (e.g., vision, dental)– Premiums for permitted insurance policies (e.g.,

specified disease or fixed indemnity per diem)– Preventive care– Suspended HRA– Retiree only HRA

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• Health FSA/HRA Coverage (cont’)– Dilemma regarding spouse’s health FSA coverage

•E.g., Employee A has single HDHP coverage but is also covered under spouse’s employer’s general purpose Health FSA. – Plan sponsors could implement “single” and

“family” Health FSAs– Administrative difficulties

– Qualifying HDHP that is FSA or HRA must be accompanied by HDHP major medical coverage• I.e., High deductible Health FSA/HRA cannot be

the only HDHP coverage– Health FSA Grace Period

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• Health FSA Grace Period:

– Notice 2005-86• if participant in general purpose Health

FSA (w/ grace period) on last day of plan year (either active or COBRA qualified beneficiary), participant disqualified from HSA establishment until first day of first month following end of grace period EVEN IF ZERO BALANCE on last day of plan year or any time prior to end of grace period

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• Health FSA Grace Period (cont’)– Example of Notice 2005-86 rule:

•Bob participates in calendar year Health FSA with 2 ½ month grace period ending March 15 of following year. Bob receives reimbursement for full election amount on December 15, 2007 so that he has $0 balance on December 31, 2007.

•Although Bob has $0 balance, Bob is not eligible for an HSA until April 1, 2008.

– Only solution provided under Notice 2005-86 was to convert FSA during grace period to limited purpose FSA for ALL HEALTH FSA PARTICIPANTS

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• Health FSA Grace Period (cont’)– New rule under HR 6111

•Grace period does not disqualify an individual if individual has zero balance on last day of plan year– This can be accomplished in one of two

ways:•Spend funds down prior to end of the

plan year•Make the one time tax free rollover

under applicable rules (see Trap #5)

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• Health FSA Grace Period (cont’)– Good news:

•Provides relief from Notice 2005-86 impediment– Allows Bob to establish HSA on January

1, 2008 instead of April 1, 2008

– Bad news: •Encourages end of year “unnecessary”

spending (the very thing the grace period avoided)

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• What about EAPs, wellness and disease management? – Participation in employee assistance

programs (EAPs), wellness programs and disease management programs do not disqualify an otherwise eligible individual so long as the programs are not considered “health plans” for HSA purposes

– Such a program is not a “health plan” if it does not provide significant benefits in the nature of medical care or treatment

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• Permissible employee assistance plans– Coverage is limited to free or low cost short

term counseling sessions on various issues including mental health, emotional disorders, and substance abuse

– Refers to an outside organization when necessary

• EAP may be a “health plan” for purposes of COBRA or other laws but not a health plan for HSA purposes

• Impact of conditioning participation in EAP on participation in health plan?

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• Permissible Disease Management Programs– Program typically provides only

•Disease specific education and information materials

•Care oversight and management (including care coordination)

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• Permissible Wellness Programs– Program offers wide range of activities designed

to improve the overall health of the employee and prevent illness, including but not limited to:• Education• Fitness• Sports• Stress management• Health screenings

– Any charge for such program is separate from the health plan

– Impact of conditioning participation in wellness program on participation in health plan?

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Trap #5: New Contribution Rules under HR 6111

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Trap #5: New Contribution Rules

• Four new contribution rules under HR 6111– Revised Maximum Annual Contribution– Pro-rata Rule Exception– Rollover from Health FSA/HRA– Rollover from IRA

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• Revised Maximum Contribution Amount– Prior rule

•Annual contribution amount is sum of “monthly limits” for each month individual is an eligible individual

– Pro-rata rule

•Monthly limit equals 1/12 of “lesser of deductible” or statutory maximum for applicable level of coverage”

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• Revised Maximum Contribution Amount (cont’)

– Example of prior rule:

– Bob (who is under age 55) is enrolled from January 1, 2007 through December 31, 2007 in an HDHP, single coverage, with a $1200 deductible.

– Under old rule, Bob may only contribute $1200 in 2007 instead of $2850 (the statutory maximum for single coverage).

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• Revised Maximum Contribution Amount (cont’)– New rule:

•Annual contribution amount is sum of “monthly limits” for each month individual is an eligible individual (same as old)

•Monthly limit equals 1/12 of statutory maximum for applicable level of coverage (i.e., single or family) WITHOUT REGARD TO HDHP DEDUCTIBLE– 2850 for single– 5650 for family

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– Example of new rule:

•Bob (who is under age 55) is enrolled from January 1, 2007 through December 31, 2007 in an HDHP, single coverage, with a $1200 deductible.

•Under new rule, Bob may contribute $2850 in 2007 instead of $1200 (the maximum contribution amount under the prior rule).

•Contribution increase=$1650

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• Revised Maximum Contribution Amount (cont’) – Good news (cont)

•Allows some employees to contribute more than deductible amount

• Eliminates complicated contribution calculation rules for – Plan’s with carry over deductible

•deductible must still meet adjusted minimum deductible rule

– Plan’s with embedded deductible •Embedded deductible must still meet

family deductible minimum– Married couples who are eligible individuals

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– Bad news

•Pro-rata rule not completely eliminated (but see special exception on next slides)

•Not valuable for those with deductible in excess of statutory maximum contribution amount

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• Pro-rata exception rule– Prior Rule:

•Maximum contribution was “sum of monthly limits” based on # of months individual was eligible individual

•Deductible under plan typically not pro-rated, which caused gap between HSA contribution amount and participant responsibility

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• Pro-rata exception rule (cont’)– Example of prior rule:

•Bob (who is under age 55) is enrolled from July 1, 2007 through December 31, 2007 in an HDHP, single coverage with a deductible of $3000.

•Bob’s monthly limit is $237.50 (1/12 of $2850). Bob is an eligible individual in 2007 for 6 months.

•Bob’s annual contribution amount for 2007 is $1425; however, Bob’s deductible is $3000 even though he is in the plan for only 6 months.

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• Pro-rata exception rule (cont’)– New rule

•Pro-rata rule still applies EXCEPT:• Individual is treated as being an eligible

individual for the entire year If – individual is an eligible individual in

December of such year and – the individual remains an eligible

individual through December of the next year (“Testing Period”)

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• Pro-rata exception rule (cont’)– New rule (cont)

•For months that individual was not an eligible individual, individual treated as having the coverage in effect in December of the year he/she became an eligible individual

•Applies to additional contribution for age 55+ accountholders

• Income and 10% excise tax if individual ceases to be an eligible individual during Testing Period:

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Trap #5: New Contribution Rules• Pro-rata exception rule (cont’)

– Example of new rule: •Bob (who is under age 55) is enrolled from

July 1, 2007 through December 31, 2007 in an HDHP, single coverage with a deductible of $3000.

•Bob’s remains eligible through December 31, 2008

•Bob’s annual contribution amount for 2007 is $2850 (as opposed to $1500 under prior rule)

• If Bob ceases to be eligible during testing period, then $1425 (6/12 of $2850 for January through June) is included in income and subject to 10% excise tax

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• Pro-rata exception rule (cont’)– Good News

•Reconciles traditional application of deductible with maximum contribution rules

– Bad news•Must remain eligible individual during

Testing Period•Does not apply unless eligible individual in

December (i.e., covered by December 1st) of year

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• IRA Distributions to HSA (Qualified HSA Funding Distributions)– Prior rule:

• IRA funds could not be transferred to HSA on a tax free basis

– New Rule:•One time tax free trustee to trustee transfer of

IRA funds to HSA permitted•Limited to maximum annual contribution amount

– May make an additional contribution if you change from single to family during the year

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• IRA Distributions to HSA (cont’)– New Rule (cont’)

•COUNTS AGAINST ANNUAL CONTRIBUTION AMOUNT

•Must remain Eligible Individual During Testing Period– The month in which distribution made

and ending last day of 12 month following such month

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• IRA Distributions to HSA (cont’)– Good News:

•Allows individuals to shift poor performing IRA funds to HSA without adverse tax consequences

•Allows individuals to use IRA funds to offset gaps between maximum contribution amount and employer contribution

– Bad news:• Must remain eligible individual during testing

period•Counts against annual contribution limit

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• Health FSA/HRA Rollover (Qualified HSA Distribution)– Prior rule:

•HRA and/or Health FSA amounts could not be transferred to an HSA on a tax free basis

– New rule:•Employer may make one-time tax free

transfer of “Applicable Balance” to HSA anytime before January 1, 2012 provided certain conditions are satisfied– Applies to Health FSA and HRA

individually

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• Health FSA/HRA Rollover (cont’)– New Rule (cont’)

•Applicable Balance=lesser of balance as of September 21, 2006 or balance as of the date the distribution is made

•Only available to those who had a balance on September 21, 2006

•“Balance” does not include expenses incurred prior to distribution but not yet reimbursed

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• Health FSA/HRA Rollover (cont’)– New rule (cont)

•Treated as a rollover contribution (thus, not counted against maximum annual contribution amount)

•Must remain eligible individual during Testing Period– The month in which distribution made

and ending last day of 12 month following such month

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• Notice 2007-22--Permanent and Transition Guidance regarding Health FSA/HRA rollovers– Permanent guidance:

•An employee with a balance in a general purpose FSA with a grace period or general purpose HRA at the end of a plan year is treated as an eligible individual for HSA purposes as of the first day of the first month of the immediately following plan year provided that the following conditions are satisfied:

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Permanent Rules--Conditions

• the employer amends the health FSA or HRA written plan effective by the last day of the plan year to allow a qualified HSA distribution;

•a qualified HSA distribution from the health FSA or HRA has not been previously made on behalf of the employee with respect to that particular health FSA or HRA;

• the employee has HDHP coverage as of the first day of the month during which the qualified HSA distribution occurs, and is otherwise an eligible individual;

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Permanent Rules--Conditions

• the employee elects by the last day of the plan year to have the employer make a qualified HSA distribution from the health FSA or HRA to the HSA of the employee;

• the health FSA or HRA makes no reimbursements to the employee after the last day of the plan year;

• the employer makes the qualified HSA distribution directly to the HSA trustee by the fifteenth day of the third calendar month following the end of the immediately preceding plan year, but after the employee becomes HSA-eligible;

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Trap #5: New Contribution Rules• Notice 2007-22 Permanent and Transition Guidance regarding

Health FSA/HRA rollovers (cont’)– Permanent Rules—Conditions

• the qualified HSA distribution from the health FSA or HRA does not exceed the lesser of the balance of the health FSA or HRA on (a) September 21, 2006, or (b) the date of the distribution; and

• after the qualified HSA distribution there is a zero balance in the health FSA or HRA, and the employee is no longer a participant in any non-HSA compatible health plan or (b) effective on or before the date of the first qualified HSA distribution the general purpose health FSA or general purpose HRA written plan is converted to an HSA-compatible health FSA or HRA, as described in Rev. Rul. 2004-45, for all participants.

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Transition Rule:

•an employee with a balance in a general purpose FSA with a grace period or general purpose HRA after December 31, 2006 is treated as an eligible individual for HSA purposes as of the first day of the first month in 2007 provided that the following conditions are satisfied:

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Transition Rule--conditions:

• the employer amends the health FSA or HRA written plan effective on or before March 15, 2007, to allow a qualified HSA distribution;

• a qualified HSA distribution from the health FSA or HRA has not been previously made on behalf of the employee with respect to that particular health FSA or HRA;

• the employee has HDHP coverage as of the first day of the month during which the qualified HSA distribution occurs, and is otherwise an eligible individual;

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Transition Guidance-conditions (cont)

• the employee elects on or before March 15, 2007, to have the employer make a qualified HSA distribution from the health FSA or HRA to the HSA of the employee;

• the qualified HSA distribution from the health FSA or HRA does not exceed the lesser of the balance of the respective health FSA or HRA on (a) September 21, 2006, or (b) the date of the distribution;

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• Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’)– Transition Guidance –conditions (cont)

• the employer makes the qualified HSA distribution directly to the HSA trustee by March 15, 2007, but after the employee becomes HSA-eligible; and

• after the qualified HSA distribution there is a zero balance in the health FSA or HRA, and the employee is no longer a participant in any non-HSA compatible health plan or (b) effective on or before the date of the first qualified HSA distribution, the general purpose health FSA or general purpose HRA written plan is converted to an HSA-compatible health FSA or HRA, as described in Rev. Rul. 2004-45, for all participants.

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• Example of new rule:

– Bob has $500 balance on September 21, 2006.– On December 31, 2008, Bob has a $300

balance in his Health FSA (with a grace period). Bob wants to enroll in HDHP and establish an HSA on January 1, 2009 but Health FSA is general purpose.

– Bob’s employer may transfer $300 to Bob’s HSA on December 31.

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• Good News:

– Does not count against the maximum annual contribution amount

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• Bad News:– Must remain eligible individual during Testing Period– Requires employer/plan sponsors and/or

administrators to maintain records of balance on September 21, 2006

– Confusing to communicate to participants – Problems if current balance is greater than balance as

of September 21, 2006•Assume Bob had $1000 on August 1, 2008 instead

of $300– Not valuable to those who did not have Health FSA or

HRA on September 21, 2006– ONLY APPLIES TO HEALTH FSAS WITH GRACE

PERIOD

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HSA/HRA Pitfalls

Trap #6: Distribution Traps

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Trap #6: Distribution Traps

• Impact of timing of HSA establishment on eligible expenses– HSA must be established BEFORE medical

expenses are incurred – Notice 2007-22

• State trust law governs• Many states indicate no trust exists until there is a

corpus (i.e. contributions)• Withdrawing funds before/in excess of eligible

expenses– Repricing dilemma and putting funds back in

an HSA – Can expenses and distributions be “netted” ?– Year-end traps

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Trap #7: Cafeteria Plan Issues

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Trap #7: Cafeteria Plan Issues

• What cafeteria plan rules apply?– Code Section 125 non-discrimination rules– Modified election rules apply

•HSA salary reduction election may be changed at any time for any reason

• IRS has informally indicated that monthly election changes MUST be allowed

•Cafeteria plan election allowed mid year to add HSA– Changes to other benefits (such as Health

FSA) only permitted if otherwise allowed under Section 125 (or the plan)

•Negative elections permitted

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Trap #8: Prohibited Transaction Issues

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Trap #8: Prohibited Transaction Rules

• Tax Code (as well as ERISA) prohibits most transactions between a plan (i.e., the HSA) and a disqualified person (e.g., any HSA service provider)

• 2 types of PTs:– 4975 PTs

• Can be committed by account holder, custodian, trustee, or other vendor

• 100% excise tax on amount involved if committed by other than account holder

• HSA disqualification if committed by account holder and all amounts treated as improper distribution subject to income and 10% excise tax

– 408 Impermissible Security for a loan• HSA amount used as security/collateral for a loan is

treated as improper distribution subject to income and 10% excise tax

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• What are the areas that might constitute a Prohibited Transaction in the HSA context:– Unreasonable fees to service provider

•Accountholder must determine if reasonable

– Hidden or unusual fees received by service provider•12b-1• Interchange from card

– All HSA Vendors must disclose

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• What are the areas that might constitute a Prohibited Transaction in the HSA context (cont’):– Extension of credit/overdraft

•See DOL. Adv. Op. 2002-03•See also FAB 2006-02

– Depends on Facts and Circumstances– See toaster rulings in Dol Adv. Op. 89-12/PTE

93-33– Receipt of personal compensation to account

holder as incentive to enroll or invest•See DOL. Adv. Op. 2004-09A•See toaster rulings in Dol Adv. Op. 89-12/PTE

93-33

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Trap #9: Employee Cash Flow Concerns

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Trap #9: Employee Cash-flow Concerns

• HSA funds generally only available once deposited

• Coverage can be “accelerated” under cafeteria plan– Employer may advance amounts up to

employee’s salary reduction amount so long as the following conditions are satisfied:• Advances equally available to all other participants• Employee repays employer

• HSA-related loans– HSA cannot be security (deemed distribution)– Extension of credit (see PT slides)

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Trap #10: Monitoring of Contribution Amounts

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Trap #10: Monitoring of Contribution Amounts

• Who is responsible for monitoring contribution amounts?– Account holder is ultimately responsible

• Does employer have any responsibility?– If it makes contributions, it must ensure that:

• If employee has HDHP coverage with employer, the HDHP coverage qualifies

• That employee has no other coverage SPONSORED BY EMPLOYER that is disqualifying coverage

• Outside coverage not an issue for employer– Failure to monitor can result in withholding liability on

amounts included in income• Does Trustee have any responsibility?

– To ensure that contributions do not exceed family statutory maximum (plus catch up) WITHOUT REGARD TO ACTUAL LEVEL OF COVERAGE• I.e. cant allow more than $5650 plus 800 in 2007

– Must monitor age

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Other Compliance Concerns

• HIPAA Privacy• COBRA and HSAs• Federal Tax Reporting

– Helpful guidance in Form 969– HSA Participant

• Must File Form 1040 (1040A and 1040EZ not allowed)

• Form 8889– Trustee/custodians

• Form 5498• Form 1099-SA

• State income and employment tax requirements

Documents

How to Avoid HSA and HRA Pitfalls and Traps: A Legal but Practical Perspective